The Collapse of Silicon Valley Bank: A Bank Theory and Operations Analysis/ Case Study

1. Introduction: Silicon Valley Bank’s Road to Collapse

The collapse of Silicon Valley marked the height of financial restraints instigated by the global inflation of 2020-2022. Silicon Valley’s avalanche followed the collapse of Signature, Silvergate and other global power banks (Pandey et al., 2023) within two weeks in what came to be known as the 2023 global banking crisis.

There is generally one way a bank can undergo failure – when its assets are not enough to settle its liabilities. In the event that a bank is unable to settle its obligations and provide cash for its depositors, it suffers the fate of dissolution by the oversight authority, which in the US is the Federal Deposits Insurance Corporation. FDIC was installed in 1933 after the Great Depression when many banks collapsed, passing on the loss to depositors. Now, the FDIC requires insurance payment for every customer deposit made to a bank. In return, the FDIC will compensate customers up to $250,000 or even reimburse all their deposits when a bank collapses. Financial regulations protect depositors’ funds and even the bank itself from collapse. In 2020, during the financial constraints presented by the COVID-19 pandemic, the requirement of a 10% cash reserve to be held by banks was lifted. Many banks then went on an investment spree, taking long-term investment opportunities that are less liquid but more profitable (Baker, 2023). SVB invested in the then much profitable treasury bonds, whose yields were very promising at the start of 2021.

Treasury bonds are debt securities issued by the US treasury. The bond’s main characteristics are a relatively long maturity period of 10-30 years, high security as it is issued by the US government, and fixed interest rates (yields) payable in six months. At the time of a bond’s maturity, the bondholder is compensated not only for the bond’s interest but also for the full face value of the bond. The US government issues treasury bonds mainly to access capital to fund development projects and finance government expenditures. Even if treasury bonds are issued by the government, the bond changes hands severally before its maturity and is a common securities exchange asset in the financial market.

SVB’s woes were mainly caused by the depreciation of its investments’ market value due to the inflation wave that hit America and the globe at large (Dinh, 2023). Any form of currency and its equivalence suffers depreciation as a fate of inflation. However, the longer term a security is, the more loss it makes as it cannot be liquidated in a short period to alleviate piling inflation effects. Since SVB had so much invested in long-term treasury bonds, the bank’s assets lost their value, almost making it unable to offset obligations and withdrawal requests (Metrick & Schmelzing, 2023). The bank had to incur more liabilities in the form of loans from other banks. The liabilities piled up to the level of superseding its assets, making it insolvent.

Cash reserves come in the form of cash and short-term investments that are highly liquid, for example, treasury bills. Banks, companies, and individuals hold cash reserves to finance a project or settle its pending obligations. While cash reserves are essential for a bank’s security off customer deposits, banks need to source income by investing the cash elsewhere. Moreover, customer deposits attract interest, and the only way for a bank to recover the interest is to loan out the cash or invest in profitable securities.

Liquidity is an essential asset to a bank’s survival. It is the best form of cushion from the worst-case scenario a bank can face – a bank run. Although SVB’s woes were caused by solid demand and supply-related inflation effects, it was the culminating bank run that finished the institution off.

2. The theory(s) of banking; on how banks make money

Functions of a bank

Many retail banks also provide commercial banking services by lending and offering monetary savings services to corporate organizations. Banks are an essential pillar in the business sector. Some of the invaluable functions of the banking sector are the facilitation of cash transactions, secure money storage, investment opportunities, issuance of credit and debit cards to facilitate spending, debt servicing, and providing investment opportunities through both cash deposit interests and securities like money market funds.

Income and Capital

Banks are very profitable businesses benefitting from bulk cash transactions with narrow interest rate margins. Therefore, for a bank to make a substantial profit, it has to handle much cash compared to the bank’s equity. Equity is also known as capital and is a bank’s net worth after deducting liabilities from its assets (Li, 2022). Non-financial businesses hold less debt per their equity, about 0.8-1.5% debt-to-equity ratio. However, the debt-to-equity ratio is relatively high for banks, at an average of 8% (Demirguc-Kunt et al., 2013). This, however, does not mean that the bank can/cannot fully offset its liabilities. What really matters is the bank’s liquidity ratio and current assets as a portion of its total assets.

Banks generate income from their activities, bar savings and deposits, which in turn incur expenses in the form of interest on deposits. Savings and deposits are also the primary liability for a bank that it uses to finance loans. Moreover, savings and deposits are catalysts to money circulation in the theory of market multiplier. Banks act as mediums in multiplying the amount of money in an economy’s circulation by receiving debt and issuing loans (Tobin, 1963). The same loan money issued by bank A is also deposited elsewhere in bank B, which also lends out, and the chain continues. At the end of the chain, the economy will result in a bigger number multiplied by banks from a single initial deposit. The multiplier theory is limited to the fact that people and companies will always deposit, banks will always lend, and loans will be paid. Import spending, bad loans, taxes, and the inability to lend are all drawbacks of the money multiplier theory and the function of the bank.

In explaining how banks work, the credit creation theory builds on the money multiplier theory in the sense that a bank creates money by lending and that the deposits result from a bank’s lending (Das & Nanda, 1999; Werner, 2016). Credit money consists of 97% of the total monetary circulation in the world and is created by a bank’s strike of a pen (Diamond & Rajan, 2006). The loaning process begins with a simple record on a bank’s books, whereby the amount is debited as an asset and credited as an account payable. The latter represents the various sources of a bank’s capital, whether its customer deposits, reserves, or a loan. Seigniorage traditionally refers to the profit a central bank makes from creating money, calculated as the difference between a currency’s face value and the cost of printing/making it.

On the other hand, retail/commercial banks generate much income from credit creation. Firstly, banks profit from the immense lending opportunities presented by credit creation. Banks also benefit from the reduced cost of capital, as the interest rate on customer savings is lower than interest on loans issued by banks.

Fractional reserve banking is the theory on which many banks base customer deposit investments. Fractional reserve banking is a system requiring/allowing banks to loan out only a fraction of the customer’s deposits (Chari & Phelan, 2014). In return, the customer collects interest on their deposits. Banks make money by levying interest on loans issued at a higher rate than the interest banks pay customers on their deposits. When a customer allows a portion to be lent out by the holding bank, they accept that the funds will not be available for withdrawal until the maturity date agreed upon by both parties (Rothbard, 1995). In the event that a customer requests a withdrawal from the bank before maturity, the customer should expect the bank to borrow the money from elsewhere. Now if more and more customers make withdrawal requests, the bank will borrow more until it has no more capacity to borrow. The result is insolvency, as it was the case with SVB. Banking regulators play a significant role in fractional reserve banking as they limit how much a bank can hold as a percent of customer deposits. Relaxed regulations allow banks to make more money, like the lifting of the 10% reserve ratio by the FDIC. On the other hand, relaxed regulations may fuel bank dissolutions in the event of bank runs, as a result of lifted or extremely low reserve ratios.

3. Surplus investments: securities, evolution of assets, inverse relationship

Banks do not lend out all the money deposited, for profitability and security reasons, and sometimes a fall in demand for loans (Lepetit et al, 2008). There exists a myriad of ventures a bank can invest funds in both long term and short-term. Individual banks’ strategies on investment are inspired by the financial situation at hand, risk tolerance, future needs for capital, and the goals of the bank. Financial situations go hand in hand with risk tolerance of securities and investments. Rough financial terrain presents an unpredictably risky adventure for bank investments. Bank failures are activated by mere here say that the bank has issues, and when customers catch wind that a bank is having any challenges their first impulse is to source security by withdrawing their money from the bank.

At a time of financial tumult, one thing matters to a bank, and that is its liquidity. Investment options differ in liquidity ratio, and this fact informs a lot of bank’s activities during financial crises. Treasury bonds have very long maturity periods, and they can only be more attractive when they are closer to their maturity dates, which means they can be liquidated easily (Cieslak, 2018). When a bank is expecting a future demand for cash/withdrawals, the second best option is to buy short-term securities, not only because they can be liquidated in the short term, but mostly because they are attractive in their more liquid form. The year 2021 presented an opportunity for banking institutions to invest in the then cheap treasury bonds. Treasury bonds’ prices act inversely with bank rates, and an increase in cost of loans leads to a decrease in price of bonds and conversely an increase in bond yields, making them more attractive (Cornell & Shapiro, 1989).

During the COVID-19 pandemic and its aftermath, the Federal Reserve lowered interest rates to make loans attractive, as a measure to alleviate financial hardships brought by the pandemic. As a result, the yields of treasury bonds were more attractive. Silicon Valley Banks is one of the banks that seized the opportunity and purchased billions worth of US Treasury bonds (Bales & Burghof, 2023). When inflation checked in later stages of the post-pandemic era, interest rates skyrocketed, reducing the worth of treasury bonds. Around March 2022, treasury bonds were plagued investments and SVB had a hard time selling them. The result was billions worth of capital loss and ensue of a panic mode, leading to the bank’s closure.

Commercial banks differ from investment banks in that the former looks at security first before profits (Read & Gill, 1989). Government bonds are very much preferred in commercial banking as they are issued by the strongest of all financial forces. Moreover, regulators require banks to hold a percentage of the customers’ money in the form of cash reserves. The reserve ratio limits bank investments but can also be a bank’s plight during bank runs. The reserves can be in the form of cash deposits in the Federal Reserves, or short-term investments that are highly liquid. Banks can also plough back surplus profits into real estate. However many the opportunities are, the bulk of a commercial bank’s income emanates from interest fees.

4. Banking regulations, interest rates, inflation and capital control, regulatory changes in the post-crisis era.

Banking regulations are laws, rules, principles and guidelines installed by a government oversight institution on country’s commercial and investment bank in order to maintain a stable and secure financial system (Battacharya et al, 1998). In the US, a contingent of regulators have been installed under the National Treasury, at both the federal and state level. Regulations in the US have been sparked by major financial crises (Barth et al, 2010). The first important regulation was made in 1864 in the form of the National Bank Act, establishing the first ever regulator – comptroller of the currency, whose work was to charter and supervise all national banks. The Federal Reserve Act passed later on in 1913 paved way for the creation of the strongest regulator to date – the Federal Reserve. Acting as US central bank, the Federal Reserve was tasked with economic and financial stability by controlling the amount of money in circulation and counter inflation (Willis, 1914).

The year 1930 saw the worst financial crisis in the history of the US of A. Bank depositors astoundingly lost all of their money as a result of uninsured deposits (Romer & Pells, 2003). Massive bank runs during the depression led to the passing of the Glass-Steagall Act of 1933 which established the Federal Deposit Insurance Corporation (FDIC) whose duty was to protect customers from losing their deposits in the event of bank closures. Banks were required to pay insurance on deposits made by customers (Crawford, 2011). In return, the FDIC would bail out the customer when a failure strikes. Silicon Valley Bank was a haven for start-up and took in billions of deposits. By March 2023, the bank’s deposits had exceeded the maximum amount insured by FDIC. About 89% of the bank’s $175 billion customer deposits were uninsured by the FDIC, leaving customers at risk of losing the money (Reuters, 2023). Although the FDIC settles customer deposits up to only $250,000 per deposit (Lucas, 2013), the US government intervened significantly to ensure all customer deposits are fully reimbursed.

Money laundering became a major issue in the 1970s when criminal activities like drug peddling was on its summit. The Bank Secrecy Act of 1970 was, as a result, established to require businesses to keep records that have a high degree of usefulness in criminal, tax and regulatory matters. In 2008, the US experienced yet another major financial crisis. In a similar way as the Glass-Steagall, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was brought in to life. The act was a response to new developments in mortgage and credit facilities which led to the crises. The Consumer Financial Protection Bureau (CFPB) was also created to supervise the enforcement of the act (American Bankers Association).

The five are the major bank regulations in the history of the US. Stemming from them are a myriad of other regulations, some short-term to counter new developments in the market, like the lifting of the 10% reserve ratio requirement by the FDIC. COVID-19 struck menacingly in 2020, instilling devastating financial breakdowns for households and businesses. The government of the day responded by passing the Coronavirus Aid, Relief, and Economic Security (CARES) Act, issuing $2.2 trillion worth of stimulus packages that cut across all sectors (Congress.Gov). As announced on March 15, 2020, the Board of the US Federal Reserve reduced bank reserve requirements to zero (0) percent (Federal Reserve Board). This regulation allowed banks to spend all customer deposits without having to cushion with liquid assets for withdrawals and offsetting emergency liabilities. The objective of the regulation was to promote borrowing and issuing of loans by banks during the COVID-19 pandemic. Banks, however, could not issue all of their money and opted to invest the idle cash elsewhere.

SVB invested more than $117 billion into bonds, with almost 80% of it into long-term held-to-maturity bonds. Liquidity was put at stake even as the investments realized more than $500 million profit in the first half of 2022 (Anwer et al, 2023). With less investment insurance made on available-for-sale short-term assets, the bank was at risk of low liquidity. In 2023, massive withdrawals were made and the bank had to sell all of its available-for-sale assets. The sale recorded a devastating $1.8 billion loss, with the demand for liquidity increasing in hours and days (Vo & Le, 2023).

Federal Reserve holds immense power in defining the prices of securities, majorly indirectly (Conti-Brown, 2018). The reserve, in 2020, reduced interest rates to promote borrowing, indirectly increasing the attractiveness of Treasury Bonds. A record high inflation hit the country and the globe at large, attributed to government stimulus packages and an un-expected recovery in demand in the post-pandemic period. The Federal Reserve had only one viable solution to curb the surging inflation – increase interest rates to reduce borrowing. As a result, the bond securities that were once booming became disregarded due to low yields.

5. Conclusion: Bank run

The many mistakes and bank strategies both informed by banks and the Federal Government surmounted to the second worst bank failure in the US of A, only after the Washington Mutual in 2008. Some causes were disguised as profitable banking strategies back then. SVB deliberated to seize the opportunity presented by its humongous deposits and relaxed regulations to invest and grow. Bank failures are very unpredictable as was with the case of SVB. Only six months into its dissolution, the 16^th largest bank in the USA by assets recorded millions of profit from the same bonds that led to its doomsday. A huge part of SVB’s deposits (89%) was uninsured. Were it not for government intervention, many depositors would have been left stranded, incurring losses transferred by the bank’s collapse. The FDIC had one job, and that was to insure deposits and monitor the adherence of banks to the insurance regulations. More enforcement would be needed to guide adherence to the various banking regulations, notwithstanding the economic conditions at hand.

Moreover, bank reserves and associated regulations should follow market dynamics at any given time. The 10% reserve requirement was lifted when the market needed a good flow of cash. More than three years have passed, and the lift is still in place, even when the country is experiencing insane inflation as a result of the same lift and associated stimuli. The lift was a short term regulation to solve a short-term problem. When the problem ceased to exist, and the financial situation changed, the lift should have been replaced with a more environment-friendly regulation.

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