Bank Runs! What’s Going On?

Banks don’t fail very often, and bank runs appear to be mostly a thing of the past. The last bank failure in the United States happened in 2020 when a small bank in Kansas with 69 million dollars in deposits failed at a cost to the FDIC of 18 million dollars. That two-year streak was broken this Wednesday with the failure of the crypto focused bank Silvergate, which was a bit bigger. As of year-end 2022, Silvergate’s deposits were over $6bn, possibly ranking it in the top 50 largest US bank failures in FDIC history. Silvergate’s importance in the recent crypto boom is possibly best described by a now-deleted testimonial from the bank’s website, “Life as a crypto firm can be divided up into before Silvergate and after Silvergate. It’s hard to overstate how much it revolutionized banking for blockchain companies.” The testimonial was written by a millennial who still lives in his parents’ basement playing video games and has had some recent run-ins with the law – His name is Sam Bankman Fried. I’m told they took it down from their website a few months ago because it doesn’t hold the same weight today as it used to.

So, let’s talk about Silvergate Bank, andtouch on the general sell off in bank stocks that we saw yesterday to understand what went wrong… If we go back ten years, Silvergate was a small San Diego based real estate lender that transformed itself into the go-to bank for the crypto industry. So how did this transformation occur? Well, in 2013 Silverlake’s CEO tells the story that he began reading about cryptocurrencies and decided to buy his first Bitcoin.

A year later Silvergate invited in crypto entrepreneurs and asked them what problems they were trying to solve and how the bank could be helpful. After this, the bank transformed itself and grew rapidly. It went public in late 2019 at a share price of $13, and a year later the stock price had risen by 1,580% as it became a key interchange point between dollars and cryptocurrencies. Major Silverlake clients included Paxos, bitFlyer, Kraken and also innovators in atonal rock music – Mars Junction, who also had some involvement in the Crypto industry. FTX and Alameda were also big customers.

The bank’s growth mirrored the growth of the crypto industry, and it declined alongside that industry too, announcing in a regulatory disclosure earlier this week that it plans to wind down operations in the face of “turmoil in digital currency markets”. This announcement was only so much of a surprise as last week Silvergate had announced that they would be unable to file an annual report with the SEC on time due to a weakening in their capital position. They announced that they might be forced to close at that time, blaming growing problems in part on pending investigations into their operations. The filing confirmed that Silvergate is being investigated by the US Department of Justice. Customers rushed over the last few months to pull money out of Silvergate.

In January they reported that customers had withdrawn more than $8bn, forcing them to sell held-to-maturity assets to fund the run, accruing losses on the sale of those securities of $718 million dollars. California’s state banking regulator said it was “monitoring the situation closely” and working with federal regulators to make sure Silvergate’s closure was “safe and expeditious”. Before we dig into how things went so wrong so fast at Silvergate, let me quickly tell you about today’s video sponsor Blinkist. Blinkist is an app that helps you understand the most important ideas in over 5500 different books and podcasts in around 15 minutes each - you can either read or play the books on your phone. The creators at Blinkist are great at extracting the most important concepts and ideas from a book and making them really entertaining. I often find myself buying more books than I have time to read, with Blinkist I can listen to lots of new titles on my commute and if I find one really interesting then read the full book.

It’s also amazing for refreshing your memory of a book that you’ve already read. Here are some of the books I'm currently listening to. They have a new feature called Blinkist connect which allows every Blinkist Premium plan to be shared by two different accounts at no additional cost. You can recommend titles and share favorites with each other too. Get 25% off Blinkist premium and enjoy 2 memberships for the price of 1! Start your 7-day free trial by clicking the link in the description or scanning the QR code. OK, so why was Silvergate so important in the world of crypto? Well, people who trade cryptocurrencies often want to use dollars to buy crypto, or they want to sell crypto and receive dollars and the dollar side of those transactions is where things get bogged down.

If you are transferring large sums of money to buy crypto, you need to deal with the US banking system who might ask you a lot of questions relating to anti money laundering regulations. Crypto people hate questions like this. Similarly, if you just sold some crypto and want to deposit the dollars you received, most banks will have a long list of questions about the source of your funds, and there is a really good chance that they will simply refuse to do the transaction. It is going to be a struggle for a US regulated financial institution to show their regulator that they have done enough due diligence to be sure that your funds are not the proceeds of crime. And the last thing a bank needs is to be accused of money laundering; they would rather just simply not deal with suspicious transactions.

For this reason, stablecoins like Tether and Terra exist – or existed. If you can convert your dollars into crypto once, you can then buy stablecoins that are supposed to always be worth a dollar, and then instead of buying and selling crypto with actual dollars you buy and sell crypto with dollar-denominated stablecoins, your money can stay “on chain”. The problem with that, is that you have to trust the stablecoin issuers, and they for some reason don’t always seem trustworthy. They won’t really tell you where the money is, they’ll sometimes announce that they are going to be audited by a top 12 auditor (I’m not really sure what a top 12 auditor is – but when you hear that – you know you are getting number 12 on the list), and you start to wonder if Friehling & Horowitz made that list.

Sometimes they’ll even fire their auditor accusing them of “excruciatingly detailed procedures”. I mean an audit is basically defined as involving excruciatingly detailed procedures. If you find an audit fun… there is possibly something wrong with you. OK, so if you don’t like stablecoins… maybe you could keep your dollars on a big trustworthy exchange… But that can have its problems too.

This problem of course goes deeper than crypto investors wanting bank accounts that can interface with their crypto trading accounts, because if you have deposited your dollars with a crypto exchange or a stablecoin provider, they still need to deposit them somewhere. They need a bank too. Now (of course), another way of dealing with this banking issue, might be to lie to your bank about what your account is being used for (SBF and the team at FTX did that), but the technical term for ‘lying to your bank’ is Bank Fraud (as Sam Bankman Fried just found out) – and you can get in trouble for that. It’s part of the reason that Sam is still living with his parents, and it’s one of the reasons that he may have a new roommate soon. So… What this all means… Is that there was significant demand for a “crypto friendly bank” and Silvergate was willing to fill that role, when no other bank was willing to take that risk.

Silvergate weren’t just crypto friendly either, they built their own payments network called the Silvergate Exchange Network to (according to their marketing documents) enable the efficient movement of U.S. dollars between participants 24 hours a day, 7 days a week, 365 days a year. As you might imagine, Silvergate (being the only bank that would deal with them) attracted a lot of big crypto customers, as these customers were able to open up accounts without lying too much. Silvergate dealt with most of the big players in the industry and they were an actual US regulated bank with excruciatingly detailed audited financial statements and capital regulation. This meant that your money was safe at Silvergate, unlike at the other venues we just went over. Now the beauty of dealing with these crypto customers, crypto exchanges, and the band members of Mars Junction, was that because you don’t have any real competition in this space, you don’t really have to pay them any interest on their deposits.

You could take the billions of dollars they deposit with you, put it all in treasuries and you get to keep all of the interest. You’ll probably have to spend some of the profits on lawyers to keep the regulators at bay, but overall you might have a profitable business. But that’s boring right… And no one gets involved in crypto for a boring life… So I suppose they decided they could lend some of the money to that crazy guy with the laser eyes to buy more Bitcoin. I’m sure that’ll be fine… Right.

But it wasn’t just that guy, there were other people too. They had a product called SEN Leverage direct lending, where they would lend people money collateralized with bitcoin. Exchanges could also borrow dollars collateralized with bitcoin for corporate treasury and other business purposes. In January they announced that total SEN Leverage commitments were $1.1 billion dollars and that all of their SEN Leverage loans “continued to perform as expected, with no losses or forced liquidations.” So, as crazy as that business might sound, it was not really the source of their problems. So, where did things go wrong then? Well, as of September, 2022 their balance sheet showed about $11.4 billion of “securities,” meaning bonds: Treasury securities, mortgage-backed securities, agency bonds and so on and $1.4 billion of “loans,” meaning the Bitcoin loans and some other real-estate lending.

They had $13.2 billion worth of deposits at the end of September, most of them being from crypto companies - so non-interest paying deposits, the best kind… The problem for Silvergate was that when FTX was exposed as being insolvent, crypto investors were considerably less willing to leave their cash on exchanges. They asked for their money back from the exchanges, meaning that the crypto companies had to ask for their money back from Silvergate, so Silvergate was faced with a good old fashioned bank run – driven not by a loss of faith in Silvergate, but by a loss of faith in crypto exchanges. By the end of December, noninterest bearing deposits at Silvergate fell from $13.2 billion dollars to just $3.9 billion dollars. There is a good chance that if you had an account at a crypto exchange, that exchange banked with Silvergate, and if you closed your account and cashed out, the cash came from a deposit at Silvergate. As people closed their crypto accounts and cashed out, that led to some of the problems at Silvergate. There were other FTX related problems too. When prosecutors started looking into the collapse of FTX, their attention was drawn to their banker - Silvergate, for hosting accounts connected to Sam Bankman-Fried.

Now, a big problem for Silvergate, was that – with their money all tied up in bonds or lent out, Silvergate had to come up with around 9 billion dollars to pay out these withdrawals. Their accounts show that by the end of December they had sold half of their bonds and had controversially borrowed $4.3 billion from the Federal Home Loan Bank of San Francisco, a government institution that is in place to give short-term secured loans to banks that have a short-term liquidity problem. This Federal Home Loan Bank loan drew the attention of a group of Senators in Washington DC. Who wrote a letter to Silvergate’s CEO, pressing him on his knowledge of FTX’s alleged misconduct and expressing that they were “disappointed by his evasive and incomplete response” to a prior letter inquiring about the bank’s relationship with FTX.

The senators took aim at both Silvergate and the Federal Reserve for their inability to “identify what we now know were extraordinary gaps in Silvergate’s due diligence process,” and said that by taking the cash injection from FHLB, Silvergate introduced crypto market risk further into the traditional banking system. In September Silvergate had shown 3.1 billion dollars’ worth of bonds as being “held to maturity” and 8.3 billion dollars’ worth of bonds as being available for sale. The difference between these two classifications (from an accounting perspective) is that the available for sale bonds have to be marked to market – or held on the books at their fair market value, while the “held to maturity” bonds could be marked at their cost price.

By the end of December there were no “held to maturity” bonds left on the balance sheet, meaning that they had either been sold, or reclassified as available for sale. One way or another, interest rates had gone up a lot in 2022, and these bonds were worth a lot less than they were being carried on the balance sheet at. The sale resulted in a loss of $751.4 million during the fourth quarter of 2022 and in addition, the Company recorded a $134.5 million dollar impairment charge related to an estimated $1.7 billion dollars of securities it “expects to sell in the first quarter of 2023 to reduce borrowings.” This is because reclassifying some of the bonds to “available for sale” meant that they now had to be marked to market and that the loss had to be recognized under GAAP accounting rules.

Silvergate also had to write down a $196 million dollar investment in “certain developed technology assets related to running a block-chain-based payment network” that it had bought in January 2022. So, all in, there was a net loss of over a billion dollars in the fourth quarter of 2022. OK, so banks have regulatory capital requirements. That means that they can’t just lend out all of the money that comes in as deposits. Some of the money being lent out has to come from shareholder capital. Thus, if some of the loans go bad, the shareholders take the hit and not the depositors. This makes sense, as deposits at American banks are insured by the FDIC, and the FDIC doesn’t want to have to pay out every time a loan goes bad.

Bank capital requirements are “risk-based” and need to be kept above 4% to be “adequately capitalized” and above 5% to be considered “well capitalized.” Different types of assets have different risk weights, and this is done to keep deposits safe. The safest assets – like treasury bonds have a zero-risk weighting, so a bank that has everything in treasury bonds only has to meet that 4% capital requirement. A bank that makes a lot of mortgage and business loans might have a capital requirement of around 8%, and assets like bitcoin have a 100% capital requirement, meaning that a bank would need to have $100 of capital for every $100 of bitcoin on its books. The minimum that a bank would want to get to is 5% regardless of the risk weighting of their assets, as below that they are no longer considered well capitalized. In September Silvergate was fine, as despite the Bitcoin loans, most of their money was in high quality bonds that had zero risk weights. But when their deposits went out the door and they had to sell assets and realize a billion-dollar net loss, they were left in a situation where an additional 19-million-dollar loss would but their capital below 5% and they would no longer be considered well capitalized.

Last week Silvergate announced that they had sold additional debt securities in January and February to repay the company’s outstanding advances from the Federal Home Loan Bank of San Francisco and that they ”expect to record further losses related to the other-than-temporary impairment on the securities portfolio”. These additional losses they said would “negatively impact the regulatory capital ratios of the Company and could result in the Bank being less than well-capitalized. In addition, they announced that they were evaluating the impact that these subsequent events have on their ability to continue as a going concern for the twelve months following the issuance of financial statements.

And none of that is considered good. This announcement caused the stock price to half that day and according to Bloomberg caused Coinbase, Galaxy, Paxos and other crypto firms to announce that they would stop accepting or initiating payments through Silvergate. These customers leaving were the final nail in the coffin, as they reduced deposits even further. So, there we go, a bank run, on a real bank, caused by crypto related losses and crypto volatility. Bank runs in general seem like something from the distant past, and that’s because they mostly are. We did see something that looked like a bank run here in the UK during the credit crunch, at a bank called Northern Rock.

The most recent U.K. bank run before that had been Overend Gurney in 1866, a London bank that overreached itself in the railway and docks boom of the 1860s. The Northern Rock bank run wasn’t even an actual bank run, as retail depositors only started lining up outside bank branches after the Bank of England had announced that it was intervening to support the bank. Although it may have seemed dramatic on television, the customers withdrawing their money came after the liquidity crisis, rather than being the event that triggered the liquidity crisis. In modern US banking, there is deposit insurance to reassure retail depositors and there are programs in place to ensure that a solvent bank can get cash to deal with withdrawals. There are bank examiners and various regulations in place like capital requirements to make sure that the banks stay solvent.

Last week, Silvergate’s customers started withdrawing their money because they were worried about Silvergate’s solvency (this is what we think of as a bank run), but late last year, when the problems started, they were withdrawing their money because crypto had collapsed. The bitcoin loans – which may seem dumb – were not really the problem at Silvergate, the problem was the crypto customers, whose own customers no longer trusted them. Contagion from the crypto crash caused the problems at Silvergate. Additionally rising interest rates caused losses in their bond portfolio, weakening their capital position. Yesterday we saw a big sell-off in big US bank stocks, which appeared to have been sparked by difficulties at Silicon Valley Bank, a small, technology-focused lender. Silicon Valley Bank had revealed on Wednesday that it had lost roughly $1.8bn following the sale of a portfolio of securities valued at $21bn, which it had to sell in response to a decline in customer deposits. The losses prompted the bank to announce a share sale to shore up its capital position. The losses on the sale of the Silicon Valley Bank bond portfolio shifted investor attention to the risks that might be lurking in the huge bond portfolios held by other US banks, many of which invested an influx of deposits during the coronavirus pandemic into long-dated securities that will have fallen in value as interest rates went up.

It was announced a few days ago that Silvergate Capital plans to wind down operations and liquidate. The press release says that “In light of recent industry and regulatory developments, Silvergate believes that an orderly wind down of bank operations and a voluntary liquidation of the bank is the best path forward.” They go on to say that “The bank’s wind-down and liquidation plan includes full repayment of all deposits.” Silvergate collapsed amid a criminal investigation by the Justice Department’s fraud division along with scrutiny from politicians and regulators. Their problems deepened as they liquidated assets at a loss and shut down their flagship payments network, which they called “the heart” of the group of services for crypto clients. Sheila Bair, who headed up the FDIC during the global financial crisis told Bloomberg yesterday that Silvergate’s troubles are as much if not more about traditional banking risks — lack of diversification, maturity mismatches — as they are about its exposure to crypto.

But it can be argued that its exposure to crypto was its lack of diversification. It was exposed to the extremely volatile and legally risky crypto industry, and the collapse of that industry, combined with the heat that it drew from the department of justice led to the collapse of Silvergate Bank. Matt Levine at Bloomberg argues that one way to think about the rise and fall of Silvergate is that the crypto boom was at its heart a low-interest-rate phenomenon (people started speculating in crypto because interest rates were below the rate of inflation) and so Silvergate was hugely exposed to interest-rate risk - simply because of its exposure to its Crypto customers.

Its assets – the bonds that it bought - were also interest rate-sensitive, and when rates went up their assets fell in value. So rising interest rates caused the deposits to evaporate at the same time as the assets backing those deposits fell in value. Levine argues that (with hindsight), Silvergate’s risk management – a year ago – should have been laser-focused on the risk of rising interest rates crushing both its assets and its customers, and it should have hedged that risk one way or another. If you found this video interesting, you should watch this one next. Don’t forget to check out our video sponsor Blinkist using the link in the description below. Have a great day, and talk to you again soon. Bye..

As found on YouTube

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