March 2023 saw the failure of America’s 16th largest bank, Silicon Valley Bank (SVB), who provided banking services to corporate clients doing business in venture-backed technology and science companies. Understanding why this collapse happened is an excellent case study into how the financial system as a whole works.
The Normal Functioning of Banks
When the economy and the banking system are running normally, banks use their clients’ deposits to either lend to other parties in order to earn interest on those loans, or they invest the funds in other assets with the goal of earning a return. If anything causes the depositors to suddenly withdraw substantial amounts of money from the bank, this may lead to a liquidity crisis for the bank if the majority of its funds are tied into such investments or loans and they are not liquid (meaning the bank cannot get those funds back on short notice). This causes a snow-ball effect known as a “run-on-the-banks,” where other clients of the bank also start demanding to withdraw their funds, not because they need it, but because they believe they may not get access to their funds when they do need it as they have lost trust in the bank.
Following the 2008 financial market collapse, regulations and policies in the US were amended, forcing banks to enhance and improve their internal risk management systems by keeping more funds in liquid, lower risk investments as a buffer for such liquidity demands. This of course meant that banks were less profitable as liquid investments, associated with lower risk, deliver lower returns. These enhanced risk management requirements are also costly as more people need to be employed to ensure the bank complies with the regulatory requirements.
The Trump administration’s rollbacks
In 2018, the Trump administration rolled back these strict liquidity requirements for smaller and mid-tier banks, which included SVB. These de-regulation reforms meant SVB could, like the other small and medium banks, take on more risk with the deposits made by clients to enhance their growth. They especially took advantage of these relaxed regulations during the near-zero interest rate period in 2020 and 2021 (arising because of the Covid-19 pandemic), when most investments delivered lower returns for the same amount of risk taken.
Let us quickly break down this concept. As explained above, investors that deposit money with a bank, carry the risk that they may not be able to withdraw the funds when they need them. In exchange for this risk, the bank pays them interest which is linked to the repo rate – so if the repo rate goes down so also will the interest that they earn from the bank. This lower return via interest on their deposit does not, however, mean that the risk of the bank not being able to repay the funds is lower. In order for the investor to get the same return as before reserve banks lowered interest rates, they will have to increase their investment risk. Remember the golden rule – returns increase when risk increases.
During this period of lowered interest rates, SVB moved assets into higher risk investments to earn returns that matched their pre-covid returns – and they could, because regulations did not restrict them from doing so. They did so by increasing their exposure to longer-term government bonds since longer-term bonds carry higher risk. This is because a longer investment period means there are more uncertainties associated with the investment and therefore more risks.
The effect of interest rate hikes on bond prices
Fast forward to March of 2022 and the Federal Reserve Bank started to hike interest rates as a measure to manage rising inflation. When interest rates increase, bond prices in the secondary market fall. This happens because when interest rates rise, newly issued bonds offer higher yields, making them more attractive to investors than older bonds issued at previously lower rates. This causes the demand for older bonds to decrease, leading to a decline in their prices in the secondary market.
When bond holders of older bonds, who bought their bonds before the interest rate hike, want to sell these older bonds, they have to lower the price to make it more appealing for investors to buy. It is however important to note that this is only a risk when the bond needs to be sold in the secondary market, which will only happen when the bond holders need liquidity. When the bond does not have to be sold, the investor can simply keep it until maturity, earning the same yield as they would have when the bond was bought. Investors therefore only lose out on earning the full bond returns, or as it is also referred to, “yield”, when they have to sell the bond in the secondary market at a lower price.
SVB’s unexpected liquidity constraints
Now back to SVB, who bought longer term government bonds to increase their risk and therefore also their return during the near-zero interest rate period. Although interest rates were being hiked two years down the line, SVB should under normal circumstances, not have had major problems since they were not planning to sell these bonds in the secondary market. What they did not bargain on was that, due to aggressive interest rate hikes, their clients started withdrawing their deposits at a higher rate than expected and fewer new deposits were made. This happened because their clients, who were mostly tech companies, used their deposits to repay their higher debt costs while also struggling to raise new venture capital funding as the market had less appetite for risk in this higher interest rate environment.
SVB then announced that they sold a big part of their security portfolio at a loss of $2.25 billion, causing their share price to plunge as investors knew they would only do so if they had liquidity constraints. Clients quickly picked up on this, fearing that they may not get access to their own deposits, and so we saw a classic run-on-the-bank, with people queuing to withdraw their funds.
Lessons Learnt
The story of how SVB failed highlights how important the concept of liquidity is and how fragile the financial system is to changing interest rates. Banks play a significant role in financial markets but if their risks are not managed responsibly, including through appropriate government regulation, they can de-stabilise the market profoundly when things go wrong.
