Risk Management: What we can learn from Silicon Valley Bank's failure

As the second largest bank crash in history, the story of Silicon Valley Bank’s failure will never be forgotten, and understanding how it happened can provide valuable lessons for investors. In this article, I will explain what happened to Silicon Valley Bank (SVB), and what lessons we can learn from it as individual investors.

So what happened?

In order to have a better understanding of why Silicon Valley Bank crashed, it is important to know who they served. SVB, unlike most banks, had a customer base comprised mostly of start-up companies and venture capital firms. A venture capital firm is an investment firm that invests primarily in start-up companies, in the hopes to make a profit as the companies grow over time. Start-up companies are often considered risky to lend to, because their products and services are new, and they often do not have proven earnings or much of a track record for lenders to assess their creditworthiness. Due to this, these companies often have difficulty finding lenders and investors to loan them money (capital) to finance their operations in the traditional lending channels, such as those found at larger banks. However, some lenders are willing to take the risk in lending to start-up companies, because they can lend to them at much higher interest rates. SVB saw this as a business opportunity and decided to specialize in servicing these start-ups, many of which have centralized operations in Silicon Valley. This strategy worked great for a number of years, largely due to start-up companies having access to funding from sources such as equity offerings, venture capital investments, and acquisitions through cheap funding with low interest notes. These large inflows from lenders and investors left many of SVB’s customers with a need for a place to deposit/store their cash. In the 3rd quarter of 2022 around 93% of SVB’s deposit base was comprised of deposits from venture capital firms and start-up companies. However, many of SVB’s customer’s deposits were well above the FDIC insurance limits which are $250,000 per depositor, per insured bank, for each account ownership category. SVB bank had around $173 billion of customer deposits at the end of 2022, of which $152 billion were reportedly uninsured (over the FDIC insurance threshold of $250,000). Approximately 88% of SVB’s customers deposits were left uninsured, leaving many depositor’s funds at risk of loss in the event of a bank failure.

During the pandemic, banks took in record levels of deposits, however, the demand for loans was weak. As a result, many banks relied on investments of customer deposits in securities portfolios or in cash equivalents to generate income for the bank. The income that the bank earns from its securities portfolio is used to pay interest earned on deposits and finance operations, with the remaining funds being the bank’s profits. When a bank buys securities for its portfolio, they typically invest in income-generating assets such as U.S. Treasuries, corporate bonds, and cash equivalents. While these assets are traditionally thought of as “safer” investments, the asset’s market values are still subject to fluctuations as interest rates change. As a way to reduce the interest rate risk in a securities portfolio, a bank will typically buy bonds with different maturities. The shorter-term bond holdings provide the bank with a way to hedge against interest rate risk, because shorter maturity bonds decline less in value as interest rates rise. The longer maturity bonds tend to pay higher interest rates as a tradeoff for the investor lending the funds for a longer period of time, but they are subject to larger declines in value as interest rates rise. However, if the bonds are held to maturity, the bondholder/investor will typically collect interest throughout the holding period and receive the last interest payment and principal value of the bond at maturity. SVB invested heavily in longer maturity bonds in an attempt to increase the return on their securities portfolio, while failing to properly account for interest rate risk.

The recent increases in interest rates over the past year created a somewhat perfect storm which crashed Silicon Valley Bank. As a result of rising interest rates, many of SVB’s customers began withdrawing their cash reserves to fund operations as outside borrowing and capital raising became unaffordable and unavailable. The withdrawals by SVB’s customers began to exceed the bank’s income from lending and interest earned on the bank’s securities portfolio, which drained available cash deposits. SVB announced that it was selling bonds from its securities portfolio for $21 billion, to meet the demand for withdrawals and that it had lost $1.8 billion on the sale. This announcement drew panic amongst the bank’s customers, which accelerated withdrawals from SVB in worries that the bank was becoming insolvent. This, along with warnings from venture capital firms to the start-up companies they had invested in about the bank’s situation, forced SVB to further liquidate their securities portfolio at a substantial loss to meet deposit demands. What followed was a bank run, which occurs when a large group of depositors withdraw their money from a bank at the same time. SVB was unable to raise the cash it needed to cover the outflows, which led regulators to come in and close the bank. Typically, in the event of a bank failure, the FDIC will take control of the bank and try to sell the bank or take over the bank’s operations. The FDIC reimburses depositors for up to the FDIC limit which is $250,000 per depositor, per insured bank, for each account ownership category. However, the FDIC, Treasury Department, and Federal Reserve implemented a “systematic risk exception” to make SVB depositors, including those with uninsured deposits over the $250,000 FDIC limit, whole by utilizing a special assessment charged to FDIC member banks to cover any amount uninsured by the FDIC Deposit Insurance Fund.

Many of the factors that lead to the downfall of SVB were due to risks that could have been avoided had they been proactively addressed. As individual investors, we can take steps to reduce risk in our personal lives, such as diversifying our investment portfolios, funding an emergency savings account, or paying down debt. Practicing proper risk management begins with having an awareness of your weaknesses, then creating a plan to address them. By being proactive, we can attempt to avoid making the same mistakes as Silicon Valley Bank.

Brandon Bergeron

Portfolio Manager, Crescent Sterling Ltd.