To say these are unprecedented times in the financial services industry is a vast understatement.

From layoffs, tech companies contracting, difficulties in fundraising and the changing regulatory environment — we’ve seen a bit of everything in the last 12 months.

What have we not experienced? A financial institution shut down. By the end of Q1 2023, there will be at least 3 banks with disruptions to their operations and regulators taking action.

The economic sentiment, increasing rates, and worries of recession are at a fever pitch. Bank customers concerned about large balances and their bank’s viability are making waves (of withdrawals) over the last month. Here’s what has taken place with Silvergate, Silicon Valley Bank, and Signature Bank — and where the financial services industry goes from here.

Silvergate

Silvergate was one of two premier banks for the cryptocurrency sector, providing a traditional banking connection between fiat & crypto payments processing since 2013. Originally a commercial real-estate lender with branches in San Diego, the bank pushed for deposits to boost operations — thus, crypto firms were welcomed within a year of launch. Silvergate would sell off most of its traditional banking lines of business to mostly target clients and institutional investors in the crypto space.

The bank launched its own internal settlement tool, the Silvergate Exchange Network (SEN), as part of its commitment to this sector. Institutional investors were able to move dollars in and out of crypto-trading platforms via SEN. The company went public in 2019 and disclosed that there were 750 crypto clients running on its platform.

As top digital asset platforms started to struggle last year and market valuations decreased, depositors lost value in holding crypto. Crypto-related deposits dropped 68% in Q4 — to make these deposits whole upon customer request, Silvergate was forced to liquidate securities on its balance sheet. A total of $718M was lost in selling the debt. Combined with the FTX collapse, its stock price sharply declined in Q4 2022.

The regulator clamp down on stablecoin yield and DeFi programs expedited the movement toward fiat. In January, there was a tri-party announcement from 3 of the top US regulators (Federal Reserve, the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp.):

“[there are] risks of “significant volatility in crypto-asset markets, the effects of which include potential impacts on deposit flows associated with crypto-asset companies and contagion risk within the crypto-asset sector resulting from interconnections among certain crypto-asset participants, including through opaque lending, investing, funding, service, and operational arrangements. These interconnections may also present concentration risks for banking organizations with exposures to the crypto-asset sector.”

Bank clients sought stability with fiat (USD) and bank rates, which resulted in a wave of outflow from Silvergate. Deposit levels were no longer as ‘sticky’, yet the bank had long-term obligations tied to customer deposits (i.e. mortgages, lending, and long-term savings). Silvergate took out approximately $4.3B in loans last year from the Federal Home Loan Bank of San Francisco. The run on deposits forced the bank to sell assets at a significant loss in order satisfy billions in withdrawal requests from January through March.

Last week, Silvergate announced that it would "voluntarily liquidate" assets and wind down operations. All deposits to be repaid in full. Major clients had already started to shut down their accounts and other companies (such as crypto platforms Coinbase, Circle, Paxos) announced that they were cutting off ties with the bank.

Despite voluntarily winding down, Silvergate became the first major bank collapse since October 2020. Its nearly 10-year crypto banking program collapsed in months. Revamping its business model to prioritize serving crypto-related firms was a risky move that it was unable to recover from.

OUTLOOK: The cryptocurrency sector is still heavily dependent on traditional banks, fiat conversion, and standard payment rails. This is how crypto firms pay employees, vendors, and facilitate money movement in/out of digital currencies. Bank partners are needed to enable these services. With the restrictive regulatory space and worsening sentiment, banks won’t be open to this sector anytime soon unless clear guidance from regulators surfaces.

Silicon Valley Bank

The ripple across banks continued last week as SVB (16th largest bank in the US known for serving tech startups) was forced to abruptly shut down by the FDIC on Friday (March 10) during trading hours (as opposed to end of business day). Regulators took swift action as they felt the bank presented substantial risk to the US economy.

Two days before, Silicon Valley Bank announced a $1.8B after-tax loss and needing to raise additional capital to cover depositor requests. The market quickly reacted, leading to more than $160B in value lost. SVB had $209B in assets and $175.4B in deposits at the time of shut down.

As the stock price tumbled, customers quickly made more withdrawals. Since banks only carry minimal deposit reserves in cash, the bank liquidates long-term bonds to cover the outflow. These investments were purchased during the pandemic (when rates were low) and sold at a loss in today’s higher rate environment. Unable to cover obligations to clients, the bank run deepened and pushed the FDIC to step in.

Over the weekend, the FDIC announced it would backstop SVB customers uninsured deposits. Prior to this announcement, companies only had access to $250K in deposits (the standard amount of coverage from the FDIC).

Many of SVB's depositors are technology workers and venture-capital backed companies. Startups and founders scrambled to find emergency alternatives to make payroll and cover short-term financial obligations. Other companies who weren’t depositors, relied on SVB for payment processing and treasury management services that are core to their operations. Within the span of days, these platforms were forced to find new banks & vendors to quickly replace the loss of services.

The leading bank for tech had faced fierce competition coming into 2023 from fintechs (such as Mercury) and bank rivals (such as First Republic Bank, CrossRiver). Deciding not to offer higher deposit yields or having subpar tech capabilities (compared to fintechs), led customers to switch banks to SVB’s competitors.

The clients that did stay with the bank were mostly mature, venture-backed companies experiencing high cash burn (prioritizing spend on growth that can lead to a higher valuation). A low volume of depositors with large balances magnifies the exposure to concentration risk. SVB’s customer deposits (often used for lending & investment) decreased at a faster rate than standard banking clients, making this a cost center (instead of profit center) for the bank.

OUTLOOK: Despite not being crypto-centric, Silicon Valley Bank faced similar struggles as Silvergate in being a niche-focused financial institution. The majority of its revenue tied to the startup sector began to unravel as companies struggled to raise additional funds (bank deposits) and the Fed increased rates (making it expensive for banks to keep customer balances). Increasing competition and the rate of outflow made the situation worse in the last months — it took a bank run to bring operations to a standstill. Spreading its focus to non-startups and other revenue streams may have helped weather the storm long enough for rates to subside, but this would mean no longer being the ‘bank for tech.’

SIGNATURE BANK

Alongside the FDIC’s announcement on Silicon Valley Bank last week, the customers at Signature Bank (another crypto-focused institution similar to Silvergate) made a run of $10B in withdrawals. This would lead to the 3rd largest US bank failure — regulators stepped in to protect depositors and the industry at large.

Signature first launched in 2001 as a business-focused alternatives to larger banks. In 2018, the institution welcomed crypto companies as clients, received a jump in deposit volume, and created a payments network for these platforms (processing & settling around the clock). The institution (based in New York) had 40 branches, $110B in assets and $88B in deposits (at the end of last year).

Signature’s fallout was directly tied to the negative sentiment with SVB. Executives looked for ways to raise capital quickly or potential acquisition opportunities at the end of last week. The run on deposits slowed over the weekend, but regulators still decided to step in and explore a sale process for the bank.

OUTLOOK: Similar to Silvergate, the concentration of crypto business clients posed a high risk to the bank. It’s unclear if regulators acted too quickly as Signature Bank had not showed any other signs of stress or reporting of losses. The open question lingering in the industry: where will US-focused crypto companies bank? If tech startups as a whole are now seen as risky, this may place crypto beyond the risk appetite of any chartered financial institution in the US.

WHERE THE INDUSTRY GOES FROM HERE

The fear from customers that uninsured deposits could be lost or locked up is causing large outflows at banks across the US. First Republic Bank and regional community banks may be the next in line. Small banks aren’t meant to absorb losses from a concentrated business sector.

Bank stocks are falling. Government leaders are doing their best to reassure all parties that the US financial system is safe.

For financial institutions, there’s a need to take a step back and evaluate the depositor mix that they currently have. Many already had a ‘no-crypto’ policy in place — however, startups (especially those with traction) were still welcomed. Even large banks (such as JPMorgan Chase and Wells Fargo) have technology banking divisions that cater to seed to late stage companies backed by VCs. Being the ‘bank of tech’ or ‘bank for crypto’ is more of a liability than a value-added differentiator.

For banks still committed to serving these segments, there will need to be increased rigor in capital requirements and long-term investment strategies to avoid a repeat of recent events.

In terms of the impact to the overall industry, a more thought-out approach that is wary of concentration risk should come out of all this. Crypto companies (especially non-enterprise firms) will struggle to find an established bank. The few remaining options will likely come from neobanks and challenger banks with a calculated risk exposure to partner banks. VCs have been outspoken in the last week about their portfolio companies presenting banking alternatives to Silicon Valley Bank.

Startups would look for higher-FDIC coverage and banks with diversified holdings, which are able to weather challenges in one or more areas of their business. Tech bankers should take a custom approach with each startup that covers expected deposit balance and withdrawal needs, which can help minimize swings in transaction activity.

The theme from regulators on the crypto sector is clear — coming off of the January announcement regarding concentration risk, they can easily be saying “I told you so” and they’d be right. Financial institutions can continue to avoid this area, but at some point these businesses will need to be part of the US financial system. It’s a heavy lift to ensure proper controls and compliance are in place, but this is the only way forward.

Lastly, scrutiny of capital reserves (quantity & quality) and banking operations by regulators should be another takeaway for the industry. Banks with high-volume depositor segments may need a higher ratio of liquid reserves to minimize the risk and impact of bank runs.

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