While this was not the planned content for this month, I thought that outlining the major points of the collapse of Silicon Valley Bank was important as we have received some questions about what it means, how it affects the financial sector and what results have come from it and what may result down the road.

What is (was) Silicon Valley Bank?

Before we get into the events that led to the bank’s downfall, let’s get an understanding of what Silicon Valley Bank (SVB) represented in the banking community.

Founded in 1983, SVB was an important growth engine for tech-based start-ups. Located in the middle of Silicon Valley, California, it worked closely with Venture Capital-backed startup companies looking for a home for their capital raises. SVB claimed to be the “financial partner of the innovation economy” and the “go-to bank for investors”. At the end of 2022, the bank claimed that “nearly half” of all U.S venture-backed startups used its services. Beyond just the startups, it also housed the Cash reserves of many VC firms themselves. Over 2,500 firms if we’re keeping count. Some of the more well-known start-ups to have signifcant amounts of capital deposited at SVB include Roku, Etsy and Roblox and many more. Through various statements issued by companies affected by the recent developments at SVB, it is unclear how much of the cash reserves these companies had will be recovered. More on that later.

So…..what happened?

In a nutshell, Silicon Valley Bank (SVB) experienced tremendous inflows of deposits during the last few years, reportedly growing from $60 billion in deposits in 2019 to over $190 billion by the end of 2022. Much of this growth in deposits came from the recent uptick in venture capital that came with low interest rates being low since 2008. A significant portion of these deposits were invested in long-duration (long-term) bonds, U.S Treasury-bills (T-bills) and mortgaged-backed securities (MBSs). Usually, this is a very safe investment strategy as U.S T-bills are guaranteed by the U.S government and MBSs are also considered to be relatively low-risk investments. But, as we discussed in a previous post, long-term, low-yielding bonds do not perform well in a rising-rate environment, much less an aggressively rising-rate environment.

So staring down the barrel of reported losses of over $15 billion on their balance sheet, SVB was facing a liquidity squeeze. If clients wanted their cash deposits back, whether to invest further in their company, pay employees or move it to another institution to take advantage of a higher rate on their deposits, SVB was having trouble doling out cash on hand without selling their long bonds at a loss. On Wednesday of last week, SVB decided to realize those losses, announcing a capital raise and a sale on their long-dated bonds in favour of newer, shorter-term investments with better yields in order to generate higher spreads on their assets vs deposits as well as shore up their cash position to facilitate client withdrawals. When I mention spreads, I mean the difference between what the bank is being paid in income from their bond portfolio and the interest they are paying out to clients. For example, on long-term T-bills, let’s say SVB was generating 1.5%/year in yield and paying out 0.5% in interest to clients. As rates increased through 2022, SVB would have been forced to increase the interest they were paying out in order to retain clients but was still locked into that 1.5% yield on their T-bills. So when announced that they were writing down losses and trying to re-position, it created a widespread panic amongst their clientele, who quickly ran for the exits, trying to withdraw as much of their capital as possible. Clients had lost faith in the bank’s ability to manage not only their assets, but their business as a whole. SVB’s stock price plummeted by 60% on Thursday and by midday Friday, the Federal Deposit Insurance Corporation (FDIC) had taken control of the bank and is now tasked with the responsibility of trying to return money back to the bank’s customers. SVB’s downfall now represents the second largest American bank to fail since Washington Mutual, which held over $300 billion in customer deposits before the 2008 financial crisis.

The next development was the financial regulators announcing that they are creating a program to protect all deposits, even those not insured by the FDIC. The FDIC, much like the Canadian Deposit Insurance Corporation (CDIC) in Canada, protects investors for up to $250,000 in deposits into a financial institution in case of insolvency from that institution. Now while $250,000 sounds like a lot of money to you and I; it represents very little insurance for those startups and VC firms we spoke about earlier. Some of these startups had hundreds of millions of dollars in deposits and in the case of Circle, a cryptocurrency firm that operates a Stablecoin hedged against the U.S dollar, who had over $3.3 billion dollars in deposits sitting inside SVB accounts. Back to the program being created by the Federal Reserve. It is called the Bank Term Funding Program (BTFP) which will “support American businesses and households by making additional funding available to eligible depository institutions to help assure bank have the ability to meet the needs of all their depositors”.

Why Did This Happen?

 Much like the volatility we saw in the broader stock market through most of 2022, the decline of SVB was brought upon mostly by fear. When SVB announced its plan to raise capital in order to bolster its cash position and re-balance it’s balance sheet, the public panicked and cause a ‘run on the bank’ where requests for withdrawals of millions upon millions of dollars made SVB’s insolvency issues even worse. But before that could occur, there were warning signs that SVB likely should have heeded before it even got to this point.

Towards the end of 2021, the Federal Reserve chair Jerome Powell announced that the Fed would discuss the speeding up of their bond-buying activities. A clear sign that the times of living in a time of quantitative easing and zero interest-rate policy (ZIRP) was likely coming to an end. SVB, who was happy to put their clients new deposits into these long-term T-bills (happy to the tune of over $90 billion) should have had the foresight to make some adjustments to the asset mix on their balance sheet. In hindsight, the banks decision to buy predominantly non-floating interest rate assets, especially to that degree, was a mistake. A mistake that led to the $15 billion loss referred to earlier and one that all but ensured immediate losses and shrinking spreads when the talk of increasing interest rates became less talk and more reality.

Another failing here sits on the shoulders of the Federal Reserve. This is the direct result of rapidly increasing interest rates throughout 2022 without giving proper time to “smaller” financial institutions to pivot their balance sheets and adjust strategies.

What Happens Now?

We likely haven’t seen the full range of fallout from this just yet. In the wake of SVB, the immediate affects of the news reached the bank stocks as a whole, erasing $52 billion in market value on Thursday of last week alone. The closure of SVB was followed quickly by the closure of Signature Bank with the FDIC being deemed the receiver by the New York State Department of Financial Services. First Republic Bank followed closely behind as it’s stock price fell from over $104 to just over $31 at the time of this writing, though the bank has managed to keep it’s doors open. The regional banks across the U.S were hit the hardest with the iShares US Regional Banks ETF falling just under 25% in the past 5 days of trading. While most big banking institutions were able to avoid the double-digits pullbacks, even Charles Schwab, a large U.S-based bank has fallen over 17% in the past week.

With the creation of the BTFP program, the U.S is likely to see more regulation on the banking system. Critics of regulation will likely oppose any stricter/new rules imposed on Wall Street but the regulations sent down by authorities following the 2008 crisis are largely well received today as banks must be able to pass rigorous stress tests to ensure their balance sheets remain healthy. The biggest concern may actually lie in Silicon Valley where cash-strapped companies are forced to delay payments to vendors and staff for the immediate future. Considering some startups have burn rates in the millions of dollars per month, you have to wonder how lean these companies can become in order to dance around their sudden insolvency.

The announcement from the Fed about covering all the deposits for clients, even those beyond the $250,000 limit is essentially another bailout, albeit for the client this time around, as opposed to the bailout being for the bank itself. The Fed will now need to create liquidity in the market in order to facilitate covering these deposits. The problem here however, is that the Fed has not finished their fight against inflation. Another rate hike at this point seems unlikely given that quantitative tightening typically occurs until something in the system becomes “broken” and a need for greater liquidity – even in the short term – will not allow for further rate increases in my opinion. This run on regional banks is not exactly a systemic problem for the financial sector, but does represent a point in time where the stresses on banks’ balance sheet cannot continue, at least for the short term. Ignore the headlines that dub SVB the 16th largest bank in the U.S because, while that is true, it is a bit of a sensationalist headline given that SVBs assets represent roughly 6.5% of the largest U.S bank (JP Morgan at $3.2 trillion) and 2.3% of the size of the largest four U.S. banks at $9.1 trillion.

Expanding on the duty bestowed upon the FDIC; their job is to find a way to extract as much value from the assets still on SVBs balance sheet. There are likely two scenarios in which that happens. Another bank purchases SVB and with it, acquires the deposits at the same time. Now becoming the custodian of these deposits, a bigger bank with much more liquidity and cash on-hand then honors the withdrawals of those requesting them. What’s the upside for the acquiring bank? They would only be making the purchase of SVB at a discount so in a hypothetical, if the balance sheet of SVB was worth $100, the acquiring bank would make a bid of say, $80, and acquire the remaining assets on the cheap.

The alternative is the FDIC does the selling, using the proceeds of the remaining T-bills, MBSs and bonds to cover the depositors while promoting stability and public confidence in the banking system as a whole. As of December 31 2022, SVB reported assets of approximately $209 billion and about $175.4 billion in total deposits. If this numbers still hold up almost 3 months later, perhaps the process of getting the depositors their money back will not be the problem it looked to be at first glace. Granted, SVB has fallen, as have other U.S based banks but if the bigger banks spot an opportunity to pick up cheap, quality assets while also picking up a win in the court of public opinion by making depositors whole, the damage could be limited.

Whatever the result, this will likely be a highly publized story to continue watching in the coming months as will the likely changes in regulation that follow.

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.