Our Bank Went Bankrupt

So our bank went bankrupt last Friday, but it's not just us. In fact, most tech startups in Silicon Valley and over 2,500 Venture Capital firms held their funds with the 16th largest bank in the United States. Of course, we're talking about the Silicon Valley Bank Run, the second largest bank failure in United States history. If you think your money is resting safely in your bank account, think again. After watching this video, you will never ever look at Banks the same way again. Welcome to a Lux.

Let's start off with how do banks actually work. Before we dive into what happened with Silicon Valley Bank, let's briefly explain how Banks actually work. So in simple terms, banks are financial institutions that help people save, borrow, and spend money. When you put money into your bank account, the bank uses it to make loans to other people or businesses, or directly invests them into Securities to make a profit. A bank is, after all, a business, not a charitable organization.

For example, let's say you deposit one hundred dollars in a bank. The bank might lend eighty dollars of that money to someone who wants to buy a car while keeping twenty dollars in reserve for safety. The person who borrows the money pays interest, which is how the bank makes money. This brings us to the concept of fractional reserve banking.

So fractional reserve banking is a system in which banks keep only a fraction of their deposits in reserve and use the rest to make loans. In the example we just gave, the bank kept twenty dollars in reserve and lent out eighty dollars. This means the bank had a reserve ratio of 20 percent. The reserve ratio is set by the government and is typically between three and ten percent. What this means is Banks can create money out of thin air by making loans, as long as they keep enough reserves on hand to meet the reserve requirement.

These loans are actually considered assets and are nothing more than just some numbers on a screen that the bank edits according to its will. For example, if a bank has one hundred dollars in deposits and a reserve requirement of 10 percent, it must keep ten dollars in reserve and can lend out ninety dollars. Fractional reserve banking allows Banks to create more money than they actually have in reserves, which can help to stimulate the economy by making more money available for people to borrow and spend.

Let's do another example: say Alice and Bob each buy a show and deposit one thousand dollars in the bank. The bank keeps two hundred dollars and does whatever they want with the other eighteen hundred. But what happens if both of them have a change of heart or they have an unforeseen payment that needs to be made, and they both need to withdraw those one thousand dollars? No problem! The banker says, "We've got enough money to give you," because, hey, Alice and Bob are not the only customers at the bank after all.

But what if all of them want to withdraw at once? Then the bank gets into some real trouble. To mitigate this risk, governments typically have systems in place to ensure bank deposits up to a certain amount, such as the FDIC in the United States. You can see where we're going with this now.

In normal economic conditions, this system works great. The economy is booming, money is cheap, investments are reliable economic instruments, and everybody's thriving. But what happens when certain events, like wars, pandemics, and supply chain issues, slow down the economy, and the production of goods and services slows down with it? Well, you get high inflation, and high inflation is tamed primarily by the central bank with rate hikes.

The primary goal of a rate hike is to control inflation and promote economic stability by increasing interest rates for the money they are borrowing. When interest rates are raised, borrowing becomes more expensive, which can lead to a decrease in consumer and business spending. So this in turn can help to slow down inflation and prevent the economy from overheating. But there's a price to pay for everything, and fractional reserve banking does not work in an extended rate hike environment.

Pay attention now, because this is probably the most important piece of the puzzle. As we mentioned earlier, when a bank gets deposits from its customers, it invests that money in various assets, such as loans, bonds, and other financial instruments. The bank earns interest on these assets, which is how it generates profits. But interest rates and bond values are inversely correlated. Allow us to explain here.

First, let's define what interest rates and bond values are. Interest rates are the percentage rates that lenders charge borrowers for the use of their money. For example, if you borrow one hundred dollars and the interest rate is five percent, you will need to pay back 105 dollars. Bond values, on the other hand, are the prices of bonds that are traded on the bond market. Bonds are essentially loans that investors make to governments or corporations in exchange for regular interest payments.

Now imagine you're an investor who wants to buy a bond that pays a fixed interest rate of 5. If interest rates in the economy rise to six percent, new bonds will be issued with a six percent interest rate, making them more attractive to investors than your five percent bond. This means if you were to sell your five percent bond on the market, you would have to lower its price to make it more attractive to potential buyers. This is because buyers would be able to get a better return on their investment by buying the new six percent bonds rather than your five percent bond.

Conversely, if interest rates were to fall to four percent, your five percent bond would become more attractive to potential buyers, as it offers a higher return than the four percent bonds. This means you could sell your bond for a higher price since buyers would be willing to pay more for the higher return on investment. So, TLDR; if a bank buys bonds in a zero percent interest rate environment, then if the FED starts to rapidly increase interest rates, they're going to lose money.

Now, banks can hide the dirt under the rug by designating the securities as held to maturity, where mark-to-market losses would not flow through the income statement. But that can only hide things for so long. If the maturity of the assets is longer than the maturity of the liabilities or deposits, it creates an asset maturity mismatch. What this means is the bank has made long-term investments with short-term deposits from clients.

So in other words, it's promised to pay back its depositors in the short term, but it's invested their money in long-term assets it may not be able to liquidate quickly. If a large number of customers suddenly decide to withdraw their deposits, the bank may not have enough cash on hand to meet those obligations, leading to a liquidity crisis, and this can trigger a bank run.

In the book "What Has Government Done to Our Money," author Murray Rothbard reminded us that the bank creates new money out of thin air and does not, like everyone else, have to acquire money by producing and selling its services. In short, the bank is already, at all times, bankrupt. But its bankruptcy is only revealed when customers get suspicious and precipitate bank runs.

So a bank run occurs when a large number of customers decide to withdraw their deposits from a bank simultaneously, usually because they believe the bank is in financial trouble and may not be able to pay them back. This sudden increase in withdrawals can cause a liquidity crisis, leaving the bank without enough cash to pay back its customers. In the early stages of a bank run, customers start to panic and withdraw their deposits, which will force the bank to sell its assets at a loss. This in turn can erode the bank's capital and create further concerns about its financial stability, leading to even more withdrawals.

If you've paid attention so far, you can see how all the pieces of the puzzle connect to each other. So to put all this together, in order for a bank run to occur, three things need to happen: an asset maturity mismatch, a decline in the value of those assets, and early withdrawals. Silicon Valley Bank checked all the boxes.

In fact, SVB held more than 50 percent of its assets in treasuries and agencies, and the problem with that is all of them were long-term investments. During the pandemic, SVB was very well positioned to take in cash deposits for its customers. Those funds came in as a combination of PPP loans, which was a pandemic help program for businesses, equity investments in VC, and cash.

Now naturally, as any bank on Earth would do, SVB quickly deployed these funds in money-making assets, given that front-end yields were only 25 bps. The management team naturally sought out to make a little bit more by tapping into longer dated bonds, which offered yields slightly above one percent. How fun and games! But by the end of 2021, the bubble in the tech sector had already popped and the pace of deposit growth slowed significantly, as seen in this graph.

In early March 2022, the FED announced the first of many rate hikes that were to come. So at this point in time, SVB started to lose money on its investments, and soon they were faced with a choice: hedge or designate the securities as held to maturity, where mark-to-market losses would not flow through the income statement. They chose the latter, which was the critical decision that ultimately led to the bank run.

By making this decision, the bank literally trapped itself into playing the long-term game, trusting that the FED would not put in any further rate hikes. Lo and behold, the FED kept raising interest rates, and SVB's 21 billion dollar bond portfolio, which was yielding an average of 1.79, got rug pulled by the current 10-year Treasury yield, which is about 3.9 percent. This required drastic measures, but the damage was already done.

Rumors started quickly spreading amongst clients, and people started withdrawing their funds in silence. On Wednesday, SVB announced it had sold a bunch of securities at a loss to give back its clients' money, and it would also sell 2.25 billion dollars in shares to shore up its balance sheet. That triggered panic amongst key venture capital firms, who reportedly advised companies to withdraw their money from the bank. An insane 42 billion dollars in deposits flowed out of SVB in two days—roughly 25 percent of total deposits—and there's just no bank that can survive that.

The bank's stock began plummeting Thursday morning, and by the afternoon, it was dragging other bank shares down with it, as investors began to fear a repeat of the 2007-2008 financial crisis. By Friday morning, trading in SVB shares was halted, and they abandoned any efforts to quickly raise capital or find a buyer. California regulators intervened, shutting the bank down and placing it in receivership under the Federal Deposit Insurance Corporation.

The aftermath: the FED bails out SVB. On Sunday, the Department of the Treasury, the FED, and the FDIC made a joint statement announcing that they're taking decisive action to protect the U.S. economy by strengthening public confidence in the banking system. TLDR; they decided they're going to bail out Silicon Valley Bank and all the other banks that were in a similar situation, confirming that customers are going to be able to withdraw their funds on Monday.

So rest assured, guys, Alux is safe. On the other hand, though, shareholders and certain unsecured debt holders got the middle finger. Senior management was removed, and any losses to the deposit insurance fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.

Now, while many see this as good news, this practice reveals a darker secret. We are all at the mercy of these institutional organizations, and they're the ones who caused all this trouble in the first place. With all of this being said, whether or not you trust the government or the bank, that decision ultimately lies with you.

And that's the wrap for today, Alexa! We suggest you watch this video at least a couple of times to make sure you fully understand the entire story. Knowing how the current banking and economic system works is vital for those who want to preserve their wealth and protect themselves against systemic risks, especially in these uncertain times. If this video helped you to learn something new today, consider tipping us with a like and a share to return the favor. And as always, thanks for watching, Alexa! If you'd like to learn some more, check out this video next.