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salty-dracon · 2 years ago

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ELI5: The Silicon Valley Bank Collapse

TL:DR SVB made a somewhat risky investment which went poorly in changing market conditions, and didn’t have the money to pay back their depositors. The FDIC has decided to fund the remaining bank accounts, but shareholders will realize a total loss on their stock.

If you haven’t been following the news, the second biggest bank collapse in American history just happened. But you probably have no idea what that means, so I’m going to explain it all in simple terms, with no frills, no biases, and no opinions.

Please let me know if I get anything wrong here. While I do work in finance, I’ve heard conflicting sources on some of the events.

The Basics of How Banks Work

Left to their own devices, people ordinarily wouldn’t just give their wealth to someone else for safekeeping. But these days there are many incentives for the average person to lend their money to a bank. Yes, there’s the matter of security (robbers can steal physical tender, such as physical bills and valuables), but there is also interest. By lending your money to a bank (like a loan!), the bank then uses your balance to invest in the stock market or major projects such as other peoples’ mortgages, with the promise that all of the money you’ve placed with them will be returned to you when you ask... with a little bit extra as interest. That’s your incentive for placing your money with them.

The point is, you placed your money with a bank, and in exchange for you lending them your money, they’ve promised to give it back to you when you ask, with a little bit extra. That’s important to understanding the next topic.

Investments, Reserves, and Insolvency

Okay, but how do banks generate the “little bit extra” that they promised to give you in exchange for borrowing your money? Through investments!

Investments can be a lot of things. Mortgages are investments- a bank can lend someone a big chunk of money, and in exchange the bank receives cash monthly that ends up being worth more than they loaned out. They can be investments into the stock market- buying stocks at low price, watching the price rise, and selling them high is a way to net profit. There are other types of investments too, like bonds (mini loans), CDs (low risk, long-term investments that guarantee profits that bank customers can take out), and options (very complicated). What they have in common is that you lend your money, and hopefully get more back (though there’s some risk of loss).

As an example, let’s pretend you’ve put $20,000 in a bank account. The bank could then take $10,000 and put it into a risk-free investment that returns at 2%. One year later, the return is $10,200, at least $10,000 of which must return to you. The bank may take $100 of that as their own profit and return the remaining $10,100 to your account- the remaining $100 is your interest. (This is a theoretical example. My own bank account hasn’t generated nearly that much in interest.)

But let’s say the investment isn’t risk-free. They’ve taken $10,000 of your money, invested in that 2% return project, and it flopped. Ouch. Now they’re out $10,000- of your money! That doesn’t seem fair!

That’s why banks have reserves. It’s a buffer/stockpile of cash or liquid assets (things that can be converted to cash really quickly) that covers a depositor’s finances should the bank’s own investments go south, OR if people need to pull out their money. Banks usually have a dedicated team of analysts that calculate the amount of reserves a bank can safely set aside to cover these sorts of events. This covers souring investments as well as times when a big customer is planning to pull out a ton of savings. That $10,000 is a drop in the bucket for them, but something like $1 million is more concerning.

So, even if the investment goes south, at least you’ve still got that guaranteed $20,000 on demand in case of, say, a medical emergency.

... At least, that’s how it should work.

If a bank doesn’t have enough reserves/quick money to fulfill its obligations of money on demand to everyone who lent it to them, it becomes insolvent- basically bankrupt unless they do a lot of stuff to get money fast really quickly. This can involve pulling money out of investments (which costs money to do, and is not something any investor would want to do unless they need a lot of money really really fast). This is the worst case scenario for any financial institution and one they want to prevent at all costs.

Understandably, the insolvency of the bank you’re keeping your money at is a terrifying situation for people who really need that money. And it was a common situation up until the 1930′s.

Bank Runs

You probably know someone who lived through the Great Depression who has a large stockpile of cash and refuses to use credit cards or banks. Some people probably even call them stupid for doing so. I’m not going to call your money hoarding grandparents stupid, since they’re operating off a very real fear- the fear that a bank won’t have the legal tender to give them their money when they ask. That situation was VERY COMMON before the FDIC was created in 1933 to insure the deposits of its member banks.

What would happen is that you’d hear that some news about how a certain bank was having financial trouble, and might close very, very soon. You freak out and realize that if they close, you’ve given your money to them, and now you’re not going to get it back! You go to a branch of the bank to withdraw all of your money, only to find that everyone else had the same thoughts as you, and the branch is already out of physical tender. As more and more people realize they’re about to lose all of their savings, the bank is drained at an exponentially increasing rate- and soon, the bank has become insolvent.

Banks have defenses for this- suspending withdrawals, limiting withdrawals, and asking their central bank for more liquid funds. But in the case of a bank run, or a bank panic, which is a bunch of banks experiencing bank runs at once, those defenses might fail entirely.

The FDIC, an American Government Corporation, was created as an insurance company for banks. Basically, banks pay dues to the FDIC, and in the case of the bank’s insolvency, the FDIC guarantees deposits up to about $250,000. It was created partially as a way to avoid future bank runs and protect consumers in the case of a bank collapse.

Interest Rates and Inflation

You’ve probably heard about the Federal Reserve hiking interest rates or keeping them low throughout the recent pandemic, but what does that actually mean, and why is it relevant here?

The Federal Reserve sets target interest rates- basically, setting the price at which major banks can borrow from the government. This ends up forming the basis for other types of loans you can get from banks- mortgages, car loans, etc.. Periodically these are revised with regards to economic conditions.

Basically, raising interest rates is used to encourage people to STOP borrowing money and START lending money- the return for lending is higher, and the price of borrowing is higher. Lowering interest rates is used to encourage people to START borrowing money and STOP lending money- the return for lending is lower, and the price of borrowing is lower.

(This is why you always want a loan with a low interest rate, btw!)

(And keep in mind that these are with regards to major economic decisions, and not necessarily the types of loans an ordinary person would get.)

Now, why is inflation relevant? Yes, it’s really high right now, and that means that the prices of everything are increasing a lot! The Federal Reserve’s answer to that is to increase interest rates- by making it more costly to borrow money, they’re hoping to stop an unsustainable level of price increases in everything else.

I think I get it. Now what’s going on?

Silicon Valley Bank was a fast-growing bank that, in recent years, held a lot of funds for entrepreneurs and tech startups- about 50% of all venture capital money in the US! What this means is a. a lot of large accounts in b. mainly one sector of the economy (technology).

That being said, the bank would most certainly not outpace inflation if they didn’t invest it. However, at the time, they couldn’t find any places they could loan money to.

Furthermore, the tech/crypto/startup sector of the economy has been going through hard times for a while. Many needed to slowly pull out funds from the bank, further straining the amount of liquid cash on hand.

In 2021, SVB instead decided to invest in mortgage-backed securities with the deposits placed with them. Mortgages are basically very long loans, but they can also be very risky. Mortgage-backed securities are based on mortgages. (The risk surrounding mortgage-backed securities is one reason for the housing crisis of 2008.) It should also be noted that they’re very susceptible to changes in interest rates- if interest rates increase, mortgage-backed securities lose their value.

In 2022, we got severe inflation.

And then, the Federal Reserve’s answer to severe inflation: raising interest rates.

And the mortgage-backed securities that SVB took out became unprofitable!

Now remember how I said that banks need to be able to not only provide customers their deposits on demand, but also give it back with interest? Because the investment in mortgage-backed securities failed, SVB didn’t have money for interest OR deposits, and not enough in reserves to fill the gap. They would be insolvent, if they didn’t come up with a lot of money really, really fast.

Word spread fast- depositors had already realized that the bank had become insolvent, and they demanded their deposits back. In other words, SVB went through a bank run, losing their money over the course of three days.

The FDIC then stepped in. Now this is a bit of an unusual case, because the FDIC only insures accounts up to $250,000. Most venture capital startups have accounts that are many times that. However, the FDIC has decided (with their own member deposits, not taxpayer money) that all of the venture capital money will be paid. All of the bankers will get their deposits back.

SVB is still closing, however, and shareholders and stockholders will not be compensated for the stock loss.

So while shareholders lose out, every creditor/depositor who invested will be getting their money back. As for Silicon Valley Bank, it’s being administered by the FDIC up until it’s time for it to close down.

#silicon valley bank #eli5 #economics #finance #the more you know!#life as an aj #okay what other tags should i put in here #please reblog if you found this informative i worked VERY hard on it!#this is 1.8k words

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