What Actually Went Wrong at Silicon Valley Bank?

Silicon Valley Bank (SVB) is the second biggest banking failure in America’s history, biggest retail banking failure after Washington Mutual Bank back in 2008. To understand the demise of this giant bank, lets first try to understand how banks work?

Business Model of Banks

From a common point of view, bank is a place where an individual keeps its hard-earned money to keep it safe and, to earn some extra amount on it in the form interest. Bank becomes the custodian of that money and owes the customer a debt. The bank can then use that money to earn income by lending it out to borrowers or investing it in financial markets. The primary sources of revenue for a bank include:

Interest income, Fee and Commissions, Trading Income, Investments and Asset Management Services. Overall, banks generate revenue by providing financial services and consultancies that individuals and businesses need to manage their money and grow their wealth.

Banks diversify their investments and generally have a large portfolio to avoid any out of the blue situation. Banks also invest the money deposited with them in stock market, government bond etc.

SVB Case Breakdown

SVB founded by Bill Biggerstaff and Robert Mederais back in 1983, has key offices in Santa Carla, California to focus on the needs of startup companies.

“Do not put all your eggs in one basket” a famous saying means as an investor you should not invest in one sector as one could lose everything.

In 1990s SVB’s 50% of the portfolio was made up of real estate business and in 1992, California’s real estate market crashed terribly. SVB realized significant losses, roughly $2M, in this market downturn, but after this, the bank became aware of this mistake and started diversifying their investments.

As discussed earlier, this bank primarily focuses on investing in startup companies especially tech startup and it has becomes its signature as well.

Wrong Judgement; Investment Decision

During the global pandemic, in March 2021, bank’s deposits reached to around $125 billion (according to The Economic Times), a 100% increase as compared to other banks and this was the turning moment for the bank as they decided to invest a huge percentage of their deposits in government bonds. The bank bought them at the time when interest rates were around 0.1%-0.25% and they expected that the interest would remain low but due to inflation government increased the interest rates. As interest rate and price of bond are inversely related so, due to increase in interest rate, the value of their bond holdings started to fall. On the other hand, the depositors wanted to withdraw their deposits as interest rate were high so they wanted to use their saved money so as to avoid loans and interest payments. Because of this, bank sold their bonds on $1.8 billion loss to meet the requirements of the depositors. Remember, banks do not hold money in cash as they invest it. So, as soon as this news broke out it had a huge impact on the bank's share price as well as the depositors rushed to withdraw their amounts. But, till this point it became impossible to avoid collapse as they lost billions and did not have enough money to meet the requirements.

Every country’s central bank has set some percentage which is obligatory for banks to keep in the form of cash and need to reserve it with central bank. In this case, the depositors were insured for only $250,000 but it is not enough because most of this bank’s customers are tech companies obviously with the deposits of millions of dollars.

Conclusion

At the end of the day, it’s all about bad decision making as, bank does not involve in any illegal activity with the deposits. But, they repeated their 90s mistake and put a large chunk of their investment in one area. To avoid such mishaps, for an individual too, diversification of investment capital is very important.