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.
What on earth happened?
In today’s Finshots, we try to break down what’s turning out to be the biggest financial disaster since 2008. Remember, this is a simplified explainer so we’ll have to sidestep some of the nuances of the US banking system.
With that, let’s dive in.
Banks are supposed to be boring.
They take deposits from people like us and pay us a low rate of interest. And lend most of these deposits out to others and earn a higher rate of interest. In the process, they make a decent chunk of money. They also 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. And of course, they keep a bit aside in cash. To be on the safe side.
Or at least that’s how it should work.
In reality, it’s not so simple. A lot of things could go wrong. Banks could make really poor lending decisions. And people don’t return the money. Or the bank might even make some bad investment decisions. They’ll invest money in complex things they don’t understand.
The economy will get into a rut. And the problems at the bank will become public news. Depositors could panic. There might be a run on the bank. This means people rush to withdraw whatever money they deposited. They lose trust. And eventually, the bank could collapse.
Suddenly, the bank is not boring anymore.
Which brings us to the collapse of Silicon Valley Bank. The fabled banker to startups that has been around since 1983.
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. Everything.
But…2023 was different. SVB was hit by a perfect storm.
Let us explain. See, 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. 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 starters, the price of a bond and its yield — which is another word for returns — 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. So you decide to sell it. Others who own the bond sell it too. Now you know that when people sell, the price takes a knock. And let’s say that the price of the bond falls to $99. Suddenly, investors realize that the bond is available at a discount of 1%. So if they buy it now, they’ll benefit from the discount and also get the 2% interest. 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. By a lot.
And this brings us to the perfect storm we told you about.
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 our 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 unravelled.
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 was the exact same playbook. 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 CEO 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.
Now there are two questions on everyone’s mind.
- Will startups collapse?
This is a little tricky to answer. There are thousands of startups who’ve parked their monies in SVB. If they’re not able to access it now, they can’t pay their employees. They can’t pay their vendors. They can’t run their business as usual. It’s quite problematic.
The other problem is that as per the rules in the US, only up to $250,000 of a person’s bank deposit is insured. And startups have millions of dollars in SVB. Now, because of how concentrated its customer base is, a massive 85% of these deposits are actually uninsured.
So startups with money stuck in the back have to hope and pray that the Federal Deposit Insurance Corporation (FDIC), which has taken over the bank, can quickly sell off whatever assets the bank owns and make good a big part of the deposits.
We don’t know yet how bad things could be.
2. Will the rot spread to other banks?
Probably not. SVB did some weird things and got caught in an environment where its biggest customers were in turmoil too. It was a perfect storm for the bank. But other banks have a diversified customer base. They might have still indulged in some poor investment choices but it may not come back to haunt them yet. The problems will be milder.
But just like how the collapse of Silvergate played a part in bringing down SVB, SVB’s collapse could scare everyone. If people lose trust in their banks and believe that all banks have poor practices, then bad stuff will happen. They could rush to pull their money out of the system. So you can expect banks to keep saying things like, “We are safe. We are fine.” over the next few days. They just need people to believe them.
Anyway, that’s the SVB story. Remember, this is still a developing story and a lot can happen between today, tomorrow, and the day after that. We’ll just have to keep our eyes and ears open. And hope that startups don’t capitulate in this mess.
Until then…fingers crossed.
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