Why Silicon Valley Bank's Collapse Was Inevitable

Introduction:

The Silicon Valley Bank of America has collapsed." It is the second biggest failure in American banking history. The biggest failure was the collapse of Washington Mutual in 2008. It was followed by a global recession because when the American financial system crashes, its impact is seen around the world. In 2008, Washington Mutual Bank gave housing loans to a large number of people, and after some time the housing market crashed. As a result of it, this bank collapsed.

The collapse of Silicon Valley Bank is causing shockwaves throughout the entire business world because it is one of the world's major and important banks. It is the epicentre of tech start-ups and supports 21 Indian start-ups.
Before understanding the complete scenario, let us first understand a bank’s business model.

Business Model of a Bank:

A bank accepts deposits from the general public and, to earn profits, lends these deposits in the form of loans. It may also invest in bonds (government or corporate) or stocks. And the proportion of its investment and lending is collectively called a bank’s portfolio.

A brief about Silicon Valley Bank:

Silicon Valley Bank (SVB) was established in 1983 in California’s Santa Clara. In its early years of establishment, 50% of its portfolio consisted of real estate investments. In 1992, the real estate market crashed, and SVB had to incur a $2.2 million loss. This is the reason why financial experts suggest having a diversified portfolio so that losses can be offset by the profits of other sectors.

The same thing has happened to this bank again, but on a larger scale this time. In the 2000s, SVB started investing in start-ups, especially tech start-ups, and that too at venture capital stages. . In 2015, it published data specifying that it was serving 65% of the American tech start-ups. While the other banks serve different types of entities, this bank was specifically designed to finance tech start-ups. In 2022, its assets reached USD 209 billion (around INR 17,00,000 crores).

The question arises: What happened to this bank?

Three years ago, when the pandemic came, venture capitalists realised the value of technology in the coming years and invested largely in tech start-ups and deposited their returns in SVB. Start-ups also used to manage their businesses and their operational capital through this bank because it was the first preference of technology-based start-ups. In March 2021, its deposits reached USD 124 billion, which is a 100% increase when compared to the deposits of the previous year (USD 62 billion).

It was usual that the bank would invest its huge deposits in bonds or in the stock market. And SVB chose to invest in government and corporate bonds.

(Bonds are issued by the government or large organisations to raise money, and they repay it at a certain rate of interest. This type of investment carries little or no risk. But exceptions are always there. There is an inverse relationship between price of the bond and rate of interest. It implies if the central bank of a country raises interest rates, bond prices will go down and the investor will have to incur losses).

This was the worst-case scenario that SVB had to face. They purchased bonds at a very low rate of 0.5%. And the Federal Reserve (the apex bank of America) hiked the rates to 5% in 2022. Due to this, loan rates increased, and people avoided taking loans and tended to withdraw money for their operational requirements. Venture capitalists were not providing funding as there was no demand for loans. This situation had become problematic for SVB. On the one hand, it was facing losses from bond investments, and people were demanding withdrawals on the other. So it started selling bonds at a loss in order to fulfil the withdrawal demands of their customers. And when it became public that the bank had sold its bonds worth $21 billion at a $1.8 billion loss, its shares went down by 60%. Its rating was downgraded.

It caused a situation of bank run, where people rush to withdraw their money from a bank because they feel that their money is no longer secured in that bank. However, every bank guarantees a specific amount of money in case a bank collapses. In America, this limit is $250,000. But as per the data revealed, around 89% of the deposits with this bank are uninsured. After this, it was impossible to avoid the collapse of SVB. The prime reason for this collapse was the hike in interest rates.

Why did the government raise interest rates?

The government did it to control inflation. During the pandemic, interest rates were lowered to encourage people to take loans and so that money can be circulated. But after the pandemic, these rates were hiked by almost every government to control inflation, and the US is no exception. Inflation was at its peak in America and Europe due to the Russia-Ukraine war, and the hike in interest rates was the only option left in the hands of the government.

Now, to safeguard those 89% of uninsured deposits, a bank merger is suggested. The California Department of Financial Protection and Innovation has taken possession of SVB. The receivership has been transferred to the Federal Deposit Insurance Corporation (FDIC), and the bank with which it is to be merged is yet to be seen.

Conclusion:

This is not a case of bank fraud or a scam. This is a case of mismanagement and bad luck. So, a bank must have a strong portfolio to avoid these situations. People are comparing this scenario with the 2008 financial crisis, but experts say that this situation is unlikely because many regulations were framed after that crisis to avoid any serious consequences. However, a negative impact can be seen on tech start-ups.