Starting last Wednesday, there has been one story to rule them all. That is, the failing of Silicon Valley Bank (SVB).
If you're an average American with a life, then you've likely never heard of SVB before this weekend.
Why, then, does every news outlet think it's most important news story since the Declaration of Independence?
Below I endeavour to explain what happened at SVB, and also why its collapse had virtually nothing to do with anything you will hear about on the news.
Okay, good, let's start with some simple terms.
Table Of Contents
Defining Terms
1) What is SVB?
SVB is (was) the 16th largest bank in America with a remarkable story of success over the past 40 years or so (the bank was founded in 1983).
It was formed to serve start-up companies as a depositee, hence the "Silicon Valley" part of the name. It also specializes in making loans directly to start-ups (more on that in a sec).
As late as February, SVB had $212B in assets.
2) What are "banking reserves"?
Banking reserves refer to the cash a bank has "on-hand" to pay for withdrawal demands.
We need to know how this works to know what happened at SVB.
In virtually all developed economies, the central bank sets a reserve ratio which dictates how much cash a bank must have available to pay withdrawals.
It is a rate that is applied to the total number of deposits a bank has.
For example, if a bank has $10,000,000 in deposits, and the Federal Reserve has set the reserve rate at 10%, then that bank must keep $1,000,000 in cash reserves in case some depositors show up to withdraw their money.
3) Why do we have a reserve ratio?
Because our banking system in the US is a "fractional-reserve" system. This means your deposits at your local bank aren't actually held at your bank.
Instead, your bank lends out the money you deposit there to other people in the form of mortgages, business loans, etc.
They pay you interest on those deposits for the privilege of risking your money for profit. And we all know how financially rewarding bank interest rates are...
Fractional-reserve banking can lead to problems if the bank loans out all of your money because if you come knocking for a withdrawal, then the bank may not be able to give your money back (I'm simplifying).
So, wisely, the Federal Reserve forces banks to keep some cash on hand in order to meet withdrawal demands. The Federal Reserve thus stands as an ever-ready watchdog against banking greed and financial profligacy.
Since 2020, the current reserve ratio in the US is 0%.
In other words, your bank can currently loan out all of your money.
4) What is A Bank Run?
A bank run is what happens when a bunch of people all come "running" to make withdrawals from a bank at the same time.
It is very important to note that there is no singular cause of bank runs, they are often self-fulfilling, and in many cases are caused by the random walks of the financial world.
Bank runs have been a somewhat common feature of banking for many centuries.
5) What is Venture Debt/ Capital?
Venture capital (VC) refers to the process of private investors investing capital (money and connections) into start-up firms.
VC groups are large funds of money, and human intelligence, that congregate around Silicon Valley to fund the next Apple, Microsoft, Google, etc.
Venture Debt (VD) is the process of of a bank or private investor loaning money directly to a start-up.
These types of loans have been rejected by large commercial banks because of the risk involved. SVB was one of the progenitors of VD.
Typically a large bank will want to see stable cash-flow in a business before giving out loans, so most start-up CEOs cannot get loans from traditional banks.
SVB steps in to save the day by providing this risky customer base with a niche banking solution — Venture Debt.
6) What are Unrealized Losses?
In general finance, unrealized losses are losses in an investment portfolio that you have liquidated (realized).
For instance, if you buy a stock at $10 per share and a month later its $8 per share, then you have a loss of $2 per share.
But that loss isn't realized until you sell the share for the loss. If the stock price climbs back up to $12 per share, then you avoid the loss.
Banks do the same thing with your deposits.
They invest your money, usually in fixed income and real estate, and if their investments don't pan out, they don't have to report any losses until the losses are "realized."
Okay, now that we have all the terms defined, the story of SVB is pretty simple.
What the Heck Happened to SVB?
The short answer is that what happened to SVB is what could happen to any bank, anywhere, at anytime.
That is — a bunch of people came to make withdrawals at the exact same time and the bank went belly-up.
Why? Because it didn't have enough cash to meet withdrawal demands.
At the end of 2022, SVB had $173.1B in demand deposits.
If SVB had kept 10 cents of every dollar deposited at the bank it would have over $17B in reserves.
If it had kept just 25 cents for every dollar, it would have been able to pay every withdrawal demand on Thursday.
I heard one VC "expert" make mention it had about 10% in reserves at the start of this month.
It did not.
It had $720 million in reserves:
That's 0.41% of the demand deposits. So, almost exactly what the Federal Reserve set the reserve ratio to in 2020.
Imagine that — $173B in liabilities with $720M to cover it if the bill comes due.
That's really all that happened here. There was a bank run, and SVB was short on cash.
Sure, we can explore why there was a bank run to begin with at all, and what role SVB had in precipitating it.
But it's important to realize that nothing about the financial management (or mismanagement) of SVB caused its bankruptcy.
The Unique Features of SVB
The biggest factor driving the SVB failure was the recent rise in interest rates. This is because both sides of SVB's balance sheet were extremely interest rate sensitive.
First, SVB relies on deposits from a single, risky, customer base (start-ups). These form the liabilities side of the bank's balance sheet.
Over the last few years, SVB's deposits have ballooned. In 2022, their deposits grew by over 25% from December of 2021, despite being in decline for almost the entire year.
Here's the thing, start-ups are dependent on VC groups for funds. VC groups are notoriously interest rate sensitive. As rates go up, VC funding goes down.
If VC funding goes down, then start-ups make fewer deposits at SVB.
SVB did see a decline in deposits, but the company was still solvent at the start of the month.
Second, once SVB has deposits, it must decide what to do with them.
Ironically, as others have pointed out, SVB almost exclusively invested in the "safest" assets in the world — US Treasuries and Mortgage-Backed-Securities (MBS).
Well wouldn't you know it, those are interest rate sensitive as well.
Why would SVB invest so heavily in Treasuries and MBS?
The short answer is that you and I will never get a mortgage from a niche bank in San Francisco. It's pretty hard to deploy $173B via loans if no one wants to get a loan from you.
Thanks to interest rate hikes, those bonds became less and less valuable.
By the end of 2022, SVB had unrealized losses of nearly $20B. Again, nowhere near enough to make the bank insolvent.
The "Crisis"
This all came to a head when SVB decided it better sell some of its bond portfolio at a loss in order to have more cash on hand for potential withdrawal demands. How ironic.
On Wed, it announced to its shareholders that it sold a portion of its portfolio for a roughly $2B loss, and it planned to release more shares of SVB to raise capital for reserves.
The next day its stock value dropped by 60%. The day after that, it dropped another 60%.
That's when VC Groups got concerned and told their portfolio companies to withdraw their deposits.
And...
Voila! You have a bank run. With the complete lack of reserves, and unable to realize its losses, SVB soon collapsed.
It was the 2nd largest banking collapse in US history, with the 3rd largest happening just a few weeks before during the collapse of Silvergate.
Conclusion: Aftermath and Getting a Grip
So there you have it: the biggest banking crisis since Lehman Brothers.
In the aftermath of the collapse, the media has had a field day claiming financial Armageddon.
As of March 12th, the FDIC has announced a radical intention to insure 100% of all the depositors.
Pundits and "experts" have called for all kinds of intervention from the Federal Reserve in order to stem the tide of the spreading contagion.
How should we react to all this?
First, I am personally not sensational about the so-called "collapse" of SVB.
The most remarkable aspect of the story is not what is reported. Yes, the bank was financially risky, but it wasn't financially irresponsible.
The most remarkable fact of the story is that the bank did exactly what it had every incentive to do as a result of loose monetary policy at the Fed.
A bank run is what caused the collapse of SVB. Yes, they were invested in long-term (interest rate sensitive) debt instruments, but that didn't cause the collapse.
Yes, they had a risky client base, also interest rate sensitive, but that didn't cause the collapse.
There was no fraud, there was no outrageously speculative investing, there was no insolvency. KPMG gave the bank the stamp of approval just a few weeks ago.
What caused the collapse was a bunch of SVB's customers coming and asking for their money. Incredibly, SVB didn't have their money. That's what caused the collapse.
This is not a unique feature of SVB. I cannot stress this enough.
Tomorrow, if we all decided to withdrawal all of our funds from JP Morgan Chase, then JP Morgan Chase would collapse tomorrow.
I know this because JP Morgan Chase, like every other bank, has reserves around zero percent of its demand deposits (0.1% to be exact).
Nothing special happened here other than that SVB has a concentrated customer base in a niche market that is controlled by the whims of VC groups.
One VC group might control a hundred of SVBs clients. If ten VC groups tell their portfolio companies to get out of SVB, then that is game over for SVB, but that was the game they were playing all along.
Is it possible other bank runs could occur? Of course! Because bank runs are dictated by any number of random causes.
Reddit is just as likely to be the cause of the next bank run as any particular investment strategy at the high levels of a bank.
Finally, the response to the SVB "crisis" seems dubious at best, very concerning at worst.
How many of us have heard of SVB before Thursday of last week? Yet, we are meant to believe this is a catastrophe the likes of which we have never seen!
The calls for the FDIC or Federal Reserve to step in and bail out the bank are not only misplaced, but likely irresponsible.
This was the collapse of a relatively small bank serving an extremely narrow set of clients.
"It was the 16th largest bank in America! This is a disaster!" Really? It has assets of $212B. That's relatively minor. JP Morgan Chase has assets of nearly $4 Trillion.
Is it possible there will be second and third order consequences? Yeah, it's possible.
Even if there are such consequences, why should we seek solutions in the Fed? The Fed created this monster.
You know what would have prevented this banking crisis? A reserve rate of 25%, or better yet of 100%.
In the coming days, I will release another article on the proposed bail out of SVB and the damage it can cause.
For now I will simply say: don't get caught up in the hysteria that is surrounding the story.
We can all rest easy knowing that the banks will continue to do exactly what they have always done —what the Federal Reserve tells them to do.
That is, not hold on to any of our money.
Great read! Thanks for synthesizing so much into a piece that's so easy to read.
You say that SVB wasn't irresponsible. But wasn't it irresponsible for SVB to choose to invest so heavily into bonds which are so correlated to their ? Did they not have less-correlated alternatives they could have invested in? (Sorry if I used the wrong terms here--I'm not very familiar with this stuff)