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Contagion risk in regional banking

6 min read

From: allin

The collapse of Silicon Valley Bank (SVB) in March 2023 highlighted significant vulnerabilities in the financial system, particularly concerning contagion risk in regional banking. The event, which escalated rapidly, caused widespread panic and raised concerns about a potential cascade effect across the broader economy. [02:46:00]

The SVB Collapse: A Lehman-Sized Event for Silicon Valley

Within 36 hours, Silicon Valley Bank imploded, with the FDIC shutting it down [02:01:00]. This event is described as a “Lehman-sized event for Silicon Valley,” reminiscent of the Lehman Brothers bankruptcy in 2008 that triggered a financial crisis [03:14:00].

Immediate Impact

Thousands of companies are unable to make payroll in the coming weeks because their money is trapped at Silicon Valley Bank [03:45:00]. This is not “Big Tech” at risk, but rather small companies with 10 to 100 employees, potentially facing an “extinction-level event” [04:27:00].

Drivers of Contagion

The primary concern stemming from the SVB collapse is the risk of a regional banking crisis [05:04:00].

  • Loss of Depositor Confidence [05:06:00]: When depositors realized their money was not safe at SVB, a top-20 bank believed to be in regulatory compliance, it raised questions about the safety of deposits at other regional banks [05:13:00]. This led to a rush to move money to larger, “too big to fail” banks like JPMorgan [05:37:00].
  • Bank Run Mechanics [11:44:00]: A bank run occurs when more customers demand their cash back than the bank has readily available [11:45:00]. This becomes a self-fulfilling prophecy; if people believe others are pulling money out, they rush to be first, regardless of the bank’s fundamental solvency [11:50:00].
  • Silicon Valley’s Herd Mentality [1:08:42]: The tightly intertwined nature of Silicon Valley, where information spreads rapidly through chat groups, amplified the bank run [1:08:42].
  • Historical Precedent [1:12:11]: Bank runs were common before the introduction of FDIC insurance, which aimed to make depositors’ money safe up to a certain limit [1:12:21]. However, for businesses, the $250,000 FDIC limit is often insufficient [1:12:29].

Contributing Factors to SVB’s Vulnerability

Several factors contributed to Silicon Valley Bank’s specific vulnerability [07:05:00]:

  • Duration Mismatch [19:46:00]: SVB held short-term deposits from customers but invested heavily in long-duration assets like 10-year U.S. Treasuries and Mortgage-Backed Securities (MBS) [10:01:00] [10:08:00].
  • Rapid Interest Rate Hikes [13:28:00]: The rapid and violent rise in interest rates by the Fed devalued these long-term bonds [32:27:00]. This created massive “unrealized losses” on their balance sheet that did not have to be recognized until the assets were sold [22:55:00].
  • Declining Deposits [12:48:00]: A decline in new venture capital investments meant startups were burning cash without new deposits coming in, leading to a net outflow [12:51:00].
  • Venture Debt Exposure [14:32:00]: Approximately 10% of SVB’s loan portfolio (around $7 billion) was in Venture debt [14:32:00]. This is considered risky as its performance is predicated on venture capitalists continuing to fund companies, which became uncertain in a bear market [25:47:00]. This asset class typically includes warrants for equity upside in startups [15:09:00].
    • Historically, venture debt has performed well, but this was during a bull market [25:50:00]. The assumption that companies would keep raising up rounds proved flawed [26:01:00].
    • Concern exists that customer deposits should not be used for such risky, illiquid investments, potentially creating systemic risk [26:18:00] [56:26:00].
  • Lack of Regulatory Oversight [20:57:00]: Critics argue that regulators were “asleep at the wheel” by allowing banks to hold long-dated bonds at book value instead of marking them to market daily [23:09:00] [53:00:00].

Systemic Risk

The Wall Street Journal reported that U.S. banks had $620 billion in unrealized losses just on treasuries alone [52:48:00]. This opacity in the system prompts a rational response from depositors: why take a chance when confidence is lost? [53:30:00]

Broader Economic Implications

The contagion risk extends beyond Silicon Valley.

  • Payment and Payroll Companies [44:12:00]: Companies like Rippling, which handle payroll for thousands of businesses (not just tech), had money tied up at SVB [44:34:00]. Delays in payroll could have cascading effects on various industries.
  • E-commerce and Small Businesses [45:17:00]: Payment processors using SVB could impact e-commerce and small business owners [45:17:00].
  • Venture Capital Funding Freeze [1:02:18]: The uncertainty has led to a “chilling effect” on venture capital funding [1:01:35]. Many VCs are diverting attention from new deals to triage their existing portfolios, potentially leading to a 60-day freeze in deal-making [1:03:06].
  • International Reach [46:53:00]: SVB served as an on-ramp for U.S. investors to send money to China, affecting China’s innovation economy as well [46:53:00].

Proposed Solutions and Path Forward

To stop the contagion, an immediate “bear hug solution” from the federal government is deemed necessary [1:15:53].

  • 100% Deposit Guarantee [45:48:00]: All depositors need to be paid 100% of their money, with cash made available by early the next week [45:51:00]. This would involve the Fed or another federal agency guaranteeing deposits, potentially without needing to deploy the full amount if confidence is restored [1:17:15].
  • TARP as a Model [41:56:00]: The Troubled Asset Relief Program (TARP) from 2008, which eventually returned a profit to taxpayers, is cited as a precedent [48:03:00]. A similar backstop for SVB could be structured to be profitable for the American people, possibly by taking warrants in companies or the bank [48:48:00].
  • Regulatory Reform [1:19:31]: Increase the FDIC insurance limit for business banking accounts to, for example, $25 million, and highly restrict what banks can do with that money [1:19:31]. This would mean requiring assets to be highly liquid and marked to market daily, preventing investments in risky or long-dated assets [1:19:38].
  • Accountability [48:54:00]: While depositors should be protected, the executives and stockholders of SVB should be wiped out for their mismanagement [48:54:00].

Current Situation

The iShares Regional Bank ETF shows a significant decline, indicating that the contagion has already begun, affecting the equity tier of other regional banks [1:17:41] [1:18:05]. This is not just a “Silicon Valley problem” but a broader regional banking concern [1:22:12].

Policymakers are urged to act decisively to prevent a further unraveling of the financial system [1:17:09].

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