Demystifying SVB Debacle

On 7th March, Silicon Valley Bank tweeted, “Proud to be on @Forbes’ annual ranking of America’s Best Banks…”

By 10th March, SVB’s stock price had tanked by 60% and the bank was taken over by an arm of the US government.?

Banking per say is very boring business. Banks take deposits from people like us at a low rate of interest. They use these funds for?

1. lend most of these deposits out to others and earn a higher rate of interest and make money.?

2. invest some of the money into things like bonds. It may not earn much money but they can sell these quickly in case of an emergency.?

3. keep a bit aside in cash. To be on the safe side.

4. Keep in Cash reserve with RBI as per regulation. ( only in India)

In reality, utilisation of deposit is?not so simple. A lot of things could go wrong.?

1. Banks could make really poor lending decisions. And people don’t return the money.?

2. the bank might even make some bad investment decisions. They’ll invest money in complex things they don’t understand.?

3. the bank could make some wrong decision on maturity of investment.?

4. The Financial market can play havoc to disrupt the banks loss estimations.?

Now with this background let’s us understand Silicon Valley Bank debacle. The fabled bank started around?1983.

It was a favourite bank for starts ups. Now being around for so many years means that SVB’s quite the experienced player. It has seen its share of bad markets — the dotcom crash, the great financial crisis, the coronavirus pandemic etc.?

But…2023 was different. SVB was hit by a perfect storm. The journey from the best bank to the bust bank turned out to be very short.

Immediately after the pandemic, the US central bank slashed interest rates to all-time lows. To nearly zero. They wanted to entice people to borrow money and spend to propel the economy.

Startups benefited greatly from this too. All this easy money meant that Venture Capital money rushed into startups by the boatload. Investors often didn’t even care about business models. They just wanted fancy stories. And while a lot of money was burnt at the altar of growth, these startups parked millions of dollars they’d raised with banks too. Naturally, since SVB was a startup darling, it got a lot of these deposits. Between 2020 and 2022, SVB’s deposits soared 3 times — from $62 billion to $190 billion.

Now as we said, SVB could do two things with this money. Lend it out or invest it.

But startups weren’t asking for loans. They didn’t need it because VC money was abundant. So,

while the deposits tripled, loans only doubled. SVB was left with a lot of spare cash. They decided to invest it.

Now, if you’re a sensible and prudent bank, you’d just take that money and invest it somewhere ultrasafe. Such as a short-term government bond. That’s the safest bet there is. You might earn peanuts. Say 0.25% interest. But you’re a bank. Safety first is the motto!

The thinking is that if companies suddenly wake up and demand their money back, you can quickly sell these government bonds. There will be plenty of buyers waiting to lap them up. Everyone’s happy. Everything’s safe.

But, SVB messed up. They got a bit greedy. Or stupid?

Out of the roughly $115 billion they invested, nearly $80 billion was into things that would make them even more money — give them interest of 2% and make their profits look fabulous. But here’s the thing about the world of finance — if you try to earn higher returns, it comes packaged with more risk. In SVB’s case, this risk was that most of these investments were made in long-term bonds. Things such as real estate securities

Now here’s the thing you need to understand. All those monies the startups deposited were SVB’s liabilities. The startups could demand it whenever they wanted. At least most of it. And that made these liabilities short-term in nature.

On the other hand, the SVB’s investments are its assets. Now it doesn’t take a genius to tell you that if liabilities are short-term in nature, its assets also better be short-term in nature. You should be able to sell the assets quickly without losing money on it. And long-term real estate securities don’t quite meet that definition.

It’s what the pros call a classic case of asset-liability mismatch. To be fair, most banks do some version of this. But SVB was, let’s say, less balanced in its approach than others.

Now there’s one more problem. See, bonds are wired a little differently.

For non financial professionals, the price of a bond and its yield move in opposite directions. The reason is actually simple. Imagine you pay $100 and buy a bond. And you get 2% interest or a yield on it. Then, the central bank raises interest rates. Suddenly, your bond is not attractive anymore and will be sold at discount. Basically, as the price falls, the overall yield rises. And vice versa.

But what’s weirder is that a long-term bond is more sensitive to this inverse relationship. When the interest rate rises, its price falls a lot.

Just look back at what happened last year. The US Federal Reserve finally raised interest rates. And it raised rates quite quickly. If you’ve followed my explanation, you’ll know by now that it’s not a good scenario for long-term bonds. The prices of SVB’s assets fell significantly. The bank was looking at losses on its books.

In a normal environment, SVB could’ve held on to these bonds. Waited for them to mature and got all their money back. Because this wasn’t a case of default. It was just some market volatility.

But…the past 12 months haven’t really been what you’d call normal. The startup world turned upside down. When interest rates shot up, VCs turned off the funding tap too. They started asking the hard questions — about profits. Startups couldn’t raise more money. And in order to keep the business running, they needed to get their hands on money. So they asked for their deposits from SVB. They began making withdrawals.

And at one point, SVB had no option but to sell its investments to make these payouts. But, because interest rates had gone up, these real estate bonds lost their value. SVB made significant losses.

Now, this wasn’t the end of the world for SVB. The bank actually had enough money to tide over this loss.

But…it had to follow the rules of the banking world. And the rules dictated that SVB needed to beef up its capital a bit because of the loss. It needed to issue shares and raise money. So it made that announcement. It told the world about its plan. And that’s when everything unraveled.

Because unfortunately for SVB, something else happened at the exact same time. The day it announced its plan to clean up the balance sheet, Silvergate — a banker to crypto firms — imploded too.?It committed the same mistakes as SVB.

And when Silvergate collapsed, it spooked the startups, which banked with SVB. Word spread quickly within tech circles that trouble was brewing. And VC firms tweeted, sent memos, had conference calls, and told their investee companies to pull out money from SVB too. The trickle of outflows turned into a flood.

And even though SVB’s Management begged people to stay calm, it didn’t help. The damage was done. At the end of the day, the same startups that SVB helped for the past many years turned their back on it.

The US regulator had to step in. It took over the bank.

Lessons learnt from SVB debacle

Collapse of Silicon Valley Bank is an important lesson for banks and its risk management policies. Some people think avoiding risk is equivalent to risk management, well #SVB found out the hard way. They invested 50% of their deposits in 10 years US treasury bonds the safest form of asset, which ultimately turned out to be their biggest mistake. Not because the bonds were not safe, but because #SVB failed to recognise the ALM mismatch and interest rate risk. The asset can be as safe as it can be but if your redemption requirement doesn’t not meet your investment maturity you will face liquidity crisis. The SVB case only validates what bankers?learnt in their early professional life. “ Top line is vanity, bottom line is sanity but liquidity is reality”. The value of your business doesn’t matter if there is no liquidity. What could have saved them was an emergency liquidity line. In past many Indian firms learned the lesson hard way e.g ILFS , they were managing long term project with short term CP funding. Eventually failed

The other thing #SVB did wrong is to have concentration risk, all its investment were made in 10 year maturity treasury Bills?at a very low rate. Means when the rate cycle turned, they faced major mark to market?losses. Eventually created a run on the bank and consequently #SVB?failed and was taken over by DIFC

Lessons: risk management is not only about choosing the right asset.?It is all about quantity, rate and the time. SVB failed because of:

1 ) Asset Liability mismatch

2 ) Concentration risk

3 ) Interest rate risk.

Hope regulators and financial institutions across globe will take note of this failure to improve their risk management policies.