Last week, two major banks collapsed: Silicon Valley Bank (SVB) and Signature. These were the second and third largest bank collapses in US history—the largest being Washington Mutual in 2008. Since I seem to be writing about finance this month, I wanted to try my hand at explaining why, for the reader who doesn’t know anything about finance.
Short answer: SVB placed a big bet long-term US treasury bonds and mortgage-backed securities. However, the prices of these assets went down. Companies with money in SVB were worried about it, so they started withdrawing a lot of money, requiring SVB to sell its assets at a loss until it was wiped out. Bank collapses tend to spread via a process called “contagion”, and Signature appears to be the first victim.
Really long answer: Okay, let’s walk through these concepts one by one.
First of all, what even is a bank? A bank is an institution that accepts deposits of money, we know that. But how does a bank pay you interest, pay expenses, and make its own profit besides? A bank basically borrows money from depositors and uses it to give out loans or make other investments. The bank makes money because its own investments give it greater returns than the interest they pay you on on your bank deposit.
You might think, why allow the bank take a cut? Cut out the middleperson, invest your money directly instead of depositing it in a bank. However, the bank account offers two distinct advantages: you are guaranteed your money back, and you can easily withdraw it at any time–with important exceptions to be discussed further down.
The ability to produce money on demand is called liquidity. If an asset is illiquid (meaning not liquid), that means that it may be difficult to sell on short notice, and you may suffer a loss from having to put on a fire sale. While depositors want their bank accounts to be completely liquid, the bank itself doesn’t need to be completely liquid. That’s because, generally speaking, depositors are not going to withdraw all their money at once. Banks need enough liquidity to cover the aggregate demand of depositors, but there’s a lot of room left for illiquid investments, which tend to have higher returns.
The way banks guarantee all your money back is by taking on almost all the risk themselves. Banks make leveraged investments, which means borrowing money (e.g. from depositors) to invest money. For example, suppose a bank makes a $100 investment with 10x leverage. They’re investing $10 of their own money, and $90 of your money. If their investment has a 10% payout, then they earn $10, doubling their money. If it had a 10% loss, they lose everything, and the bank becomes insolvent, which could lead to collapse. But it doesn’t really affect deposits unless the bank suffers more than 10% loss, in which case depositors might lose some money.
A bank run is a situation where lots of people try to withdraw their money all at once. This poses a problem for the bank, because they will have to sell off illiquid assets at a loss. Bank runs occur when people are worried that the bank will collapse, causing them to lose their deposits. So they rush to withdraw before the bank collapses–while also causing the bank to collapse.
To protect against bank runs, US banks have deposit insurance from the Federal Deposit Insurance Commission (FDIC). In case of bank collapse, the FDIC will take over, and depositors will be guaranteed up to $250k of their deposit back. This is usually enough to discourage bank runs. In return, banks must follow a bunch of regulations to manage their risk and liquidity–which reduces banks’ profits, but also reduces the probability that the bank will collapse.
SVB’s losses are attributed to its investments in US treasury bonds and mortgage-backed securities. Many people may recall that mortgage-backed securities played a big role in the 2008 financial crisis, but I’m here to tell you that it’s not the same. In 2008, the problem was that banks were giving out mortgages to people unable to pay–often fraudulently. Here, the problem doesn’t have to do with the mortgages themselves, and more to do with what they have in common with treasury bonds. So for simplicity, I’ll focus on the treasury bonds.
What is a US treasury bond? This is basically a promise by the US government to pay you a fixed amount at a later date. These are traditionally considered “safe” investments because the US government is unlikely to miss the payment (current threats from Republicans notwithstanding). However, when you buy a treasury bond, you’re still committing money now to get money later, and sometimes money now is more valuable. Prices of treasury bonds can go up and down based on the relative value of money now vs money later, and this can be amplified by the leverage that banks use.
The price of treasury bonds is predominantly controlled by the US Federal Reserve (“the Feds”). Typically, this is described as the federal interest rate. The interest rate describes the size of the final payout relative to its current price, so a higher interest rate implies cheaper bonds. This retroactively affects the price of all bonds, as well as other comparable investments with fixed-money payouts.
In the past year, the Feds increased interest rates from less than 0.5% to about 4.5%. This is a matter of monetary policy, used to stabilize the economy. Rising interest rates are a common response to inflation, the rising cost of goods. So ultimately, this is likely caused by the war in Ukraine, which reduced the global supply of oil, which makes it harder to produce stuff. And now there’s too much money relative to the amount of stuff to buy with it, so stuff is more expensive, and that’s inflation.
How do interest rates mitigate inflation? Interest rates are effectively the floor on investment returns, because if your investment doesn’t give you enough returns, you may as well have bought treasury bonds instead. Treasury bonds differ from other investments, because other investments leave money circulating in the system, while treasury bonds remove it from the system. Thus, higher interest rates reduce the supply of money. Another way of putting it, it encourages you to save your money instead of spending it on all that stuff we don’t have enough of.
Rising interest rates are typically said to benefit banks. Cheaper bonds means banks have easy access to investments with better returns. The exception is if the bank bought long-term bonds while they were still expensive, before the interest rate increased. Banks are not supposed to gamble on the interest rates staying low forever, they’re supposed to balance their risks by also investing in other types of assets that do well in case of interest rate increase.
So what happened at SVB? SVB, as a bank, specializes in venture capital depositors. Venture capitalists raised a lot of money for startups 2020 and 2021, and SVB’s total deposits increased from $49 billion in 2018 to $189 billion in 2021. This is likely related to the pandemic… but I admit I don’t understand why venture capitalists got an increase of funds during the pandemic rather than a loss of funds. Given the large increase in deposits, SVB had to find investments relatively quickly, and apparently that included a lot of long-term treasury bonds and mortgage-backed securities. Long-term bonds were a bit cheaper than short-term bonds, perhaps because many people in the market expected interest rates to increase in the future–but apparently SVB wasn’t worried, or not worried enough.
Then in 2022, startups lost a lot of funding. I’m not sure why, but it’s probably also ultimately caused by inflation. So the combination of bond prices going down, and increased withdrawals caused SVB to be low on liquidity. SVB tried to raise money, but failed, and instead spurred a bank run. (And from what I hear, it doesn’t help that some venture capitalists are on Twitter.) While bank runs are usually prevented by deposit insurance, venture capitalists generally have a lot more than $250k in the bank, so according to some estimates, only about 3% of deposits were covered by insurance. This is much lower than the typical amount (35-50% for large US banks).
In response to SVB’s collapse, we’re going to hear about possible bailouts. In this case, the primary beneficiaries would not be the bank (whose stockholders already lost everything), but rather depositors. So, venture capitalists, mostly. No love for the venture capitalists, but if startups missed payroll for employees, that could cause some hardship. But personally I’m not convinced that bailouts will be necessary. If depositors recover 80-90 cents on the dollar, I’d be okay with that. I know all this banking stuff is pretty obscure to you and me, but venture capitalists really should be aware of and prepared for these risks, that’s part of the job.
The main reason to consider bailouts is to prevent contagion—the infectious nature of financial collapse. There isn’t any single mechanism for contagion, but if people think depositors won’t recover all their funds, they might be looking at their accounts with weaker banks, and wondering if they ought to withdraw before a bank run occurs—causing another bank run. Signature was looking particularly weak because, well, it had invested in crypto. Not coincidentally, the other major crypto-invested bank, Silvergate, also collapsed two weeks ago—although it was a much smaller bank.
There are also other policy implications. Most banks in the developed world outside the US are subject to Basel III regulations, an international standard which includes minimum liquidity requirements. For some reason (*cough* Trump *cough*) “small” US banks are exempt from a lot of regulations. SVB was the 16th largest bank with $200 billion in deposits… so that’s small enough, right? It remains to be seen if SVB was uniquely bad at managing risk, or if similar problems will be revealed at other banks.
In summary: In response to inflation, the US Federal Reserve decided to reduce the supply of money. SVB had poorly managed its risk, placing a large bet that this would not happen. Politicians may talk about bailouts, although perhaps the correct response is better bank regulation.
Pierce R. Butler says
… I don’t understand why venture capitalists got an increase of funds during the pandemic …
Just about everything internet-related got a big boost from the pandemic “lockdown” – and took a big hit from the return to “normality” (hence most of the recent tech-sector layoffs).
… in 2022, startups lost a lot of funding.
Most businesses, but especially new ones, rely heavily on loans. When interest rates (aka “the cost of money”) went up – as anyone watching the federal pandemic spending jump and the inevitable Federal Reserve response could predict – those businesses faced increased hardship across the board. The war in Ukraine may have played a part by raising some commodity prices, but in the US it also led to more military-industrial complex spending, typically an economic booster (at least in the short term).
… perhaps the correct response is better bank regulation.
Yup – Senator Warren has some good ideas about that.
Pierce R. Butler says
A good SVB summary here (via Digby.
@Pierce R Butler,
Thanks for the additions and the article link!
I heard last night on my local TV news that my now “senior” senator, Josh Hawley (I’m not to blame for him, I promise), is advocating for a return of Glass-Steagall. 😎
I didn’t hear anything about it on DW News, BBC World New America, or NBC Nightly News (and I didn’t catch the PBS Newshour); so I guess nobody is paying any attention to him, which is generally a Good Thing, although this time he’s probably right for the wrong reasons.