Examining the Reasons for Silvergate and Silicon Valley Bank’s Downfall

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This week has seen major turmoil for financial institutions associated with the most modern and advanced industries. Silvergate Capital, a bank that had put a lot of faith in servicing the crypto economy since 2016, declared on Thursday that it will close its banking operations. On the other hand, Silicon Valley Bank (SVB), which had been managing money for venture capital-funded startups, was closed down by state regulators on Friday.

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Basically, both banks were brought down by the same problem: the classic bank runs. Their customers, whether crypto exchanges or tech startups, were facing various business challenges due to financial and economic conditions. This led to a decrease in deposits and an increase in cash withdrawals at a time when most of the banks’ long-term non-cash holdings were also being adversely affected by the markets.

Silvergate and Silicon Valley Bank were then forced to sell their collateral assets at a loss. Silvergate reported a $1 billion loss in the fourth quarter of last year due to the sale of assets, while Silicon Valley Bank (with a bigger total balance sheet) also incurred a $1.8 billion loss when liquidating its holdings. It is crucial to note that, in both cases, a large portion of the money-losing liquidation was made up of U.S. Treasury bonds.

(This is in stark contrast to the careless mischaracterizations of FTX’s fall as a “bank run” by many big media organizations back in November. What happened at FTX has very little in common with the liquidity crises that Silvergate and SVB faced.)

The root of these issues can be traced back to two sources: actual business cycle problems and the Federal Reserve’s interest rate tightening. These two factors are related and are essentially linked to the disruptions caused by COVID.

The most immediate pressure that Silvergate and Silicon Valley Bank felt was due to the Fed’s rate hikes. I have been warning about this conventional risk in this sector for almost a year now: The rise in yields on U.S. Treasurys would push away new investments in risky sectors, such as tech and crypto.

However, the rate hikes also presented another, often overlooked threat to the stability of the banks. As the Wall Street Journal explained in simple terms, the issuance of new Treasury bonds with higher yields has led to the decrease in the market value of pre-hike bonds with lower yields. Most banks are required by law to hold a large amount of Treasurys as collateral, meaning the same risk that hit Silvergate and Silicon Valley Bank applies to a lot of other banks. This is the reason why the stocks of regional and mid-sized banks are hitting rock bottom this morning.

Silvergate and Silicon Valley Bank were also affected by specific business cycle issues that may not apply to other banks. Both of them catered to sectors – crypto and venture-funded tech firms – that witnessed tremendous growth in the early days of the COVID-19 pandemic. Both industries were helped by the lockdowns and crypto, in particular, was boosted by the pandemic relief checks sent to Americans.

As a result, both banks would have bought more bonds as collateral to back up the increase in deposits – at a time when the rates on these bonds were still around 1%. With the Fed’s rate hikes, the rates on the new bonds are now closer to 4%, thus lowering the demand for the older bonds. This is why, when their customers started to withdraw their deposits, Silvergate and SVB had to turn to liquid assets and take a loss.

It is easy to pick out the people to blame for this situation based on your personal preferences. However, it is likely that everyone is just trying to survive the same COVID-induced shipwreck in the same dinghy and fighting over who will be eaten first.

For instance, some may point fingers at the Fed for hiking the rates, but this is a necessary action to restrain inflation. This inflation was caused by both the real cost increases due to COVID-19 and the money supply that was significantly expanded by pandemic relief and bailout policies. It will take some time to measure the overall cost and benefit of these policies, but criticizing the Fed for its current actions is at best misguided.

On the other hand, many in the mainstream will blame the crypto sector for the potential banking crisis. The clearest evidence for this claim is that Silvergate, “the crypto bank,” collapsed first. In the coming weeks, the bank may be referred to as “the first domino to fall”, but this is not the truth.

It is true that Silvergate was more vulnerable as it took part in a sector-wide degenerate long bet on crypto, which was way ahead of the actual adoption and sustainable income. Nevertheless, this was not the cause of its liquidity crisis, and its downfall will not have a significant impact on any future bank failures.

The reality is that all banks in the US, whether they are managing server farms or a local grocery store, are facing many of the same structural pressures. The ultimate cause of this is the massive real-world disruption brought about by the virus, which has killed more than six million people. The lesson to be learned from this is that financial instruments are not enough to counter such real-world chaos.

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