Silicon Valley Bank: A study on bank failure

One of the corporate world's most heavily regulated entities is the banking industry. In addition to all of the requirements, such as licensing, registration, high equity capital, public listing, margins with all trading counterparties, etc., they are also subject to invasive supervision by the central bank of the respective nation. The likelihood of bank failures has decreased as a result of these norms becoming stricter with each bank failure.

Since the Global Financial Crisis (GFC), which included Lehman, Bear Stearns, Wachovia, and many other major banks worldwide, is still fresh in our memories, the majority of us won't believe that banks don’t fail frequently. In the box lines, I offer a brief aside on the causes of the GFC and why it wasn't like a typical failure of a single bank.

Let's first set aside the worry about the GFC, which is an exceptional circumstance called systemic risk or contagion. The country central banks (e.g., the Federal Reserve in the US, the RBI in India, etc.) and the Bureau of International Settlements (BIS), a group of central banks, have issued strict checks and balances for the banking sector. The fact that a bank typically generates a Return on Equity (ROE) in the low teens is evidence that these standards are quite effective. Therefore, banks cannot take unusual risks to produce unusual returns.

However, banks have strong relationships with both other banks and the economies of both the world and the country in question. High systemic risk vulnerability results from this. In other words, if a big ball were to drop (i.e., wars, natural disasters, widespread financial fraud, devaluation of currency, etc.), the local economy and lenders would unavoidably suffer losses. Larger exposure lenders (also known as weak banks) will suffer greater losses and may fail. Since this Weak Bank/lender is a significant counterparty to other banks, they will also bear losses as a result of their exposure to the Weak Bank in addition to their direct exposure. This would mean multiple banks at the same time would deplete their equity (which is their loss bearing capacity). Since equity prices are at record lows and there is a banking crisis underway, it is obvious that this would not be the ideal time for these banks to raise equity. This calls for a few undercapitalized banks to fail or be acquired by stronger banks, followed by a move by the central bank or government to temporarily halt bank losses.

Now let's talk about the reasons why an individual bank, like Silicon Valley Bank (SVB), fails. SVB is The 16th largest commercial bank in the US by asset size. Regarding the start-up clients it serves and the investors who provide their funding for them, it is somewhat unique. It accepts short-term deposits from customers who have plenty of cash and want to store their unused funds. It uses these funds to lend to or invest in new businesses, looking for working capital or longer-term loans with higher yields. Consequently, as a key player in this start-up ecosystem, you stand to gain from this win-win situation.

But keep in mind that at its core, it is just like any other commercial bank, being financed by on-demand deposits (which can be withdrawn at any time) and lending to clients for longer tenors that aren't liquid (banks cannot call a loan back at any time). Similar to other failed individual banks in history, this is the primary cause of SVB's failure.

SVB was founded in Silicon Valley in the early 1980s with a focus on banking venture capital funds. It did well to concentrate on this particular niche customer segment (which will make up 56% of its portfolio in 2022) and cater to their particular needs.

SVB could also bank the investee companies because venture capitalists have a significant impact on the businesses, they invest in. In the US, SVB had partnerships with more than half of all venture-backed businesses. Since interest rates were low between 2009 and 2018, deposit yields in the US were nearly zero percent, as is well known for the growth story of venture capital and start-ups over the past 20 years. SVB continued to experience rapid growth and established a global presence in every significant city with a vibrant start-up community, including Bangalore and Mumbai. Never forget that whether an investment succeeds or fails, a banker and a lawyer always profit. Trouble begins... When the Covid crisis hit, interest rates once more dropped to zero percent and a sizable portion of the money in VC/PE funds was being stored in secure locations (like banks). Placing the money with banks, even at 0% interest, made sense because not even start-ups were using their funds quickly. Deposits held by SVB increased from $61.76 billion in 2019 to $189 billion in 2021. However, SVB was also unable to use these funds, which was understandable given that there were fewer opportunities to lend at rates appropriate for a startup's level of risk and a decrease in demand for capital as a result of the slowing economy. This is significant when compared to a larger commercial bank, which offers working capital and other loans to larger corporations that must continue operating. g. manufacturers of automobiles, buildings, drugs, and the like.

SVB had to use these funds to purchase publicly traded debt in order to generate some profit. It had to invest in longer-dated debt securities because shorter-dated debt had extremely low yields, again close to 0%, and it needed to produce at least a 1% net interest margin. It did so in a variety of debt securities, with a sizable portion ($80 billion) in 10 year Mortgage Backed Securities (MBSs) with a weighted average yield of 1 point 56 percent. In order for them to actually produce this yield, they were all intended to be held until maturity. Even though there was a huge asset-liability mismatch developing, everything seemed reasonable.

For two years, the problem simmers. The Fed then began raising interest rates in 2022. Banks typically gain during cycles of rising interest rates because they can reprice their loans faster than they must reprice their deposits, allowing them to do so at higher rates. For the majority of commercial banks, this occurred. The asset book of SVB, however, was locked in long-dated MBSs at low yields, which actually lost value (as yields rise, existing low yielding bonds lose value to investors).

Initially, depositors might have overlooked this RED FLAG because it was so obvious. However, the Fed continued to raise rates until the end of 2022, and the value of the SVB asset book continued to decline. According to a small accounting quirk, unlike the available-for-sale (AFS) asset book at each reporting cycle, the held-to-maturity (HTM) asset book does not have to be market valued (marked-to-market). Losses are thus not recorded until the maturity or sale of the securities.

The inevitable falls apart.

When some sizable depositors requested their money in February 2023, SVB was forced to advise them against doing so because doing so would require them to liquidate some of their MBS positions and incur a loss. These substantial depositors were alarmed and further recommended to their network to liquidate deposits at SVB.

The main source of risk in the banking industry is that while deposits (liabilities) can be called in at any time, assets can only be sold with a significant loss. Banks control this by behavioralizing deposits—an estimation based on historical data of the amount of deposits that might be redeemed quickly—and matching the maturity of liquid assets. thereby preventing a liability mismatch while allowing the remaining assets to be invested for longer periods of time and generate higher yields.

Given the pressure to redeem deposits, SVB had no choice but to bite the bullet and decide to sell these securities for a loss of $21 billion, raising an additional $2.25 billion in equity as a result to strengthen its capital. Unfortunately, this was misrepresented to investors in a press release at the beginning of March 2023. Investors and depositors were frightened by it rather than feeling more confident. As a result, customers lined up for four days to withdraw their money from the bank, causing a run on the institution. The rest is history, of course.

Do the tertiary effects exist?

The depositors will gradually receive their money as the bank's assets are sold off, and the shareholders and bondholders will be responsible for covering the loss now that the FDIC has taken over and closed the bank. Three significant issues are brought up by this:.

1. This method takes time. Lack of access to deposits will cause a liquidity crisis for many VC funds and start-ups. For some, this might even signal a shutdown.

2. SVB has assets that can't be quickly liquidated because they are investments in or loans to startups. Consequently, it cannot be used to pay the depositors right away. For several years, this could result in a stalemate.

3. There has been a disappearance of a significant player in the startup ecosystem. The search for alternative banking partners is currently in a frenzy among start-ups all over the world. This setback may only last a short while.

As the writer, I sincerely hope that this piece of writing was worth reading and added value to your knowledge.

Thank you for taking the time to engage with my work.