Was Silvergate on Borrowed Time as Regulators Backed Banks Away From Crypto?

One of the crypto sector’s core banks, Silvergate Capital Corp., is being hollowed out in a classic customer retreat familiar to students of bank-run history.

The latest and most severe flight of customers from the La Jolla, California-based institution was accelerated this week by the bank’s own disclosures, including an admission that its health could be threatened by “investigations from our banking regulators,” according to a March 1 document filed with the U.S. Securities and Exchange Commission. With that disclosure and Silvergate’s open questioning of “the viability of the company’s digital asset focused business,” major customers such as Coinbase, Paxos, Circle Internet Financial and Galaxy Digital moved to sever ties.

Recent hard times for crypto firms have definitely been shared by their favorite banks, but the banking regulators have also been targeting those lenders with warnings about leaning too heavily into crypto, arguing that the banks’ stability could suffer from exposure to a volatile market. Silvergate was basically what they were talking about, as illustrated by the sudden flight of its top crypto customers.

The company had become virtually synonymous with crypto banking, and the opening page of its website still touts the relationships it built with the industry after seeing “digital currency’s potential” in the early years. Part of that relationship may have become toxic for Silvergate as it was reportedly linked to investigations of the FTX exchange’s fraudulent activity.

U.S. banking regulators, including the Federal Reserve and the Federal Deposit Insurance Corp., have been campaigning to erect a barrier between the banking system they oversee and the crypto industry they’ve labeled as a leading hazard for the traditional financial sector. The agencies’ policy statements carefully laid out a case against banks that concentrate on digital assets and the companies that issue and trade them. And in a new statement just last week, they again warned the banks their deposits could drain quickly away as “customers react to crypto-asset-sector-related market events, media reports, and uncertainty.”

“Clearly, they’re urging extreme caution,” said Alexandra Barrage, a banking lawyer at Davis Wright Tremaine who was previously a senior official at the FDIC. She said they likely had Silvergate and similar banks in mind when they issued these warnings, which she said have shown an unusual willingness for the banking agencies to “provide some guardrails” about what they don’t want to see.

Silvergate, which has delayed the filing of its annual report, disclosed this week that it was uncertain about its “ability to comply with the heightened regulatory scrutiny of banking institutions that provide products and services to the digital asset industry.”

When it refers to its banking regulators, Silvergate is talking about the Federal Reserve on the federal level and the California Department of Financial Protection and Innovation at the state level.

One of the jobs of Fed supervisors is to watch an institution’s capital levels, ensuring they don’t slide below the danger line. Last year, a key measure – Silvergate’s so-called leverage ratio that measures its own capital as a share of its overall assets – slid almost 6 percentage points from a healthy 11% to a little over 5%. The cutoff for a bank to still be considered well-capitalized is 5%, and the bank was already dropping toward that mark a couple of months ago.

A bank getting close to the danger level of 4% will generally hear from the FDIC, Barrage said. The FDIC is the U.S. agency responsible for handling bank failures and ensuring that customers are harmed as little as possible.

“I’m sure there’s a lot of stuff happening behind the scenes,” Barrage said, adding that they’re likely “trying to figure out if there’s a solution that works.”

A spokeswoman for the FDIC told CoinDesk that “we don’t discuss open and operating institutions.” When asked why the Fed hasn’t been seen to intervene, a spokesman for the U.S. central bank declined to comment on its supervision of the institution. However, if regulators had privately stepped in and made demands about the company’s management, their interactions would not necessarily have been public, so it’s unclear how much the agencies may have been involved with Silvergate’s struggles. A spokesman for the California regulator also declined to comment.

A Silvergate representative declined to address the bank’s regulatory pressures and capital woes on Thursday, sending a statement to CoinDesk that it’s “working diligently” to file its annual report and has no further comment.

One banking industry veteran now in the crypto sector said he wondered why it’s taking regulators so long to deal with a floundering bank. The policy executive, who declined to be named, said the FDIC should probably have knocked on their door months ago.

When banks fail, they typically go down on a Friday night. A crew from the FDIC shows up and takes the keys so their specialists can work over the weekend and get the customer base on secure footing by the next Monday. Usually, they hand the deposits over to a new owner to manage and they get started finding buyers for the remaining assets.

Thanks to FDIC insurance, U.S. depositors’ money is safe, as long as it’s not more than $250,000. Even if the ownership transition isn’t smooth, the federal government guarantees every penny up to the limit – as it’s done through every bank crisis of the past 89 years – and the FDIC can cut a check if there’s no new bank to point customers to.

The FDIC took down hundreds of institutions in the wake of the 2008 financial crisis, but it hasn’t had a closure to deal with in the past two years.

The agency does not, however, insure digital assets. Any cryptocurrencies held on behalf of a bank’s clients are not shielded by any government protections.

Were Silvergate to fail and enter into an FDIC teardown, it would break unfortunate new ground for the industry.

“This would mark the first crypto-specific receivership,” Barrage said.

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