Lessons from the collapse of SVB (and why we're avoiding Banks)

You may have read over the weekend that Silicon Valley Bank (SVB), the 18^th-largest bank in the US with $200 billion in assets, is insolvent and being wound up by the banking regulator.

In this wire I explain in simple terms why the bank failed, what lessons investors can draw from this incident, and some of the potential consequences.

Why did SVB fail?

1. Rapid growth in deposits
   SVB focussed on providing banking services to startups and venture capital funds in the US. In 2020 and 2021, with interest rates at all-time lows and a bubble in tech valuations, its customers were flush with cash. SVB’s customer deposits grew from $60 billion at the end of 2019 to $190 billion at the end of 2021.
   
   
2. SVB invested in long-dated bonds
   Banks primarily generate profits by gathering money from customer deposits, on which they pay interest, and then lending out or investing that money at a higher rate. SVB was bringing in money so quickly that it couldn’t lend it out fast enough. It instead decided to buy long-term US government bonds with around 10 years to maturity, which offered higher interest than the near-zero rates on short-term bonds.
   
   
3. Interest rates rose
   As central banks started raising interest rates, the market value of these bonds fell substantially since investors could now buy other bonds offering higher interest rates. If SVB held its bonds to their maturity it would still get paid in full, but if it had to sell them early then it would make a loss.
   
   
4. Customers began withdrawing funds
   SVB’s startup customers started to struggle themselves as interest rates rose and tech valuations burst. SVB’s deposits stopped growing, and in fact customers started withdrawing their deposits to fund their business losses.
   
   
5. SVB couldn't meet its customer's withdrawals
   SVB was stuck. On one hand, it needed to be able to return customers their deposited money when they ask for it. But on the other, it had locked up their money into long-term bonds that were currently trading for less than they’re worth at maturity. If it were forced to sell these bonds today at a loss, to meet customer’s withdrawals, then overall it wouldn’t have enough funds to pay out all of its customers.
   
   
6. A classic bank run
   When SVB tried to raise new funds from shareholders it further spooked its customers, which resulted in a flood of withdrawal requests that SVB clearly couldn’t meet. Within 24 hours the bank was declared insolvent.

SVB didn’t fail because it made poor lending decisions – it failed because it made poor investing decisions, creating a timing mismatch between its long-term investments and its short-term obligations to customers.

What lessons can investors take from this?

1. Banks are high-risk investments
   There’s a lot that can go wrong inside a bank, whether it’s making poor-quality lending decisions, poor investment decisions, or having poor compliance and anti-money laundering controls. And shareholders are usually the last to find out, as was the case with SVB. For this reason, the Aoris International Fund will never own any banks.
   
   
2. Some businesses aren’t in control of their destiny
   Banks are subject to many forces outside their control: interest rates, regulations, general economic conditions which can affect their losses on loans, and the behaviour of their customers. At Aoris, we won’t invest in businesses that only thrive in certain economic conditions, which also means we won’t own insurers, energy and commodity producers, and highly regulated utilities and pharmaceutical companies.
   
   
3. It’s dangerous to rely on rules of thumb in investing
   A broad market narrative has been that banks will benefit from higher interest rates, because they can increase the interest rate on their loans by more than the interest they pay on customer deposits. As investors jumped on this thematic banks were one of the top-performing market sectors in 2021 (returning +34.6% in AUD vs. global equity markets +26.3%) and 2022 (banks returned -2.9% in AUD vs. global equity markets -11.9%). But this shortcut investment thesis failed to account for other potential impacts of rising rates.
   
   
4. The benefits of breadth in a business
   SVB built its business around serving commercial customers in technology. This is a much narrower book of business than the average bank which serves a range of businesses and also deals in mortgages, auto loans and credit cards. SVB's narrowness introduced fragility into the business that wasn't apparent when the tech market was running hot. Aoris looks to invest in businesses that serve a broad base of customers and end markets, where weakness in any one end market can be offset by strength elsewhere.
   
   

What happens now?

SVB’s customers are currently unable to withdraw any of their funds with the bank. This could cause problems for companies that need to pay their employees and suppliers.

As is the case in Australia, the US financial regulator guarantees the first $250,000 held by each customer at each bank. Every customer will get back at least $250,000 of their funds on Monday.

Unfortunately, the majority of SVB’s customers were companies that held large cash balances with the bank. Of the bank’s $161 billion in current deposits, 93% are above this threshold, and customers may not get all of their money back. Some surprisingly large companies held part of their cash with SVB including Airbnb, Roku, Shopify and Pinterest.

It’s possible that regulators may negotiate with a larger bank to acquire SVB in which case customer’s deposits may be safe. The worst case scenario is that SVB has to sell all its long-term bonds at a loss, and those losses will be shared among its customers.

SVB also had listed shares which were valued at a $44 billion market capitalisation in 2021 and were still collectively worth $17 billion just a week ago. They are now worthless.

There are likely other banks out there with a similar timing mismatch between their deposits and their investments, which will come to light if customers rapidly withdraw their funds.