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Commentary on Silicon Valley Bank, Silvergate Capital Corp, and Signature Bank

March 17, 2023

What Happened?

In 2018, the Trump administration increased the asset threshold for banks deemed systemically important financial institutions (SIFI) from $50 billion in assets to $250 billion in assets. SIFIs are required to adhere to higher levels of compliance referred to as ‘enhanced prudential standards, which include certain deposit ratios, liquidity and risk management measures. This opened the door for smaller, regional banks to grow significantly without this additional oversight.

Over the past week, three regional US banks have failed due to liquidity crunches caused by the US Federal Reserves’ significant rate hikes over the last 12 months as well as asset-liability mismatches within these particular banks. We’ve outlined the circumstances that each bank is in that led to this failure.

 

Silicon Valley Bank

Silicon Valley Bank’s (SVB) assets had grown to $200 billion. As a major lender to start-ups and venture capital firms, SVB had underestimated the effect that the sharp increase in interest rates would have on its balance sheet. Simply put, SVB had too many illiquid deposits, experienced losses on their bond portfolio, and were unable to meet the demand for loans and withdrawals. This came to a head last week when $40-50 billion was withdrawn in approximately 24 hours ending when the regulator seized the bank on Friday.

Silvergate Capital Corp

Over the years, Silvergate one of the largest banks in the cryptocurrency market, providing banking services for some of the largest cryptocurrency exchanges, including the now bankrupt FTX. With cryptocurrencies’ significant losses, as well as the downfall of several firms in the industry, Silvergate began experiencing heavy losses as well – $1 billion in 2022 Q4. With the loss of key clients and heavier withdrawals, Silvergate decided to wind up the bank last week.

Signature Bank

Fear from SVB and Silvergate’s failure caused many depositors of Signature Bank to begin withdrawing their funds, fearing a similar fate. Signature was smaller, with assets of $110 billion. In 2018, Signature had became one of few banks allowing deposits in the form of cryptocurrency, which in itself is volatile and not ideal for stabilizing a balance sheet. After state regulators saw the withdrawal concerns from SVB’s failure, they took control of Signature a few days later to ensure stability of the bank as depositors withdrew.

 

Is this a repeat of 2008?

After 2008, the Obama administration passed the Dodd-Frank Wall Street Reform Act, increasing banking regulations to help protect consumers and the banking system from the systemic failures that caused the Financial Crisis. While the headlines may feel like 2008 déjà vu, a closer look at SVB, Signature and Silvergate’s fates reveal a much different scenario.

Investors that have been around the block will remember the 2008 financial crisis that started in the US banking and housing system that led to a global economic crisis and bank bailouts, layoffs, bankruptcies, and people losing their homes. The failures that led to the ‘Great Recession’ were caused by bad loans (credit granted to sub-par borrowers) that were repackaged multiple times by the largest banks, mixed with some good loans, given better credit ratings than warranted, and sold to investors as solid, low-risk investments, repeatedly. In other words, it started with loans to people that should not have received loans, and when the Federal Reserve began raising interest rates in 2007 and they couldn’t repay those loans, the dominos began to fall. In economic terms, this is referred to as a ‘solvency crisis’.

The failure of SVB, Signature and Silvergate have a very different cause than 2008 did, this time brought on by higher demand for loans and withdrawals while these banks suffered from a lack of short-term cashflow or liquid assets to meet the demand. This is referred to as a ‘liquidity crunch’ and can happen when a sharp hike in interest rates causes an institution to sell assets at significant losses, all while taking in fewer deposits. While 2008 started with increasing interest rates, it soon became apparent that the crux of the problem was actually solvency – the ability of borrowers to repay debts. The downfall of these three banks was caused by a maturity mismatch as well as a lack of diverse depositors. All of these banks were lending heavily in the technology, bio-technology, healthcare, start-up, and cryptocurrency sectors – industries that typically require significant upfront investment before becoming profitable. While they are credit-worthy, the lender often has assets to secure the loan which they invest in Treasury bonds which may not mature (i.e. become liquid) for years. If a bank cannot liquidate sufficient assets or raise additional deposits to meet the withdrawal or loan demands, it experiences a liquidity crunch.

While a $250 billion institution may not look like an insignificant organization, by comparison, JPMorgan Chase has more than $3 trillion in assets. Other than the difference in root cause of the 2008 vs. SVB, Signature, and Silvergate’s downfalls, the other noteworthy difference is how similar these three bank’s are compared to the rest of US banks. These banks were focused on a niche industry, with a set of customers, depositors and clients that were mostly businesses, usually with large, uninsured deposits that were used for working capital in the business. With a much smaller number of bigger clients, in high-volatility industries with deposits that were not long-term savings, cashflow in and out of the banks was substantially more volatile and unpredictable than a large, national-size bank catering to individuals and businesses of all types, many of who are keeping long-term savings on deposit.

 

What’s Next?

Currently, SVB and Signature have been seized by regulators to allow for orderly outflow of assets to customers, while the US Treasury has agreed to ensure liquidity (at the banks’ cost) for these customers on their deposits. As Silvergate decided to wind up operations on its own accord, this is also being monitored by regulators.

With boots on the ground at the SVB and Signature branches, regulators are monitoring where these withdrawals are flowing to in order to ensure there isn’t systemic risk. In the meantime, regulators are beginning to sell the banks’ assets to raise additional liquidity, with coordination between the UK, US and Canada happening over the weekend. Customers who were relying on lines of credit are also working to secure similar lines at other banks.

The big question investors are concerned about is the larger impact. While markets dropped last week with concerns about larger issues in the banking system, clarity over what caused these failures has brought a new prospect to light: will this failure be the ‘break’ in the economy that the US Federal Reserve has needed to seal the end of inflation and therefore, the end of interest rate hikes? Only time will tell. The Federal Reserve Chairman, Jerome Powell, will need to weigh this event against his main nemesis, inflation.

 

References:

https://www.nytimes.com/article/svb-silicon-valley-bank-explainer.html

https://www.marketwatch.com/story/what-happened-to-silvergate-capital-and-why-does-it-matter-28cd13a

https://www.theglobeandmail.com/world/article-regulators-urged-to-find-silicon-valley-bank-buyer-as-industry-frets/

 

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