Silicon Valley Bank's Collapse: A Convergence of External Forces and Internal Decisions
When something bad happens, the first thing we want to know is "Whose fault is it"? It's a natural human tendency and an easy and excellent defense mechanism.
Let's do a case study on what did go wrong with SVB or whose fault it is. This article contains many financial terminologies, and I have done my best to provide explanations for them.
Silicon Valley Bank
SVB was a leading financial institution, that catered to the tech industry and had become the preferred bank of almost half of all venture-backed tech startups. SVB's rise to success was impressive, as it grew to become the 16th largest bank in the United States within a mere four decades since its establishment. However, its decline was just as swift as it took only a day and a half for the bank to collapse, leaving its stakeholders reeling from the sudden and unexpected turn of events.
How do Banks work?
Banks are financial institutions that offer various financial services to individuals, businesses, and other organizations. The core function of a bank is to accept deposits from customers and use those funds to make loans and investments like lower-risk bonds. Banks earn a profit by borrowing money from depositors and other sources at a lower interest rate and lending it out to borrowers at a higher interest rate. The difference between the interest rate paid on deposits and the interest rate charged on loans is known as the net interest margin, which represents the bank's profit margin. This is a fundamental way in which banks earn money and stay in business, and is known as the traditional banking model.
Let's analyze the potential factors that may have contributed to the collapse of SVB, and determine who may be held responsible
Despite the challenges posed by the pandemic, SVB experienced a period of significant growth, with 2021 being its most profitable year to date. Then how can we blame COVID for SVB's failure?
The COVID-19 pandemic has had a significant impact on global supply chains, causing shortages of goods and services and resulting in higher prices. Additionally, governments have responded to the economic fallout of the pandemic by increasing currency printing to provide relief to individuals and businesses, further exacerbating concerns about inflation and economic stability. Governments have implemented large-scale fiscal stimulus packages and quantitative easing programs, which involve buying government bonds and other assets to inject money into the economy. The US Federal Reserve reduced its benchmark interest rate to near zero in March 2020. Which made it easier for businesses to obtain loans and mortgages.
As a result, many companies deposited their excess funds in SVB during the pandemic, and the near-zero interest rate environment made it challenging for banks to earn profits from these deposits. So SVB invested billions of dollars in longer-term government bonds and other securities, which are considered safe, low-risk investments. When the US Federal Reserve responded to inflation concerns by aggressively raising interest rates, the prices of government bonds held by SVB began to decline. This is because bond prices are inversely related to interest rates - when interest rates go up, bond prices go down. All these have contributed to an asset bubble, which has affected not only SVB but also other banks holding government bonds. As a result, the value of their bond holdings has declined, which could potentially impact their financial stability and profitability.
Good to Know: An asset bubble is a situation in which the price of a particular asset, such as stocks, real estate, or commodities, becomes significantly inflated beyond its fundamental value. This means that the market price of the asset is not justified by the underlying economic fundamentals, such as the earnings potential of a company or the demand for a commodity.
The US federal reserve:
The US Federal Reserve is responsible for managing the country's monetary policy and ensuring economic stability. One of their key tools in controlling inflation is adjusting interest rates. During periods of inflation, the Fed typically increases interest rates to slow down economic activity and counteract rising prices. However, during the pandemic, the Fed has been hesitant to raise interest rates despite a noticeable increase in inflation. The Fed initially attributed the inflationary pressures to temporary factors and expected prices to stabilize on their own, without the need for intervention. Once the Fed realized that the inflation was not, in fact, transitory, they decided to take action and increase interest rates to make up for the lost time. This move was aimed at cooling down the economy and curbing inflationary pressures.
Good to know: Inflation refers to a sustained increase in the general level of prices for goods and services in an economy over a period of time. This means that the purchasing power of money decreases as it becomes able to buy fewer goods or services. Inflation is measured by calculating the percentage change in the price of a basket of goods and services, known as the Consumer Price Index (CPI), over a specific period of time
Silicon Valley Bank :
SVB's risk management team failed to address interest rate risk, which played a significant role in the bank's collapse. Furthermore, during this critical time, the bank did not have an official chief risk officer, which further exacerbated the risk management issues. The increase in interest rates has led to a decline in the value of tech companies' investments, causing Funding Winter. As well the high-interest rates have resulted in decreased borrowing and reduced investment opportunities, resulting in a negative impact on their overall performance. The companies are forced to withdraw their deposits from SVB to raise their capital. This panic withdrawal caused a bank run at SVB which left the bank with a negative cash balance. The heavy withdrawal of funds from the bank caused it's internal systems to crash, intensifying the panic among depositors. Adding to the concern was the fact that the FDIC, which provides deposit insurance, only guarantees refunds up to $250,000. Unfortunately, 97% of the deposits at SVB exceeded this amount, further compounding the crisis
SVB announced selling off its entire liquid portfolio to fund the withdrawals. This announcement have caused concern among investors, started selling their shares in mass, leading to a significant drop in the company's stock price, which reportedly plummeted 60% in just one day.
Source: U.S. Federal Reserve.
US Fed raises interest rates to fight 40-year-high inflation
Good to Know: Interest rate risk is the potential for changes in interest rates to negatively affect the value of an investment or a financial institution's financial position. Interest rate risk can occur when interest rates rise or fall, affecting the value of assets and liabilities differently. For example, if a bank has more loans than deposits, and interest rates rise, it may have to pay more to attract deposits while earning less on its loans. This can reduce the bank's net interest margin, which is the difference between the interest earned on assets and the interest paid on liabilities. Interest rate risk is a common concern for financial institutions, especially banks because they typically have large portfolios of assets and liabilities with different maturities and interest rate structures. To manage interest rate risk, banks may use various strategies, such as matching the maturities of their assets and liabilities, using interest rate swaps and other derivatives to hedge against changes in interest rates, or adjusting their loan and deposit pricing to reflect changes in market interest rates.
Good to Know: Funding winter refers to a period of time in which the availability of funding for startups and other businesses is significantly reduced. During a funding winter, venture capitalists, angel investors, and other sources of funding may become more risk-averse and reluctant to invest in new ventures. This can result in fewer new businesses being launched, as well as a slowdown in innovation and growth in the startup ecosystem. In general, funding winters can occur during economic downturns, as well as during periods of overvaluation or saturation in certain industries.
Good to Know: Bank Run is a situation where a large number of depositors attempt to withdraw their funds from a bank at the same time due to concerns about the bank's solvency or liquidity. Bank runs are typically triggered by rumors or news reports about a bank's financial instability or by a loss of confidence in the banking system as a whole.
Good to Know: Deposit insurance is a financial protection mechanism that is designed to safeguard the deposits of individual customers in financial institutions such as banks and credit unions. It is an important tool to help maintain public confidence in the banking system and to promote financial stability. Deposit insurance works by providing customers with a guarantee that their deposits will be repaid, up to a certain amount, in the event that the financial institution holding their funds, fails. Deposit insurance is typically provided by a government agency or a designated third-party organization, which is responsible for collecting premiums from financial institutions and maintaining a reserve fund to cover potential payouts.
Good to Know: Liquid portfolio refers to a set of investments that can be readily converted into cash without incurring substantial losses in their value. Liquid assets are those that can be easily traded in the market with minimal impact on their market price. These typically include cash, stocks, and bonds, among other investments that can be quickly bought or sold.
In summary, the failure of SVB can be attributed to a combination of these major factors: the COVID-19 pandemic, the actions of the Federal Reserve, and decisions made by SVB management. While the pandemic was largely beyond our control, both the Federal Reserve and SVB could have taken steps to mitigate the impact of the pandemic and make more prudent choices that may have prevented the collapse of SVB.
The information included in this article is for general, informational purposes only. The historical and current information contained in this document is a summary of information prepared from other reliable sources.