When the liquidity tide goes out – gradually, then suddenly

The collapse of Silicon Valley Bank (SVB) has fulfilled a satisfying range of economic truisms.

“How did you go bankrupt? Two ways. Gradually, then suddenly (Hemingway).”

“When the Fed starts to raise rates it does so until something breaks (Wall St)”

“Please give me regular crises – just not big ones (Prudential regulators)”

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SVB’s failure, as rising rates crunched the risk market – and notably startups – kneecapped bond investments and sparked a crisis of confidence, is not the crisis of the collapse of Lehman Bros in 2008. (This was written before Credit Suisse. ed)

“SVB was a relatively small, regional bank and like many regional banks it had both geographic and sectoral concentrations of risk – albeit in this case the geography was Silicon Valley and the sector risk was tech companies.”

It is not – at the moment – a big one. It has been coming, gradually, if silently, for more than a year. And it’s a graphic sign monetary tightening is working because things are starting to break.

Despite the carnage on markets since the US Federal Reserve took over SVB on Friday, and the ongoing fallout across the tech and banking sectors, it’s actually not the sudden part of the bankruptcy that is most enlightening. It’s the gradual part.

The factors which have ultimately killed SVB have been building since the rate cycle turned, playing out in the very concentrated market in which the bank operates. And some factors on the regulatory front have been building far longer.

Given this is the most acute and most sustained interest rate tightening cycle in two decades – meaning many market participants have never seen its like – and rates were coming off zero or even below zero, the adjustment to a new reality is going to volatile, painful and at times unpredictable. Strap in.

The sudden part of SVB’s failure is actually quite straightforward and not dissimilar to the way banks have been failing for centuries – and continue to do so at the rate of around a dozen a year in the US alone. Chris Joye at Livewire and the Australian Financial Review has written a forensic analysis of how SVB failed.

SVB was a relatively small, regional bank and like many regional banks it had both geographic and sectoral concentrations of risk – albeit in this case the geography was Silicon Valley and the sector risk was tech companies. Meanwhile, both its liquidity availability (to cover the risk depositors suddenly want their money back) and its interest rate risk (the risk a change in interest rates would impact its solvency) were inadequate or inadequately hedged.

Unlike most banks, SVB’s problems in part stemmed from having too many deposits rather than too few. Banks typically lend out more than they take in via deposits. That’s how they make money – a deposit is a liability for a bank, it has to pay out the interest and pay out the principal. A loan is an asset – the loan repayments provide revenue.

But because of SVB’s client base, tech companies which up until the cycle turned where raising billions in equity from venture capital and other investors, it had plenty of deposits. But for that same reason – its clients had no trouble raising equity – it wasn’t making enough loans to generate income. So it reinvested its deposits in what looked like secure government securities.

This introduced the interest rate risk -which wasn’t hedged. If bonds are held to maturity, interest and principal are paid (unless there's a default). But if traded before maturity, they are subject to market forces and if interest rates rise, their price falls. Some have spoken of a perfect storm hitting SVB with a run on its deposits and a price collapse on its income-producing securities which had to be fire-sold to provide liquidity. But actually these were all part of the same weather system, the upheaval of the tech ecosystem which began with the end of free money last year.

Even before these latest events, the – albeit rapid – normalisation of interest rates was dramatically changing the outlook for startups to the extent many were predicting the end of the fintech era. When official rates are near zero risky assets offering a bit more look good. But when official rates are 3, 4, 5 per cent, they don’t ….

That we are not experiencing a Lehman-style shock of the kind which catalysed the global financial crisis in 2008 is because most regulators relearned the lesson that banks don’t fail because they are insolvent but because they lack liquidity – maybe because funding markets freeze or maybe because nervous or needy depositors spark a run.

The financial crisis taught many big lessons, many of which thankfully were taken to heart in Australia, Europe and elsewhere. Notably around the primacy of quality capital and the need to be aware of and transparent about interest rate risk embedded in a bank’s balance sheet.

In the aftermath of the global financial crisis I wrote a series for the Australian Financial Review on why Australian banks survived so well. Yes, there was some luck but the over-riding lesson was bank management and regulators had learned the lessons of previous crises and so had dodged most of the toxic securities at the heart of the crisis and had managed risk well.

In the US not all these lessons were taken to heart and while regulation was ramped up, the regulatory overlay for banks has turned out to be piecemeal and vulnerable to regulatory arbitrage. SVB’s regulator was California-based and actually in charge of both prudential soundness and innovation in the local economy – two things which are difficult to reconcile even in stable times. Large, stable boring institutions are good for system stability but poor for innovation.

This was a lesson of the financial crisis too: in the UK the Financial Services Authority (FSA) had a mandate for prudential stability and consumer protection. It couldn’t do both. As the Bank of England notes in its review of the crisis there were “problems with the way banks were supervised in the UK. Prior to the crisis, both prudential and conduct regulation were the responsibility of the FSA. This left the FSA with too many objectives to juggle, and in 2013 it was abolished”.

This was also learned in Australia which already had a standalone prudential supervisor - but not in the US where regulatory arbitrage and mixed mandates remain.

However the standout lesson from SVB is the gradual part of the failure.

One of the bank’s biggest supporters and clients, Michael Moritz of Sequoia Capital, provided the Financial Times with a particularly eloquent and telling opinion on the collapse entitled “SVB provided for tech when everyone else ignored us”.

In essence, he argues, SVB was exactly what a regional bank should be, not just a financier but a part of the local community, shaping that community’s fortunes but also hostage to them. SVB’s community was the tech sector based in Silicon Valley which it serviced and grew with for decades.

Moritz argues, and we are already seeing it, the loss of the bank is going to hit the sector hard. But that sector was already in the throes of massive disruption as interest rates rose, funding dried up and investors factored in they could now get returns for far less risk in a different world to start-ups.

CB Insights latest Blockchain report looks at one chapter of the story noting “global venture funding to blockchain and crypto companies reached a new record of $US26.8 billion in 2022, largely propped up by a strong first half. But as the year progressed, the crypto winter coupled with macroeconomic pressures caused three straight quarters of declines in funding and deals.”

As for how enmeshed SVB is, CB Insights noted “for its 2,690+ fintech clients, SVB is more than just a bank. In addition to the venture debt financing and startup banking that it’s known for, SVB is a gateway for commercial payments and online payments acceptance. In fact, it markets itself not as a bank, but as a financial technology partner. According to SVB, its clients account for 71 per cent of all fintech IPOs since 2020.”

This is the new world, not just for blockchain and crypto but for fintech and startups – and specialist banks like SVB. The tide is going out on the liquidity tsunami of the last decade and this latest wave of bank failures won’t be the last. The fortunes of a bank and its environment are entwined.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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