Introduction
Before the end of last week (10 March 2023) it would be fair to assume that the name “Silicon Valley Bank” (“SVB”) was not a household name. SVB was formed forty years ago, according to some of the recent and heavy press coverage, following a game of poker in which a couple of financiers saw an opportunity to provide specialist banking services to technology businesses. By the start of this week – 13 March 2023 – there will be few people, both in and outside the technology sector, who have not heard of SVB or the dramatic sequence of events leading to its collapse and the spectacular rescue of the UK subsidiary through its sale to HSBC. This note looks at the events leading to the failure to SVB, both in the US and the UK. It then looks at the way those failures were resolved, and concludes with some of the practical lessons arising from the biggest banking failure in the US since Washington Mutual in 2008.
Above all, the SVB saga is a salutary reminder of an often overlooked fact. Money “deposited” in a bank account does not belong to individual bank customers. All those customers receive is a debt claim against the bank concerned. Where the bank’s assets are less than its liabilities, those debts will not be repaid in full. Most importantly, SVB has reminded us that at the end of the day, the viability of any banking institution is founded on the trust and confidence of its depositors. Lose that trust and confidence and the business model will unravel in days, perhaps even hours.
SVB US
Until 10th March, SVB’s US business was one of a number of specialist financiers for the tech sector. SVB held itself out as being able to meet the technology sector’s need, both for specialist lending facilities and for a low-risk home for the cash balances accumulated by many start-up technology businesses. A distinguishing trait of these businesses is that in their initial phase of existence, incoming cash flow will be weak, whilst the proceeds of funding rounds need to be held as safely and accessibly as is possible to meet day-to-day operating expenses. The result was that SVB in the US had in total fewer than 38,000 customers. The greater part of those customers – nearer to 90% - had placed deposits with SVB that were many times in excess of the US $250,000 deposit guaranty amount payable on the failure of a United States credit institution.
SVB had invested much of the funds paid to it by customers into government bonds – low risk financial instruments paying out low interest rates. In the pre-Ukraine fiscal climate, that was a reasonable treasury management strategy. However, as interest rates rose, SVB found itself sitting upon substantial unrealised losses. This was because as trading conditions worsened, SVB’s customers steadily withdrew deposits to meet their day-to-day expenses. To meet those withdrawals, SVB sold a material part of its bond portfolio. However, the effect of the steady upward move in interest rates against bonds resulted in the crystallisation of a US $1.8 billion loss. In order to meet that, in the week commencing 6 March 2023, SVB launched a US $2.2 billion share issue. SVB’s management also stated that the share issue was not a reason to panic.
Neither SVB’s depositors nor the wider financial markets accepted this request for calm. Within two days, depositors in the US withdrew a fifth of SVB’s deposits – US $42 billion. In the meantime, the share issue proved unsuccessful with only US $500 million of new capital raised.
On the afternoon of 10th March 2023, the US regulators called a halt to proceedings placing SVB US into receivership. The objective of the receivership was to allow depositors access to their deposits - initially only to the US $250,000 guaranteed amount of those deposits. Over the weekend, the US regulatory authorities announced that all deposits would be underwritten by the Insurance Guaranty Fund. A new financial institution – Deposit Income National Bank – was established to give depositors immediate access to their funds and in so doing, prevent the cashflow paralysis within the tech sector, that would have been likely to result, had customers been denied access to their funds and become in consequence less able to meet payroll and other suppliers’ costs.
A fundamental difference between the position in the US and that in the UK following the HSBC purchase of SVB UK is that borrowers from SVB in the US will need to make alternative arrangements to replace lines of credit previously available to them through SVB.
In the immediate aftermath of the failure, the shares in a number of financial institutions came under pressure. That has particularly been the case with the smaller US credit institutions, such as First Republic Bank whose shares lost 65% in value before trading was halted.
Silicon Valley Bank UK Limited (SVB UK)
Until September 2022, SVB’s United Kingdom operations were conducted through a branch of SVB. In September 2022 and as a part of a wider expansion drive, SVB’s branch assets were transferred into a wholly owned subsidiary of SVB, Silicon Valley Bank UK Limited (“SVB UK”). SVB UK’s operations thus came under the supervision of the Financial Conduct Authority (“FCA”), PRA and Bank of England. SVB’s United Kingdom operations amounted to 15% of its total business. In addition, SVB was conducting business through a Canadian branch and a Chinese joint venture. The Canadian banking regulator took control of the Canadian branch on the evening of 12 March 2023.
By the start of 2023, SVB UK employed approximately 650 staff and held deposits of some £7 billion. Once again, a material proportion of these deposits - more than 50% - exceeded the Financial Services Compensation Scheme threshold of £85,000 per individual customer. Initially, SVB UK maintained that it was a freestanding business and that its customers need not be concerned by the events in the US. Late on the evening of 10th March, the Bank of England stepped in. The Bank announced that absent any “meaningful further information” it would apply to the Court to place SVB UK into a bank insolvency procedure.
In substance, “bank insolvency” is liquidation. The principal objective of a bank insolvency is to enable eligible depositors to be paid up to the protected limit of £85,000 per depositor. The Bank of England’s statement continued by saying that as SVB UK had a “limited presence” in the UK and “no critical functions” supporting the financial system, this was the most appropriate course of action to be taken in respect of SVB UK. The statement concluded by saying that SVB UK would stop making payments to customers or accepting deposits.
In short order, around 200 tech chief executives lobbied the government, stressing that without a timely intervention, their companies would be unable to make payroll or pay suppliers, with the result that many of them would collapse. The position of those with SVB credit lines was exacerbated since the result of the Bank of England’s action was to remove access both to those credit lines and deposits.
Over the weekend, messaging from government shifted, with statements that the Treasury and Bank of England were working “at pace” to come up with a solution that protected tech companies from what had been described as “existential threat” to the industry sector. The sale to HSBC was negotiated and implemented over the weekend and announced early in the morning of 13 March. It followed an intense series of negotiations and expressions of interest from the Middle East investors and a series of UK challenger banks, including OakNorth.
The transfer of SVB UK to become a subsidiary of HSBC took place under the special resolution regime put in place by the Banking Act 2009 in the immediate aftermath of the 2008 global financial crisis and subsequent nationalisations of the Royal Bank of Scotland and Lloyds Banking groups. The private sector transfer is one of five “stabilisation options” prescribed by the Banking Act 2009. At the opposite end of the spectrum to sale to a private sector purchaser is “temporary public sector ownership”. The other “stabilisation options” include transfers of assets to asset management vehicles, or to a temporary “bridge bank”. The conditions for “resolution” include that a bank is “failing, or likely to fail”. The resolution process must also satisfy specific objectives set out in the Banking Act 2009. These include “protecting and enhancing” the stability of the UK financial system, public confidence and the protection of public funds, investors, depositors and client assets.
Commentary
In the 48 hours preceding the sale, we – along with some other commercial law firms – had received requests for urgent assistance from clients for help in understanding SVB UK’s position, strategic options support and, in some cases, urgent assistance in raising additional funds. In the most extreme situations, the managers and founders of SVB UK’s tech customers were facing the possibility of having to shut up shop on account of lost liquidity and access to credit facilities. For all of these businesses – as well as the UK Government - the successful sale of SVB UK to HSBC represents the best of all worlds. SVB UK’s depositors can once more and in short order access their cash balances and credit facilities. Payrolls will be met, suppliers’ invoices settled and investment plans preserved. For the UK Government, damaging political fallout has been averted, all without the need for the heavy investment of tax payer’s funds pumped into RBS, Lloyds Banking Group and others in the height of the 2008 financial crisis.
SVB UK: Some Lessons?
It is of course all too easy to be wise after the event. However, the turbulence in the market caused by the failure of SVB highlight a number of practical lessons that are all too easily forgotten unless or until the “unthinkable” occurs. They are as follows:
- Remember that cash deposits are, ultimately, loans to the relevant account provider. Think carefully about the credit quality of the account provider (particularly if well above market rates are on offer). This applies equally to e-money / prepaid card providers. We expect the recent events surrounding SVB to prompt market participants to refocus on credit quality of institutions holding debtor group cash deposits.
- Having few – strong – banking relationships can bring efficiencies. However, balance that against the possible risks of having all your “eggs in one basket”. For many early stage businesses this will be unavoidable (in part given the practice of lenders to insist on being the sole or main banking provider to their early stage borrower clients) but, even for early stage business, it is worth keeping the concept in mind.
- Related to the previous point, try to avoid agreeing to any request from a lender that all cash deposits should remain with that lender and no one else. We expect borrower groups to re-focus on the risks of accepting such requirements and seek to agree a right to maintain at least some meaningful cash resources with other institutions.
- Know your cash flows. In the immediate aftermath of the SVB turmoil, those clients who knew what alternative sources of funds were available to them, along with the timing and amount of their major overheads such as payroll and rent, were the ones best placed to ride the immediate uncertainties thrown up by the SVB crisis.
- Be aware of the extent, timing and specific wording of borrowing covenants. Where a lender encounters financial difficulty, the delay in (or restrictions on) access to and any reductions in liquidity could (depending on the drafting) end up making an otherwise routine covenant test become instead a problematic process.
- In financing transactions involving a lender group (such as club or syndicated deals), borrower groups should consider using any available syndicate management tools (such as defaulting lender term out, yank and other related devices commonly available in the market) as a mitigant to the impact of longer term individual lender distress. Borrowers going into new deals should re-focus on these devices and seek as far possible to ensure they are included in new deal documentation.
- In bilateral scenarios, where possible, borrower groups might re-focus on the situations in which payment obligations (such as commitment fees or exit fees) are payable and try to limit the obligation to pay for any period whilst the lender is in default or the exit results or occurs when the lender is in default. This has historically not been an easy point for borrowers (other than sponsored or the stronger corporates) to win in bilateral deals. Typical market hedging documentation includes devices to suspend payment obligations to defaulting counterparties – borrowers entering into new hedges should, where applicable, ensure those provisions are included and not amended.
- Keep clear and up to date lists and copies of all facility and security agreements. If the unthinkable happens – and in particular, if your financial institution enters resolution or bankruptcy proceedings - you may need to be able to prove your credit and asset position to potential new funders in very short order and in competition with others facing similar pressures. If market conditions harden, it really will be a case of “first come, first served.
- As a general matter, when financial stress/distress is forecast, early engagement with creditors is advisable. However, the speed at which the SVB situation developed and its effect on a wide range of otherwise performing businesses meant many businesses may have been caught by surprise. Having a contingency plan and agreed team structure in place that can be implemented at short notice and out of business hours if necessary could be invaluable.
- Be ready to seek – and act upon – competent and timely financial and legal advice.
As the events of this last weekend show, do not be afraid to think the unthinkable. Experience shows that the unthinkable does indeed happen – generally at the most unexpected and unwanted of times.
