Silicon Valley Bank Run

It’s been a horrible week for banks.

Silicon Valley Bank (SVB), one of the 20 largest banks in the country, collapsed last week. It was the second largest bank failure in U.S. history.

Federal Deposit Insurance Corporation (FDIC) – an independent agency of the U.S government that provides insurance to bank depositors – was appointed as the receiver for the bank. Put simply, FDIC took over Silicon Valley Bank, with the intention to create the best outcome for bank depositors.

The SVB story has a lot of moving parts, but its demise ultimately boils down to an old-fashioned bank run. A flood of withdrawals from depositors destroyed the bank. 

Comparisons have been made to gym memberships; if every gym member showed up at the same time, not everybody can get a workout in. Banks are similar in this respect, if every depositor wants their money back at the same time, not everyone can get their money back.

At their core, banks are facilitators. Depositors lend their money to a bank, they get paid interest on those deposits, and banks in turn, lend out those deposits with the goal of earning more interest than they pay depositors.

The business model is generally very effective – depositors get a lower interest rate, but they can pull their money out at any time. The loans made out by the bank earn higher interest rates, but they often take years to get paid back.

In essence, there is a duration mismatch. However, the reason it works is because banks usually have a diverse set of depositors. Inflows and outflows from an individual account happen regularly, but in aggregate, the deposit base remains steady over time. This provides the ability for banks to make long-term loans.

Herein lies a key issue with Silicon Valley Bank. Their depositor base was not diversified; it was heavily concentrated in the technology sector.

Per JP Morgan’s Michael Cembalest, SVB “was in a league of its own with an unusually high reliance on corporate and venture capital funding and a very low reliance on stickier retail deposits” that define most banks.

This view was formed from the graphic below which shows the higher risk SVB (ticker: SIVB) had relative to banking peers.

The simple takeaway is that SVB carved out a unique niche—focusing on higher-risk customers—and it laid the foundation for potential capital shortfalls.

SVB’s Unique Business Model

Many of SVB’s depositors were venture capital backed start-up companies. The market environment over the past few years made SVB’s business look wonderful.

Per public filings, SVB’s deposit base jumped from $61 billion at the end of 2019 to $189 billion at the end of 2021. Venture capital funding was at all-time highs during this period and start-ups receiving funding were often putting the money into SVB bank accounts.

Putting that growth in perspective, SVB’s deposit base grew by approximately 250% in this period while industry deposit growth was roughly 37%.

Interest Rates Created Problems for SVB

As deposits grew rapidly at SVB, it reached a tipping point where they had more deposits than they could lend out.

As a result, they purchased a large amount (nearly $80 billion) in bonds with these deposits. The bonds they purchased (primarily mortgages) were high-quality, but it was long duration, with 97% of them maturing in 10 years or longer.

What happened after they purchased these bonds created a serious problem. The Federal Reserve began one of their most aggressive rate hiking periods in history.

As interest rates then rose, the value of these bonds fell in value, creating an increasing mismatch between the value of its deposits and the falling value of its liquid assets that could fund immediate withdrawals.

In theory, the bond losses only existed on paper. If SVB held the bonds until maturity, they would get all their money back, plus interest. However, that scenario didn’t play out.

Depositors became skittish, started redeeming their money, and SVB became a forced seller of many of those bonds to meet redemptions. The paper losses turned into actual losses and laid the foundation for SVB’s death spiral.

This ultimately led to a loss of confidence and created the bank run, as deposit holders withdrew funds and equity investors refused to provide extra capital.

Another Lehman Moment?

The SVB situation is leading to 2008 comparisons with Lehman Brothers and Bear Sterns. One important point to keep in mind is that those institutions were investment banks, while SVB is a commercial bank that takes in deposits.

2008 was defined by banks holding toxic assets—primarily mortgages that could never be repaid—on razor thin capital bases. Credit quality, or the lack thereof, was a primary driver of the Great Financial Crisis (GFC).

While commercial banks can certainly get in trouble, they can’t have anywhere near the 30x leverage that Lehman had when it collapsed.

Government regulation, particularly around banks holding adequate levels of capital, has made significant progress since 2008. The banking industry is more capitalized today than it’s ever been.

During the GFC, banks failed due to bad credit. In this instance, credit quality is not the primary driver that put SVB out of business.

A secondary concern could be, what type of impact could there be on big money-center banks like JP Morgan or Wells Fargo? Michael Barr, the Federal Reserve’s vice chair for supervision, mentioned recently:

“There are obviously larger institutions that are also exposed to these risks too, but the exposure tends to be a very small part of their balance sheet. So even if they experience the same deposit outflows, they are more insulated.”

In short, it seems unlikely we’re facing another Lehman moment.

The End of Silicon Valley Bank

SVB had a market cap greater than $44 billion in November 2021. That equity is now essentially worthless.

It’s hard to identify one single point of failure in the SVB saga. Many facts compounded on one another to lead to one of the fastest bank failures in American history. It can be distilled into the following:

•  SVB had a concentrated base of depositors, a significant portion of which was money losing technology companies backed by venture capital.

•  SVB rode the venture capital funding wave and saw their deposit base grow significantly faster than the banking industry.

• Being flooded with venture capital deposits was a blessing until it wasn’t. When the market turned in 2021, new funding dried up and much of SVB’s deposit base was pulling deposits from the bank while not replenishing it with new money.

• As this was happening, SVB’s management had invested a large portion of the deposits into bonds with long maturities.

•  When redemptions came, SVB was forced to liquidate bond holdings at large losses.

• Rumors started to spread that SVB was functionally insolvent, and depositors weren’t going to take any chances. It’s been reported $42 billion of withdrawals were processed in 24 hours and death spiral started from there.

Confidence grows slowly and evaporates quickly. In the case of SVB, confidence evaporated at light speed.

JP Morgan is famous for telling bank tellers in 1907 to count money slowly to buy the banking system time to sort itself out. In the digital age, that’s no longer possible.

Once rumors began spreading, SVB basically went under inside of 48 hours. Free flowing information and digital banking is the biggest difference between SVB, and bank runs of the past.

In the weekend after the collapse, regulators moved quickly. The Federal Reserve made the decision to guarantee all bank deposits at SVB, in attempt to shore up confidence in the banking system.

The government’s guarantee covers all deposits at the bank, rather than the standard $250,000 FDIC usually covers.

The contagion from this event is not over. There is more to figure out, and some of it – particularly new regulations – will likely take years to debate and put into effect.

Taking a wider investor-centric view, when financial markets are the top story in the news, it’s more likely to create opportunity for investors, rather than problems.

A period of volatility will likely result from this – even in areas of the market that are unrelated to SVB – but it could also be viewed as a potential period of opportunity.