Falling of the Crypto Banks – phase 2

In September last year crypto lenders Celsius, Vauld and Voyager Digital closed and now the collapsing dominoes of crypto have reached the crypto banks with Silvergate and Silcon Valley Bank (SVB) closing last week. There are three common factors behind the 2 bank failures this week; first both had concentration risk in their deposit base as they went ‘all-in’ for certain sectors – crypto in case of Silvergate and start-up and venture capital firms in case of SVB. Second common factor is that both banks had poor risk management and were ill-equipped to deal with the age-old ‘run on the bank’ or a situation where customer withdraw their deposits in masses from the bank which forces the bank then to liquidate assets to meet the depositors demands. The third common factor was that both Silvergate and SVB had majority of their assets in US treasuries and in selling them they incurred big losses as the valuation of these assets has gone down since last year due to the 450 basis point rise in short term (Red funds) rates.

Silvergate collapsed on March 8th when it voluntarily announced that it is shutting down operations. The run on Silvergate started in second half of last year and accelerated after the collapse of FTX which had $1 billion in deposits at Silvergate as noted by Wall Street Journal (WSJ). According to WSJ, crypto related assets were more than 90% of the deposit base for Silvergate highlighting the massive concentration risk the bank was taking. Crypto deposits in Silvergate fell by a whopping 68% in Q4 as per their regulatory filing and to meet the cash needs of the deposits Silvergate had to liquidate assets primarily US treasuries. While most banks use the deposits to do residential or corporate lending, Silvergate had made a decision to go ‘all-in’ for crypto and had sold off or closed their traditional lending operations and this lack of diversification proved to be their fatal mistake. Silvergate kept most of the crypto deposits invested in cash and liquid instruments like US Treasuries and so that liquidity was not a risk. However these US treasuries have fallen in value as the Fed Fund rates have risen by 4.5% since January last year and Silvergate had to realize these losses to the amount of $718 million which spooked shareholders and depositors when it announced this loss in January this year. This started a death spiral because as depositors withdrew more funds, Silvergate had to realize more losses by selling it’s assets and ultimately announced its closure on March 8th.

Now moving to SVB which was one of the most prominent banks in the Silicon Valley until last week and was a lender and banker to the biggest venture capital firms and more than half of the start-up’s but carried concentration risk. The low interest rate environment following the pandemic caused start-up funding to explode and this was reflected in the deposit base of SVB which saw non-interest-bearing deposits soar to $126 billion in 2021 from $67 billion in 2020. SVB invested these deposits in loans to venture and private-equity firms and invested the rest in long term US treasuries to reach for yield and their long term portfolio grew from $17 billion to $98 billion from 2020 to 2021. Similar to Silvergate the valuation of these long term securities held by SVB went down due to the rise in Fed Funds rate and SVB reported unrealized losses of $15 billion in their SEC filing at end of 2022 causing fear among shareholders and depositors. Another consequence of this rate rise was that SVB’s interest expenses increased and since start up funding had slowed the deposit base started dropping and reached $40 billion at the end of 2022. What triggered the bank run in case of SVB was an announcement on March 8th by the bank that it was raising $2 billion in capital as a result of the loss in deposits and the realized losses. This announcement triggered a massive deposit outflow over 48 hours which ended in the regulators announcing on Friday that they were closing the bank. More details are now emerging which show that SVB while being a lender to some of the most innovative companies had very poor risk management practices and did not follow time-accepted traditional risk management techniques.

As times goes by more details will emerge about what caused the demise of these two banks but at this point in time it appears that while both of these banks embraced the ‘new, shiny thing’ i.e. the crypto depositors and the start up community they both failed to implement proven risk management practices present in the banking industry of managing concentration risk, interest rate risk, asset-liability mismatch and were woefully inadequately prepared for a bank run and reacted to the fast pace of rate increases and deposit withdrawls like deer caught in a headlight.

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