The takeover of Silicon Valley Bank (SVB) by the Federal Deposit Insurance Corporation (FDIC), the independent agency created by the US Congress to maintain stability and public confidence in the country’s financial system, has sent shockwaves through the financial system. With an asset base of $219 billion, SVB’s is the second largest bank collapse in US history.
The FDIC insures deposits for the safety, soundness, and consumer protection, investigates and supervises financial institutions, enables resolution of large and complex financial institutions, and administers receivership, among other things.
It said depositors would be allowed to withdraw up to $250,000 per account from Monday. The rest of their deposits will be stuck indefinitely.
The good news is that given a good asset base, the principal is likely to come back eventually. The bad news is that only about 3% of the $169 billion in deposits are below that $250,000 threshold, so a lot of money will be in deposits until the FDIC figures come in.
The bulk of the deposits are all corporate, largely comprising funds from VCs and startups. This means that the startup ecosystem may become more starved for funding, which is not healthy for any industry and is probably dangerous for cash-starved, loss-making businesses. And, of course, equity stakeholders in the listed SVB entity have seen the value of their shares effectively drop to zero.
what went wrong?
SVB’s deposit base to grow from $61 billion in 2019 to $181 billion in 2021 amid the pandemic. At the time, the Fed and other central banks were keeping policy rates near zero to stimulate Covid-hit economies.
SVB put a large portion of those deposits into mortgage-backed securities (MBS), which earned it a reasonable return. The MBS basket was long-term (many in the 10-year range) and delivered annual returns of around 1.5%. But the principal will be redeemable only over a longer period. MBS are liquid in the sense that they can be sold in the bond market, but the price is not necessarily face value.
In 2022, the Federal Reserve began raising policy rates and the bond market suffered. If interest rates rise, the value of a debt instrument that paid an earlier, lower interest rate falls. The US rate has increased by 500 basis points in the last year. In addition, the Fed has made a series of aggressive statements that indicate it may raise rates aggressively again. The market value of MBS has collapsed and these bonds can now only be sold at a steep discount to their face value.
In the midst of this cycle of rate hikes, many depositors of SVB sought to cash in their cash. This is not very surprising. The bulk of SVB’s clients were commercial organisations, who could see a scenario where they could reinvest their cash for better returns.
The bank sees its deposit base shrinking to $169 billion in 2023 and faces an additional $41 billion in redemption requests. It had to sell some of its bonds at a loss to try and meet those requests and posted a loss of $1.8 billion selling about $20 billion of its portfolio.
It then tried to raise $2 billion or more in cash in an equity-cum-debt proposal but was unsuccessful. The stock crashed as soon as the liquidity crisis became apparent. When it became clear that SVB would not be able to find a lender or an investor, the FDIC took over.
The fact that senior SVB executives sold $4.4 million worth of shares before the crisis became public, may not have gone over well with depositors, besides noting regulators. But the consensus is that SVB has a sound balance sheet and the liquidity crisis should not turn into an insolvency crisis. It will be up to the FDIC and other regulatory authorities to ensure that this does not lead to generalized panic and pressure on other banks.
In case of bank failure, the depositors get their money back on first priority. The bank’s other secured lenders come second, and equity holders get whatever is left. This sequence can be broken in special circumstances. For example, Yes Bank’s rescue plan envisaged that holders of Permanent Additional Tier 1 bonds would get nothing, while smaller shareholders would get whatever market value they could get.
There are many possibilities. The FDIC can keep the asset portfolio open or freeze it until the MBS term expires. Since the asset base appears to be solid, depositors should eventually get their money back. Alternatively, another lender of last resort may appear or someone may buy the SVB. The impact on the startup ecosystem will be severe, but luckily it will not be a 2008 global crisis.
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