Why SVB failed and the continued importance of smart regulation in finance

The rapid and shocking collapse of the Silicon Valley Bank (SVB), the second largest bank failure in United States history, is a stark reminder of the necessary role that financial regulators play in ensuring stability and security in the banking sector. In this post, we will cover why SVB failed, how the FDIC prevented a larger catastrophe, and what was learned from the event.

Why SVB failed

A multitude of reasons led to the downfall of SVB. First, they set the table with a series of what would prove to be disastrously-timed investments. SVB had channeled a large portion of its customer deposits into long-term treasury securities, a seemingly safe investment. However, this move tied up significant amounts of capital in fixed-rate assets and left SVB exposed to inflation risk and interest rate fluctuations. A sudden surge in inflation rates coupled with the Federal Reserve’s decision to ramp up interest rates all came together to form the perfect storm for SVB, resulting in a dramatic depreciation in the value of its investments.

Then, there was the instigation of a panic-induced ‘bank run’, which is a situation where customers demand withdrawal of their deposits beyond the bank’s capacity in liquid cash reserves. SVB is headquartered in Silicon Valley, its namesake, and many of its customers were California-based tech companies and startups. Multiple prominent investors privately advised their companies to withdraw all of their funds from SVB, and many of those accounts were large corporate accounts with significant funding. This private advice soon became public knowledge, and a bank run ensued.

FDIC (mostly) stops the bleeding

SVB’s failure brings into sharp focus the role of financial regulators and agencies such as the FDIC. The FDIC, a government-sanctioned insurance program created in response to the bank runs of the early 20th century, serves as a safety net for depositors in the event of a bank failure by guaranteeing insurance coverage for deposits up to $250,000 per customer per bank. This is typically enough to cover most depositors, but in wealthy Silicon Valley an alarming 90 percent of SVB customer deposits were uninsured. 

To rectify this and shore up confidence in the US banking system overall, the FDIC, in an extraordinary collaboration with the Federal Reserve and the US Treasury, took the unprecedented step of guaranteeing all customer deposits, irrespective of whether they were insured or not. This succeeded in averting systemic complications and the feared ‘contagion’ that could lead to more bank runs nationwide. This fear was validated when First Republic Bank, whose customer base overlapped significantly with SVB’s, fell victim to a similar bank run in the ensuing month in spite of being in a better financial position.

The government’s decision to guarantee all customer deposits in SVB’s case marks a significant departure from normal practice during bank failures where uninsured depositors are relegated to the status of general creditors of the bank, often risking significant losses if the bank goes under. This change in strategy reflects the government’s acknowledgment of the domino effect of bank failures on the banking sector and greater economy. It also shows the importance of keeping depositors’ funds safe to maintain public trust in the banking system.

Learning from the SVB collapse

The SVB collapse simultaneously underscores the necessity for effective risk management and consistent oversight by financial regulators. Lack of proper supervision and risk management personnel at SVB throughout 2022 left the bank vulnerable to the risks involved in its investments. Effectual risk management strategies, such as hedging against bond-related risks like inflation, could have softened the blow of the losses incurred by SVB from their treasury purchases and helped them avoid setting the stage for a significant bank run.

SVB’s swift collapse sent shockwaves through the entire banking sector for a significant portion of 2022. The collapse unnerved investors, triggering a sharp decline in many smaller regional bank stocks and stirring up worries about the stability of other financial institutions. This led other banks to spring into action and open lines of credit to ward off a similar catastrophe. This, combined with the FDIC’s unprecedented response, managed to calm the spooked herd of investors and depositors nationwide. However, if they hadn’t, there is not much that banks can do in the face of a true bank run, and the ripple effect on the broader economy would have been – and this is not hyperbole – catastrophic. This incident underscores the need for oversight and regulation to prevent a repeat of such bank failures and their potential ripple effect on the economy.

Conclusion

Summarizing, the fall of the Silicon Valley Bank illustrates the crucial role of financial regulators, especially the FDIC, in ensuring the stability and safety of the banking sector. The SVB saga underlines the importance of effective risk management, constant vigilance, and comprehensive insurance coverage provided by regulatory bodies to protect depositors’ funds and uphold public faith in the banking system. The shift in the government’s approach towards guaranteeing all customer deposits in SVB’s case indicates an evolution in strategy aimed at avoiding systemic issues and maintaining stability in our financial system, but it is not necessarily one that taxpayers will happily bear again. The lessons we learned from SVB’s collapse reiterate the importance of robust regulatory frameworks and proactive risk management in safeguarding the integrity and the resilience of the banking sector.