Banks are, at their core, facilitators: depositors lend their money to a bank, for which they are paid interest, and banks lend that money out, again for interest. A bank is profitable if the interest rate they charge for loans is greater than the interest rate they pay to depositors. Banks achieve this by leveraging time: depositors earn a lower interest rate in exchange for being able to withdraw their money at any time; loans earn higher interest rates, but take years to pay back. The reason this works is because a bank ideally has a diverse set of depositors, whose funds come and go on an individual account basis, but on an aggregate basis are steady; this provides the stability for those long-term loans.
A common failure mode for banks is a bank run: a bank does not have sufficient assets to pay back all of its depositors at once, because those assets have been distributed elsewhere as loans. Unfortunately a bank run can become a self-fulfilling prophecy: if depositors fear that a bank is running out of liquid assets, then the rational response is to quickly pull their funds, which makes the problem worse. Moreover, bank runs can be contagious: if depositors hear about a bank run at another bank, they may start to question the safety of their deposits in their own bank, starting another run.
This is what happened in the Great Depression: 650 banks failed in 1929, and more than 1,300 in 1930; over 9,000 banks would fail in total. What ultimately stopped the contagion was the establishment of the Federal Deposit Insurance Corporation in 1933: the FDIC, which was funded by member banks, insured $2,500 per account; even if a bank went out of business depositors would get their money back.
The impact of this insurance was less about what was paid out and more about its existence: the idea — and effect — was to stop bank runs before they even started, because depositors didn’t need to worry that they would lose their money. In this the FDIC actually protected bank accounts that exceeded the insurance limit as well, because the best way to not lose money was to put it in a bank that didn’t fail.
What Happened to Silicon Valley Bank
There are certain complexities about what happened to Silicon Valley Bank last week; three good overviews were written by Marc Rubinstein, Matt Levine, and Noah Smith. At the end of the day, though, the mechanics were pretty simple:
- Silicon Valley Bank’s depositors, many of whom were startups, deposited the cash they received from investors; the amount of deposits was particularly high over the last few years thanks to the ocean of money unleashed during COVID, much of which found its way to the tech sector.
- Silicon Valley Bank effectively lent a large portion of that money to the federal government (in the form of U.S. Treasuries) and home owners (in the form of agency mortgage-backed securities1). While Silicon Valley Bank used to primarily lend out money on shorter-term durations, in 2021 the bank shifted to longer-term securities in search of more yield; this, in retrospect, was the critical mistake — and to be clear, Silicon Valley Bank’s management bears ultimate culpability for the bank’s fate.
- When interest rates rose, (1) fewer deposits came in as venture capital funding dried up and (2) the market value of those securities plummeted: who would want to buy a 10 year Treasury paying out 1% when you can buy one from the government for 3.5%?
In fact, Silicon Valley Bank has been technically insolvent for months: the company had more assets than liabilities, but a huge chunk of those assets could not be liquidated without taking a major loss; everything would be ok, though, because those securities would mature in time, paying back their value in full.2 The big loser would be Silicon Valley Bank stock holders, who would forego all of the unrealized interest on the more attractive securities the bank could not buy in the meantime; small wonder the stock lost 66% of its value last year:
Still, Silicon Valley Bank was still a bank, albeit a less profitable one — unless there was a bank run.
The Bank Run
I’m actually not sure when I first heard about Silicon Valley Bank’s technical insolvency, but it was on the order of months ago.3 I say this not to brag — I never wrote about it — but rather to note that I was under the impression it was fairly common knowledge; after all, business was proceeding as usual, and again, Silicon Valley Bank would be fine, albeit less profitable, as its hold-to-maturity bonds gradually matured.
Obviously I was wrong. From the Financial Times:
Although SVB’s deposits had been dropping for four straight quarters as tech valuations crashed from their pandemic-era highs, they plunged faster than expected in February and March. Becker and his finance team decided to liquidate almost all of the bank’s “available for sale” securities portfolio and to reinvest the proceeds in shorter-term assets that would earn higher interest rates and improve the pressure on its profitability. The sale meant taking a $1.8bn hit, as the value of the securities had fallen since SVB had purchased them due to surging interest rates. To compensate for this, Becker arranged for a public offering of the bank’s shares, led by Goldman Sachs. It included a large investment from General Atlantic, which committed to buy $500mn of stock.
The deal was announced on Wednesday night but by Thursday morning looked set to flop. SVB’s decision to sell the securities had surprised some investors and signalled to them that it had exhausted other avenues to raise cash. By lunchtime, Silicon Valley financiers were receiving last-ditch calls from Goldman, which briefly attempted to put together a larger group of investors alongside General Atlantic to raise capital, as SVB’s share price was tanking.
At the same time, some large venture investors, including Peter Thiel’s Founders Fund, advised companies to pull their money from SVB. Becker, in a series of calls with SVB’s customers and investors, told people not to panic. “If everyone is telling each other SVB is in trouble, that would be a challenge,” he said. Suddenly, the risk that had been building on SVB’s balance sheet for more than a year became a reality. If deposits fell further, SVB would be forced to sell its held-to-maturity bond portfolio and recognise a $15bn loss, moving closer to insolvency.
What appears to have happened is that Moody’s downgraded Silicon Valley Bank’s debt on Wednesday, prompting the rushed sale of the available-for-sale portfolio and capital raise, but the rushed nature of the raise meant it was never completed; word quickly spread — perhaps because Silicon Valley Bank was trying to raise money from Silicon Valley — that Silicon Valley Bank might be insolvent. This led startups to withdraw their money, prompting fears amongst others that the bank would run out of money, leading to more withdrawals. In other words, a textbook bank run.
The problem for Silicon Valley Bank’s customer base is that the vast majority of them had deposits well in excess of the FDIC’s now-$250,000 limit, and in most cases, for good reason: the working capital needs of even a relatively small company, including bills, payroll, etc., are much greater than $250,000. Moreover, while any company with significant assets in the bank ought to have most of it in U.S. Treasuries or money-market accounts, you can understand why small startups in particular may have just left the money in their primary account: presumably the team is busy actually trying to find product-market fit. After all, the goal of a startup is to realize a valuation that is many multiples higher than the money in the bank, not to eke out a better return on deposits.
This has been, for the 39-year history of Silicon Valley Bank, and the 89-year history of the FDIC, fine: uninsured funds benefited from FDIC insurance because banks were much less likely to suffer bank runs, and Silicon Valley Bank specifically, which has always had a far greater share of uninsured funds as compared to most banks, was deeply enmeshed in the Silicon Valley ecosystem. That ecosystem, as venture capitalists love to tell you, is about trust. Victor Hwang, the co-author of “The Rainforest: The Secret to Building the Next Silicon Valley”, wrote in an op-ed column in The Washington Post in 2012:
One helpful way to think of Silicon Valley is as a rainforest, which thrives because its many elements combine to create new and unexpected flora and fauna. And the rainforest model is not just an analogy. An innovation ecosystem is not merely like a biological system; it is a biological system. Flowing through this biological system are nutrients: talent, ideas and capital. And the system becomes more productive the faster the nutrients flow. That’s where the issue of culture comes into play.
In the real world, economic systems are made of human beings, not anonymous gears. And in the real world, human nature gets in the way. Our brains are instinctively tribal. We are designed to trust people closer to us and to distrust those farther from us. Yet scientists are discovering that innovation and human emotion are intertwined. Human nature, with its innate prejudices, creates enormous transaction costs in society. Thus, what we think of as free markets are actually not that free. They are still constrained by transaction costs caused by invisible social barriers based on geographical distance, lack of trust, differences in language and culture and inefficient social networks.
To build rainforests and maximize business innovation, we must transform culture. And people learn culture not from top-down instruction, but through actual practice: role modeling, peer-to-peer interaction with diverse partners, feedback mechanisms that penalize bad behavior and making social contracts explicit. Silicon Valley has created a culture that encourages people with diverse talents and backgrounds to meet, to trust each other and to take a chance together. That culture is firmly in place because crucial keystone institutions, from venture capital firms to attorneys to entrepreneurs, treat the broader community as more important than the “winning” of any individual transaction. It is a culture based on, among other things, seeking fairness, not advantage.
I think this was right in 2012; I’m not sure it’s right now. It seems to me my top-line error about Silicon Valley Bank being fine was undergirded by two more fundamental errors:
- First, I assumed that the venture capitalist set knew about Silicon Valley Bank’s situation.
- Second, I assumed that Silicon Valley broadly was in the business of taking care of their own.
Last week showed that both were totally wrong: the panicked reaction to Thursday’s failed capital raise made it clear that nearly everyone in tech was blindsided by Silicon Valley Bank’s situation — which again, absent a bank run, was an issue of profitability, not viability — and the bank run that resulted made it clear that everyone, from venture capitalists to the startups they advised, were solely concerned about their own welfare, not about the ecosystem as a whole.
I don’t, to be clear, begrudge anyone this point of view, particularly startup founders: you have one runway, and even if I might give you a pass for not extending that runway a few feet with a money market fund, I absolutely understand and endorse making sure you don’t have a significant chunk of that runway vaporized in a bank run. I have more mixed feelings about the venture capitalists that advised them: on one hand, telling companies to take their money and run was right in isolation; on the other hand, the seeming lack of awareness of Silicon Valley Bank’s issues before last Thursday seems like a dereliction of duty, particularly since that lack of awareness seems to have driven the initial bout of panic.
A similar critique could be applied to the behavior of some subset of VCs on Twitter over the weekend, which at times seemed directed towards sparking bank runs in other regional banks, with the goal of forcing the FDIC to step in and make depositors whole, whether or not their funds were insured or not. It was pretty ugly to observe, but ultimately, it was successful: the FDIC, Treasury Department, and Federal Reserve stepped in.
Government and the Trust Dividend
The FDIC, Treasury Department, and Federal Reserve released a joint statement on Sunday afternoon:
Today we are taking decisive actions to protect the U.S. economy by strengthening public confidence in our banking system. This step will ensure that the U.S. banking system continues to perform its vital roles of protecting deposits and providing access to credit to households and businesses in a manner that promotes strong and sustainable economic growth.
After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer…
Shareholders and certain unsecured debtholders will not be protected. Senior management has also been removed. Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law. Finally, the Federal Reserve Board on Sunday announced it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.
This action effectively means the $250,000 FDIC limit is meaningless: all deposits in any bank are presumably insured by the full faith and credit of the United States. The reasoning for this move is the same as what motivated the creation of the FDIC in the first place: given that most businesses need more than $250,000 in working capital, the rational response of any business in any sector to Silicon Valley Bank depositors losing their money would be to shift their accounts to the banks which have already been deemed too big to fail (JPMorgan Chase, Bank of America, Wells Fargo, and Citibank); this would mean bank runs on everyone else.
The federal government’s action is, in my estimation, the right thing to do for this moment in time. There will, though, be long-term consequences for fundamentally changing the nature of a bank: remember, depositors are a bank’s creditors, who are compensated for lending money to the bank; if there is no risk in lending that money, why should depositors make anything? Banks, meanwhile, are now motivated to pursue even riskier strategies, knowing that depositors will be safe; the answer will almost certainly be far more stringent regulation on small banks, of the sort imposed on the big four after 2008. That, in turn, will mean tighter credit and more fees for consumers, in addition to what will be a big increase in FDIC insurance premiums. And, while taxpayers may not be directly infusing money into failing banks, taking on all of those low-interest rate securities is real opportunity cost.
To put it another way, before the events of last week the U.S. benefited from a banking trust dividend: businesses technically should have been worried about money that exceeded the $250,000 insurance limit, but in practice few gave it much concern. This made their operations more efficient, and made money more widely available for banks to lend. Regional banks, meanwhile, got away with lower capital requirements and less regulation, making it easier to extend credit and offer bespoke services. The FDIC, meanwhile, charged relatively low fees of member banks because it was only insuring $250,000 per account, even though its presence made the overall system much safer and more reliable for accounts of all sizes. That trust dividend is now gone, and the costs of replacing trust with explicit rules and regulations will accumulate forevermore.
The Silicon Valley Dilemma
A bank run is a classic example of a Prisoners’ Dilemma, which I described in 2017’s The Uber Dilemma:
The dilemma is normally presented in a payoff matrix like the following:
What makes the Prisoners’ Dilemma so fascinating is that the result of both prisoners behaving rationally — that is betraying the other, which always leads to a better outcome for the individual — is a worse outcome overall: two years in prison instead of only one (had both prisoners behaved irrationally and stayed silent). To put it in more technical terms, mutual betrayal is the only Nash equilibrium: once both prisoners realize that betrayal is the optimal individual strategy, there is no gain to unilaterally changing it.
As I explained in that Article, the way out of a Prisoners’ Dilemma is to make it into an iterated game:
What, though, if you played the game multiple times in a row, with full memory of what had occurred previously (this is known as an iterated game)? To test what would happen, Robert Axelrod set up a tournament and invited fourteen game theorists to submit computer programs with the algorithm of their choice; Axelrod described the winner in The Evolution of Cooperation:
TIT FOR TAT, submitted by Professor Anatol Rapoport of the University of Toronto, won the tournament. This was the simplest of all submitted programs and it turned out to be the best! TIT FOR TAT, of course, starts with a cooperative choice, and thereafter does what the other player did on the previous move…
Analysis of the results showed that neither the discipline of the author, the brevity of the program—nor its length—accounts for a rule’s relative success…Surprisingly, there is a single property which distinguishes the relatively high-scoring entries from the relatively low-scoring entries. This is the property of being nice, which is to say never being the first to defect.
This is the exact opposite outcome of a single-shot Prisoners’ Dilemma, where the rational strategy is to be mean; when you’re playing for the long run it is better to be nice — you’ll make up any short-term losses with long-term gains.
Silicon Valley worked because it was an iterated game:
What happens in Silicon Valley is far more complex than what can be described in a simple game of Prisoners’ Dilemma: instead of two actors, there are millions, and “games” are witnessed by even more. That, though, accentuates the degree to which Silicon Valley as a whole is an iterated game writ large: sure, short-term outcomes matter, but long-term outcomes matter most of all.
That, for example, is why few folks are willing to criticize their colleagues or former companies: today’s former co-worker or former manager is tomorrow’s angel investor or job reference, and memories are long and reputations longer. That holds particularly true for venture capitalists: as Marc Andreessen told Barry Ritholtz on a recent podcast, “We make our money on the [startups] that work and we make our reputation on the ones that don’t.”
Note the use of plurals: a venture capitalist will invest in tens if not hundreds of companies over their career, while most founders will only ever start one company; that means that for the venture capitalist investing is an iterated game. Sure, there may be short-term gain in screwing over a founder or bailing on a floundering company, but it simply is not worth it in the long-run: word will spread, and a venture capitalists’ deal flow is only as good as their reputation.
That Article was called “The Uber Dilemma” because my argument was that Uber’s then-unprecedented private valuation had transformed the relationship between Uber and Benchmark, its lead investor, from an iterated game to a one-shot game; specifically, Benchmark was willing to sue founder and then-CEO Travis Kalanick, destroying its reputation amongst founders, because the absolute return that would result from getting Uber to an IPO was worth so much more than any other investment, past and future.
What I increasingly suspect is that Uber was not a one-off, but rather a preview of a new era for Silicon Valley. In the six years since that Article it became normal to have private company valuations in the tens of billions; venture capital firms ballooned to billions of dollars under management, effectively changing their economic model from one driven by returns to one driven by fees; in both cases success became less about a series of victories and more about going big or going home.
This happened even as tech itself reached The End of the Beginning, and it became clear that there was no paradigm shift on the horizon beyond the public cloud and mobile (AI offers hope, but it may be dominated by the big companies). That meant that tech has been shifting away from greenfield opportunities and expanding the pie to taking share in zero sum contests for end users, from their attention to their pocketbooks.
The End of Silicon Valley (Myth)
This is an environment that is fatal to quixotic paeans about “rainforests” and treating “community as more important than the ‘winning’ of any individual transaction.” When the stakes are so high, and the perceived opportunity space increasingly narrowed, every decision becomes a Prisoner’s Dilemma — and, in retrospect, what happened to Silicon Valley Bank becomes inevitable. Moreover, it probably won’t be the only bad outcome of this new environment; it’s hard to understand the value of trust until it’s gone, and the full accounting of what has been lost will take years.
The irony in this loss of trust is that the ultimate driver is tech itself. What made the Silicon Valley Bank run unique was (1) the ease with which its customers could execute withdrawals and (2) the speed with which news of Silicon Valley Bank’s impending demise spread. Just to put the scale of this collapse in context, a total of $7 billion in depositors’ assets was lost in The Great Depression; $7 billion then is $161 billion today. Silicon Valley Bank, meanwhile, processed $42 billion in withdrawals in 24 hours. It was the speed, fueled by zero distribution costs for both rumors and withdrawals, that was so destabilizing for an entity predicated on arbitraging time.
That destabilization and resultant loss of trust, meanwhile, is everywhere around us, from our politics to business to every aspect of media. This increased uncertainty and destabilization has and will continue to drive demands for more government intervention — and, like this weekend, it may not even be wrong! More government, though, means replacing trust with more rules, regulations, and restrictions, which will have a long-term effect on innovation. This, perhaps, is the inevitable outcome of tech having set disruption as its objective function: the ultimate casualty may be the Silicon Valley that once was, not just its bank.
“Agency” is an important distinction: these weren’t the ugly subprime mortgages that were at the heart of the 2008 financial crisis; these were mortgages ultimately backed by federal mortgage programs ↩
This is why Silicon Valley Bank was not actually insolvent; most of these securities were designated as “Hold To Maturity”, which means they were held on the books at par value, not their market value ↩
Update: I think it was this Seeking Alpha post. ↩