Mar 24, 2023

Why Do Banks Fail? Breaking Down the Lines of Defense

by Allan Smallwood

At The General Partnership, we are fortunate to have a team of experienced builders to support founders in crisis. Allan typically works with our fintech portfolio, leveraging his deep expertise in capital markets to help shape their products and navigate viable paths to growth. When Silicon Valley Bank collapsed, our first step as a firm was to support our founders who were directly impacted, but we also asked Allan WTF just happened. Below, he explains our thinking on the market dynamics that led to this massive loss in the startup ecosystem. 

The reasons Silicon Valley Bank failed are becoming increasingly clear. Following the 2021 venture boom, SVB was flush with new deposits. However, it made a critical mistake in the way it constructed its asset portfolio, choosing to invest in interest-rate sensitive fixed-income securities instead of originating loans with the new deposits. This decision was based on the assumption that a low-interest rate environment would persist, and if it didn't, the change would be in line with historical norms. Unfortunately, this assumption had a substantial impact on SVB’s business because of the unique qualities of its startup-centric customer base. At first, low-interest rates drove more investments in venture capital funds and startups, so deposits in SVB rose unusually quickly. But as we all learned, when interest rates rose, investments in startups fell, and the rest is history. 

As the Fed began an aggressive policy-tightening campaign to rein in inflation, it exposed the significant mismatch SVB had built into its asset-liability duration. Duration is the average time period— usually measured in years—in which an asset or liability’s cash flows are realized. As rates rose, the value of SVB’s fixed-income securities assets fell. The rising interest rate environment also slowed venture funding, forcing SVB’s depositors to spend down their cash at a rate that was faster than the duration SVB had assumed for these liabilities. This shift in deposit duration was the beginning of the inadvertent bank run. 

But let’s back up. Silicon Valley Bank was a blue-chip financial institution. Over the past decade, it garnered a large share of wallet servicing venture funds, the startups they back, and the people those startups employ. Riding the startup wave proved to be a brilliant strategic choice for SVB—they built a world-class brand known for servicing the unique and unmet needs of what would ultimately prove to be a lucrative customer segment. 

However, at the end of the day, banks play two key social functions in our economy—they provide a safe place to store money (deposits), and they use this money to mediate credit to consumers and businesses (loans). In accounting terms, deposits are the liability, and loans are the assets. The most important job banks have is to ensure that the duration of assets and liabilities are matched so that when depositors show up to withdraw cash, enough is on hand to honor the request. 

Yet, despite existing to honor these social contracts, most banks are for-profit businesses where owners risk capital to deliver a return. For bankers, that means the assets they buy with depositor funds have to create income that exceeds the rate they pay on deposits and the cost of their operations. To do this, they have to find the right balance of duration mismatch—they borrow short to lend long. The magic that allows this mismatch to work lies in the fact that not every customer wants all their money back every day. 

However, there is no rule that what is typical is also constant. Banks are aware of this fact and have built multiple lines of defense into their operating models to protect against a loss of faith that would result in a collapse.

The first line of defense: Portfolio construction and asset-liability management

To fulfill these objectives, banks have to carry a lot of overhead. The deposit function generates some revenue from fees paid by customers but nowhere near enough to cover the full cost of operating a bank (let alone generate a profit for the bank’s owners). Instead, banks transform deposits into a portfolio of assets that generate revenue in the form of interest income. The portfolio they construct is broadly spread into three buckets: cash to meet the immediate needs of depositors, a portfolio of mostly liquid and publicly traded fixed-income securities in case depositor needs rise above expectations, and a portfolio of relatively illiquid, private loans to consumers and businesses. 

The potential interest income of these products is typically a function of their liquidity, credit risk, and tenor, and it’s typically fixed from the time they’re purchased. Therefore, the bank knows—with some level of certainty—when it will be paid interest and get principal returned. 

The weakness in this line of defense is that asset values can change. As interest rates increase, the price of the asset must fall by a commensurate amount to keep its yield in line with the prevailing rate. If prices fall too much, they wipe out the net worth of the bank (the final line of defense) and impair depositors' ability to recover their money. Therefore, the amount of interest rate sensitivity, measured by duration, is important when choosing the type and tenor of assets to include in the bank's portfolio.

SVB made several decisions in its portfolio construction process that ultimately proved to carry risks they did not anticipate. Coming out of the venture funding boom of 2021, SVB saw its deposit base triple from inflows. This money needed to be put to work creating assets, and its liquidity forecast was updated to account for the eventual use of these funds by customers. SVB opted to invest a large amount of this cash in its securities portfolio but faced an anemic yield environment as the Fed had yet to normalize its interest rate policy response to the pandemic. In an effort to optimize yields, their securities portfolio purchases favored longer-dated, interest rate-sensitive securities such as mortgage-backed securities. Their bet was that rates were not going to increase materially, or if they did, the deposits would not draw down faster than they received the interest and principal payments on the portfolio.

Both of these assumptions proved incorrect as the Fed embarked on an unprecedented and aggressive campaign of hiking interest rates to fight inflation. Then startup deposit inflows reversed to net outflows as VC funding dried up. SVB was left with a securities portfolio that was quickly losing value and a deposit base that was demanding more liquidity than it had modeled. 

The second line of defense: Accounting methodology for securities

Recognizing deposit liabilities must be transformed into assets that are sensitive to changes in interest rates. This covers the cost of operations and provides an opportunity for bank owners to earn a profit. It’s worth noting that banks have accounting standards that are intended to diminish the risk of asset price changes. 

While assets can fall in value, losses are not typically realized unless those assets are sold. Assets only need to be sold if the deposit duration exceeds the asset duration. Further, while their value may decline if held to maturity, assets are typically repaid in full, and no loss is realized. Bank accounting standards recognize these dynamics by letting a bank segment the securities in their portfolio into “Available For Sale” and “Held to Maturity” buckets. This reflects the intended and expected nature of the portfolio construction exercise. There will be times cash on hand is insufficient to meet liquidity demands, and some securities will be sold. There may be a time the number of securities sold will be larger than expected in an extreme case. 

This means securities categorized as “Available for Sale” are accounted for on a mark-to-market basis, with gains and losses recognized daily in the PnL, regardless of whether they are sold or not. Securities categorized as “Held to Maturity” are held at cost with no impact on PnL unless recategorized or liquidated. However, their market values are disclosed in the footnotes of the bank’s quarterly and annual financial statements. 

The weakness of accounting methodology loopholes is that they can create a false sense of security and hide risk in an operating model. If the relative balance of assets across these categories proves inconsistent with the actual liquidity needs of the bank, liquidating a portion of the Held to Maturity portfolio and the required mark-to-market of the remaining assets in that HTM bucket may wipe out the net worth of the bank. 

SVB, like many other banks, used this accounting loophole to stem the impacts of the incorrect assumptions it made in its portfolio construction in the wake of 2021’s deposit boom and the subsequent reversal of Fed policy in 2022. A large portion of its securities portfolio was losing value and was designated as Held to Maturity to avoid recognizing losses on the PnL. This signaled to the equity market that SVB was confident it had adequate liquidity to meet demands and avoided a write-down that would have required a dilutive capital raise.   

The third line of defense: Collateralized borrowing for liquidity management

When decisions in portfolio construction and the use of accounting loopholes constrain a bank’s ability to meet liquidity demands, the final option is to borrow money to meet them. Vagaries in the deposit base and fluctuations in asset values are nothing new to banks. With each crisis, new sources of liquidity have evolved to help banks withstand outlier events that result in these variations reaching extremes. These include short-term (aka overnight) inter-bank lending networks and, of course, the lender of last resort—the Fed. Loans of this type require collateral, and the size of the loan is struck with a haircut to the collateral value to ensure the lender a margin of safety against further price declines.

This line of defense is fragile and potentially compounds mistakes. These loans are short-term in nature and offer a respite, not a long-term solution. Because they are collateralized, they will reduce the assets available to depositors in an ultimate liquidation scenario. When these loans are used, it’s disclosed in financial statements and can confer a powerful signaling effect. 

In an effort to further manage the fallout from the loss in value on its asset portfolio and growing burndown in deposits, SVB also utilized short-term funding markets to manage its liquidity needs. Most notably, the bank turned to the “lender-of-second-to-last-resort”, the Federal Home Loan Bank of San Francisco. The latest filings indicated that SVB had borrowed roughly $15 billion, making it by far the biggest borrower from this lender at the time.

The fourth line of defense: Equity and subordinated capital 

The final line of defense for a bank is subordinated capital, typically in the form of equity. Its role is to protect depositors from losses while storing their money. In exchange for providing this service, depositors have ceded a claim on most of the upside provided by the transformation of their deposit liabilities into securities and loan assets. This arrangement provides material structural leverage to owners of the bank’s equity. Even with losses and the cost of operations, most banks can reasonably generate a consistent mid-teens return on their equity capital over a long-term investment horizon.

The key distinction here is that the returns of an average bank are consistent on average over time, not perfectly linear year-to-year. There will be bumps along the way when mistakes are made, and the potential solutions available will heavily influence the returns to equity holders. They are: 

  • Take a loss and try to earn it back. Minor mistakes when using the tools above can usually be recovered over time. Equity prices will fail to account for this reality, but the bank remains solvent and its earnings power intact.

  • Take dilution. If a mistake proves to be material enough to threaten solvency, but the future prospects for generating returns to equity remain intact, the bank can usually find new investors willing to provide equity, albeit at a discount.

  • Sell to a competitor. If there is a threat to solvency and the prospects for survival are dim, most banks maintain enough enterprise value for a larger competitor to consider an acquisition. 

  • Walk away. In some instances, there is no way to salvage the organization, and the bank should wind down. In these instances, the FDIC insurance fund steps in to protect depositors with up to $250,000 in cash and issues a claim on funds that exceeds this amount. Regulators then work diligently to liquidate assets in a prudent manner that prioritizes depositor claims, which usually results in debt and equity holders losing their investments.   

When the music finally stopped for SVB, it was far too late to simply take a loss and rely on its sterling position as the bank in the tech industry to earn its way back. It needed to take a loss and try to raise more capital. As such, they simultaneously announced a major liquidation of their securities portfolio which crystallized a loss of $1.8 billion and a plan to raise $2.25 billion in new capital. This extreme measure proved insufficient, and a massive bank run ensued. This was not irrational as over 90% of SVB’s deposits were uninsured, meaning they exceeded the $250,000 insurance limit. The average balance carried by an uninsured depositor prior to the bank run is estimated to have been as high as $4.25 million. 

The prospect of a long and uncertain recovery process for startup founders and their investors was untenable relative to the financials required to build a valuable business. As the run escalated, regulators stepped in and took control in the hopes of finding a suitable buyer for the bank in a short period of time. As we all know, the regulators failed to do so and were left with no other option but to wind the bank down. 

The road ahead

While SVB’s target customer segment left it uniquely exposed to the risk of a bank run, the challenges it faced were not unique. Nearly every bank experienced a boom in deposits during 2021, not just banks catering to cash-flush, VC-backed startups. Many banks were also caught with too much interest rate sensitivity and tried to manage through the morass with clever accounting and timely short-term lending. 

In the days following the SVB collapse, the regulators who tried to resolve the situation worried other depositors in different banks might also begin to question the safety of their deposits, sparking a systemic contagion. To address this, they moved swiftly to make SVB’s depositors whole by guaranteeing their uninsured deposits and extending an emergency lending facility to any bank in need of extra liquidity. These actions may bolster the third line of defense (collateralized borrowing for liquidity) for other banks and remove the incentive for depositors to flee their banks. 

But it’s important to consider the long-term ramifications of these emergency actions, especially for startups. Let's explore.

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