Most Americans were not familiar with Silicon Valley Bank until Wednesday of last week when the California-based bank announced that they were looking to raise several billion dollars to fund a shortfall in reserves. What ensued was a run on deposits and instant pariah status for a bank that catered to high-growth tech start-ups and IPO candidates. From 2016 to 2021, business was booming. As we learned last week, that all changed in 2022. So, what happened?
It’s important to remember that banks don’t operate like a brokerage account. When a customer deposits funds into a bank account, those dollars aren’t left there, reserved specifically for the account holder should they need them. Banks earn money by lending those funds out and charging interest or by investing conservatively in securities. Usually, this involves bond-like instruments that don’t fluctuate much in value.
The two main risks to banks are poor lending/investment decisions and too many account holders requesting funds at the same time. In 2022, SVB experienced both. Bonds had their worst year on record resulting in large losses for the bank’s own investment portfolio. At the same time, the bank’s many start-up customers were burning through cash because of a lack of IPO’s (initial public offerings) and venture capital funding in 2022. These cash infusions typically fund the early growth and cash flow needs of young companies. The lack of cash inflows meant heavy bank withdrawals were needed from business customers at a time when SVB was already feeling the pressure of its own under-performing portfolio. After some poorly-timed communication to the public and the ensuing panic, SVB found themselves in the midst of a classic bank run.
Looking at the big picture, based on what we know today, there were four key ingredients in the SVB collapse:
- Poor management of the bank’s balance sheet – i.e. they owned the type of bonds that couldn’t withstand a high-interest rate environment.
- Fed interest rate hikes in 2022 which left no room for #1.
- Poor communication leading to panic via quarterly earnings call.
- Short-sellers (investors betting a stock will go down) did everything in their power to push SVB off the cliff of their own making.
What happens next?
On the surface, banking seems like a high-risk proposition for a depositor, and it certainly can be. This is why the Federal Deposit Insurance Corporation (FDIC) was created after the crash of 1929. Today, deposits are insured by FDIC up to $250,000 per account registration.
At Silicon Valley Bank, most of the deposits (perhaps 85%) were in excess of the individual FDIC limit, and there remains concern about what will happen to businesses who held funds there. Most bank runs are as much a matter of not enough time, as they are of not enough money. If SVB could have found a line of credit to get them through this period, depositors could have eventually been made whole. You might remember the scene in the classic movie “It’s a Wonderful Life”, when Mary Bailey walks into the Bailey Building and Loan with George Bailey’s wad of cash and yells “How much do you need?” They buy enough time to handle withdrawal requests, and business continues as normal. A Hollywood over-simplification notwithstanding, SVB faces the same problem. Unfortunately, they’ve passed the point of no return when it comes to asking for patience. The available funds have already been pulled by customers, and the FDIC has put the bank in receivership. So, what happens next?
It’s likely that the bank will be taken over by a large investor or another bank. The US Treasury has announced that they will not “bail out” SVB like we saw during the Financial Crisis, but they will want to make sure that customers are made whole. Not finding a way to do that could cause a general crisis of confidence in other regional banks not subject to the same “Too Big To Fail” stress tests required by the U.S. banking regulators since the 2008 financial crisis. We think another bank or investor with deep enough pockets will likely take over the bank, re-brand it, and essentially buy a bank in a wealthy region for pennies on the dollar in a Warren Buffett-like maneuver. The auction process reportedly began this weekend.
What should you do?
The events of the past week have and will probably continue to lead to some market volatility. Those invested for the long-term should not alter strategy due to a short-term event such as the SVB failure. However, if you do have uninsured deposits at a regional bank, consider transferring enough funds to another institution to obtain full FDIC coverage and avoid the potential for future problems. The risk of other bank failures remains extremely low, but even in good times, it is never wise to keep more money on deposit at a bank than is insured by FDIC. Please contact us if you have questions about your individual banking circumstances.
Will other banks fail?
As long as the government offers the needed reassurance and lifeline to SVB customers, we don’t think we’ll see broad bank failures. The operating style of SVB was very unusual. However, when the Fed keeps interest rates at zero for long periods, it encourages risky behavior. When rates finally rise again, some businesses with hasty practices “break”. This is a textbook example, and likely a sign that the lag-effect of the Fed’s policies over the past year are coming home to roost. The silver lining? Inflation seems to be coming down fast as well. We’ll know more in the coming weeks and will reflect on what we learn in our upcoming market commentary at the end of the quarter.