Market Update | March 2023
THE SVB FINANCIAL FAILURE
On Friday of last week, the FDIC took control of Silicon Valley Bank, ending a frenetic 48 hours which saw the bank go from being solvent to insolvent. With $209 billion in assets, SVB is the 2nd largest bank failure since Washington Mutual’s failure in 2008. Below we summarize what transpired, we provide our opinion on the risk of further contagion, and we discuss the potential impact this failure has on the direction of interest rates and the economy.
Silicon Valley Bank – What Happened?
The core business of a bank is to take in customer deposits which the bank, in turn, lends out or invests. The profitability of a bank is dependent on the spread between the interest they pay depositors and the interest they earn on their loans /investments.
Customer deposits are liabilities on the bank’s balance sheet, and they’re considered short-term because a customer’s demand for their cash must be immediately met. While these liabilities are short-term, not all the bank’s assets (the loans and investments they made with the cash) are. Bank reserves contemplate this duration mismatch; however, the sufficiency of those reserves depends on the unique facts and circumstances. In the case of SVB, those facts and circumstances resulted in the failure of the bank.
The composition of SVB’s depositor base made them uniquely susceptible to a bank run in the current environment. SVB primarily catered to venture capital sponsored start-ups. During the pandemic, low interest rates and monetary easing allowed start-ups to raise capital in droves. That cash was deposited at SVB which, in turn, loaned that cash to borrowers or invested that cash in mortgage-backed securities, Treasuries, etc. Rapidly rising interest rates in 2022 caused two problems for SVB:
First, rising interest rates and the tightening credit environment made it difficult (and expensive) for SVB’s depositor base to attract additional venture capital financing. As a result, their customers increasingly needed to use their cash. The large cash inflow SVB experienced in 2020 and 2021, turned into a large outflow.
Second, the increase in interest rates in 2022 devalued SVB’s asset base. Traditionally, the investment securities SVB purchased would be held to maturity, allowing SVB to recoup their losses. However, with so many of their depositors withdrawing their deposits, holding assets to maturity was no longer an option and liquidating those investments at a loss risked the bank’s solvency. Simply put, SVB took too much duration risk in their portfolio.
SVB attempted to address the problem by raising additional equity capital. However, their attempt unnerved both investors and their customers which further accelerated withdrawal requests. The bank run began and ended quickly.