SVB Meltdown (Part I): “Risky-Reserve Banking”

It’s been all over the news lately that Silicon Valley Bank (SVB) had just collapsed, resulting in the second-biggest bank collapse in United States history, behind the default of Washington Mutual during the 2008 financial crisis. And SVB’s downfall took less than 48 hours. So what happened? We’ll try to answer that question in this two-part series, and you’re currently reading part one.

Let’s start with the basics. Founded in 1983 by Roger V. Smith, SVB is on the list of the largest banks in the United States and is a subsidiary of SVB Financial Group. The financial institution defaulted on March 10th, 2023. And it isn’t just a bank anyone could put their money into. Its primary customers are venture-backed tech startups, which the name ‘silicon valley’ may hint at. But besides having fundamentally different customers, SVB works very similarly to other banks in how it operates, and unfortunately, has the same fatal flaw: Bank runs.

A bank run, otherwise known as a run on the bank, starts with a large percentage of a bank’s depositors believing that the institution could collapse. They may think that putting their cash elsewhere, like in another stabler bank, is much safer than doing nothing, so depositors withdraw. When many people think this way and do the same, we get a bank run, which sometimes does, surprisingly, involve running to the bank’s doorstep and demanding your money back. Okay, the bank takes cash out of their vaults and gives everyone their share, right? That shouldn’t seem like anything ‘fatal’. However, the answer isn’t that simple because the bank doesn’t have its depositor’s money, or at least not all of it.

That is when things get counter-intuitive. The idea of banks revolved around creating a safe place for people to keep their money, either away from house robbers or just to save up for later. So the fact that your hard-earned money isn’t there when you need it may seem like a significant mistake in the banking system, though it isn’t; Banks, or at least fractional-reserve banking, were designed to be this way.

Let me explain. Fractional-reserve banking is a popular business model many large banks use, including SVB. By its name, you can tell that banks may not have all their depositors’ money in their vaults. These banks only keep a fraction of that money. How much that fraction should depend on where the bank is, as different countries require banks to have varying amounts, which usually range between 5% and 10% of total deposits. The remaining depositors’ money the bank puts into low-risk investments, like in SVB’s case, government bonds. Even though these investments offer low returns, they also are very reliable, and as banks usually invest billions at a time, they still get a substantial profit. It doesn’t sound like the safest move you could make, as that fraction of the money wouldn’t nearly be enough to pay back customers in a bank run. More like “risky-reserve banking”. And for SVB, it’s that first step which leads it onto the path of its collapse.

In normal circumstances, SVB’s business model would have worked out exactly as planned, and the bank would have gotten the money back, plus some interest, when the time was up. However, the United States Federal Reserve (the Fed) started hiking interest rates during the pandemic to combat inflation. It raised interest rates by three percentage points in 2022 alone! So what did the Federal Reserve’s actions mean for SVB?

To find out, please remember to come back tomorrow, where you’ll find the follow-up part two with further analysis of the SVB collapse. That’s the end of this production from the New News Newsminute, and thank you for reading.