March 13, 2023
We believe the fallout from the collapse of Silicon Valley Bank, Silvergate Capital, and Signature Bank will remain localized and will not impact the rest of the banking system. Federal regulators have guaranteed that all depositors will have access to their money, even on non-FDIC insured deposits. These three banks had unique risks based on their business model that other banks don’t necessarily have.
How did these three banks fail? In the past, we have discussed the market distortions brought on by over a decade of zero interest rates combined with unprecedented COVID stimulus. With interest rates at zero, investors were searching for higher yields and returns in a number of areas including venture capital funds and cryptocurrencies. Startups typically do not have fixed assets or steady cash flow, so they raise money by offering equity to investors. Cryptocurrency firms are often denied access to the traditional banking system due to concerns about money laundering and custody. However, these companies still need a place to hold their cash.
Silicon Valley Bank became the bank of choice for startups, while Silvergate Capital and Signature Bank became the banks of choice for cryptocurrency firms. All three banks grew a substantial deposit base. Normally, banks offer loans and reinvest the deposits in safe investments while holding a layer of reserves to protect against credit risk (risk of loans not repaid). However, in 2021, startups had plenty of money, no need to borrow, and safe investment yields were near zero. As a result, these banks invested deposits in longer term securities such as agency mortgage-backed securities and Treasuries which increased their interest rate risk (risk of bond prices falling when interest rates rise).
For years, we have counseled clients against significant investments in bonds. The yields were very low and unlikely to go lower, while the downside in a rising interest rate environment was high. To the extent that our clients wanted fixed-income investments, we advised them to keep the maturity as short as possible. Following the inflation spike in 2021, the Fed rapidly hiked rates from near zero to 4.5% and has signaled more hikes are coming. Holders of long-term bonds saw double digit drops in prices.
In a relatively short period of time, Silicon Valley Bank, Silvergate Capital, and Signature Bank faced a unique set of circumstances. On one hand, the torrent of money flowing into startups and cryptocurrency firms slowed to a trickle. On the other, their long-dated assets declined in value more than what they held in reserves. While the banks did not advertise this, they did disclose these unrealized losses in the footnotes of their SEC filings. Commentators on Twitter noticed this disclosure and word spread to venture capital firms. Last week, venture capital firms began counseling their startups to move funds out of Silicon Valley Bank. As depositors withdrew funds, Silicon Valley Bank had to sell the securities on its balance sheet to cover withdrawals, which had substantially declined in value. Eventually, they could not raise enough money to meet demands, and the FDIC moved them into receivership.
These three banks are not alone in holding long term bonds that have declined in value, but other banks have better risk management practices to mitigate interest rate risk. Banks are better capitalized than they were in 2007 and 2008, and borrower defaults have remained low. While people are concerned about their bank deposits, the Federal government response should reassure them that their money is safe.
If you want to read further about this, I recommend Matt Levine’s Money Stuff column in Bloomberg. His last three columns do an excellent job of explaining this in layman’s terms. You can subscribe to his email newsletter for free here: https://www.bloomberg.com/account/newsletters/money-stuff.
Ryan Visniski, CFA
Vice President