The failures of Silicon Valley Bank (SIVB) and Signature Bank (SBNY) in March 2023 mark the greatest banking failures since the 2008 Financial Crisis. Silicon Valley Bank alone had nearly $175 billion in deposit liabilities which it was unable to satisfy.

As regulators bail out depositors in a response to the liquidity crisis, shareholders and unsecured creditors have been completely wiped out. Therefore, it’s particularly important for investors to understand the root causes of this crisis and what concrete signals they can use to avoid future calamities.

Duration Mismatch

The proximate cause of the crisis was a classic run on the bank. Depositors observed that SVB did not have enough liquid assets to pay everyone, so they started to withdraw their funds, which made the underlying problem worse. This classic process reinforced itself until the bank lacked the ability to meet its clients’ withdrawal claims, the mark of a banking failure.

But the intermediate cause was the fact that the bank had a duration mismatch between the liquidity of its assets and liabilities. Deposits are a liability for a bank, as clients are entitled to withdraw their funds at any time. However, the banking business model often necessitates that banks lend a significant portion of these deposits to other clients as loans. At the least, banks may use these funds to hold high-quality assets like government bonds (i.e., U.S. Treasuries) or agency securities.

These bonds and loans tend to have long-term maturities, spanning anywhere from 1-20 years. The risk is that if too much of a bank’s assets are held as illiquid securities, then the bank itself may have a liquidity problem which magnifies a panic into a total collapse. Although these assets were of high quality, they simply were not as liquid as cash, so the bank was at risk for a bank run.

These factors should be considered in the context of a tougher environment for venture capital and startups, which constituted the bulk of Silicon Valley Bank’s client base. With VC financing plummeting from records in 2020-2021, many unprofitable startups have continued to burn through their cash. As these companies deplete the funds in their accounts, pressure mounted on SVB as their depository institution, which saw increasing drains on its liquidity.

Key Takeaways

• For any company you invest in, ensure that their assets are at least as liquid as their liabilities. Note the asymmetry: their liabilities do not necessarily need to be as liquid as their assets.
• Financial institutions are particularly prone to this risk because they bear the most liquid liabilities in existence: claims on cash.

Balance Sheet Valuations

Perhaps the most fundamental cause of the crisis is the fact that monetary policy has been tightening since March 2022. Restrictive monetary policy (e.g. higher interest rates, quantitative tightening) tends to raise the cost of capital and decrease the price of financial assets, especially equities, and credit.

(Click on image to enlarge)

Short Term Interest Rates, Federal Reserve

Banks generally hold some mix of cash, loans, government bonds, and mortgage securities as assets on their balance sheet. As interest rates rise, the value of these loans, bonds, and mortgage securities tend to fall in value. However, many of these assets are not accounted for on their market value; instead, they are shown according to their value at maturity.

In theory, these assets are still worth their full par value and interest payments if one can hold them until maturity. But in reality, banks may be unable to actually wait that long, because depositors may demand their funds before maturity ever comes. As a result, the bank may have to sell these assets in the market in order to satisfy the demands of depositors. But because interest rates have risen, the market value of these assets has fallen, so the bank may actually take a loss on the transaction. This can further reinforce the panic, since the decline in the bank’s solvency makes depositors more concerned about the bank’s ability to pay them back.

In SVB’s case, the discrepancy between value at maturity and current market value was wide enough to wipe out all the company’s equity. Taking a look at their balance sheet, stockholder equity (also known as book value) was reportedly around $16 billion as of December 31, 2022 (the most recent reporting period). However, this calculation considered the value of their Held-to-maturity securities to be ~$91 billion, although the disclosed fair value was ~$76 billion). This $15 billion haircut would have wiped out nearly all of SVB’s reported $16 billion in book value. Considering that most recent developments (e.g., the depositor panic) may have had further detrimental impacts on SVB’s balance sheet, the current book value may have well been negative.

(Click on image to enlarge)

From SVB’s most recent 10-K filing with the SEC

It’s important to note that many other financial institutions have taken these risks historically but have survived nonetheless. That is because those firms take advantage of financial instruments to hedge the interest rate risk that is an inherent part of their operations. SVB failed to hedge this risk accordingly, for reasons we will explore in the next section.

Key Takeaways

• Ensure that your portfolio companies are solvent.
• If you are willing to take the risk of investing in an insolvent company, you must be fully aware of that risk when making the investment.
• You should also adjust (decrease) your position size accordingly and ensure that you are compensated with a strong risk-reward ratio.

Corporate Governance

Another important cause of the crisis at Silicon Valley was the failure of the company’s board of directors to properly manage and report about these material issues to their investors. Corporate directors have a duty of care and duty of loyalty to their shareholders, and there is a strong chance that this board failed to fulfill those responsibilities. As a result, shareholders are now filing a shareholder class-action lawsuit against SVB for this negligence.

According to SVB’s Corporate Governance Guidelines, their board of directors had twelve principal functions to fulfill. Most notably:

1. To Review and Approve the Company’s Strategic Direction and Annual Operating Plan and Monitor the Company’s Performance
2. To Oversee the Company’s Risk Management, including its Risk Appetite Statement
3. To Advise and Counsel Management
4. To Provide Oversight in Maintaining the Integrity of Financial Reporting

As it is now clear, the board failed to properly execute these core functions in relation to the company’s risk and performance. The board also had a specific Risk Committee which should bear most of the blame for these deficiencies. Importantly, the company was missing its Chief Risk Officer who had left the company in April 2022. The role remained unfilled until the current crisis and restructuring of the bank.

From SVB’s 2023 Proxy Statement, we can see that their directors were fairly well-balanced from a high-level perspective. There was a fair mix of director tenure and other attributes, but there was a severe imbalance between independent-dependent directors, and the board probably could have used more refreshment Of the 11 board members, only one director (the CEO) was not independent:

(Click on image to enlarge)

From SVB’s proxy statement

This raises issues because independent directors tend to have less knowledge about company operations and risks, while insiders tend to have a more intimate understanding of how the company is doing. Without knowing the directors personally, it could be hard to tell whether they were very proactive in their roles. But if anything is clear from this rapid collapse, it is that this board completely failed in its oversight responsibilities.

Another example of great surface-level attributes by this board is their skills and experience. Again from the company’s proxy statement, we can see that directors had a wide array of skills that would seem relevant:

(Click on image to enlarge)

From SVB’s proxy statement

Directors had other notable features as:

• Directors for the Federal Reserve Bank of San Francisco, Hyundai Motor Company, Rite Aid, Fastly, Janus Henderson, Fiserv, the Royal Bank of Scotland, the Stanford Institute of Economic Policy Research, and various nonprofits
• MBAs from prestigious schools
• Venture capitalists

The central point here is that fancy titles and positions are nothing more than qualifications for a position; directors must actively apply their knowledge, skills and experience to create an effective board.

Key Takeaways

• A board and each of its members must be capable, but capability alone is not sufficient to achieve great results and to avoid tragic mistakes.
• Do not be fooled by the surface-level attributes of individual directors. Instead, examine the specific contributions and track records of each director as a member of the board.
• The failure of shareholders to proactively demand accountability by the board is a source of failure in the system.
• In cases where corporate directors fail to satisfy their fiduciary duties, shareholders can retroactively take legal action to address their grievances, but such actions may ultimately provide limited recourse.

Desperate Stock Sale

Another issue was SVB’s proposed stock sale, which attempted to raise nearly $1.75 billion in total capital. This financing move was taken as a signal of desperation by a company that was rapidly approaching a liquidity crunch. This proposal was also made in conjunction with an announcement regarding SVB’s sale of assets to meet client withdrawals.

On March 8, 2023, the company announced that it had sold ~$21 billion of securities, which would result in an after tax loss of ~$1.8 billion. In fairness to the board of directors, they were transparent about this material event at the time of the sale. However, they failed to communicate or address this risk in advance of the panic, which was irresponsible.

Just as the initial panic made depositors more concerned about their deposits, investors also become more concerned about providing capital to the bank. When creditors stop lending, or shareholders dispose of their holdings, then the bank may have difficulty raising capital from financial markets, reinforcing the overall panic. This sequence of events occurred when SVB tried to issue the additional sale of common and preferred stock on March 8. Many investors took the sale as a sign of fundamental weakness and rushed for the exits.

Key Takeaways

• When a company depletes its cash and needs to raise capital, liquidity problems may become acute if the market deems the company to be beyond saving. Such issues may arise if the company is operating at a loss or its assets are declining in value.

Other Mismatch Risks

While a duration or liquidity mismatch was the intermediate cause of Silicon Valley Bank’s collapse, there are other types of asset-liability mismatch that investors should be cognizant of. Looking back in history, the other two types of mismatch risk which have destroyed financial institutions are:

• Interest rate mismatch
• Currency mismatch

An interest rate mismatch is when the rate of return on a company’s assets and liabilities becomes unprofitable. In the most typical case, a company may borrow at a variable interest rate (say 5%) and lend at a fixed rate (say 7%). While this transaction is profitable at first, it is prone to interest rate risk. If the variable interest rate rises above the fixed rate, then the company may actually take a loss on the transaction. As a result, they may generate negative cash flow, which is financially unsustainable.

This risk generally occurs if the going market rate (which is set by the Federal Reserve) is increased and maintained at a high level for an extended period of time. This is the type of problem that led to the Savings and Loan Crisis in the 1980s.

Currency mismatch occurs when a company’s assets and liabilities are denominated in different currencies. In the case of a bank, it may borrow in one currency and lend in another. This type of crisis is relatively uncommon for American banks, since the U.S. Dollar has been a fairly strong currency throughout history. But the strength of the U.S. Dollar has actually caused weaknesses for foreign banks many times.

This was the case in the Latin American Debt Crisis of the 1980s. Several Latin American countries including Mexico, Brazil, Argentina, and Venezuela had accumulated significant amounts of dollar-denominated debt. When exchange rates adjusted and the Dollar appreciated, these liabilities became more difficult to pay off. As a result, many Latin American governments and financial institutions defaulted on their debts throughout this period.

Key Takeaways

• Watch out for interest rate and currency mismatches in a company’s balance sheet
• If a company is taking these risks, ensure that they have hedged these risks through the use of derivatives or other financial instruments

Conclusion

Although the downfall of Silicon Valley Bank was quick and sudden, these issues are hardly unique to that one bank. Other financial institutions, and non-financial companies, may suffer a similar fate. Investors should be careful to look out for these risks and should proactively mitigate their exposure to such events, especially to the extent that monetary policy remains restrictive going forward.

More By This Author:

The Limitations Of Passive Investing