How duration risk sunk Silicon Valley Bank

The collapse of Silicon Valley Bank (SVB) was the second biggest bank failure in US history.

As with events like this, there are often many contributing factors for the failure, and that was certainly the case at SVB.

Some of the key contributing factors include:

• A lack of diversification amongst the bank’s depositors. Most were tech startups. As Daniel Cohen, former Chairman of The Bancorp said, ‘Similar depositors will walk in similar ways all at the same time’.
• There was stress in the tech startup sector. Over the past year, tech companies had been drawing heavily from their deposits, to cover the sector’s ongoing cash-burn.
• Most of the bank’s deposits (around 93%) were uninsured, making the tech companies understandably nervous about their deposits.
• SVB had spent $500k lobbying the Trump government to reduce regulations. This removed some of the regulatory oversight on the bank.

However, the biggest factor contributing to the bank’s collapse, was its massive purchase of long-term bonds and mortgage-backed securities. As US interest rates rose sharply, the market value of the bonds fell significantly. The bond portfolio was also mostly unhedged.

Duration Risk

Duration risk is not a term we hear a lot about, but it is what ultimately undid SVB. Duration risk is the risk that changes in interest rates will either increase or decrease the value of a bond.

Bonds are issued by the government or a corporation when they want to raise money. All bonds have a face value, coupon interest rate and maturity date. If you hold the bond through to its maturity date, you will receive the face value of the bond back. By holding a bond, you also receive interest payments along the way.

If you sell the bond before the maturity date, you will receive the current market price for that bond. This market price can fluctuate, but works inversely to the direction of interest rates. As interest rates rise, the market value of the bond drops, and if interest rates fall, the value of the bond increases.

If you hold the bond to maturity though, you get your money back, but SVB didn’t get that chance.

Tech Boom

In 2021, SVB was flying. The tech boom was in full swing, and tech companies had raised $330bn through IPOs, SPAC deals, and private placements.

Interest rates were near all-time lows, and a good proportion of the cash being raised was deposited at SVB. From March 2020 to March 2021, SVB’s deposits had grown from $62bn to $124bn.

Rather than keeping the surplus deposit money in cash, SVB decided to load up into long-term government bonds and mortgage-backed securities.

As interest rates rose sharply, the market value of the bonds decreased significantly, and by the end of 2022, SVB had mark-to-market losses of over $15bn.

After a meeting with Moody’s, SVB were informed that they were in risk of a downgrade. In an attempt to solve their balance sheet problems, they sold $21bn of bonds for a $1.8bn loss, and began plans for a capital raising.

By this time, depositors became aware of the situation, and within a single day, withdrew $42bn of deposits. The rest as they say, is history.

Finger pointing

Many have blamed the depositors for bailing out of SVB so quickly. However, withdrawing your cash when you’re in imminent danger of losing it all (as it was uninsured), is a perfectly rational thing to do.

Much of the blame, however, lies with SVB’s CEO, Board and risk management team. Asking to loosen regulations, should have been a red flag. They also made one of the most elementary errors in banking, which is taking short-term money and investing it long term. It’s how many banks have failed in the past.

The Federal Reserve has also been blamed for hiking rates so aggressively. Raising rates sharply until something breaks is not a prudent economic practice.

Regulations

Responsible regulations are put in place to help people, society, and the planet. Whether it be water, food, air quality, endangered species, or banks, regulations are there to help us. It was deregulation in the banking industry that led to the GFC.

After the GFC, much regulatory reform went into the banking sector with the goal of preventing any future GFCs. Much of that change is still in place, so hopefully it should be enough to avert another banking crisis.

Lessons

There are a number of lessons we can learn from Silicon Valley Bank. Here are three:

1. Diversification. It’s important to ensure you diversify your investments across asset classes, industries, and geographies.
2. Cash. SVB failed because it didn’t have liquidity when it needed it, so it became a forced seller. In your finances, it’s always good to have a “cash cushion”, just in case you need funds quickly. The last thing you want to be, is a forced seller interrupting the compounding of your investments.
3. Risk management. SVB made some huge errors, which ended up costing them dearly when interest rates rose. So too, it pays to minimise risk, and have your finances set up in a way that can handle any economic eventuality.

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