Lessons from Silicon Valley Bank’s collapse

The failure of Silicon Valley Bank (SVB) on March 10, 2023, was the second-largest bank failure in U.S. history. In less than 48 hours after the capital raise announcement that started the collapse, the 39-year-old bank was seized by regulators. How did SVB fail so suddenly, and what were the mistakes made?

How it all happened

While SVB’s announcement that it would raise capital by selling its shares on March 8 ultimately triggered the failure, sources from Reuters claim that it all started during the week of March 3 when the rating firm Moody’s notified SVB that they would be downgrading the bank.

To avoid a multi-notch downgrade and in an attempt to adjust its financial position, SVB sold $21 billion of its available-for-sale securities leading up to March 8, taking a $1.8 billion loss. To fill this loss, the bank announced on March 8, after market close, that it planned to sell shares to raise capital.

On March 9, shares of the company fell by over 60 percent. Shaken by the capital raise and uncertainties, venture capitalists and other startup investors urged their portfolio companies to pull money from SVB. In a single day, depositors and investors attempted to withdraw $42 billion from SVB. On Friday, March 10, following another 60 percent drop pre-market, the stock was halted for trading pending news. Later in the day, SVB was closed by California’s regulators, and the Federal Deposit Insurance Corporation (FDIC) was appointed as the receiver, marking an end to what was once the 16th largest bank in the U.S.

Why did SVB fail?

SVB had a concentrated client base of mainly startups and venture capital funds in the technology sector. During 2021, due to a combination of low-interest rates, stimulus, easy access to liquidity, and almost feverish investor sentiment fuelling higher and higher valuations, money poured into technology startups, and SVB’s deposits ballooned. To use the additional capital, SVB invested in securities like treasuries, which at the time yielded less than two percent.

As the startup hype died down and valuations dropped significantly, venture capital investment declined. Startups struggled to raise funds and continued to burn cash, which led to increased fund outflows from SVB. The bank then had to sell its investment securities to raise cash to meet these outflows. Unfortunately, interest rates rapidly rose over the last year, and the bank did not adjust to the new interest rate environment. This meant that SVB had to sell its investments at significant losses, eventually leading to the need to raise capital, causing customers to lose faith in the institution and triggering a run on the bank.

Beyond the lack of client diversification, SVB also failed in risk management. Despite the Federal Reserve signalling that interest rates will be much higher throughout 2022, SVB did not adjust to the changing interest rate environment. Notably, SVB did not have a chief risk officer from April 29, 2022, to January 3, 2023. One has to question why this crucial position was vacant for over eight months during one of the most volatile periods for interest rates over the past few decades.

Outlook

The failure of SVB highlights the need for businesses to diversify their customer base and to properly assess the impacts of changing macroeconomic conditions. Given the current volatility in interest rates, companies must rigorously evaluate their sensitivity to changes in interest rates and stress test scenarios where interest rates remain elevated for longer than expected. Strategies for a possible recession should also be considered.

Beyond the failure of this one bank, investors should be concerned about the potential for contagion risk, which brings to light liquidity and risk management issues at other institutions. The pressures of high interest rates, sector declines and the changing sentiment of an institution’s customers can create tidal events. As Warren Buffet says: “Only when the tide goes out do you learn who has been swimming naked.” The Savings and Loan collapse in the 1990s and, to a much larger extent, the 2008 economic collapse began with a few badly run institutions that impacted the entire economy. Considering recent news of problems at Credit Suisse, more banks may fall in the aftershock of the SVB collapse. However, the swift action of the U.S. government to protect depositors to an unlimited extent could mitigate the risk of a failure of faith in financial institutions turning into a run on the banks.

Certainly, the failure of SVB will prolong the nuclear winter that prevails in the technology sector. After an exuberant 2021 with tech companies achieving record valuations, these declined significantly in 2022, followed by layoffs across the board. We can expect now that a technology firm seeking financing will need a robust business plan and be generating profits.

One positive outcome of this failure could be the explicit example of the impact of poor risk management serving as a lesson for better conduct. Seeing this could cause investors to exercise more prudence, move to quality investments and, by that, aid the economic slowdown central banks are trying to achieve through raising interest rates.