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
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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..
