Key takeaways from the fall of Silicon Valley Bank

29 Mar 2023 , 09:23 AM

The intent of the testimony was to identify key gaps in regulation and supervision of SVB; which eventually led to the collapse of the bank. 

The Fed has responsibility at 3 levels. Firstly, it has to ensure sound multi-level regulation of the banks and the banking system. Secondly, it must ensure there are internal controls and risk management systems so that the deposits of the people who entrust money to the banks are protected. Lastly, the Fed has to also ensure that a systemic crisis is prevented. It is in this light that the testimony must be seen.

First Observation: SVB did not manage risk effectively

While the rising interest rates have been cited as the reason for the fall of SVB, that is obviously not the full story. Every bank in the US was exposed to that risk. In the case of SVB, the problem was that the interest rate risk and the liquidity risk was not managed the way it should have been done. Normally depositors are OK with their deposits in a bank as long as the risk management systems are robust. 

When SVB started to desperately look for funds to fill the $1.8 billion loss from the fire sale of bonds, it was clear that risk management at SVB had gone for a toss. That was when the uninsured deposits panicked and the $40 billion withdrawal of deposits on 09th March 2023, led to the collapse of the bank the next day. It was not like the run on deposits caused the collapse of the bank. Instead, it was bad risk management that caused the run on deposits. The deposit exodus was not the cause of the collapse, but rather it was the outcome of poor risk management standards at SVB.

Second Observation: Too much concentration in the SVB model

Barr noted in his testimony that SVB had an inherently risky model, and had grown by leaps and bounds during the start-up boom of 2020 and 2021. However, the situation had changed sharply in 2022 with start-up funding hard to come by. SVB had a very narrow focus on serving the technology and venture capital sector. It also grew very fast and nearly tripled its asset base between 2019 and 2022. 

That was not the real problem. In order to enhance yields on its investments, it invested a chunk of its flows into very long term bonds for higher yields. However, longer tenure bonds are also the most vulnerable amid rising rates and that is what unravelled when SVB had to resort to a fire sale of bonds. To add to this asset mix gaffe, SVB did not effectively manage the interest rate risk of those securities; nor did it follow accepted tools, models, and metrics for handling risk.

Third Observation: Liability profile was also concentrated

This was something that exposed the bank to a very high degree of risk. For instance, the liabilities of the bank were largely composed of deposits from venture capital outfits, private equity firms and the technology start-ups. The problem was that most of these start-ups were cash burning machines. They had revenues, but ran huge losses. 

Hence, once the fund raising was deposited with the banks, there were no additional inflows. However, there were regular drawdowns as they used bank deposits to make payroll and for operating expenses. Broadly, their clients included start-ups, PE firms and VC firms. But in terms of funding cycles, they were all eerily similar. The problems of one sector would immediately rub off on the other and that is how the situation exacerbated rapidly.

Fourth Observation: A contagion is best prevented, whatever the cost

There have been concerns that the cost of preventing the contagion was high. However, it has been seen in the past that the cost of preventing the contagion will always outweigh the effects of a contagion. From that perspective, Fed moved in quickly to guarantee total deposits of SVB Bank and Signature Bank. If uninsured depositors had not been being able to access funds, it would have led to depositors questioning the safety and soundness of the US commercial banks. 

That is why the US Federal Reserve and the FDIC approved systemic risk exceptions for the failures of SVB and Signature. As a special case, the FDIC guaranteed all the deposits of SVB and Signature Bank. However, the holders of equity shares and other liability holders of both the banks were not protected and became worthless. However, saving the depositors, prevented a banking system contagion in the US.

Fifth Observation: Matching growth and risk management

That has always been the challenge and that problem gets more pronounced when it comes to banking. According to the testimony of Michael Barr, SVB had inadequate risk management and internal controls in place, which did not keep pace with the rapid growth of the bank. By 2021, SVB had moved into the category of large and foreign banking organization (LFBO) category, subjecting it to higher supervision levels. 

In late 2021, Fed found clear deficiencies in SVB’s liquidity and interest risk management. The stress test also revealed shortfalls. In 2022, the management rating of SVB had been lowered due to poor internal controls, weak risk management and lack of an ecosystem to manage liquidity and interest rate risk. In short, there have been a series of warning signals, although the challenge is to make such warnings more decisive and conclusive.

Sixth Observation: Size may not always be a good proxy for risk

Currently, banking supervision by the Fed is size based. In terms of size, the banks in the US are classified as Systematically Important Banks (SIBs), Large & Foreign Banking Organizations (LFBO), Regional Banking Organizations (RBOs) and Community Banking Organizations (CBO). With size, the regulation becomes more stringent. The billion dollar question is whether size alone is a good proxy for risk? Obviously, it is not!

According to Barr, size is not always a good proxy for risk, particularly for non-traditional banking model. However, Fed has now set up a novel activity supervisory group, for specialized risks like in the case of SVB. The regulators are also changing rapidly in the US. According to Barr, looking at risks as discrete items may not help much. It is the combination of risks that really sets off a contagion. In the case of SVB, it was the combination of overt focus on technology sector, mismanagement of interest rate and liquidity risks as well as cautious regulation that did them in.

Summing it all up for the Fed

The bottom line is that banking regulation has to evolve in the light of changing technologies and emerging risks. Risks can emanate from banking methodology and internal controls, but such risks can get exacerbated by volatile customer behaviour, focused business models and social media magnification. Regulation of banking must not look at risks in discrete form but as an amalgam of risks hitting simultaneously. Also, the Fed regulation must consider the causes of banking risk and the aggravators of bank risk to be able to come up with a workable solution. That looks like a very smart way to move ahead!