Demystifying Silicon Valley Bank’s Failure: A High-Tech Version of an Old-Fashioned Bank Run

There’s an old saying on Wall Street: “[w]hen the Fed hits the brakes, someone goes through the windshield.” Silicon Valley Bank (“SVB”) has arguably been the biggest victim of the Federal Reserve’s incessant rate hikes which started in March of 2022. The failure of SVB however, also highlights glaring gaps in the current financial regulatory ecosystem.

What Happened?

SVB had invested a lion’s share of its customer deposits in fixed-income securities such as U.S. treasury bonds. While these are traditionally low-risk investments, they are highly vulnerable to interest rate risks. The interest rate on one-year U.S. Treasury notes hit a 17-year-high of 5.25% in March of 2023 – up from less than 0.5% at the beginning of 2022. This shattered the market value of SVB’s treasury bonds, most of which they bought in 2020 and 2021. Had SVB been able to hold these 10-year bonds until maturity, this decline in market value would not have affected them, as they would have received the entire amount of principal back. However, a large chunk of SVB’s customers were tech companies, and in the aftermath of the tech crisis of 2022, many of their customers made sizeable withdrawals to tide over the crisis.

SVB’s cash reserves were not enough to fund these withdrawals, forcing SVB to liquidate $21 billion of their securities portfolio at a loss of $1.8 billion also resulting in a rating downgrade for the Californian lender. To make up for this loss, the bank raised a call for equity to the tune of nearly $2 billion resulting in a loss in confidence among SVB’s other customers who quickly started to withdraw their own funds, resulting in a massive bank run.

The strangest part of this story is that when you imagine bank failures rooted in terrible risk management policies, you imagine that the bank has overextended itself in complex financial products. Silicon Valley Bank, however, mismanaged its risk using the safest, plain-vanilla assets known to mankind.

What Was Unique to the SVP Bank Run?

The SVB Bank run is quite novel. This is because it is possibly the first bank run in the Digital Age. The last run of a bank of global significance was on Northern Rock which still evokes images of depositors patiently waiting in branches spread over suburban England to withdraw their money. In 2022, when customers interact with their bank through their phone, a bank run meant most of SVB’s customer base could withdraw their money with a tap of their fingers, thus depleting the Californian lender’s resources in a matter of hours. On March 9th and 10th, Twitter was rife with tweets about venture capital companies instructing their portfolio companies to withdraw their deposits in SVB, giving it no chance to slow the run.

When a bank has a customer base as concentrated as SVB, where most customers know and communicate with one another, the chances of stopping a bank run are extremely remote. In December 2022, the Bank had only 37,000 customers with holdings in excess of $250,000 – the ceiling on deposit insurance in the United States. In a bank run these 37,000 customers would be the most incentivized to withdraw their money as quickly as possible. SVB’s depositor base was so concentrated that the deposits of these 37,000 customers made up 93% of SVB’s deposit base and amounted to a whopping $151 billion.

How Did Applicable Financial Regulations Allow This to Happen?

In response to the financial crisis of 2008, U.S. regulators ushered in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) which imposed new Enhanced Prudential Supervision (“EPS”) norms to ensure proper oversight and regulation of banks with more than $50 billion in consolidated assets. However, in 2018, with a view to “unshackle banks”, Congress scaled back Dodd-Frank and lifted this threshold to $250 billion (“Mid-Size Banks”). With consolidated assets in the range of $212 billion, SVB, America’s 16th largest lender, was free of the EPS. I analyze below how the removal of three of Dodd-Frank’s primal safeguards proved terminal for SVB.

1. Dodd Frank’s compulsory annual stress test could have identified the glaring structural gaps in SVB’s capital management. With the relaxation of Dodd-Frank, SVB was not stress tested in 2021 or 2022, thereby allowing the bank’s capital allocation mistakes to continue unchecked. A stress test would have brought more attention to the lopsided portfolio and would have gotten regulators to insist that SVB invest in interest rate swaps or similar instruments which provide an adequate hedge against the inherent interest rate risk their portfolio was exposed to.

2. 2018 relaxations allowed SVB’s account statements to hide the true picture of SVB’s capital structure. As per the 2018 relaxations, Mid-Size Banks did not have to show unrealized losses on their balance sheet. Hence SVB did not have to reflect the losses it sustained due to the declining value of its bonds on its balance sheet. There is data today to show that if the losses on these bonds were taken into account (fully recognized), they would have had a disastrous effect on SVB’s primary regulatory capital ratio. This is the core financial buffer a bank is required to have to absorb losses and protect depositors. If these losses were shown on SVB’s balance sheet, “its regulatory capital ratio would have fallen from a comfortable 12% of assets all the way down to zero, a level so far below regulatory minimums that rating agencies would downgrade SVB, and regulators might be compelled to take over the bank.”

3. 2018 relaxations scaled back SVB’s compulsory liquidity requirements which ultimately proved fatal. Prior to the 2018 relaxations, SVB would be mandated to maintain sufficient high-quality liquid assets on hand to meet mass withdrawal requests (known as the modified liquidity coverage ratio) as it faced during its run. Banking experts estimate that the rollback of Dodd-Frank prompted Mid-Size Banks to drop their capital ratios by around 1%. While I indulge in a little Monday night quarterbacking, had SVB not dropped its capital ratio by 1%, it would have had about $2.15 billion of additional liquid cash on hand, which would have covered the losses it faced while selling its treasury bonds. Additionally, while purely speculative, it might also never have had to issue the fatal $2 billion call on equity, which along with its negative publicity brought the bank to its knees.

The Way Forward

An obvious solution would be to bring back the pre-2018 version of Dodd-Frank. While this is something that is already being debated in Congress, there are a couple of recent changes that future regulation must take into account.

1. Increase the amount of mandatory share capital: There is empirical data which shows that banks with higher amounts of share capital make smarter investments and have more effective risk management strategies.

2. Mandate mark-to-market accounting requirements for banks: In simple terms, mark-to-market accounting shows the current market value of assets whose values fluctuate over time (instead of the book value). With such requirements, SVB could not have swept its unrecognized losses under the carpet, and regulators and depositors would have been alert to risks much quicker.

3. Require banks to have exposure to diverse sectors: While this is somewhat reactionary and anti-free market, SVB showed us that when a bank’s depositor base is so heavily focused on one area (tech in SVB’s case), a crisis within the sector has the potential to close down a bank. Thus, regulation that ensures that a bank has exposure to multiple sectors can go a long way in insulating it from sector-specific risk catastrophes.

Sanjit Ganguli is a Corporation LL.M. candidate at NYU and serves as a Graduate Editor of the NYU Journal of Law & Business. Prior to attending NYU, Sanjit worked for four years as an in-house counsel with ICICI Bank, a systemically important financial institution, at their offices in India and Singapore. At ICICI, his practice largely focused on project finance (both domestic and overseas) and cross-border structured finance as well as debt capital markets.