The Collapse of Silicon Valley Bank

​ The very mention of a “bank failure” sends chills up and down the spines of all Americans. Thus, it is not surprising that the recent collapse of Silicon Valley Bank (“SVB”), the nation’s16th largest bank with assets of $212 billion, conjured up thoughts of the Great Depression and sent shock waves through U.S. financial markets. While bank failures are fairly common occurrences, panics over the soundness of the nation’s banking system tend to be rare. That’s because in 1934 the Federal Deposit Insurance Corporation (or “FDIC”) was created in response to the scores of bank failures that were then taking place. Since then the only major threat to the nation’s banking system occurred in 2008-9 following the collapse of home mortgage market and Lehman Brothers.

  The FDIC is an insurance company created and backed by the federal government and operates like most other insurers. It collects premiums from nearly all U.S. banks and uses those monies to protect the funds (currently up to a maximum of $250,000) of individuals and companies deposited in banks that become insolvent. Insured deposits include monies in checking and savings accounts as well as notes and certificates of deposits (or CDs). By contrast, it does not protect the value of ownership interests and other securities issued by insured banks. The purpose of this scheme was to create a sense of security to prevent panics among bank depositors who might race to withdraw their funds from banks believed to be insolvent or on the verge of insolvency.

  At the time, President Roosevelt and many others feared that creating such an insurance mechanism might encourage banks to accept a greater level of risks (which economists characterize as a “moral hazard”). In the end, Roosevelt signed the Glass-Steagall Act creating the FDIC’s insurance program. In doing so he explained that banks only hold a relatively small portion of their assets in the form of cash or other assets immediately convertible into cash. The remainder of their funds are invested in home mortgages and securities (primarily debt instruments) issued by corporations and federal, state and local governments. In this way, they are able to generate revenues by investing their customer’s monies, most of which revenues are used to pay interest on their customer’s deposits and to cover the bank’s own expenses. This, however, creates a temptation for banks to invest their depositors’ monies in assets that pay a high rate of return. Such increased returns allows them to pay higher salaries to their executives and higher dividends to their shareholders. The problem is that investments that generate higher returns also present a higher risk of loss.

  To guard against bank insolvencies, all banks are subject to a panoply of regulations relating to how much liquid assets they must hold so they will always have sufficient funds on hand to cover their depositors’ cash withdrawals. Federal regulations also specify what classes of assets banks may invest in so as to prevent them from taking undue risks with their depositor’s monies. Like most for-profit enterprises, banks don’t like governments to tell them what they can and cannot do. It’s for that reason they uniformly opposed the enactment of the Dodd-Frank Act which added new banking regulations in the wake of the collapse of the financial markets in 2008-9. They did that even though they had gladly accepted the roughly $700 billion that the federal government loaned to the nation’s 25 largest banks in an effort to resuscitate the financial markets which had ground to a halt following the collapse in the home mortgage market. Their opposition to the new bank regulations was echoed by their allies in the U.S. Congress where only three Republicans in the Senate and three in the House of Representatives voted in favor of the Dodd-Frank legislation.

  Specifically, the Dodd-Frank Act required banks holding assets in excess of $50 billion (denominated as “Systemically Important Financial Institutions” or “SIFI’s”) to be subjected to additional requirements including periodic “stress tests” to assure that they would be able to withstand potential threats to their solvency. The Dodd-Frank legislation also required SIFIs to hold enough High Quality Liquid Assets (or “HQLAs”) to cover 30 days of their normal cash outlays. These requirements were in addition to the duty of the regional Federal Reserve Banks (like the San Francisco Fed) to monitor and regulate the activities of its member banks.

  Shortly after his election, Donald Trump, arguing that the banks were being “eaten alive” by  regulations, proposed legislation amending the Dodd-Frank Act to change the definition of SIFIs to only include banks with assets in excess of $250 billion. This action was supported by the banking community’ which contended that the failure of a bank with less than $250 billion in assets could not have a major impact on the nation’s economy. While this proposal was being debated, both the Congressional Budget Office and Senator Warren warned that raising this regulatory threshold would increase the risk of failures among banks with assets of between $100 and $250 billion. Nevertheless, this legislation was passed with significant Democratic support.

  Following the Great Recession of 2008-9 interest rates in the U.S. remained at a very low level. To obtain a higher return on its investments, SVB chose to invest a substantial portion of its assets in long-term fixed income securities. It wasn’t that the issuers of these securities were likely to default. In fact, the great bulk of them were issued by the U.S. government. The risk was that the bank could not quickly liquidate its investments in those securities at their face values in the event that interest rates rose. With the onset of inflation in mid-2022, the Fed began to sharply increase interest rates in an effort to prevent inflationary pressures from getting out of control. It must be understood that there is an inverse relationship between interest rates and the value of fixed-income securities; i.e., when interest rates rise, the value of outstanding fixed-income securities decline and vice versa. Stated another way, an outstanding bond with a 3% interest rate is less valuable than a newly issued bond with the same face amount yielding interest at 4%. That is particularly true of bonds whose expiration dates are many years hence. In addition, the very speed at which the Fed raised interest rates almost assured that SVB and scores of other banks were going to experience a decline in the values their investment holdings. Such declines, while unrealized, nevertheless must be disclosed.

  In many respects SVB was unique and that was very instrumental in compressing the time frame in which it had to adjust its financial holdings to avoid a panic by its depositors. SVB catered to tech start-ups by being one of the few banks willing to loan monies to “risky young companies” and their employees which it did at low interest rates. Indeed, it is reported that 50% of SVB’s depositors were in the high-tech industry. The mere concentration of customers in a single industry is itself a risk factor. According to Paul Krugman, SVB portrayed itself as “the bank of the global innovation economy, which might lead you to think that SVB was mostly investing in highly speculative technology projects.” In fact, while SVB did provide financial services to start-ups, it didn’t lend them a lot of money since most of them were flush with cash provided by their venture capital investors. Instead, according to Krugman, “the cash flow went in the opposite direction, with tech businesses depositing large sums with SVB.”

  More importantly, SVB served more than 2,500 venture capital companies that funded tech start-ups; and the vast majority of its deposits came from its venture capital clients. These companies deposited huge amounts of cash with SVB, some ranging into the billions of dollars. At least one client (a crypto firm) is reported to have had $3.3 billion parked at SVB. Because of the magnitude of their deposits, these customers were effectively uninsured. Indeed, it is estimated that 90% of SVB’s depositors and 97% of its deposits were not covered by FDIC insurance. This prompted SVB’s venture capital customers to continuously monitor its financial condition. These same customers were also closely connected with numerous high-tech companies who also parked their cash assets with SVB. Therefore, when the Silicon Valley venture capital community became concerned about SVB’s financial conditions, it was only a matter of a few hours before SVB was overwhelmed with withdrawal demands.

  In February 2022, Larry Summers and other economists began sounding warnings that the nation was heading into a period of inflation and recommended that steps be taken to prevent a “wage-price spiral”, a condition when the very expectation of continuing inflation fuels further inflation. In March 2022, the Federal Reserve Board responded to this threat by increasing interest rates, beginning with a 0.25% increase. Over the course of the next seven months the Fed raised interest rates a total of seven times resulting in a cumulative increase of 4.25%. This rapid increase in interest rates caused bond prices to fall.

  While this was happening, SVB was heavily invested in 10-year Treasury bonds yielding 01.79% and did little to fortify its solvency. This may have been because SVB was operating without a Chief Risk Officer from May 2022 until January 2023. It wasn’t until March 2023 that SVB finally became alarmed . That was when it received a call from Moody’s that its credit rating was about to be downgraded. This prompted SVC to sell $21 billion of its bond holdings to Goldman Sachs at a $1.8 billion loss. The disclosure of this loss as well as SVB’s announcement on Wednesday, March 8th that it would be making a public offering of its stock designed to raise another $2.25 billion raised fears that SVB might be in trouble. Paradoxically, rather than provide assurances to its depositors, these moves spooked them into withdrawing their funds. Venture Capital companies that worked closely with SVB high tech depositors advised their clients to immediately withdraw their funds. According to California regulators, investors and depositors withdrew $42 billion from SVB by the end of the next day. Those withdrawals sealed SVB’s fate.

​ Within 48 hours following the collapse of SVB, New York State bank regulators forced the closure of Signature Bank, a 24-year old bank with approximately 40 locations and $100 billion in total assets. Faced with the possibility that the closure of these two banks might trigger depositors in other banks to panic and withdraw their funds, the Biden administration decided that it had to act quickly to thwart that possibility. Its response was to declare that the deposits of all customers of these two banks, including those whose bank balances exceeded the $250,000 limit of the FDIC’s insurance, would be protected. To offer this additional protection, the FDIC invoked the “systemic risk exception,” which allows the federal government to reimburse uninsured depositors to prevent dire consequences for the economy or financial instability. In addition, the Fed announced that it would set up an emergency lending program to provide additional funding to eligible banks and help ensure that they were able to “meet the needs of all their depositors.”

  Mindful of the criticism launched at Presidents Bush and Obama for bailing out the large banks in 2008 and the auto industry in 2009, President Biden stated “No losses will be borne by the taxpayers.” Although the federal government is to be the vehicle for assuring that the SVB and Signature Bank depositors will receive 100% of their deposits, it will not be providing the funds for making those payments. Instead, they will be advanced by the Federal Reserve Bank and any shortfall will be paid out of the new fund to be supported by assessments levied on all banks.  The President’s explanation, however, did not stop denunciations of his administration’s actions as a government “bailout.” Nor did it stop politicians from assigning blame for SVB’s failure.

  The collapse of the two banks and the administration’s response quickly became the subjects of a verbal food fight. Many democrats were quick to blame SVB’s collapse on the relaxation of regulatory requirements on regional banks enacted during the Trump administration. Republicans were just as quick to assert that those regulatory changes were not causally related to SVB’s collapse. Instead, Former President Trump and Florida Governor DeSantis blamed SVB’s collapse on its “woke policies.” It’s not entirely clear what they had in mind when they made their accusations other than to associate a cataclysmic event with a culture which their voters have been programed to detest. It’s possible that their references to “woke policies” were intended to refer to the fact that the bank’s board of directors included a number of women and ethnic and racial minorities.  Jim Comer, the Chair of the House Oversight Committee, blamed SVB’s demise on the bank’s investment policies which he asserted were guided by ESG (environmental, social and governance) considerations. None of these assertions, however, can withstand scrutiny. They are simply the games politicians play to energize their supporters and denigrate the policies of their opponents.

  It seems unlikely that requiring SVB to conduct biennial stress tests and maintaining a higher percentage of liquid assets would have prevented it from failing. No calculation of SVB’s required amount of liquid assets would have even approached the 38+% of SBV’s total assets that were withdrawn in the span of a single day. Similarly, it would have been pure luck that holding a biennial (every other year) stress test would have taken place at the time that would have avoided SVB’s demise. The best that can be said is that if SVB had been required to undergo biennial stress tests it might not have allowed itself to be without a Chief Risk Officer during those eight critical months when interest rates were being raised so rapidly. Had there been someone at SVB closely monitoring interest rate increases, the bank might have taken remedial action early enough to avoid triggering a panic among its depositors.

  SVB’s management has also been criticized for selling their shares in the bank immediately prior to its collapse. While this sounds like a clear case of insider trading, it has been suggested that at least some of those sales were pursuant to pre-existing plans which would make them perfectly legal. In any event, the SEC and DOJ are now investigating them. It has also been pointed out that annual bonuses were paid to SVB’s executives earlier during the very week that the bank collapsed. That too sounds more pernicious than it actually was since SVB had traditionally paid bonuses in the second week in March for work performed during the preceding year. Still, it seems clear that SVB’s management did less than a stellar job in managing their company during 2022 and it’s hard to argue that SVB’s executives actually deserved the bonuses they received.

  Jeanna Smialek, in an article published in The New York Times, asserts that the Federal Reserve Bank of San Francisco was also not without blame. The San Francisco Fed was very much aware of problems facing SVB as early as 2021; and in the ensuing months issued six citations relating to “matters requiring attention.” These citations, however, were ignored by SVB’s management. In July 2022, SVB became the subject of a “full supervisory review” and was advised of deficiencies in its governance and controls. This review culminated in a meeting held in the fall of 2022 between members of the San Francisco Fed and SVB’s senior officers to discuss the bank’s ability to access cash in the event of a crisis. Although the Fed continued to monitor SVB’s condition and point out weaknesses it appears to have failed to prompt any meaningful action on the part of SVB.

  There are two potential reasons why SVB was allowed to proceed without addressing the declining value of its bond portfolio as interest rates were being increased. One explanation is that neither the San Francisco Fed nor SVB’s management fully appreciated the dangers posed by the fact that virtually all of SVB’s deposits were uninsured and that the vast majority of SVB’s depositors were closely tied together. Another explanation is that the San Francisco Fed simply chose not to pressure SVB into taking action because its CEO, Greg Becker, was also a member of the Board of Directors of the San Francisco Fed. The Federal Reserve Bank in Washington has appointed its Vice Chair, Michael S. Barr, to lead an investigation into why the regulatory oversight process failed to prevent the collapse of SVB. Kevin O’Leary, an outspoken panelist on “Shark Tank”, has already concluded that SVB’s management is responsible for their bank’s demise. He characterized SVB’s CEO as an ”idiot” and its Board as “incompetent.”

  Even though SVB was unique in many important respects, the losses it was incurring in its investment portfolio were not unique. Indeed, the investment portfolios of virtually all banks are currently being adversely affected by the Fed’s increases in interest rates. Matthew Sedacca, writing in The New York Post, disclosed that there are at least another 200 U.S. banks in danger of experiencing a “bank run.” This raises the specter that many more banks may soon become insolvent, a fear underscored by the collapse of Signature Bank two days after the collapse of SVB which was followed by Moody’s warnings to six other banks that it was poised to downgrade their credit ratings. One of those banks was Republic National Bank which had to be bailed out by a $30 billion loan from a group of major bank.

  In the meantime the Fed seems likely to raise interest rates another 0.25% in the coming days and there is no reason to believe that this will be its last rate increase. This means that there may be more bank failures looming ahead. According to Aaron Klein, a senior economics fellow at the Brookings Institute, there is always a risk of contagion when a bank fails because the banking industry is built on trust and when trust comes into question depositors seek to withdraw their assets.

​ If there are additional bank failures, the Biden administration will be faced with the decision as to whether it should arrange for the protection of the uninsured depositors of those banks. CNBC has reported that a coalition of mid-size banks has already requested the FDIC to suspend the limits on deposit insurance for the next two years. Whether any such action will be taken will depend upon the extent to which there are likely to be even more bank failures. While the Biden administration will surely continue to be criticized for the actions it has already taken, shoring up public confidence in the nation’s banking system clearly seems to have been worth the risk that bailing out depositors will not encourage risky behavior on the part of bank managements. To guard against that possibility President Biden has requested Congress to enable bank regulators to recover bonuses received by executives of failed banks. It might also help to give them the authority to recapture profits made on the sale of bank shares leading up to a bank failure, including sales made pursuit to established divestiture plans.

  Once the current threat of bank runs has subsided, Congress must also face up to the fact that $250,000 of deposit insurance no longer seems adequate to maintain public confidence in the nation’s banks. This problem was underscored in an article by Andrew Ross Sorkin appearing in the March 18th edition of The New York Times. In his article Sorkin relates the story of Giannis Antetokounmpo, an NBA player then making roughly $25 million/year, who insisted that all of his salary be held in banks fully covered by FDIC insurance. This required the team’s owners to deposit the monies to cover his salary in no less than 50 banks. This same problem could be faced by countless small businesses across the country with monthly payrolls in excess of $250,000.  The logical solution seems to be to raise the available level of deposit insurance.

  Some pundits have suggested that any limitation on the amount insured by the FDIC is an anachronism as it has been set aside numerous times since the 1980s to maintain confidence in the nation’s banking system. In that connection, Ro Khanna, a California member of the House of Representatives, is reported to be working on a bill to do just that. The problem this proposal raises is just how do you fund an open-ended insurance scheme. Jay Clayton and Gary Cohn, in an Op-Ed published in The New York Times, have suggested that the FDIC insurance ceiling be raised to $2 million. Because banks range in size  from those with assets of only a few million dollars to those with over three trillion dollars, what is needed is a deposit insurance system that can work for banks of all sizes. While banks might welcome such a change, they probably won’t welcome the additional oversight that such a change might require.

  Congress also needs to recognize the role the internet played in speeding the crescendo of withdrawal demands leading to the collapse of SVB.  It doesn’t take a lot of imagination to envision the impact of a rumor circulating on the internet that a bank is about to become insolvent. This is not a small concern in an era in which disinformation has become a common feature of international warfare. It raises the question as to whether defamation laws should specifically address spreading false rumors about the financial condition of a bank. A few states, like California, Florida and Idaho, already have such statutes. The problem is that these are criminal statutes which  generally require proof of malicious intent. A more effective deterrent might be to create a civil cause of action giving injured depositors standing to assert such claims in the form of a class action. Even that might not be sufficient to prevent the kind of advice given by one or more of SVB’s venture capital customers to their investees; namely, “Don’t ask any questions, just withdraw your money now!”