Too big to fail, too ambitious to succeed : the case of SVB

The Silicon Valley Bank, once a symbol of the tech industry’s entrepreneurial spirit, has fallen from grace. With its recent bankruptcy announcement, the bank’s downfall marks the end of an era for a company that was once synonymous with the startup culture of Silicon Valley. As one of the most prominent financial institutions in the technology sector, its collapse is a sign of the industry’s struggles in a rapidly changing landscape. In this article, we will explore the reasons behind Silicon Valley Bank’s bankruptcy.

A specialized bank caters to a specific industry or sector, offering tailored financial services that meet their customers’ unique needs and challenges, Silicon Valley Bank is a prime example of a specialized bank. Founded in Silicon Valley, California, in 1983, it quickly established itself as a leading financial institution in the technology and innovation sector. The bank focused on providing banking and financial services to startups, venture capitalists, and high-growth companies. With its specialized focus and deep understanding of the needs of the technology industry, Silicon Valley Bank became a trusted partner for many of the biggest names in the industry.

As you’re reading this article, the Silicon Valley Bank has failed. The bankruptcy of Silicon Valley Bank is being hailed as one of the biggest failures in the financial industry since the collapse of Lehman Brothers in 2008. The bank’s failure has sent shockwaves through the technology and innovation industry, which relied heavily on the specialized services offered by the bank. But you may ask, why? Let me explain the few reasons behind the failure of the startup specialized bank.

Fighting inflation makes the investors risk averse

One of the primary reasons behind the fall of SVB could be the rise of the interest rates. With inflation on the rise, the Federal Reserve has resorted to a powerful tool: raising interest rates to control the money supply. But what does this mean for businesses and consumers? Simply put, higher interest rates make borrowing more expensive, which reduces the flow of money in the economy. This decrease in the money supply leads to a decrease in the value of each unit of currency and a drop in prices. While this helps to reduce inflation, it also has its downsides. Investment levels may decrease as borrowing becomes more expensive, and businesses may be less likely to take out loans to fund new projects. In this article, we’ll explore the effects of rising interest rates and how they impact the economy.

The startup industry is often considered a high-risk, high-reward investment opportunity. Startups are typically early-stage companies that have not yet established a track record of profitability or success. As such, they are inherently riskier than established companies that have a proven business model and a track record of generating consistent revenue. Investing in startups also carries unique risks. For example, startups may face significant challenges in securing funding, attracting talent, and developing and scaling their products or services. In addition, startups may be more vulnerable to changes in market conditions, shifts in consumer preferences, and competition from larger and more established companies. Given these risks, investors in the startup industry must be prepared to accept a higher level of risk than they would in other investments. While investing in startups can potentially yield significant returns, it can also result in substantial losses if a startup fails to achieve success. No one wants to endure the high-risk investment losses in such difficult times, the time at which central banks around the world are battling inflation.

We can get a bit more technical and apply an economic model such as Stiglitz-Weiss model (we’re economists after all). The Stiglitz-Weiss curve could be applied to the case of the Silicon Valley Bank in the following way: As the central bank raised interest rates in response to inflation, borrowers in the technology sector faced higher borrowing costs. This, in turn, could have deterred some borrowers from taking on riskier projects or investments, as the cost of borrowing became increasingly expensive. As a result, the bank’s customers may have been less likely to engage in projects with a higher potential for failure, which could have contributed to a decline in the bank’s profitability. Understanding the Stiglitz-Weiss curve in this context allows us to see how the balance between expected returns and the risk of moral hazard and adverse selection can have a significant impact on the behavior of borrowers and lenders in the credit market.

Bank Run

In response to higher interest rates that we discussed previously, the bank was forced to sell securities to realign its portfolio, while it manages lower deposit levels from clients. After announcing that it had sold a group of securities at a loss and that it planned to sell $2.25 billion in new shares to strengthen its financial position, Silicon Valley Bank’s disclosure reportedly caused alarm among important venture capital firms. According to reports, these firms advised their portfolio companies to withdraw their funds from the bank. Once the clients of the bank were advised to withdraw their money from the bank, this is when the bank run started. A bank run can quickly lead to the bank’s failure, as it may not have enough liquid assets on hand to meet the demands of all its depositors, which was the case for SVB.

What happened at SVB would not have caused alarm at most regular, medium-sized regional banks. Selling assets and encountering liquidity problems are routine matters for banks, and they often raise short-term capital to resolve these issues. Typically, such actions go unnoticed or seem unimportant to customers. However, SVB’s depositors are not your average customers; they consist of start-up founders and investors who are highly alert to banks’ securities filings, risk, and volatility. Most importantly, they communicate with each other constantly on the internet. As a result, once a few people in the tech industry raised concerns about SVB’s solvency, this sparked a frenzy of warnings from venture capitalists on Slack channels and Twitter feeds, leading to widespread panic.

To get a little bit more academic in this article, we could rely on a macroeconomic and banking model created by Diamond and Dybvig, that carries their name, to explain how and why bank runs occur, and eventually how to prevent them and heal them if it occurs. As the Diamond-Dybvig model suggests that bank runs can be prevented using deposit insurance or other forms of government intervention. By providing a guarantee that depositors will be able to recover their funds, even in the event of a bank failure, the government can help to prevent bank runs and stabilize the financial system. The Nobel prize winners’ model has been used in the past to explain and analyze bank runs and this time again, comes in handy interpreting the situation and proposing effective solutions.

Suspension of convertibility is another method that has been used to avoid bank runs. This involves temporarily suspending the ability of depositors to convert their deposits into cash or other liquid assets. By doing so, banks can prevent a rush of withdrawals that could lead to a liquidity crisis. Suspension of convertibility has been used in a variety of contexts, including during the Great Depression in the United States and more recently during the eurozone debt crisis. While this approach can be effective in stopping bank runs, it also has the potential to create a broader financial panic, as depositors may lose confidence in the banking system as a whole. As a result, suspension of convertibility is typically seen as a last resort measure, to be used only when other options have failed. In general, policymakers and regulators prefer to rely on methods such as deposit insurance and central bank interventions to prevent bank runs, as these are seen as less disruptive to the overall functioning of the financial system.

As of today, the FDIC (federal deposit insurance corporation) took over the SVB and promised to the depositors 250.000$ maximum. Meanwhile, it will start the long search for the potential takeover of the bank, that in the most optimistic case would be a bank, and in the worst case it would be the government.

Too Big To Fail

Given the importance of SVB to the technology and innovation industry, the bank is often viewed as a « too big to fail » institution. This means that, in the event of a crisis, the government may step in to provide support and prevent the bank from failing. While this approach can help to prevent systemic risks to the economy, it also raises concerns about moral hazard, as it can create an expectation among investors and businesses that they will be bailed out if they take on excessive risk. In the long term, the danger is that the government might end up bailing SVB out, giving a signal that all banks are too big to fail in the American financial system.

An important detail that should be mentioned is that when the government steps up to bail out a bank, no one wishes to buy anymore, it finances the rescue with the taxpayer’s money. Perhaps we could say that while the losses are made public, the profits stay private in the vast unstable financial system.

Conclusion

The bankruptcy of Silicon Valley Bank is a wake-up call for the technology industry and the broader financial sector. Once a symbol of the entrepreneurial spirit of Silicon Valley, the bank’s downfall highlights the challenges faced by specialized financial institutions in a rapidly changing economic landscape. As we have seen, rising interest rates, a run on the bank, and the danger of moral hazard are among the factors that contributed to the bank’s failure. The collapse of Silicon Valley Bank raises important questions about the role of government intervention in the banking system, and the potential for bailouts to create moral hazard. Ultimately, the lessons of Silicon Valley Bank’s failure are clear: in a volatile and unpredictable market, banks must be vigilant and responsive to changing economic conditions. As we move forward, it will be essential to adopt new approaches to regulation, risk management, and crisis response, in order to ensure the stability and resilience of the financial system for years to come.

* Editor’s note: between the time of writing and the publishing of the article, the american government decided to fully bailout the bank, confirming the worst case scenario mentioned earlier.