Why did Silicon Valley Bank collapse?

From an innovative start up to bankruptcy, American bank SVB’s collapse has left global markets gripped in terror

By Ahmed Azzam | @3zzamous | 21 March 2023

The aftershock of Silicon Valley Bank’s collapse in March 2023 has rippled across global markets
Many investors in fear that another 2008 recession is looming
US Federal Reserve interest hikes left SVB’s bond portfolio in serious decline, accelerated by depreciation in the tech sector
American bank regulators called for SVB’s bankruptcy, then followed with halting the proceedings of several other banks

SVB’s foundation and rapid growth

Silicon Valley Bank (SVB) was founded in the early 1980s by Bill Biggerstaff and Robert Medearis, former Bank of America executives. The primary objective of the bank was to address the unique funding needs of start-up firms in Silicon Valley, which were often overlooked by traditional banking institutions. SVB offered an innovative approach to structuring loans and risk management that acknowledged the time required for start-ups to start generating revenue.

In addition to customised financial services, SVB offered its clients access to a vast network of venture capital, law and accounting firms. The bank's strategy was to collect deposits from companies financed through venture capital, which was highly successful.

The US technology industry experienced a significant surge between 2020 and 2021 as the Federal Reserve sought to mitigate the impact of the Covid-19 pandemic. The Nasdaq 100 index nearly doubled during this period, and start-ups raced to go public and raise funds from venture capital investors.

As a result, SVB’s business grew extremely with client deposits exceeding $200 billion by early 2022. This growth resulted in a significant increase in the bank's stock price, making SVB the 16th largest bank in the US and the second largest in California.

However, this rapid growth also brought challenges, and SVB had to make carefully considered investment decisions to ensure optimal returns for its stakeholders.

Investment strategy that ultimately led to disaster

After its rapid growth, Silicon Valley Bank had to decide what to do with the significant amount of funds it received. Banks usually collect deposits at lower rates and provide loans to reliable companies at higher interest rates. This approach was not suitable for SVB because most start-ups in the area were not stable businesses with predictable cash flows.

To tackle this challenge, SVB decided to invest the funds in the stock market but exercised caution and avoided volatile assets like leveraged shares. The bank opted for more reliable investment options such as US Treasuries and mortgage-backed securities with suitable collateral in the form of real estate.

In response to the economic downturn caused by the pandemic, the US Federal Reserve cut interest rates causing the yield on short-term investments like US Treasuries to drop to almost zero. SVB bankers realised that investing in these securities wasn’t profitable and they decided to invest most of the bank's capital in longer-term bonds with maturities ranging from 5 to 10 years. These bonds had an annual yield of just over 1.5% at the time, providing a more attractive investment opportunity for the bank.

The interest rate hike started SVB's downward spiral

The fall of bond prices as a result of rising interest rates is a well-known phenomenon in the investment world. When bond prices drop, it becomes difficult for investors to sell them, as their market value falls below their face value.

In 2022, the US Federal Reserve raised interest rates from near zero to nearly 5%, causing the Silicon Valley Bank's bond portfolio to fall between 9% and 17%. This loss was significant but not immediately catastrophic, as accounting standards allowed for losses to be recognized over time. However, the bank could not rely on it because depositors could withdraw their funds at any time.

In mid-2022, there was a gradual outflow of deposits from Silicon Valley Bank, at the same time that the technology sector was in decline and attracting new investors was challenging. It became inevitable for SVB to sell bonds at a loss to return money to its clients.

In 2023, the bank began to sell long-term bonds at a loss but there was not enough money to return deposits for all the clients. More companies started to withdraw their money resulting in a full run on the bank and on March 10, US banking regulators initiated bankruptcy proceedings for SVB.

While Silicon Valley Bank is not the first bank to experience failure, its collapse has had a significant impact on the banking industry. The bankruptcy of SVB started a period of uncertainty that has led to the collapse of other banks such as Silvergate and Signature Bank.