Compiled By: Coinlive
Author: TechFlow

Small and medium-sized banks in the United States have been collapsing one after another!

On March 8th, Silvergate Bank, a bank famous for its cryptocurrency-friendly policies, announced its liquidation and the return of all deposits to its customers.

On March 10th, Silicon Valley Bank, which specializes in providing financial services to technology companies in Silicon Valley, sold $21 billion worth of marketable securities and suffered a loss of $1.8 billion, suspected to be due to liquidity issues. Its stock price plummeted by more than 60% on Thursday, evaporating $9.4 billion from its market value in just one day.

This has also frightened many Silicon Valley elites.

Peter Thiel's venture capital fund, Founders Fund, directly advised companies it invests in to divest from Silicon Valley Bank, while Y Combinator CEO Garry Tan issued a warning, suggesting that invested enterprises consider limiting their exposure to lenders and not exceeding $250,000.

What's even more frightening is that Silicon Valley Bank may be the first domino to trigger a crisis, not only affecting other US banks, but also potentially striking a blow to technology startups in Silicon Valley.

So, what happened?

Today, we will tell a story about how banks go bankrupt.

Interpreting the Bank Business Model
First, we need to understand the business model of the banking industry.

Simply put, a commercial bank is a company that deals with currency. The business model of a bank is fundamentally no different from any other business — buy low, sell high. The only difference is that the commodity is money.

Banks get money from depositors or capital markets and then lend it to borrowers, making a profit from the interest differential.

For example, a bank borrows money from depositors at an annual interest rate of 2% and then lends it to borrowers at an annual interest rate of 6%. The bank makes a profit of 4% from the interest differential, which is its net interest income. In addition, banks can earn profits from basic fee-based services and other services, which are their non-interest income. Net interest income and non-interest income combined form a bank's net income.

Therefore, just like selling goods, if banks want to make more profit, the best situation is to have no inventory, that is, lending out all the low-cost deposits at high prices. After all, deposits have a cost, and interest must be paid to depositors.

This also constitutes the two ends of a bank's balance sheet.

Equity + Liabilities: Equity is the capital, and customer deposits held by the bank are essentially loans from customers, which are liabilities. For banks, the more liabilities, the better, and the lower the cost, the better. Banks like Silvergate mainly attract deposits from the cryptocurrency world by providing unique services such as the SEN network.

Assets: Corresponding to deposits, the loans that banks issue to customers are the bank's claims and assets, including various types of mortgage loans, credit loans for ordinary consumers, and various bonds, such as government bonds, municipal bonds, mortgage-backed securities (MBS), or high-rated corporate bonds.

So, how do banks with such a simple business model go bankrupt?

When a bank encounters a crisis, it means that its balance sheet has a problem, usually due to two situations: bad debts and maturity mismatch.

Bank bad debts: Normally, banks make a profit by collecting loans. If the loans issued or purchased are a pile of rubbish that defaults one after another, the bank will face actual losses. Lehman Brothers, which went bankrupt during the subprime mortgage crisis, held a large number of bad loans, and the loss of assets on the balance sheet far exceeded the bank's capital, that is, it became insolvent.

Maturity mismatch: The maturity of the assets side and the liability side do not match, mainly manifested as "short-term deposits and long-term loans", that is, the source of funds is short-term, and the use of funds is long-term.

For example, suppose you have to pay rent on the 1st of this month, but your only cash flow income is your salary, which will be paid on the 10th of this month. Your cash inflow and outflow are mismatched, which leads to maturity mismatch, that is, a liquidity crisis. What do you do in this situation? Either sell assets such as stocks, funds, or cryptocurrencies for cash or borrow money from friends to deal with the current crisis.

Returning to Silvergate and Silicon Valley Bank, maturity mismatch is the reason they fell into a crisis.

Not only these two banks, but various crypto unicorns that have previously fallen into crises, such as Celsius, Bibox, AEX, etc., all went bankrupt due to a liquidity crisis caused by maturity mismatch.

Ultimately, this is all related to the Federal Reserve's interest rate hikes, and they are all casualties of the US dollar cycle.

How could Silvergate go bankrupt?
Silvergate Capital Corp (stock code: SI), founded in 1986, is a community retail bank located in California, USA. It remained relatively unknown for decades until Alan Lane decided to enter the cryptocurrency industry in 2013.

Silvergate Bank is known for being very friendly to cryptocurrency, accepting deposits from cryptocurrency trading platforms and traders, and establishing its own cryptocurrency settlement payment network, the Silvergate Exchange Network (SEN), to facilitate deposits and withdrawals for exchanges and customers. It has become an important bridge connecting fiat and cryptocurrency, with FTX using SEN for fiat deposits and withdrawals.

As of December 2022, Silvergate has a total of 1620 clients, including 104 exchanges.

During the cryptocurrency bull market, a large amount of funds entered the industry and deposits from clients in the cryptocurrency industry increased sharply, especially due to the existence of SEN, causing a large amount of funds from exchanges to be deposited in Silvergate.

From the third quarter of 2020 to the fourth quarter of 2021, Silvergate's deposits soared from $2.3 billion to $14.3 billion, nearly seven times the growth.

The cryptocurrency-friendly nature of the bank and the cryptocurrency bull market led to a sharp expansion of deposits, which forced the company to "buy assets". However, the loan cycle was too long, and this was not Silvergate's strength, so it chose to purchase billions of dollars worth of long-term municipal bonds and mortgage-backed securities (MBS) during 2021.

As of September 30, 2022, the company's balance sheet shows approximately $11.4 billion in bonds, with only about $1.4 billion in loans. Therefore, Silvergate is essentially an "investment company" that arbitrage between the cryptocurrency world and the traditional financial market: it uses its banking license and SEN to attract deposits from cryptocurrency institutions at low or even zero interest rates and then invests in bonds to earn the spread.

The coexistence of cheap deposits and high-quality assets seemed perfect until two black swan events occurred in 2022.

In 2022, the Federal Reserve entered a crazy interest rate hike mode, and interest rates rose rapidly, causing bond prices to drop.

There is an equation in financial products, today's price * interest rate = future cash flow. The feature of bonds is that the amount of principal and interest to be repaid at maturity has already been determined, and the future cash flow will not change. Therefore, the higher the interest rate, the lower the price today.

As of the end of Q3 2022, the securities held by Silvergate had unrealized losses of more than $1 billion.

In addition, during the cryptocurrency bull market, Silvergate, with deep pockets, acquired Diem, Facebook's failed stablecoin project, for nearly $200 million in stock and cash at the beginning of 2022. In January 2023, Silvergate disclosed that it had recognized impairment charges of $196 million in the fourth quarter of 2022, reducing the value of intellectual property and technology acquired from Diem Group at the beginning of last year, which was equivalent to the entire $200 million going down the drain.

In short, Silvergate bought too many high-priced assets at the peak of the bubble. However, as long as the liability side of the balance sheet does not encounter problems, it can still land safely. Unfortunately, at this time, Silvergate's super-customer FTX went bankrupt.

In November 2022, FTX declared bankruptcy. Under panic, Silvergate's depositors began to withdraw funds frantically.

In the fourth quarter of 2022, Silvergate's deposits fell by 68%, with withdrawals exceeding $8 billion. This situation is what we often call a bank run.

As the liquidity crisis approached, in order to cope with the redemption of depositors, Silvergate had no choice but to borrow money or sell assets.

First, Silvergate was forced to sell previously purchased high-priced securities in the fourth quarter of 2022 and January of this year to obtain liquidity, resulting in losses of about $900 million in securities, which is equivalent to 70% of its equity.

In addition, Silvergate obtained some cash by borrowing $4.3 billion from the Federal Home Loan Bank of San Francisco, a government-chartered institution whose main business is to provide short-term collateral loans to banks in urgent need of cash.

As for what happened later, everyone knows that on March 9th, Silvergate Bank announced its liquidation, stating that it would orderly and gradually end operations and voluntarily liquidate in accordance with applicable regulatory procedures and fully repay all deposits.

Silicon Valley Bank Crisis
If you understand the crisis of Silvergate Bank, then the liquidity crisis of Silicon Valley Bank (SVB) is almost the same, except that SVB is larger and more influential in Silicon Valley's technology and life science startup companies.

SVB has always been one of the most popular financial institutions among Silicon Valley's technology and life science startup companies. Once SVB collapses, it will inevitably affect various types of startups, bringing a dual crisis of technology and finance.

The trigger of the event was SVB's sale of $21 billion in bonds in a "fire sale" manner, resulting in a real loss of $1.8 billion. SVB then announced that it would raise $2.3 billion by selling stocks to offset the losses related to the bond sales.

This scared various Silicon Valley venture capital firms.

"Father of Silicon Valley" Peter Thiel's venture capital fund, Founders Fund, directly advised companies it invested in to withdraw their funds from Silicon Valley Bank; Union Square Ventures told its portfolio companies to "keep the least amount of funds possible in SVB's cash accounts";

Y Combinator CEO Garry Tan warned its invested startups that SVB's solvency risk is real and suggested that they should consider limiting exposure to lenders, preferably not exceeding $250,000;

Tribe Capital advised many portfolio companies to withdraw some funds if they could not extract cash completely from Silicon Valley Bank.

As a result, bank runs occurred, and Silicon Valley Bank fell into a deeper liquidity crisis.

Let's analyze its assets and liabilities.
On the liability side, due to the low interest rates in the entire currency market, SVB attracted a large amount of deposits with a 0.25% deposit rate, coupled with the good technology venture capital and IPO market in the past few years, which has led to a rapid growth of SVB's liabilities, from $61.76 billion in 2019 to $189.2 billion at the end of 2021.

However, the technology venture capital market has become sluggish nowadays, especially the IPO market has been very quiet in the past year. SVB's deposits continue to decline, and for depositors, directly buying US Treasuries is a more cost-effective choice.

On the asset side, like Silvergate Bank, when there are a large number of deposits that cannot be released through traditional lending methods, SVB also chooses to buy bonds such as MBS. The key problem is that it is not just buying a little, but almost "all in."

When interest rates are low, major US banks still put more deposits into government debt and accept lower yields during uncertain economic periods. Silicon Valley Bank thought that interest rates would remain low for a long time, and invested most of its deposits in MBS for higher yields.

As of the end of 2022, SVB had $120 billion in investment securities, including a $91 billion mortgage-backed securities portfolio, far exceeding its total loans of $74 billion.

According to SVB's public information, the company's $21 billion bond investment portfolio has a yield of 1.79% and a duration of 3.6 years. In comparison, on March 10th, the 3-year US Treasury yield was 4.4%.

As interest rates soar, the decline in bond prices will cause losses for Silicon Valley Bank.

SVB holds a $91 billion bond portfolio until maturity, and its current market value is only $76 billion, equivalent to $15 billion in unrealized losses.

SVB CEO Greg Becker said in a media interview: "We expect interest rates to rise, but we didn't expect it to be this much."

Overall, the dilemma of Silvergate and SVB is mainly due to the misjudgment of the pace of Fed rate hikes, leading to incorrect investment decisions. "All-in" on bonds is fun in the short term, but it is difficult to deal with when the US dollar is raised.