How to Lose a Bank in a couple of days….

  Unlike every guru’s take on the Silicon Valley Bank debacle, we at the Ribotsky Institute decided to break down the bank’s failure for the rest of us mortals.  

News organizations and pundits love to throw around the term “failure” or “demise” but these are loosely used terms.  How did Silicon Valley Bank fail?  Why did it fail? And what does it mean that a bank failed?  Most of you may not know that a business may not be a failure in the classic sense of the terminology, but it may have made some crucial errors in its existence and business plan that due to outside forces combined with those aforementioned decisions, the business ceased to be viable as a going concern.

Taking a step back if you didn’t know Silicon Valley Bank you do now obviously.   It was a bank built on supporting venture capitalist-backed companies as well as some of the actual venture capitalists themselves.  Based upon that the clientele Silicon Valley Bank was exposed to definitively had more risk attached to them than normal banks would.   As an institution in a niche market, the bank often attempted to market itself to main street but fell short of actually being successful at it.

Having experienced intense growth from approximately 2019 through 2022 the bank had more than doubled the size of depositors and deposits on its books.   As most may not know, or may not think of it in this vain, a deposit while part of what a bank exists for is actually a liability to the bank.  It eventually, owes that money back to the depositor(s) when they ask for it.  So for all intents and purposes to a bank, a deposit is a liability as it must have enough cash on hand to hand withdrawals of said deposits but also to provide services to its depositors/customers.   So, there is an overhead factor that also goes into handling deposits.  That means in terms of running a bank, an additional liability. 

In order to make money, a bank (this goes for all banks) takes those deposited dollars by its customers and turns it into revenue or assets.   It does that by lending it out to others and/or buying assets that produce income back to the bank.   Sounds somewhat simple enough, right? A bank typically makes small business loans and gives out mortgages and other income-producing products.  If that is not something the bank is comfortable doing, it then can purchase loans or other securities that have already been structured.   These products range from other firms’ mortgage-backed securities, and loan portfolios to United States Treasuries and short-term investments.

Now, as this bank, Silicon Valley Bank, is in a niche market with a specific type of depositor and business clientele, it had exposure to funded and startup clients.  Due to that fact, the bank’s management claims to have been really careful about what it did with depositors’ money, trying inherently not to take too much risk.   As a lot of the new clients of Silicon Valley Bank were venture capital-funded businesses the deposits made by these entities were rather large in nature.  Keep in mind as well most of these deposits were venture-funded money and not actual revenue by each of these businesses. So as the amounts quickly increased it often became too difficult for the bank to lend this money out conservatively.  As lending typically takes time to put together.

Instead of making loans that would have more risk, the bank’s management purchased US Treasuries and other mortgage-backed securities.  Some of the treasuries and bonds purchased by the bank had ten-year or longer durations.   These types of securities lose value when interest rates go up, which they have been over the past year or so.   As most in banking and finance are well aware, typically for every year of duration (time till the security matures) in a rising interest rate environment, the value of that security goes down.  So as interest rates have been rising, the value of Silicon Valley Bank’s fixed income portfolio deteriorated since it had an extremely long duration time.   

Now here comes the real issue that affects the actual demise, leverage.  All banks are leveraged, and Silicon Valley Bank was no different.  Most banks are levered at a very high level, some ten to one.  So, for every dollar, they actually have they have borrowed an additional ten.   Now, if there is a loss on their investments, which the leverage was utilized to purchase, that loss does what?  It grows exponentially and creates a much larger hole to fill, as the loss is greater than the actual value of cash on hand since it, is levered. 

In the case of Silicon Valley Bank and then by extension Signature Bank in New York, a loss on the valuation of the investments is merely a “mark to market” loss and as long as the bank continues to operate and the depositors do not all want their money back at the same time (or a majority thereof) the bank will be fine and eventually the loss should (operative word) turn out to be less or turn positive.   Or at least that is the theoretical financial model banks are run on.  

But unfortunately, with the downgrade in confidence in the bank, depositors wanted their large sums back quickly or the majority did at the same time.   Well not to alarm the world, but if all the depositors in most banks all wanted their money out right now, it would be virtually impossible without the bank going to the Federal Reserve window and borrowing or selling some of its assets.  

In Silicon Valley Bank’s case, it had to sell the assets it held at a market-to-market loss to try to meet the demands of depositors wanting their money back.  So what could have been just a mere loss on paper for a short while becomes a realized loss once those assets are sold at their current market-to-market loss.   From that sale, the bank may not have enough capital created to meet the demands of all depositors who want their money today.    

Of course, as the story now goes, once the word gets out that the bank may not have the ability to give everyone their money, the situation goes viral and a self-fulfilling prophecy becomes reality.  Just like when you were in kindergarten and you played musical chairs, the same applies to investments and banking.   When the music stopped you did not want to be the one without a chair right?  By way of analogy, no one wants to be the last depositor in what is considered to be a sinking bank.     You have what is referred to as a “Run on the Bank”.    

Then like any other illness, a cold, the flu, or COVID for that matter, financial contagion spreads.   Once Silicon Valley Bank got hit it spilled over and became contagious.   All banks work with other banks, buy and sell securities, assets, trade, leverage, and/or operate in the same arena and all those who have similar clients and/or businesses are vulnerable to similar issues of their businesses but more likely, to their depositors.  

This is what the greatest fear is right?  You go to the bank to get your money and it is not there.  Or you cannot get it.  It is somehow not available or gone.  So, depositors race for the finish line and try to get out.   While there are definitive mistakes that were made here and only time will tell exactly which ones were avoidable, rest assured the panic invoked played a key role in this contagion.

Keep in mind everyone that this may not be the last bank that fails due to this mishap and the handling of things such as cryptocurrency assets.   Also, keep in mind that these banks that did fail catered to a certain clientele and specific businesses that potentially have volatility attached to them.   Stay Tuned…….

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