What Happened to Signature Bank and Silicon Valley Bank?
If you’ve been watching the news lately, you’ve probably heard about the recent FDIC takeovers of Silicon Valley Bank (SVB) and Signature Bank. What happened that caused them to close so abruptly? In a nutshell, it’s called “duration mismatch,” which is a timing difference in the maturity dates of a bank’s assets and liabilities.
Why do banks have a duration mismatch?
In the simplest form, banks borrow short-term from their deposit holders (liabilities) and then they invest in longer term loans (assets). Typically, in a period of a normal yield curve, longer-term duration assets yield higher more than shorter-term duration assets. This typically works well for banks because they’re able to profit on the difference from what they collect on their assets to what they pay of their liabilities. For instance, if a bank pays it deposit holders 1% and lends out at 5%, the banks gross profit will be the 4% difference.
Why did Silicon Valley Bank and Signature close so fast?
Silicon Valley Bank and Signature grew significantly over the past few years. SVB’s deposits grew over 25% in 2020 alone. They both grew so fast that they had a hard time placing the deposits into quality loans, which are typically variable rate loans. So instead of placing the deposits in consumer loans that are variable, or can swapped for variable rates, these banks bought US Treasuries. In most normal times, US Treasuries are seen as the gold standard of bonds. Banks are actually encouraged by regulators to buy these assets.
So why did this go wrong? While US Treasuries are extremely safe assets if held to maturity, they’re not immune to interest rate risk. As yields go up, asset prices go down. As the Fed raised rates at the fastest pace in recent history, the prices of these assets declined just as fast. Since the value of their assets declined, these banks had to report unrealized losses. This caused the deposit holders (short term liabilities) to get nervous and pull their deposits. And in order for the bank to meet their depositor needs, the banks had to sell their assets at a loss. This caused realized losses, and more fear. To make matters worse, the deposits were concentrated, SVB in Tech and Signature in the Crypto industry. The concentration of deposits only accelerated the bank run.
How could this have been prevented?
The short answer is hedging and basic risk management This is done a couple ways. One is to lend out at variable rates. This ensures that the rates on assets go up, and down, with the market. In the case of SVB, they had a significant amount of their assets in fixed rate US Treasuries. Once these banks learned that rates were going up, they should have either sold those treasuries immediately for either shorted dated notes, or at least purchased interest rate hedges. This would have protected them against the drop in asset values and most likely prevented the bank run.
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