Explainer: The Collapse of Silicon Valley Bank

Anyone who cares about tech would have heard about the collapse of Silicon Valley Bank by now. On Friday, Silicon Valley Bank (SVB) was closed by banking regulators due to a rapid and unexpected collapse, which is now the second-largest bank failure in US history. SVB had indicated just two days earlier that it was experiencing a financial shortage. The bank initially attempted to raise funds by selling shares and then attempted to sell itself, but this unsettled investors and resulted in its ultimate demise.

But first, let’s start from scratch…

“What Kind of Bank is SVB and Why is it Important?”

Founded in 1983 in Santa Clara, California, Silicon Valley Bank was established to cater to the growing tech sector and its financiers. By 2021, the bank claimed to serve nearly half of all US venture-backed startups. On its website, it said that 44% of the US venture-backed technology and healthcare companies that went public in the whole of 2022 are its clients. According to Federal Reserve data, the bank had assets worth around $209 billion and ranked 16th among U.S. banks.

“So, What Happened to It?”

Before I explain, let me clarify something important: Fractional Banking. In a fractional reserve banking system, which also applies in Nigeria, banks are required to keep a portion of their deposits as reserves with the central bank (known as cash reserves) and can use the remainder for activities such as lending and trading. This system is straightforward. The current cash reserve ratio in Nigeria is 27.5% (this may have changed slightly), which means that banks are required to hold at least 27.5% of their deposits as reserves with the Central Bank of Nigeria (CBN). They can lend out the rest. For example, if you keep $100 in the bank, the bank can take out $72.5 and use it for its operations. However, the US operates under a no-reserve banking system with a cash reserve of 0%. This means that once a customer deposits $100, the bank can use the entire amount as it sees fit.

“Why is that?”

This change was implemented around the time of the COVID-19 pandemic, perhaps to stimulate growth in the US economy. And it really helped SVB. If you remember, during COVID-19, the stock market boomed, and many tech companies got high valuations. Many of these companies parked their excess funds in SVB. That’s how they got the $209 billion, according to the Wall Street Journal. SVB, in turn, invested the funds in generally safe securities, like bonds. However, the Federal Reserve (America’s central bank) has been raising interest rates to stem inflation. They have increased it from 0.08% to 4.65%. Interest rates impact bond rates. There is an inverse relationship between interest rates and bond prices, i.e., the higher the interest rate, the lower the bond price and vice versa.

“Hold it there! You have started with the jargon. What are interest rates and bond rates?”

Imagine you are lending your friend $10, and you want your friend to pay you some extra money for borrowing the $10. This extra money is called “interest.” The same thing happens when you keep your money in the bank. They pay interest on your deposits. Similarly, when you buy a bond, you are lending money to a company or government. The bond pays you interest as a reward for lending the money. Now, if interest rates go up, the government is basically instructing the banks to pay you more for your deposits (from 0.08% to 4.65%). The idea is that if you park your funds in the bank, you will have less money to buy goods and services, and the prices of goods and services would come down (remember demand and supply? Less money chasing goods leads to lower prices, which leads to inflation slowing down). The corollary of this is that the bond rates fall because people can earn more interest on their money in other investments, such as savings accounts, than the interest they would get from buying bonds. So, fewer people will want to buy bonds, and the price of bonds will go down. The higher the interest rate hike by the Federal Reserve, the lower the bond rate.

“Got it. You can continue with SVB.”

Because of the high interest rate, the bonds being held by SVB as investments became unattractive. I read that the Mortgage-backed securities (MBS), which is the name of a bond, being held by SVB have tanked to 1.5%. That would have been fine because SVB would have just seen the investment through and taken the funds at the end of the agreed period of the investment. Unfortunately, this period coincided with the time when tech startups also began losing money. It has gotten so bad that in 2022, more than 200,000 people were reportedly laid off. On March 3, Crunchbase reported that more than 94,000 workers have been laid off in mass job cuts so far in 2023. The startups were running out of funds and needed their money. So, they turned to SVB. SVB could not wait, so they pulled their funds from the job market, losing nearly $2 billion in the process.

“$2 billion? Why?”

Because they had to sell to give startups their funds, it became like an auction. Just imagine you needing money urgently for an emergency, you would sell your property at a value less than it is worth. In this case, the bond rate had gone down and those ready to buy were only willing to buy at a much-reduced price. Again, they would have been fine if they waited till maturity date to sell, but they couldn’t wait, so they sold at a $2 billion loss.

“Ouch.”

Yeah. That escalated the problem. When other tech companies heard this, they panicked and requested their funds. Customers withdrew a staggering $42 billion of deposits by the end of Thursday and by the close of business that day, SVB had a negative cash balance of $958 million. Earlier on Thursday, the bank’s stock had already started to fall rapidly, and by the afternoon, it pulled down the shares of other banks as well. On Friday, both San Francisco-based First Republic Bank and New York-based Signature Bank saw their shares drop over 20 percent. This created fear among investors that a financial crisis similar to the one that occurred between 2007–2008 might happen again. That’s scary to imagine because the 2007–2008 financial crisis started in the United States and spread to other countries and was caused by a combination of factors, including the failure of major financial institutions. The crisis resulted in a severe economic downturn, with millions of people losing their jobs and homes. Many financial institutions went bankrupt, and governments had to intervene with bailouts to prevent a complete collapse of the financial system.

“What?”

Yeah. SVB is giving signs of that. On the same Friday, trading of SVB shares was stopped as the bank was unable to quickly raise capital or find a buyer. Regulators in California intervened and shut down the bank, placing it in receivership under the Federal Deposit Insurance Corporation.

“Shut down? All funds gone?”

Fortunately, that’s not the case. The FDIC has stated that insured depositors will have complete access to their insured deposits by Monday morning at the latest. Uninsured depositors will receive an ‘advance dividend’ within the next week, as per the FDIC.

“Insured funds? What does this mean?”

The FDIC insures deposit, meaning that if anything happens to your deposit, they will bear the cost of withdrawal. The problem here is that the FDIC only insures deposits of up to $250,000 per client (it’s N500,000 in Nigeria). It means that if you saved $200,000, you will get $200,000 in full. But if you saved $50 million, you are only entitled to $250,000. Even worse in this case, according to CNBC, because they are as a bank primarily serving businesses, roughly 95% of SVB’s deposits are uninsured. So, they have no $250k to fall back to.

“Going forward, what does this mean for Silicon Valley and startups in the long run?”

A couple of things are being thrown around by insiders in the Valley but I finished reading ‘Range: Why Generalists Triumph in a Specialized World’ by David Epstein today and one of the things he convinced me about is that the average expert is a horrific forecaster. Their areas of specialty, years of experience, academic degrees, and even (for some) access to classified information makes no difference. They are bad at short-term forecasting, bad at long-term forecasting, and bad at forecasting in every domain. So, I will not say I know what will happen in the future. Let’s see what happens next week.

Update

The US government has just informed anxious SVB depositors that they’d have access to all the money they stashed with the lender today, even if the amount exceeded the $250,000 limit insured by the FDIC. In addition to backstopping depositors, the Fed is offering additional funding to some banks to limit the contagion from spreading across the banking sector. Without this intervention, we could have had a full-blown banking crisis that might have rippled across the globe.