Silicon Valley Bank: An accident waiting to happen?

Silicon Valley Bank: An accident waiting to happen?

The problem with the banking as a business

Ordinarily significant events in financial markets take a few days to migrate from the relatively staid pages of the Financial Times to the mainstream media. The collapse this weekend of the relatively obscure Silicon Valley Bank (SVB) is probably just about noteworthy enough to do so. Therefore, if you haven’t heard about it yet, then it is only a matter of time.

Silicon Valley has come to elicit, not unlike Wall Street, much more than just a geographical location, but also the epicentre of innovation and high technology. SVB was a bank that focused entirely on serving this industry. It specialised in taking deposits from and lending money to the businesses being created to change the world.

These businesses were often not profitable, generated no cash and existed only to the extent that their investors were prepared to keep putting their hands into their pockets. This is how venture capitalism works and unfortunately these investors periodically lose the ability, or indeed the willingness to continue funding such enterprises. What could possibly go wrong?

All businesses endeavours are inherently risky, but banking is especially challenging. This is why it is so heavily regulated and is precisely the reason why scrutiny of the industry was so acute in the years immediately after Lehman Brothers collapsed back in 2008. All banks have essentially the same business model. They take money from individuals or businesses and pay interest on these deposits. These deposits are in turn either invested in interest bearing securities or lent to other businesses and individuals. The bank makes money by paying less interest on the deposit balances than it receives from the investments it has acquired or the loans extended. That is the extent of it.

The Achilles heel of the banking business model is this; deposits can be withdrawn by the customer immediately or at least much more quickly than the loans can be called in or the investments sold. When depositors lose confidence in the financial strength of their bank a so called ‘run on the bank’ occurs. The SVB collapse was an example of this with two important lessons.

Why did SVB Fail?

First, the very early-stage businesses it took deposits from were largely loss making and were rapidly spending the cash they had on the deposit. SVB’s depositor base was not sufficiently diversified, and investors should avoid banks serving only one industry. In fact, this is a lesson that every generation of investors keeps having to learn, going back all the way to the banks that financed the railroads. They experienced a similar fate.

Second, investors are relying on the competence and judgement of each bank’s executives to lend and invest prudently. A dubious proposition because corporate leaders often have no better grasp of the future than the rest of us. As it turned out SVB’s management did not invest the deposits they received in this manner and instead incurred large losses on their investment portfolio as interest rates began to rise in 2022.

Summary

In summary SVB’s depositors abandoned them and their investments suffered a serious loss of value. Our expectation is that there will as a result be further banking regulation, industry consolidation and market volatility as investors grapple with whether there is likely to be any contagion.

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