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SVB’s preventable crisis
The full extent of the financial fallout from the tragic collapse of Silicon Valley Bank (SVB) is still unclear. But what is infuriating about this bank failure–the second largest in U.S. history–is that it was entirely preventable.
This was a classic case of risk management failure. SVB’s disregard for risk management principles is simply unacceptable. It is hard to imagine how such a seasoned player in the industry could have allowed such violations. SVB either consciously ignored or was unwittingly exposed to violations of nearly every fundamental principle of risk management known in the industry.
There’s much to be learned from this event. We need to take steps to ensure that risk management principles are respected and embedded in our organizations’ very fabric.
So what went wrong?
Management Risk
SVB lacked a Chief Risk Officer for eight months before its collapse during a tough transition in the venture capital market, which SVB serviced closely. Its poor policies on both sides of the balance sheet created overwhelming risks, with a colossal failure in asset-liability risk management. SVB’s potential systemic issue is due to the reshaping of the yield curve, affecting most financial institutions that were better prepared to handle such market fluctuations.
Also, some of SVB’s top management, including CEO Greg Becker and CFO Dan Beck, sold their stocks worth millions days before the collapse, raising serious concerns.
Duration Risk
SVB’s heavy reliance on long-term treasury and agency bonds was a crucial error, leaving them vulnerable to rising interest rates. When they needed to meet deposit obligations, they sold these bonds at a significant loss, worsening their situation. Their deposit base was volatile, and they had to pay higher interest rates to retain customers while holding bonds that paid less than 2%. This resulted in a significant interest deficit and operating losses. It is shocking that SVB, despite being vulnerable to interest rate hikes during an aggressive Fed policy, did little to protect themselves against duration and convexity risk, which is a standard market risk management practice for financial institutions.
Concentration Risk
SVB’s credit portfolio was heavily focused on tech startups and Silicon Valley executives, who were also their primary depositors. Their rapid expansion strategy involved offering large loans to companies receiving new VC funding, which led to an imbalanced growth trajectory. This approach proved disastrous when interest rates rose, forcing SVB to pay higher interest rates to their financially sophisticated depositor base. This resulted in a liquidity crisis and an unprecedented single-day bank run of $42B. Overconcentration in a single market sector is a recipe for disaster, and institutions must manage risk more prudently by diversifying their portfolios.
Liquidity Risk
SVB’s balance sheet was heavily weighted towards low-yielding AFS and HTM bonds. The bank’s Available for Sale (AFS) portfolio of $26B and Held to Maturity (HTM) bonds of $91B generated returns of just 1.79% and 1.63%, respectively. These investments were predominantly made before the sharp increase in rates, leading to low yields and limited options for effective management. The market volatility of 2022 resulted in a liquidity crisis for SVB, with a significant outflow of depositors, mainly wholesale clients driven by the excellent yields on Treasuries. SVB was forced to sell all its AFS bonds, resulting in a pre-tax loss of around $2.4B or 11%, and had to issue a $1.25B stock offering to restore its financial position.
Default Risk
In late 2022, SVB boasted an impressive $175 billion in deposits and $74 billion in loans. Despite some traditional lending, SVB’s true passion was in the dynamic world of tech startups, pioneering risky, tailored loan products and outbidding peers with aggressive underwriting. The venture debt loan product for startups left the bank vulnerable to significant losses from loan defaults when interest rates rose, and company valuations plummeted.
Reputational Risk
The announcement of a share sale by SVB caused panic at billionaire VC Peter Thiel’s Founders Fund, a large venture capital firm that did most of its banking with SVB. They moved quickly to shift the firm’s capital to bigger banks, and portfolio companies were advised to move their money out of SVB. The ensuing bank run will be swift and total when Peter Thiel advises withdrawing your funds. Once the darling of Silicon Valley, SVB lost the trust of its esteemed clients due to its blatant lack of risk management. This failure was evident to sophisticated investors like Thiel, and when people like Thiel tweet, people listen.
Regulatory Risk
SVB’s lack of oversight raises concerns about the effectiveness of the current regulatory framework for regional banks. In 2018 lawmakers relaxed asset requirements for banks to be deemed “systemically important“, leaving banks like SVB, with $209 billion in assets, unburdened by stress testing requirements designed to protect against major economic shocks. These banks may not be “systemically important,” but their size could threaten the entire banking system. This regulatory gap highlights the need for a more robust regulatory framework to ensure financial stability.
Valuation Risk
The tech industry is experiencing a significant decline in valuations, even among well-established companies, since the peak of SVB’s assets and deposits in 2022. Ernst & Young’s IPO report showed a 95% drop in US IPO deal proceeds. Late-stage startup valuations have dropped 54% from a year ago, bringing them closer to their publicly traded counterparts. This puts more than 1,200 active unicorns at risk of down rounds and potential loan defaults. SVB serviced about 50% of all venture-backed companies.
What should founders do now?
While it was a harrowing couple of weeks for many founders trying to navigate the SVB debacle, there are some key takeaways from the ongoing crisis.
Be aware, be smart
As founders, our greatest responsibility is to ensure that we meet payroll obligations for our employees. As a director of your company, you are personally responsible for ensuring employee wages are paid, so know your legal obligations. Don’t let your investors put you in a compromising position or accept deals that don’t serve your long-term interests. Remember, as directors, investors share equal responsibility for meeting the company’s payroll obligations.
When seeking new loans or renegotiating existing SVB loans, demand terms that limit your risk. Keep no more than 60% of deposits at the lending bank, with at least 3 payroll cycles’ deposits held elsewhere. Venture debt deals often require 100% of deposits at the lending bank, making you vulnerable during a crisis. To reduce risk, suggest using a DACA (Deposit Account Control Agreement) at other banks where you have deposits, allowing the lender to secure your account in case of default, which limits the lender bank’s risk on the loan while protecting your business.
Manage your treasury
Founders must prioritize instituting a strategy for treasury management, even during hectic execution phases, until the authorities conduct a regulatory analysis and the situation stabilizes.
Diversify your deposits. Don’t keep more than 30-40% of your funds in one institution. Remember that big banks won’t provide the same level of service as an SVB, First Republic Bank, or Signature Bank unless you have north of ~$50 million in deposits. Carefully consider the pros and cons of each institution before making your choice.
Watch the space
Founders can use treasury management in a crisis, but managing multiple deposit accounts is an operational burden. Look out for upcoming regulatory changes in the banking system, such as stress tests and liquidity requirements. The FDIC may raise the limit on deposit insurance. The Fed may ease banks’ access to its discount window.
Will the Fed and banks take the necessary measures to prevent another crisis in six months? Watch this space closely.
More pain to come
The failure of SVB and other regional banks like First Republic and Signature Bank will dramatically alter the technology industry’s landscape. This disruption will persist until a stronger, more regulated leader emerges. The ramifications will be felt across multiple levels, with many factors requiring realignment before we can restore a healthy venture capital ecosystem.
Hard time for underfunded founders
SVB’s collapse hurts diversity and inclusion in tech. It’s a blow to underrepresented founders who struggle to secure capital from traditional sources due to systemic biases. These founders usually relied on the bank as a critical funding source. SVB’s expertise and network were pivotal in fostering investor relationships for entrepreneurs of color and female founders.
Similarly, regional banks like Signature Bank have been instrumental in offering creative solutions for businesses with unique challenges that do not fit the accepted credit mold.
Specialization and tailored offerings are critical for innovation and progress in the industry. The tech industry will now need to find banks to support diversity and innovation.
Losing SVB’s expertise in venture capital and startups, and its probable sale in parts is a setback. Other banks may try to replicate SVB’s products and services. But replacing its unique advantages with better risk management protocols and a healthier balance sheet is not easy.
Credit will dry up
The regional banking crisis has wreaked havoc on the financial sector, causing billions of dollars in losses. It has had ripple effects on already shaky institutions like Credit Suisse. The aftermath of this crisis will likely bring about a credit tightening and economic slowdown, with banks becoming less tolerant of risk.
An industry veteran I spoke to said, “SVB was the leader in venture debt. Its collapse will strain an already troubled funding environment for startups. We have yet to evaluate the after-effects on other non-bank venture debt lenders like Hercules and Trinity Capital, which had syndicated loans with SVB. We will see reduced risk appetite for venture debt deals, which is a vital source of capital for risky early-stage companies while keeping more equity in the hands of founders.”
Funding will tighten further with slower access to capital
VCs rely on Venture Debt and Capital Call Lines of Credit to increase capital for portfolio companies, leading to a higher IRR with shorter investment horizons. If Venture Debt dries up, it would worsen an already tight funding environment. This will force VCs to increase support for successful portfolio companies while cutting funding for new innovations. As a result, many promising businesses may perish without seeing the light of day.
Expect a slowdown in closing funding deals as Capital Call Lines of Credit, popularized by SVB, become disrupted. This will cause liquidity challenges for VCs. SVB’s Capital Call Lines of Credit is a commonly used credit facility by VCs, allowing them to draw down funds for investments without calling Limited Partners (LPs). The flow of LP capital may suffer disruption, resulting in liquidity challenges. Founders should prepare for delayed capital allocations by adding extra cash runway buffers.
The financial world is changing, with challenges for both investors and founders. We expect more corrections, but it’s also an opportunity to reflect and reimagine strategies. The key is to stay resilient, adaptable, and forward-thinking for long-term sustainability in uncertain times.