The Startup Bank That Ran Down

In a sudden, extraordinary development, a large California bank serving over half of tech startups, with over $200 billion in assets failed in a mere 48 hours. Not only was this bank one of the top 20 largest U.S. banks by asset size, it was also well-capitalized (12.1% Tier 1 capital), profitable (13.8% return on equity) and with low-credit risk (0.05% non-performing assets). The failure by Silicon Valley Bank (SVB) constitutes the second largest bank failure in U.S. history. SVB was also no Silvergate Capital or Signature Bank - it was recently identified as one of the best banks of 2022 by Forbes. SVB depositors panicked and withdrew $42B from the bank on March 9, leaving SVB unable to raise new funds or find a suitor thus forcing the FDIC to take over the bank before the market opened the next morning. Why did SVB fail so spectacularly, and what can we learn from this failure?  Is this the Lehman moment of 2023?

How Did SVB Get to This Position?

While large, well-capitalized, profitable, and with a low credit risk, SVB was very aggressive regarding its asset-liability management, or its interest rate exposure. First, it had only about $26B in Treasury and agency securities available for trade and over $91B in Treasury and agency securities held-to-maturity as of its last 10-K filing. Of the $26B in available-to-trade assets, only $1.1B had a maturity less than one year while $7.2B had a maturity of more than ten years. Thus, SVB’s immediate emergency funds that can be raised without taking capital losses appear to be on the order of about $1B. Even if all of these $26B in assets were to be sold quickly, they fell well short of being able to meet SVB’s run on deposits of $42B. Consequently, SVB was forced to either raise additional capital or be bought out on short notice. Both of these attempts failed on March 9, forcing the FDIC to take control of the bank instead. 

Of the $91B in net value of securities held to maturity held on SVB’s balance sheet, more than $86B (or 95%) had maturities over ten years. Furthermore, these assets were yielding only 1.63% based on book value. By regulation, these assets were not available to be sold in case of a liquidity shock, such as the one SVB experienced on March 9. In addition, long-term Treasury assets like these are also highly vulnerable to interest rate increases.

In the past, to increase its profitability slightly, SVB reached for long-duration Treasuries during years of extraordinarily low interest rates. It also classified most of its Treasury assets as held-to-maturity so that it did not have to mark these assets to lower market values in a rising interest rate environment. This classification allowed SVB to fly under the radar during a year and a half of the rising interest rate environment without having to report any of its capital losses on its long-term assets.

Unfortunately for SVB shareholders and some depositors, the truth came out last week. Some alert uninsured Silicon Valley depositors saw through this veil and realized that SVB may be sitting on huge unrealized, and undeclared capital losses on its held-to-maturity assets. These uninsured depositors immediately panicked and wanted their money asap. Their panic in turn caused everyone else to panic.

What Happens in a Bank Run? 

In a bank run, everyone ends up in a classic prisoners’ dilemma. Regardless of what other depositors do and regardless of what you think about the bank’s health, you would rush to withdraw your deposits and hope to get in front of an (either short or long) line. The same logic applies to everyone else. If you rush and show up at the front of the line in a bank run, you get paid immediately and in full. If you wait and end up at the back end of a long line, you may have trouble accessing your deposits for a long time and also realize losses. This gives everyone incentives to rush and withdraw their deposits first and ask questions about the bank’s health later. This mad dash to withdraw resulted in a bank run of $42B in withdrawals within 24 hours on March 9. The next morning, the window to withdraw deposits was closed, even before the bank opened

What Role Did Rising Interest Rates Play in the SVB Insolvency?

Uninsured depositors were certainly right to be concerned. Based on a simple rule of thumb, a 200 basis point increase in long-term interest rates would cause more than a 20% decline in value of SVB’s more-than-10-years, held-to-maturity $86B Treasury securities, wiping out at least another $17B from its market cap, or more than the entire value of SVB’s equity. If the average maturity of these $86B of long-term assets is 20 or more years (this is not reported on the 10-K), then the additional losses can easily exceed $35B. No wonder uninsured depositors and investors panicked so suddenly. SVB did not just have a liquidity problem. It also had a solvency problem. 

This distinction between liquidity and solvency is highly important. In a liquidity crisis, depositors simply end up with delays in accessing their money. However, eventually, they are paid in full. In a solvency crisis, depositors not only wait for a long time but they also take losses on what they thought were risk-free investments. 

To restate the obvious now, the Federal Reserve’s recent interest rate increases broke the back of one of America’s best banks. By law, the Fed is charged with ensuring financial stability above all else. If the Fed has broken one of the best banks, what is next? What about all the weaker banks? Who is next in line? Will depositors panic again? Are we likely to have a period of bank panics as in 1907 or 1930s?

How is the FDIC Handling the SVB collapse?

For an answer to this question, let’s turn to the FDIC statement: “All depositors will have full access to their insured deposits no later than Monday morning, March 13, 2023. The FDIC will pay uninsured depositors an advance dividend within the next week. Uninsured depositors will receive a receivership certificate for the remaining amount of their uninsured funds. As the FDIC sells the assets of Silicon Valley Bank, future dividend payments may be made to uninsured depositors.”

This announcement clearly indicates that FDIC has forcibly converted uninsured deposits (over $250,000) into some sort of equity or junior claims (receivership certificate) in SVB. The FDIC will liquidate all of SVB’s assets, fully realize the losses on SVB’s long-term held-to-maturity Treasuries, and if anything is left after paying all senior claims such as insured deposits or secured debt, the junior uninsured depositors will get something. The exact order of priority (whether uninsured depositors are ahead of some or all debtholders) is not clear at this time. In all likelihood, under the current announcement, uninsured depositors are likely to suffer large amounts of damages since current equity holders as well as some junior debtholders are probably already wiped out. 

It appears that the FDIC is interested in imposing discipline (and losses) on uninsured depositors. While discipline may be a good idea in the case of a particularly mismanaged bank, SVB does not seem to fit this profile. While SVB holds some responsibility for its aggressive interest-rate posture, most of SVB’s troubles are due to Fed’s actions which also affect thousands of other U.S. banks. By keeping interest rates artificially low for too long, the Fed tempted all banks (not just SVB) to reach for duration in longer term bonds. The subsequent raising of rates so suddenly and spectacularly within a year destroyed the market value of these assets.