Headquarters of Silicon Valley Bank, Santa Clara, California
Silicon Valley Bank was a renowned financial institution that was taken over by federal regulators on March 10th 2023.
This article looks at what went wrong at the bank to fail so spectacularly, and the financial lessons we can learn from its downfall.
Silicon Valley Bank predominantly served technology and innovation-driven companies such as startups. They became the 16th largest bank in the US, having tripled in size between 2019 and 2022.
How did it happen?
Over a short period of time, the bank tripled in size, meaning that many companies had deposited their money with the bank.
As of December 31st 2022, the bank had assets of $209 billion and deposits of $175 billion. They decided to mainly buy treasury bonds, which are viewed as a low-risk investment. The bank would receive interest payments on the bonds every six months. This would not have been an issue if interest rates had remained low.
Let me explain this by making up a simplified explanation of how this happened. Silicon Valley Bank used all their cash to buy treasury bonds (US Government bonds). This was made up of $175 billion deposits from their clients, and $34 billion of cash they had on hand. In this over-simplified scenario, let’s say they invested in one treasury bond, with a coupon (interest rate) of 2%, and maturity in 20 years.
So, $209 billion at 2%, would provide interest of $4.18 billion per year, or $2.09 billion every six months, for the next 20 years. At maturity, the principal amount ($209 billion) would then be paid back to the bank. Along as the bank does not sell the bond, and holds onto it until maturity, there is no problem for them. However, what happens when they need to have cash on hand if their clients decide to pull their funds from the bank?
This is what happened to Silicon Valley Bank, and it all started with the rise in interest rates in the United States to fight inflation. For a very long time, rates were kept at near zero levels but started to rise to 0.5% in March 2022, and by July 2023 they rose to 5.5%. If we take the example of the above bond that is paying 2% to the bank, we can see that it doesn’t look as attractive to the bank now. If they were to go out onto the market and purchase bonds now, the bonds would be paying them much more interest than before.
The treasury bonds that SVB bought were now less attractive than other bonds available on the market. This would not be a problem if they didn’t sell them, but unfortunately for the bank, many of the bank’s clients needed to withdraw money at the same time. This was related to market conditions getting worse, which was also triggered by the large interest rate rises, which signalled the end of the availability of cheap money in the system.
SVB now had to sell assets it had in order to get cash so it could pay its clients who needed their deposits back. On February 1st 2023, the rate rose to 4.75% from 4.50%. In our example above, SVB had to sell some of its treasury bonds. However, the coupon on the bonds was only 2%. As such, they were not viewed as valuable as other bonds now available with a coupon of 4.75%. In order to rebalance the value of the bond, the price had to go down, in order for the yield to match the current market rate of 4.75%. In our example, the price would have to go down as follows.
$209’000’000’000 at 2%
For the yield to match the 4.75%, the price would need to go down.
yield = coupon amount/price
If we want the yield to match 4.75% then:
4.75% = 2% / price
Price = $42.105 (multiplied by 100, as the starting price of a bond is 100)
We can see here that in this example, the price that SVB could sell this bond on the market, taking into consideration the interest rate change, is less than half what they bought it for. They bought it for $209 billion, and if they sold all the bonds, they would only make:
$209 billion x 42.105% = $88 billion roughly
Had they held onto the bonds until maturity they could continue to receive interest and would have received the $209 billion back at the end. Of course, the bank did not hold one bond of $209 billion but had a large portfolio of bonds. In reality, the situation was more complex, but what was illustrated above with the price falling would have happened to most of their assets.
Now that the bank posted that they had made large losses on their bond positions, news started to spread. This in turn led more of their clients to want to remove their money from the bank, which led to a death spiral. This also led to SVB’s parent company, SVB Financial Group’s shares to tank, meaning that their attempt to sell shares to gain cash would bring them less money, and continue to push the value of the shares down. There was no way to stop it. In the end, the federal regulators took over the bank on March 10, 2023.
How did they not see it coming?
On March 17th 2022 the Fed began to increase rates, to heights that had not been seen since before the 2008 financial crash. Indeed, the rates had been near zero, apart from a small increase before COVID-19 hit, which then went back to near zero. So, interest rates were at historic lows, and the only possible direction they could go was up. It appears that this basic fact was overlooked by the SVB board, and additionally by the regulators.
What could they have done?
- SVB should have anticipated that interest rates would eventually go up.
- They should have sold some of their treasury bonds before the rates went up, and the price of their bonds was still high.
- However, if they sold the bonds too early before the rates rise in 2022, they would have missed out on interest.
- It looks like they did not believe a rate hike was incoming, and got caught with their metaphorical pants down.
- They could have also purchased an interest-rate derivative, which could have offset the fall in the price of their bond. Interest rate derivatives are too large a topic for this particular article.
Conclusions
In the complex world of finance, it's not just about the choices made but the ability to foresee and manage the consequences of those choices effectively.
In retrospect, the downfall of Silicon Valley Bank serves as a stark reminder of the intricate and sometimes treacherous nature of the financial world. While it may be tempting to view the bank's catastrophic turn of events as an isolated incident, it raises broader questions about risk management and the capacity to adapt to a rapidly changing economic landscape.
Silicon Valley Bank's dramatic growth in a short span of time and its reliance on treasury bonds, while initially prudent, ultimately left them vulnerable to changes in interest rates. The bank's decision to hold onto these bonds rather than diversify its holdings or employ interest rate derivatives proved to be a costly misstep.
The rise in interest rates, which was not unforeseeable given the historical context, left the bank in a precarious position. They found themselves compelled to liquidate their assets at a loss, igniting a cascade of events that led to a loss of client trust, plummeting share values, and ultimately, a federal takeover.
What Silicon Valley Bank could have done differently remains a crucial question. Hindsight reveals the importance of a more flexible investment strategy, one that considers potential fluctuations in interest rates and their impact on bond values. The use of interest rate derivatives could have mitigated the risk of falling bond prices.
The Silicon Valley Bank story is a stark lesson for financial institutions and investors alike. It highlights the need for constant vigilance, adaptability, and a willingness to employ risk mitigation strategies even when things appear to be running smoothly. In the complex world of finance, it's not just about the choices made but the ability to foresee and manage the consequences of those choices effectively.
While Silicon Valley Bank's fall from grace may be seen as a cautionary tale, it is also a testament to the intricate and ever-evolving world of finance. In the end, what went wrong at Silicon Valley Bank was a combination of factors, highlighting the importance of vigilance, adaptability, and prudent risk management in an industry where complacency can lead to catastrophe.
By the same author:
Banking’s Quantum Leap: The Introduction of T+1 Settlement in the US Banking Industry
Sources:
Investopedia
Bankrate
Forbes
Image: Minh Nguyen, CC BY-SA 4.0, via Wikimedia Commons
