Week 3 | SVB Is Totally A Prisoner’s Dilemma

I just had an idea come to mind… I want to model my economic game off of the Silicon Valley Bank (SVB) bank failure. I imagine that you might have some questions about how I aim to do that, or even what the whole situation is about. I hope this blog post can address those questions~~ 

What happened? 

The latest fiasco in the banking industry and possibly the largest ever bank run in United States’ history—SVB. Essentially, a bank run happens when many customers simultaneously withdraw their funds, leading to liquidity and insolvency issues for the bank. In the case of SVB, $42 billion of deposits were withdrawn on March 9th, and the bank was shut down by federal regulators on the following day. 

What is SVB? 

SVB was owned by parent company SVB Financial Group and it held $211 billion in total assets by the end of fiscal year 2022. SVB primarily catered to startups and venture-backed firms, which all had great amounts of deposits in the bank. 

What caused SVB to collapse? T

he bank run was a huge contributing factor, but it was sort of the end result and doesn’t account for the factors that led up to it. 

As SVB grew during the COVID-19 pandemic, it utilized its deposits to invest in long-term treasury bonds. These investments are generally low-risk since they are protected by the United States government. 

However, with rising interest rates to combat high inflation, the value of the bonds that SVB invested into decreased. This is because newly issued bonds carry higher interest rates and are thus more enticing to investors than the pre-existing ones, which drives the value of already-issued bonds down. This propensity for bond value to change based on interest rates is known as duration. 

Alright, so SVB’s portfolio of investments were decreasing in value. But could they have held onto those bonds until maturity and they would’ve been fine? 

Yes, SVB would’ve been fine if they held onto those bonds, collected their coupons, and waited until maturity. However, the bank needed money to accommodate customer withdrawals, so it sold some of its treasury bonds at a value less than par value. This resulted in a $1.8 billion loss.

 Why didn’t the bank have any cash in its reserves in the first place? This dates back to 2018, when President Donald Trump changed a provision in the Dodd-Frank Act. Originally, the act subjected banks with more than $50 billion in assets to tougher regulations and risk assessments. This was put in place after the 2008 financial crisis as a safety measure. Trump’s Economic Growth, Regulatory Relief, and Consumer Protection Act loosened the requirement to banks with over $250 billion in assets. As a result, SVB wasn’t under any scrutiny by federal regulators. 

In addition, the COVID-19 pandemic witnessed a change in United States banking from a fractional reserve system to a no reserve system. In the past, banks were required to keep a portion of their deposits on hand; however, in an effort to boost the economy during the pandemic, reserve requirements were removed so banks could lend more money or invest in securities. 

Well… SVB used the extra cash to invest in treasury bonds, and high interest rates led to an overall loss on those investments. 

Okay, so it seems like high interest rates played a pretty big factor in SVB’s collapse. What led to high interest rates in the first place? 

Raising interest rates is a strategy used by the Federal Reserve to combat high inflation. In order to slow the economy down, higher interest rates will lead to less consumer demand and spending as people borrow less money (the cost of borrowing is more expensive and the return on savings is greater). 

Technically, the Fed is only changing the federal funds rate, which is the interest rate for commercial banks to borrow and lend amongst each other. However, this change has a rippling effect across consumer loans, such as mortgages, auto loans, and lines of credit. 

Inflation. Every problem seems to come back to inflation. Is there even a root cause? No one can pinpoint a single event or moment in time that spurred high inflation in the macroeconomy. Inflation is a lagging indicator, meaning that it reflects past performance. We don’t really know whether we’re experiencing inflation until the high prices start to hurt our pockets. 

The COVID-19 pandemic, government stimulus checks, supply-chain issues, the Russo-Ukrainian war… they can all be said to have contributed to high inflation. 

Back to my project… 

Ahahaha, that was a pretty big tangent, yet what I summarized is only the tip of the iceberg. But seriously, the whole situation is genuinely very interesting and I think we can extract a lot of things to be learned from this bank failure.

As I mentioned earlier, SVB would’ve been fine if they held onto their portfolio and if clients cooperated/did not withdraw everything all at once. Sound familiar? Yes, I think the situation is like a mass-scale prisoner’s dilemma where SVB and the clients chose the most rational choice for themselves, missing out on the socially-optimal choice for everyone. 

That revelation sparked something in me LOL. If the choices leading up to SVB’s collapse can be explained by behavioral finance, I can model it using an economic game. I’m hoping to apply different treatments so I can study potential ways that SVB could’ve prevented the bank runs. 

For example, perhaps not spooking out their customers and telling them they lost $1.8 billion? (Even though that’s not transparent and I am in no way advocating for that). In addition, the Fed came in too late to reassure clients that their deposits would be guaranteed. That’s also a potential problem I can explore. 

Still a lot of thinking and brainstorming to be done… How will I create the game to best model SVB?  

Dr. Wang and I are hoping to churn out some details at our meeting next week. This was not what I was thinking of originally (since I could not foretell the future back in December), but it actually fits quite well into what I wanted to study.

Fingers crossed, 

Cindy 

Sources https://www.axios.com/2023/03/11/the-largest-bank-run-in-history https://www.cnbc.com/2023/03/10/silicon-valley-bank-collapse-how-it-happened.html https://www.cnbc.com/2023/03/17/financial-psychology-and-bank-runs.html https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp https://www.investopedia.com/terms/r/requiredreserves.asp https://www.investopedia.com/what-happened-to-silicon-valley-bank-7368676