💸 What exactly happened with Silicon Bank Valley? How does this collapse differ from what happened to the Lehman Brothers bankruptcy? How do banks actually make money?

Silicon Valley Bank (SVB), which held $200 billion worth of deposits, collapsed, sending shockwaves through the industry. Banking regulators shut down SVB after the bank's valuation collapsed, resulting in the second-largest bank failure in US history after Lehman Brothers. With the help of the government and private sector, the focus was on containing the contagion and ensuring that businesses could stay afloat.

In this episode, we’ll look at what happened at SVB over the past few months, the investment choices the bank made and the impact of the rise in interest rates that had led to deposit withdrawals and a loss of capital.

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1. how do banks make money?

• Banks are lenders - they only keep a portion of their assets in cash and reinvest the majority in long term investments. Hence, they make money by capturing the spread (difference) between short term rates and long term rates. For example, they pay you/a company 1% on your deposits while they invest this cash at 4% in 10-y government bonds.

• Treasury bonds (U.S. 10-Year Bonds) are debt securities issued by the US government. Their prices reflect economic conditions, inflation, and interest rates.

• You lend money to the government by purchasing a bond at a predetermined interest rate:

  • the government will pay you a fixed interest rate annually or semi annually for a set duration of time

  • When the loan reaches its maturity date (10 years), you are getting your money back (the bond’s face value).

• The interest rate paid on deposits is influenced by the interest rate set by central banks (it's the way for them to control inflation). When interest rates are high, you are supposed to earn more on your savings or deposits.

• In normal times, yields (=interest rates) on deposit (your current account) are lower than long term yields simply due to the fact that the more risk you take the bigger the reward should be. 

• Since you have less visibility on what will happen in 10 years time you ask to be compensated with a higher yield: this is called a positively sloped yield curve. 

what happened at svb?

• SVB, founded 40 years ago, had played a crucial role in the tech industry's success and was among the top 20 banks in the US by assets. It has primarily served venture capital firms and tech startups around the world.

• As startups raised large rounds of funding and deposited more money in 2021 and 2022, SVB's deposits increased from $102 billion to $189 billion, leaving the bank with an excess of liquidity. 

• This coincided with a period of historically low interest rates, which meant that the bank invested its excess cash at a low yield in government bonds.

• The tide started to turn. As inflation has been consistently increasing following the pandemic, and the war in Ukraine, central banks were compelled to intervene by raising interest rates. 

• This marked the end of the "easy money" era thanks to low interest rates, resulting in less money raised by companies and fewer deposits for the bank. 

• At the same time, to maximize profits, SVB continued to pay low interest rates on its deposits. 

• Investors woke up to the fact that they could get a better yield on their cash than what SVB was offering to them! Indeed since rates have been near zero for a record amount of time, it took time for companies/retail to digest these rate hikes.

• Many companies began withdrawing their deposits en masse and moving their money to money market funds, which invest in short-term securities that track the central bank's main rate. In the US, the key rate is currently at 4.75%.

• This withdrawal of deposits also spread quickly as prominent venture capital funds urged their portfolio companies to do the same. 

Why has this sudden outflow of deposits became a significant problem for SVB?

• SVB was forced to sell its government bond holdings, but like every asset they have what we call a mark-to-market. As rates, growth and inflation change, these assets go up and down in value. As inflation picked up, short term rates shot up as central banks hiked interest rates while long term interest rates went up by a lesser amount. It inverted the yield curve with higher short term rates than long ones. Banks couldn’t raise interest rates on short term deposits without jeopardising their profitability.

• The problem arose since yields recently went up significantly (hence prices have gone down). The government bonds that SVB bought a year ago were now under water but as long as the bank did not sell them it wouldn't be a problem since they redeem at par at maturity (that simply means that they return all the originally invested capital). 

• Unfortunately SVB was forced to sell these long term bonds at a loss to meet the wave of redemption before the government bond matured.

• In a final attempt, SVB tried to raise $2.25 billion in equity to cover their $1.8 billion loss, but failed to do so. This created panic among deposit holders and the financial markets.

What has been the impact of the collapse?

• The collapse of the bank on Friday sent a wave of panic to startups, as it locked clients' deposits and threatened to prevent companies from running their day-to-day operations.

• Money in the bank in case of such collapse is insured up to $250k in the US and £85k in the UK, leaving most of the large tech companies unable to pay staff.

• Pressure mounted in the tech industry, with venture capitalists, founders and governments trying to find a quick and swift way to money to continue funding their operations. It was short of a shock in the markets.

• On Sunday, the US government assured SVB depositors that they will be able to access all of their money quickly by guaranteeing all deposits. The US Treasury says all deposits in SVB are safe. Unfortunately, the shareholders of the bank lost all their stocks as its value collapsed to zero.

• In the UK, the UK arm of SVB Bank is to be bought by HSBC. The chancellor says the sale will provide security to UK customers, including tech firms the government was keen to protect from the bank's demise.

• It’s important to note that the banks were not bailed out by the government and this shouldn’t cost money to taxpayers. Deposits and interests from individuals, businesses and the financial system should be protected. We have to understand that the banking sector is very central and essential to our economies, safeguarding assets and supplying credit (loans) to individuals and businesses.

Is SVB the new Lehman?

• This weekend reminded me of the feeling I had while working at Lehman at the time of the bankruptcy. 

• This has led to fears of a contagion spreading across the financial system with the obvious extreme parallel being the Lehman Brothers crash that helped kick off the global financial crisis. 

• SVB invested their cash in longer-term treasuries and mortgage-backed securities that have lost value with rising rates. So they could not sell those assets for what they paid for them. 

• While the situation with SVB was driven by depositors wanting their money back, Lehman Brothers had invested heavily in high-risk real estate and subprime mortgages that were deemed so illiquid that LEhman couldn’t find any buyers for them. Hence when markets turned, Lehman couldn’t raise enough cash to stay in business. Both had a liquidity problem (not enough cash on hand).

Could this be the start of a banking crisis?

• The governments quick response in guaranteeing all deposits aimed at limiting widespread contagion. Indeed as more and more people worried about the financial health of banks where they invested their cash, it could have triggered a domino effect that could have put the financial system at risk if everyone wanted to withdraw their money all at once. Governments basically told the public, dont worry your money is safe where it is. 

• Unfortunately, this episode was in part triggered by the inversion of the yield curve. As many, included the  World Economic Forum have warned, this inversion usually announces a coming recession should history be trusted.

• Markets reacted strongly to the SVB fallout with stocks performing negatively since it could be the first cracks of something bigger yet to come.

• Coming back to interest rates, with a stronger than ever job market in the US, the Fed is still trying hard to control inflation and analysts expect further interest rate hikes are likely. Fed Chair Jerome Powell warned that the US central bank was prepared to speed up the pace of interest rate hikes and could lift rates higher than earlier anticipated if needed to tackle persistent inflation.

What are the lessons to be learnt for us and our money?

While it’s important to understand the big picture, I have also tried to draw some important long term lessons from the SVB collapse for our money and investments:

• Diversification reduces risk: don’t put all your eggs in one basket. Just as SVB could have diversified their investments more, do the same with yours. A balanced portfolio is generally composed of equities (shares), bonds and cash. Depending on your goals, the time you have until you need the money, you can change this allocation to adjust your risk / return profile.

• Protection is key: your money is protected with the FSCS (​​Financial Services Compensation Scheme), the UK's statutory deposit insurance and investors compensation scheme for customers of authorised financial services firms up until £85,000 or up to £170,000 for joint accounts in case your financial institution goes bust. So make sure first of all that the place where you hold your deposits is insured by them (and the FCA) and 2/ if you have more money than this, you may want to consider spreading your money across different institutions. The same applies to your investments.

• Remain agile: it has been a stressful time for anyone with deposits at SVB. Remember that cash is king especially in the short term. Before investing, make sure you can service your debt (pay your interests - even if interest rates continue to go up), and have some emergency savings.

• In investing, people say: “Don’t catch a falling knife” -  it is an expression for when a trader buys a stock after a big drop in its share price, hoping the price will rebound (imagine buying SVB a few hours before collapse), but the stock price continues to fall and the investor ends up losing lots of money. Remember why you invest, your long term approach and not being a short term stock picker or speculator. Investing regularly in the long term, in a diversified way reduces risk and helps to generate long term returns.

I hope this summary was useful. It’s not about being worried about such events but understanding what they happen, what could have been done, and what is the impact on the markets, and the economy.

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