Bold Business Logo

Built-to-Fail Banks and Bad Bankers

Two large banks, Silicon Valley Bank and First Republic, have failed. Everyone is asking why they failed, but in hindsight, you could see it coming from miles away. But before we discuss these banks, let’s talk about one of my all-time favorite movies: 1946’s “It’s a Wonderful Life.”

Remember that classic? The story builds upon the consequences of a bank run and a possible local bank failure. 

First Republic Bank was a built-to-fail bank
First Republic Bank was a built-to-fail bank–and now it has failed.

George Bailey, the hero, is distressed. Bank runs and failures ruin people’s lives, and the bank in his small town faces collapse because nearly all of its depositors have lost confidence in the institution. They want to withdraw the money in their accounts. Clearly, it’s a wonderful life until you realize that your hard-earned cash sits uninsured and is subject to the pitfalls of tenuous market conditions–then it’s time to panic! 

What’s poor George to do, besides contemplate his existence and listen to the wisdom of a would-be angel, Clarence? The climactic ending results in the community, not the US government, raising money for a bailout of “Bailey Brothers Building & Loan” and filling in the capital deficit. 

Unfortunately, the founders and management of Silicon Valley Bank and First Republic Bank learned nothing from this iconic movie released 77 years ago. They designed their banks for failure.

A lot has been written already on the many factors that helped cause the failure of Silicon Valley Bank and First Republic (including this explainer by Bold Business immediately after the collapse of Silicon Valley Bank). But an important question remains, which is why were the conditions of such a colossal failure in place to start with? 

To answer this question, you have to go back to the bank’s formation, because it was wrong at its inception!

Uninsured Depositors: The Silicon Valley Bank and First Republic Bank Original Strategy Flaw

All banks have market strategies, and this includes the strategies for customer loans, deposits and revenue that are at the core of the identity of a financial institution.

Many banks have a regional or geographic focus for deposits and loans. 

Some are primarily consumer-oriented versus business-oriented. 

Some develop specialized expertise in lending, in such areas as home mortgages, commercial real estate, car and equipment leasing and all types of business loans. 

This focus fosters a strategy that impacts customer make up, which in turn subjects the bank to unique risk and growth opportunities based on the type of customer focus and geographies an institution chooses. In 2009, some financial institutions were wiped out based on home loan concentration. 

Silicon Valley Bank, which was founded on October 17, 1983, was one of the first banks to primarily strategically focus on early-stage companies backed by venture capitalists. In fact, its name helps describe its market focus–they were a bank that catered to startups and growth companies, many of whom planted roots in Silicon Valley. 

The strategic flaw for Silicon Valley Bank was not a venture capital industry issue, as many banks also lend to VC-backed companies. Nor was it its bond portfolio, although that contributed. 

No, its flaw was a deposit strategy; deposits from consumers tend to be more stable, while VC-backed corporate deposits are not as stable. 

Built to fail banks and leaking pails
The U.S. banking crisis can be blamed on bad banking strategy and bad bankers.

Young company corporate deposits are more unstable because young companies typically burn through money–they’re constantly making withdrawals, and they are often over the $250,000 insurance limits. 

Imagine a water pail with a hole in it. The water going in must be faster than the rate of water going out, otherwise the pail will empty completely. 

Now imagine Silicon Valley Bank or First Republic Bank is the pail with the hole, with the water going in being the deposits, primarily from fundraising, and the water going out the spending by the companies. The bank’s deposit strategy was built on the premise that new deposits from fundraising would come in faster than outflows or corporate spending.  

The combination of reduced VC fundings over the last nine months and the increased use of corporate funds and just transfers to other banks brought the strategic flaw to light.  Banks with high amounts of uninsured deposits are the most likely to topple from bank runs. Silicon Valley Bank, as well as First Republic Bank (founded in 1985), had an unusually high deposit composition–many of which were uninsured–and that made it highly vulnerable to a bank run.

Silicon Valley Bank Was an Extreme Uninsured Deposits Outlier

When comparing the major banking institutions and how much of their deposits are insured, consider the following charts:

A chart listing non-built-to-fail banks plus SVB
Want to create a built-to-fail bank? Have lots of uninsured deposits!

According to the data, UBS Investment Bank had 84.69% of its deposits insured. By comparison, Silicon Valley Bank had only 8.29% insured. 

A comparative chart of SVB vs other banks
The numbers paint a stark picture: SVB was a problem child from the outset.

When it comes to insured deposits versus uninsured deposits, it’s clear that if customers ever got nervous about their money, the deck was stacked against Silicon Valley Bank! Their vulnerability was framed by the limits of FDIC insurance ($250,000), and the big depositors whose money exceeded that limit.

Predictable Disruption in the Capital Markets also Contributed to the Run

Like a smoldering flame struggling to burst into a full-fledged blazing bonfire, young companies burn through cash like it’s oxygen, and they need more and more for the flames to catch. That cash comes, in theory, in the form of ever-increasing rounds of fresh capital–and for years, the startups have had plenty of oxygen. 

But when the capital markets are disrupted and the rounds dry up, the cash for young companies goes up in smoke… as do the deposits that they’d normally be forking over to their banks.

For Silicon Valley Bank, this created the need to sell bonds and realize losses that put pressure on their precious capital ratios, thus weakening them. Customers at other banks often put money into 12-month- and larger CDs, and their capital is stickier and more reliable. But Silicon Valley Bank was not like other banks!

Of course, it should have known this weakening would occur, and that it would be susceptible to predictable disruptions in the capital markets.

The Need for Private Insurance: Uncle Sam Can’t Always Save You!

It’s important to appreciate shortcomings involving the FDIC’s depository protections. However, it’s just as important to take a look at how these banks interacted with their startup clients. Based on agreements at Silicon Valley Bank and First Republic Bank with companies, there were several red flags that should have concerned clients. But given the challenges associated with accessing capital and funds, many entrepreneurs chose to ignore best practices. Now that their funds are tied up in federal oversight control, they’re wishing they had been wiser in their approach. Because of this, it’s worth examining the missteps that occurred leading to the recent financial debacle.

A black and white of a built-to-fail bank
Is there a U.S. banking crisis underway? Only for the banks built to fail.

Have I Got a Deal for You–If I Go Under, You Go Under!  

 Silicon Valley Bank targeted a very select group of clients. The vast majority of its patrons were technology startups that needed early funding to proceed, and many of these startups also received venture capital funding and needed depositories. It was during this time that these select banks accrued sizable assets. In fact, Silicon Valley Bank had since become the 16th largest bank in the nation via this strategy and others. And one its most impactful approaches involved requiring banking exclusivity from their clients. Preventing them from enjoying banking diversification was a major factor in the large deposits that exceeded FDIC guarantees. 

The problem with the banking exclusivity demands by Silicon Valley Bank and others relates to the effect it has on vulnerable startups. It was a form of a suicide pact! If you engage with the bank, and the bank goes under, you will lose all of your uninsured cash deposits. That means death for companies if it happens!  

A Contagion Designed into the System

With their deposit exclusivity arrangements, the management of Silicon Valley Bank and First Republic Bank created a contagion designed right into the system, one that ensured that if they got sick, all the companies using them would get sick, too.  

Deposit exclusivity arrangements are not necessary to protect bank lending, as many banks and non-bank lenders have alternative lien and lockbox mechanisms to access assets to protect loans. But these arrangements were primarily used to keep inexpensive deposits at the bank for profitability reasons.

Startups struggle with funding, especially when they’re new. Ideally, startups would prefer banking diversification in an effort to protect their financial assets and utilize FDIC protections. 

But when banks willing to provide such capital are scarce, those that do offer support can make unreasonable requests. Like a loan shark preying on a captive audience, Silicon Valley Bank and First Republic Bank included various banking exclusivity clauses in their agreements. As much as anything else, this practice helped to create the dangerous situation that ultimately led to their collapse. 

It’s worth noting that the management at the startups and the venture backers are also at fault here, as they traded deposit insurance for better terms in their loans.

The U.S. banking crisis via a quote from Ed
Does your bank have sufficient insurance to cover your money?

Trapping Uninsured Deposits through Banking Exclusivity Clauses 

 When it came to Silicon Valley Bank’s and First Republic’s banking exclusivity demands, they varied the language and requirements per client. However, in all cases, these clauses limited the means by which companies could enjoy banking diversification. The following provides some specific examples of precisely how these agreements were constructed. These agreements prevented startups from pursuing banking diversification without the threat of losing lending support. 

  • Docusign – In the early days of Docusign, they were involved with Silicon Valley Bank in a banking exclusivity agreement. The agreement was dated May 2015, and Silicon Valley Bank had several demands that prevented banking diversification. These included a requirement that Docusign have all primary depository, operating, and securities accounts with Silicon Valley Bank. With the exception of prior accounts held at Wells Fargo, these were the stipulations Silicon Valley Bank included in the agreement.
  • Dexcom – Dexcom is a maker of diabetes products, and prior to 2016, it had banking exclusivity arrangements with Silicon Valley Bank. In their agreement with the bank, Dexcom was required to maintain accounts at Silicon Valley Bank and to transfer all cash to Silicon Valley Bank within 90 days. Silicon Valley Bank also insisted that Dexcom have a majority of their securities holdings with them. Today, Dexcom no longer has such an agreement and enjoys banking diversification as a result.
  • Edgio – Edgio used to be called Limelight Networks, which also had banking exclusivity agreements with Silicon Valley Bank. Like other agreements, Silicon Valley Bank required all operating, depository, and cash accounts to be in its bank. In addition, however, Silicon Valley Bank also further prevented banking diversification by insisting Limelight use one Silicon Valley Bank credit card. Though Silicon Valley Bank made exceptions for international accounts, it maintained a stronghold over Limelight’s banking activities.
  • Sprout Social – This social media management company went public in 2019. However, prior to this, it also had banking exclusivity arrangements with Silicon Valley Bank. In fact, its agreement was among the most extensive in terms of limiting banking diversification abilities. Clauses required that Sprout Social keep all of its operating, depository, securities, investments and cash collateral accounts at Silicon Valley Bank. Today, this is no longer the case. But it again highlights how common this strategy was for Silicon Valley Bank among startups.
  • Upstart Holdings – This multimillion-dollar online lending platform wasn’t always self-sufficient. It too relied on Silicon Valley Bank asset funding years prior before going public in 2020. Like Sprout Social, Upstart Holdings also had requirements for its operating, depository, securities, investments and cash collateral accounts. Silicon Valley Bank did make exceptions in unique instances for the company to pursue banking diversification with other banks. But even with these allowances, strict limits on funds were cited as to how much could be held. The company no longer has banking exclusivity agreements in place with Silicon Valley Bank.
The numbers don't look good for CS
The banking crash of 2008 saw a couple major banks crumble. This time, Credit Suisse takes the fall.

Hard Lessons Learned

The Silicon Valley Bank/First Republic Bank debacle has left us with some hard lessons that must be learned.

  • As this whole situation arose from a faulty banking strategy, in the future, banks with large uninsured deposit makeups need scrutiny and, where appropriate, some altering and course corrections. In addition, depositors should receive a warning of the increased likelihood of failure when the bank’s uninsured total reaches a certain threshold. Yes, this would be akin to the warning label on a pack of cigarettes, but if that’s what it takes for people to reconsider smoking tobacco and dealing with risky banks, so be it!
  • Company executives and their financial executives need to look carefully at the exclusivity clauses of the banks they’ve engaged with, and lower failure risk from extraneous bank failures. System contagions should not be built into a bank’s strategy. For the companies, are better loan terms worth taking a new risk of a complete failure?
  • The FDIC needs to reassess its approach to bailouts, and specifically tell banks they will not save them if they take on too much risk. Uncle Sam should not save these businesses and banks taking these bad risks, and these businesses and banks should know this!

The Final Word: They Were Bad Bankers

In view of the outcome–failure–it is obvious now that Silicon Valley Bank and First Republic were poorly designed banks that grew by capitalizing on risk that they thought would never materialize. Bank managements sold the banks’ conservative souls for growth. 

It worked for a while.  

In the end? Bank managements took large unnecessary systemic risks. They were just bad bankers.

 

Ed Kopko, CEO and Publisher of Bold Business

      
Edward Kopko
CEO & Publisher
———————
Ed Kopko is BoldBusiness.com’s CEO and Publisher. He has a passion for business, economics and media. A serial entrepreneur, Ed has launched Bold Business to help broadcast the great accomplishments that come from business and entrepreneurial activity. He believes the very real and amazing Bold Impacts that these activities have created also make a micro economic case for trade and commerce. Ed’s previous media experience was as CEO, Publisher and Owner of Chief Executive Magazine and its related media activities. He has been published in many media venues including the Wall St. Journal, Detroit Free Press and Forbes.com. He has also been a sought after commentator and appeared numerous times on CNBC, MSNBC, Fox News and other media outlets.