A major bank failed. What happened?

On Friday, March 10, 2023, Silicon Valley Bank (SVB) failed spectacularly and seemingly out of nowhere, sending shockwaves throughout the financial world. Federal regulators quickly moved in to place the bank in receivership. The collapse of SVB put significant duress on several other banks, and was followed by the failure of Signature Bank two days later. Together, these two bank failures represent the second and third largest bank failures in the U.S. by total assets, behind only Washington Mutual in 2008.

Largest bank failures in the United States
Bank	Year	Asset value at time of failure
Washington Mutual	2008	$307 billion
Silicon Valley Bank	2023	$209 billion
Signature Bank	2023	$118 billion
Continental Illinois National Bank and Trust	1984	$40 billion
First Republic Bank Corporation	1988	$32.5 billion

Source: wikipedia.com

Naturally, a failure of this magnitude raises questions about the underlying stability of our banking system and whether any of our money is “safe”. The long-term effects of SVB’s failure remain to be seen, but now is as good a time as any to review what we do know and answer some basic questions.

Why did SVB fail?

SVB failed due to a liquidity problem, as it did not have sufficient cash to cover withdrawal requests. It suffered a classic bank run.

SVB was initially founded with a focus to provide banking services to startup companies. For decades, it served this niche exceptionally well, and SVB became the bank of choice for many tech startups in Silicon Valley and around the country. Due to the nature of SVB’s clientele, their cashflow needs were perhaps somewhat more volatile than typical bank customers.

Banks in most countries operate under a system known as fractional reserve banking. This means that at any given time, a bank only holds a fraction of all the deposits it receives in “reserve” as cash. The remainder can be loaned out or invested in order to generate profits. This is what allows banks to pay interest on deposits and offer many its services free of charge to the consumer. The specific requirements for how much reserve a bank must hold are determined by law. However, in March 2020, the Federal Reserve reduced this requirement to zero, essentially eliminating reserve requirements and allowing a system of zero reserve banking. This was done due to the impact of the Covid-19 pandemic on the economy.

In practice, banks still maintain some liquidity to fund daily operations and honor withdrawal requests. But because this represents only a small portion of a bank’s total deposits, it is impossible for any bank to pay all of its depositors all at once. If there is a sudden influx in withdrawals, banks may suddenly find themselves unable to meet the surge. The bank then needs to either sell some assets, borrow some money, or find another way to raise cash quickly. Banks fail when they are no longer able to meet their depositor’s withdrawal requests.

Unfortunately, bank runs have a tendency to snowball out of control. When depositors get wind that a bank is having trouble meeting withdrawals, their first instinct is to get their own deposits out as soon as possible, out of fear that if the bank fails, they won’t have access to their money, or that their money will be lost. This creates a self-fulfilling prophecy where once a bank run starts, action by the bank-runners only worsens the bank’s liquidity problem, and the bank run becomes almost impossible to stop. It’s a financial manifestation of mass hysteria.

Bank runs were common in the period leading up to the Great Depression, and customers who did not act quickly enough to withdraw their funds once a bank run started did in fact face the prospect of losing all their money. The Federal Deposit Insurance Corporation, or FDIC, was created in 1933 to protect consumers from losing their deposits. Since that time, bank runs have occurred less frequently, and with less financially ruinous consequences for consumers.

If the FDIC insures deposits, why do bank runs still happen?

FDIC insurance works exceptionally well. The FDIC states “Since FDIC insurance began in 1934, no depositor has lost a single penny of insured funds due to bank failure.”

However, the FDIC only insures deposits up to $250,000 per depositor, per bank, and per account. This limit generally isn’t a problem for most personal depositors, as most people probably don’t keep this amount in their bank account. It is also easy to get around this limit by opening new accounts at the same bank or different banks. However, some individuals and many businesses have deposits far in excess of FDIC insurance limits. Therefore, the prospect of losing your money if your bank fails remains quite real, and continues to contribute to bank runs. News outlets reported that 89% of SVB’s total deposits exceeded the FDIC insurance limits, so a lot of money was at risk.

Are all banks susceptible to this?

Any bank operating under fractional reserve banking can suffer a bank run, regardless of whether it is in any actual financial trouble or not. For this reason, banks take multiple measures to project an image of confidence and stability. Generally, larger banks are less susceptible to bank runs due to having greater reserves. No bank has enough cash on hand to cover all of it’s depositors trying to withdraw money at once.

The government is protecting all deposits. Is this typical?

While the FDIC insurance has a limit, the government announced that in this case all deposits will be protected. Smaller banks can fail without broader repercussions, but allowing a bank of SVB’s size and prominence to fail could cause catastrophic consequences for both the banking industry and the economy as a whole.

The FDIC does not guarantee all deposits by default, although this is certainly not without precedent. During the 2008 financial crisis, government made a similar unlimited deposit insurance guarantee, which lasted until 2013.

Why doesn’t the FDIC just insure all deposits?

There are calls to raise the FDIC insurance deposit limits, or to eliminate them entirely. Proponents generally content that this will help further stabilize the banking industry, promote consumer confidence, reduce the likelihood of future bank runs, and cite the fact that the government has already been making exceptions anyway, including in the case of SVB. Opponents, however, argue that this will create something known as a “moral hazard”, where banks will continue to engage in risky and reckless behavior with customer deposits, knowing that the government will ultimately bail them out and protect them from the consequences.

Did rising interest rates cause SVB to fail?

Rising interest rates likely contributed to the situation. It is widely reported that SVB made large investments in Treasury bonds. These assets are typically very safe, conservative investments that pay regular dividends and are guaranteed by the U.S. government. It is not possible to lose money per se when holding a Treasury bond.

Unfortunately, if a Treasury bond must be sold prior to maturity (to raise liquidity), it cannot be redeemed with the government, and must be sold in the secondary market instead. In the secondary market, bond values can fall when interest rates rise. This is because existing bonds are less attractive to a buyer when they can simply get a new bond that pays more interest. Despite the conservative nature of most bonds, they carry some surprising risks, including interest rate risk.

Therefore, as of 2023, SVB’s Treasury bonds had declined significantly in value, although these losses were unrealized, until the bank run forced SVB to sell many of its investments at a loss. This certainly contributed to SVB’s financial woes.

Did a focus on diversity cause SVB to fail?

One of the more bizzare twists in this story is the claim that SVB’s focus on DEI (diversity, equity, and inclusion) programs contributed to its failure. This came after a quote by Florida governor Ron DeSantis, who said “They’re so concerned with (diversity, equity and inclusion) and politics and all kinds of stuff. I think that really diverted from them focusing on their core mission”. Similar sentiments were subsequently echoed by other Republican politicians and pundits.

Diversity initiatives are commonplace at many major companies, including many large banks and other financial institutions. While studies, including this one by the Harvard Business Review, have found that corporate diversity programs are often ineffective, at this time I have not seen any convincing evidence that a focus on diversity contributed to SVB’s failure.

How will customers be affected?

Most of SVB’s clients were businesses. Many businesses and startups were affected by SVB’s collapse, as they were unable to access their deposits to make payroll or other operating expenses. This resulted in some businesses having to take out loans, delay payments, furlough workers, or take more drastic measures. The full consequences on SVB’s business clients remains to be seen.

SVB also offered personal banking services. Since the government has stepped in and guaranteed all deposits, customers should be fine in the long run.

What is the consumer’s experience when the FDIC takes over?

I don’t know what clients of SVB are going through at the moment. However, I have an anecdotal story to share about Washington Mutual’s failure in 2008. I had a checking and savings account with Wamu and it was my primary bank. Granted, I was much less knowledgable about finances back then. When Washington Mutual failed, it was placed in receivership by the FDIC, and later acquired by JP Morgan Chase.

Throughout this time, my account remained accessible, although keep in mind that the first Iphone had just been released in 2007, so this failure occured prior to the widespread use of online banking and phone apps. Nonetheless, direct deposits still went in, and bills were paid. My routing and account numbers were unchanged. A few months later, the physical branch of my Washington Mutual sported Chase signage instead. The account was converted into a Chase account at some point. To this day, my routing and account numbers remain the same. For all intents and purposes, the failure of Washington Mutual was invisible to me, as a consumer. Washington Mutual was a household name and the largest bank failure in the history of the United States, so I think this says something about the robustness of the FDIC. Of course, other people may have experienced significant disruptions, but I did not.

Image is from public domain

Do my investments or brokerage accounts have any kind of protection?

Yes, the SIPC insures your brokerage accounts, for up to $500,000.

There are significant limitations to SIPC insurance. The SIPC does NOT protect the underlying value of your investments (i.e., from market losses). You can read more about SPIC insurance in my article about protecting your wealth.

Is there anything I should do?

As a consumer, probably not, although it’s never a bad time to take stock of your financial situation, make sure you have an adequate emergency fund, and make sure that your deposits at any bank do not exceed FDIC limits. In the long term, the markets and banking industry will weather this storm, just as it has many others. The worse-case scenario, a widespread collapse of the banking and financial system, is not realistic, and is not something you can protect yourself from.

As always, thanks for reading and happy investing!