I’m sure you’ve heard by now that Silicon Valley bank that was closed by regulators late last week.
A little back story, interestingly enough, a little over 20 years ago, I worked for a bank that competed directly with Silicon Valley bank. The bank I worked for, The Venture Banking Group in Palo Alto, financed early-stage venture backed technology companies. We were a division of a larger regional bank called Cupertino National Bank which subsequently years later was purchased by Wells Fargo.
Our parent bank, Cupertino National Bank was always mindful of not being overly concentrated in technology related startup companies and therefore our division was a relatively small group within the larger regional bank. This was for prudent risk management purposes. The 800-pound gorilla was Silicon Valley Bank, as they dominated the venture banking market.
From what I’ve reviewed of Silicon Valley Banks balance sheet and read about the events that took place, there were two primary driving forces that caused their quick collapse:
- Poor risk management
- Inappropriate investments on their balance sheet.
- Concentration of deposits.
- Dramatic withdrawal of bank deposits
The poor risk management was a mismatch between their short-term liabilities (bank deposits) and their asset base (customer loans and investments). Their huge misstep was purchasing long-dated treasuries and mortgage-backed securities. Bankers will tell you that it’s imperative to match your assets and your liabilities. Silicon Valley Bank didn’t do this, and any hedges they had in previous years were taken off by the end of 2022.
Credit quality was NOT the issue like it was during the financial crisis, it was a timing issue.
A Very Simple Example: Imagine you said that you need money next month for a large down payment on a home, and instead of keeping the money in cash, you took the money and invested in something that could lose substantial value over the next month. This wouldn’t be prudent, even if the investment was guaranteed to do well over the long-term. In this example, your need for cash is short-term, but your investment was long-term. This is what’s called an asset-liability mismatch.
What Does This All Mean?
The various regulators stepped in and are guaranteeing that all depositors will be made whole. However, the investors (stockholders and bondholders) and executives will not get the government guarantee, so they are expected to lose a lot. Which I think is the right thing to do on both fronts.
So how does this affect the overall banking industry and how does it affect the economy. The short answer is nobody knows exactly. But more than likely there will be some spillover effects as it seems reasonable that it will be more expensive for startup companies and early-stage tech companies to get financing. Typically, what causes a lot of short-term stress in the markets are all the 2nd and 3rd order effects which tend to be difficult to fully assess.
How Does This Affect The Markets?
We are already seeing some effects with other banks and the financial services sector in general. As I mentioned before there will be some spillover effects, but I think they will be very modest, fortunately overall the banking system is very secure.
Most importantly, this event explicitly shows just how important diversification is – something Silicon Valley Bank learned the hard way. Because one company, or two companies, or even a handful of companies that fail should not hinder your portfolio from doing well over time – if you are properly diversified. As investors know, market gyrations cannot be avoided and are not a bug in the system, but rather a feature.
Volatility in the market is unavoidable, while it’s never pleasant or enjoyable sometimes great opportunities come from such volatility. In this case, it’s advisable to look at this as the glass being half full, rather than the alternative.
In real estate, when buying property, the key phrase that comes up time and time again is, Location, Location, Location. In the stock & bond market, it’s Diversification, Diversification, Diversification.
-Paul R. Rossi, CFA