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A bank takes money from depositors, who are paid interest for delaying spending. The bank then lends these funds to borrowers, who pay interest for accelerating spending. The bank profits on the spread.
Sounds simple enough, but the recent collapse of Silicon Valley Bank and others proves banking is tricky. Deposits are liabilities to the bank, while loans are assets. The danger is the mismatch between the short-term nature of deposits versus the long-term nature of loans. Depositors can demand their funds be returned immediately, while loan repayments typically stretch for multiple years.
What was true for the Bailey Bros. Building & Loan in “It’s a Wonderful Life” still rings true for J.P. Morgan today: If too many depositors demand their money back at the same time (a bank “run”), you can’t pay them all, and the bank fails.
Regulators seized Silicon Valley Bank on March 10, citing “inadequate liquidity and insolvency.”
While the end came quickly for SVB, the seeds of its destruction were sown years before. The technology startup ecosystem in California is dominated by an exclusive “club” of venture capital and private equity firms led by Stanford and Ivy League-educated masters of the universe.
CEO Greg Becker (who grew up on a farm in Indiana and received a business degree from Indiana University) desperately wanted SVB to become a member of this elite club. He was wildly successful in making SVB the “one-stop-shop” bank for venture capital and private equity firms, the startups they funded and their founders. SVB understood and welcomed money-losing “disruptors” and their cash-poor founders when bigger, traditional banks shunned them. For this, the startups were required to keep all of their deposits with SVB.
The Federal Reserve slashed short-term interest rates to 0% at the start of the pandemic, unleashing a flood of liquidity that made it to VC/PE firms, who competed to invest the funds with startups, much of which found its way to SVB. Indeed, SVB’s deposits almost doubled, from about $102 billion at the end of 2020 to $189 billion a year later.
With short-term rates near 0%, SVB decided it needed to pick up yield by redeploying this torrent of deposits into longer-term U.S. Treasury and agency-backed mortgage bonds.
Bond owners are subject to credit risk (the risk the bond issuer doesn’t pay you back) and interest rate risk. When interest rates rise, prices of existing bonds fall. Conversely, when rates decline, existing bonds go up in price. Picture a teeter-totter with rates on one end and bond prices on the other.
Persistently high inflation caused the Fed to abandon its zero-interest rate policy and aggressively hike short-term rates nine times over the past year to its current level of 4.75%-5.00%, crushing prices on even the “safest” (from a credit risk perspective) bonds. Indeed, the Bloomberg U.S. Aggregate Bond Index lost a record 13% in 2022, dwarfing the prior record loss of 3% in 1994.
This caused the combined unrealized losses in SVB’s “available for sale” (bonds they might sell prior to maturity) and “hold to maturity” portfolios to explode from $1.7 billion at the end of 2021 to a whopping $17.7 billion a year later, an amount that would completely wipeout SVB’s capital if those bonds had to be sold.
With the “free money” spigot suddenly shut off, SVB’s cash-burning customers started withdrawing deposits at twice the prior rate, leading to a severe liquidity crunch. Moody’s informed SVB in February it planned to downgrade SVB’s credit rating. SVB turned to Goldman Sachs for advice and announced late on March 8 it had sold its entire $21 billion available-for-sale portfolio (to Goldman, coincidentally), realizing a loss of $1.8 billion and a plan (prayer?) to issue $2.25 billion in new SVB securities.
The announcement was meant to assure customers, but panic ensued instead. Becker pleaded with fellow club members to stay loyal, but they responded by withdrawing $42 billion in deposits the next day, dooming the bank.
Becker received $9.9 million in compensation for 2022 and sold $3.6 million of SVB stock on February 27. SVB’s prior chief risk officer departed abruptly last April with over $7.1 million and wasn’t replaced for eight months. KPMG was SVB’s independent auditor and gave SVB a “clean bill of health” on Feb. 24.
The San Francisco Fed was SVB’s primary regulator and apparently became alarmed at SVB’s breakneck growth, exposure to rising interest rates and the fact an astounding 94% of SVB’s deposits (about $152 billion) were above the FDIC’s $250,000/account insurance limit, making it vulnerable to a run. Still, nothing changed. Becker was a member of the board of directors of the San Francisco Fed from 2019 until March 10.
Banks and the banking system make it to tomorrow by making sure depositors never all want their money back at the same time. This state of happiness is dependent on an apparatus built on strong management, effective regulation and supervision and government insurance, all held together by a gossamer thin thread called “confidence.” That thread is fraying and will be difficult and expensive to repair.•
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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.
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