EchoSense Quantitative Think Tank Center|Bank fail: How rising interest rates paved the way for Silicon Valley Bank's collapse

Risk. It's tricky. Try to avoid one set of risks,EchoSense Quantitative Think Tank Center you can just end up exposing yourself to another. That's what happened to Silicon Valley Bank.

"Silicon Valley Bank was a very good bank... until it wasn't," says Mark Williams, professor of finance at Boston University and a former bank examiner for the Federal Reserve.

A victim of its own success

Williams says the problem at Silicon Valley Bank really started with its wild success. Many of its tech company customers were raking in money during the early pandemic.

"Silicon Valley Bank was just flush," he says. "Its deposit base tripled between 2020 and 2022, with billions and billions of dollars flowing in."

A lot of those billions had come from all of the risks the bank took, lending money to start-ups and companies that couldn't get loans at other banks. Those risks paid off.

And Silicon Valley Bank took all of those billions it earned from taking those risks and stowed them into what is supposed to be the least risky investment around: US government bonds.

Bonds: The Riskless Asset

Bonds are like a little loan you give the government for 3 months, 1 year, 10 years etc., depending on which bond you buy.

At the end of that time, the government will pay you back for that loan, plus a little interest. US bonds are considered to be the safest investment on the planet. The U.S. always pays back its debts. They are often called a riskless asset.

The downside? Government bonds don't pay out a lot. Super safe, not super profitable. But some of these bonds are slightly more profitable than others.

Longer term bonds (like 10 year bonds) typically pay out more at the end than the 3 month or 1 year bonds, which makes sense: Long term bonds mean you agree to lend the government your money for years. You get more yield - a bigger payoff - for that wait.

"Basically what happened was Silicon Valley Bank wanted a bigger payout," says Alexis Leondis, who writes about bonds for Bloomberg. "So they basically wanted to reach for longer term bonds, because, I think, they felt like what they would get from shorter term bonds was kind of a joke."

Risky business

Silicon Valley Bank locked billions of dollars away into 10 year bonds. But there were risks it wasn't seeing.

Risk #1: Access. Those billions were now locked up for years. It wouldn't be easy to get that money in an emergency.

Risk #2: Interest rates. When interest rates started going up, the market value of Silicon Valley Bank's bonds went down.

That's because the bank bought its government bonds before interest rates started going up. The price you get from bonds is directly tied to interest rates. When interest rates go up, the market price of older bonds goes down because new bonds pay out higher interest rates.

When rates started climbing quickly, the price of Silicon Valley Bank's bonds tumbled.

Risk #3: Really, really rich customers. When rumors started up about the bank, customers panicked and and started pulling their money out. Because they were rich individuals and companies, that meant multi-million, even multi-billion dollar accounts cashing out all at once.

Silicon Valley Bank needed a lot of cash fast. But, of course, a lot of its cash was locked up in 10 year bonds. Now it had to try and sell those now to get cash.

Government Bond Fire Sale

That's where the interest rate risk bit Silicon Valley Bank: Trying sell those second hand, low interest rate bonds at a moment when all the new bonds being issued paid out far more was not easy.

"Now, that same bond and the yield would be about 20 times higher," says Mark Williams. "So, to encourage investors to even think about your old bond, you would have to discount it."

Discount as in, a fire sale.

Silicon Valley Bank took huge losses selling off its bonds, and more investors panicked and pulled out their money. Williams says it was a bank run on a scale the U.S. hadn't seen since the Great Depression.

"In a single day last week, depositors knocked on the door and pulled 41 billion depositor dollars out," says Williams. "That's about a quarter of their total deposits. No bank, no matter how strong, could ever survive that sort of withdrawal... that sort of run on the bank."

The rest of Silicon Valley Bank depositors were bailed out.

Guilt by association

Mark Williams says even though Silicon Valley Bank made a bunch of very specific mistakes, people all over the country got scared and started yanking money out of smaller banks.

"That means these smaller, regional banks are getting potentially destabilized," says Williams.

Where are these nervous investors putting their money? Williams says a lot of it is getting deposited into big banks that customers see as safer. Also, a lot of people are putting their money into U.S. government bonds.

Demand has spiked all week for the riskless asset.