Bank failures

Answer

Introduction

The financial world was shaken in March by the second largest bank failure in US history, as Silicon Valley Bank (SVB) was shut down by regulators. Like any bank failure, the causes were complex, but ultimately came down to a liquidity crisis: SVB didn’t have enough money to meet the demands of its customers. Understanding how SVB reached this point sheds light not only on where banking can go wrong, but also illustrates the complexities of how the banking and financial system operates, whether in the US, the UK, or any other country with a sophisticated financial system.

What was SVB?

SVB was a bank based in California, with a niche in providing banking services to the technology industry. SVB’s core business was that of a classic bank. It took in money deposits from its customers (mainly tech companies), and then used these deposits to make loans. The loans were largely made to venture capital and private equity funds, and to the tech companies which they held stakes in. These funds and tech companies would then continue to deposit their cash with SVB, and so on.

A good problem to have

SVB’s issues began with what might be seen as a good problem: having too much money. During the coronavirus pandemic, the tech industry experienced a boom. Share prices for tech companies rocketed, allowing those companies to raise vast amounts of cash. Due to its tech-focused customer base, a large proportion of this cash was deposited with SVB, causing the deposits held at SVB to nearly double during this period.

The problem with this is that for a bank, holding cash is costly. When a customer deposits money with a bank, they’re essentially loaning that money to the bank for a rate of interest. In order to make a profit, the bank must then lend that money at a higher rate of interest than the bank is paying its customers. SVB’s problem was that it was receiving new deposits more quickly than it could make new loans, leaving it with excess cash.

SVB therefore decided to put this excess cash into a different asset: long dated securities – mainly mortgage-backed securities and US treasuries. These securities are issued by banks and the government when they borrow money. Essentially, in return for money, they issue the security as a kind of IOU voucher, which pays a fixed rate of interest and returns the original loan amount on maturity. These securities can then be bought and sold in the financial markets at whatever price the market is willing to pay for them. As these securities are backed either by property or by the government, they’re considered incredibly safe investments. SVB purchased roughly $91 billion of these securities to protect its position should the tech boom begin to wane.

A bad problem to have

Most commentators predicted rising inflation in the aftermath of the pandemic, as a logical result of governments paying the population to stay at home and not produce any goods or services for the economy. SVB would’ve been fully aware of this when making its investment decisions. However, SVB’s problems truly began as inflation rates rose to unexpected levels, caused in no small part by Russia’s invasion of Ukraine in 2022.

Inflation became a problem for SVB primarily due to the government’s standard response to inflation: raising interest rates. Raising interest rates tackles inflation by reducing the amount of money in the economy, which reduces demand for goods and services and causes prices to fall. Essentially, central banks increase the rate of interest they charge on loans made to commercial banks, and which they pay on the money which those banks deposit with them. As the cost of borrowing money increases for the banks, and as they have a readily available deposit facility at the central bank with an increased rate of interest, they begin to charge a higher rate of interest on the loans they make to businesses and individuals. As the cost of borrowing money increases across the economy, there are generally fewer loans made and decreased business investment, and as existing loans are repaid, the amount of money in the economy decreases. 

In many ways, rising interest rates were not a problem for banks. Although banks’ funding costs (ie the interest rate banks pay when borrowing money, whether from other banks or by way of customer deposits) increased, generally the interest rate they charged on the loans they made to customers increased by a greater amount, resulting in healthy profits.

However, SVB found itself in a tight space. On its liabilities side, SVB shared the pain of other banks in paying a greater interest rate to depositors. However, on its asset side, SVB was struggling. The tech boom had come to a halt. Tech company share values plummeted, and venture capital and private equity firms no longer had the same appetite for borrowing. SVB therefore struggled to maintain its core business of lending to the tech industry, and struggled to capitalise on the benefit of charging higher interest rates on loans.

To compound matters, the long-dated securities held by SVB were losing value. These securities continued to pay out interest to SVB, however that interest rate was fixed prior to the increase in central bank interest rates. It was therefore a lower rate than the interest rate on new securities being issued. Therefore, the securities held by SVB became unattractive, and their market price fell.

By the beginning of March, SVB faced a loss of $15 billion on these securities. However, SVB had a cunning plan. Rather than selling the securities and realising this loss, it would simply hold the securities until maturity, continuing to earn interest, albeit at a low rate. Although it wasn’t necessarily a profit maximising move, it was a loss avoiding move in the short term.

Crunch time

At this point, it seemed that SVB was managing its problems well. It had parked its excess cash into safe securities, and although it had lost value, it could be held to maturity without realising any loss.

So how did SVB end up collapsing?

Most banking crises come down to one thing: liquidity. The business of banking involves borrowing short term (ie, taking in deposits from customers that are repayable to those customers on demand) and lending long term (ie, making loans for terms of several years). Banks are required by regulations to hold a proportion of their assets as ‘reserves’ (which are essentially cash or cash-equivalent securities) so that while the majority of their cash is locked up in long-term loans, they can continue to meet their customers’ demands for deposits, whether these be cash withdrawals or payments made to other companies and institutions. Problems arise when the demands on deposits held at a bank exceed the reserves the bank holds.

SVB found itself in exactly this situation. With tech companies struggling to raise new finance, fewer new deposits were being placed with SVB. Tech companies were spending the money that they’d already deposited with SVB, effectively demanding their money from SVB without SVB having a steady flow of incoming cash to meet the demands. To generate the necessary cash, SVB had to sell some of its assets. SVB chose to sell $21 billion worth of the long-term securities, at a $1.8 billion loss. 

This was the confluence of all of SVB’s problems. Less money was flowing in to SVB, customers continued to demand their money, and SVB both held and sold securities at a massive loss. In an attempt to support its capital position and generate cash, SVB announced that it‘d issue new shares. However, this plan was short lived. By this point, SVB’s problems were well known in the market, and the value of its existing shares crashed. This, coupled with the growing realisation that SVB’s business was on a knife edge, meant that the new share sale couldn’t be completed, and the black hole in SVB’s capital position widened daily.

SVB’s tech company and venture capital customers quickly began to lose confidence, and not only continued to spend their deposits, but also began to actively withdraw their deposits to place elsewhere. It was a classic example of a bank run. Customers were worried that if SVB failed, their deposits would be lost. This is because, as mentioned above, when a company or individual deposits money at a bank, they’re essentially lending their money to the bank. If the bank can’t pay this back, the customer’s money is lost. Although it’s rational for bank customers to withdraw their cash if they lose confidence in their bank, if every customer does the same thing, it’d cause the collapse of the bank as it wouldn’t be able to meet every demand at once.

To avoid bank runs, and to generally maintain confidence in the stability of the banking system, governments usually guarantee bank deposits up to a certain amount. In the US, the Federal Deposit Insurance Corporation guarantees deposits of up to $250,000. However, SVB again found itself in a tricky position. Many of the companies with money deposited at SVB either weren’t eligible for this guarantee or had deposits well in excess of $250,000. Of the $173 billion of deposits at SVB, $151 billion weren’t covered. The Federal Deposit Insurance Corporation therefore did little to prevent the run on SVB.

Things finally came to a head on 10 March. SVB’s customers withdrew $42 billion of their deposits, one-quarter of all the deposits held at SVB. SVB was unable to meet these demands and, in response, the Federal Reserve shut SVB down. SVB had failed.

Conclusion

The consequences of SVB’s collapse will continue to unravel over the coming months and even years. For now, though, SVB’s story is a perfect illustration of how the banking system, wider financial system and the economy as a whole interacts and overlaps, and where problems emerge and cracks begin to grow.

James Warhurst is a second seat trainee in the banking, restructuring and finance team in Southampton at Womble Bond Dickinson.