View this article online: https://www.insurancejournal.com/news/national/2023/03/14/712038.htm
As someone who had a front row seat at the largest bank failure in U.S. history, Washington Mutual, the demise of Silicon Valley Bank (SVB) brings back memories of how seemingly well-run banks can in an instant run into trouble due to unexpected events that catch these firms off guard. As in the case of Washington Mutual, poor governance and management of key risks sealed SVB’s fate.
Although the business models for SVB and WaMu were very different, SVB catered to the venture capital crowd and tech companies, and WaMu largely focused on the home loan business, they both were far too concentrated in one sector. SVB probably never imagined it could experience a run of $42 billion in a single day, accounting for about one-quarter of all deposits at the bank. So, what happened to cause SVB to be abruptly taken over by the FDIC?
Anatomy of SVB’s Failure
We now have a better glimpse inside as to what brought SVB down. Technically, the bank failed due to a liquidity crisis, i.e., a lack of sufficient cash inflows to sustain it during a period of significant cash outflows. Think about getting in your car to go to work and you hear a clunk, and the car just stops running. The mechanic tells you that you’ll have to replace the transmission for $5,000. Your heart sinks as you realize your checking account has $100 in it, your credit cards are maxed out and your family and friends won’t extend you any credit. That’s a personal liquidity crisis. Magnify that by billions and you get the idea of what SVB was dealing with when a good part of their depositor base evaporated.
One of the risks it seems SVB didn’t account for was the degree and speed by which its depositors would withdraw money from the bank upon hearing that SVB was experiencing a “cash burn” that required them to raise capital in an attempt to shore up losses from sales in investment securities that are held in the available-for-sale (AFS) part of the balance sheet. That announcement spooked investors and sent the stock spiraling down, precipitating the largest bank run of all time.
How did SVB get into this position? After all, it touted that it had solid risk management practices and effective controls in its financial disclosures. It turns out that things aren’t always what they seem on the surface. The company made several risk management blunders. The first was in placing large bets on interest rates. Bank balance sheets split assets into two groups, AFS, or those assets that firms expect to transact over some time and held-to-maturity (HTM) assets that are expected to be held for long-term investment purposes. HTM assets are held at book values while AFS assets are marked-to-market according to fair value accounting principles.
At the end of 2022, SVB reported $120 billion of investment securities, representing 55% of its assets, or more than double the average of all US banks. Further, three-quarters of their investment portfolio were in HTM securities, largely in U.S. Treasuries and mortgage-backed securities (MBS). While Treasuries and MBS are very safe investments from a credit risk perspective, they pose substantial interest rate risk. The weighted average duration of these investments was about six years, implying that if interest rates rose by 100 basis points (1%), the value of those securities would decline by 6%. In a low yield environment prior to the Fed’s rate hiking plan, the quest to ride the yield curve for income was very much in focus by banks including SVB.
The strategy was to invest a significant amount of deposits in the HTM portfolio where the investments would not have to be marked-to-market. However, the AFS side of the portfolio is subject to reporting unrealized gains or losses because of changes in the valuations of those assets that remain on the balance sheet. With interest rates rising quickly in 2022, the value of those assets declined (for bond portfolios, yields and prices move inversely) and SVB had to do something to stop the bleeding as those unrealized gains hit against the balance sheet, specifically equity in the form of accumulated other comprehensive income or loss (AOCI). It turns out that unrealized losses when reported under AOCI do not affect a bank’s regulatory capital but will affect their nonregulatory total common equity (TCE) ratio. SVB’s TCE ratio was severely dented by the steady unrealized losses it was sustaining and so was forced to sell AFS assets at a loss, thereby igniting the stampede to withdraw deposits once the word got out.
SVB maintained in its regulatory filings that it conducted regular and sophisticated market risk analysis and interest rate risk hedging activity. However, the amount of interest rate hedging was quite small in comparison with the AFS investments. Only $550 million in notional value of interest rate derivatives stipulated as interest rate hedges were reported at the end of 2022. And clearly their risk modeling didn’t anticipate the combination of interest rate and liquidity risk shocks it would face.
It seems apparent now that SVB’s liquidity risk management practices were deficient. Best practice banks will employ a number of methods to understand the sensitivity of their liquidity risk profile to various shocks including contingency liquidity planning scenario exercises. The largest banks go further and are required to calculate the amount of high-quality liquid assets (HQLA) as a percent of stress net cash outflows over a 30-day horizon, referred to as the Liquidity Coverage Ratio (LCR). These banks also must calculate a similar ratio over a one-year horizon on the stability of their funding. But in the end, even if SVB had technically been compliant with LCR, (we’ll never know since they weren’t large enough to require LCR compliance) the size of the bank run would likely have resulted in the same outcome.
Poor Risk Oversight
Compounding SVB’s problems was an apparent lack of risk management oversight by the board and the risk team. SVB had a risk committee charter documenting all the components of risk management that should be in place to manage risk well. So clearly there was a disconnect between what they said on paper and their actions. SVB was without their senior most risk officer for about eight months in 2022 and only in January brought a new Chief Risk Officer on board. That leadership gap could have left the board and the risk management team in the dark on emerging risk in the portfolio and the poor strategy and practices put in place to manage their market and liquidity risks.
Another major issue that is pervasive across banking is the lack of risk expertise represented on bank boards. Most bank boards today are not equipped to challenge management on risks affecting the enterprise. Of the seven board members assigned to SVB’s Risk Committee, only one had any background remotely related to risk management and none, according to the information provided on SVB’s 2023 Proxy Statement ever held a senior risk management role such as CRO. This calls into mind how boards can ask the right questions of management regarding risks and mitigation strategies given the technical complexities of bank risks.
Aftermath
SVB’s stunning collapse is a reminder that despite our best efforts to regulate the banking sector following the 2008 financial crisis, banks can and will fail from time to time. In the case of SVB, an unusual confluence of events; over-concentration in a volatile sector, poor investment strategy, risk management practices and board risk oversight ultimately doomed this bank. Concerns voiced by regulators over buildups of unrealized losses at many banks because of rapidly rising interest rates on fixed-income investments are legitimate in that a large bank run on SVB can be a catalyst for contagion effects where bank runs at other institutions with large unrealized losses start happening. The FDIC and other banking regulators need to speedily address any such immediate contagion threat from SVB’s failure and longer-term take a closer look at the effectiveness of boards to effectively oversee, and companies to competently manage complex and integrated risks.
Photo: People look at signs posted outside of an entrance to Silicon Valley Bank in Santa Clara, California on March 10. (AP Photo/Jeff Chiu)