Traditionally, banks take deposits from people who have money, and make loans to people who need money. In other words, banks make money by taking on credit risk. They get to know their customers, they get good at knowing which of them will be able to pay back loans, and then they make loans to these good customers.
But if you are a specialized bank that exclusively focuses on certain industries — like startups or crypto — that makes your structure a bit rickety. This is exactly what has gone wrong at Silvergate Capital (the bank of crypto) and Silicon Valley Bank (the bank of startups).
The problem of having too much money
In 2021 and 2022, providing services to the startup and crypto industry was extremely lucrative. Investors kept flinging money at startups (or crypto exchanges), and the startups would deposit them at these specialized banks.
The problem was that the bank’s customers (startups or crypto exchanges) didn’t need loans, partly because investors kept pouring money, but also because startups generally don’t have a lot of fixed assets or consistent cash flows, and thus are not very good borrowers. So the specialized banks had all this cash and they needed to do something with it.
Remember that interest rates were almost zero in 2021, so Treasury bills would pay almost no interest, and the banks needed to make money. So the bank would have to buy longer dated, but also very safe securities like Treasury bonds and mortgage-backed securities. Unlike traditional banks which would take deposits and make loans, Silicon Valley Bank and Silvergate Capital took deposits and bought bonds.
Credit risk vs. Interest rate risk
As we’ve noted above, traditional banks make money by making loans and taking on credit risk. Since Silicon Valley Bank could not make money by taking on credit risk (startups didn’t need loans), they had to make money by taking interest rate risk.
When interest rates go up, most banks have to pay more interest on deposits, but they also get paid more interest on their loans. But Silicon Valley Bank owned a lot of long-duration bonds, the market value of which goes down as interest rates go up. Holders of long-duration bonds would get paid in full if they held these bonds to maturity, but they would have to take losses if they tried to sell these bonds at market value before maturity.
Every bank has some mix of these long-dated securities, but things are a bit more balanced than Silicon Valley Bank or Silvergate Capital. At the end of 2022, Silicon Valley Bank had about $74 billion of loans and about $120 billion of investment securities.
Very few banks have as much of their assets locked up in fixed-rate securities as Silicon Valley Bank. While SVB had about 60% of their assets in securities, most other banks tend to keep it between 20-30%.
A low-interest-rate phenomenon
But Silicon Valley Bank has another, more dangerous exposure. Startups are a low-interest-rate phenomenon. When interest rates are low, the startup business model of losing money for a decade and raking in lots of cash in the far future sounds good. But when interest rates are higher, investors want consistent cash flows. When interest rates were low for a while and then suddenly became high, all the cash flowing towards startups was cut off. As interest rates go up, startups don’t have spare money anymore. They stop depositing new money but they still need to take out money from the bank to pay rent and salaries.
Double sensitivity to higher interest rates
Here’s the double whammy for Silicon Valley Bank and Silvergate Capital. The main customers (startups) were flush with cash because of low interest rates, but this cash inflow would dry up in a high interest rate scenario. To add to this, the bank invested a significant portion of the customers’ cash in longer-dated fixed-income securities, which would lose value when rates went up.
When interest rates went up, startups didn’t have money anymore. So they withdrew their deposits, and the bank was forced to sell their securities at a loss to pay customers. As the bank booked losses, their financials looked shaky, so customers got spooked and withdrew more money, which forced the bank to sell more securities at losses, which made the financials look more shaky, which spooked more customers…
Silvergate Capital should have been better off than Silicon Valley Bank because all of its deposits were non-interest-bearing demand deposits. Silvergate’s interest expense on deposits was $0, crypto firms had parked their money with Silvergate for transactional and convenience reasons. But similar to SVB, Silvergate had put its money into real estate loans, municipal bonds, and mortgage-backed securities, and longer-dated Treasuries that had longer duration.
Don’t put all your eggs in one basket
Another reason for the trouble at Silicon Valley Bank (and Silvergate) is the lack of diversification among their depositors. What you want as a bank is a certain amount of diversity among your depositors. That way, if some depositors get spooked and take their money out, or if some depositors are dealing with an industry-wide or sector-wide problem, at least other depositors would evaluate your balance sheet, decide that things are fine, and keep their money with you.
A lot more bank runs?
As of December 31, 2022, Silicon Valley Bank had only a small sliver of insured deposits (i.e. deposits under the $250,000 FDIC limit). Out of the total deposits of $173 billion, only $8 billion was insured. According to FDIC’s statement, the total amount of uninsured deposits was undetermined when the bank collapsed into FDIC receivership on Friday (March 10, 2023).
Since the IndyMac Bancorp failure in 2008, it seems to be an FDIC goal to get the uninsured depositors paid. In the case of IndyMac, the uninsured depositors received 50 cents on the dollar, although the uninsured amounts were relatively small.
In the case of Silicon Valley Bank, if the uninsured depositors do lose their deposits, there could be a lot more bank runs. A number of businesses keep uninsured deposits at banks, and if the outcome of SVB is that uninsured deposits can vanish overnight, businesses will rapidly move their money out of weaker banks. This would be bad, and largely self-fulfilling, for a lot of weaker banks. It seems unlikely that the FDIC will wind up a big high-profile bank in a way that causes significant losses for uninsured depositors.
Are bank runs inevitable?
Customers want to earn returns on their idle cash (savings) and they could earn attractive returns if they invested that money. But they’re also concerned that they might not get the money when they need it. Banks allow their customers to hedge the need to access funds on short notice. And customers are willing to pay banks to manage this risk by accepting a less-than-attractive return that they would have gotten by aggressively investing on their own.
The banks provide this service by investing in illiquid assets that earn a high return—real estate, for example. Banks improved upon the outcomes that individual depositors could achieve by investing elsewhere, by recognizing that while each depositor may have uncertain liquidity demands, few would need money on short notice. By pooling many of the deposits, the banks essentially offered insurance—they gave each depositor the right to withdraw those deposits upon demand, while relying on the fact that few depositors would need to do so.
The banks then offer depositors an interesting contract. Say you’re in a six-month certificate of deposit. If you’re patient and leave your money in for the full six months, you accept a less-attractive return than you could have gotten by aggressively investing on your own. If you’re impatient and withdraw early, the bank will penalize you by offering a lower interest rate that nevertheless beats what you would have gotten if you had conservatively invested your money yourself.
This liquidity insurance is attractive, but it comes with a dark side. If all depositors were to ask for their money back at the first opportunity, a bank could not possibly repay them all. An inevitable consequence of what banks do to help their customers, by offering a short-dated claim against a longer-dated asset, makes them vulnerable to the possibility of a bank run.
Preventing runs and panics
There is little reason to think bank runs and panics are going away. But governments can implement safety nets to prevent and mitigate bank runs.
Lender of last resort: The first component of a safety net is the lender of last resort. This is generally a central bank that is prepared to lend without limit to solvent firms against good collateral at a penalty rate. The central bank supplies an elastic currency in the face of financial disruption. Provided that banks are well capitalized, the existence of a credible lender of last resort should deter bank runs.
Government guarantee: The second component of a safety net is a government guarantee. Government guarantees make bank liabilities information-insensitive: that is, news about the performance of a bank’s assets does not alter the attractiveness of holding that bank’s liabilities. Unless depositors doubt the willingness or ability of the government to pay, there is no incentive to run. And, even if one bank were to fail, there would be no incentive to run on any other bank. Credible guarantees prevent panics.
Deposit insurance or government undertakings: Deposit insurance, originating in the United States with the FDIC and now implemented in nearly 150 countries, is a common form of government guarantee. Government owned banks or government undertakings are another way for governments to guarantee bank liabilities.
Too big to fail: In addition to the explicit guarantees noted above, governments may also provide implicit guarantees. An official “too big to fail” designation or even the perception of it can lead counterparties to anticipate a bailout when insolvency occurs.
Moral hazard: Government guarantees also foster moral hazard and create incentives for banks to take more risk. While guarantees make bank liabilities information-insensitive, they encourage banks’ owners and managers to take on greater leverage and acquire riskier assets, increasing the vulnerability of the banking system to a shock. Consequently, the tools to prevent bank runs need to include self-insurance to limit moral hazard created by such government guarantees. Just as casualty insurance deductibles and co-pays encourage the insured to take care, bank capital and liquidity requirements give banks an incentive to manage the risks they undertake. These shock absorbers also limit the destabilizing feedback across the banking system when a particular bank comes under stress.
Can a bank run be stopped?
Since most banks use what is known as fractional reserve banking, not all customer deposits are available at banks in cash for immediate withdrawal. The core business model of a bank is to take depositors’ money and lend it out. So even a strong bank would be in trouble if all the depositors suddenly decide to take their money out. A full-blown run can sink a bank in an afternoon. Once a run starts, there are four ways to stop it:
Suspend convertibility: In extreme cases, the banks can be closed for a few days. While this stops a run by brute force, it causes severe and unrepairable reputational damage. This move can also cause a full-blown panic which can cause a run on other banks.
Slow it down: In the 19th century, when bank runs were common in the U.S., banks who feared a run would have employees and relatives line up in front of the tellers and make tiny deposits or withdrawals, to pass the time until the bank closed. Banks can limit withdrawals for a few days, which would provide them just enough time to enhance liquidity and issue clarification. This is a temporary measure though, and would work only if the bank is adequately capitalized.
Borrow money: People rush to withdraw their money from the bank when they’re afraid that the bank is about to run out of money. So if the bank can borrow a bunch of money from the central bank or other banks, that usually stops the run. This is a very effective strategy when the issue is limited to a particular bank which holds long-term securities but requires immediate cash. Long-term securities can be used as collateral to borrow money and get immediate liquidity. Once the situation is stabilized, the bank can repurchase the long-term securities that were put up as collateral (this is typically how repo markets function).
Extend your runway: Banks can contact current and potential investors to see if they can wire cash quickly with no terms. If banks have any other potential way to get cash on their hands, they would be wise to call that in at such a time. Banks can model their daily cash outflow for the next month, and defer as many payments as possible, paying only the ones they absolutely need to right now. They should plan out a cash deferral plan for salaries, and that includes salaries for the Founder/C-Suite as well. Banks should brief their employees, customers, suppliers, and investors on the situation regularly. Banks need to remember that runs are caused by panics. Transparency and upfront communication can go a long way in reestablishing faith in the institution.
How would the government treat uninsured depositors after a bank run?
When Jerome Powell started at the U.S. Treasury in 1990, it wasn’t the easiest year to start working there. It was, however, the perfect time to learn firsthand how to deal with unpredictable crises. In 1991, Jerome Powell found himself at the center of a disaster involving the Bank of New England. Powell and his Treasury colleagues, the Federal Reserve Board, and the Federal Deposit Insurance Corporation (FDIC) wrestled with the potential consequences of a bailout.
As they huddled at a Treasury Department conference room on a Sunday morning, the key question was: Should the government run to the rescue because it has a responsibility to prevent shocks to the bigger economy? Or should the government let market forces wash away poorly managed institutions? And if the government runs to the rescue, would it create a “moral hazard” – a term the insurance industry uses to refer to people who take risks knowing they’re protected against larger loses.
John LaWare, the Federal Governor at that time, laid out the Fed’s line:
“You’re the government, and you can do whatever you want, but here’s what we think will happen if we haircut uninsured depositors. There will be a run on every American bank when they open Monday, and all these money-center banks will be at our door. Do you really want to run that test?”
“We chose the first option, without dissent.” Powell said, as he recounted the episode in his speech in 2013, one of his first as a Fed Governor. The fear of a bigger crisis trumped the concern about bailouts that day.
Conclusion
In summary, Silicon Valley Bank and Silvergate Capital had an incredibly simple, boring, old-school and reasonably safe banking business model, borrowing short and lending long, taking demand deposits at low interest rates and investing the money in a fairly conservative portfolio of longer-maturity mortgages and bonds. Here’s what brought them down:
- When interest rates go up rapidly, if your assets are long-dated bonds, they will go down in value.
- Banks typically deal with this risk by holding their assets to maturity and not marking them to market. If you have a 10-year bond and interest rates go up, your bond’s market value goes down, but if you wait 10 years, you will still be paid in full.
- Banks also limit their exposure to long-dated bonds, and thus interest rate risk. As noted earlier, banks tend to keep 20-30% of their assets in long-dated securities, whereas Silicon Valley Bank had about 60% exposure.
- Silicon Valley Bank and Silvergate Capital exclusively focused on startups and crypto, respectively. Startups and crypto were both a low-interest-rate phenomenon, people got into these industries because bank accounts paid zero interest. When interest rates went up and the free flow of money dried up, startups and crypto had to dip into their deposits to pay salaries and rent. As a result, SVB and Silvergate could no longer hold their assets to maturity as they needed cash to pay their depositors. They were forced to sell assets at a loss, which left them thinly capitalized, which led to more withdrawals, which led to more asset sales at losses, which ultimately ended both Silicon Valley Bank and Silvergate.
- Silicon Valley Bank may have collapsed, and the depositors that got their money out were lucky, but this is also a self-fulfilling prophecy. If all startups hadn’t decided all at once to pull their money, SVB probably wouldn’t have collapsed.
In the case of Silicon Valley Bank, if the uninsured depositors do lose their deposits, there could be a lot more bank runs as businesses will rapidly move their money out of weaker banks. It seems unlikely that the FDIC will wind up a big high-profile bank in a way that causes significant losses for uninsured depositors.
Once a run starts, banks may be able to stop it by suspending withdrawals or limiting them, borrowing money, or by utilizing other means to extend their runway. These strategies can buy time to enhance liquidity and communicate with stakeholders, but they are effective only if the bank is well capitalized.
Governments can prevent and mitigate bank runs by creating a lender of last resort, through government guarantees, deposit insurance, and by creating self-insurance tools to limit moral hazard.
In addition to managing the tradeoff between preventing and mitigating financial disruptions, governments and regulators also face a challenge of containing panics while preserving the benefits of a competitive banking system. The more control governments exert, the less freedom banks have to act (and the less they face the consequences of their actions), the more stable the system will be. But a financial system that never experiences stress is one that is almost surely very inefficient at performing its fundamental tasks. Ultimately, governments must make a choice of where on these tradeoffs they want their banking systems to be.