The crypto bank Silvergate Capital (SI 10.17%) has found itself on the ropes after a difficult fourth quarter in which it saw close to 70% of its digital-asset-related deposits leave the bank.

The FTX debacle triggered a crisis of confidence in crypto, which in turn triggered a run on the bank. Silvergate appears to have survived the event, but it wiped out a significant amount of shareholders' equity in the process because it had to sell bonds while they traded at a loss to meet the deposit outflows. The bank took a hefty more than $1 billion loss in the fourth quarter.

While crypto has since bounced back a bit in 2023, it still very much feels like a risk-off environment for crypto, which raises the question of where Silvergate goes from here. 

The current state of the bank

Crypto exchanges and institutional investors use Silvergate because of its Silvergate Exchange Network (SEN), which is a real-time payments system that allows multiple parties on the network to clear and settle transactions instantly and at all times. These customers bring large sums of non-interest-bearing deposits that essentially serve as a free source of funding which Silvergate can invest into bonds and loans, and make money on the spread.

Person looking at computer monitors.

Image source: Getty Images.

But the FTX bankruptcy and scandal surrounding the organization has really shaken the faith of crypto investors. Complicating matters, FTX had been a client of Silvergate's and accounted for 10% of the bank's digital-asset-related deposits when the large crypto exchange declared bankruptcy. In a preliminary update earlier this month, Silvergate's CEO Alan Lane said proprietary traders and market makers that were clients of the bank and had been doing business together for at least six years simply stopped and pulled their deposits.

Unlike most banks, Silvergate puts very little credit exposure on its balance sheet and instead deploys most of its deposits into bonds, which makes its business model heavily reliant on deposits. The significant loss of its digital-asset-related deposits, which the bank pays no interest on, forced Silvergate in the fourth quarter to bring billions of higher-cost borrowings onto its balance sheet, which significantly hurt its margins.

The deposit run has also made management very cautious, and rightfully so. The bank is now holding close to $4.6 billion of cash and cash equivalents on its balance sheet, which is more than the $3.8 billion of digital-asset-related deposits at the bank at the end of 2022. This will also be a drag on profitability.

For Silvergate to really bounce back, it's going to need crypto investors to shift to a risk-on environment in which they are willing to invest and trade again. Silvergate itself will also need to have the confidence that the industry is more stable and will not result in another crypto run so it can reduce the amount of cash it is going to hold.

Will the bank need to raise capital?

When Silvergate sold bonds to cover deposit outflows, it reported a more than $751 million loss on the sale of bonds. After that and other losses, Silvergate saw its shareholders' equity fall from about $1.33 billion to just over $603 million.

That has put a strain on one of its key regulatory capital ratios called the tier 1 leverage ratio, which looks at a bank's tier 1 capital as a percentage of its average assets. Silvergate's tier 1 leverage ratio fell from 10.7% in the third quarter of 2022 to 5.36% at the end of the year, which is just over its 5% regulatory requirement.

This brings up the question of whether or not the bank will need to raise capital and dilute shareholders further. However, average total assets at the end of 2022 were still close to $15 billion, and that's going to come down significantly as Silvergate pays down higher-cost borrowings and right-sizes the balance sheet to reflect where digital-asset-related deposits are at. Hopefully, this can get the tier 1 leverage ratio to where it needs to be so the bank doesn't need to raise capital, but we'll see.

Does the business model need to change?

There is still a lot that needs to happen before Silvergate can truly move forward. Management needs to right-size the balance sheet and get back to profitability. Many investors are also concerned that the bank may face some kind of regulatory consent order and fines for its connection to FTX. Only time will tell, but investors are certainly looking for clarity on this front.

Management also needs to think about what the business model looks like moving forward. Currently, clients are allowed to use SEN for free because the bank has been happy with the model's ability to generate zero-interest deposits. 

But given the volatility, some analysts have questioned whether or not Silvergate should be charging clients to use the platform in an effort to diversify revenue. That would certainly be great, although it's a matter of whether or not clients would actually pay to use SEN and how much competition will pop up in the meantime.

Ultimately, the path forward for Silvergate is still quite murky, so I would still recommend waiting to buy this stock until there is more clarity. In the meantime, the bank needs to clean up the balance sheet, improve its tier 1 leverage ratio, and hopefully find a way past the regulatory uncertainty hanging over the stock.