Silicon Valley Bank’s Monumental Failure

How bank executives and supervisors watched and waited until it was too late, and the largest bank run in history was already underway.

Table Of Contents

• Introduction
• Bank Management Didn’t Understand The Risks
• Supervisors Treated SVB Like The Small Bank It Once Was
• Regulation Opened The Door For Mistakes
• Depositors Were Unique In The Risks They Introduced
• Looking Forward

Introduction

Beginning on March 9 this year, the US faced the largest bank run in history. Depositors withdrew over $40 billion from Silicon Valley Bank (SVB) in just one day, and the bank expected another $100 billion to go the following day [1, p. 24]. Businesses, investors, and consumers all panicked as the safety of their deposits came into question. Signature Bank failed 2 days later, and First Republic Bank held on until May 1. But as quickly as the chaos began, it was over. The economy was “saved”, as the FDIC acted to cover all SVB and Signature Bank deposits with a “systemic risk exception”. Banking contagion was stopped, the government quickly stepped in to ease fears and instill confidence, and businesses banking with SVB were able to make payroll. However, while the White House has insisted that “No losses will be borne by the taxpayers” [2], banks will most likely pass on $15.8 billion of the $18.5 billion dollar cost from SVB and Signature Bank’s failure [3] straight through to consumers. This isn’t just the fault of the banks or the government. The bank executives, supervisors, regulators, and even the depositors at SVB all played a role in what has amounted to yet another bailout funded by the American taxpayers.

Bank Management Didn’t Understand The Risks

The executives at SVB grossly mismanaged the bank’s liquidity and invested in a way that was fundamentally disconnected from the nature of its deposits. The bank catered largely to venture capital and startups, claiming to bank with “Nearly half” of “U.S. venture-backed technology and life sciences companies” and “45%” of “U.S. venture-backed technology and healthcare IPOs YTD 2022” as of September 30, 2022. [4]. These business clients mostly had uninsured deposits, and SVB’s deposits were 94% uninsured overall in Q4 2022. On average, large bank organizations with more than $100 billion in assets had 41% of deposits uninsured at that time, according to the FED [1, p. 23]. On May 16 2023, SVB’s former CEO Gregory Becker testified before the Senate Committee on Banking, Housing, and Urban Affairs about the collapse of his bank. He stated that “our clients have always had substantial amounts of cash” and “uninsured deposits were always roughly between 85 and 90 percent of our balance sheet” [5–0:37]. However, it seems that the bank was not prepared for the risk such deposits bring. That risk can be observed in the collapse of First Republic Bank, which was drawn out over a much longer timeframe. First Republic Bank faced its own run on deposits as clients panicked in the wake of SVB’s collapse. However, the banking industry came together to deposit $30 billion in unsecured deposits in First Republic Bank, to signal confidence in the banking sector and reassure depositors. First Republic Bank held on until it reported quarterly financials on April 24th. The company’s stock had already fallen from $147 in February to just $16 before releasing Q1 2023 earnings, but dropped another 49% the following day. The bank was closed by the FDIC on May 1, and sold to JP Morgan Chase, which the FDIC estimated would cost the deposit insurance fund $13 billion. The data in the bank’s destructive financials quite clearly demonstrates the risks uninsured depositors pose. In principle, it makes sense to assert that uninsured depositors are more likely to withdraw their at-risk capital when they lose confidence in their bank. However, the degree at which uninsured depositors fled First Republic Bank is staggering. 83% of uninsured deposits fled the bank between 12/31/22 and 3/31/23, making up 97% of the bank’s total deposit flight within that period (excluding the $30 billion in emergency deposits from the banking sector) [6].

(First Republic Bank deposits as reported in their Q1 2023 Results, excluding $30 billion in deposits from large U.S. Banks)

SVB carried a huge level of risk in the composition of its uninsured, concentrated, startup deposits that it failed to manage appropriately. Asynchronously to the nature of these volatile deposits, SVB invested its massive deposit inflow between 2019 and 2021 “primarily in securities with longer-term maturities”. As interest rates rose in 2022, SVB removed interest rate hedges and took short term profits [1, pp. 2–3]. Rates continued to rise, and SVB accumulated huge unrealized losses on its long term securities, until it was finally forced to sell $21 billion of available for sale securities for a $1.8 billion after-tax loss and announce a planned equity offering of $2.25 billion to meet deposit outflows [1, p. 23]. The announcement was made on March 8, 2023, and drove depositors and investors to run with their money the following morning. Thus, SVB failed to appropriately balance its assets and liabilities at a basic, fundamental level, and finally faced the consequences after years of inaction by the bank and its supervisors.

Supervisors Treated SVB Like The Small Bank It Once Was

The FED had a responsibility to supervise SVB, along with access to nonpublic information and means of communication with the bank’s executives. It was slow to respond to SVB’s rapid growth and failed to take decisive action. The FED identified some of the issues SVB faced, and issued supervisory findings such as “matters requiring attention” (MRA) and “matters requiring immediate attention” (MRIA). MRIAs are “calls for immediate action and priority attention to address important or lingering weaknesses that could lead to further deterioration in a bank’s soundness” [1, pp. 102]. When it failed, SVB had 31 open, unresolved supervisory findings from the FED going back as far as June 2019, including 12 MRIAs going back as far as June 2020. The FED was in the process of issuing an informal enforcement action, a “Memorandum of Understanding” (MOU) over issues covered in the FED’s 2021 Liquidity exams and 2022 Governance and Risk Management exams of SVB, when the bank failed in 2023. The FED failed to undertake timely enforcement actions against the problems it managed to discover at SVB for far too long. The FED also failed to appropriately test SVB for years, as it grew in size and transitioned from the FED’s regional banking organization (RBO) portfolio to its large and foreign banking organization (LFBO) portfolio, when it crossed the $100 billion in assets threshold on February 25, 2021. LFBO banks are supposed to be subject to Horizontal Liquidity Reviews (HLR), Horizontal Capital Reviews (HCR), and LFI rating. However, the FED’s first HCR began on April 25, 2022, its first LFI rating began on August 22, 2022, and its first HLR was delayed until January 1, 2023 [1, p. 40]. The HLR wasn’t completed when the bank failed, but its preliminary findings would’ve led to an additional MRIA over “insufficiently supported deposit outflow speed assumptions” and likely a rating downgrade [1, p. 58]. The FED still hadn’t completed all its first annual reviews of SVB as a LFBO, after being in the category for over 2 years. There are many possible reasons for the FED’s lax enforcement and testing, and it points out some of them in its report on its handling of SVB. One is that FED staff “repeatedly mention changes in expectations and practices, including pressure to reduce burden on firms, meet a higher burden of proof for supervisory conclusion, and demonstrate due process when considering supervisory actions” based on internal discussions and observed behavior within the FED [1, p. 36]. While keeping compliance costs reasonable makes more sense for smaller banks, there should be no reason for financial supervisors to “reduce burden” on large, systemically important banks that can afford the additional costs. In SVB’s case, had supervisors forced the bank to make changes to protect itself and better manage its risks sooner, it might still be in business today, instead of costing taxpayers billions of dollars. It is also worth noting that the CEO of SVB, Greg Becker, served as a class A director on the board of the San Francisco FED, which is hardly mentioned in the FED’s internal review. He may not have had the power to directly affect his bank from his FED board position, but his presence could have indirectly influenced the level of supervision his bank received from the SF FED staff. There are 9 total directors at each Federal Reserve Bank, split into 3 classes of 3 directors. The member banks of each district elect 6 of the 9 directors, 3 of whom represent the banks. Greg Becker was one of these directors, and perhaps his bank’s failure calls into question the system of bank appointed directors at those banks’ supervisor. For many reasons, SVB failed to receive effective enforcement from supervisors and created a burden for the whole banking sector.

Regulation Opened The Door For Mistakes

The lawmakers behind the FED’s powers and responsibilities made a difference too. When trying to pinpoint the causes of their lack of enforcement, the FED points to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA). It was signed into law in 2018, and relaxed the FED’s required level of scrutiny over large banks. The law raised the required threshold for generally applying Enhanced Prudential Standards from $50 billion in assets to $250 billion, and allowed the FED to apply the standards discretionarily to banks with between $100 billion and $250 billion in assets. In response, the FED Board of Governors created a tailoring rule in 2019 to categorize large banks and apply EPS. Without the EGRRCPA and tailoring rule, SVB would’ve undergone additional supervisory stress testing that it hadn’t yet gone through and been required to meet additional liquidity and capital requirements [1, p. 87]. The EGRRCPA was a change to the Dodd-Frank Act, and involved reforms like those SVB’s CEO Greg Becker wrote to Congress to advocate for in 2015. In a statement entered into the record of the Senate Committee on Banking, Housing, and Urban Affairs, Becker argued that the $50 billion threshold for Enhanced Prudential Standards could be raised to $100 billion, or even $250 billion. He also stated “we believe we are effectively managing the risks of our business and reasonably planning for possible unfavorable future business scenarios” and “SVB, like our mid-sized bank peers, does not present systemic risks.” [7, pp. 116–120] While this testimony was written when SVB had almost $40 billion in assets, Becker also wrote that he expected to cross the $50 billion threshold. 3 years later, and the threshold of higher banking standards was raised by a bipartisan majority in the House of Representatives and Senate. SVB continued to grow rapidly, supervisors continued to treat it like a small bank, and regulators only decided that it was a systemic risk after it was too late.

Depositors Were Unique In The Risks They Introduced

SVB’s uninsured depositors faced a tense weekend after the bank collapsed, until the government announced that all depositors would be made whole. But why did so many companies banking with SVB choose to keep all their money in one place? FDIC insurance covers up to $250,000 at each bank a corporation holds accounts with. Companies can choose to hold accounts in multiple banks to ensure all their deposits are insured. Financial tools like sweep accounts allow larger accounts to automatically be spread out among banks. The high proportion of uninsured deposits at SVB comes in part from its concentrated client base. SVB also required some borrowers to “maintain their operating and securities accounts with SVB and to obtain asset management, letters of credit, and cash management services from SVB or an SVB affiliate” [1, p. 78]. The FED report briefly mentions these loan provisions and states that “the types of covenants included in SVB’s loan agreements are often seen as prudent credit risk management tools”. SVB’s startup clients likely faced difficulties in securing financing from less startup friendly banks, and therefore may have been more willing to accept loan terms that required them to keep their primary accounts with one bank. SVB operated as if it understood its clients and their unique financial needs, but in the end completely underestimated the volatile nature of its uninsured deposits.

Looking Forward

The end of SVB raised questions about the future of banking and the strength of our financial system, and the government signaled in kind. The senate hearings in the aftermath of the bailout are full of bank supervisors declaring that the US banking system is sound and resilient. Now that depositors at “too big to fail” banks were made whole, some may move their large accounts to other giant banks that the government would have to save in the worst case scenario. The FDIC released a report on May 1 that advocated for significantly raising the deposit insurance limit for business payment accounts. Regulators seem to be willing to do anything to prevent catastrophe in the banking sector. The FED will likely and hopefully see changes to the standards to which it holds banks, via its own policies and culture or by changes to the law. But the economy marches on, and soon the FDIC’s special assessment will distribute the cost of someone’s fundamental risk mismanagement to our banks.

Sources

[1] “Review of the Federal Reserve’s supervision and regulation of Silicon Valley Bank.” federalreserve.gov. https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf.

[2] “Remarks by president Biden on maintaining a resilient banking system and protecting our historic economic recovery.” The White House. https://www.whitehouse.gov/briefing-room/speeches-remarks/2023/03/13/remarks-by-president-biden-on-maintaining-a-resilient-banking-system-and-protecting-our-historic-economic-recovery/.

[3] “Remarks by chairman Martin J. Gruenberg on ‘oversight of Prudential Regulators’ before the Committee on Financial Services, United States House of Representatives.” FDIC. https://www.fdic.gov/news/speeches/2023/spmay1523.html.

[4] Silicon Valley Bank Corporate Overview. svb.com. https://www.svb.com/globalassets/library/uploadedfiles/svb_corporate_overview_q3_2022.pdf.

[5] United States Committee on Banking, Housing, and Urban Affairs. Examining the Failures of Silicon Valley Bank and Signature (May 16, 2023). [Online Video]. Available: https://www.banking.senate.gov/hearings/examining-the-failures-of-silicon-valley-bank-and-signature-bank.

[6] “FEDERAL DEPOSIT INSURANCE CORPORATION form 8-K — First Republic Bank.” firstrepublic.com https://ir.firstrepublic.com/static-files/b006131c-9494-47a0-90ba-9ce71908016e.

[7] “Examining the Regulatory Regime for Regional Banks.” Hearing before the Committee on Banking, Housing, and Urban Affairs, United States Senate. https://www.govinfo.gov/content/pkg/CHRG-114shrg94375/pdf/CHRG-114shrg94375.pdf.