Banking 101 and the SVB Collapse
This week, I’m putting my finance professor hat on, because it’s fairly obvious from the media coverage and fallout from last week’s implosion of Silicon Valley Bank that we need a bit of basic education on how banks work. We all have a role to play in the banking system, so spending time going over the basics will be helpful.
At its most fundamental level, a bank accepts deposits from individuals, businesses, and institutions, and then invests the majority of those deposits in the form of loans to individuals, businesses, and institutions. A portion of deposits are held back in cash and cash equivalents as reserves to ensure the bank has enough liquidity to facilitate depositor withdrawals.
Banks pay interest on deposits and collect fees on deposit accounts and interest on the loans it makes. Deposits are classified as liabilities of the bank and its assets are loans and other investments the bank has made using deposits. The difference between the average interest rate received from loans and/or investments, and the average interest rate paid to depositors is called the spread. In addition to fees, this is how a bank makes money.
What is typically lost in banking conversations are myriad risks a bank deals with every day. Here are just a few:
Liquidity Risk: Since a bank only has a small proportion of deposits on hand in the form of available cash on any given day, it runs the risk that depositors will withdraw more of their money than expected, forcing a liquidity crisis. To solve for the ebbs and flows of depositor withdrawals, most banks have secondary arrangements with the Federal Reserve and other banking institutions to temporarily cover normal peaks and troughs of depositor activity. However, when more depositors show up at the teller window for their money than expected, there may be delays in getting cash to depositors. News of any kind of delay can spread like wildfire and a “bank run” can quickly ensue—overwhelming the ability of the bank to secure enough cash to make good on depositor requests for withdrawals.
Interest Rate Risk: Since banks expect to earn more from their assets (loans and other investments) than they pay for their liabilities (deposits), the interest rate sensitivity of their assets and liabilities is of paramount importance. But to understand interest rate risk, we must first discuss how interest rate sensitive assets like loans and bonds change in value as interest rates change.
Generally speaking, if the level of interest rates in the broader economy rises, the value of existing bonds will fall. Why? Because new bonds will carry a higher rate of interest, making new bonds more attractive to investors than existing bonds that carry a lower rate of interest. Alternatively, if interest rates fall, the value of an existing bond will rise, because existing bonds will have higher rates of interest (a.k.a. the coupon) than new bonds that are issued with lower rates of interest. It is this inverse relationship between interest rates and bond prices that can be confusing to most new investors. Remember this: interest rates up, existing (already issued) bond prices down. Interest rates down, existing bond prices up.
Another important point about interest rate risk is that the longer the term to maturity of a bond, the greater its interest rate risk. Shorter term bonds have lower interest rate risk. We don’t have time to get into the specifics of present value math, but there is a formula that finance professionals use to estimate interest rate risk, and that formula goes by the name duration. In general, if a bond has a high duration, it has a longer maturity and is exposed to more interest rate risk. A bond with a low duration will have a shorter maturity and lower interest rate risk. Put simply, the closer a monetary obligation is to the present, the lower its duration and the lower its interest rate risk. The farther into the future that a monetary obligation is due, the higher its duration and the higher its interest rate risk. To illustrate, If $100 is due tomorrow, interest rate risk is effectively zero. Since you’re getting $100 tomorrow, interest rate changes will have a negligible effect on the present value of your money. Alternatively if $100 is due ten years from now, then a change in interest rates will have a much larger effect on today’s value of this $100 payment you’ll get 10 years in the future.
So what does all this have to do with the risk a bank faces? If the bank’s assets (loans and other investments) are exposed to greater interest rate risk than the bank’s liabilities (deposits), rising interest rates can cause the value of the bank’s assets to fall faster and farther than the value of its liabilities, forcing a squeeze on the equity position of the bank. As a reminder, equity equals assets minus liabilities. If you own a home, you know all about this as the equity you have in your home is its market value (asset) minus the outstanding value of your mortgage (liability).
Portfolio Risk: Banks are made up of portfolios. They have a portfolio of customers, a portfolio of assets (loans and other investments), and a portfolio of deposits (long-term, short-term, checking, savings, commercial, retail, etc). Banks are typically keen to ensure each of their portfolios are properly diversified. To illustrate the concept of diversitification, if I hold a diversified portfolio of investments, that means that I’ve purchased stocks and bonds from different industries, sectors, geographies, and with different income/return characteristics. In a nutshell, diversification helps reduce volatility and improve overall investment performance, all else being equal. If we apply the concept of diversification to a banking environment, banks want customers that come from different demographic, geographic, and economic backgrounds to limit exposure to economic challenges one particular group of customers may face. Same thing applies to the bank's assets and liabilities. Diversification matters.
So what happened at SVB? First and foremost, the bank’s business model focused on serving the venture capital and business start-up sector, which is inherently risky. Add in the fact that SVB primarily served VCs and start-ups in the technology sector, and you have a built-in environment of customer portfolio risk that’s higher than most other banks.
Second, SVB held a portfolio of assets that consisted of direct loans to customers and significant investments in government securities. While government bonds are some of the safest assets on the planet in terms of default risk, they are not immune to interest rate risk. Interest rate risk and portfolio risk were the primary contributors to the bank’s collapse. Why? Interest rates have risen dramatically over the past year, forcing a reduction in the value of the bank’s assets and their portfolio of assets was not well diversified. So as rates rose, the market value of the bank’s assets fell. A proper bank risk management strategy would have included hedges to protect against this, but it appears that this was not the case.
Third, the bank did not maintain an appropriate level of liquidity to cover depositor withdrawals. As more astute bank clients began to figure out that the bank’s assets were more exposed to interest rate changes than usual, they began withdrawing funds. Over the course of just a few days, the actions of the clients who were paying attention bled over to clients that began reacting and following the crowd. It is this last bit that’s the death knell. Once the psychology of crowds kick in, a full-on bank run is damn near impossible to stop. The next morning, regulators had taken over because withdrawal requests far exceeded the bank’s reserve capacity.
So what does all this mean for you?
Most importantly, the global banking system thrives because of the unwritten social contract that exists between banks, their investors, and clients (individuals, businesses, and institutions). The banking system relies on the willingness of its customers to understand that loans (assets) are supported by deposits (liabilities) and that the predictability and reliability of the relationship between assets and liabilities is what keeps the doors of the bank open. Said differently, the entire system relies on investor and depositor confidence.
When confidence in the system is challenged, bad things happen and depositors start to leave in droves. Once reserves have been depleted, then the bank needs to start selling assets (loans and other investments) to raise cash to meet depositor withdrawal obligations. Since many of the bank’s assets (loans to customers) are long-term in nature and not highly liquid (meaning they can’t be sold quickly at a fair price), then the bank struggles to raise cash and a nasty downward spiral ensues—ultimately leading to collapse and closure. The 1946 holiday classic film It’s a Wonderful Life starring James Stewart has a wonderful segment near the end that explains clearly how a bank works and how detrimental a crisis of confidence can be.
So the bottom line is this. The banking system depends on rational investor and depositor behavior. The banking system depends on the management of a wide array of risks. Trust in the banking system is a two-way street, relying on well educated clients and investors and good, prudent bank management. Your obligation is to be informed, to be objective, and to ensure that your risk tolerance matches that of the institutions you do business with.
Yes, the Federal Government steps in during extraordinary events to protect the banking sector and the public, but this should be considered a last resort. We all have an obligation to be informed and operate in a way that keeps the banking sector healthy.
Keep calm and carry on…
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Interested in learning more about financial concepts? I recommend listening to “The Indicator from Planet Money,” an NPR podcast. Its parent podcast, “Planet Money” is also very well done.
https://www.npr.org/2023/03/15/1163269781/silicon-valley-bank-svb-collapse-history
https://www.vox.com/technology/23634433/silicon-valley-bank-collapse-silvergate-first-republic-fdic
