THE END GAME OF A MARQUEE BANK FOR STARTUPS
THE COLLAPSE OF THE SILICONE VALLEY BANK – CAUSES & CONSEQUENCES
In the startup ecosystem one of the most critical components is the support needed in the form of finance, however viable your projects and proposals appear to be on paper. This is a truism that can be ignored only at your own peril. When talking of finances, the critical role that a banker plays cannot be over emphasised. Startups, typically, have insatiable appetite for money for obvious reasons. Instances of the role of financial institutions in handholding startups are legion and legendary. The Silicon Valley Bank (SVB for short) was born way back in 1985 in this background. It was set up in the Bay Area in California. The Bank, when set up, kept the requirements of startups at the centre of all its operations. The focus and the plans that the Bank would subsequently pursue were truly reflected by the Bank’s name itself. The words Silicone Valley conjure up visions of projects that are built on dreams and run on inspirations. Apart from catering to the funding requirements of dreamy-eyed entrepreneurs, SVB provided a bouquet of services catering to the peculiar needs of budding entrepreneurs. The business model of the SVB was so fine-tuned that the Bank had even developed well designed systems to seamlessly integrate the data of its tech clients with itself for faster processing of inter-se transaction between the customer and the bank itself. No wonder that the Bank became the darling of the state-of-the-art tech startups. With that kind of a business model, it did not take too long for the Bank to become the sixteenth largest bank in the US despite it being only a regional bank in the US. That is when nemesis struck and how.
On 10th March 2023 the Silicon Valley Bank (SVB) failed after a bank run, causing the largest bank failure since the 2008 financial crisis and the second largest in U.S. history. Earlier, rumours in the form of whispers, had already started doing the rounds that there were troubles brewing in the corridors of the bank. Sensing rating downgrades that could seriously undermine the confidence of investors and clients on the bank’s financial health, last ditch efforts made by Greg Becker, CEO of the bank to get some much-needed help from Goldman Sacks also did not yield any results. The bank decided to sell $20 billion of its low yielding long term bonds. That proposal only helped to further spook the investors. The bank managed to sell bonds incurring a whopping loss of $1.80 billion. Inevitably when the news got out, SVB’s shares plunged and prepared the ground for a bank run. The Venture Capitalists who had their accounts in the bank got a whiff of something unusual happening to the bank. Matters came to a head when news went out that the promoter of the bank had sold sizeable holdings in the bank. The VCs on their part started advising their clients to withdraw whatever they possibly could and bolt. A classic bank run was playing out in full view. News got out that the promoter entity was trying to increase the capital base of the bank that exacerbated the crisis further, for a perceived need to increase capital is a sure sign of trouble for a bank as it pointed to a need to shore up the capital base of the bank itself. Thus started the troubles for the startup bank. The Federal Reserve wasted no time and shut the operations of the bank. When it did so, it had two more banks that were also being taken to the cleaners – the Signature Bank and the Silver Gates Capital which were more invested in the crypto sector. The spectre of a banking contagion was there for all to see.
It did not take too long thereafter for people to figure out what exactly had happened at the iconic bank. In a manner of speaking, the bank had become a victim of its own success. In banking lexicon what happened was a case of asset – liability mismatch. A bank makes money by lending to people in need of money by charging interest. It does so by taking deposits from the public based on its solemn commitment to return these deposits with interest. The interest differential between these two transactions goes towards the profit of the bank. This presupposes that deposits taken should ideally be for long periods and the loans extended are for shorter periods. This is so because banks must return the money to depositors whenever they demand. This becomes the bank’s liability. Similarly, the loans given to customers become the assets of the bank. Having got this equation in perspective, let us look at what was happening to SVB. The deposit rates in the US were zero or near zero. This situation came about by easy availability of credit at no cost or near zero costs till its Federal Bank felt that the party had gone too far becoming in the process, the cause of unbridled inflation. It decided that enough was enough and started increasing the interest rates steeply, abruptly and at short intervals. This process resulted in intended consequences of taming inflation but also a lot of unintended consequences not to the liking banks like SVB.
The disastrous consequences of bank failure particularly for the middle class cannot be overemphasised. Deposits are insured only up to the limit of $2,50,000. Deposits exceeding this limit will have to bear the losses themselves. It so happened that more than ninety percent of depositors in the SVB had deposits valued more than this upper limit. The authorities had to act decisively and fast to prevent the run from becoming a contagion. Biden administration did exactly that. The administration assured the public that no depositor in the bank will lose any money. That decision was the easier part of the solution. The real question was who will foot the bill. The administration decided that the normal taxpayer will not have to subsidise the losses of this largess. The loss would fall on other depositors of all other banks. As of writing this piece, Janet Yellen, the Treasury Secretary had declared that she had no intention of giving a blanket insurance coverage for all depositors of all banks. The details of the proposed plan are yet not known. Capitalism without bankruptcy is like Christianity without hell. So goes the saying. Another dimension of bailing out a failed bank with no one to pick up the tag is anathema for a country like the US. There is a reason for this. In such an event the banks would fail to do the required due diligence and could indulge in practices bordering on profligacy. Consequently, the banking system itself would incentivise the very practice that it seeks to prevent.
Now it is time to figure out how this kind of bank failure could happen at all in today’s market and that too in a well-regulated environment. After the 2008 melt down of the financial markets some steps were taken to prevent such mishaps. However, banks like SVB in one sense unwittingly programmed their own undoing. After the 2008 experience the country had enacted the Dodd-Frank Act. This Act was intended to curb the extremely risky financial industry activities that led to the financial crisis of 2007–2008. Its goal was, and still is, to protect consumers and taxpayers from egregious practices like predatory lending. As time passed the Act got diluted to the delight of banks like the SVB. The threshold of capital of $50 billion was raised to $250 billion with the blessing of the then President Donald Trump. The amendments to the Act enabled banks like SVB from closer scrutiny leading to its eventual collapse. With the Fed deciding when to act and when not to, as per its convenience as in this case, led to the Bond prices also to collapse. This has exposed the Fed to avoidable criticisms. As events have turned out, it looked like “capitalism was for the poor and socialism was for the rich” as someone quipped, tongue in cheek.
How do the developments in the US affect the Indian banking system especially since we are affected by what happens in the US profoundly, even if we pretend otherwise. “The collapse of SVB will definitely compound the negative sentiment prevailing in the Indian equity market. Indian markets have been overvalued due to infusion of domestic liquidity” according to Sandeep Bagla, CEO, Trust MF. According to Jefferies what happened in the US is unlikely to be a systemic risk in India. Experts in India feel that the pain generated because of the developments in the US will be limited here. It remains to be seen as to what happens to the resolve of the Fed to continue the rate hikes on interest to contain inflation. According to Anish Teli, the Managing Partner, QED Capital “Regulating banks like utilities could help prevent the kind of reckless behaviour and risk taking that led to the 2008 crisis and current SVB bailout. Taxpayers’ money is used in the bailout when they do not have any share in the profits. They should look at the best interest of the society than maximise profits for shareholders”. Well said. In the end the regulator also needs to carry part of the blame – first for not trying to curb the runaway inflation and then trying to attempt to do things unmindful of their consequences. The Fed should also take the blame for imposing an inverted yield curve on the banking sector. ET Prime aptly summarises the whole situation. “Banking crises are becoming more of a feature than a bug in the greater financial system. It is either due to the irrational exuberance of CEOs or the insensitivity of the banking regulator. It has happened in the past. It will happen in the future. It hurts financial markets – sometimes even for the long term”. I hope not.
It is necessary to look at some of the collateral damages that have come to visit the banking sector consequent to the failure of SVB. As of writing this piece, another major bank situated in the Macca of banking and finance has folded up. This piece will not be complete without making a brief reference to some of those developments. Credit Suisse is a Swiss bank and by any standard to be considered as one that is ‘too big to fail’. It was an open secret that things are not hunky-dory in this Swiss bank, of late. Credit Suisse is the second biggest bank in Switzerland. What was unthinkable once not too long ago, was on the verge of collapse. It had its own set of problems ever since it had come to light that it had connections to some other dubious financial institutions that had recently collapsed. With the interest rates tightening with alarming regularity, the Swiss authorities had no option but invoke the necessary steps to prevent a total collapse of the bank. Here it is necessary to take a deeper dive into the world of Coco Bonds.
Contingent Convertible Bonds (CoCo Bonds) are convertible debt instruments mostly issued by the European financial institutions. These Contingent Convertibles work in a way similar to traditional convertible bonds. They have a specific strike price that, once breached, can automatically convert the bond into equity or stock of an entity. The primary investors for CoCos are individual investors in Europe and Asia and private banks. In the banking industry, their use is to shore up bank’s balance sheets by allowing it to convert its debt to stock if specific capital conditions arise. Contingent convertibles were created to help undercapitalised banks and prevent another financial crisis like the 2007-2008 global financial calamity. CoCos are high-yield, high-risk products popular in Europe. These hybrid debt securities carry specialised options that help the issuing financial institution to absorb capital losses. By the way, in India these kind of convertible bonds in the banking sector are known AT1 bonds that became a bone of contention in the ongoing resolution process of Yes Bank. These bonds in India are qualified to be categorised as Tier 1 Capital of the Bank.
The Swiss authorities had no option but to invoke these statutory yet salutary provisions when stress was noticed in the case of Credit Suisse. That way the authorities could prevent a total collapse of the bank by getting UBS, the bitter critic and competitor of Credit Suisse to take over the bank. It remains to be seen how things are going to develop. Is it the beginning of the banking system itself unravelling or the end of a crisis? If the crisis in 2008 is any indication the crisis has just begun and has some distance to travel. Bloomberg Opinion had this to say about the Swiss today. I quote: “When Asterix the Gaul visited the “Helvetians” in his 1970 comic-strip adventure, he came across a Swiss banker who embodied the nation’s inviolable privacy laws, ironclad stability, and geopolitical neutrality. “Chocolate, cuckoo clocks, and bank secrecy were the Swiss cliches of the day. “If Asterix met Zurix today, he’d find someone very different.” Do I need to say more?
What lessons do we learn from the failure of an iconic banking institution like SVB? These are the important ones that come to my mind:
- Any bank, however big, can fail – remember the principle: caveat emptor.
- For a bank, failure to constantly track the interest rate risk could be fatal.
- Government Bonds are safe only as long you understand what is ‘marked to market’.
- Tracking constantly Asset-Liability mismatch is a solemn duty of a bank at all times.
- Understand who carries the can in case of a bankruptcy – the depositor or shareholder?
Finally, here is my two-bit on the bank run. The more I know, the less I understand the subject.
Venkat R Venkitachalam
Practicing Company Secretary