When VCs Benefit from FDIC Funds: Examining the Implications

According to a new Bloomberg report, in the recent collapse of Silicon Valley Bank (SVB), the Federal Deposit Insurance Corporation (FDIC) allegedly provided billions of dollars to insure deposits for some of SVB’s top customers, who happen to include some of Silicon Valley’s biggest names.

Bloomberg’s report is founded on an FDIC document, which was supposedly obtained through a Freedom of Information Act (FOIA) request. It reveals that Sequoia Capital, a prominent venture capital (VC) firm, along with other firms such as Founders Fund and Andreessen Horowitz, has been identified as a beneficiary of the FDIC’s extended coverage. According to the document, Sequoia, which had a substantial $1 billion deposited with SVB at the time of its collapse, has significantly profited from the FDIC insurance.

This information raises concerns about the appropriateness of providing such coverage, typically limited to $250,000 per account, for some of the wealthiest Americans and their investment firms. The principle is straightforward: Main Street should not bail out Wall Street, and it should also not bail out Sand Hill Road. It is ethically wrong to employ taxpayer funds to rescue private firms that failed to effectively manage and diversify risks, including keeping a significant portion of their assets in a collapsed bank.

The 2008 financial crisis, which witnessed the downfall of major banks like Lehman Brothers, Bear Stearns, and Washington Mutual, highlighted the perils of the “Too-Big-To-Fail” (TBTF) phenomenon. These financial institutions were deemed so immense and interconnected that their failure would have catastrophic ramifications for the economy. Consequently, in 2008, it was Main Street that bore the brunt of the consequences when banks engaged in risky investments and mismanaged risk. The government intervened to bail out these sizable and sophisticated banks to prevent a domino effect that could have resulted in the collapse of the entire financial system. This led to a growing sentiment against big banks, with some commentators even advocating for their breakup.

One of the primary drivers behind the public’s negative sentiment towards TBTF banks was the perception that these institutions held excessive power and influence over the economy. The 2008 financial crisis laid bare the fact that these banks were taking on immense risks and resorting to fraudulent and unethical practices in order to maximize their profits. This erosion of trust in the banking system resulted in a widespread belief that the banks were unjustly benefiting from government bailouts and other forms of support.

Another factor fueling the anti-sentiment towards TBTF banks was the concern that they prioritized the interests of their wealthy clients over the well-being of ordinary people. This growing frustration and anger towards the banks have given rise to a demand for greater accountability and transparency, as there is a prevailing sentiment that these banks are not adequately serving the needs of the general population.

We recently encountered a somewhat analogous situation where certain VC firms faced difficulties due to the collapse of the bank where they had substantial funds deposited. Had it not been for the extension of FDIC insurance to an unlimited amount, surpassing the usual cap of $250,000, these firms, along with other clients of the bank, would have suffered substantial losses. In a way, their funds were effectively rescued, resulting in a de facto bailout. However, we must ponder upon the question of why Main Street should bear the burden of the mistakes made by VC firms.

Furthermore, akin to the situation with major banks in 2008, it is reasonable to assert that at least some of these VC firms had taken on significant risks, lacked sufficient due diligence in evaluating the companies they invested in, and failed to adequately monitor them. This is exemplified by Sequoia’s public apology to its limited partners after it came to light that they had invested in FTX without conducting thorough due diligence. In its apology the VC firm stated that it would work to improve its due diligence process going forward.

It is important to acknowledge the significance of VC firms, as they play a crucial role in funding and nurturing innovative startups that have the potential to disrupt and revolutionize various sectors. Similar to the banking industry, the VC industry also holds fundamental importance for the economy and society. It actively contributes to driving economic growth, creating job opportunities, and enhancing the overall quality of life by introducing innovative products, services, and technologies. Moreover, unlike the concern with banks, where there is a perception that they primarily serve the interests of wealthy clients, VC firms, in a way, cater to the needs of both ordinary people and affluent clients. The success of VC investments can have a trickle-down effect, benefiting not only the wealthy but also employees of startups and the broader population. Hence, we should recognize the importance of the VC industry for its significant contributions in fostering innovation and creating new opportunities for global prosperity and growth.

However, it is crucial to note that while some private VC firms manage public funds from investors like pension funds or insurance companies, it is unfair to utilize taxpayer money to bail out VC firms, particularly through FDIC funds. The FDIC was established in 1933 in response to the banking crisis during the Great Depression. Its primary objective is to safeguard depositors and promote stability in the banking system. It achieves this by providing insurance for deposits held at FDIC-insured banks, ensuring that if a bank fails, depositors will receive their insured deposits up to a limit of $250,000 per depositor, per insured bank, for each account ownership category. This limit was raised from $100,000 to $250,000 in 2008 in response to the financial crisis.

The primary objective of FDIC insurance is to instill confidence in depositors by assuring the safety and security of their funds, thus contributing to the stability of the banking system. The presence of FDIC insurance encourages depositors to keep their money in banks rather than withdrawing it and resorting to alternative assets or cash, which could trigger a bank run and result in the collapse of the banking system. The guarantee of unlimited coverage for the substantial funds deposited by VC firms does not align with the original goals for which the FDIC was established. These funds, belonging to influential and presumably sophisticated entities are not the depositors’ funds that the FDIC insurance aims to protect.

FDIC insurance safeguards individuals, businesses, state and local governments, and non-profit organizations, covering a wide range of account types. However, regardless of the size of the depositor’s account, the FDIC insurance provides limited protection. There are valid reasons behind this approach. Firstly, it encourages responsible banking practices by ensuring that banks do not take excessive risks with depositors’ money, as complete coverage would eliminate the need for caution. Secondly, it aims to maintain the stability of the banking system. The funding for FDIC insurance coverage comes from premiums paid by member banks. If coverage were unlimited, it would be challenging for the FDIC to set premiums that adequately cover potential losses. This could result in instability within the banking system if the FDIC were unable to fulfill its obligations. Lastly, it is essential to consider the prevention of moral hazard, a concept I have previously discussed in the context of the 2008 financial crisis. People have a tendency to take on greater risks when they are shielded from the consequences of their actions, as seen with the TBTF phenomenon. By imposing limitations on insurance coverage, the FDIC actively discourages depositors from concentrating all their funds in a single bank. Instead, it promotes diversification of holdings as a means to mitigate risk. This approach helps maintain a sense of responsibility and prudence among depositors, reducing the likelihood of excessive risk-taking based on the assumption of full protection.

In conclusion, it is morally unjust for Main Street to rescue Sand Hill Road. VC firms, akin to major banks, should not be relying on or expecting bailouts. It is crucial to avoid setting a detrimental precedent by rescuing companies that have failed to effectively manage risks. Instead, our focus should be on fostering an environment that promotes innovation and entrepreneurship, a domain in which VC firms have undoubtedly demonstrated remarkable success in the past decade. However, it is equally important to emphasize the importance of responsible risk management alongside entrepreneurial pursuits.