Silvergate and Silicon Valley Bank show the risks of banks concentrating in one area

Published Sat, Mar 11 20238:54 AM EST

Crypto-focused Silvergate , which announced its plans to liquidate this week, is suffering from woes similar to that of failed Silicon Valley Bank . That is, Silvergate's distress is linked to rising interest rates – rather than the whims of digital assets. Silvergate had faced several financial challenges since the collapse of crypto exchange FTX , a former customer. In January, Silvergate reported massive fourth-quarter withdrawals in light of the FTX collapse. Then in February, the Department of Justice opened an investigation into the bank's dealings with FTX and its sister company Alameda Research. Last week, Silvergate warned investors that it may not survive much longer . Its shares are down 85% this year. SI 1Y mountain Silvergate Capital shares have cratered. Despite all of that, it's clear to many that crypto as a nascent and risky asset class was not the central problem with Silvergate. Rather, the issue in part stems from Silvergate's business being too concentrated in a high-risk industry like crypto. There is also an impact from the rising interest rate environment banks now find themselves in. "The banks that were banking this [crypto] industry needed to just sit in cash and not play the yield curve as the banks did," said Caitlin Long, CEO of Custodia Bank, which also serves crypto companies. She is a long-time critic of leverage and speculation within the cryptocurrency industry. A risk inherent in long-dated bonds Silvergate invested customer deposits in long-term bonds in the face of a Fed tightening cycle, Long explained. With interest rates rising, the bonds lost value. Eventually, as customers lost confidence in Silvergate's ability to continue operating, the bank had to sell those bonds – and realize that loss of value – to generate liquidity. Silvergate wasn't alone in doing this, she added. "It's not a shock what happened here," said Long. "The punchline is what happened has nothing to do with crypto. It has to do with the old-fashioned 'borrow short and lend long' business model which everyone now recognizes is not appropriate for banking the digital asset industry." If there were any doubts about that, they were challenged on Thursday when Silicon Valley Bank announced a plan to raise more than $2 billion in capital to help offset losses on bond sales. In about two days , the Federal Deposit Insurance Corporation would force it to shut down, making it the largest U.S. bank failure since the global financial crisis. "SVB was the case of a classic bank run combined with an asset-liability mismatch, its demise being accelerated by depositors losing confidence around the same time that SVB had to sell longer-dated fixed income securities at a loss – from where they were held on the balance sheet in order to meet withdrawals," said Amit Sinha, head of multi-asset design at Voya Investment Management. An asset-liability mismatch, rather than crypto risk Though SVB's customers were predominantly startups at the center of tech and innovation, which may include crypto, the bank wasn't focused specifically on digital assets. That said, the Silvergate situation appears to be fueling regulators' extra attention on the sector. Sen. Elizabeth Warren, D-Mass., was among the first to highlight this. "As the bank of choice for crypto, Silvergate Bank's failure is disappointing, but predictable," she tweeted Wednesday afternoon . "I warned of Silvergate's risky, if not illegal, activity — and identified severe due diligence failures. Now, customers must be made whole [and] regulators should step up against crypto risk." Separately, the Federal Reserve said Thursday that it's forming a "specialized team of experts" to help it supervise the crypto sector. It may be true that crypto needs more clear regulation in the U.S. While regulatory scrutiny is ramping in the U.S., Hong Kong is planning to legalize retail crypto trading as part of a bigger push to become a global crypto hub, reportedly with quiet support from China. Also, Europe looks well positioned to provide better onramps into crypto, thanks to regulatory clarity in the form of the Markets in Crypto-Assets , or MiCA, regulation. It's also true that banking crypto companies comes with big liquidity risks, as three U.S. banking regulators warned in February, and that financial institutions wanting to serve them should have strong risk management protocols in place. Nevertheless, while crypto happened to be at an unfortunate confluence of events this week, the biggest problem goes beyond it – to the broader financial system, the economic backdrop and, in particular, the rising interest rate environment. "It's the financial institutions that rely a lot on deposits that are under a lot of pressure," said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. "The whole concern about deposits leaving banks, the cost to keep those deposits in terms of having to pay out higher interest rates so that investors don't flee to areas where they can get better yields – that's really hitting the financial sector and that bleeds over to the cryptocurrency space." "Crypto aspirations are very much benefited by a banking system that is doing well and has trends going in its favor," he added. Banks "want to shy away from the areas that might feel the worst strains. What probably naturally comes to mind is the crypto space," he said.