A bank with over $200 billion in assets has collapsed… how?

You may have heard in the news this week that the Silicon Valley Bank in the US, a bank which specialised in working with innovators and entrepreneurs, has collapsed. Or in other words, failed.

But what does this really mean, can a bank really collapse and just cease to be a bank anymore? And what happens to all the money which clients have deposited? Two very good questions… Let me put your mind at ease and give you the simple (ish) explanation.

Firstly, lets just recap how commercial banks work. It all starts with a deposit. That is, a person or a business wishes to keep their money safe so they deposit it in the bank. The bank will pay the customer a modest interest rate and the customer can feel happy in the knowledge that their hard-earned cash is somewhere much safer than under their bed. The bank then takes these deposits, which in the case of SVB was in excess of $175 billion, and either loans it back out at a higher interest rate or invests it elsewhere to a make healthy profit.

Now let us bring this back to SVB. With most of their clients being technology startups, the bank was riding a high from the buoyant tech sector during the pandemic. They saw a surge in deposits the last two years and invested most of it in US treasury bonds. OK, stop again.

A what what? A treasury bond – perhaps time for another explanation…

Treasury bonds are like loans to the US government. When the government wants to raise revenue to fund their own expenditure, they can issue bonds which are essentially requests for cash today, which they will pay you back with interest in the future. Most of these bonds are long-term, with fixed interest rates for 10 to 20 years. As very safe investments, the interest is usually around 2% per year. Like any financial asset, the bonds can be bought and sold on the free-market at any time before they mature.

So SVB was playing it safe by buying bonds, right? So why did they fail?

Another good question. The answer to this is mismanagement. No investment is risk free. Especially when the money you are investing is not even yours!

The problem with treasury bonds is that their value decreases if the federal reserve (America’s central bank) raises the interest rate. This inverse relationship is because new bonds would become more valuable, as does just saving in the bank, so the value of the existing bond starts to fall. This means all that money which was invested is starting to lose value. Not a problem if you can wait till it matures – unless you need to sell them early, and guess who did?

With the tech sector drying up after the pandemic boom, many cash-strapped startups needed to draw more on their savings. This put pressure on SVB to ensure they held enough cash for withdrawals. Fearing a lack of cash, they were forced to sell some of their treasury bonds at a significant loss. When depositors caught wind of the situation, it led to a run on the bank – this is when people rush to withdraw their money in fear of losing it all. The result… SVB very quickly ran out of money, couldn’t pay back their customers, and thus collapsed.

So what happens to all the money that was deposited?

Unless the government bails out the bank, or a buyer can be found who will honour any existing debt, the money is gone. The dominos could be falling already though before this is even settled. With many firms now unable to access their funds, this could mean they can’t pay wages and cover their costs. This is bad news for many tech firms, their employees and the general public. Especially because a lot of SVB’s customers are small start ups working on cutting edge technology and ideas which could lose years of momentum.

All in all, this is a disaster, and just shows how fragile the banking system is!