Silicon Valley Bank: Warning signs of a looming Financial Crisis

On Friday, Silicon Valley Bank, a 40-year-old institution, collapsed, causing the FDIC to take over and put nearly $175 billion in customer deposits under the regulator's control. The bank's failure is the second-largest in US history and the largest since the financial crisis of 2008. The move evokes memories of the global financial panic of a decade and a half ago but did not immediately touch off fears of widespread destruction in the financial industry or the global economy.

Shares of America's banks saw a significant drop, with First Republic, PacWest Bancorp, Western Alliance Bancorp, and Signature Bank experiencing the largest plunges, amid growing concerns of contagion following the largest bank failure since 2008.

The looming Financial Crisis

As we approach the anniversary of the Great Financial Crisis, it's concerning to see similar warning signs emerging.

The US Treasury yield curve has recently inverted to its deepest level since 1981, while bankruptcies filings in the EU and US have hit a high not seen since the GFC. This, combined with the diverging profitability between European and American banks, paints a bleak picture for the financial sector.

The Problem with Held-to-Maturity (HTM) Investments

One of the key contributors to this potential crisis is the outdated accounting treatment for banks' held-to-maturity (HTM) investments. Banks purchase these securities to acquire predictable cash flow and meet liquidity requirements. However, the current accounting treatment for HTM investments is based on their original cost rather than their current market value. This creates a mismatch between the duration of the HTM investments and the short-term nature of bank borrowing, leaving banks vulnerable to losses on disposal if interest rates rise or market conditions change.

COVID and the lessons from the Lehman Brothers Collapse

The COVID-19 pandemic has caused loose credit practices similar to those leading to the subprime mortgage crisis and the 2008 financial crisis. Lehman Brothers also had a similar issue with their HTM investments, ultimately leading to their collapse and the global financial crisis. Banks holding risky loans and assets face substantial losses on disposal. The downfall of Lehman Brothers serves as a warning for banks to take timely action to mitigate risk and prevent bankruptcies.

Outdated accounting treatment for banks' investments raises concerns about another financial crisis.

The outdated accounting treatment of HTM investments must be changed to avoid the overvaluation of bank assets and underestimation of risk exposure.

Silvergate and Silicon Valley Bank

This is precisely what happened to Silvergate and Silicon Valley Bank, who experienced significant losses on their HTM investments and were forced to sell, contributing to their bankruptcy. The weighted-average duration of Silicon Valley Bank's HTM securities portfolio was 6.2 years on December 31, 2022, compared to 4.1 years on December 31, 2021, indicating a duration mismatch.

To prevent a similar wave of bankruptcies, banks must act now to tighten credit standards and diversify their investment strategies. Learning from history, we can see that an inverted yield curve and risky lending practices can lead to financial crises. Banks can mitigate risks and enable timely risk management by updating their accounting treatment for investment strategies.

The Contagion Effect: The Threat to Tech and VC/PE Industry

The potential contagion of Silicon Valley Bank's bankruptcy to the tech and VC/PE industry is not just a hypothetical scenario - it's a legitimate threat. A catastrophic event like this would have cascading effects on the entire market, ultimately leading to a widespread economic downturn.

The impact would be immense and long-lasting, as it would shake the very foundation of the tech and VC/PE sector, which is the backbone of innovation and growth. The potential implications of this doomsday scenario are almost too dire to contemplate: millions of jobs lost, countless startups shut down, and a wave of investor panic leading to a global recession.