I’m going to try and explain this ELI5 (explain like I’m 5) style.
Fundamentally, banks borrow short in order to lend long. By taking deposits that can be withdrawn at any time and compensating depositors with peanuts, they lend money out at a higher interest rate to others.
And when they loan this money, it could be in the form of mortgages, commercial loans or investing in long-maturity assets.
When a large quantity of depositors withdraw at the same time, they have to sell some of these long-maturity assets to meet these redemption needs.
Normally, this wouldn't be a biggie. If interest rates were constant all the time, they would simply liquidate these assets and get back what they paid for.
The problem arises when interest rates rise…
Now imagine you bought an asset for $100 paying 5%.
You’ll $5 in interest per year.
Now, imagine if interest rates rose to 10%.
Meaning, an asset at $100 paying 10% will give $10 in interest per year.
In order for you to sell the asset paying 5%, you have to offer a discount (or haircut in finance parlance).
Otherwise, no one will buy your asset from you! They would much rather buy from the market and get $10 on their $100 investment.
To match the market, you’ll have to sell your original $100 investment at $50!
Because it only pays $5 in interest, the new buyer demanding a 10% interest will only pay $50 for your asset.
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And this is what happened to SVB, they had to sell their long-maturity assets at a loss to meet redemption needs!
SVB didn’t buy insurance against interest rate increases
Now, borrowing short to lend long is actually pretty normal in the banking industry.
The mistake SVB committed was that they didn’t buy insurance (again, in finance parlance, interest rate swaps) to protect themselves against interest rate increases.
As with the insurance you and I purchase, there’s costs involved but it protects us against catastrophic events.
And in this case, SVB is like that friend who thinks that insurance is a waste of money and decided that they didn’t need it.
If you are wondering how they saved in expenses for not insuring themselves, it is a whopping 0.4% increase in net interest margin according to the Financial Times.
*Clarification: The proper term is called interest rate swaps, not insurance. But the idea is the same, they were going for higher yield and decided not to swap the fixed rates back to floating rates using interest rate swaps.
Banks are in the business of trust
When news broke out that they’re in trouble, former SVB CEO Greg Becker told everyone to “stay calm” and that “everyone says that SVB has problems, but it’s not.”
That’s a horrible way to communicate. It’s like telling someone who is fuming to chill. It doesn’t work that way.
Peter Thiel’s Founders Fund told its companies to pull money out of SVB and many others ensued.
And there you have it, SVB bank run, ELI5 style.
