What caused Silicon Valley Bank to collapse?

Background:

The 1983-founded California-based Silicon Valley Bank [SVB] focusses on serving Silicon Valley startups. SVB provided financing for almost half of US venture-backed technology and health care companies. As per FDIC its one of the top 20 commercial banks (16th largest) at the end of last year. Comparing to size of HDFC Bank (Rs. 18 lakh cr.) or Canara Bank (Rs 19 lakh cr,) in India.

Major causes:

1.      Treasury, ALM Management and CRAR management.

More details below

2.      Could it have been saved? Possibly yes.

Through better communication management, will explain you how?

3.      Was the business model weak?

No; it had best assets – credit losses were very low. Let’s see details.

4.      What caused run? - Quick unfolding of events causing an eventual fall.

Even for a best bank if 20% of depositors queue up for drawal, it will collapse.

5.      Was the regulation not adequate vs India.

Not – but looks not intensive but superficial, see the nos. which I am going to share.

6.      Will India get affected like Lehman Bros.?

Least likely

7.      Will there be ripple effect in our PE/VC eco system.

Possibly, Yes depending on extent of deposits with SVB by some of the Indian startups domiciled/registered overseas.

First Treasury Management:

• SIVB was in a league of its own: a high level of loans plus securities as a percentage of deposits, and very low reliance on stickier retail deposits as a share of total deposits.
• Retail deposits < 10% - Loans plus securities as % of deposits 110% (Q42022)
• Much of the $ was from VC-backed companies that needed a place to deposit the $ they raised.      VC s you know were raising money in 2022 as if there is no tomorrow.
• Out of SIVB’s $173 billion of customer deposits at the end of 2022, $152 billion were reportedly uninsured (i.e., over the $250,000 FDIC insurance threshold) and only $4.8 billion were fully insured. It’s fair to ask about the underwriting discipline of VC firms that put most of their liquidity in a single bank with this kind of risk profile.
• Deposits were pouring in too fast to lend responsibly. SVB recognized that. Rather than make dumb loans, SVB bought assets guaranteed by the US government - Treasuries and MBS. But it bought long duration. Often 10+ year bonds.

o  More than 50% of its assets were held in MBS at fixed coupons.

o  Bank holding US 10 y T Bill of at a weighted average return of 1.79% as against the funding cost of 5.50%. 10 Y T Bill moved from 0.00% (prior to 16.03.22) to 4.75% (Jan 31, 2023) in the last 10 plus months. Now there is a bullish talk by Fed to hike the rates by another 50 bps by 03.05.23. You can imagine the impact on notional MTM which was reported at > $15 bn.

o  Another interesting point -US 10yr - 2yr yield are inverted as the Fed turned hawkish 2yr at 5% and 10yr at 4% Such inversion hasn’t happened in 50 years.

Bottom line: SIVB carved out a distinct and riskier niche than other banks, setting itself up for large potential capital shortfalls in case of rising interest rates, deposit outflows and forced asset sales. It is obvious therefore that major amount should not have been kept in fixed coupon, long term bonds/MBS when the rates are rising.

ALM Management

• Silicon Valley Bank (SVB) was thriving. Credit losses are fairly low. Its deposits tripled from 2019 to ‘21. How is that a problem?
• Between Q4 2019 and the first quarter of 2022, deposits at US banks rose by $5.4 trillion and due to weak loan demand, only ~15% was lent out; the rest was invested in securities portfolios or kept as cash.  Banks can designate these securities as being “available-for-sale” (AFS) or in “hold-to-maturity” (HTM) portfolios instead.
• SVB was one of the banks that relied extensively on HTM treatment for its growing securities portfolio: since 2019, its AFS book grew from $14 to $27 bn while its HTM book grew from $14 to $99 bn. Selling HTM securities is complicated, since it results in larger parts of the portfolio being suddenly marked to market, which can in turn then result in the need for a capital raise.

o  SVB’s $21 billion bond portfolio was yielding an average of 1.79% — the current 10-year Treasury yield is about 3.9%. Market report says it sold these bonds at $1.8 bn loss.

Bottomline: how much duration risk did each bank take in its investment portfolio during the deposit surge, and how much was invested at the lows in Treasury yields?  

This is where India excels – Banks required to keep its securities - 19.5% relaxed to 23% (of NDTL) due to Covid- meaning balance to be necessarily in AFS and thus MTM.

o  (INR - Reverse Repo.) moved from 4.00 to 6.50% (Feb 2023).  As against almost 500% increase in interest rate in US, the rates have moved only by 62.5% in India.

o  Inflation reasonably contained in India compared to US – where it is at 7.4% compared to long term average of 3.5%.

SVB was in investment duration world of its own as of the end of 2022, The irony of SVB is that most banks have historically failed due to credit risk issues. This is the first major one I recall where the primary issue was a duration mismatch between high quality assets and deposit liabilities.

Being flooded with deposits from fast-money VC firms and other corporate accounts at a time of historically low interest rates might have been more of a curse than a blessing.

Capital Risk management:

• When rates rise, fixed income prices fall.

o  A general rule of thumb is for every one year of “duration,” each 1% interest rate move impacts the price of the bond by:1%. A 1% move on a 9 yr duration bond is ~9% +/- on the bond price.

o  So SVB bought high quality assets, but it bought tons of them with LONG duration at LOW interest rates. When the Fed raised rates, those assets declined in value…1% x Duration. Those losses, multiplied through the leverage at SVB, caused a big problem!

o  Banks like SVB are levered 10:1 or more: owing $10+ for every $1 of shareholder equity.

o  If you’re levered 10x, a 10% loss on assets is a 100% wipeout of capital?

• While its Common Tier I capital ratio was 12% (higher than requirement of 9%).

o  Adjusted for unrealised losses on securities – this goes down to just 0.6% (Q42022)

• In India, such exposures like what SVB had would have required nearly 250% of CAR and hence would have been unsustainable; but in US it is bank based and there is no one size fits all.
• Tier 1 capital ratios are exaggerated on the high side due to the high level of unrealized losses in hold-to-maturity portfolios, which got exposed when these HTM portfolio had to be liquidated.

Unfolding of events to bank run:

• First, there was the Federal Reserve, which began raising interest rates a year ago to tame inflation. The Fed moved aggressively, and higher borrowing costs sapped the momentum of tech stocks that had benefited SVB.
• Higher interest rates also eroded the value of long-term bonds that SVB and other banks gobbled up during the era of ultra-low, near-zero interest rates.
• Moody’s was considering downgrading its rating after the value of bonds in which SVB had invested its money fell due to higher interest rates.
• The bank’s management — with the help of Goldman Sachs, its adviser — chose to raise new equity from the venture capital firm General Atlantic and also to sell a convertible bond to the public.
• At the same time, venture capital began drying up, forcing startups to draw down funds held by SVB. So, the bank was sitting on a mountain of unrealized losses in bonds just as the pace of customer withdrawals was escalating.
• Venture capitalists such as Peter Thiel Founder’s Fund, Coatue Management and Union Square Ventures gave instructions to portfolio businesses to minimise their exposure towards SVB and withdraw their cash from the banks. This went public. Other venture capital firms have also instructed portfolio companies to shift some of their capital from the bank.
• Then, the bank’s management chose to sell $21 billion of bonds at a $1.8 billion loss,
• Moody's credit rating agency lowered the bank's rating, but only by one level, considering SVB's sale of the bond portfolio and its strategy to increase capital.
• On Wednesday, the 8th of March, SVB announced it had sold a bunch of securities at a loss, and that it would also sell $2.25 billion in new shares to shore up its balance sheet. That triggered a panic among key venture capital firms, who reportedly advised companies to withdraw their money from the bank.
• The bank’s stock began plummeting Thursday morning and by the afternoon it was dragging other bank shares down with it as investors began to fear a repeat of the 2007-2008 financial crisis.
• The SVB shares suffered their worst drop in about 35 years on Thursday. Following the capital offering, the stock fell 60 percent leading to a loss of $80 billion.
• By Friday morning, trading in SVB shares was halted and it had abandoned efforts to quickly raise capital or find a buyer. California regulators intervened, shutting the bank down and placing it in receivership under the Federal Deposit Insurance Corporation
• The failure of Silicon Valley Bank was thus caused by a run on the bank. Any bank will fail if all the depositors chose to withdraw money beyond a point. But banking is an enterprise that relies as much on confidence as on cash — and if that runs out, the game is over.
• Liquidity risk + Interest Rate Risk + Compliance Risk (effective or adjusted low  CRAR) - Altogether resulted in the current position.

Communication/PR management – big failure?

• The collapse may have been an unforced, self-inflicted error.
• Over the last weekend, SVB developed a plan to increase the worth of its assets. The plan involved selling more than $20 billion worth of low-yielding bonds and reinvesting the proceeds in assets that deliver higher returns. The transaction would generate a loss, but if SVB could fill the funding hole by selling shares, it would avoid a multi-notch downgrade.
• As SVB executives debated when to proceed with the fundraising, they received news from Moody's that the downgrade was imminent. The bank acted quickly to soften the blow, lining up private equity firm General Atlantic, which agreed to buy $500 million of the $2.25 billion stock sale.  However, it was unable to reach an agreement within SVB's schedule.
• It isn’t clear if the bond sale or the fund-raising, at least initially, had been made under duress. It was meant to reassure investors.
• But it had the opposite effect: It so surprised the market that it led the bank’s very smart client base of venture capitalists to direct their portfolio clients to withdraw their deposits en masse.
• The bank and its advisers may have also made a tactical mistake: The General Atlantic equity investment could have been completed overnight, but the bank’s management also chose to sell convertible preferred stock, which couldn’t be sold until the next day. That left time for investors — and, more important, clients — to start scratching their heads and sow doubt about the firm, leading to an exodus of deposits.
• To salvage the business, SVB Chief Executive Officer Greg Becker held a conference call with the clients of SVB and venture capital investors of the bank, requesting them to “stay calm” in the hope of not having to face further withdrawals. In a letter to multiple shareholders on Wednesday, he said, “We are taking these actions because we expect continued higher interest rates, pressured public and private markets, and elevated cash-burn levels from our clients as they invest in their businesses.”.
• On Thursday, SVB's stock plunged on news of the share sale, ending the day down 60% at $106.04. Bankers at Goldman Sachs remained optimistic about finalizing the sale at $95. However, things took a turn when venture capital firms instructed startups, they had funded to withdraw their funds from Silicon Valley Bank due to concerns of an impending bank run.
• This quickly became a self-fulfilling prophecy: General Atlantic and other investors walked away, and the stock sale collapsed.

o  You are in the market for raising equity from VC firms; who are your depositors – same venture capital firms; what kind of message are you giving?

o  Ideally, the stock sale would have been completed before the market opened on Thursday to avoid the sale being jeopardized by any declines in SVB's shares once news of the sale got out.

Business Model

Best bank ranked by Forbes for the 5th consecutive year.

 Model worked something like this:      

             Series A raises $ 1 million.

             SVB gives venture debt say $ 2.5 bn.

             Series B raises $ 20 million.        

             This comes back to the bank as deposits – floating.

             One of the best business models any bank could possibly conceive of. Though all banks create Money Multiplier effect, deposits may go to other banks; here in SVB, the captive customers are the same VC Funds and portfolio companies, who perforce keep the money with SVB only.

Regulation India vs US

The primary issue with SVB if it would seem lies with the quality of regulations. But global financial crisis brought enhanced regulations – higher capital requirements, diversification rules, higher loss reserves. SVB, though reasonably large – does not fall under such enhanced oversight.

In 2018 regulations were loosened for regional banks like SVB among other things, it reduced the amount of potential loss reserves mandated for these banks. Given the small size and relatively concentrated deposit/creditor base, SVB’s network effects on the financial system are likely to be small.

Since 2008 more than 500 small banks have failed in the US, but most were absorbed by other institutions and depositors have mostly been protected.

Another problem is the multiplicity of authority in US. FDIC as a parallel regulator and supervisor gets into the picture once bank is in problem. In India, if the problem is only one of liquidity and not solvency, the RBI gets into the function of lender of last resort. SVB like situation which is of liquidity and not solvency could have been managed much better in India. However, SVB with such similar exposures to venture eco system would have needed much higher capital and could not have managed with such large investments resting in HTM.

Impact:

• Valuation in VC funded firms in US, likely to fall further.
• Venture capital firms that used the bank may struggle to gain access to their money — and possibly that of their limited partners, including pension funds, that had forwarded money intended for investments. This, in turn, may make it hard to fund current and new investments — or to rescue other companies inside and outside their portfolios.
• However, the possible impact of 'indirect' exposures on SVB by Indian Banks (ie. For example, SBI having an exposure of USD 500 Mio on another US Bank which is having a significant exposure on SVB) is yet to be probed.

In my opinion, since Indian Forex market is so vibrant in terms of liquidity and fine-ness of pricing, the indirect exposure is also expected to be 'low.

Going by the unfolding of events in Silicon Valley Bank, it appears regulations in India by Reserve Bank of India are much superior to protect the interests of all stakeholders.

Source:, Articles published in Bloomberg, Moneycontol, Businesstoday, ET during last 2 days