Silicon Valley Bank Collapse Explained: What Happened?

Silicon Valley Bank Collapse Explained: What Happened?

It was one of the largest banks in the United States and the biggest bank in Silicon Valley based on deposits and market share. However, on 10 March 2023, the Silicon Valley Bank collapsed. The California Department of Financial Protection and Innovation specifically shut it down due to inadequate liquidity and insolvency.

The demise of this once acclaimed bank has been considered the second-largest bank failure in the history of U.S. banking. It also drew comparisons to the catastrophic banking crisis that rocked the world during the 2007-2008 Financial Crisis.

Nevertheless, the immediate impacts of the collapse were substantial. Streaming media company Roku revealed that some of its cash reserves amounting to USD 487 million were held in Silicon Valley Bank. Roblox Corporation and Vimeo were also depositors. Several startups were even left without a choice but to take out loans for their payroll.

Explaining and Understanding the Collapse of Silicon Valley Bank

The simplest reason behind the collapse of Silicon Valley Bank was a bank run. However, it is important to understand the specific causes and factors that triggered this bank run. What exactly happened to Silicon Valley Bank? What compelled its clients to withdraw their deposits? Why did it lack sufficient liquidity or cash to pay its depositors? What happened to the money of its depositors? How did the bank manage its deposits?

Background of Silicon Valley Bank

Silicon Valley Bank was a commercial bank that specialized in serving business clients to include startups, emerging organizations, and established tech companies.

The bank also lent to tech companies, provided multiple services to venture capital, revenue-based financing, and private equity firms with investment interest in tech companies, and rendered private banking services for high-net-worth individuals.

It also operated its own venture capital and private equity divisions. These divisions sometimes invested in its commercial banking clients.

The bank had 29 offices in the United States and other parts of the world including Canada, China, Denmark, Germany, Hong Kong, India, Ireland, Israel, the United Kingdom, and Sweden. These offices operated as full-service commercial banks.

It was considered one of the largest commercial banks in the U.S. and even one of the largest in the world in terms of deposits, market shares, and even earnings.

The bank had earned a favorable reputation. Startups were drawn to it due to its long history of catering to the needs of early-stage and high-growth companies. It also provided specialized and value-added services that benefitted emerging and established businesses.

It also had a reliable network of connections that helped startup companies access funding and connect with potential partners and investor.

Silicon Valley Bank experienced a period of steady growth in both deposits and revenues from 2002 to 2010. It even performed well during the 2007-2008 Financial Crisis and its revenue grew from 2013 and 2018 and exponentially grew further in 2020 and 2021.

However, in late 2022 and the beginning of 2023, the bank had an emerging problem involving earnings, liquidity, and poor investment decisions.

Relevant Events Before the Collapse

Banks earn money through service charges and management fees, by investing deposits to other securities, and through interest from their lending activities.

Silicon Valley Bank saw its revenues doubling between 2019 and 2021 due to the influx of deposits from new business ventures that emerged as part of the startup boom and due to the positive offshoots of the coronavirus pandemic.

The bank ended 2020 with around USD 60 billion in total deposits and this amount skyrocketed to about USD 200 billion by the end of the first quarter of 2022.

Nevertheless, with fresh deposits on hand, it had to determine the best option to maximize the earning potential of these deposits. It decided to take its usual route of investing in bonds and government-backed securities while keeping a small amount of deposits.

Banks in the U.S. were once required to observe fractional-reserve banking. This involved holding a portion of their deposit liabilities in liquid assets as a reserve.

However, beginning in 26 March 2020, the Federal Reserve announced that it was lifting its reserve requirement and that banks now have an almost free rein to lend out the deposits they hold or use them to invest in other assets or securities.

Silicon Valley Bank bought safe and long-duration bonds and assets. These were U.S. Treasuries and government-issued mortgage-backed securities.

Its investment decision were reasonable at the time it was made. The assets it bought were low-return albeit low-risk investment options that were ideal for investors with moderate to conservative risk profiles and longer investment horizon.

The coronavirus pandemic made low-risk and long-term investments such as bonds appealing to some individual and institutional investors.

Low-Return Investment and Inflation

Note that the assets that the bank bought had a fixed interest rate. This means it would receive the same interest rate regardless of the market condition.

Rates were low but suitable. These rates were determined in 2021. Long-termed assets were also ideal before because interest rates were kept low due to the expansionary policies under the coronavirus pandemic response.

However, it is important to note that newer bonds and money market assets later became more attractive to investors due to their higher potential returns.

The Federal Reserve, as the central bank of the United States, had issued several interest rate hikes as part of its monetary policy to combat the 2021-2023 Global Inflation Surge.

A central bank influences the interest rates of commercial banks and even the yields of bonds and returns of money market assets whenever it raises its base interest rate. Nevertheless, whenever this happens, bonds purchased earlier become problematic.

High inflation is the worst enemy of bonds because it erodes the purchasing power of the future cash flow of an entire bond portfolio.

Inflation and interest rates also tend to move in the opposite direction from bond prices. Silicon Valley Bank was locked in long-duration bond investments with fixed rates and low yields. This should not be a problem if it did not need cash to service its depositors.

Deposit accounts earn interest. The series of base interest hikes made to combat inflation had also induced banks to pay their depositors with higher interest.

Silicon Valley Bank fundamentally needed cash to sustain its deposit liabilities. What happened was that the bank was earning far less from its low-return investments while incurring higher obligations to its depositors.

Investors were also not too keen to purchase the bonds it held because its entire bonds portfolio became less attractive and even worthless compared to other investment options.

Liquidity Problem Due to Bank Run

A bank run occurs when a large number of depositors, often in large groups, decide to withdraw their money from several banks or a single bank at the same time.

Silicon Valley Bank did not expect a bank run but it was still aware that it needed liquid assets because the worsening economic condition had increased instances of partial withdrawal orders from its startup and other business clients.

The bank decided solved its liquidity issue. However, while this should be a good strategy, the manner in which it raised cash was a main factor behind its eventual collapse.

Fears drive depositors to rush to their banks and close their accounts. This is what happened to Silicon Valley Bank. Its depositors became concerned about the safety of their deposits after getting wind of its brewing financial problems and investment dilemmas.

The bank specifically announced on 8 March 2023 that it had sold USD 21 billion of its investment portfolio at a loss of nearly USD 2 billion.

It also announced that it would be raising USD 2.25 billion in equity and debt to resolve its balance sheet woes. Remember that the bank had kept minimal portion of deposits as its reserves because it invested most of its cash in long-term assets and securities.

Nevertheless, the announcement triggered panic among several venture capital firms, with some advising businesses to withdraw their money from the bank.

Public trading of Silicon Valley Bank was halted. This was another blow because it meant losing another option to raise capital quickly. The series of events prompted depositors to withdraw their money until the bank became insolvent.

State regulators eventually shut down the bank on 10 March 2023 after agents determined that it did not have enough cash and immediate access to cash to pay its depositors.

Reasons Behind the Collapse of Silicon Valley Bank in A Nutshell

Bank run is the main reason behind the collapse of Silicon Valley Bank. However, there are more specific factors contributing to its catastrophic downfall.

The bank made investment decisions that used to be suitable for the time they were made but later became inapplicable because of the changing landscape of the financial markets and the evolving macroeconomic environment.

It specifically invested in long-duration bonds and other low-risk albeit low-return securities during the time when inflation rate was nearly close to zero due to the expansionary policies of the coronavirus pandemic response.

A series of events affected the macroeconomic environment. Inflation rate shoot up. The Federal Reserve was compelled to raise its base interest rate to control consumption activities by encouraging deposits and discouraging borrowing activities

The record-high inflation and the series of interest rate hikes endangered the investment portfolio of Silicon Valley Bank and even its deposit liabilities.

It was earning less from its long-duration investments but its liabilities were growing due to the high interests of the deposit accounts it held. It also needed to become liquid because its clients were withdrawing cash more often.

Nevertheless, to solve its liquidity issue, it raised cash by selling a portion of its investment portfolio at a loss, issuing new shares for an immediate access to capital, and borrowing money. These solutions did not sit well with its depositors and a bank run ensued.

Photo credit: Coolceasar/Silicon Valley Bank Headquarters in Santa Clara, California/CC BY-SA 4.0/Adapted