SVB Woes Highlight Innovation-Regulation Gap
We need a better link between innovators and regulators.
The SVB series of unfortunate events has made one thing clear: there is a missing link between innovators and regulators.
Innovative SVB…
Silicon Valley Bank (SVB) was founded in 1983 with a focus on providing banking services to technology startups in Silicon Valley. From the beginning, SVB recognized that startups had unique financial needs that traditional banks were not equipped to handle. Their key insight was to offer lines of credit to startups based on venture capital funding. No product or profits required. Startups would get access to cheaper capital (compared to “expensive” equity financing) and SVB effectively unlocked a new market.
So far, so good. What happened? Over the past couple weeks, regulators have pointed out several “red flags” with SVB’s operations. Most notably, they suffered from:
A risky and homogenous deposit base: SVB had an unusually high proportion (~94%) of uninsured corporate deposits financed by startups and venture clients. Their business model was entirely focused on tapping the “innovation economy” which is code for having high-risk clients.
Poor interest rate management: SVB had a large portfolio of ordinary US government bonds. This was designed to be a safe play. And it was safe during COVID since it was a historically low interest rate period. But in 2023’s high interest rate climate, bond value plummeted. Unfortunately, SVB didn’t hedge against growing interest rate exposure. Unrealized losses meant they were at risk for a credit downgrade (which ended up happening). Instead of selling bonds at a massive loss, SVB tried to raise more capital. Cue the panic! Startups rushed to withdraw cash.
Social media: Add some Twitter-fuel to the fire, and the panic was high enough to prompt a full fledged modern-day bank run.
…Meets the Regulatory State (just not in time)
Why did regulators not realize the risks in time? SVB’s financials were publicly available and certainly not a secret to regulators. A decent answer is that they just weren’t looking.
Regulators were criticized for being hyper focused on “systemically important” banks and liquidity requirements. They’re not really thinking about what it means for a bank to have a significant and homogenous class of risky depositors or the power of social media to spread fear. According to Tom Vartanian, General Counsel of the Federal Home Loan Bank Board during the savings and loan crisis in the 1980s: “tech is obsoleting the current regulatory structure.”
To regulators’ credit, once the crisis became clear, they responded. The Federal Deposit Insurance Corporation (FDIC), Treasury, and the Federal Reserve were the main characters, but not the only players. Here’s what to know:
SVB was placed into “receivership”: California’s Department of Financial Protection and Innovation appointed the FDIC as receiver, and all of SVB’s insured deposits were temporarily transferred to Deposit Insurance National Bank of Santa Clara (DINB). Receiverships give the FDIC tons of power, and can be executed much faster than traditional bankruptcy proceedings. The goal was to make sure customers could access their deposits as soon as possible. Note: technically, only bank holding companies can file for Ch. 11 bankruptcy. Banks are ineligible. This is why SVB Financial (SVB’s parent company) filed for bankruptcy, not SVB itself.
Regulators invoked a “systemic risk exception” (SRE): Normally, depositors would have only received up to the FDIC coverage limit: $250K per depositor. However, in a commendably swift act of partnership, the FDIC, The Federal Reserve, and President Biden authorized a SRE to ensure that all depositors be made fully whole. The FDIC transferred all deposits (uninsured and insured) and assets from SVB/DINB to Silicon Valley Bridge Bank. The bridge bank bought the FDIC some much needed time to devise a broader solution (read: find a buyer and quell the panic). Here’s when VCs got in on the action and declared their support.
The Fed created the Bank Term Funding Program (BTFP): Later, the Fed announced a new Bank Term Funding Program which made additional funding available so banks could meet their depositor’s needs. The program offers loans up to one year in length to banks and other eligible depository institutions. The point is to boost confidence and prevent a cascade of bank failures.
Zooming out: we’ve been here before.
The financial sector has a long history of such clashes. The savings and loan crisis of the 1980s, the collapse of Long-Term Capital Management in the late 1990s, the 2008-2009 financial crisis, and the COVID pandemic all highlight the tension between regulation and innovation. In each case, financial institutions were pushing the boundaries of what was possible, often with very real consequences. Interestingly, the SRE was first authorized by the Federal Deposit Insurance Corporation Improvement Act in 1991, but wasn’t used until 2008-2009 for Wachovia and Citigroup. Now, 14 years later, it has been invoked to support both SVB and Signature Bank. Using this regulatory exemption wasn’t enough to stop the global financial crisis in 2008. Only time will tell if it works in 2023.
💡 What is needed is a better link between regulators and innovators.
The SVB saga is a cautionary tale. Regulators need to understand innovations that are being developed, and innovators must understand the regulatory environment in which they operate.
The finger pointing we see between both sides makes sense if you have a vision of innovators and regulators as rivals. But what would happen if the two are viewed as partners instead of adversaries? Regulators and innovators are simply different market actors with distinct competencies. Innovators are good at trailblazing and moving quickly. Regulators are good at managing systemic risk. At least that’s how it’s supposed to be. The key to changing the tenor of this important relationship is leveraging both to their strengths. And (re)building trust along the way.