Silicon Valley’s Clown Bank and the Failed Fed Supervision
The US banking sector had its worst week in the last 50 years.Yes, it was even worse than the Great Financial Crisis (GFC) of 2008.
In a week, three large banks collapsed. All of them were either VC-facing or crypto-facing: Silvergate, Silicon Valley Bank, and Signature Bank.
Only Silvergate closed down orderly, opting to liquidate its assets. The other two had a combined worth of deposits at $263.6 billion, barely topping the GFC.
As the name suggests, Silicon Valley Bank was deep into commercial lending for venture capital (VC) firms and the healthcare sector. You’ve undoubtedly heard of some of them as funders of top blockchain projects, such as a16z and Sequoia Capital.
These types of FinTech-savvy clients are also considered to be less sticky. So when the bank run was triggered, it was more forceful than usual.
The bank run was sparked by a sale of $1.75 billion SIVB shares on March 8th. That sale was supposed to cover the realized $1.8 billion loss by the firesale of its deprecating $21 billion bond portfolio.
It was then that investors realized that SVB had made the wrong bet. Although it is typical for a bank to invest in fixed-income securities (bonds, treasury securities, and mortgage-backed securities), they don’t do well when the Federal Reserve switches from a near-zero interest regime to the fastest hiking cycle in the last 40 years.
That’s because when new securities’ yields rise, they make existing securities less attractive. Therefore, having a large portfolio of long-term US Treasuries, SVB’s liquidity was at risk, triggering the bank run. As a result, at the end of 2022, SVB had an enormous percentage of its assets invested in securities, at 57%, in contrast to the average bank’s 24%.
But shouldn’t the bank know all about this? Yes, it should. Let’s recap:
- If a bank invests in 5-year treasuries, it will receive a fixed yield.
- However, when the Fed hikes interest rates, those yields decrease as the yields on newly issued Treasury bonds increase.
- The bank then stands to lose money in that scenario.
- To hedge against such risk, the bank could conduct an interest rate swap. By hedging, the bank agrees to pay a fixed yield to another party and gain variable payments in return.
In the interest rate swap setup, when the Fed is hiking, the bank receives more money from the swap as it loses money on its Treasuries investment. And if the Fed starts cutting rates, the bank would earn less from the Treasuries but also pay less in the swap.
Consequently, the biggest mistake SVB made was failing to hedge against that exposure. In the aftermath, it is now understandable why. SVB last had a Chief Risk Officer (CRO) in April after Laura Izurieta left the bank.
In charge of regulating SVB, the San Francisco Fed is currently probing the bank, scheduled to deliver a full report on May 1st. Not having a CRO for such a large bank is highly unusual. The departure of the previous CRO is also quite indicative, according to Reed Kathrein, a lawyer specializing in shareholder suits:
“It means perhaps management was hiding something or didn’t want to disclose something, or had disagreements over the risks it was taking”