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 haven familiar to students of banking history.

The latest and most serious exodus of customers from the La Jolla, Calif.-based institution was precipitated this week by the bank’s own disclosures, including an admission that its health could be threatened by “investigations by our banking regulators,” according to a March 1 document filed with Securities and Exchange Commission. With this revelation, and Silvergate’s open questions about the “viability of the company’s digital asset-focused business,” major clients such as Coinbase, Paxos, Circle Internet Financial and Galaxy Digital moved to cut ties.

Recent hard times for crypto firms have certainly been shared by their favorite banks, but banking regulators have also targeted these lenders with warnings about leaning too heavily into crypto, arguing that 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 all the biggest crypto customers.

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

U.S. banking regulators, including the Federal Reserve and the Federal Deposit Insurance Corp., have campaigned to build a barrier between the banking system they oversee and the crypto industry they have labeled a leading danger to 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 in them. And in a new statement last week, they again warned banks that their deposits could drain quickly as “customers react to market events, media reports and uncertainty related to the crypto-asset sector”.

“Obviously, they’re urging extreme caution,” said Alexandra Barrage, a banking attorney at Davis Wright Tremaine who was formerly a senior official at the FDIC. She said they probably had Silvergate and similar banks in mind when they issued those warnings, which she said have shown an unusual willingness by the banking agencies to “provide some railings” about what they don’t want to see.

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

When referring to its bank regulators, Silvergate talks about the Federal Reserve at the federal level and the California Department of Financial Protection and Innovation at the state level.

One of the tasks of the Fed’s supervisors is to monitor an institution’s capital levels, ensuring that they do not slip below the danger threshold. Last year, a key measure – Silvergate’s so-called leverage ratio which measures equity as a proportion of its total assets – fell almost 6 percentage points from a healthy 11% to just over 5%. The threshold for a bank to still be considered well capitalized is 5%, and the bank already fell a couple of months ago.

A bank approaching the 4% hazard level will generally hear from the FDIC, Barrage said. The FDIC is the US agency responsible for dealing with bank failures and ensuring that customers are harmed as little as possible.

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

An FDIC spokeswoman told CoinDesk that “we do not discuss open and operating institutions.” Asked why the Fed has not been seen to intervene, a spokesman for the US central bank declined to comment on its oversight of the institution. But if regulators had privately stepped in and made demands on the company’s management, their interactions wouldn’t necessarily have been public, so it’s unclear how much the agencies might have been involved in 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 issues on Thursday, sending a statement to CoinDesk that it is “working diligently” to file its annual report and had no further comment.

A banking industry veteran now in the crypto sector said he wondered why it was taking so long for regulators to deal with a failing bank. The police chief, who declined to be named, said the FDIC probably should have knocked on their door months ago.

When banks go down, they usually go down on a Friday night. A crew from the FDIC shows up and takes the keys, allowing their specialists to work over the weekend and get the customer base safe by next Monday. Typically, they hand over the deposits to a new owner to manage, and they begin to find buyers for the remaining assets.

Thanks to FDIC insurance, American depositors’ money is safe, as long as it’s not more than $250,000. Although the ownership transition is not smooth, the federal government guarantees every penny up to the limit—as it has through every banking crisis of the past 89 years— and the FDIC can cut a check if there is no new bank to refer customers to.

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

However, the agency does not insure digital assets. Any cryptocurrencies held on behalf of a bank’s customers are not shielded by any government protection.

Should Silvergate fail and enter an FDIC takedown, it would break unfortunate new ground for the industry.

“This will mark the first crypto-specific reception,” Barrage said.