A business may be profitable but it can still be wiped out by liquidity problems - that is, not having sufficient cash to meet immediate requirements. This is especially important for banks. If all customers were to turn up suddenly at commercial banks and demand to withdraw their deposits, all such banks in the world, including all the strongest ones, will collapse. This is because when customers place their deposits, the bank will keep a certain amount in their reserve account with the central bank (as required by regulation), invest some in low earning liquid assets, and the balance loaned out to borrowers or invested in non-liquid assets in order to earn enough to pay interest to their depositors and make some profit.
Banks keep a certain amount of currency notes for day-to-day needs of their customers. In a bank run, these currency notes run out very fast. The bank then uses their money in the reserve accounts to requisite more currency notes from the central bank. If this is not enough, the banks sell their liquid assets. Still not enough, the central bank allows the bank to draw on temporary credit facility in exercise of their lender of last resort function. This occurs only if the bank is viable and the the situation is seen only as a liquidity problem. Bank runs occur often due to rumours. When the situation is clarified and trust returns, the bank run stops. Because the withdrawal is in physical cash, it takes a long time to clear the queues. In addition, even under normal conditions, there is also a limit on maximum cash withdrawal. Large retail and corporate accounts would need to withdraw by transfers or cashiers orders which require a couple of days for clearance. There is sufficient time for the bank and the authorities to clear the rumour and bring trust back.
In today's digital world, electronic banking and online apps enable depositors to move their funds out in seconds. Thus in a bank run, such services would immediately be shut down as it would lead to an immediate collapse of the bank. We saw this with crypto exchange platforms where withdrawal apps were shut down immediately in a run. As I understand, SVB operation is not very high tech, so they most probably have no online banking apps. This makes sense as they are not in the retail business.
SVB financial highlights (US$) :
Cash -- $14b
Securities -- $120b
Loans to customers -- $74b
Equity -- $16
Customers' deposits -- $173b
Borrowed -- $19b (short term - $14b)
On paper, SVB is solvent. It has enough assets to settle liabilities with equity still intact.
Of the securities, $91b are in their HTM (hold-to-maturity) portfolio. These are securities that will be held till maturity when they will be repaid at face value. Accounting treatment of HTM securities is to book at cost. There is no mark to market. A valuation would have shown the portfolio has an unrealised loss of $15b. This would have almost totally wiped out its equity, but SVB remains solvent on paper.
It's loans of $74b are to a few market segments, primarily tech sector, start-ups, and venture capitalists.
SVB business model :
The bank started in 1983 to concentrate only on the tech sector. It rose very fast with the dot com boom to later suffer big losses in the dot com burst. It then rebuilt its business on the private equity ecosystem. The era of cheap money saw great wealth amassed by the few. More billionaires were born whose money has to go somewhere. Most end up in the stock and real estate markets causing asset valuations to soar. With too much liquidity chasing higher yields, money then poured into the higher risk private unlisted companies. Soon investor money found a new darling in the tech start-up sector. It's a good marriage of the filthy rich investors and the money gobblers of tech start-ups which use the 'cash and burn' business model. As the private equity capital market boomed, SVB rode on its back and expanded rapidly to become the 16th largest financial group in US.
Start-ups have no revenue and normal banking credits are not available to them. SVB helps put up some seed capital collateralised on founders' shares. It connects founders to its network of private equity capitalists. These start-ups then work their way up the funding timelines till they IPO. This way, SVB became a key player in the start-up sector and customers it helped continued to bank with it after IPO. By 2022 about 56% of all tech start-ups in the US, both in incubation and those that IPO'd, bank with SVP.
Commercial banks invest heavily in promotion to build up their deposit base. Customer deposits is a crucial source of funds. SVB has no need to attract depositors. When their start-up customers receive funding, they deposit their cash with SVB in non-interest bearing current accounts and some in time deposits. Each funding round is in the tens to hundreds of millions. Almost all these start-ups bank only with SVP which end up having cash like manna from the skies.
Flushed with depositor money, SVP has to make the money work. SVP's charter is a commercial bank but it does not operate as one. It is more a special purpose bank. The bank simply put a big chunk of their money (57%) into securities. It does some commercial lending in a selective market segment (35%). In short, SVP basically lived off fixed income from their securities portfolio. Which is pretty much a low risk operation.
In the 2 years 2020 and 2021, SVP deposit money increased by an astounding $127b. The reason is simple. The pandemic drove start-ups to require more cash so more funding rounds took place. Interest rates have already been very low, but with the pandemic, rates were further lowered to spur the economy. With Treasury bills at almost zero rates, SVP was forced to invest in longer term securities to seek higher yield. With a normal yield curve, the longer term bonds have a higher interest rate. SVP securities portfolio has an average term of 10 years at average rate of 1.56% pa.
Risk management failure :
For 8 months SVB had no Chief Risk Officer after Laura Izurieta left April 2022, at the inopportune time when the yield curve reversed. The new CRO Kim Olson only came on board January 2023.
Going into 2022, SVB had 3 challenges on hand:
(1) A liquidity problem due to high cash out by start up depositors experiencing private equity capital pull back. It must quickly arrange for liquid assets to meet increased withdrawals. What did they do? The bank arranged $15b short term loan. This can be seen in their liabilities of $19b borrowing which included $14b balance of the short term loan. The funds borrowed is reflected in the Cash balance of $14b. With no bank run, they bought themselves enough time and safety net.
(2) An interest rate problem that's hurting the bottom line. SVB had non-interest bearing customer deposits of $81b which is cost free. The balance $92b is interest bearing. Due to an upward movement in interest rates, the bank experienced higher cost of funds. If we use a 3-month term deposit as example, the interest rate is about 3.88% pa. Since their fixed income on securities average 1.56%, that means with every $1 earned on the investment of the $92b deposit, SVB is paying out more than $2 in interest. They were staring at huge interest losses.
(3) A valuation problem of unrealised losses on their HTM securities portfolio of $91b. With portfolio average rate of 1.56% and short term Treasury Bills now at 4.7%, the portfolio carries an unrealised loss of about $15b. The bank has 2 options:
(a) Hold to maturity. Unrealised losses on HTM securities is not recognised in the profit & loss. By holding to maturity, the bank will eventually recover the full face value. But in the meantime, the assets are low return fixed income earners and the bank suffer interest losses; or
(b) Rebalance the portfolio. Sell the securities, recognise the losses immediately, but invest the proceeds in higher yielding shorter term securities. They suffer valuation losses in the year of sale, but fixed income interest earnings improve in future years.
In summary, SVP took on short term debt of $15b, sold long term securities of $21b which as expected, wrote off losses of $1.8b. It took further steps to shore up capital by arranging to issue $2.25b worth of new shares.
In reality, SVP did everything right by the book but nobody is talking about this. On Wednesday Mar 7, the bank was still solvent. So why the bank run and the collapse?
Wrong reasons for the bank run :
Leaving aside the bigger macro issues of the economy, there are 3 reasons you hear and read about which are all wrong. These are -
(1) Massive withdrawals by depositors caused the bank run.
Wrong.This is putting the cart before the horse. The geeks from the tech start-ups do not have their focus on the banking scene. They had no difficulties drawing for their payroll or other bills prior to the run. There was no cause for concern up to Thursday morning Mar 8.
(2) SVB's huge exposure to start-up tech companies is a huge risk that worried investors.
Wrong.This turns on it's own head. The bank has a small loan exposure to the sector, but it is actually holding $174b of the money of start-up customers. The tech start-ups together has a $174b exposure to the bank. The credit risk is actually the other way round.
(3) The securities loss of $1.8b and new share capital issue of $2.25b spooked the market.
Wrong. The bank balance sheet is still relatively strong. With balance sheet size of $212b it can absorb the loss. The $1.8b loss would normally have seen a slight price correction, not a 60% drop in one single day.
How the bank run occurred :
It's the investors who watch market development, not the geeks in the start-up companies. Primarily, it was Peter Thiel, the Paypal founder. Thiel runs the venture capital Founders Fund. Shortly after SVB announced the $1.8b securities loss and capital issue of $2.25b, Thield advised all his portfolio companies to get out of SVB. Thiel was soon followed be a few other big VC funds who also asked their portfolio companies to dump SVP. The fund managers' advice amounted to fear mongering which triggered the big sell down. These are all big boys and their mass exodus caused the SVB price to tumble 60% last Thursday. Shares tumbled in like manner as the shorting of Adani's company. For all we know, don't be surprised Thiel shorted SVB big time.
By Thursday afternoon, depositors saw the developments in the equities market and rushed to get their money out. It was panicky investors who caused depositors to rush to the bank, not a bank run that caused the share prices to drop.
