We Answer Your Questions After the Silicon Valley Bank Failure
Last week we witnessed the second-largest bank failure in history. Silicon Valley Bank (SVB) capitulated in just a few days, eventually leading to a government backstop this past weekend. While the failure of SVB is a classic example of a bank run, we’ve received many questions from clients wanting assurance that the money we manage for them is safe.
To put minds at ease, we want to explain what happened with SVB as well as the important structural differences between banks, like SVB, and brokerage firms, like Charles Schwab and Fidelity.
What Happened With Silicon Valley Bank
To understand how SVB could fail, you must first understand the bank’s customer base. SVB grew tremendously by catering to technology companies, technology company founders and early investors. This group is a tightknit community, as many of these companies share early investors and employees migrate from one opportunity to the next.
Part of what made SVB unique is that they would allow these company founders and employees to borrow against their company stock once a “value” was established in the initial investor rounds, often well before they were profitable. This practice provided these individuals with access to cash they could spend based on stock gains before the company had its initial public offering (IPO), when the stock would begin to be sold.
So, if you worked at a tech startup company and had stock suddenly valued at $20 million, SVB would give you a line of credit to provide you with cash so that you could, for instance, buy a new Ferrari and not have to wait. This practice worked well until technology company funding and valuations plummeted. At that point, companies once thought to be worth $20 million became worth less — sometimes much less than their SVB line of credit. Once these types of issues, along with others, started to become apparent in the tech community, word spread … and like a kegger in a college town, people showed up in droves to be served. Here’s a timeline of what happened:
- March 8: Mass cash withdrawal requests caused SVB to sell $21 billion of securities to meet demand. Unfortunately, these securities were mostly long-term Treasury bonds that had dropped in market value since they were purchased in 2020 and 2021, when money was falling from the sky from tech company clients. This realized a loss of $1.8 billion.
- March 9: SVB’s stock declined 41% as the market learned about withdrawal requests and the loss realized in selling the securities.
- March 10: Prominent tech investors told the companies they owned that it was time to abandon ship and take all cash from SVB. By the end of the day, California regulators and the Federal Deposit Insurance Corporation (FDIC) took over SVB.
- March 12: The Federal Reserve and Treasury stepped in to backstop depositors and allow the bank to resume operations.
How Banks Are Structured
The primary way banks generate profits is by taking your cash deposits, paying you a small amount of interest and lending that money out to other customers for higher rates. Banks keep very little of the cash you deposit on hand, and most of it is loaned out. This amount of cash held is known as the reserve requirement, and it is set by the government.
While this multiplication factor helps our economy grow, it also creates cross-contamination of credit for customers at a certain bank. The customers of a single bank are tied together, as the ability to meet withdrawal requests is dependent on other customers’ ability to repay debt. The FDIC was created to help guard against this interdependency by guaranteeing at least a minimum amount of bank deposits for each customer. This interdependency also makes customer base diversification important, as you don’t want all your bank’s customers to be in the same industry — because difficult times in that industry (like what happened recently with tech) could cause the bank to fail.
How Brokerage Firms Are Structured
Brokerage firms are structured differently. Their primary business is buying/selling securities and holding them in a segregated account on your behalf. You don’t have cross-contamination of credit between customers, and your ability to access funds is not dependent on the performance of others. Brokerage firms also don’t have the ability to use your assets to pay their creditors in the event of their failure, unless you have borrowed from the firm (i.e., margin).
This segregation makes brokerages the preferred holding place for cash reserves not needed for normal operations of a company. This safety advantage was illustrated in 2008 when Lehman Brothers, which has both a bank and brokerage, failed. As the New York Fed noted, “Lehman’s bankruptcy caused minimal disruptions to most customers of its broker dealer, Lehman Brothers Inc. (LBI). One reason is that, by law, customer assets and Lehman’s own assets were segregated.”1 Brokerage firms also carry insurance for account holders from the Securities Investor Protection Corporation (SIPC) to help safeguard assets in the event of a firm’s failure. We’ve provided links at the bottom of this article for more details on SIPC and industry insight.
Our Recommendations to Clients
So, how should clients manage their cash?
For your personal accounts, we don’t recommend maintaining a balance of more than the FDIC insures at a bank. Should you have amounts exceeding this coverage that need to be liquid, we can hold funds in your brokerage account invested in a money market that owns only U.S. government-issued debt. As of this writing, this fund is yielding approximately 4.25%, so at the moment it will likely provide a higher yield than that of your bank. This fund can be sold, and cash proceeds can be transferred back to your bank within two business days if needed.
For larger business accounts, we use similar strategies and might also purchase short-term individual Treasury bonds (that currently yield more than 4.75%). We also recommend businesses give very careful consideration to the size and customer base diversification of the bank where they hold corporate accounts. SVB has provided us with an unfortunate illustration of concentration risk, and it won’t be the last to do so.
Additional Information on SIPC and Industry Oversight
- How Schwab Protects Your Assets
- Financial Security: Account Protection — Why Fidelity
- Silicon Valley Bank: What Happened and the Coming Fallout
- Schwab’s Perspective on Recent Industry Events