The Downfall of Two Major American Banks

Introduction

Two major American banks, Silicon Valley Bank and Signature Bank, have collapsed, leading to concerns about the potential for another recession similar to the 2008 financial crisis. Silicon Valley Bank, headquartered in Santa Carla, California, is particularly significant due to its status as the primary bank for technology-based startups and venture capital firms in the Silicon Valley area. The bank had initially invested heavily in real estate but diversified its portfolio following a significant loss in 1992 during the California real estate market crash. In the 2000s, Silicon Valley Bank became known for its significant investment in technology-based startups, providing loans to companies in the venture stage. By 2015, it was reported that the bank had served 65% of all startups in America, with the tech industry representing its largest customer base. While other banks typically look for a diversified customer base to provide loans to, Silicon Valley Bank was unique in its focus on technology-based startups. Despite the bank's collapse, it is expected that management will not be significantly impacted, but investors in the bank are unlikely to be protected.

Moving on from 1995 to the 2000s, Silicon Valley Bank (SVB) became known for its heavy investments in startups, particularly those in the technology sector. The bank specifically provided loans to venture-stage technology companies. By 2015, the bank had expanded so much that it was reported that 65% of all startups in America were being served by SVB. The bank's biggest customers were technology-based companies, making it a natural fit for the Silicon Valley region. In this regard, SVB was quite unique as other banks looked for diversified customers to give loans to.

However, with such a heavy reliance on the technology sector, the bank's fortunes became increasingly tied to the success of its startup clients. As the technology industry experienced a downturn, SVB's loan portfolio began to sour. The bank's loan losses grew from $27 million in 2015 to $40 million in 2016. By 2018, the bank was grappling with rising delinquency rates and loan losses in its venture capital and private equity lending divisions. In response, the bank began to shift its focus to more mature technology companies and diversify its portfolio, but it was not enough to stave off the inevitable.

In March of 2023, SVB collapsed, sending shockwaves through the business world. The bank's stock lost 80% of its value over the course of a week, with 60% of that loss coming in a single day. The collapse of SVB and New York's Signature Bank is the second-largest banking failure in American history, after the 2008 collapse of Washington Mutual Bank. While the management of the banks will likely be fine, investors in the banks will not be protected. There are concerns that this banking collapse may lead to another global recession, as the impact of a crash in America's financial system would be felt around the world.

Rise of Silicon Valley Bank

All sorts of organizations take loans from the bank, and companies across different industries also utilize its services. However, Silicon Valley Bank (SVB) was an exception. By the end of 2022, SVB had become the 16th largest lender in the United States, with total assets worth $209 billion, equivalent to ₹17 trillion. Unfortunately, the bank faced problems with the onset of the Covid-19 pandemic. Venture capitalists worldwide began investing in software-based companies as these companies proved to be the most successful during the lockdown, running through computers and mobile phones. As a result, startups in 2021 raised a total of $330 billion, almost double the previous year's record. With all this money, these technology-based startups preferred to deposit their funds with SVB, making it their number one choice. In March 2021, the total deposits with SVB amounted to around $124 billion, an increase of 100% from the previous year's $62 billion. In comparison, other banks, such as JP Morgan Chase, only saw an increase of 24%. Having so much money in the form of customer deposits, SVB decided to invest it and make even more money. The bank invested billions of dollars in government and corporate bonds, which is a common practice for banks to make money. However, when SVB invested in bonds, interest rates were very low, between 0% and 0.25%. It was expected that these rates would remain low, but they didn't. They increased instead. When interest rates rise, bond prices fall, and SVB's investment portfolio suffered losses. This led to a worst-case scenario for the bank when the American government raised interest rates.

Bank Run

A bank run is a situation where a large number of customers of a bank withdraw their deposits simultaneously, due to concerns about the bank's solvency. In this case, the news of SVB's losses and downgraded rating led to a loss of confidence in the bank, which triggered a bank run.

When a bank run occurs, it creates a self-fulfilling prophecy. As more and more customers withdraw their deposits, the bank's reserves deplete, making it harder for the bank to honor withdrawal requests from other customers. This leads to even more withdrawals, which further depletes the bank's reserves and can lead to the bank's collapse.

In some cases, central banks step in to prevent a bank run by providing emergency funding to the bank. However, in the case of SVB, it is unclear if any such intervention took place.

Overall, the SVB case highlights the interconnectedness of financial markets and the potential for events in one part of the financial system to have ripple effects across the system. It also underscores the importance of risk management and proper financial regulation to prevent such events from occurring in the first place.

So what just happened?

But the actual reason why this situation was created was different in the other 2 cases. Whatever happened here, according to the publicly available information, there was no scam. The bank did not commit any fraud. Though it is true that the bank hid some facts and did not make timely disclosures to the public, this is a case of bad decision-making. People in charge of the management of the bank made wrong decisions. It turned out to be the wrong time, and to some extent, this was simply bad luck.

You might be thinking that the root cause was the increase in interest rates by the US government. Why did the government do this? Friends, there’s a simple reason for it. To control inflation. Friends, there’s an interesting relationship between inflation and interest rates. I explained this in the video on Inflation. When the economy of a country is facing a slowdown, the central bank often reduces the interest rates. So that it is easier for people to take loans. With low-interest rates, more people would want to take loans. With more loans, more people would have expendable money. More expendable money would mean that they can spend on various things. With this, the money circulation in the economy would increase and it would boost the GDP. This is why the government lowered interest rates during the pandemic. On the other hand, if inflation is on the rise in an economy, interest rates are increased to control it. Increasing interest rates would make loans more expensive. Fewer people would want to take loans. People would not have enough money to spend, and the spending would decrease. With lower spending, inflation could be controlled. This is a general and simplified explanation.

Over the last several months, inflation was rapidly increasing in America and Europe due to several reasons, one of which is the Russia-Ukraine War. To control this inflation, the Federal Reserve increased interest rates. Though this can be considered the root cause, bad decision-making by the bank was also at play here. Interest rates will continue to fluctuate, you need to have a robust portfolio so that it can bear these fluctuations.

The next question was what would happen to the funds of the people and companies that were deposited with the bank? There’s a limit to insurance. To a certain limit, the money deposited with the banks is insured. That is the law. In America, the limit is $250,000. This might seem like a large limit. But the clients and customers of SVB were startups with a lot of money. It is reported that 89% of the deposits were uninsured. But the response of the American government was similar to the Indian government’s response when Indian banks crashed. The California Department of Financial Protection and Innovation pounced on the SVB’s office. The receivership of the bank was handed over to the FDIC. Federal Deposit Insurance Corporation. Customer deposits to the tune of $175 billion were used by FDIC to create a new bank. National Bank of Santa Clara. The assets of SVB were taken over so that usual business activities could be continued. And then began the search for a bank willing to merge with SVB. That’s right. The merger is a solution here.

2.5 years ago, when the PMC bank crashed in India, the Indian government did the same thing. The PMC Bank was merged with the Unity Small Finance Bank. To ensure that public deposits could be safeguarded and later could be withdrawn safely. In the case of SVB, it is yet to be seen which bank would it merge into. But US President Joe Biden has assured that the deposits made with the bank would be safe. That even the uninsured money would be unlikely. However, it is still too early to determine the full extent of the impact.

In conclusion, the Silicon Valley Bank crash of 2022 was a result of bad decision-making by the bank's management, coupled with the increase in interest rates to control inflation. The crash had a significant impact on the startups and companies that deposited their money with the bank, with many losing a considerable amount of their share value. However, the American government stepped in to safeguard the deposits and ensure that the bank's assets were taken over so that business activities could continue. The long-term impact of the crash on the global economy is yet to be determined, but experts believe that it is unlikely to lead to a global financial crisis.