What does the failure of Silicon Valley Bank say about the state of finance?

We actually do not know much about SVB’s exposures, since they fell below the Fed’s threshold for annual collection of Form FR Y-14A Capital Assessments and Stress Testing. At the moment, we also cannot track what fraction of SVB’s deposits was connected to the local venture capital (VC) ecosystem that it was serving. But we do know that that this bank was different, and it is highlighted in its name and in the history of its public statement.

Also read: SVB and Credit Suisse failure, and how it will affect your equity portfolio

For example, it is very clear that there is no other bank with over half of its loan portfolio dedicated to private equity subscription lines—that is, lines secured by VC and private equity fund commitments but ones used to fund investments in the short- to mid-term in lieu of capital call. It appears that this unusual specialized business model might have introduced significant correlation between large deposits and its business of revolving credit, on which it had substantial exposure. To add to that, the SVB leadership’s unorthodox approach to management of liquidity pressures clearly backfired.

The bottom line: The art is not to predict whether a run might take place, but when. The triggers of the run on SVB were no more apparent than the runs we have seen in the crypto space. The swift government actions to back regional banks, in my view, are commendable, although more targeted to managing general confidence than reflecting the isolated nature of the SVB troubles. They should be effective in reestablishing confidence in the broader financial system.

As to SVB, its credit specialization in the VC space is leaving an important void. I am less concerned about subscription lines, although this might temporarily bounce into pension liquidity. These events, however, are likely to have other lasting effects on the VC industry side, a subject for another day.

Victoria Ivashina is the Lovett-Learned Professor of Finance and head of the Finance Unit.

Also see: Silicon Valley Bank: The rise and fall of tech industry's favourite finance house

Erik Stafford: Interest rate exposure and customer withdrawals were devastating

SVB was unique in some ways, but also did some pretty normal bank activities. The business of banking involves investing in assets that are a little bit longer-term and a little bit riskier than the liabilities used to fund these investments. Banks invest in assets like US Treasury bonds, mortgages, and corporate loans. The liability side of their portfolio is a combination of checking and savings deposits, CDs, and debt.

Most deposit rates reset fairly often, so they represent relatively short-term borrowing for the bank. The equity receives the net cash flows and realizes the net gains and losses from value changes. Bank annual reports emphasize that bank earnings or cash flows are relatively insensitive to changes in interest rates.

Additionally, the stability of net interest margin (interest received minus interest paid) is pointed to as evidence that banks have little interest rate exposure. Many bank loans to businesses have floating interest rates, but most bank loans are mortgages, which tend to have fixed interest rates, and US Treasury bonds have fixed interest rates, too. Of course, because the interest payments are fixed, the value of these assets is sensitive to changes in market interest rates.

From an investment perspective, the value sensitivity to changes in interest rates is the most relevant. Note that it is typically difficult to hedge both the value and cash flow interest rate exposure, so the fact that the cash flows appear insensitive to interest rate changes suggests that the value-based interest rate exposure has not been hedged.

Banks are highly levered, which magnifies the asset risk exposures for the equity. Suppose that bank assets resemble two-year bonds, interest rates increase quickly from 1 percent to 5 percent, and banks have equity of $20 for every $100 of assets. In order for the two-year bonds to earn the new market rate of 5 percent, their value will need to fall by about 7.5 percent, so assets of $100 now have a market value of $92.50. Because of the leverage, this $7.50 loss per $100 of assets represents a loss of $7.50 per $20 of equity, or around -38 percent.

One unique feature of SVB was their large uninsured deposit base. It is often argued that the present value of the ongoing profits that will be generated from deposit accounts effectively hedge the value-based interest rate exposure of the bank assets. In other words, the value of these accounts to the bank increase when interest rates increase, which offsets, at least partially, the interest rate exposure of the assets described above. One interesting feature of the SVB situation is that the value of their deposits fell as interest rates increased in a somewhat unexpected way. Well before the bank run last week, their deposit customers had been withdrawing money to pay their operating expenses, while their deposit inflows from new VC funding slowed, which produced large net withdrawals of deposits.

In this case, deposits appear to have added, rather than hedged, value-based interest rate exposure. The bank run was devastating for SVB, but the real problems that triggered this event were the underlying interest rate exposure and the slow withdrawal of deposits. SVB was forced to issue a large amount of equity, which brought a lot of attention to their situation. There is now a lot of attention on the situation at all banks. The underlying interest rate exposure is common across banks, so some drop in bank equity values is appropriate. An important question to be determined is whether there are other banks who have been experiencing a slow withdrawal of customer deposit balances. This is quickly being investigated by investors and regulators.

Erik Stafford is the John A. Paulson Professor of Business Administration.