Expert Commentary

Silicon Valley Bank and deregulation: A research-based explainer

Get up to speed on what happened with Silicon Valley Bank, why it happened, and regulatory implications for the dozens of midsize banks that are regional economic engines across the U.S.

Silicon Valley Bank
(Alpha Photo / Flickr / Creative Commons)

On March 10, Silicon Valley Bank, the banker of choice for many firms in the tech world, achieved ignominy as the second-biggest bank failure in U.S. history.

The recent images published by news outlets across the world of customers lining up outside the failed bank’s Santa Clara, California headquarters struck a familiar chord for those who know the long history of bank runs, which refers to large numbers of customers at once demanding their deposits.

This is what happened: As inflation rose over recent months, the value of the bank’s store of long-term U.S. Treasury bonds and mortgage-backed securities fell. Interest rate hikes meant to quell inflation made it more expensive for venture capitalists to borrow, which slowed incoming deposits.

So, Silicon Valley Bank had billions tied up in securities of declining value. And the bank had fewer deposits coming in. Bank executives tried to cut their losses to help make up for the slowing deposits and sold tens of billions worth of devalued securities.

Depositors noticed the bank’s troubles and tried to pull their money en masse.

The run was on, and Silicon Valley Bank didn’t have the cash to meet its obligations.

“The basic math is easy enough to understand: deposits went away, slowly and then all at once,” Semafor business and finance editor Liz Hoffman wrote on March 17.

Fallout from the Silicon Valley Bank failure is still playing out. The good news is that widespread runs on numerous other midsize banks have not materialized, so far.

But there has been collateral damage. Startups had to scramble to meet payroll. Construction was halted on an affordable housing project in San Francisco. The project’s financing deal with Silicon Valley Bank was set to close the day the bank failed, according to Dana Hull and Sarah Holder reporting for Bloomberg CityLab.

Globally, the major bad news is that instability from the tech bank’s downfall put banking giant Credit Suisse, already feeling the weight of recent scandals and mismanagement, teetering on the brink of collapse. Credit Suisse was bought on March 19 by rival UBS for just $3 billion in a sale forced by Swiss regulators.

Whether the current shock is a mere tough moment or sounds the opening bell of a global recession will be clearer in coming weeks. So far, central bankers in the U.S. have been willing to shore up hundreds of billions in losses.

What rattled SVB customers?

Trouble for Silicon Valley Bank began percolating in public on March 8, when the bank announced it was selling roughly $21 billion in securities at a $1.8 billion loss, while seeking to raise $2.25 billion in a public offering of company shares.

These actions rattled clients, who wondered why bank leaders felt they needed so much cash. Clients didn’t wait to find out: They wanted their money.

On March 9, customers initiated withdrawals worth $42 billion, leaving Silicon Valley Bank short nearly $1 billion. The Federal Deposit Insurance Corporation, the government institution that exists to maintain confidence in the banking system by federally insuring bank deposits, took over the bank on March 10.

Notably, the FDIC insures $250,000 worth of deposits per account holder, for both individuals and businesses. Nearly 94% of Silicon Valley Bank’s deposits exceeded this statutory limit, making the bank highly vulnerable to a run. Among the largest U.S.-based banks, Citibank has the biggest share of uninsured deposits at 74%, while Bank of America is lowest at 46%, according to data from S&P Global Market Intelligence. Overall, about 46% of domestic deposits, worth nearly $8 trillion held at large U.S. banks are not FDIC insured, according to S&P.

“The bank run was devastating for SVB, but the real problems that triggered this event were the underlying interest rate exposure and the slow withdrawal of deposits,” Harvard Business School finance professor Erik Stafford explained recently to HBS Working Knowledge senior editor Dina Gerdeman. “SVB was forced to issue a large amount of equity, which brought a lot of attention to their situation. There is now a lot of attention on the situation at all banks.”

Tech firms held deposits with the bank for various purposes, including operational needs, such as payroll. The bank in many ways looked like any other corporate bank, but leaders in tech thought of it as “their kind of bank,” as economist Paul Krugman put it in a recent New York Times column.

The Federal Reserve, the U.S. Securities and Exchange Commission and the Justice Department have opened investigations into what happened. Federal Reserve Board members have said they will release the investigation’s findings by May 1, while the existence of the other two investigations has only come out in news reports.

What happened next?

Tech CEOs on March 11 petitioned Treasury Secretary Janet Yellen and other government officials for help.

At stake: Not a bank, but American economic innovation, according to the more than 5,000 executives who signed the petition. “We are not asking for a bailout for the bank equity holders or its management; we are asking you to save innovation in the American economy,” they reasoned, in existential terms.

Then came the failure of New York City based Signature Bank, which served cryptocurrency investors. On March 12, it became the third-largest bank to fail in U.S. history.

Signature Bank was also taken over by the FDIC.

On March 12, the FDIC announced it had established two banks, called bridge banks, which would honor $175 billion worth of deposits in Silicon Valley Bank and $89 billion worth at Signature Bank. On March 19, Flagstar Bank, a subsidiary of New York Community Bancorp, bought roughly half of Signature Bank’s assets, while $60 billion worth of loans remain with the FDIC’s bridge bank.

And on March 16, a consortium of the largest banks in the country, including Bank of America, Citigroup and JPMorgan Chase, announced they would add $30 billion to the flailing (though not yet failing) First Republic Bank, headquartered in San Francisco.

This action echoes a bailout worth tens of millions of dollars spread across Wall Street and orchestrated over a century ago by financier J.P. Morgan — following the chaos of the Panic of 1907, which was also precipitated by a bank run. This private bailout was a direct precursor to the establishment of a public entity that could help address financial crises moving forward: The Federal Reserve System.

Has the FDIC done this before?

Silicon Valley Bank
A New York City bank run in the early 1900s. (Library of Congress / Bain Collection )

Legally, the federal government taking over the private banks and managing their operations is made possible through what is called a systemic risk exception. This exception was made law in 1991 and first used in 2008. Leaders at the FDIC and the Federal Reserve need to recommend the exception and the Treasury secretary, after consulting with the president, needs to agree to put the exception into action.

Despite the images of clients gathering outside Silicon Valley Bank’s headquarters in Santa Clara, this was a bank run for the Internet age. House Financial Services Committee Chairman Patrick McHenry called it the “first Twitter fueled bank run,” referring to panicky social media outbursts from analysts and venture capitalists the day before the bank failed and the government took it over.

In the U.S., bank failures have been rare in recent years, according to data from the FDIC. It had been well over a decade since a bank run caught the nation’s attention: The last significant withdrawal of bank deposits occurred during the start of the Great Recession, in the late 2000s.

Toward the end of 2008, for example, Wachovia and Washington Mutual banks “experienced heavy deposit outflows and other important liquidity pressures,” Federal Reserve historian Jonathan Rose recounts in a 2015 discussion paper, “Old-Fashioned Deposit Runs.”

Who is to blame?

This is one of the big questions journalists and others are trying to figure out. The prevailing narratives federal legislators are expressing through the news media are:

  • Regulators, including at the Federal Reserve Bank of San Francisco, which oversees banking on the west coast, had enough legal authority to effectively supervise banks, but they did not do their jobs.
  • A 2018 law, which relaxed regulations for smaller banks, coupled with other deregulatory measures, led to Silicon Valley Bank going under.

On the last point, Stafford, the finance professor, notes in HBS Working Knowledge that “We actually do not know much about SVB’s exposures, since they fell below the Fed’s threshold for annual collection of Form FR Y-14A Capital Assessments and Stress Testing.”

With less than $250 billion in assets, Silicon Valley Bank did not have to submit to regular stress tests, which the Federal Reserve uses to assess whether banks have enough cash on hand, or easy access to cash, to make it through financial challenges, such as a swarm of depositors demanding their money.

The core of the stress tests are hypothetical, economically damaging scenarios the central bank uses to see how banks’ balance sheets would fare. For the 2023 stress tests, the Federal Reserve will assess how banks would be able to weather unemployment peaking at 10% accompanied by volatility in securities markets.

Before the 2018 law, banks with more than $50 billion in assets had to submit to regular stress tests — though the Federal Reserve was given discretion to require more stringent oversight for individual financial firms worth between $100 billion and $250 billion.

Recent reporting from The New York Times’ Jeanna Smialek reveals supervisors at the San Francisco Fed warned Silicon Valley Bank multiple times since 2021 about the bank’s weaknesses. “But the bank did not fix its vulnerabilities,” Smialek writes. “By July 2022, Silicon Valley Bank was in a full supervisory review — getting a more careful look — and was ultimately rated deficient for governance and controls.”

What happened with risk at midsize banks?

After the deregulation bill became law in May 2018, the Federal Reserve began taking steps to loosen Volcker Rule restrictions. Named for former Federal Reserve chair Paul Volcker, the rule prohibited banks from making certain potentially risky investments, such as with hedge funds. The banking industry criticized the rule as an imposing regulatory burden for small banks — those with less than $10 billion in assets, which account for nearly all FDIC-insured banks, as New York University business professors Matthew Richardson, Kermit Schoenholtz and Lawrence White note in “Deregulating Wall Street,” published in October 2018 in Annual Review of Financial Economics.

For small banks, those with less than $10 billion in assets, deregulation reduced the costs of complying with regulation, according to a September 2022 paper in the Journal of Accounting and Finance by Arkansas State University professor Dwayne Powell.

Midsize banks, those with $50 billion to $250 billion in assets, also enjoyed reduced regulatory costs and higher profits following the 2018 deregulation. But they faced increased risk of failure as measured by available cash to meet demand, among other indicators, finds a January 2023 paper in the Journal of Financial Stability by economic researchers Dimitris Chronopoulosa, John Wilson and Muhammed Yilmaz.

But even if the Volcker Rule were still in place, it does not appear it would have directly prevented the run at Silicon Valley Bank. The rule did not restrict banks from investing in government bonds, as Richardson, Shoenholtz and White explain in their paper. Treasury bonds are one type of security that Silicon Valley Bank lost big on as inflation spiked.

What are some future policy considerations?

One point of interest among academic researchers that would be a consideration for federal legislators debating whether to tighten regulations is whether the failure of several medium-sized banks would represent less risk to the overall economic system than the failure of one large bank. In the parlance of banking, there are a few dozen banks globally that are “systemically important,” or too-big-to-fail.

The question is, would the economic fallout from the failure of a number of midsize banks be less bad than a single too-big-to-fail bank going under? “If the answer is no, then it is doubtful that medium-sized banks collectively should be subject to lower capital requirements or less stringent prudential regulation,” write Richardson, Shoenholtz and White.

In other words, the authors argue that if a few medium banks are as economically important as one big bank, those midsize banks should be regulated in a manner similar to the big banks. At the same time, regulatory measures should be laser-focused on reducing systemic risk, such as mandating stress tests, the authors write.

But stress tests need to be calibrated to policy and economic reality. Even if Silicon Valley Bank had been subject to regular stress tests, the Federal Reserve’s recent stress tests for larger banks did not incorporate interest rates hikes, note Santa Clara University economics professor Kris James Mitchener and Louisiana State University finance professor Joseph Mason, writing in the Wall Street Journal on March 15.

“If stress testing is meant to warn regulators about banks in advance of runs, the Fed needs to include scenarios that reflect its own policies,” Mitchener and Mason conclude. “Applying appropriate stress testing to large as well as midsize banks would help ensure that the next SVB isn’t a sitting duck waiting for a run.”

Another consideration for legislators and regulatory policymakers moving forward has to do with operational risks. This type of risk has to do with internal executive decisions. Wells Fargo fraudulently opening millions of customer accounts without permission from 2002 to 2016 is an example of an operational decision.

The failure of Silicon Valley Bank leaders to heed warnings from the Federal Reserve indicate operational risk is a potential problem for midsize banks as well as large ones. But operational risk is overall mostly an issue for larger banks, according to “Are the Largest Banking Organizations Operationally More Risky?” published August 2022 in the Journal of Money, Credit and Banking by Federal Reserve economists Filippo Curti and W. Scott Frame and University of Kansas finance professor Atanas Mihov.

“We show that larger [banks] experience higher operational losses per dollar of assets,” the authors write. “This relation is driven by losses from failures in obligations to clients, faulty product design, and business practices, and to a lesser extent by losses from the disruption of business or system failures. Past operational problems are persistent at the largest institutions, suggesting that size hinders efficient reformation and elimination of operationally risky practices.”

Further reading

Why do banks invest in MBS?” Itamar Drechsler, Alexi Savov, and Philipp Schnabl. NYU Stern working paper, March 2023.

Regulatory oversight and bank risk,” Dimitris Chronopoulos, John O.S. Wilson and Muhammed Yilmaz. Journal of Financial Stability, January 2023.

Are the Largest Banking Organizations Operationally More Risky?” Filippo Curti, W. Scott Frame and Atanas Mihov. Journal of Money, Credit and Banking, August 2022.

Quantitative Analysis of the Impact of The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 on the Cost of Regulatory Burden on Community Banks,” Dwayne Powell. Journal of Accounting and Finance, September 2022.

Has ‘Too Big To Fail’ Been Solved? A Longitudinal Analysis of Major U.S. Banks,” Satish Thosar and Bradley Schwandt. Journal of Risk and Financial Management, February 2019.

Deregulating Wall Street,” Matthew Richardson, Kermit Schoenholtz and Lawrence White. Annual Review of Financial Economics, October 2018.

Regulatory Reform,” Andrew Metrick and June Rhee. Annual Review of Financial Economics, September 2018.

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