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Understanding the SVB Meltdown: A Comprehensive Analysis of Banking and Bond Theory

Introduction:

In March of 2023, the collapse of Silicon Valley Bank, the 16th largest bank in the US, occurred. This event shocked the financial world and created concerns among households and firms about the banking system. Generally, SVB failure was a result of a combination of factors, including a lack of diversification, a bank run fueled by social media, and the consequences of rising interest rates on its bond portfolio. In this article, we will examine the events that led to the SVB collapse, analyze the banking and bond theories involved, and explore the aftermath and lessons learned from this significant event.





Section One – Summary of SVB Background:

The SVB was founded in 1983 by two tennis buddies, Bill Biggerstaff and Robert Medearis, who came up with the idea of creating it while playing poker. Their intention was to create a bank that would focus on high-risk startups, most of which were from the tech industry, and venture capital firms who backed them. This bank was different from others as it realized that startups do not earn revenue immediately, so the structure of loans was more friendly, and because its clients had the ability to access SVB network, which could help startups connect with venture capital, law, and firms that offer other services. The SVB did find its customers and soon many venture capital firms started requiring startup businesses to hold money in the Silicon Valley Bank, which resulted in 21 consecutive quarters of profit. Then, during the Covid-19 pandemic, the bank grew even larger due to increased demand for digital services and electronics, resulting in tech firms sending tons of money to SVB.






Section Two - The Events Leading to SVB's Collapse:

Now that we know some basic information about SVB history, we can move on to talk about the causes and reasons for its downfall. To start with, as we all know, since the beginning of the Russian invasion of Ukraine on February 24, 2022, most economies in the world have been heavily impacted by it. The disruptions in energy and overall world supply have caused food and gas prices to surge, which, in combination with massive spending of money accumulated by excessive savings during COVID-19, have led to a sudden increase in inflation rates all around the world as Aggregate Demand rose while Aggregate Supply fell. To counteract the inflation, central banks and governments implemented contractionary fiscal and monetary policies, but for this article, I am going to focus mostly on monetary policy changes as they had the most significant impact on SVB's collapse.





To combat inflation, central banks around the world started raising interest rates, and in particular, the US Federal Reserve raised the Federal Funds Rate from 0.25% in March 2022 to 4.75% by February 2023. To understand how this led to the SVB collapse, let's look back at the time when COVID-19 occurred. As I mentioned in the first section, during this pandemic, Silicon Valley Bank received a lot of deposits and loans. In numerical terms, from 2019 to 2022, loan balances increased from $33 billion in 2019 to $74 billion in 2022, while deposits grew even faster, soaring from $55 billion in 2019 to $186 billion in 2022. Because of this massive increase in deposits, SVB had to invest the money left after giving out loans into something, and because interest rates were really low after the pandemic, the only way out of this situation was to buy bonds with longer duration than most banks were willing to purchase, with maturities ranging from 5 to 30 years or longer. At that time, the longer the maturity, the higher was yield on the bond. As a result, their bond portfolio was larger than those of other banks, and in return for these higher yields, they committed one of the biggest banking sins – investing short-term deposits in long-term bonds, creating a mismatch of maturities and thus exposing themselves to the risk of rising interest rates. This is a problem for two reasons: first, rising interest rates would mean that SVB would have to raise rates paid on deposits to match the market rates, while the bonds in the bank's portfolio would bring the same returns as they have the same yield rate; second, and more importantly, the market value of bonds falls whenever interest rates rise. The second reason is true because whenever the central bank raises its benchmark interest rate, it affects short-term interest rates in the economy. As a result, other interest rates in the financial market, such as the yields on government bonds, tend to rise as well, which is caused by investors demanding higher returns to compensate for the increased borrowing costs. Also, this inverse relationship between interest rates and bond prices occurs because existing bonds with lower coupon (interest) rates become less attractive compared to new bonds issued with higher coupon rates in the higher interest rate environment. Investors would prefer to buy new bonds with higher yields, which leads to a decrease in demand for existing bonds. As demand for existing bonds falls, their prices decrease to reach a new equilibrium at which their yields become competitive with those of newly issued bonds.





As you might recall, inflation in 2022 and 2023 was high and accelerating, prompting central banks around the world to increase interest rates to decrease aggregate demand (AD) and curb inflationary pressure. Considering that SVB had a significant amount of money invested in long-term bonds, the increase in interest rates caused a substantial drop in the value of the bank's assets, the bank lost $1.8 billion on its U.S. Treasury bond portfolio. Then, due to massive deposit withdrawals from SVB customers, caused by the 2022 technology sector decline and loss of confidence in the economy, Silicon Valley Bank had to deplete its cash reserves and short-term liquid assets to meet the deposit demand. Unfortunately, this wasn't enough, so the bank had to sell its bonds, whose prices had fallen dramatically. Soon, SVB had to announce a $1.75 billion capital raising plan on March 8th, which spread panic among clients. Fears about the bank's insolvency spread quickly on social media platforms like Twitter and WhatsApp. This led to a bank run, where customers started to withdraw their money in large amounts, fearing the bank's insolvency, and as we can see, their expectations had self-fulfilling properties. SVB's stock plummeted by 60% on March 9, and California regulators shut the bank down on March 10.


Section three – the FDIC intervention and SVB acquisition:

On the 12th of March, the FDIC had to step in and announce emergency measures. Usually, your deposits are insured by the FDIC up to $250,000, but in the case of SVB, because most of the deposits were around $5 million, the FDIC had to make an exception and guarantee to return money to everyone, even to those whose money was uninsured. Investors, however, won't have as much luck. The FDIC can protect depositors from losses, but it is unable to provide the same protection for stockholders and holders of unsecured debt. In other words, those who held stock in SVB Financial Group may not be able to recover their money. Overall, the FDIC estimated that the SVB failure cost nearly $20 billion.





On March 26, 2023, the FDIC announced that First Citizens Bank would purchase Silicon Valley Bank and assume the majority of its deposits and loans. First Citizens Bank agreed to buy approximately $72 billion of SVB's assets at a discounted rate of $16.5 billion. But still, even after the acquisition, the FDIC was left to manage $90 billion worth of assets.


Section four – Lessons Learned:

The best thing that we can to today about it is to learn lessons from it and prevent events like this from happening in future. To start with, the SVB collapse reveals flaws in the post-2008 financial policy, particularly in monetary and regulatory policies. The dangers were not appropriately addressed until it was too late, and prolonged low interest rates followed by rapidly rising rates should have served as a warning signal to management and regulators. The quick increase of deposits and assets at SVB increased its susceptibility, emphasizing the need for banks to carefully regulate expansion. The SVB case also highlights the difficulties central banks encounter when attempting to strike a balance between the necessity to fight inflation and the potential impact on financial stability. Rapidly increasing interest rates might jeopardize the stability of banks that have substantial bond exposure. Lastly, the SVB collapse underscores the importance of accurate risk identification and transparency with clients, as even wealthy IT firms and venture capital firms missed the opportunity to examine the dangers SVB faced from its regular accounting disclosures.


Sources:

4. https://www.techtarget.com/whatis/feature/Silicon-Valley-Bank-collapse-explained-What-you-need-to-know


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Dmitriy D.
Dmitriy D.
25 abr 2023

I wonder what would you do if you were in the position of the SVB management when you realized that the US borrowing rate began to rise dramatically? How could the trend be reversed and the bank saved?

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Thank you for your comment! It's an interesting question to consider. Before I answer your question, I want to say that I believe their mistakes were quite unprofessional, and that the lack of SVB's proper risk management is just an outlier among other banks, so this situation could have been prevented. If I were in the position of Silicon Valley Bank management and saw the prospects of interest rates rising to critical levels, I would have considered doing two things. First, I would try to diversify the portfolio by investing more in short-term bonds or floating-rate bonds. It is the task of the bank to assess the risk of assets in their portfolio, so rising interest rates would definitely signal…

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Great article. Thanks, it was interesting

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