Credit: Kyle Calzia
Stakeholders and financial systems alike are still reeling from the collapse of powerhouse lender Silicon Valley Bank (SVB). Weighing in as the 30th-largest bank by assets at the end of 2022, according to Federal Reserve data, its failure constitutes the second largest bank failure in U.S. history. So, how did we get here? Before we dive into a detailed analysis of SVB’s holdings and ultimate failure amidst unusual regulatory trends, this article will summarize some of the key U.S. legislative and regulatory developments that helped set the stage upon which this drama unfolded.
The Dodd-Frank Act
In the years leading up to the 2008 recession, the U.S. had been increasingly deregulating the banking industry, and financial services firms began to take risky gambles on questionable loans. As a result of such activities, the U.S. housing market experienced an unprecedented bubble starting in 2008, ultimately crashing stock markets, collapsing the bond market, and wreaking havoc on the banking industry. The 2008 financial crisis led to major legal reforms, the most influential of which is the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”), intended to restore stability in the U.S. economy and prevent a similar crisis from occurring again.
In 2010, Congress enacted the Dodd-Frank Act, which implemented new regulations for banks and financial institutions. In addition, the Act revamped several existing regulations: adding new protections for whistleblowers under the Sarbanes-Oxley Act of 2002, tightening investment requirements under the Investment Company Act and Investment Advisers Act of 1940, and creating new oversight frameworks under the Securities Act of 1933 and the Securities Exchange Act of 1934. The Dodd-Frank Act also implemented new regulations for banks and financial institutions, increasing industry oversight in five major ways.
Primarily, The Act created The Consumer Financial Protection Bureau (CFPB), which protects consumers from certain financial products such as vague or risky consumer loans, student loans, and banking fees, of which consumers rarely understand fully. Consumers are also permitted to submit complaints to the bureau, which can fine lenders who violate its regulations.
Additionally, The Act empowered the Financial Stability Oversight Council (FSOC) to aid in preventing another “too big to fail” catastrophe. The Council monitors individual firms in an effort to prevent them from becoming so large or important to the economy that their failure would result in country-wide economic turmoil. The council consists of officials from the Federal Reserve and Treasury Department and can even “break up firms that pose major risks to the economy.”
The Dodd-Frank Act also required the Federal Reserve to monitor large financial institutions, including banks and insurance companies, and mandated that banks undergo stress tests annually to ensure that they were prepared in the event of an economic downturn. Each stress test evaluates the impact different financial “shocks” would have on the institution’s stability. The Federal Reserve has the power to suspend some of the bank’s actions, such as a bank’s ability to buy back shares or cap dividends, to ensure that the bank can survive such shocks.
Another important consideration is the Volcker rule within the Dodd-Frank Act which impedes banks from engaging in risky investments that arise from using the bank’s own funds to make a profit. The rule limits banks to trading only when necessary to run their business or when working as an agent for their customers.
Lastly, The Act tasked the Commodities Future Trading Commission (CFTC) and the SEC in overseeing derivatives transactions known as swaps. In other words, the Act allows these regulatory authorities to regulate trading involving, inter alia, bonds, commodities, currencies, interest rates, market indexes, and stocks.
The Financial Industry Regulatory Authority
In 2007 the National Association of Securities Dealers (NASD) and the member regulation, enforcement, and arbitration operations of the New York Stock Exchange (NYSE) merged with one another in order to streamline oversight and reduce the complexity of compliance. The consolidation created what we know today as the Financial Industry Regulatory Authority (FINRA). This independent regulatory body coordinates the testing and licensing of all financial professionals in the United States, regulates some aspects of the stock market, and works with the Securities Exchange Commission (SEC) to enforce regulations. FINRA regulates the trading of equities, corporate bonds, securities futures, and options. These regulations aim to ensure that transactions are fair, client investments are protected, and financial professionals don’t mismanage funds.
Modern FDIC Coverage Limits
Another investor protection mechanism was reinforced at the peak of the Great Recession when the Emergency Economic Stabilization Act (EESA) was signed into law by President Bush, temporarily raising the Federal Deposit Insurance Corporation (FDIC) coverage limit to $250,000. In addition to beefing up existing regulations and constructing additional protections, in 2010 the Dodd-Frank Act memorialized the FDIC’s increased investment coverage limit of $250,000. This is a per depositor, per ownership category, per FDIC-insured institution coverage, meaning that a person’s or entity’s investments at any such bank are covered up to the limit.
While the Dodd-Frank Act played a large role in correcting the 2008 collapse, and the Great Recession faded into the rearview mirror, the industry was left bearing the weight of the Act. Proponents of the Act championed efforts to further insulate the market while opponents critiqued the Act’s continued implementation and highlighted its impact on the market. While many of us remember the dark days of the Great Recession vividly, the public memory faded in its newfound, hard-earned tranquility.
Deregulation under the Trump Administration
Believing that modern oversight and legislation was too restrictive, the Trump Administration endeavored to weaken the restraints placed upon the financial industry by exempting certain banks, including small and regional banks, from many regulations. A bill signed by President Trump in 2018, called the Economic Growth, Regulatory Relief and Consumer Protection Act, removed some of the oversight capabilities that regulatory bodies had previously wielded over large banks and weakened the requirements for stress tests. The Trump Administration legislation also changed the Volcker Rule, allowing banks to make investments in venture-capital funds and lowering the capital requirements that banks were mandated to meet.
Additionally, as a result of political pressure from the Trump administration, the former director of the CFPB, Richard Cordray, resigned in 2017, and his replacement, Mick Mulvaney, further loosened banking restrictions and fully replaced the twenty-five member advisory board.
Recent deregulation, unprecedented world-wide phenomena like the pandemic, and rapid inflation alongside soaring growth in technology and other sectors provided slippery footing upon which inattentive banks, like SVB, were unknowingly teetering.
The Rise of SVB
Founded in 1983 over a game of poker, SVB aimed to capture the growing financial needs of Silicon Valley’s thriving technology and innovation industry. As venture-backed startups grew, so did SVB. In fact, from 2020 to 2022, the bank experienced a significant increase in its deposit base, nearly tripling from $60 billion in 2020 to an estimated $175 billion in 2022 – far outpacing its rivals. As a testament to its success, SVB’s clientele in 2021 and 2022 encompassed a staggering 50% of all venture-backed technology and life science companies.
This influx of deposits was fueled by record-setting years for venture capital during the COVID-19 pandemic. In 2021 alone, venture funds raised an unprecedented $330 billion, effectively doubling the previous year's record. Dubbed as the “age of easy money,” interest rates remained historically low and deposits skyrocketed.
As deposits in the bank swelled, the question for SVB loomed: what to do with all this excess cash? Confident that rates would stay low, SVB channeled their venture-backed dollars into seemingly safe long-term government issued bonds—a decision that would ultimately prove to be its undoing.
A Bonding Experience Gone Wrong
Before diving deeper, it is important to first understand how bonds work (if you are comfortable with your understanding, feel free to skip ahead to “The Perfect Storm”). A bond is a fixed-income security issued by entities like corporations or governments to raise capital. Like a loan, the issuer borrows money from investors and promises to repay the principal through periodic payments over the security’s life. In essence, bonds provide a steady, predictable stream of income in the form of interest payments allowing banks like SVB to profit from the difference in interest received and paid out. The higher the bond yield, or annual rate of return, the more profits generated.
While bonds, especially those issued by the government, are thought to be lower risk (at least compared to equity securities) and sometimes even “risk-free,” there are inherent risks, namely interest rate risk.
What happens when interest rates rise?
Bonds have an inverse relationship with interest rates; as rates rise, bond prices fall. This is primarily due to the economic forces of supply and demand. When interest rates rise, bonds that were issued at the lower rates decrease in value and become less attractive, leading to price discounts.
The magnitude of a bond’s price sensitivity to the changes in interest rates can be measured by its “duration.” As a general rule, when interest rates rise, bonds with longer durations tend to experience a greater drop in price compared to bonds with shorter durations. There is a tradeoff, however. Bonds with longer terms typically have higher yields to compensate for the increased risk.
The Accounting Trick
Everyone’s favorite subject, we know. But bear with us. Falling bond prices are typically not a problem unless banks intend to sell. For this reason, securities, such as bonds, can be held as either available-for-sale (AFS) or held-to-maturity (HTM) with the key difference being how the changes in bond value are reported on balance sheets. HTM securities are reported at cost whereas AFS securities are reported at fair market value. This distinction puts banks in a difficult situation when left with depreciating securities. If a bank ever needed to raise funds by selling bonds, it would need to appraise them to market values transforming unrealized "paper losses" into tangible losses.
By the end of 2022, the FDIC estimated that the banking industry held approximately $620 billion in unrealized losses. For SVB, this amounted to an unrealized loss of roughly $16 billion, nearly equivalent to its equity value. However, in an email, former SVB CEO Dan Beck prophetically asserted:
There are no implications for SVB because, as we said in our Q3 earnings call, we do not intend to sell our HTM [held to maturity] securities.
The Perfect Storm
No surprise, SVB did need to sell their securities. While a majority of SVB’s holdings were indeed HTM securities, they were faced with a growing problem. Venture capital funding had fallen 30% in 2022 compared to the prior year, yet client cash burn remained elevated. This imbalance meant that new deposits weren’t replenishing cash outflows, placing SVB in an unsustainable position.
Needing funds urgently, SVB revealed plans to raise capital, announcing that it would take a $1.8 billion loss on the sale of $21 billion of securities and an intent to raise an additional $2.25 billion through equity offerings.
In response to this, the market crashed, investors fled, and depositors panicked. Compounding the already tense situation, 94% of SVB’s depositors exceeded the FDIC’s $250,000 insurance limit, making them prone to flight at the first hint of trouble. In one day, SVB’s customer base withdrew $42 billion in what is being deemed as a case of “viral panic spreading.” A former SVB executive highlighted the irony, noting that the "biggest risk" actually came from the concentrated group of undiversified investors exhibiting “herd-like” behavior, the same group that had earlier fueled SVB’s remarkable growth.
“Calm” After the Storm
SVB collapsed March 10, 2023. The institution’s domestic operations were subsequently placed under the control of the FDIC before First Citizens Bank announced their intent on March 26 to purchase the remaining assets, deposits, and loans. First Citizens has since taken over roughly $119 billion deposits, and $72 billion of SVB's loans at a $16.5 billion discount. The FDIC will continue to hold roughly $90 billion of securities and other assets.
SVB’s collapse sent shockwaves across the financial industry: small and local lenders and banks were pressed, the bond market swung wildly, and interested parties have been calling for the Federal Reserve to dial back its interest rate hikes, despite persistent inflation. These calls fell on deaf ears, however, as the Federal Reserve announced another 25 basis point interest rate hike Wednesday, March 22, 2023, raising the rate from 4.75% to 5%, the highest it’s been since 2007. One basis point, a common unit of measure for interest rates and other financial percentages, equals 1/100th of 1%, or 0.01% (and .0001 in decimal form). While we have seen higher rates in the last half-century, these hikes land a heavier blow than normal due to the incredibly low interest rate environment enjoyed over the last several years. This increase, the ninth consecutive rate hike in a row, is meant to further discourage inflation by increasing the cost of borrowing, which can slow the economy and bring about recessive tendencies.
While there was some speculation that the Fed would pause rate hikes amidst recent bank failures such as SVB, Chair Jerome Powell has repeatedly said that price stability is the central bank’s “overarching focus.” Accordingly, while the impact of SVB’s failure is likely still ringing in the ears of stakeholders, hopefully prompting some internal reviews, it seems unlikely the Fed is intending to change course in any immediate fashion.
Please check out more on the SVB Collapse series below.
*The views expressed in this article do not represent the views of Santa Clara University.