On Friday, March 10th, Silicon Valley Bank (SVB) collapsed. It was the largest bank failure (by assets) since the 2008 financial crisis and the second-largest failure of a Federal Deposit Insurance Corporation (FDIC) bank. So, what led to the bank failure? A combination of bad risk management and the Federal Reserve’s aggressive anti-inflationary measures. Silicon Valley Bank was started in the 1980s in California. It catered to tech companies and expanded alongside the tech sector. However, in 2011, when Greg Becker became CEO of the SVB Financial Group, the bank became even more attractive to start-ups and venture capitalist clients, as it allowed these start-ups to keep cash at the bank, get a line of credit, invest the personal wealth of their founders, borrow against their private stock and even provide mortgages for founders’ personal residences. Allowing start-up firms, which often do not earn a profit for several years - or sometimes never, to borrow against their own stock and get a line of credit is risky for any bank. It’s a gamble. Tech Start-ups typically don’t have the hard assets to secure a line of credit and their privately held stock is too volatile to be stable insurance. For a time, SVB’s aggressive approach, some would say a lack of risk management, paid off - its stock price roughly tripled from 2018 to 2021. The bank’s deposits nearly quadrupled in that same period.
Why did SVB pursue this strategy? Let’s take a step back and explain how banks make money off of deposits, a system known as fractional reserve banking. Banks in the U.S. keep a fraction of their deposits (usually a little more than the Fed’s required reserve ratio) and loan out the rest of the money. That’s how they turn a profit - they pay interest on the money deposited to the bank and then loan out much of that money to borrowers willing to pay a higher interest rate. They make their profit on the difference between what they pay depositors and what borrowers pay them.
Like many other banks, SVB invested a portion of its deposits into US Treasury bonds - widely considered the safest investment in the world. Typically, this would be seen as a safe and non-controversial approach. You can’t lend out all of your deposits to your customers. You want to keep some of those funds available in case something goes wrong or you need the money. At the same time, you can’t afford to have that money sitting around not earning anything either. So, you buy US treasuries to make some money on those deposits. However, instead of buying a mix of short- and long-term bonds, SVB invested primarily in 10-30 year bonds, which were paying a higher interest rate than the short term bonds. By the end of 2022, fixed-rate securities like mortgages and long-term T-bonds made up around 60% of the bank’s assets. That lack of diversity in their investment portfolio was a big risk that unfortunately materialized when the Federal Reserve dramatically increased interest rates by roughly 5% from March 2022 to March 2023, the most rapid increase on record. The Fed is pursuing a contractionary monetary policy in response to high inflation, with inflation peaking at 9% in June 2022. Contractionary monetary policy involves the Fed decreasing the money supply by raising interest rates, which then slows investment and cools the economy. So, when the Fed hiked up the discount rate, which serves as a base interest rate for the country, venture capitalists took notice and investment stalled. Suddenly money was expensive. The stock market - particularly the tech heavy NASDAQ - tanked. The VCs got nervous and the cash that start-ups depend on to pay their bills got scarce. As a result, the start-up firms that make up a large portion of SVB’s portfolio needed money and, logically, turned to their deposits to pay their bills. However, as I mentioned previously, the U.S. banking system is based on fractional reserve banking, which operates on the idea that depositors do not need access to the majority of their funds at any given time. So, SVB found itself strapped for cash and on March 8th, it was forced to sell $21 B worth of bonds to Goldman Sachs at a $1.8 B loss. Why? Because as the Fed raised rates, the value of SVB’s long-term, lower interest rate bonds plummeted. When the loss was reported, it triggered a bank run as depositors rushed to pull their money out of the bank. It was a bit of a self-fulfilling prophecy - depositors feared a collapse and essentially caused one when they rushed the bank. Since then, the Federal Reserve has seized the bank and is auctioning off portions of it. Furthermore, the Fed has promised that all depositors would be made whole. The collapse of SVB has had ripple effects throughout the banking system.
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