The Collapse of SVB

The luxurious life of low interest rates is over.

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Low-Interest Rates

For the majority of the last decade, the Federal Reserve has pursued a policy of low-interest rates as a means of stimulating economic growth and supporting employment. Following the 2008 financial crisis, the Fed lowered its benchmark interest rate, the federal funds rate, to near zero and kept it there until late 2015. During this time, the Fed also engaged in a series of quantitative easing programs, buying large amounts of Treasury bonds and mortgage-backed securities to inject liquidity into the financial system and stimulate lending.

In response to the COVID-19 pandemic in 2020, the Fed once again lowered interest rates to near zero and implemented a range of other measures, including buying corporate bonds and expanding its lending facilities, to provide support to the economy.

It has only been within the last year or so that the Federal Reserve’s interest rate policy has done a remarkable 180-degree pivot. As inflation became more persistent and aggressive, the Federal Reserve started to hike interest rates to levels not seen in over a decade. This drastic shift in policy was bound to have some serious economic consequences and the collapse of Silicon Valley Bank (SVB) this week is one such consequence.

In order to understand the collapse of SVB though it’s important to understand what kind of behavior low-interest rate environments incentivize and the consequences of switching policies.

The federal funds rate, which makes all the news, is the interest rate that the Federal Reserve sets. Banks are required to keep a percentage of their deposits (the money put into an account with a bank) at the Federal Reserve, called reserve requirements, as a means of ensuring that banks have enough funds available to meet their obligations to depositors and to prevent bank runs. Over the course of business, banks may end up with fewer reserves at the Federal Reserve than is required, so they make up the difference by borrowing from another bank that has more than required. The interest rate that banks charge each other for this is the federal funds rate.

With a low federal funds rate, the Federal Reserve makes it cheaper for banks to borrow money, which has a trickle-down effect of lowering interest rates all across the economy (specifically, the federal funds rate is meant to lower short-term interest rates, but for our purposes, we can just think of interest rates broadly). This is meant to encourage economic activity as the cheaper it is to borrow money, the more people will borrow money for economically productive ends.

This sounds fantastic, so why doesn’t the Federal Reserve keep interest rates low? Normally, the answer is that it can lead to inflation, but the Federal Reserve maintained historically low interest rates for the vast majority of the last decade and inflation has only been an issue recently. Not to mention, Japan’s central bank has lowered interest rates (even going negative) well beyond what the Federal Reserve has, and inflation hasn’t been a problem there.

The real problem with maintaining low-interest rates indefinitely is that it leads to asset bubbles that have to eventually burst.

In finance, the “risk-free rate” is a vitally important concept. It is the rate of return an investor can expect to earn from an investment that is completely free of risk. In practice, there is no investment that is completely risk-free, but government bonds of stable countries like the United States are typically used as proxies for the risk-free rate. This is because these countries are seen as very unlikely to default on their bond obligations, and so their bonds are considered to be the closest thing to a risk-free investment.

Investors use the risk-free rate as a benchmark for other investments. An investor will compare whatever they expect a stock or a bond to return to the risk-free rate to determine if the investment is worth the risk.

For example, you have $1000 to invest. Let’s say the risk-free rate of a US government bond is 10% (it hasn’t been that high in forever but for the sake of example), which means you are guaranteed with no risk to make $100 on your $1000 investment. This means that there is no point in taking on any risk of potentially losing money unless the investment can return at least 10%. It would make no sense to risk losing your $1000 (no matter how little the risk) by buying Microsoft’s stock to potentially earn $50 in return when you could be guaranteed to get your money back and make $100 by buying the US government bond. As a result, any non-risk-free investment with a potential return of less than 10% becomes worthless.

However, this also lowers the values of non-risk-free investments with potential returns above 10%. Would you risk losing your money for a potential return of 11%? Going back to our example, is the extra $10 worth the risk? I have a feeling there would be quite a few people that wouldn’t think so thus lowering the demand for such an investment and its value.

(There are issues with keeping interest rates too high, but that hasn’t been the case recently, so it isn’t worth getting into now.)

Now, let’s say the risk-free rate is 1% instead of 10%. You are now only guaranteed to make $10 on your $1,000 investment. Risking your money by buying Microsoft’s stock to potentially earn $50 suddenly doesn’t look so bad. This increases demand for Microsoft’s stock, which pushes the price/value up.

Microsoft is a basic example, but this risk/reward calculation is done by banks, venture capital funds, and other investors throughout the economy. Many times, these more sophisticated investors have a specific target return that they are tasked with achieving (let’s say 15% return a year). As the risk-free rate goes down, a 15% return becomes much harder to achieve, which forces investors to take more risk to achieve it. In a low-interest rate environment, a company with enormous potential returns, but also enormous risks, can convince banks to loan to them because such returns are so hard to find.

Silicon Valley Bank (SVB)

With all of this in mind, let’s get back to SVB. Silicon Valley Bank (SVB) was a US-based financial institution that primarily served the technology and innovation sectors. Founded in 1983, the bank was headquartered in Santa Clara, California but had branches in all sorts of other places.

While SVB was not known to the average person before this week, it was known in the tech/Silicon Valley world as it focused on serving startups, venture capital firms, and other innovative companies. It provided specialized banking services and offered various other resources to help support entrepreneurship and innovation, such as networking events, educational programs, and research reports. In fact, SVB was among the top 20 American commercial banks with $209 billion in total assets at the end of last year. This makes SVB’s collapse the largest bank collapse since the 2008 Financial Crisis.

SVB was able to grow to such an immense size largely because the very sector in which it specialized, techy start-ups in Silicon Valley, were some of the investments in hottest demand in the low-interest rate environment of the last decade plus. Tech start-ups promised immense returns in an era of hard-to-find returns, which made many investors willing to take the risk in investing in them. This made it easy for tech start-ups, and tech companies in general, to find a willing investor to give it money if it needed to grow or pay expenses.

So, what happened?

As the Federal Reserve began to raise interest rates, investors started to reconsider the amount of risk they were willing to take in order to achieve returns for all the reasons mentioned above. The tech industry, which had benefitted so much from low-interest rates, was now hit the hardest as interest rates rose. There weren’t as many investors who were willing to risk losing their money by investing in these risky companies.

A large tech company like Google can weather this storm, as it is an immensely profitable company even if it has to cut some costs along the way. However, a tech start-up may not be profitable yet, which means that it has to severely cut costs and rely on the money it has saved up in order to survive.

As tech companies have had to rely more on the money they have saved up instead of getting it from investors, this put immense pressure on SVB. The tech-focused bank saw an increase in money withdrawn from its clients. Like every other bank, SVB had invested this money in other forms of investments and needed to sell these investments in order to raise the cash needed to pay its clients.

Some of these investments that SVB had to sell were bonds that they bought back when interest rates were much lower. The price of these bonds tanked as interest rates went higher (fewer people are going to buy a bond returning 1% when they can buy the same bond from a later issue date that returns 4%), which means SVB lost a ton of money from these bonds. SVB also announced it needed to sell more of its shares to raise the necessary money.

This created panic among SVB customers that maybe their money wasn’t as safe in the bank as they thought. A classic bank run ensued and within 48 hours SVB collapsed and was taken over by the Federal Deposit Insurance Commission (FDIC). There were some fears that this may be the start of another financial crisis, but those fears quickly subsided, as it became clear that the collapse of SVB was an isolated event.

While the collapse of SVB is an isolated event in the larger banking industry, it is not an entirely isolated event. Its rise and subsequent downfall is a story of the perils of maintaining a low-interest rate environment for far too long. It will also almost certainly not be the last example that we see. There are consequences to a decade-plus of (I would argue arbitrarily) low-interest rates.

God Bless,

Hunter Burnett