The Fall of Silicon Valley Bank: A Caution

2023-11-30 13:28:47

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Silicon Valley Bank (SVB) was a renowned financial institution that was taken over by federal regulators on March 10, 2023.

This article examines what happened to cause the bank to fail so spectacularly and the financial lessons we can learn from its downfall.

SVB primarily served technology and innovation-focused companies such as start-ups. She became the 16th largest bank in the United States, having tripled in size between 2019 and 2022.

How did this happen?

In a short time, the bank tripled in size, meaning many businesses had deposited their money in the bank.

As of December 31, 2022, the bank had assets of $209 billion and deposits of $175 billion. They decided to buy primarily Treasury bonds (US government bonds), considered a low-risk investment. The bank would receive interest payments on the bonds every six months. This would not have been a problem if interest rates had remained low.

To clarify this, here is a simplified explanation of how this happened. SVB used all its money to buy Treasury bonds. These were made up of $175 billion in customer deposits and $34 billion in cash they had on hand. In this simplified scenario, let’s say they invested in a Treasury bond, with a coupon (interest rate) of 2% and a maturity of 20 years.

So $209 billion at 2% would provide interest of $4.18 billion per year, or $2.09 billion every six months, for the next 20 years. At maturity, the principal amount ($209 billion) would then be repaid to the bank. As long as the bank does not sell the bond and holds it until maturity, there is no problem for them. However, what happens when she needs to have money available if her clients decide to withdraw their funds from the bank?

Rising interest rates

This is what happened to SVB. It all started with interest rates rising in the United States to combat inflation. For a very long time, rates remained near zero, but they started to increase, reaching 0.5% in March 2022, and in July 2023, they rose to 5.5%. If we take the example of the bond above that pays 2% to the bank, we can see that it is no longer as attractive to the bank. If she were to go into the market and buy bonds now, the bonds would earn her much more interest than before.

The Treasury bonds that SVB purchased were now less attractive than other bonds available in the market. This wouldn’t be a problem if they didn’t sell them, but unfortunately for the bank, many of the bank’s customers needed to withdraw money at the same time. Indeed, market conditions were worsening, which was also triggered by sharp rises in interest rates, signaling the end of the availability of cheap money in the system.

Sale of assets at a loss

SVB now had to sell assets it owned in order to get money to be able to pay its customers who needed their deposits back. 1is February 2023, the rate rose to 4.75% from 4.50%. In our example above, SVB had to sell some of its Treasury bonds. However, the coupon on the bonds was only 2%. As such, they were not considered as valuable as other bonds now available with a 4.75% coupon. To rebalance the value of the bond, the price had to fall, so that the yield would match the current market rate of 4.75%. In our example, the price should have fallen as follows.

The bank has $209,000,000,000 at 2%

For the yield to match 4.75%, the price would have to fall.

Yield = coupon amount/price

If we want the yield to be 4.75%, then:

4,75 % = 2 % / prix

Price = $42.105 (multiplied by 100, because the initial price of a bond is 100)

In this example, we can see here that the price at which SVB could have sold this bond in the market, taking into account the change in the interest rate, is less than half of the price at which it bought it. She bought it for $209 billion, and if she sold all the bonds it would only:

$209 billion x 42.105% = approximately $88 billion

If the bank had held the bonds until maturity, it could have continued to receive interest and would have received the $209 billion at the end. Of course, she didn’t keep a $209 billion bond, but had a large bond portfolio. In reality the situation was more complex, but what was illustrated above with the price drop could have happened to most of their assets.

Losses and declines in stocks: a downward spiral

Now that the bank has announced that it has suffered heavy losses on its bond positions, the news has spread. This led to more of their customers wanting to withdraw their money from the bank, which led to a downward spiral. This also led to shares of SVB’s parent company, SVB Financial Group, falling, meaning their attempt to sell shares to get cash would make them less money and continue to drive down the value of shares. actions. There was no way to stop it. Ultimately, federal regulators took control of the bank on March 10, 2023.

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How did SVB not see this coming?

On March 17, 2022, the Fed began raising rates, to levels not seen since before the 2008 financial crisis. Indeed, rates had remained near zero except for a small hike before the COVID-19 hit, which then returned to near zero. So, interest rates were at historic lows, and the only possible direction was up. It seems that this fundamental fact has been overlooked by the SVB board, and moreover by the regulators.

What could she have done?

SVB should have anticipated that interest rates would eventually rise. It should have sold some of its Treasury bonds before the rate hike, when its bond prices were still high. However, if she sold the bonds too early before the 2022 rate hike, she would have missed out on the interest. It seems she didn’t believe in an imminent rate hike and got caught with her “metaphorical pants” down. She could also have purchased an interest rate derivative, which could have offset the drop in the price of their bond. However, interest rate derivatives are too broad a topic for this particular article.

Conclusions

In the complex world of finance, it is not just about the choices made, but the ability to predict and effectively manage the consequences of those choices.

In retrospect, the fall of Silicon Valley Bank serves as a stark reminder of the complex and sometimes treacherous nature of the financial world. While it may be tempting to view the bank’s catastrophic turn as an isolated incident, it raises broader questions about risk management and the ability to adapt to a rapidly changing economic landscape.

SVB’s spectacular growth in a short period of time and its reliance on Treasury bonds, while initially cautious, ultimately made it vulnerable to changes in interest rates. The bank’s decision to hold these bonds rather than diversify its holdings or use interest rate derivatives proved to be a costly mistake.

The rise in interest rates, which was not unpredictable given the historical context, left the bank in a precarious position. She found herself forced to liquidate her assets at a loss, setting off a cascade of events that led to a loss of customer confidence, a fall in stock values, and ultimately a federal takeover.

What SVB could have done differently remains a crucial question. Looking back reveals the importance of a more flexible investment strategy, one that takes into account potential interest rate fluctuations and their impact on bond values. The use of interest rate derivatives could have mitigated the risk of falling bond prices.

The story of SVB is a striking lesson for financial institutions and investors. It highlights the need for constant vigilance, adaptability and a willingness to use risk mitigation strategies even when everything seems to be going well. In the complex world of finance, it is not just about the choices made, but the ability to predict and effectively manage the consequences of those choices.

While the fall of Silicon Valley Bank can be seen as a cautionary tale, it is also a testament to the complex and ever-changing world of finance. Ultimately, what went wrong at SVB was a combination of factors, highlighting the importance of vigilance, adaptability and careful risk management in an industry where complacency can lead to disaster.

From the same author :

The Downfall of Silicon Valley Bank: A Cautionary Tale

Banking’s Quantum Leap: The Introduction of T+1 Settlement in the US Banking Industry

Sources:

Investopedia

Bankrate

Forbes

Photo credit : Minh NguyenCC BY-SA 4.0, via Wikimedia Commons

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