In the years before Silicon Valley Bank’s sudden failure, federal regulators gave the firm a special exemption from rules designed to prevent deposit-taking banks from engaging in risky investments and financial speculation, according to records reviewed by The Lever.
The move — which was a precursor to regulators later extending a similar exemption to the entire banking industry — coincided with Silicon Valley Bank, or SVB, continuing to invest in the high-risk venture capital industry in the lead-up to its collapse, which is the second-largest bank failure in U.S. history.
As the federal government now protects SVB’s depositors from losses, the bank’s demise has touched off alarms about broader risk in the financial industry, just a few years after both lawmakers and federal bank overseers began rolling back some of the reforms that followed the 2008 financial crisis.
In this particular example of that deregulation, the Federal Reserve created significant carve-outs to the so-called Volcker Rule, named after former Fed chairman Paul Volcker. That regulation was supposed to prevent federally insured banks from owning or investing in private equity or hedge funds — opaque pools of assets that are considered illiquid, meaning they cannot be easily sold and turned into cash.
In 2017, the Fed granted SVB a five-year reprieve from the Volcker Rule. The decision allowed SVB, a major lender to the tech industry, to remain a traditional deposit-taking bank while also maintaining its risky investments in venture capital — a form of private equity that funds startups in the tech industry, which has recently been battered by mass layoffs and financial losses.
A few years later, the Trump administration effectively granted this same exemption to the whole banking industry, allowing banks to sponsor and invest heavily in venture capital funds. As a result, SVB was able to continue investing in assets that the Fed deemed too risky for a federally-insured bank in 2017.
Although SVB was an outlier in terms of its high exposure to venture capital funds, other banks that became distressed as turmoil spread this week are also known for investing in and working with VC funds, including First Republic, PacWest, Western Alliance, Customers Bancorp, Zions Bancorp, and Comerica.
Experts say the pool of venture capital investments that regulators permitted to remain on SVB’s balance sheet is worth examining when determining the causes of its collapse last week. Many of those assets were illiquid. Shortly before SVB failed, the bank was forced to sell off almost every one of its assets deemed “available for sale,” according to the Financial Times. That effort led to heavy losses and ultimately helped accelerate the run on the bank.
“We’ll never know if the bank would have collapsed had it followed the standard rules, like Volcker, and best practices,” said a former congressional aide who helped draft the legislation establishing the basis for the rule, who was unauthorized to speak publicly on the matter in his current role.
He noted, though, that SVB had substantial venture capital investments, and said that analyses of the bank’s collapse should consider whether it was appropriate for regulators to permit such activities.
Enabling Banks To “Engage In High-Risk Activities”
SVB’s business was closely tied to the venture capital industry. The bank, founded in 1983, invested in venture capital and loaned tens of billions to VC firms to help them manage their cash flow. Venture capital-backed tech firms were also big depositors at SVB.
The bank’s growth prospects faced headwinds when Democrats passed their 2010 Dodd-Frank Wall Street reform law, in response to the 2008 financial crisis. That’s because the law included a long-delayed provision, called the Volcker rule, which was supposed to prevent banks from putting their money into riskier private equity and hedge fund investments.
In 2012, SVB lobbied the Obama administration to exempt venture capital investments from the Volcker rule. “Venture investments are not the type of high-risk, ‘casino-like’ activities Congress designed the Volcker Rule to eliminate,” the bank wrote in a letter to federal regulators.
However, the final Volcker rule issued by the Obama administration, which went into effect in 2015, did not exclude venture capital. Officials explained that “Congress explicitly recognized and treated venture capital funds as a subset of private equity funds in various parts of the Dodd-Frank Act.”
Still, the Fed granted SVB their Volcker Rule exemption in 2017, with Federal Reserve officials justifying the decision by saying that the bank needed time to “conform its ownership interest” in “illiquid funds.” Agency officials enumerated which funds concerned them in the exemption letter, but the list was redacted. The Fed did not respond to a request for comment, but did announce Monday that it would be reviewing its supervision of Silicon Valley Bank.
Public records indicate that the list of illiquid investments referred to VC-linked funds. In its latest annual report, SVB discussed the expiration of its Volcker Rule exemption in July 2022, and said that it never needed to fully comply with the Fed’s request to reduce its exposure to illiquid assets because regulators eventually extended a Volcker Rule exemption for venture capital investments to the entire banking industry.
The industry-wide exemption, which went into effect in October 2020, was a major victory for SVB, after the bank spent years lobbying for the outcome.
When that venture capital carve-out was proposed in January 2020, Federal Reserve Chair Jerome Powell said that banks offering “limited service” to venture capital did “not raise the types of concerns the Volcker rule was intended to address.”
SVB was a member of two lobbying groups, the American Bankers Association and Bank Policy Institute, that submitted regulatory comments backing the exemption.
One member of the Fed Board of Governors publicly questioned the proposed exemption.
“I am concerned that several of the proposed changes will weaken core protections in the Volcker Rule and enable banking firms again to engage in high-risk activities,” said Fed Governor Lael Brainard, a Democrat who now serves as a top economic aide to President Biden, in a dissenting vote on the carve-out. “The proposal opens the door for firms to invest without limit in venture capital funds and credit funds.”
“A Piece Of The Puzzle”
SVB’s balance sheet ballooned in the years after the Fed first granted the bank its Volcker Rule exemption in 2017, as deregulatory policymaking and low interest rates fueled the proliferation of tech start-ups.
One trade publication reported that 55 percent of the bank’s loan portfolio, which grew to $61 billion by late 2021, consisted of loans to VC and private equity firms, which in turn brought the bank “a surfeit of low-cost deposits” from startups “in the technology, health care, and life sciences industries.”
When the new industry-wide exemption went into effect in October 2020, SVB grew more emboldened to expand before running into headwinds in 2022, as deposits and asset valuations shrank as the Fed hiked interest rates. But the bank’s illiquid funds could stay on the books, managers noted, thanks to the Fed’s light-touch approach to venture capital assets.
“As a result of various subsequent amendments to the Volcker Rule,” SVB wrote last year, “we believe that substantially all of our Restricted Volcker Investments (i) qualify for new exclusions under the amended rules, (ii) otherwise are excluded from the definition of ‘covered fund’ or (iii) commenced or completed a liquidation or dissolution process prior to July 2022.”
The firm noted that these amendments included “the adoption of new exclusions from the definition of ‘covered fund’ for venture capital funds and credit funds.”
But all of these investments were inherently highly risky, because stakes in startup companies can’t easily be sold, unlike shares in publicly-traded companies.
In another excerpt from the report discussing the Volcker Rule, SVB explained that their VC investments are illiquid. The bank said that it makes “commitments to invest in venture capital and private equity funds, which in turn make investments generally in, or in some cases make loans to, privately-held companies” and that the money typically can’t be withdrawn for years.
“Commitments to invest in these funds are generally made for a 10-year period from the inception of the fund,” the company said. “Although the limited partnership agreements governing these investments typically do not restrict the general partners from calling 100 percent of committed capital in one year, it is customary for these funds to generally call most of the capital commitments over 5 to 7 years.”
To make matters more volatile, Silicon Valley Bank’s loan portfolio was highly concentrated. The bank disclosed that “a significant portion of our loan portfolio is comprised of larger loans,” including “credit to our private equity and venture capital clients,” and that these lines of credit “could increase the impact on us of any single borrower default.”
“As of December 31, 2022, loans equal to or greater than $20 million to any single client (individually or in the aggregate) totaled $46.8 billion, or 63 percent of our portfolio,” the annual report read.
Sure enough, SVB’s investment strategy began to falter in the second quarter of 2022. As the Fed hiked interest rates and VC activity ebbed, the bank’s cash flow reversed, leading to a steady stream of depositors fleeing the institution throughout the year.
The exodus eventually prompted the bank to sell off $21 billion in bonds at a loss, which led managers last Wednesday to seek private funding to stay solvent. A sharp increase in withdrawal requests followed on Thursday, causing a run on deposits. By Friday, SVB failed, and regulators took control of the firm.
The crash created a panic among Silicon Valley tech investors: The Federal Deposit Insurance Corporation only insures up to $250,000 in each customer’s deposits, and it turned out that more than 90 percent of SVB’s deposits were uninsured at the end of 2022.
Some of those depositors threw fits on social media over the weekend after regulators said that uninsured depositors would have to wait for SVB assets to be liquidated before they could start recovering their money. On Sunday, the Fed and other regulatory agencies announced extraordinary measures, guaranteeing those uninsured deposits independent of the outcome of the SVB firesale.
But if it weren’t for the Fed itself granting SVB an exemption to the Volcker Rule, the trajectory of the bank might have looked very different, according to the former congressional aide who helped draft the Dodd-Frank financial reform law.
“We know Silicon Valley Bank was extraordinarily unique in that it grew very rapidly over the last several years, fueled in part by fickle corporate deposits from venture capital-related companies,” said the ex-staffer. “We also know that it invested those in very long-dated, very low-interest bearing debt securities that lost significant value when the Fed hiked rates. And we know that Silicon Valley Bank had a significant amount of private fund exposure courtesy of the Fed’s slow implementation of the Volcker Rule and its decision to grant the bank an exemption.”
The ex-staffer noted that he was personally lobbied by Silicon Valley Bank on a Volcker Rule exemption as the firm led industry efforts to shield venture capital from the effects of the regulation.
Another expert who spoke to The Lever agreed with the ex-staffer’s assertion that the exemption needed to be examined.
“Yes, that’s certainly a piece of the puzzle,” said Bartlett Naylor, financial policy advocate for the nonprofit consumer advocacy organization Public Citizen. Naylor noted that SVB had been lobbying to weaken the Volcker rule since 2010, the year Congress passed the Dodd-Frank financial reforms. Other relevant factors, Naylor said, include the Dodd-Frank roll-back passed by Congress in 2018, which subjected banks like SVB to less stringent oversight, and the Fed’s decision to weaken liquidity rules for banks with fewer than $700 billion assets. He noted that Silicon Valley Bank pushed for both of these outcomes.
