This article first appeared in The Edge Malaysia Weekly on March 20, 2023 - March 26, 2023

ON Friday March 10, Silicon Valley Bank (SVB), the 16th largest bank in the US with US$209 billion (RM941.2 billion) in assets, and a key cog in the wheel of the innovation start-up ecosystem, imploded. It was the second-biggest bank failure since Washington Mutual’s collapse at the height of the 2008 global financial crisis. The way I see it, banks in the US as well as the entire tech ecosystem, the key driver of American growth for the past 15 years, will never be the same again.

Founded in 1983, SVB was unlike any other bank in America. Its depositor base was one of the most concentrated of any financial institution on earth — mostly venture capital firms, or VCs, their limited partners, or LPs, and their investee firms, which are  tech and biotech start-ups. It was the beneficiary of most of the money that large VCs were ploughing into start-ups. More than 50% of Silicon Valley start-ups did business with SVB, and it had a hand in 44% of VC-backed tech initial public offerings (IPOs) last year. Among its early clients was Cisco Systems Inc, the darling of the tech boom in 2000. Big depositors included streaming device maker Roku Inc, video gaming platform Roblox Corp and aerospace manufacturer Rocket Lab USA Inc.

The bank was also the biggest lender to start-ups, which don’t just raise a ton of money from VCs in funding rounds but also borrow a ton along the way. Yet a loan to a pre-revenue start-up that hasn’t even begun testing its business model is the riskiest loan any bank can make. That said, one in a million start-ups ends up becoming the next Google.

SVB was also more than just a commercial bank. It owned an investment bank which three years ago bought a biotech-focused investment bank. It had a growing private banking business to cater to the nouveau mega rich in the Silicon Valley. Moreover, the bank to the VCs was a VC itself, taking stakes in start-ups it did business with through its US$9.5 billion VC fund, which also owned stakes in VC giants like Sequoia Capital and Marc Andreessen’s a16z. It also lent money to young founders, including those running promising early-stage start-ups, giving them mortgages for mansions or vineyards, or loans to buy sports cars using their overvalued start-up stakes as collateral.

Yet the recent implosion was not due to any FTX-like fraud but just the lack of proper risk management. Put simply, the SVB collapse was about asset-liability duration mismatch. Banks make money taking short-term deposits and lending it longer term. They pay depositors a pittance and charge borrowers more. The difference is their net interest margin. Make no mistake, banks make a lot of money. In 2021, JPMorgan Chase & Co posted US$48 billion in net income. It all works well until customers lose confidence in a bank or indeed, the entire banking system. Don’t let anyone tell you that good banking is about stellar balance sheets. It is actually all about confidence. The moment that confidence is lost, it is game over.

Depositors can ask for their money back at any point. Banks themselves have far less leeway selling long-term instruments — Treasuries, government-backed mortgage securities, or even loans. If a lot of depositors ask for their deposits back at the same time, the bank, in most cases, is toast. That’s what happened at SVB.

On social media’s megaphone, anyone can trigger a bank run with a few random tweets. If something smells like smoke and you scream “Fire”, there will be a stampede even if nothing is actually burning. Here’s how it all unfolded: A bunch of big VCs in the Valley decided that it was no longer smart to bank with SVB. A handful of customers yanking their business normally makes little difference to a bank with a diversified asset and deposit base. But SVB had substantial exposure concentrated in 25 or so large VCs in the Valley. Each of those VCs was in turn invested in 40 to 60 or so start-ups, which accounted for close to 25% of SVB’s total deposits.

VCs and start-ups are nothing if not extremely tech savvy. Everyone is on Twitter all the time. They do their business digitally, making most transactions through their ­iPhone apps. One big VC, right-wing billionaire and Donald Trump crony Peter Thiel, urged everyone on Twitter to withdraw all their deposits from SVB immediately. That led to huge withdrawals — not just from the VCs as well as their investee companies but also their employees, friends and acquaintances. A total of US$42 billion, or 24% of SVB’s US$175 billion in deposits, was withdrawn in a single day. Everything, everywhere, all at once collapsed like that bank run scene immortalised in the classic movie, It’s a Wonderful Life.

Although that movie was released long before I was born, I did witness a real bank run, on Standard Chartered, in Hong Kong in 1991. As I walked to my office one morning, I saw queues outside its branches. Rumours had spread that the bank’s licence was being withdrawn by UK regulators. Hong Kong authorities kept the branches open until late, promising depositors all their money back. It took two days to calm depositors.

For its part, SVB took deposits from VCs. It then deployed over 90% of that money into Treasuries or government-backed mortgage securities. These are, of course, the safest of instruments any bank can hold. Yet here’s the twist: SVB was in long-dated instruments that cannot be cashed at short notice. If you sell them in a hurry, you might get 90 cents on the dollar.

After rating agency Moody’s indicated it was ready to downgrade SVB’s debt to junk status on Feb 28, the bank sought to raise US$2.25 billion in new capital, including US$500 million from giant VC General Atlantic. Regulators had been asleep at wheel. They knew that SVB was holding Treasuries with three- and five-year maturities but holding them until maturity is no good when 25% of the depositors want their money back immediately. SVB’s portfolio was not marked to market. The US Federal Reserve has raised interest rates from zero to 4.75% over the past 12 months in the fastest rate hike cycle in history. When rates rise, bond prices fall. The easiest to sell part of SVB’s bond portfolio was at the time worth around 92 cents on the dollar.

SVB’s banker, giant investment bank Goldman Sachs, advised that in the interim, it should sell some of its Treasuries. Goldman itself bought US$21.4 billion in government securities from SVB at a loss of around US$1.8 billion. It also charged SVB US$100 million in fees. Now that two-year Treasury yields have fallen from 5.1% to 3.9%, the government-backed mortgage securities that Goldman holds are worth a lot more. All told, Goldman could walk away with nearly US$1 billion in profits and fees while SVB has been wiped out.

Yet without the capital raising, SVB was essentially bankrupt. The market had gotten wind of that, SVB stock plunged and VCs like Thiel who had been key beneficiaries of the bank’s ecosystem started pulling their money out. Twitter feeds of VCs exploded, everyone rushed to the door and the bank in the end didn’t have enough money to keep paying depositors.

As for the blame game, aside from SVB’s risk management issues, look no further than the regulators. Until now, only up to US$250,000 in deposits was insured by the Federal Deposit Insurance Corp (FDIC), so small depositors did not have to worry about banks going belly up. Only 2% of SVB deposits were protected by the FDIC. In trying to rescue SVB, the regulators gave out wrong signals. Instead of telling the bank: “We know you have long-dated government securities that can’t be sold quickly. We will take those assets and help you secure a cheap loan so you can pay depositors who are queueing up.” That would have ended the bank run and regulators taking over SVB bonds would have made US$1 billion in profit instead of Goldman Sachs. Yet the Fed, FDIC and Treasury secretary Janet Yellen dragged their feet, which led to depositors yanking out 24% of all SVB deposits. From now on, depositors and borrowers will flock to bigger, safer too-big-to-fail players like JPMorgan, Citigroup, Bank of America and Wells Fargo. Small banks are toast because the government is unwilling to say it will do whatever it takes as long as they have good assets. Confidence in small banks has been shattered.

There are far too many banks in America — 4,150 or so at the end of last year. Don’t be surprised to see a rapid consolidation among US banks over next 10 years. A vast majority of the small banks will either merge with larger players, or fail. Moreover, if regulators are now implicitly guaranteeing all deposits, even those over US$250,000, the cost of that guarantee will continue to rise. And, it is the small banks that will pay the FDIC to insure all of the deposits. They would rather merge than lose depositors to JPMorgan or pay higher costs. To stem the tide, some smaller banks will also be forced to raise deposit rates, which means lower interest margins for them. Sure, small community banks with a single branch in a small town and no ATM might still thrive but everyone in between the big four banks and the community banks is now vulnerable. Small banks are well capitalised and their deposits are backed by the safest US Treasuries. The problem is that many of them, like SVB,  hold long-dated instruments that can only be sold quickly at a loss when rates are rising.

Why didn’t regulators see the red flags? The Dodd-Frank Act of 2009 allows stress tests of banks to make sure that if one is failing, it doesn’t bring others down as well. Until 2018, banks with more than US$50 billion in assets had to undergo an annual stress test. The Trump administration pushed Congress to raise that limit to US$250 billion. That allowed SVB, and Signature Bank, the other bank that went belly up recently, to evade the mandatory stress tests. If the two had been stress tested, and their bond portfolios marked to market, they wouldn’t have to be shuttered and require a backstop for depositors. Higher interest rates on deposits will mean lower net margins.

Changes in how banks operate aside, there will be an even bigger shakeout in the start-up ecosystem and the larger tech sector. More smaller tech companies will likely fail or be forced to merge with bigger players because they can no longer access cheaper capital from specialised banks like SVB. Fewer start-ups will get funding from VCs who themselves now have to bank with the biggest banks. Fewer start-ups will be able to access bank debts now that SVB is out of the picture. Why would Citigroup make a loan to a pre-revenue start-up? Why would Wells Fargo give a mortgage to a start-up founder for a mansion or a vineyard? Moreover, start-ups with dodgy business models will find it hard to get funding and those that have funding will find the IPO process or the exit for their founders and big shareholders will be a big issue.

That means less innovation and indeed slower economic growth in the US. Whatever the failings of SVB, the start-up ecosystem and VCs, until now they have helped build a robust engine of growth for the US economy. That engine is now smaller, burdened with more regulations and driven by large, more risk-averse banks. Surely that can’t be good for the tech sector and the US economy as it tries to crawl out from the hole that it is in due to the persistent rate hikes of the past 12 months.

Assif Shameen is a technology writer based in North America

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