Why did Silicon Valley Bank Fail?

Summary

The video script delves into the collapse of Silicon Valley Bank, highlighting a critical oversight in risk management. It explains the bank's business model, centered on tech startup deposits and long-term bonds, and the resulting maturity mismatch. The script outlines how rising interest rates led to a bank run, as the bank's liquidity reserves were insufficient to handle rapid deposit withdrawals. The bank's failure to assess interest rate risk accurately and the absence of a chief risk officer contributed to its downfall, illustrating the fragility of the financial system.

Takeaways

• 🏦 Silicon Valley Bank (SVB) had a specialized business model catering primarily to technology startups, which made up the majority of its deposits.
• 📈 From 2018 to 2021, the bank experienced rapid growth in deposits as tech startups flourished, leading to an increase in the bank's asset holdings, particularly long-term government and mortgage bonds.
• 🔄 The bank's strategy involved a maturity mismatch, where deposits could be withdrawn at any time, but a significant portion of its assets were tied up in long-term bonds.
• 📉 Rising interest rates from 2021 to 2022 caused a decrease in the market value of bonds in the trading book and a reduction in the present value of bonds in the banking book.
• 💡 The concept of interest rate risk in the banking book was highlighted, explaining how bonds held to maturity can still be affected by market interest rate fluctuations.
• 💸 Tech startups faced funding difficulties due to high interest rates, leading them to withdraw their deposits from SVB, which in turn reduced the bank's liquidity reserves.
• 🚨 As liquidity reserves dwindled, SVB was forced to sell off its long-term bonds at a loss, due to the market value being lower than the purchase price.
• 💔 The losses from selling bonds at a loss wiped out SVB's equity, signaling financial distress and prompting a bank run.
• 📉 The bank run on March 8th saw a massive withdrawal of funds, which SVB could not cover with its liquidity reserves, leading to its failure.
• 🛑 The script suggests that SVB's downfall was due to a lack of understanding and management of interest rate risk, as well as liquidity risk.
• 📋 The absence of stringent regulatory requirements for banks of SVB's size and the lack of a chief risk officer during a critical period contributed to the bank's inability to manage risks effectively.

Q & A

What was the primary business model of Silicon Valley Bank?

Silicon Valley Bank's primary business model was to cater to Silicon Valley startups, with most of its deposits coming from these technology companies rather than private individuals.

What type of assets did Silicon Valley Bank hold on its balance sheet?

Silicon Valley Bank held a significant amount of government bonds and mortgage bonds on its balance sheet, with these bonds having a maturity of 10 to 30 years.

How did the deposits at Silicon Valley Bank change from 2018 to 2021?

The deposits at Silicon Valley Bank grew rapidly from 2018 to 2021 due to the success of the startups, which led to an increase in the amount of money they deposited into the bank.

What is the concept of maturity mismatch and how did it apply to Silicon Valley Bank?

Maturity mismatch refers to the situation where the bank's liabilities (deposits) can be withdrawn at any time, while the assets (bonds) are tied up for a long period, creating a liquidity issue. Silicon Valley Bank faced this issue as it held long-term bonds while having to meet short-term deposit withdrawal demands.

What is the standard formula for valuing a bond, and how does it relate to market interest rates?

The standard formula for valuing a bond is to take the future payment and divide it by (1 + the market interest rate). As market interest rates rise, the present value of bonds falls, which can impact the bank's asset valuation.

What are the two main risk factors that were relevant for Silicon Valley Bank?

The two main risk factors for Silicon Valley Bank were interest rate risk in the banking book and liquidity risk.

How does interest rate risk in the banking book affect a bank's assets?

Interest rate risk in the banking book affects a bank's assets by changing the present value of the bonds they hold. If interest rates rise, the present value of these bonds falls, which can lead to losses if the bank is forced to sell them before maturity.

What is liquidity risk in the context of banking, and how did it impact Silicon Valley Bank?

Liquidity risk in banking refers to the risk that a bank may not have enough liquid assets to meet its short-term obligations. Silicon Valley Bank faced liquidity risk when startups withdrew their deposits rapidly, forcing the bank to sell its bonds at a loss to meet these obligations.

Why did Silicon Valley Bank need to sell its bonds, and what was the outcome?

Silicon Valley Bank needed to sell its bonds due to a rapid withdrawal of deposits by startups, which depleted its liquidity reserves. The outcome was a loss on the sale of these bonds, as they had to be sold at market prices lower than their purchase value.

What triggered the bank run on Silicon Valley Bank, and what was the final outcome?

The bank run on Silicon Valley Bank was triggered by the realization that the bank had to sell its bonds at a loss, which wiped out its equity. The final outcome was the bank's failure due to its inability to manage liquidity and assess interest rate risks accurately.

How did regulatory changes under President Donald Trump affect Silicon Valley Bank's risk management?

Regulatory changes under President Donald Trump lifted certain banking regulations, including the requirement for banks with a balance sheet under 250 billion euros to perform interest rate risk in the banking book calculations. Since Silicon Valley Bank's balance sheet was around 212 billion euros, they were not required to perform these calculations, which may have contributed to their failure to manage interest rate risks.

Outlines

00:00

🏦 Silicon Valley Bank's Risk Management Failure

The first paragraph introduces the topic of Silicon Valley Bank's collapse, highlighting the bank's flawed risk management. It explains the bank's business model, which was heavily reliant on deposits from technology startups. The bank's balance sheet is discussed, showing a significant portion of long-term government and mortgage bonds as assets, financed by customer deposits. The paragraph also explains the concept of maturity mismatch, where deposits are liquid but the bonds are not, setting the stage for potential liquidity issues.

05:02

📉 Impact of Rising Interest Rates on Bond Values

The second paragraph delves into the dynamics of bond valuation and the associated risks for Silicon Valley Bank. It explains how rising interest rates can lead to a decrease in bond prices, which in turn affects the bank's assets. The paragraph further discusses two types of interest rate risk in the banking book: the present value view and the net interest income view. The former assesses the current worth of bonds, while the latter evaluates the cash flow mismatches that could arise from changes in interest rates. Liquidity risk is also introduced as a critical factor for banks, particularly when they invest in long-term assets with short-term liabilities.

10:02

💡 Silicon Valley Bank's Liquidity Crisis and Collapse

The third paragraph outlines the sequence of events leading to Silicon Valley Bank's failure. It describes how startups, facing difficulties in securing funding due to high interest rates, began withdrawing their deposits, causing a rapid shrinkage of the bank's liquidity reserves. As a result, the bank was forced to sell off its bonds at a loss, which significantly impacted its equity. The paragraph concludes with the bank's inability to manage the liquidity crisis, leading to a bank run and ultimately, the bank's bankruptcy. It also touches on regulatory changes and the absence of a chief risk officer, which contributed to the bank's inability to manage its risks effectively.

Keywords

💡Silicon Valley Bank

Silicon Valley Bank (SVB) is a financial institution that specializes in banking for technology and life science companies. In the video, it is the primary subject of the analysis, with the speaker discussing its failure due to mismanagement of risk and liquidity issues. The example of SVB's balance sheet and its reliance on deposits from startups illustrate the bank's unique business model and how it was affected by external economic changes.

💡Risk Management

Risk management is the process of identifying, assessing, and controlling risks to minimize or avoid potential losses. In the context of the video, it is highlighted as a critical failure point for SVB, where the bank is said to have an 'incredible fake layer of risk management,' indicating that their risk management practices were inadequate or deceptive, leading to the bank's downfall.

💡Balance Sheet

A balance sheet is a financial statement that presents a company's financial position by listing its assets, liabilities, and equity at a specific point in time. The video script delves into SVB's balance sheet, emphasizing the composition of its equity, deposits, and assets, particularly focusing on the rapid growth of deposits from technology startups and the bank's investment in long-term bonds.

💡Equity

Equity in the context of a bank's balance sheet refers to the ownership interest or the value of the assets minus the liabilities. The script mentions that SVB had about 12.5% equity of its balance sheet, which is a measure of the bank's financial stability. The failure of SVB is partly attributed to the loss of this equity due to poor investment decisions and market conditions.

💡Deposits

Deposits are funds placed into a bank by customers, which the bank can then use to provide loans or invest. The video script describes how SVB's deposits primarily came from technology startups, which grew rapidly from 2018 to 2021. However, the script also highlights the risk associated with these deposits due to their potential for rapid withdrawal, which later contributed to SVB's liquidity crisis.

💡Government Bonds

Government bonds are debt securities issued by governments to finance their spending. In the video, it is mentioned that SVB had a significant portion of its assets in long-term government bonds, which were expected to yield a higher interest rate than the deposits they paid out. However, the rising interest rates led to a decrease in the market value of these bonds, impacting SVB's financial health.

💡Maturity Mismatch

Maturity mismatch occurs when the terms of a bank's assets do not align with the terms of its liabilities. The script explains that SVB had a maturity mismatch because it held long-term bonds while having to meet short-term deposit withdrawal demands from its customers. This mismatch became a critical issue when the bank faced a liquidity crisis and had to sell these bonds at a loss.

💡Interest Rate Risk

Interest rate risk is the risk that changes in market interest rates will negatively impact the value of a bank's assets or liabilities. The video discusses two types of interest rate risk relevant to SVB: in the banking book and in the trading book. The bank's failure to manage this risk, especially with rising interest rates, contributed to the decline in the value of its bond portfolio and ultimately to its insolvency.

💡Liquidity Risk

Liquidity risk is the risk that a bank will not be able to meet its short-term obligations due to an inability to liquidate assets quickly enough. The script uses the analogy of a CEO unable to pay the janitor despite having the money to illustrate liquidity risk. SVB's liquidity risk became a reality when it had to sell off its long-term bonds to meet deposit withdrawal demands, resulting in significant losses.

💡Bank Run

A bank run occurs when a large number of customers simultaneously withdraw their deposits due to a loss of confidence in the bank's solvency. The video script describes how SVB experienced a bank run on March 8th, with 42 billion euros being withdrawn, which overwhelmed the bank's liquidity reserves and led to its failure.

💡Chief Risk Officer

A Chief Risk Officer (CRO) is a senior executive responsible for assessing and managing the risks faced by an organization. The script mentions that SVB did not have a CRO for a period of time, which may have contributed to the bank's failure to properly assess and manage its interest rate and liquidity risks.

Highlights

Silicon Valley Bank's failure was due to a fake layer of risk management.

The bank had a specialized business model focusing on Silicon Valley startups.

Most deposits at Silicon Valley Bank came from technology startups, not private individuals.

The bank's asset side was heavily invested in long-term government and mortgage bonds.

A rapid growth in deposits from 2018 to 2021 led to an increase in bond purchases.

The bank faced a maturity mismatch between short-term deposits and long-term bonds.

Rising interest rates from 2021 to 2022 caused a decrease in bond values in the trading book.

Silicon Valley Bank did not revalue bonds in the banking book to market value, hiding losses.

Startups began to withdraw deposits as funding became difficult due to high interest rates.

The bank's liquidity reserves were insufficient to handle the rapid withdrawal of deposits.

Silicon Valley Bank had to sell off bonds at a loss to meet liquidity needs.

The loss from bond sales wiped out the bank's equity, leading to insolvency.

The bank's failure to manage interest rate risk in the banking book was a key factor in its downfall.

A bank run occurred on March 8th, with 42 billion euros withdrawn, overwhelming the bank's reserves.

The lack of a chief risk officer and relaxed banking regulations contributed to the bank's failure.

Silicon Valley Bank's collapse highlights a failure to manage basic banking risks.

The incident reflects a concerning state of the financial system, where such a failure could occur.

Transcripts

so I'm gonna give you an in-deter view

of why Silicon Valley Bank failed and

you'll understand that it was that this

was an incredible fake layer of the risk

management at Silicon Valley bank so I'm

first going to go over the theory that

we need and then I'm going to go over

the timeline of events and what actually

led to the failure of the bank but let's

look first at the balance sheet of

Silicon Valley Bank so as every Bank

Silicon Valley Bank has equity

it's about 12.5 percent of their balance

sheet and Silicon Valley Bank has

deposits so that's in theory you and me

who can give money to the bank as in a

bank account but Silicon Valley Bank is

specialized on Silicon Valley startups

so here you can actually see how their

deposits are made up and you see that

most of the deposits are technology

startups so most of those deposits

actually come from technology or Silicon

Valley startups that's their kind of

business model so most of the deposits

are not private people but startups with

a lot of money

and on the asset side Silicon Valley had

a lot of government bonds

and so something interesting happened

from 2018 to 2021.

the startups go really well so what

happens is that the startups can raise a

lot of money and put a lot more deposits

into the bank so what happens is that

the deposits grow rapidly in the time

period from 2018 to 2021

and what does the bank do well the bank

has gets money

and they have to pay low interest rates

here so maybe 0.5 percent and they want

to earn money with this so what they do

is they buy more bonds and they buy

long-term government bonds or mortgage

bonds and those bonds are

10 year to 30-year bonds so you get your

money back after 10 to 30 years and they

pay slightly higher interest rates I

think they got about 1.8 interest rates

on those bonds and so you see

that in theory

Silicon Valley Bank makes money right

1.3 percent is the difference between

what they pay on the liability side and

what they get on the asset side but

there is a catch here there's a maturity

mismatch

because

the depositors well they can get their

money at any time and the money that is

in bonds that is bound in the bonds so

the bonds have 10 to 30 year maturity so

this money is not very liquid so far so

good because this is the normal business

model of a bank so let's

go a bit into bonds because I need to

explain to you one important concept so

this is for example a one-year Bond you

buy this financial product and you get

105 Euros a year so the question is what

do you have to pay for this Bond today

and the standard formula for valuing

such a bond is to say Okay I I take what

I get in a year and I divide this by one

plus the interest rate on the market so

let's say the interest rate is five

percent what's the value of our bond in

this case it's 100 euros

let's just say the interest rate is not

five percent but ten percent what's the

value of our bond then well the value of

our bond is roughly 95 Euros so what

does that mean well with Rising interest

rates

bond prices fall

okay so let's get into the risk factors

that were relevant for Silicon Valley

Bank and for them there were especially

two risk factors one is interest rate

risk in the banking book and the second

one is liquidity risk let's start with

interest rate risks in the banking book

so to understand what this means we need

to look closer at those Bonds in the

portfolio of Silicon Valley Bank and for

for every Bank there are two types of

assets there are assets in the trading

book

and Assets in the banking book

Assets in the trading book they are held

short term and the bank wants to trade

with them in other words buys them and

wants to sell them in the near future

they are valued to Market so in the

balance sheet they appear on market

value

and the bonds in the banking book the

bank buys them and wants to hold them to

maturity in other words if we have this

one year bond the bank buys it at its

price at the start of the year and then

Waits until the bond pays its final

payment of 105 euros

that is the case so if the bank wants to

hold the bond until maturity then it's

in the banking book and bonds in the

banking book are not valued at market

value but at purchase value

so in other words if if Silicon Valley

Bank would plan to sell the bond in the

middle of the year it would be in the

trading book and it would appear with

market value on the balance sheet if

however Silicon Valley Bank plans to

hold the bond then it is in the banking

book and it will appear with purchase

value

and

even with Bonds in the banking book

there is risk and this risk is called

interest rate risk in the banking book

and this risk is typically measured in

two ways in the present value way and in

the net interest income way I have made

a detailed video on interest rate risk

in the banking book and here's only a

short overview so what is the present

value view well the present value view

looks at all the payments that are

coming from the bonds over time so this

may be year one year two year three and

gear 4. and it asks okay what are those

bonds worth today

why is this an important question well

even if I do not plan on selling my

bonds sometimes it can be sometimes I

may be forced to do it maybe the owners

of the bank want to shut shut down the

bank right now

then they have to sell all the assets

even the ones in the banking book and

that can be unforeseen so it's important

to understand what is my portfolio worth

today and that is what the present value

approach looks at the second approach or

the second approach in interest rate

risk in the banking book is so-called

net interest income approach and the net

interest income report approach I also

look at the time axis but I look at the

following I look at how much interest I

have to pay for my liabilities so that's

the interest I have to pay and I look at

how much interest I get from my bonds

and maybe if the interest that I get for

my bonds is plus 100 but I have to pay

minus 50 on the liability side in year

one then I'm fine

and I do this for every year in the

future

so I always look at what what comes in

what goes out and do they match and it

might be that I identify a mismatch so

that I only get 50 euros for my bonds

but that I have to pay

100 on my

interest and if I have identified such a

problem well I need to take measures for

instance hold more cash or do other

things

okay so this is the net interest income

View and the second risk that is

important for Silicon Valley Bank is the

liquidity risk

um the example I always like to give to

give is well let's just think about the

CEO sits in his office and he has to pay

the janitor and there's a Picasso on the

wall but he has forgotten his wallet

then he can't pay the January although

he technically has the money so he's ill

liquid and that's classical liquidity

risk and banking that is typically the

case when a bank gets money from

people

so from individual depositors

and puts the money in a 30-year mortgage

then the depositors can get their money

anytime but the money and the mortgage

is Bound for maybe 30 years so that's

where liquidity risk comes from in

banking

so now that we have the basics down I've

talked about the balance sheet of

Silicon Valley Bank I've talked about

bonds and I've talked about interest

rate risk and liquidity risk we can

actually understand what happened at

Silicon Valley Bank so I already told

you that in their balance sheet they had

their equity

and they had the deposits which were

rapidly growing from 2018 to 2021

and you had a lot of bonds

on the asset side and a lot and most of

those Bonds were part of the banking

book

and some of those bonds are part of the

trading book

so now in 21 21 to 2022 interest rates

start Rising that means that our bonds

in the trading books start to lose in

value

so some of the value here gets lost

however Silicon Valley Bank does not

have as much Bonds in the trading book

so that's not really a problem

on the balance sheet you do not really

see a loss in value for Bonds in the

banking book because they are not

revalued but you see a loss in present

value of the bonds

so the present value of the bonds goes

down

this is what you see in your interest

rate risk in the backing book

calculations but you will not see this

on the balance sheet because the ones in

the banking book are not marked to

market value

then what happens in the beginning of

2022 that a lot of the startups have

trouble to get funding

why because they have high interest

rates and they do not want to get

additional funding at those High

interest rates so in order to get money

what they do is they use their deposits

so what happens is a lot of the

companies that have that have their

money at Silicon Valley Bank start to

withdraw it from their accounts so the

deposits start to shrink

and now comes the big problem as the

deposits shrink very rapidly the

liquidity reserve of the bank which is

usually only a very small part of the

asset side usually it's two percent of

the portfolio so

very roughly Silicon Valley Bank had a

200 billion dollar portfolio so you

would expect that their liquidity

Reserve is at

um 4 billion

so what happens is as a lot of the

startups withdraw their deposits their

liquidity Reserve gets

um gets used

and they have to sell Bonds in the

banking book

and of course if they have to sell those

Bonds in the banking book they have to

sell them to the market but of course

when you sell those bonds you have to

sell them at market price so what

happens is they lose money of those on

those bonds because they have those

bonds at purchase price in the balance

sheet but they have to sell at market

price and with Rising interest rates

those bonds are worth a lot less so what

happens is they sell those bonds they

make a loss and this loss basically

wipes out all their Equity so that's bad

the bank bank doesn't have Equity

because it has made a lot of losses on

selling those bonds

so what does the bank do well the bank

says oh we need new Equity so we need

investors to get equity and what happens

then is people start to realize that

and what happens on 8th of March is that

42 billion billion euros

are withdrawn from the bank and as I've

told you the liquidity reserve of a bank

is usually two percent of the balance

sheets so in the case of Silicon Valley

Bank 4 billion there's no way that

Silicon Valley Bank can unravel their

assets that fast

and with this Bank Run the bank goes

bust

so to summarize why this happened is

basically because Silicon Valley Bank

didn't understand their interest rate

risk in the banking book and because of

the unfolding interest rate risk because

of the higher interest rates a bank run

came and they could not manage liquidity

so in other words their failure in the

end was a fair year of liquidity but it

was caused by Rising interest rates and

a failure to accurately assess interest

rate risks they did not pay enough

attention to the loss and present value

of their portfolio

and

this is what basically

brought them to fall down because they

had to sell a lot of those assets at a

lower present value they had a lot of

junk risk in those bonds and they did

not hedge that risk accurately

in my opinion

the sad thing here is that President

Donald Trump

actually had lifted banking regulations

while banks have to do interest rate

risk in the banking book until 2018 in

2018 Donald Trump said well we only

required this for banks with an asset

with a balance sheet larger than 250

billion euros the balance sheet of

Silicon Valley Bank is at about 212

billion euros so they did not have to do

those calculations also they did not

have a chief risk officer during that

time because their Chief risk officer

left and they took about six to eight

months to hire a new one so what Silicon

Valley Bank actually did is they failed

to manage one of the most basic risks in

banking and I think this is a very very

sad picture of the state of the

financial system that something like

this

can happen