Bottom Line, Up Front
Over the past weekend, U.S. regulators took control of both Silicon Valley Bank (SVB) and Signature Bank (SB). Deeming the banks large enough to be a risk to the global financial system, officials took the extraordinary step of guaranteeing all depositors will have access to their funds today.
SVB’s main mistake was a mismatch between their assets (bond portfolio) and their liabilities (deposits), which surfaced after they announced the need for capital to offset portfolio losses.
Please note— this is not a bailout. Investors who held stocks or bonds in the banks will not be protected. Federal regulators said any losses to the government’s fund would be recovered in a special assessment on banks, meaning that U.S. taxpayers wouldn’t bear any losses.
Understanding the Bank Business
The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by Congress to maintain a stable banking system. FDIC insurance had previously covered up to $250,000 per depositor, per insured bank.
Every deposit is a liability for the bank because you could request to withdraw your funds at any time. This is why banks are required to conform to government-mandated capital and liquidity ratios. Banks invest your deposits in bonds to make more interest than what they pay you.
Interest rates had been falling for the last decade before the Federal Reserve started raising interest rates last year. This change was great for the banks because when interest rates fell, the value of their bond portfolio went up.
For accounting purposes, bonds can be classified in two ways: Held to Maturity or Available for Sale. The change in market value for bonds classified as Held to Maturity are ignored for purposes of reporting their earnings, equity, and regulatory capital. Bonds can be held to maturity, making the changes in interest rates meaningless. The bank’s bond portfolio really doesn’t matter unless the bank’s depositors want to access their money.
Silicon Valley Bank Was Unique
- The depositor base for SVB was concentrated among technology company startups — and their investors — which were taking in huge sums of money during the post-COVID tech boom. Their deposits reached a staggering $198 billion on March 31, 2022.
- SVB invested in federal agency mortgage-backed securities. These carry minimal credit risk but can have sizeable interest rate risk. Their key mistake was buying securities with more than ten years to maturity, rather than shorter-maturity U.S. Treasury Bills. These bonds were classified as Held to Maturity, so any change in value would go unreported.
- With the technology sector’s struggles last year, the bank’s cash flows from depositors turned from inflows to outflows. They experienced net outflows for the last three quarters, with the bank’s deposits dropping to $157 billion by the end of 2022.
- Even worse, interest rates started rising, which in turn created huge losses on their bond portfolio. Their $91 billion bond portfolio reportedly lost $15 billion, and losses of this size relative to the size of their capital base are unusual to say the least.
- On Wednesday, March 8th, 2023, SVB announced a $21 billion sale of their portfolio for extra liquidity. The estimated loss: $1.8 billion. To stay in compliance with the capital and liquidity ratios, they announced they were looking to raise $2 billion to help cover the loss on the portfolio. Shareholders were not happy about their stock being devalued and subsequently sold their shares. At the beginning of the week, the stock price started at $286.52/share. Once the news was out Wednesday night, the stock plummeted, closing at $106.04/share on Thursday. It would never trade again.
- The news created a run on the bank, with depositors requesting $42 billion of outflows on Thursday. By Friday, the bank was under regulators control and stock trading was halted.
Social media spread the news quicker than regulators could have imagined back in 2008. Depositors could instantly withdraw funds from their accounts using their phones. The very technology industry that created their success is the very same technology industry that contributed to their eventual downfall.