Over the past two weeks, three medium-size banks—Silvergate Capital, Silicon Valley, and Signature—went out of business. They all had similar problems. They had financed their assets largely with debt, rather than equity. That is, they used substantial “leverage” to run their businesses.* In addition, there were indications that the value of their assets may be insufficient to meet regulatory equity minimums or, possibly, to cover the large, fixed claims of their creditors.
Why the banks failed
The real or potential financial weakness of these banks was revealed when large uninsured depositors—creditors with the ability to call debt instantly—began withdrawing funds. In the case of Silicon Valley and Silvergate, the forced sale of assets to meet depositor demands for cash showed that bank assets had lost value because of adverse market events. It became clear that Silicon Valley was insolvent, with the value of its debt exceeding the value of its assets, and that Silvergate’s equity levels were heading in the wrong direction. So Silicon Valley was shut down by regulators, and Silvergate voluntarily liquidated itself. In the case of Signature, New York state banking regulators apparently concluded that the bank could not survive an uninsured depositor run and shut it down.
The characteristics of the uninsured depositors differed across banks. In the case of Silicon Valley, many uninsured deposits were from tech firms. At Silvergate, a significant share of uninsured deposits were from crypto exchanges and hedge funds, which used the banks to transact with one another. Nearly 90 percent of Signature deposits were uninsured, and about 18 percent of its total deposits were digital-asset related, but it is not clear what fraction of the digital-related assets were uninsured.
The motivations for initial withdrawals were diverse. In the case of Silicon Valley, early withdrawals appear to have been tied to conditions in the tech industry. For Silvergate, the collapse of FTX and much of the crypto world appears to have started the ball rolling. The situation at Signature is less clear and may have been the consequence of contagion.
Whatever the starting point, the cash calls led to disaster because the banks had relied heavily on debt to finance their assets, rather than equity from their shareholders.
Whatever the starting point, the cash calls led to disaster because the banks had relied heavily on debt to finance their assets, rather than equity from their shareholders.
In the case of Silicon Valley, the value of its assets had declined because of increasing interest rates. A large part of the bank’s assets were Treasury bonds and agency mortgage-backed securities, bought between 2020 and 2022 as uninsured deposits increased dramatically. When interest rates increased, the market value of these assets declined. At the end of 2022, Silicon Valley had unrealized losses of $15 billion on the “held to maturity” securities in its portfolio. This nearly equaled its entire book equity of $16.2 billion.** So when Silicon Valley sold $21 billion in bonds to raise cash, and was forced to realize losses, its financial weakness became obvious.
The bank’s uninsured depositors recognized the bank’s precarious position, and a classic depositor run began. Last Friday alone, there were $42 billion in withdrawals, a huge amount for a bank with $175 billion in deposits. Because it was on the verge of failure, the bank was closed by California regulators, the FDIC was appointed receiver, and a bridge bank was established. Using a systemic risk exception to the law governing federal deposit insurance, all Silicon Valley depositors, not just insured depositors, will be made whole.
A similar dynamic involving a run by uninsured depositors developed at Signature. The bank was shut down by New York state banking regulators on Sunday, reflecting their judgement that the bank could not survive. The systemic risk exception will also protect Signature Bank’s uninsured depositors.
Lack of bank equity led to these unfortunate developments. If the banks had financed a sufficiently large portion of their assets with equity, then they would have been able to sell their equity-financed assets to pay depositors. Losses then would have been borne by the banks’ owners, with some part of their equity used to pay creditors. Unfortunately, the equity levels of the banks were simply too small to insure creditors against loss.
The Federal Reserve’s new bank term lending facility is a recognition that inadequate equity may be a problem for other banks. By allowing banks to sell assets such as Treasury bonds or agency mortgage-backed securities to the Fed at par—the value at which the banks carried those assets on their books—rather than market value, banks will not be forced to recognize losses in the market value of these assets if they need to sell in order to raise cash. There would be no need for this kind of facility if leverage were lower and banks could cover losses by selling their own assets.
Banking regulation is intended to lower the likelihood of individual bank failures and limit the need for systematic rescue. Rules specify, among other things, minimum equity-asset ratios that a bank must maintain. However, as events have shown, current requirements are insufficient for these tasks. This fundamental weakness was amplified by regulatory changes made in 2018, which weakened stress testing, risk management, liquidity, and resolution planning requirements for banks with less than $250 million in assets.
Equity requirements should be higher so that all banks are more effectively self-insured
There is no real reason why equity requirements should not be substantially higher for all banks, set at levels large enough that banks are more effectively self-insured against adverse market events and the effects of creditor runs. As Anat Admati and Martin Hellwig show convincingly in The Bankers’ New Clothes, greater reliance on equity finance rather than debt would improve bank incentives to account for risk and efficiently reduce bank fragility. So why not require more equity, implement better monitoring of actual bank equity ratios, and thereby reduce threats to financial stability like the one currently occurring?
The federal banking regulators will be called upon to take steps in the aftermath of these failures. Now is the time for them to raise equity requirements to prevent banking history from repeating itself yet again. This is certainly preferable to ad hoc guarantees of bank assets and large bank depositors, which raise the level of moral hazard by creating implicit guarantees where none existed before.
* Author’s note: At the end of 2022, Silvergate’s Tier 1 Leverage ratio was 5.4 percent, Silicon Valley’s ratio was 7.96 percent, and Signature’s ratio was 8.79 percent.
** Author’s note: See the sources in the first note. For further background information, see this blog post from the CFA Institute.