At the end of last week, the Silicon Valley Bank (SVB) collapsed, just a few days after a much smaller lender, Silvergate, announced a plan to wind down its operations. The bank had USD 212bn in assets, a market valuation of around USD 16bn as recently as Wednesday last week, and a valuation of USD 44bn less than 18 months ago. At the end of December 2022, SVB had USD 173bn in deposits. However, on Thursday the bank suffered a USD 42bn withdrawal of deposits, after losing USD 1.8bn in a USD 21bn sale of part of its bond portfolio (made up of Treasuries and mortgage-backed securities).
SVB tried to make a final, desperate attempt to shore up its capital by issuing USD 1.25bn of its common stock, plus USD 0.5bn of mandatory convertible preferred shares (which are slightly less dilutive to existing shareholders), while private equity (PE) firm General Atlantic had previously agreed to buy 0.5bn of SBV’s common stock in a separate private transaction. But this last attempt failed, and the bank was shut down by the Federal Deposit Insurance Corporation (FDIC), the US regulator that guarantees bank deposits of up to USD 250,000. Following that, the Bank of England put the UK arm of SVB into insolvency as well.
Why did the bank fail? Being exposed to crypto trading (Circle, the operator of one of the world’s largest stablecoins, said that USD 3.3bn of its reserves were held at SVB) and start-ups, including in the healthcare sector, one could think that the bank failed given the collapse in tech and crypto assets valuations over the last year. But the reality is much simpler, and to a certain extent is even more alarming.
The business model of SVB was surprisingly “conservative”. The bank would receive large deposits from tech and crypto companies that had raised their funds through venture capitalists and PE firms. These deposits were reinvested into ultra-safe bonds – in particular Treasuries and mortgage-backed securities, both of them held in massive quantities by the Federal Reserve – and also foreign government bonds. As of the end of 2022, the bank had $26.1bn in available-for-sale securities and around $91bn of securities in a held-to-maturity portfolio.
This business model would make money as long as policy interest rates were low, such that the cost of deposits would be minimal and the value of the bond portfolio would remain high. But as the Fed increased its policy rates by around 5% in one year, the cost of deposits rose from 0.14% to 2.33% in the same time-span, while the value of the bond portfolio declined. For this reason, the bank had reported a loss of USD 15bn at the end of last year.
So, the bank didn’t fail because it had invested in assets that were too speculative, or followed a business model that was too risky. It collapsed because the most basic risk management practices were not followed. Banks tend to have a diversified depositor base, with a number of small – fully insured – depositors. They would not run at the first bad news. But the vast majority of SVB’s depositors were not insured, so they wanted their money out as soon as they perceived an increased default risk. Furthermore, banks would normally invests in floating rate notes, which gain in value if interest rates go up, or they would enter into swap agreements to insure against rising interest rates. This didn’t happen.
So, why this is scary? We discussed how recently the New York Fed had defined an r** rate, a rate over which financial stability episodes could emerge. If r** was below the neutral interest rate, r*, or in any case if it was below the terminal rate, the central bank may be forced to stop its tightening cycle in order to prevent further episodes from emerging So, as Hyman Minsky predicted in his Financial Instability Hypothesis, downturns in financial markets occur when interest rates go up. SVB was a fragile bank, from a Minskian perspective, for the reasons exposed above. But other lenders may fall from similar difficulties if interest rates continue to increase at this speed. And all this is happening just days before the next FOMC meeting, in which the Fed may decide to ratchet up the pace of its tightening cycle again, by 50bps, in response to the positive news from the labour market and the stubbornly high inflation rate.
