We have seen coordination failure and its consequence in bank runs and what might have happened at Silicon Valley Bank last week. Two videos on YouTube (A and B) have prompted me to write this post. Video A is about a CEO who just managed to pull out her money from the bank before the collapse, an event partly transpired by actions such as hers. The second video shows the pivotal moment from the movie, “It’s A Wonderful Life” (1946), where the hero James Stewart single-handedly prevented a bank from collapsing. Real heroism!
Bank’s decision making
So what happened at the 2023 bank scene? SVB held large quantities (in the order of $200B) of deposits from start-up companies. The bank keeps the required minimum cash or fractional reserve banking, typically about 10%, in their vaults; the rest is turned around to make profits (earning from the investing – the interest paid to the depositor). SVB has invested ca. $90B of its cash in what is known as held-to-maturity (bonds). There is nothing wrong so far, as these instruments are pretty risk-free, but not this time! The bank invested its money at ca. 2% return for about four years in 2021, and the Federal Reserve raised the interest rate a year later, making a heavy dent in the current market value of the 2021 investment.
Meanwhile the investors
Two things happened at the investor’s end. The depositors (the technology companies) wanted to take out more money from the bank as the funding started declining for the firms. The news of the declining fair value of the 90 billion bonds became public with the annual report. The second news made the depositors and their seed investors nervous; they wanted to withdraw all their money.
Perfect storm
The end result was a perfect bank run. On March 10, the bank announced they had failed to raise capital and were looking for a buyer. A few hours later, the bank was shut down by the regulator.
The math behind the trouble
Imagine the bank had bought treasury bonds worth $100 in 2021 for four years at a rate of return of 2%, and the Fed raised the interest rate to 5% immediately after that. If the bank waits for four years, it will get 100 x (1.02)4 = 108.2 at 2% returns. If the bank wants to encash before, it must go to the secondary market to sell. The buyer at the secondary market, who can now get 5% returns on a bond, therefore, will value the bank’s bonds at $88 (108/(1.05)4).
The psychology behind the trouble
But the math is just a catalyst to the trouble. The broader issues are the decision-making by the bank that invested significant cash in long-term bonds (duration risk). And the depositors, triggered by their investors, wanted to withdraw their money all at once (irrationality). And alas, the Jimmy Stewarts, who could charm the depositors from carrying extreme actions, exist only in movies and textbooks.
Further Watch
A) CEO describes pulling money from bank hours before collapse: CNN
B) Bank Run Scene from “It’s A Wonderful Life” (1946): Ian Broff
Why Banks Are Collapsing: Graham Stephan
