Three reasons Silicon Valley Bank failed (and what happens next)

Silicon Valley Bank (SVB) has collapsed. UNSW Business School's Mark Humphery-Jenner explains how this happened and what to expect next

The Santa Clara, California-based Silicon Valley Bank (SVB) has collapsed. This is the second largest banking failure in US history and the largest failure since the Global Financial Crisis (GFC).

The US Government has stepped in to protect depositors. The government will not bailout SVB. Shareholders are not protected. The deposit protection is funded by a special impost on banks rather than by taxpayers per see. These are reminiscent scenes of the 1930s, which also saw bank runs and bank failures all while the Federal Reserve (the Fed) hiked rates.

But why did the US bank fail? Should we expect the Great Depression and heightened volatility all over again for the financial system? Or are there more company specific factors at play in the SVB collapse?

Let’s see how the banking sector disaster unfolded, causing US regulators to step in in the collapse of Silicon Valley bank.

Reason 1: A bedrock of bad deposits

“Don’t put all your eggs in one basket” – so goes the cliché saying. But this adage has some truth in it.

Silicon Valley Bank indeed put all its eggs in one basket. As the name suggests, the financial institution focused on startups, venture capital funds, and the broader Silicon Valley ecosystem. The deposit base was highly concentrated. This is a bad foundation for a bank.

The problem is that those clients have similar economic exposures. If one client must withdraw their funds, it is very likely that myriad other clients must do so. This is analogous to the mortgage-backed security crisis in 2008: when one borrower defaults, it is likely that many more will also do so.  

Silicon Valley Bank had a steady increase in withdrawals. It has been a tough last year for startups and the tech industry. Since the pandemic, VC funds have tightened their belts. Enterprise sales are taking longer. So-called ‘down rounds’ are more frequent. And so, tech startups – and VC funds – increasingly needed their cash, triggering more withdrawals and fewer bank deposits.

This caused Silicon Valley Bank’s cost of capital to increase. With money leaving deposit accounts, Silicon Valley Bank must now pay depositors higher rates to retain them, or rely on higher-cost external sources of funding.

Read more: Short selling Adani: how Hindenburg Research triggered the price plunge

Reason 2: A problem with assets

Suppose you buy a house in the US. You lock in a 30-year mortgage and you secured an ultra-low rate covid era loan. But now, overtime has been cut, you need cash whereas property prices have fallen. What do you do? Your assets have plummeted, your cash needs have increased. If only you could hold on until you’ve paid off the house. Silicon Valley Bank faced a similar conundrum.

Silicon Valley Bank had a similar problem: It needed cash now, its assets had fallen in value, and its cash flow was declining relative to its cash needs.

Let’s dig into the weeds of this a bit.

Silicon Valley Bank’s main assets – with which to meet depositors  - had several major components: (1) assets for sale, (2) assets held to maturity, (3) other non-marketable securities, (4) cash, and (5) loans. Of these, only Assets for Sale and Cash are designed to be liquid.

Here we can see an immediate liquidity issue: if there is a bank run, Silicon Valley Bank simply would not be able to satisfy all its withdrawals as it simply does not store the deposits as cash per se.

Silicon Valley Bank’s assets have also fallen in value. Most of Silicon Valley Bank’s assets are loans and bonds. A bond is a loan. When you buy a bond (or a loan), you buy the right to the future cash flow stream underlying that loan. Banks – such as Silicon Valley Bank – don’t need to record the current market value of those bonds if they intend to hold the bond until the loan is fully repaid.

As interest rates go up, so too does the required return on any recently issued bond. Think of how mortgage rates have changed for household loans. It is much the same for corporate debt.

But the old bonds that had locked in a low interest rate are now worth significantly less because they pay less than what investors could obtain on new loans.

This is a problem. Silicon Valley Bank held many US government bonds and mortgage-backed securities. These have yields below 2 per cent. Meanwhile the Fed Funds rate increased to well over 4 per cent. Thus, SVB sold its ‘available for sale’ bonds, incurring a $1.8 billion loss in so doing. SVB’s ‘held to maturity’ assets have also fallen in value.

The asset base can also create a cash flow problem. Silicon Valley Bank’s funding costs increased. As indicated, this owes to higher interest rates. However, many of Silicon Valley Bank’s assets have locked in low interest rates. This created an ongoing cash flow concern.

Reason 3: A capital raise that spooked the market

Because of this situation, Silicon Valley Bank decided to embark on a capital raise in order to support its balance sheet and ensure adequate liquidity. In this raise, it revealed that it had sold bonds. It requested around $2.25 Billion. The market responded badly. This was likely on the news that Silicon Valley Bank has sold all its ‘available for sale’ securities and was in a dire liquidity and solvency position.

A classic bank run ensued. Within a day, $42 billion was withdrawn. This largely followed VC funds extracting their deposits and instructing their portfolio companies to do so. This created an immediate liquidity (and potentially solvency) problem for Silicon Valley Bank.

Banking regulators stepped in and took control of Silicon Valley Bank. Silicon Valley Bank collapsed.

How bad is the damage? Will Silicon Valley Bank be bailed out?

The SVB Financial Group might attract a buyer. It has real assets. And these assets might go some way to meeting most of its deposits. The government has indicated that it will not bailout SVB however depositors will be protected. The distinction is important.

Subscribe to BusinessThink for the latest research, analysis and insights from UNSW Business School

In a bailout, shareholders and lenders often receive at least some government support. However, with SVB, the US government has indicated that “Shareholders and certain unsecured debtholders will not be protected”. SVB will not be bailed out. Rather, depositors will be protected and this will be funded by a “special assessment [levy] on banks”.

Another bank might acquire what remains of Silicon Valley Bank. This investment thesis would be to obtain SVB’s banking and finance licences, its branch network, and its set of depositors. Being seen to support the startup sector might also engender goodwill with a high-value customer base.

Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals, and his research interests include corporate finance, venture capital and law. For more information, please contact A/Prof. Humphery-Jenner directly.