Four questions, many answers: What banks need to know about Silvergate

Silvergate faced a run on deposits and liquidity crisis in November after the collapse of FTX and its trading firm Alameda Research. When other crypto exchanges that were depositors at Silvergate started pulling their money out of the bank in the wake of the failure, Silvergate also sought to shore up its liquidity by tapping the Federal Home Loan Bank of San Francisco for $4.3 billion in the fourth quarter. 

While the San Francisco bank provided Silvergate with a low-cost, short-term loan, it also highlighted the larger liquidity problem. The bulk of Silvergate's $4.6 billion in cash in January came from the Home Loan bank, according to Silvergate's own select financial metrics. 

Silvergate's management could have sold assets to outside investors at fair market value, but doing so would have resulted in losses, experts said. Silvergate instead chose to tap the Home Loan Bank System for emergency cash, which set off a cascade of events with news stories highlighting the bank's need for emergency funding, triggering more depositors to flee. In early February Silvergate was reportedly enmeshed in a criminal investigation by the Department of Justice's fraud unit looking into the crypto bank's dealings with bankrupt FTX and Alameda.

In a call report filed in late January, Silvergate listed 503 accounts totaling $3.8 billion in which depositors had more than $250,000. Another 3,302 accounts totaling $2.5 billion were for deposits of $250,000 or less, according to the report filed Jan. 27 with the Federal Financial Institutions Examination Council. Silvergate declined to comment beyond its published statements.

Steven Sugarman, founder of Change Company and a former founder of Banc of California, compared what happened to Silvergate to a run on deposits at IndyMac Bank in 2008. Sen. Chuck Schumer, D-N.Y., had warned that he was concerned about a withdrawal of deposits, which sparked a run on the California bank. Within weeks, after billions of withdrawals, federal regulators had taken over the bank.

"It doesn't help to provide emergency liquidity, it helps to provide liquidity in the ordinary course," said Sugarman. "Anytime you take emergency financing where your current assets and current liabilities don't match, depositors get scared. It's kind of funny because it's the crypto people depositing money that got nervous about having the money in an FDIC-insured bank."

Silvergate's liquidity issues were exacerbated by old-fashioned interest rate risk, not crypto-related credit losses. Silvergate warned investors in a Securities and Exchange Commission filing on March 1 that it projected taking additional losses from the sale of securities to repay the Home Loan Bank of San Francisco. It also issued a warning that it might not continue as a "going concern." 

Bank liquidations, distinct from bank failures, are not unheard of — but several industry experts agree self-liquidation events like Silvergate's are unusual.

"[These are] very unusual," John Soffronoff, partner at the consulting firm Capco, wrote in an email. "Even with a bank failure, there is typically an acquiring bank. Based on our research, the most recent [voluntary liquidation] was January 2022, when Marlin Business Bank ceased operations after its parent company sale."

Unlike most banks, Silvergate heavily relied on crypto-investor-funded deposits, which amounted to 82% of its deposit base as of late 2021. Given the warning signs, some industry experts say regulators could have seen the bank's demise coming and acted sooner to prevent it.

Karen Petrou, managing partner at Federal Financial Analytics, characterizes Silvergate's downfall as a regulatory failure to prevent Silvergate from concentrating so much of its deposit base in one business line.

"No bank failure is a regulatory success," Petrou said. "Silvergate's 'voluntary' liquidation is a failure and then some that could and should have been averted had the agencies taken action on funding-concentration risk and other blinking red lights going back at least a year on the bank's balance sheet."

Ian Katz, managing director of Capital Alpha Partners, said that regulators had already made abundantly clear the risks crypto posed, and that Silvergate's liquidation was well timed for crypto skeptics looking to turn the screws on crypto banks.

"Regulators have already been warning about the dangers of getting involved in crypto, and they will use Silvergate as a cautionary tale," Katz wrote in an email.

Bart Naylor, a financial policy advocate for Public Citizen, echoed that sentiment, saying regulators and markets can and should use this episode as a reason not to get deeply involved in crypto. But he also said it would probably not lead to new or changed regulations.

"I hope this clarifies the industry's understanding that bank regulators don't look kindly on the fake-money business," Naylor said. "I don't foresee rule changes; simply enforcement of current law."

Indeed, all but the most bullish crypto banks have taken steps to limit their exposure to crypto markets. Other major crypto banks like Signature Bank — which recently scaled back its crypto exposure — will be the focus of greater scrutiny and concern because of their exposure to similar assets and clients.

"I'd expect examiners to emphasize two basic tenets of risk management: customer due diligence and third-party risk management," wrote Soffronoff, who also noted that ultimately Congress will need to enact a regulatory framework to translate existing rules to the crypto space.

"The ball is with Congress to pass laws that direct the relevant agencies to create implementing regulations," he added.

"I would think the [Federal Reserve] (from a market perspective), the SEC (from an investor protection perspective — although they aren't securities, there is certainly investment risk), and maybe the [Consumer Financial Protection Bureau] (from a consumer protection perspective)" will have a role to play in a crypto regulatory regime, Soffronoff said. "Ultimately Congress will have to decide."

Whether the bank's supervisors — the Federal Reserve and the California Department of Financial Protection and Innovation — used their authority to ensure the safety and soundness of the institution is a debatable question. 

Julie Hill, a University of Alabama law professor who specializes in bank regulation, said that the fact that Silvergate was able to dissolve without broader financial consequences — and at no cost to depositors or the federal government — is proof that supervisors were on top of the situation.

"This is, by and large, a good story for banking supervision," Hill said. "They let a supervised bank try something new, it didn't work out perfectly, but now it looks like they'll have a failure without consequence. All the depositors will get their money back with no loss to the Deposit Insurance Fund."

But others say the fact that Silvergate found itself in this place to begin with reflects poorly on the bank's supervisors. Dan Awrey, a Cornell University professor of corporate law and financial regulation, said the outcome raises questions about the supervision of Silvergate, given how concentrated the bank seems to have been in risky, crypto-related activities. 

Awrey also noted that regulators not only let the bank incorporate Federal Home Loan bank advances into its capital plan, but also, ultimately, allowed the bank to use them to stave off a bank run spurred by FTX's collapse.

"I don't really see any evidence that supervision worked here, especially in the wider view where Silvergate's business model appears to have been so highly concentrated in crypto and reliant on crypto-related deposits and yet was still able to tap liquidity from the FHLB System," he said.

Still, Awrey said the unwinding of Silvergate has been "remarkably smooth." Whether regulators had a hand in that process, it appears to have been the right course of action. 

"If it works, it's not a bad outcome," he said.

In public remarks on crypto regulation Thursday, Fed Vice Chair for Supervision Michael Barr (pictured above) said liquidity risks and concentration have been the two of the pillars for the central bank's approach to crypto supervision. 

Barr did not address Silvergate directly, but he said the Fed has attempted to educate banks about these risks related to crypto, pointing to public guidance issued alongside the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency in recent weeks. He also noted that the onus of managing these risks, particularly in smaller banks, falls on the banks themselves.

"We tend to have a very light touch approach to smaller institutions," he said. "And so there's more of an impetus on them to actually be paying attention to these new and novel risks, and we need to make sure that they understand them."

Todd Phillips, an independent consultant and former FDIC lawyer, said the risks and concentrations of crypto-related deposits and assets on Silvergate's balance sheet should have been flagged by the Fed or California's DFPI. Yet, he said, it's difficult to render a verdict about the efficacy of the state and federal supervisors without knowing what conversations and actions occurred behind the scenes.

"It's an opaque process, and it's difficult for us outside the bank to have a really good idea of what happened," Phillips said, noting that an outside review of what transpired could be in order once the bank is fully dissolved. 

Hill said the Silvergate episode can now serve as a learning experience for both banks and supervisors, to realize what works and what does not, both from a business and supervisory perspective.

She said the debate about whether Silvergate's unwinding should be celebrated by supervisors ultimately hinges on whether one believes their job is to make banks as risk-averse as possible, or if they should make sure risks taken by banks do not have broader consequences.

"Regulators and banks could take a very conservative approach and say, 'We're not going to ever have banks close or ever have bank failures,'" Hill said. "But the danger with that is that you choke off new ideas — not just for business models, but for technology and innovation — and you cut off credit to people whose lives would be improved by it. We don't need tons and tons of bank failures, but we have lots of banks, so it isn't the worst thing in the world to have a bank failure every now and then."