Following the Silicon Valley Bank (SVB) story has been like watching a car crash – equal parts captivating and scary. It’s hard to look away from coverage like this:
We have plenty of cameras pointed at the wreckage, running instant replays of the crash, and showing police guarding bank branches!? What we don’t have as much of is the proverbial, pesky “so what?”.
This post will be longer-term focused. I’ll spend a few minutes summarizing what happened so we have that shared context in mind, and then I’ll focus on what comes next.
What Happened
A story in three parts:
SVB invested in long-term bonds to earn money. Because the Fed was fighting inflation by raising interest rates, the value of those bonds went down.
As the Fed raised rates, risky capital started to dry up. Startups stopped fundraising and continued burning cash. This meant shrinking deposits for SVB.
With customer deposits shrinking, SVB was eventually forced to sell those long-term bonds at a loss to have enough liquidity to keep operating. They announced as much, and their depositors panicked and withdrew $42 billion in a single day.
From analyses I’ve read, there’s consensus that #1 boils down to bad bank leadership. The banking industry knew interest rates near zero couldn’t last and the Fed would eventually step in to raise them. So even though the bonds themselves weren’t risky (no risk of not getting paid back), the long duration of the bonds made them extremely risky. I’ll lean on William Cohan here, who’s forgotten more about the financial world than I’ll ever know. He spent 17 years doing M&A at Lazard, Merrill Lynch, and JP Morgan Chase. Here’s what he had to say:
Why in the world would they invest their depositors’ excess money in the bond market at a time when the bond market was un-investable? Everyone knew that zero interest rate policies were going to end, so if you bought a bond at par, you were going to get hammered… That is malpractice in my mind.
Even after the Fed first started raising interest rates, SVB stubbornly refused to change course and take an early (smaller) loss on those long-term bonds. They were making a bet that the Fed would halt and then reverse interest rate increases. With inflation at its highest point in decades, and the Fed showing a clear commitment to continued interest rate increases, this was not a smart bet.
SVB has also come under fire for #3 – being reactive, ineffective communicators. Their statement, from the day prior to the crash, came as part of a rare mid-quarter investor update (not normal – already a red flag). It essentially said: we sold all our liquid securities, we’re going to raise $2.25B by issuing new SVB stock, and we just took a $2B loss by selling long-term bonds at a loss.
They stopped just short of announcing a garage sale.
It’s not that these aren’t good ideas, but it sounds scary when you pull out all the stops in one shot, reversing months of assurances to investors that SVB had the right strategy and was in good shape.
As for whether VCs/startups should bear any blame, things are a bit murkier. While some have claimed that the run on the bank was maliciously instigated by a few large VCs, I’m not yet convinced there’s proof of that. Instead, I think it’s more accurate to conclude that this particular group of bank customers as a whole are more likely to be involved in a bank run (even if they don’t directly start it). That’s because they are:
Extremely well-connected and interdependent, making it easy to share information quickly
Under heavy pressure from interest rate increases (which tend to hurt risky businesses first, like startups and venture capital)
Concentrated in just a few banks, which means:
SVB’s deposit base isn’t well diversified
Customer deposits in SVB are way above FDIC insurance limits
Check out this graph from Statista showing how few of their deposit dollars were within the limit:
If you’re a startup or a VC with an account way larger than $250k, and you hear about SVB’s garage sale, would you risk your funds and leave them there? Or would you take two minutes to log-in online and withdraw? Of course you get your money out.
What Happens Next
Well, the leadership and shareholders of SVB are getting wiped out. Customers are going to be fully paid out – not just the FDIC insured $250K, but their full balance before the crash. Thankfully, the Fed isn’t printing money to cover customers; it is tapping the FDIC’s insurance fund and will ask big banks to help replenish the fund if needed. Compared to the 2008 crisis – where many bank leaders (the bad decisionmakers of their day) got bonuses and pats on the back on the way out, while customers got wiped out – this seems fairer. But that’s not to say we’ve dodged all side effects.
For one thing, this man’s job just got a lot harder.
Fed Chair Jerome Powell’s gameplan (the only Fed gameplan that exists for inflation) is to raise interest rates until inflation falls back to the 2% target. If he starts to get close to that, or something breaks, then he can stop. Something big just broke, inflation is 6%, and it started at 9.1%! We aren’t even halfway to where we need to go. So much for a soft landing. The other thing that sometimes breaks, employment, has never been better – it’s positively humming. Unemployment in January was 3.4%, it’s lowest level since 1969 (3.6% for February according to recent data). So if you’re Powell, trying to come up with reasons that you need to stop raising rates, that is not a helpful statistic. This means the Fed will probably have to continue raising interest rates, even if they pause or slow down for a few months. I wrote in January that I thought we’d bottom out economically and start improving again by Q3 (see New Year, New Layoffs) but that’s going to be wrong. Any pausing or slowing down Powell has to do will lengthen the duration of the pain here. That pain will be felt by all businesses (not just startups) and their banks, which leads me to my next predicted side effect.
Consolidation in the banking industry will accelerate, beyond just having SVB customers spread out into the other banks. This will sustain the trend we’ve seen in banking consolidation:
Number of FDIC Insured Banks in the US (2000-2023)
Consolidation will accelerate because of heavier regulation and higher withdrawals. First, regulators will set a higher bar for any banks that want to operate in the US, and meeting that higher bar will require higher costs. Democrats have already announced new legislation to impose higher regulatory scrutiny on midsize banks. Second, there will be continued withdrawals from banks as their customers suffer, which will lead to lower revenues. And as we’ve already discussed, we should now be expecting a longer downturn, which means sustained pressure on those revenues. Some banks simply won’t be able to handle those lower revenues and higher costs. I don’t know if we’ll see any other blow-ups, but over time more of them will just quietly close.
As a final side effect of SVB’s collapse, increased regulation and consolidation will make crypto and other disruptive entrants harder to stop.
Hear me out, and think of Uber vs. the taxi business while I make my case.
When any industry has fewer players and/or is protected by regulators, consumers tend to pay higher prices for a lower quality product. Eventually, consumers jump to new products that offer lower prices or higher quality. When customers make that jump, incumbents are slow to respond, because:
Turning a large ship is hard – big incumbents have to coordinate a larger group of people
Regulation creates fear – big incumbents have more to lose from being “out-of-bounds”
Cannibalization is frowned upon– it hurts to sacrifice existing revenue to stand-up a new business
If regulation and consolidation continue to hit banking, it’s natural to expect prices to go up and quality to go down. Higher prices mean customers pay higher interest on loans and earn lower interest on savings accounts. Lower quality could mean clunky online tools and bad customer service. Over time, the opportunity to disrupt gets bigger and more attractive to would-be-disruptors.
As we’ve seen with crypto (and Uber, and Airbnb…), the upstarts don’t stop taking shots at innovation just because regulators step-in to play defense. I discussed this in detail in The People of Crypto – Part 3… Eventually, a few of those upstarts will get momentum, and the banking industry will scramble to try to meet the threat.
Anyway, those are my predictions for now. I’ll definitely keep an eye on this and update my thinking if when the facts change. Regardless, I hope you’ve enjoyed zooming-out and looking away from the car crash for a few minutes.
Now, let’s all make more popcorn and check back in.