Analysis: After Silicon Valley Bank & Signature Bank, Is America’s Banking System At Risk?

March 2023 brought wall-to-wall coverage of the second- and third-largest bank failures in American history involving Santa Clara, California-based Silicon Valley Bank, and New York-based Signature Bank. With $209 billion in assets, SVB was the 16th largest American bank; it was also the second-largest U.S. bank to collapse in history, only surpassed by Washington Mutual in 2008. What’s more, the combined assets of SVB and Signature equal about 85 percent of the assets of WaMu and half of the assets of Lehman Brothers, the fourth-largest U.S. investment bank whose bankruptcy that year kicked off the Great Recession.

Both Silicon Valley Bank and Signature were regional business banks that served a much more specialized customer mix than tier-one full-service banks like JPMorgan Chase, Bank of America, or Wells Fargo with large proportions of consumer accounts. About 50 percent of the venture-backed startups that went public in 2022 banked with SVB.

What’s more, Silicon Valley Bank’s client list reads like a Who’s Who of technology, bioengineering, and venture capital firms over the past 40 years, including Airbnb, Cisco Systems, Pinterest, Square and Fitbit, and Apple’s Steve Jobs was one of the bank’s first private banking clients in 1984.

By contrast, Signature served wealthy private banking clients and high-profile law firms in New York and California while cultivating ties to the crypto industry.

How Silicon Valley Bank Collapsed

It’s still not yet clear what happened to Signature. However, a picture is emerging of how Silicon Valley Bank collapsed, and it was even predicted in a prescient Blow Up Risk analysis on the investor platform Seeking Alpha three months prior in December 2022.

As most BSchools readers already know, banks have two choices for earning interest from customer deposits: they can either loan those deposits to borrowers or they can invest those deposits in securities. Because of startup company customers who went public or were bought out during the lockdown-driven, work-at-home tech and online education booms between 2020 and 2022, SVB had seen their deposits triple since 2019, growing to $173 billion in December 2022. When SVB couldn’t loan out most of this “liquidity flood,” it invested the funds predominantly in long-term government bonds and mortgage-backed securities, paying only around 1 percent in interest.

During periods with stable interest rates, securities like those have traditionally been considered “risk-free.” However, SVB wasn’t planning on the Federal Reserve’s raising interest rates nine times preceding the collapse, from less than 1 percent to nearly 5 percent, in what is now considered the most rapid and aggressive contractionary monetary policy in history.

As a result, these securities depreciated sharply in value as interest rates soared. Remember that an inverse relationship exists between the value of a bond—as reflected in its price—and the interest rate level.

While the Fed started to increase interest rates, the 2020-2022 startup boom abruptly ended, plummeting SVB’s deposits from venture funding, initial public offerings, and startup buyouts. This trend meant that the bank’s income had suddenly plunged. Yet its current early-stage startup customers continued to burn cash to fund their operations, meaning they were continuing to withdraw deposits that were no longer being replenished through the bank’s traditional mechanisms and in the usual large amounts.

Meanwhile, further deposit outflows compounded the bank’s depreciating asset crisis, once savers realized they could earn higher yields from competing investment opportunities while interest rates rapidly climbed.

On March 8, SVB sent a poorly-written letter to stakeholders announcing that the bank had been forced to sell about $2.1 billion of these long-term government bonds and mortgage-backed securities to ensure enough liquidity was available to depositors. Because of this “fire sale,” the bank realized a loss of about $1.8 billion. SVB then reported it needed to raise an additional $2.25 billion in capital through a stock sale to maintain enough liquidity for its depositors.

Panic ensued as investors sold off their bank stocks. The S&P 500 Banks Group index tumbled by nearly 6 percent that Thursday—its biggest one-day plummet in over two years. What’s more, SVB’s stock collapsed by 60 percent, which caused depositors to feel alarmed about the bank’s financial stability. Those questions drove the bank’s scramble to reassure its depositors that their funds were safe.

However, these depositors were clearly “flight risks.” Unlike insured consumer depositors who rarely run with their deposits to other banks, the Financial Times reports that at Silicon Valley Bank, about 96 percent of depositors were uninsured by the Federal Deposit Insurance Corporation (FDIC) because they exceeded the $250,000 coverage limit—compared with only 38 percent at Bank of America. Moreover, SVB’s average account balance exceeded $1 million; for example, the digital TV provider Roku had nearly half a billion dollars on deposit with SVB.

Withdrawals: $1,000,000 Per Second

If holding on to these depositors wasn’t difficult enough, SVB’s damage control operation then crashed into one obstacle after another. When venture capital firms saw the letter and observed the market’s swift reaction, they immediately told their client companies to withdraw all their funds from SVB. Their instructions caused one of the largest bank runs in history, amounting to $48 billion in total withdrawals. Here is how banking industry management expert Chris Nichols with SouthState Bank described this unfolding calamity:

About a dozen customers of SVB had outsized influence on almost their entire customer base. Well-known venture capitalists were able to influence other venture capitalists, which all controlled their portfolio companies. Banks often ignore this risk, particularly those with limited geographical footprints where community members talk. SVB showed what happens when this risk is realized. . .

SVB had one of the highest penetrations of digital usage in banking. Access to wires via mobile and online banking apps has sped up money movement. When it came to withdrawing funds, SVB had a record $42 billion leave the bank in about five hours. That is $4.2 billion per hour or more than $1 million per second. To put this in perspective, Washington Mutual was heretofore considered the fastest bank run, in terms of outflow velocity, at $8 billion over several days (emphasis ours).

Systemic Risk?

On March 10, the State of California seized and shut down Silicon Valley Bank, and appointed the FDIC as the receiver. Similarly, two days later, New York State took possession of Signature Bank. Federal officials also pledged that day to insure all the deposits of those two banks irrespective of how much money was in the accounts, which would ensure that these banks’ business clients could meet their employee payrolls. From the statement:

After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.

We are also announcing a similar systemic risk exception for Signature Bank, New York, New York, which was closed today by its state chartering authority. All depositors of this institution will be made whole. As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.

But what is this “systemic risk” that the statement mentions? That’s the risk that If the SVB and Signature depositors weren’t promptly made whole, business customers would soon abandon thousands of smaller regional banks nationwide in favor of only four or five huge tier-one banks. That outcome could cripple economic growth across the United States because the risk of sudden deposit outflows might cause banks to become far more cautious about their lending.

$1 Trillion in Lost Deposits

In this video, Professor Scott Galloway at New York University’s Stern School of Business warned about the potential consequences from depositor flight:

If the depositors get 70, 80, 90 percent on the dollar and they don’t have access to that capital for a while, why wouldn’t every venture capitalist demand as part of their investment in any company that they only bank with a company that has at least two trillion dollars under assets?

I think that if they don’t back the deposits, effectively what you have is that every regional or niche or specialty bank in America begins a slow march to death. . .

Then what depositor, what small company, why would Prof G, why would anyone, why would Vox Media who also had money there, or Roku, why wouldn’t anyone just say, “OK, there’s now three or four banks we’ll do business with and no one else.” Because if it can happen to these guys at $200 billion, it can happen to First National, it can happen to the other banks that aren’t JPMorgan, Bank of America, Citi, Wells Fargo, and Goldman Sachs.

And then what happens? When you have a concentration like that or a flight to strength, or a flight to the biggest players, those players love it but ultimately they begin raising the fees, they start practicing their oligopoly power or abusing their oligopoly leverage. You have a less robust banking system because now you have a concentration of banks that are so important that they literally are too big to fail—and most of them are already. And I think the systemic risk goes up and fees on the end customer go up over the medium and long term.

Some of the “flight to safety” that Professor Galloway predicted already appears to have happened. Analysts at JPMorgan Chase estimate that the “most vulnerable” banks in the United States have already lost about $1 trillion in deposits since 2022, with about 50 percent of those losses occurring in March after SVB collapsed. Later reports suggest those deposit flights might have slowed, but the extent of the long-term damage to America’s banking system is not yet known.

More Business School Professors Weigh In

Following the SVB and Signature shutdowns, the news started to brighten. The financial community and regulators teamed up to swiftly defuse other potential crises. For example, in a rare display of teamwork among industry rivals, 11 United States banks moved $30 billion to quickly shore up America’s 22nd largest bank, San Francisco-based First Republic Bank. Next, the Swiss National Bank helped UBS buy the long-troubled and scandal-plagued financial services firm Credit Suisse for $3.2 billion. And North Carolina-based First Citizens Bank bought $72 billion of SVB’s assets, fueling a 200-point Dow rally.

Meanwhile, officials had embarked on a public relations blitz to inspire confidence in the banking system. On March 16, Treasury Secretary Janet Yellen testified before Congress that “our banking system is sound and that Americans can feel confident that their deposits will be there when they need them.” And on March 22, Federal Reserve Board Chair Jerome Powell told a press conference that “our banking system is sound and resilient,” and that the Fed stood ready to use all of the board’s tools to keep the system safe.

At this point, it seemed like everyone could relax. But that’s when teams of business school professors released new research suggesting that the banking crisis might not end right away. In fact, it might just be getting started.

Regular BSchools readers will recall our recent article, “The FDIC Meeting that Blew Up the Internet.” In that report, we pointed out the likely reason for all the visible anxiety on the video of an FDIC advisory committee meeting in November 2022. It was because the members were aware that the value of unrealized losses from securities carried on the books of the U.S. banks that are FDIC members was almost half a trillion dollars. This massive total is approximately ten times the amount of unrealized securities losses during the Great Recession—a period when roughly 500 American banks failed.

However, finance professors Dr. Alexi Savov and Dr. Philipp Schnabl from NYU Stern and Dr. Itamar Drechsler from the University of Pennsylvania’s Wharton School explain in a recent paper that these estimated losses from securities only make up a fraction of the total unrealized losses from the skyrocketing interest rates. They write:

Loans, like securities, also lose value when interest rates go up. Total loans plus securities as of December 2022 was $17.5 trillion. Applying the average duration of loans and securities (3.9 years), the total unrealized losses on total bank credit as of December 2022 is 17.5 x 3.9 x 2.5% = $1.7 trillion. This is only slightly less than total bank equity capital of $2.1 trillion in 2022.

In other words, this team is pointing out that the U.S. banking industry is actually facing much greater unrealized losses of about $1.7 trillion. Moreover, these losses from the Fed’s interest rate increases are roughly equivalent to the total equity within the entire banking system.

The professors argue that these staggering unrealized losses are a substantial reason that contributed to the bankruptcy of Silicon Valley Bank. However, such losses are not the only reason, as this analysis published in Seeking Alpha explains. The SA article also faults managerial incompetence because SVB’s executive team paid attention to their portfolio’s credit risk but ignored duration risk. Under federal banking regulations, they were not required to manage duration risk because an exemption to the Dodd-Frank Act allows smaller banks like SVB to omit unrealized gains and losses from their regulatory capital ratios.

In fact, SVB’s CEO Gregory Becker even lobbied the U.S. Senate for this exemption in 2015. Senator Elizabeth Warren attacked his effort in a scathing letter, criticizing the “atrocious risk management policies at your bank.”

Nevertheless, as the interest rates exploded, all the banks holding treasury bonds and mortgage-backed securities across the nation have been subjected to massive unrealized losses. The NYU and Wharton professors emphasize that the Silicon Valley Bank situation is not isolated, in that there are hundreds of other banks across America in situations similar to SVB that are also at risk.

What’s more, a second team of business school researchers found that the assets held by U.S. banks have lost 10 percent of their value in only the past year. Their paper also points out that of the roughly $17 trillion in American bank deposits, only $10 trillion of those deposits—or about 59 percent—are FDIC-insured.

These professors argue that potentially $300 billion in insured deposits would be at risk across 190 banks even if only about 50 percent of the uninsured depositors withdraw their funds.

Dr. Erica Xuewei Jiang of the University of Southern California, Dr. Gregor Matvos of Northwestern University, Dr. Tomasz Piskorski of the Columbia Business School, and Stanford University’s Dr. Amit Seru conclude that if withdrawals by these uninsured depositors cause even small fire sales, more banks will be at risk. “[R]ecent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs,” the team concludes.

In other words, despite the pronouncements by Yellen and Powell, the professors argue that all these rapid rate hikes have suddenly transformed America’s formerly robust banking system into one that’s fragile—and potentially at risk.