Many people awoke this morning to news of a bank that suddenly collapsed – Silicon Valley Bank, or SVB. While information is still developing, I thought I would provide some background information on what is known so far.

SVB is the go-to bank for Silicon Valley startups. Over the last few years, the tech bubble has been growing and growing and growing, focused especially around Silicon Valley. That meant a lot of banking was happening, and it was happening with SVB. That is where the various companies put their deposits. 

How does a bank make money? By lending out deposits. In 2021, at the height of the tech bubble (and, not coincidentally, at a historically low-interest rate environment). The bank did what most banks do and bought very safe bonds.  In order to increase their yield slightly, they bought long-term bonds, and this is where the trouble begins.

As the interest rates begin to grow, the startups begin to fail. As startups fail, their money gets withdrawn from the bank and doesn’t get replenished. However, the bank’s assets are in long-term debt, so the bank loses the ability to supply cash for people asking for their money back. Eventually, they have to sell their long-term assets, but, since we are now in a higher interest-rate environment, they have to sell these for a loss.

Lost Confidence

The trigger that led to the bank run was their announcement that they had sold $21 billion worth of assets for a $1.8 billion loss, and were now seeking investment to cover the newly-formed hole in their balance sheet. This led to a loss of confidence by many of the remaining companies that use the bank. Therefore, more companies withdrew their money, and this exacerbated the problem quickly until failure.

Initially, the federal reserve had said there would not be any bailouts, and only FDIC-insured deposits would be made whole.  However, since FDIC only covers $250,000, and most of the bank’s customers were multimillion-dollar enterprises, this meant that FDIC insurance would only cover a tiny fraction of the bank’s customers. This meant that many medium-sized companies were at risk for also failing because they would lose access to all of their money.  Additionally, individuals were also being hurt because many companies were running their payroll through SVB, and therefore, could not send money to their employees even though the company itself had plenty of money. Additionally, with SVB’s failure, this is leading to a lot of people getting nervous about their money, and there were growing concerns about other bank runs happening throughout the economy.  This is definitely a risk since the interest rate environment has changed so much in the last year.

Therefore, in order to mitigate the risk of contagion, the federal reserve issued a statement this morning saying that all deposits will be made whole, not just the FDIC-insured deposits, and this will be financed by essentially taxing all remaining banks. 

Many people have taken umbrage at this announcement for a variety of reasons. First of all, it is self-serving to the federal reserve, as it seems they are trying to paper over problems caused by their policies. Since they set interest rates, and many of these problems are caused by the recent interest rate increases, they are trying to prevent too many people from asking questions, as would happen if this bank failure caused a rash of companies who banked with SVB to fail.  Second, Silicon Valley is filled with a certain attitude of investor which says that laws and public policy don’t apply to them.  They say that regulation only holds them down.  However, when trouble comes, all of a sudden they are running back to the government for help.  This is often termed as “privatized gains and socialized losses,” meaning that individuals can take big risks and reap big rewards for themselves, but leave the problems for the rest of society to clean up.  Without allowing such investors to feel the pain of their own attitude, we can simply expect more of this behavior to go unabated.

Moral Hazard for Banks

Finally, this creates a huge moral hazard for banks. The banks that didn’t fail are having to pay for the ones that did. This means that if a bank has wiser policies that lead to success, they are penalized by having to pay the penalty for the ones that were not wise. It also means that customers will not use this wisdom as a means of choosing banks—if the government is going to make you whole anyway, why bother looking for a more solid bank? On the other side, if you are a banker, most bankers feel a fiduciary duty to their depositors. But, if the bankers know the government will fix any potential problem, why spend all the time managing risk?

One final note—a second bank was also closed with less hoopla—Signature Bank New York (SBNY) but for the same reasons.  I should also note that, as far as I am aware, neither bank was guilty of extravagant investing, as their primary losses were actually in treasury bonds (which are considered a 100% safe investment). Additionally, until last week SVB had an “A” rating from its credit agency, Moody’s.