Far from wonderful strife at Silicon Valley Bank

Published in The Sunday Times on March 19th 2023.

Ever since the collapse of Silicon Valley Bank (SVB) there have been many parallels drawn with Frank Capra’s holiday classic It’s a Wonderful Life. Recalled more for its warm and fuzzy message about the value of love and family, the film's plot also touches on financial topics, such as the nature of banking.

A bank run occurs when depositors try to pull out all their money at once. As the movie explains, sometimes the cash isn’t immediately there because the bank has used it for other things. The most memorable scene shows the main protagonist, George Bailey, saying “The money’s not there!” as he tries to explain how deposits get rolled into other products, not just tucked away in a vault. 

The movie speaks to how much people don’t know about how banks work. It’s not clear to the people of Bedford Falls. They really think all their money is sitting there in the safe. They don’t stop to think how the bank is then able to distribute so much money as home loans; “It’s in Joe’s house” Bailey tries to explain.

Silicon Valley Bank was very niche

SVB was an unusual type of bank – not unique, but certainly within a very niche category. 93% of the deposits were corporates, which is unusual. And within those corporates, they were very concentrated in early-stage technology companies. That said, the SVB debacle reminds us how much of banking is a confidence game.

Matt Levine from Bloomberg explains this very well. Let’s say you open a bank with $10 capital. You receive $100 deposits (your liability) from customers for which you offer 1% interest p.a. You reinvest that money in a 3-year government bond paying 2% interest (your corresponding asset). So far so nice. The net interest income of 1%, ignoring costs, on a capital base of $10, is a decent 10% return on invested capital.

But what if the Fed raises short-term interest rates from 1% to 4%? The market interest rate on your liabilities (deposits) will probably go up. But your asset (bond) still pays only 2%, so it is worth less.

The simplified maths might show that a new 3-year government bond pays say $5 of interest per year for 5 years ($25 total), while your bond pays only $2 of interest for 5 years ($10 total). Your bond is worth about $15 less, so people would pay you about $85 for it.

There’s a difference between illiquid and insolvent

Your bank is losing money on interest rates, so your capital is slowly going down. But it is solvent: it has assets of $110 ($100 of bonds plus $10 of cash) and liabilities of only $100 (the deposits).

But if your bank put out financial statements showing that it had $85 of bonds (their current market value), it would be insolvent: it would have assets of $95 against liabilities of $100. If depositors realise the bank is insolvent and rush to take their money out, the bank would have to sell those bonds for $85. Then it really would be insolvent.

In simplistic terms, this is essentially what happened at SVB. It’s possible that it could have muddled through and been profitable if people had just kept their money in the bank. According to Bloomberg, its maturities were laddered (not all at 3 years as in the example above). The rates it had to pay on deposit weren’t going up that much. If people had just kept their money in, the bonds would have matured and been replaced by higher-earning bonds and SVB may well have been fine.

What may have been in the interests of the collective, were not in the interests of the individual. Depositors lost confidence. And the bank collapsed. 

The last crisis was driven by credit and liquidity risks

Since the great financial crisis in 2008, central banks spent years worrying about credit and liquidity risks, since these were at the core of the crash. Lehman Brothers was in OK shape on September 10th, 2008. Its Tier 1 capital ratio – a measure of a bank’s ability to endure loss – was reported to be 11%, almost three times the regulatory minimum. Five days later it was bankrupt.

The greatest change during those five days was investors’ faith in the company. One day they believed in the company. The next they didn’t and stopped buying the debt that funded Lehman’s balance sheet.

SVB’s problem was an interest rate risk one. It did not make bad loans to bad borrowers and so regulators fighting the last war failed to notice. 

Confidence would probably not have saved Lehman, as its problems were more solvency than liquidity. But it certainly played a pivotal role in the demise of SVB. But confidence is the one thing that is hard to quantify, hard to model and hard to predict. As a fund manager friend once opined: “Banks are expensive at every price.”

The repercussions of the SVB collapse may well be limited. It’s too early to say, though market movement in Credit Suisse shows what can happen when investors lose faith. At times of heightened capital market volatility there’s a very fine line between stupid and clever decisions. Stick to core principles, which should be to avoid overreacting and don’t try to catch any falling knives.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.