Gradually, Then Suddenly
3 Personal Finance Lessons from the Collapse of SVB
On Friday, Federal regulators shut down Silicon Valley Bank (SVB) after its parent company hinted at impending problems, resulting in one of finance's simplest, most vicious collisions with human nature.
We got ourselves a good old-fashioned bank run.
On Sunday afternoon, the government stepped in to ensure depositors would be made whole, though investors in the bank itself will not be as lucky. I mostly avoid opinions about policy decisions, but I'll say briefly that on the spectrum of outcomes, this is a really reasonable one. It may not be perfect, but it's certainly not critically flawed.
How did this happen?
We trust banks to keep our deposits safe; in fact, the de facto holding place for many risk-averse people is their bank account.
But banks are businesses, so your money doesn't just sit there. They promise you an interest rate, and their job is to go make more money, with your money, than they owe you in interest. Consider two very different options for the bank:
Guarantee you 1% interest, and then go buy technology stocks
Guarantee you 1% interest, and then go try to guarantee themselves 2%
The first option should feel mismatched. Technology stocks are tremendously volatile and without guarantees, while you and I as bank customers want consistent and predictable access to our deposits (plus the promised interest).
But it's not like the first option wouldn't work out fabulously sometimes...
$10,000 invested in the technology index since 1984 is worth almost $450,000 today. Whereas the bank paying you 1% interest on a $10,000 initial deposit since 1984 would cost them only $4,741 total. This is a good outcome for an investor, like a bank, if they don't need to touch their money for 39 years.
But that ain't a bank. Sometimes we, as depositors, want our money back now, and it's our money they're using. So the second option — locking in a small amount for themselves above what they owe us, is more what we should expect. Since the big risk the bank faces is that all their clients want their money back at the same time, if a bank were to really immunize themselves, they'd need the ability to be fully liquid in a very short period (and never at a loss).
But if the additional earnings is tiny when choosing ultra-short, ultra-safe investments, the business model struggles. So banks ask themselves the same question many investors ask:
How much can we earn while still being generally safe?
Indeed, this is how banks operate: a very high probability that things will be fine, but not 100%. We learned this during the 2008 banking crisis, and right now in real time.
Instead of risk-free investments (i.e. treasury bonds), they might buy almost risk-free investments (e.g. a bond from a quality corporation) that yields slightly more.
Instead of the ability to be fully liquid within a day, they might notice that 90% of their depositors never pull money out of the account anyway; so they might choose instead the ability to be somewhat liquid within a month, or a year, and earn a little more yield for doing so.
Banks are highly regulated, and so this is just context around their tradeoffs and decision-making inputs. They aren't required to fully immunize risks, and so they typically accept small ones that are unlikely to manifest into bigger problems.
From 2020-2021, SVB's deposits doubled from around $62B to $124B. And as they put all this cash to work, they started buying assets (e.g. 5 year treasury bonds) that couldn't guarantee both profits and daily liquidity. Easy to deliver on one of those, but not both.
Consider only the lightest-grey line below, the various treasury yields in 2021:
SVB could have considered 1-month treasury bills that yield basically 0% but will mature quickly (more liquid, more predictable), or buy 3 or 5 or 7-year bonds that yield higher, but SVB would not be guaranteed that yield unless the bonds were held to maturity. Many banks look at scenarios like this and take the risk, especially if they know the profile of their depositors is to not historically drain their bank accounts...as it cushions the risk.
But last week, when it was apparent that SVB might be in trouble, clients indeed started pulling their deposits. There are some additional nuanced accounting rules, but they aren't necessary to understand what generally happened: SVB went too far out on the risk curve with other people's money. In the age of digital banking, and with a client base that was mostly involved in the technology space, their risk was acute, concentrated, and unraveled quickly: friends and tech-industry peers began texting, calling, worrying, sharing anxieties, etc...and then they just opened their phone app and pulled their money.
As Hemingway wrote in The Sun Also Rises — going broke happens gradually, then suddenly. But gradual-to-sudden with smartphones might be mere minutes.
Finance is the harmony (or disharmony) of risk, reward, and probabilities. SVB is a corporate finance failure, but there are takeaways for all investors, not just banks.
3 personal finance lessons from the ashes of SVB:
1. Improperly addressed, time is risk. Beware of safe assets that have a different timeline than when you might need them.
2. Low-probability risks often eat like an ant and shit like an elephant. No one knows the future. We live in a world of survivorship biases: just because a bank hasn't ever gone bankrupt, doesn't mean it won't. On an infinite horizon, every single company goes bankrupt. Duck, duck, duck, then goose. Portfolios should be robustly designed to remove the risk that any one event can ruin us — because we never know what will happen, why it will happen, how it will happen, or when it will happen.
3. Don't lend money, or love, or friendship — if you can't deliver on the expected timeline. Of all the things we have in this world, our reliability is the one that underpins our trust and integrity. It doesn't work if we're needed now but only ever available then. We can't help others with their needs if it always has to be on our timeline.
Life has ant moments and elephant moments. Whether it's financial or emotional, we really just want predictable and reliable partners.