As the fallout from the collapse of Silicon Valley Bank (SVB) continues to fan outward, a mountain of questions remains about the regulatory failures that let it happen. Federal Reserve chair Jerome Powell — who cited systemic risk as a reason to bail out the bank’s depositors despite explicitly declaring that there was no such risk just two years ago — recently called out its management for having “failed badly.”
“They grew the bank very quickly,” he said. “They exposed the bank to significant liquidity risk and interest-rate risk, didn’t hedge that risk.”
Powell’s statement begs the question of why regulators went so easy on the bank, given the reckless behavior of its management, let alone why elected officials went along with the bank’s lobbying campaign to exempt itself from stricter regulations. These questions are even more pertinent when you consider that SVB’s penchant for riskiness wasn’t a recent development, but a core, highly prominent feature of its public-facing image for decades — and one that had gotten it in financial trouble many times before.
“We Are Good Bankers”
SVB got its start in 1983, shortly after presidents Jimmy Carter and Ronald Reagan and bipartisan majorities in Congress deregulated the banking industry. In an interview decades later, the bank’s founders, Roger V. Smith and Robert Medearis, pointed to this deregulation as a major factor in the bank’s creation, at a time when budding tech creators were on the hunt for capital.
“A lot of them came and wanted to find out how they could get financing from banks because they just weren’t — if you had an idea, venture capitalists weren’t around yet,” said Medearis. “I got the idea that hey, maybe, just maybe, after Reagan came in and eased up the regulatory structure, that there could be a financial institution.”
Medearis explained Reagan’s role in the interview as merely “the easing on the process of the formulation of the bank.” But the deregulation had other benefits for SVB.
The 1982 elimination of interest-rate ceilings opened the door for financial institutions to put much higher interest rates on deposits, with SVB later charging start-ups rates that were between 125 and 325 basis points higher than what major banks charged, serving as a fiscal cushion for the bank as it engaged in risky lending. Deregulation more generally transformed the entire banking system — from a boring industry in which being a banker was just another humdrum job, as it had become after New Deal reforms — back to the high-wage, “innovative,” casino-like sector it had been in the years leading up to the Great Depression. And, as a 1997 Federal Deposit Insurance Corporation (FDIC) paper argued, with restrictions on real estate lending relaxed and new financial products to play with, “many banks shifted funds to commercial real estate lending — an area involving greater risk.”
This was exactly what first got SVB in trouble, as the booming California real estate sector was living on borrowed time. By 1988, the then-four-year-old bank cited its lending to real estate construction as part of its massive growth, its quarterly earnings up 127 percent from the previous year. Three years later, nearly 30 percent of its loans were tied up in Northern California real estate that critics warned was looking worryingly shaky.
“You had to ask: Were they getting high yields on those [real estate] loans because they were smart, taking advantage of the savings and loan institutions being out of the market, or were they getting high yields because of the great risks?” asked one fund manager whose firm had sold its stake in SVB over concerns about its real estate portfolio in August 1991.
Sure enough, by the time California’s worst real estate crash since 1925 was in full swing, SVB was in trouble. Half of the $28 million it set aside to cover predicted loan losses was invested into just one bank’s collapsed commercial real estate enterprise, and the San Francisco Examiner reported that chances were good that the bank “will lose millions.” Its nonperforming assets climbed to a little under 8 percent by the close of 1992, where they had been 3 percent the same time the previous year.
Smith at the time insisted that many bankers hadn’t predicted the severity of the real estate downturn. The bank reportedly also made a criminal referral to federal authorities concerning two commercial clients who had “engaged in allegedly fraudulent business practices against the bank.”
“We are good bankers,” Smith said. “We just got caught up in the failing real estate markets.”
But not many good bankers get slapped with a three-year-long cease and desist order from the Federal Reserve, as SVB did on April 15, 1993, something the central bank says it does for “violation of law, rule, or regulation” and “engagement in an unsafe or unsound practice.” That was one day before the Fed’s board issued a consent order against the bank, which entered into “formal supervisory orders,” according to Securities and Exchange Commission (SEC) filings, under the Federal Reserve Bank of San Francisco and the California State Banking Department.
Under the orders, SVB had to stop paying out dividends, make a slew of changes to its loan policies, improve its loan portfolio, and make a plan to maintain “adequate capital levels subject to regulatory approval,” among other things. The bank carried out “an extensive review” of its loan policies and procedures and “hired experienced loan administrators and loan review officers,” according to filings. Its chief banking officer and real estate division manager both departed, while Smith himself moved down the bank’s hierarchical ladder in the wake of the crisis, from president and chief executive to vice chairman, as the bank went looking to hire a new CEO who would be approved by regulators.
Otherwise, the bank took it in stride. It was soon unloading its underwater housing stock for dirt cheap on the auction market, the head of its real estate division calling anything else a drain on “time that can better be employed on productive things.” While others tried to quietly move on from the fiasco, SVB seemed almost to want to advertise its expunging of real estate.
A Comfort With Risk
The episode seemingly did little to change SVB’s appetite for risk. This had, after all, been a core part of its brand from the start, that of the plucky, forward-thinking bank that lent out to clients other banks wouldn’t touch. In 1991, Smith had told an assembly of venture capitalists that the moment to invest in a firm “is that point in time in which greed overtakes fear.”
“The bank had a comfort level with risk, which made us feel they were the right one to do business with,” one tech executive would later tell the Baltimore Sun. SVB would be there for the early-stage financing, where “we understand their risks” and “we’re willing to take those risks,” chief financial officer Chris Lutes said at the close of the decade. But once firms went public, the bank cut the rope and let them go to bigger, more mainstream banks.
Most banks would insist on collateral, certain revenue and profit levels, or several years’ worth of financial statements and a history of earnings from a prospective client before handing out a loan. Not SVB. “Some banks will say to companies: We want you to be older and have a history of operations before we lend to you,” Smith told the Boston Globe in 1991. “But we have a saying: New is not bad.”
“What’s more relevant is where the company is going and how it’s going to get there,” one of its Boston branch executives explained.
How did SVB figure out where a company was going? “We aren’t that smart. We can’t figure out what’s going to sell in five years,” Smith said, adding that “we don’t spend as much time as people would think analyzing technology.” Instead, executives told the press, the bank looked at factors like a clients’ management experience, cash-flow potential, equity, and if they made products people would want to buy. In one instance, an SVB regional manager bluntly explained that “we piggyback on the venture capitalists’ due diligence,” picking start-ups that venture capital firms had already carefully vetted and invested in.
This didn’t stop SVB from suffering yet more major losses as a result of imprudent lending. In 1998, just five years after its Fed-enforced cease and desist order, the bank was forced to write off millions of dollars’ worth of bad loans to tech companies whose products never made it to market, according to the Raleigh News and Observer — meaning they not only didn’t pay back SVB’s loans, but had no real assets for the bank to claw back some of what was lost.
An SEC filing for 1998 reported $28.9 million in net charge-offs — or the total value of debt that had to be written off after losses were recouped — compared to $5.1 million the year before. More than $17 million worth of loans were charged off in the third quarter alone, a massive increase from the $1.7 million recorded in the same period the previous year. Another three loans worth roughly $11.1 million were judged by management “to have a higher than normal risk of becoming nonperforming,” the filing stated.
SVB disclosed to the press at the time that the cause of its ills were loans the bank had given out to firms in the semiconductor and health care industries, something backed by its SEC filings. Yet the bank had strongly pushed the latter, with its executive vice president Rita Pirkl promoting the industry at multiple biotechnology conferences through 1998. “We’re very bullish on the biotech industry,” she said in May. “We think we’re coming out of a bear market and into a bull market.”
The other problem was the ongoing fiscal crisis in Asia, which had been dragging on since 1997 and which SVB was heavily exposed to, given Silicon Valley’s general reliance on Asian economies importing its products. One analyst had warned seven years earlier about this very scenario hitting SVB, cautioning that “when your fortunes are tied so closely to one business, if it goes through a slump, you go through a slump.” But Smith had waved it away at the time: “Many banks go down this path for a couple of years and that path for a couple of years.”
By this point, SVB had come up with a variety of what the industry would call “innovations” to further cushion itself from the losses its risk-taking begat. It started lending against intellectual property assets like patents and trademarks, at one point entering into a tech version of a type of financing agreement made popular by entertainers like David Bowie, lending $6 million to a firm making digital imaging technology on the back of future royalties from the licensing agreements it signed with other companies. The bank also made heavy use of what was then the new innovation of stock warrants, in which lenders are given the right to buy a company’s stock for a fixed, attractive price, so that they can later sell it for a potential windfall if it goes public or is sold. By 2003, it had 1,818 warrants in 1,355 companies.
“It was unheard of,” Medearis later recalled. “Now, it was not an easy thing to get approved. I really spent a lot of time on that one, and particularly with the lower-level regulators, to get that approved.”
But all this didn’t stop the bank from again falling under the scrutiny of regulators only a few years after their first run-in. In September 1999, SVB entered into an “informal arrangement” with the Federal Reserve and the California Department of Financial Institutions over “issues raised” by both entities, according to its annual report. As part of this arrangement, it had to maintain higher capitalization standards than other banks, improve and regularly report to regulators about its credit policies, and was barred from paying out dividends, incurring debt, or making any acquisitions without getting the regulators’ say-so first.
Yet despite the fact that, as Bloomberg News put it in 2000, “regulators had discovered a small California lender with a history of financial trouble might be binging on risky loans,” SVB’s share price only surged, quadrupling in the same half a year that it operated under regulators’ watchful eye.
An Unbroken Chain
In the years leading up to SVB’s collapse, the bank continued to run up headlines that suggested it was still operating by throwing caution to the wind.
There was its role in the 2008 collapse of HRJ Capital, an investment firm started nine years earlier by three former San Francisco 49ers stars. The SVB money spigot was integral to the firm’s reckless practice of “warehousing”: as a way of proving its connections and access to capital, it promised money to investors that it didn’t actually have, then borrowed millions of dollars from SVB to cover these commitments, in turn repaying the bank with money it got from new investors it drew in.
This house of cards held for five whole years, until the 2008 crisis triggered a credit crunch, leaving HRJ unable to raise the cash needed to pay off a mountain of debt and $68.9 million in the hole to SVB. Even so, in spite of this gross mismanagement, SVB cited the firm’s “strong investment team” as one of HRJ’s “key strengths” in a 2008 filing.
SVB took over HRJ’s funds at the close of 2008, before quickly selling some of its assets — and unbeknownst to the buyer, its legal liabilities — to the Swiss firm Capital Dynamics, as a way of washing its hands of the whole affair. Two former HRJ fund managers sued, alleging that everyone involved had stiffed them on more than $17 million of wages that had been earlier agreed upon, so that the big players could instead secure the debt owed to SVB. The bank settled for $2 million with the plaintiffs in 2012, who eventually won their case and got a further settlement payout.
At the same time, SVB continued to maintain its well-publicized brand of taking the kind of risks other banks wouldn’t dare. “They are willing to kiss a lot of frogs; they meet a lot of companies that don’t get very far,” the Los Angeles Times quoted one client as saying, an employee management services company that secured loans from the bank on the back of future revenue from work it hadn’t actually done yet. “But that willingness to work with riskier clients puts them in an advantageous position later on.”
Then, in 2021, SVB was the victim of what federal prosecutors called “brazen fraud” by private equity manager Elliot Smerling, who used forged documents to get a $95 million line of credit from the bank, leaving it with a potential loss worth $70 million. The bank was handing out the loan via a subscription line, a type of loan popular for its speed and lower administrative burden, by which money is lent out based on investors’ pledged commitments to the debt involved, rather than actually drawing funds from investors. Though subscription lines were originally a type of short-term bridge loan, their use has exploded in popularity in recent years, partly a result of the past decade or so of low interest rates.
According to the criminal complaint, Smerling’s forgeries had numerous problems. That included the fact that the firm meant to have audited his fund neither had him as a client, nor had its current address listed on the forgery he made. There was also the fact that the signature provided for the chief investment officer of one of the university funds meant to have committed $45 million to Smerling didn’t match the officer’s real signature.
Smerling’s ability to get the massive loan from SVB despite these issues inspired consternation in the private equity world over the lax due diligence involved in subscription credit lines. This was particularly relevant for SVB, which had disclosed that such lending was its largest source of loan growth over the preceding seven years, and more than half of its total loans.
“The bottom line is that there is no direct contact by the bank with investors in the vast majority of these transactions,” one industry player told private equity trade publication Private Funds CFO. “The market has definitely moved to a position where there is a little bit more of a trust factor involved,” a banker likewise told the outlet. “You’re not validating individual investor commitments, which used to be part of more standard operating procedure.”
Financial services firm SEI Investments concluded that the importance of “thorough operational due diligence” was the lesson of the episode, noting that had SVB carried out a background check on Smerling, it would’ve found a 1993 bankruptcy in his history. Reflecting on this and similar incidents, an industry panel similarly decided that the big takeaway here was “know your borrower” — something one would think would have already been a preexisting practice, especially given the vast sums of money involved.
SVB (Scandal via Banking)
SVB’s existence has been one long series of red flags, from its multiple run-ins with regulators, to its history of financial troubles, to its self-conscious promotion of its risky practices as a virtue.
This kind of fly-by-the-seat-of-your-pants financial derring-do may have passed muster when SVB was, to quote one analyst at the turn of the century, an “itty-bitty, teeny-weeny bank” with only $3.7 billion worth of assets. But by the time it folded in March this year, and the Fed chair deemed it a systemic risk necessitating a bailout, it was the sixteenth-largest bank in the United States with more than $200 billion in assets, demanding greater scrutiny of its behavior.
The question is why this scrutiny didn’t come until too late, and how, despite its checkered history, SVB was allowed to grow and grow with seemingly little check on its behavior — even having regulations lightened on itself through a powerful lobbying effort. Perhaps a better question is how many more times we’ll allow this tragic, avoidable history to repeat.