[Updated Sections 3 and 4 and added Section 6 on 2023.03.14, 8:41PM]
Blaming rising rates takes the focus off other systemic and firm-specific issues.
WHY IT MATTERS: Understanding the full context of Silicon Valley Bank’s (SVB) failure provides perspective on financial system operations and stability.
By now we all have heard about Silicon Valley Bank’s collapse: HTML. In this post I look at five contributors to SVB’s collapse:
- Balance sheet imbalance.
- Rising rates.
- Where were the regulators?
- Crypto contagion.
- Cut-off the nose to spite the face panic.
1. Balance sheet imbalance
Table 1 shows differences between Bank and industrial company balance sheets.
|Bank||Loans. Treasury securities. Other marketable securities (HTML).||Deposits. Short-term borrowings.||Assets – Liabilities.|
|Industrials||Operating: Manufacturing equipment.|
Non-operating: Investment securities.
|Long-term and short term debt.||Assets – Liabilities.|
As I tell my students, the “balance” in balance sheets comes from beer, specifically ALE:
Assets = Liabilities + Equity
Commercial banks like SVB provide an asset transformation service. Many short-term highly liquid deposit accounts are transformed into fewer long-term income generating assets such as Treasury securities (HTML), home loans, and loans to businesses. As liabilities are reduced (depositors withdraw) the balance must be maintained through the sale of assets.
In theory, Equity > 0 because the bank operates profitably within the economic environment in such a way that Assets > Liabilities. However, SVB got to the point of having Assets < Liabilities. To “balance” the balance sheet they planned a sale of $2.25 billion in new shares.
That proposed sale sparked a panic in both equity markets (stock plummeting) and with SVB’s own customers (depositors rushed to withdraw money). If you have $72 in assets and $100 in depositors wanting their money, what do you do when you can’t raise > $28 through stock issuance? Collapse.
But let’s move on to how SVB got to this $72 in Assets and $100 in Liabilities situation (by the way, I just pulled $72 and $100 out of the air for illustrative purposes).
2. Rising rates
Rising rates reduce asset values – it’s just math
Presume a $500,000 home loan was issued last year at 3.5% interest. Today, home loan rates are twice that at around 7.0% (Bankrate.com: HTML). So, if the originating bank wants to sell that loan today, it needs to earn 7%. how does a $500,000 loan paying 3.5% interest earn 7%? If that loan sells (banks and investors buy and sell loans) for $337,474, with the payments unchanged, it will earn 7%.
So, the increase in mortgage rates from 3.5%to 7% resulted in the value of this bank asset dropping from $500,000 to $337,474 (a 32.5% reduction in value) – in just one year. The same algebra applies to other fixed-rate assets held by the bank such as Treasuries.
Rising rates make raising capital more costly
Many of Silicon Valley Bank’s customers (depositors and borrowers) are startup companies. Startup companies tend to have less (dare I say negative) cash flow. As such they need to raise capital periodically to sustain operations, R&D, etc. Capital is raised either in equity markets (share issuances be it IPO or SEO) or debt markets (borrowing). Well, with rising rates the appetite for risk in both markets declined.
So what does a startup do that needs cash flow for operations do when it can’t raise more capital, or at least not efficiently? They burn through cash. From SVB’s perspective, that means withdraw deposits. But again, as more and more of SVB’s depositors do this, SVB has to come up with the cash by selling assets. As I described in the previous section, the value of those assets decline during a rising rate environment.
Sacramento State University launched a Masters of Science in Finance this past Fall: HTML. I teach FIN210, Financial Institutions Management. In fact, I taught it just this past October. I last taught the course in 2008 at the University of Memphis. So, every time I teach this course we are staring at financial system calamity. But it’s not my fault.
Financial Institutions Management boils down to a simple goal: measure and manage risk. I won’t go into SVB’s financial details here (full disclosure: I haven’t looked at them. I’ll make it an assignment for this coming October’s cohort!). However, something clearly went awry with the measurement and management of risk.
One thing the management did seem to do, and it was a very human thing to do – protect their interests. See 2023.03.10 Bloomberg, SVB CEO Sold $3.6 Million in Stock Days Before Bank’s Failure: HTML. Also, to further vilify executives, check out this 2013 post of mine on corporate bailouts: HTML.
2023.03.14 update: However, concentrating your customer base to startups only, and forcing those startups to sign exclusivity agreements, clearly did not help: HTML.
4. Where were the regulators?
Again, I haven’t looked at SVB’s financial details. However, as taught in FIN210 at Sac State’s MSF program (yes, that is a shameless plug for the program), banks should comply with numerous U.S. and international regulatory capital metrics (e.g., Tier 1 capital ratio, Tier 1 Common Equity / Risk-Weighted Asset ratio, etc.). Was SVB compliant with all capital adequacy ratios? If so, perhaps regulators need to rethink the adequacy of their capital adequacy ratios.
2023.03.14 update: It turns out the regulators were called off by the previous United States President’s Administration: HTML. As such, I do not believe you can fully blame the regulators which were not allowed to apply stricter standards on SVB as a result of the 2018 deregulation move. Although, there is certainly a cased for shared blame: HTML.
5. Crypto contagion
Silicon Valley Bank and Crypto are understandably intertwined. Silicon Valley is a global center of startups. Crypto startups need financing. SVB is there. However, with collapses of crypto exchanges like FTX (HTML), Crypto lenders like Silvergate (HTML), destabilization of so-called stable coins (HTML), crypto wallet thefts (HTML), and general “rat poison squared” nature of crypto as espoused by Warren Buffett (HTML), I question the prudence of intermingling regulated commercial bank operations with unregulated crypto so-called currency operations.
DISCLAIMER: I have JOMO (joy of missing out) with regard to crypto. Never have been a fan. Never “invested” a penny in crypto “assets.” One fundamental problem I have with crypto fanatics is when they say “the USD has no value, it isn’t backed by anything.” Well, then why do you quote the price of your crypto so-called currency in “worthless” USD?
Moving on, SVB was in the business of providing banking services to not just startups, but even some crypto-related startups. A deeper dive into their financials will be an ongoing case study.
6. Panic induced from within startup ecosystem
2023.03.14 update: A former MBA student asked me “What about Peter Thiel inducing this panic.” At present, I have only two things to say about this:
- “Feelings are an unreliable guide to reality.” -some Buddhist-related quote.
- It is ironic that the very bank, or at least type of bank, that financed Thiel’s companies is one that Thiel served as a downfall catalyst. Human greed and selfishness were on full display.
Something went awry at SVB. Risk was not properly measured and managed. One risk to be measured and managed is interest rate risk. Specific details on SVB’s missteps in this regard require further analysis. I look forward to pushing that off onto FIN210 students in October. For instance, how does SVB’s capital adequacy ratios and interest rate risk measures look over time and vs. other banks.
In regards to other banks, I do think (and hope) that SVB’s collapse is not a widespread issue. However, I do not think SVB will be the last bank failure, especially of those intertwined with unregulated crypto businesses. Keeping my fingers crossed that my credit union has avoided crypto and measured and managed risk wisely.
Update (2023.03.12 4:15PM)
A joint statement by Treasury, Federal Reserve, and FDIC says all depositors (even those with more than the $250,000 FDIC limit) will be made whole – at no expense to taxpayers: HTML. Who pays the expense: “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.”
 The notion that the USD “isn’t backed by anything” is false. The USD is backed by a government that can tax a productive population. The population is productive because we have resources. We have resources because we have a military that can protect and take more. We also have resources due to good ‘ol American ingenuity. However, I won’t go into the role of slavery in the initial capital and resource accumulation of this country. In a similar vain, banks don’t “create money out of thin air” either. When you get a home loan for $500,000, the bank does create a corresponding deposit (liability) of $500,000. However, that $500,000 is backed by the bank’s ability to collect principal and interest from you over the years. The bank has a claim to the future fruits of your labor. Hence, “the borrower is servant to the lender.” I will stop here before I go on another Dr. Moore tangent.
[*] Thanks to CB for editorial suggestions.