The insolvency of SVB Financial (NASDAQ:SIVB) almost guarantees that its equity holders are unlikely to recoup their investments in the bank’s stock. At the same time, there is a risk that the fall of SVB could lead to a bank run from regional banks which could become a systemic event that could threaten the stability of the financial system. As such, there’s a case to be made that the government would get itself involved since the loss of confidence in regional banks could have unintended consequences for the whole financial system, as the Great Financial Crises has already shown that rescuing a single bank is likely to be less expensive than to try and save the whole system.

How Did We Get Here?

SVB has been one of the biggest beneficiaries of the injection of liquidity by the Federal Reserve during the 2020-2021 market bull run as the aggressive growth of the tech companies during that period ensured that the bank would receive new clients from the tech sector which would lead to the increase of the overall deposits. At the end of 2022, SVB already had $173 billion in customer deposits, up from $61.8 billion in 2019. In addition, due to the zero-interest rate environment at that time, the bank’s management decided to invest those deposits into long-term bonds that were yielding greater returns in comparison to the short-term bonds at that time. As a result, SVB’s held-to-maturity securities portfolio increased from $13.6 billion at the end of 2019 to nearly $100 billion at the end of 2021.

However, the biggest issue with such a decision is that the bank’s management did not appropriately hedge its exposure against the risks of rising interest rates which eventually led to SVB’s downfall. Some reports suggest that back in September 2021, the bank bought billions worth of long-term bonds with a 10-year maturity at an average yield of only 1.63%. Once the Federal Reserve began to raise rates and tighten the economy to tame the rising inflation, SVB’s portfolio began to incur losses. What’s worse is that even after the initial increase in rates in the first half of last year, the management hasn’t been actively hedging its risks which led to mark-to-market accounting losses of over $15 billion for securities held to maturity at the end of 2022.

As rates began to rise, savers began to seek higher yield opportunities instead of keeping their cash in the bank and earning minimal returns there. On top of that, the rising rates have also made it harder for SVB’s tech clients to raise additional funds to cover their burn rate and as a result prompted them to withdraw their deposits as well as to cover their existing expenses that led to the decrease of the bank’s overall liquidity. As a result of this, SVB entered a perfect storm as the pulling of funds forced it to quickly raise additional capital by selling its investment portfolio at a loss to increase its cash on hand. However, the selling of its portfolio at a major loss along with the announcement that the bank sold substantially all of its available-for-sale securities portfolio caused its customers to panic and led to the bank run on fears that SVB is facing a liquidity crunch .

That’s exactly what happened last Friday when the FDIC agents entered the offices of SVB to assess the bank’s finances and later had DFPI issue an order to take over the bank’s possessions due to its insolvency and appoint the FDIC as its receiver. As a result of this, SVB has become the second-largest banking failure in US history in a matter of days and all of this was possible mostly due to the signing of the bill in 2018 that lessened regulatory scrutiny for regional banks such as SVB and made them reduce the amount of time that they needed to submit to stress tests by the Fed.

As SVB is now insolvent, the biggest issue is whether its downfall would lead to a systemic event that could take the whole financial system down to its knees as was the case back in 2007-2008 during the Great Financial Crisis.

Is This A Systemic Event?

Currently, SVB has $173 billion in total deposits. Since FDIC insures deposits that are worth up to $250,000, it’s safe to assume that a significant portion of deposits of its tech clients is uninsured. Some reports indicate that over 95% of those deposits are uninsured and we know for a fact that companies like Roblox (RBLX), Roku (ROKU), and others held millions of dollars in the bank. The FDIC has already stated that it will sell the bank’s assets and the payments that it receives from it will go to uninsured depositors. We do know that the book value of SVB’s assets should be ~$210 billion, so the uninsured depositors should eventually get their funds back if the market value of those assets remains greater than the value of total deposits at the time of the sale.

However, that’s not the main issue here. Even if the uninsured deposits are not recovered and SVB clients lose their funds, a bank run that we’ve witnessed in recent days could lead to a systemic event that could bring the financial system down. There’s already a risk that thousands of startups and businesses that were customers of SVB won’t be able to make payroll and would be prompted to cut their workforce if FDIC won’t be able to release a significant portion of their deposits in the upcoming days . At the same time, there is also a possibility that we could witness a regional banking crisis since financial history suggests that bank runs are contagious. We already saw how the US banks lost over $50 billion in market capitalization in recent days due to the insolvency of SVB.

One way to fix this is for the government and the Fed to bail out SVB depositors by publicly announcing that the uninsured deposits will be fully covered. If there are no reassurances that deposits are safe and SVB is allowed to fail along with its depositors, then there’s a possibility that we could witness a liquidity drain from other regional banks due to the market panic as there’s a possibility that other banks are also holding similar low yield treasury securities that now trade at a loss. A loss of confidence in regional banks could have unintended consequences for the whole financial system as the Great Financial Crises has already shown that rescuing a single bank is likely to be less costly than to try and save the whole system.

The Bottom Line

The downfall of SVB shows the importance of doing extensive due diligence before deciding whether to invest in any asset. The bank’s management has been failing to hedge the rising interest risks for a long time until it became too late to save the situation, yet it didn’t stop the Street analysts from recommending buying shares of SVB when they were trading above $200 per share. Given the latest developments, it becomes obvious that equity holders should forget about recoupling their investment into the SIVB stock.

At the same time, if the bank run extends to other regional banks, then there’s a possibility that the government would need to get involved to prevent any threats to the stability of the financial system and restore its confidence.