Signals: "SVB, Signature, & Silvergate"-gate

Hey fintech friends,

At the time we're hitting "Publish" on this post, there are still more open questions than there are answers about the past week's bank collapses. It feels like now is a good time to recap what's happened, how we got here, and the takeaways so far.

tl;dr

Over the past week, we’ve witnessed a series of the so-far fastest bank runs in US history. The institutions that have collapsed are not tiny, unsubstantial banks:

In the 1980s, the economy overheated while interest rates climbed into the range of 8%-20%, and a string of bank runs caused 1,617 banks to fail in what has been dubbed the “Savings and Loan Crisis”. These runs were caused by a combination of factors:

The latest bank failures are to a large extent echoing these themes.

If you're reading this newsletter, you're probably familiar with how banks make money i.e. profiting on the spread between interest paid for deposits and interest charged on loans (we covered net interest income for those who want to nerd out a level deeper).

Banks also need to maintain capital ratios that ensure they'll always have enough money to let depositors withdraw their funds. SVB's and Silvergate's common equity Tier 1 capital ratios were reasonably higher than what's required by regulators, at 15.26% and 53.42% respectively vs. the Fed's 4.5% requirement. But when markets started tightening last year and customers started running down deposits, SVB and Silvergate had to shore up liquid funding to cover the increases in withdrawals.

Last week, Silvergate announced it was doing so by selling chunks of its bond portfolio; SVB announced it would start selling off equity, which plunged stock at both institutions and triggered a frenzied run on the banks. Signature Bank was swept into receivership by state regulators amid concerns that its crypto exposure would lead to another failure (but its leaders argue that it would have survived, and that their closure had more to do with regulators’ disapproval of crypto).

So far, HSBC has stepped in to acquire SVB's UK business for a whopping £1 and the US's FDIC, Fed and Treasury have jointly announced that they will backstop deposits at closed banks and make funding available to banks who may start feeling similar pressure on liquidity.

And yet, the banks most heavily indexed to the startup and crypto worlds are not out of the woods. First Republic bank’s stock fell over 50% the day after the FDIC announced that it would backstop SVB depositors, as more account-holders scramble to pull their funds from non-top 20 banks.

As short seller Edwin Dorsey wrote in November ‘22, Provident Bancorp (PVBC), Customers Bancorp (CUBI), New York Community Bancorp (NYCB), and Metropolitan Bank (MCB) all took on business from the most quickly-growing fringes of tech in the past few years. Provident rebranded as BankProv and attracted “over $100 million in “digital asset customer deposits,” while its “loans to digital asset companies” increased from $15 million in December ‘20 to $138 million in June ‘22.

How is this happening to banks who, on paper, maintain such strong capital positions?

A good starting point for understanding these collapses is the regulatory capital on the banks' balance sheets. Regulatory capital– liquid assets like cash, equity– helps banks meet the capital ratios needed to fund depositors' withdrawals. Banks don't like to let their cash sit idle, so they'll typically invest a portion of regulatory capital in "safe" assets like mortgage-backed securities & Treasuries.

Ideally, banks invest in a combination of short- and longer-term debt securities to maximize yield until there comes a point where the bank needs liquidity to cover withdrawals. Banks also need to account for duration risk, or the risk that longer-term debt securities lose value as interest rates rise.

Interest rates started soaring last March.

As a result of higher short-term interest rates– and a yield curve that’s been inverting since April– banks have taken serious losses on long-term debt investments.

This should have raised alarms about the depletion of regulatory capital at SVB and Silvergate, especially considering that banks report their regulatory capital positions on a quarterly basis, and these disclosures account for unrealized losses from “available-for-sale securities” (AFSs). But there’s a loophole in this accounting: Banks don’t have to mark these securities to market– i.e. report unrealized gains/losses as market values change– if the securities are classified as “held-to-maturity securities” (HTMs). Instead, losses on HTMs are recognized when they’re sold at maturity.

Banks take advantage of this blind spot to cover up duration risk by reclassifying AFSs as HTMs…

… though losses are looking the same across the board for these securities…

… and SVB reported a uniquely high share of its securities as HTMs, blurring the losses driven by rate hikes:

Silvergate didn’t hold HTMs, but they did suffer from overconcentration in another asset: Over 90% of deposits came from crypto-related customers. The bank was also heavily involved in crypto payments via the Silvergate Exchange Network, and offered loans collateralized by Bitcoin. When FTX collapsed and crypto prices plummeted, the Fed and OCC flagged that crypto-friendly banks could face “liquidity risks”, prompting depositors to withdraw en masse.

There are fears that other crypto-friendly banks follow in Silvergate’s footsteps, further removing offramps for crypto holders– this drove USDC and DAI to temporarily lose their dollar pegs over the weekend– but seemingly, crypto has other bank partners to turn to who are (hopefully) drawing lessons about customer diversification.

In fairness, SVB and Silvergate weren’t trying to hide the details of their capital positions (SVB’s CEO even told the WSJ that its HTM portfolio had racked up $15.9 billion in unrealized losses back in November), and they very well could have covered withdrawals had depositors not gotten spooked. The issue is that these banks’ customers– in SVB’s case, primarily tech startups, and in Silvergate’s, crypto companies– were relatively sensitive to slowing economic conditions.

Our takeaways & open questions so far:

Regulation needs to be updated reinstated. There’s been widespread criticism that these failures could have been prevented by certain guardrails in Dodd-Frank that were repealed in a 2018 bipartisan deregulation law.

Bank runs now happen faster than ever before. SVB experienced the fastest bank run in history, deemed “the first social media bank run.”

Banks only focused on one specific customer type are overexposed to sector risk. Sector-specific banking used to be the job of co-ops & credit unions, but for-profit, vertical banks are becoming more prominent than ever before.

Capital costs are rising as investors & lenders lose trust in counterparties.

Demand for alternative stores of cash is growing as depositors race to move funds to products like CDs.

Banks will likely have a harder time supporting crypto firms & funds, with regulators already showing tougher love towards crypto banks in (allegedly) shutting down Signature before it had the chance to recover.