Silicon Valley Bank is already relegated to the finance history books as a case of liquidity and funding mismanagement
Out of the blue in 2023 came the hearty rumbles from Silicon Valley. The shocks rippled around the globe and perhaps led to grave concern about the health of banks and the financial system from here to Switzerland.
We all know and have heard about the demise of Silicon Valley Bank. We have, too, observed the countless critiques, observations and accounts of what happened. And we have watched the "blame game": What happened? Why? Was there incompetence among those responsible for managing liquidity risk and short-term funding at the bank?
There has arguably been as much analysis and second-guessing and finger-pointing in regards to Silicon Valley Bank as there were the number of people who were familiar with the bank before the FDIC stormed into Northern California.
Silicon Valley Bank risk managers, in effect, under-estimated the risk of maintaining a concentrated deposit base (corporate deposits from technology companies and the venture capital funds and investors of many of those same companies). It mis-read the behavior of such depositors and overlooked the scenario that many of them would choose to withdraw funds en masse in a short time frame. It also mis-calculated the probability that it would need to sell off long-term U.S. Treasury (and Federal agency) bonds to meet such run-offs.
It invested in such fixed-income bonds in the first place, because (most of the time) long-term bonds generate a higher yield (and higher earnings) than do shorter-term bonds. They intended to hold the bonds until maturity. The urgency to purchase such bonds was explained by a decade or so of low interest rates. Banks feel compelled to invest funds to achieve the highest returns on assets, whether the assets are consumer loans, corporate loans or investments in securities.
With its surge in deposits (mostly from corporates, almost negligibly from consumers), it couldn't increase loans at the same pace. All that idle cash had to be invested somewhere. The bank was lured by the relatively higher yields on longer-term bonds.
Students of fixed-income markets know--and Silicon Valley Bank risk managers probably knew--that when interest rates rise, as they have done so steadily the past year or so, the market value of such long-term fixed-rate bonds decline.
The amount of the decline is a function of the maturity of the bonds. More specific, bond analysts, traders and investors compute the "(modified) duration" of such bonds, which more specifically suggest precisely how much the values of such bonds can decline if rates rise.
"Modified duration" is not the same as the maturity of a bond, but it is a function of it. A 10-year U.S. Treasury bond paying a 2% coupon interest rate will have a duration of about 8.8. That implies that if interest rates rise by 100 basis points (1%), then the bond will lose about 8.8% in value.
Silicon Valley risk managers likely were aware of these basic bond principles. However, they naively presumed they would never be forced to sell long-term maturities suddenly and without warning. They never addressed the scenario that it could lose over $2 billion and be forced to realize such losses after a sale of bonds.
Banks around the world have experienced the same--banks from Citigroup and JPMorgan Chase to community banks in the neighborhood. Massive amounts of their similar investment portfolios in fixed-income securities have also been clobbered in value.
Larger banks with more experience and competence in derivatives markets may have successfully hedged against interest-rate rises. (Some had reported booked "deferred interest-rate swaps" or "interest-rate swaptions," where losses in investment portfolios could be offset by marked-to-market gains in related derivatives activities.)
Regulators are aware of the same risks and examine banks closely to see if they understand the same risks and are managing them properly. For banks smaller than the top-tier systemically important banks (like the Goldmans and JPMorgans), losses in an investment portfolio are not deducted from capital until the bank has sold the investments or realized the losses in earnings. In some sense, the banks are granted earnings and capital relief under the premise that banks are investing idle funds and plan to hold them in these securities for long periods. They are not speculating and trading. The longer they hold the investments, the more likely they would recoup their unrealized losses.
Unlike banks in the same regulatory segment (size) as Silicon Value Bank, the larger "globally systemically important banks" are required to deduct those losses in value in capital totals, especially the capital that counts as a regulatory cushion. And larger banks (those with assets that exceed $700 billion in assets) are subject to much greater scrutiny and liquidity requirements than those that fall below. Larger banks, too, as many have learned the past month, are subject to rigorous stress tests administered by the Federal Reserve.
(The Federal Reserve's stress tests for 2023, naturally, will include a more rigorous test for deposit run-offs than it has done in previous years.)
Liquidity risk managers at Silicon Valley (or more formally, those who lead a bank's "Asset-Liability Committee") deserve the criticism they are receiving. But what happened at SVB could easily have happened at dozens (if not hundreds) of other banks in the U.S. SVB managers likely quantified the risks. Some report or some model would have showed that if interest rates rise by 100 basis points, then 10-year Government bonds would decline by 8% or more in market value. Regulators look for such models and report.
SVB's big bet--the gamble that large corporate depositors would not likely withdraw funds all at once and they would not need to sell investments so quickly--went awry.
The stories have also been well chronicled about the bank's concentration of deposits. Despite the legends of tales of retail depositors lining up to withdrawn funds from a bank rumored to be failing, most banks enjoy the "stickiness" of retail deposits. Large, familiar investment banks like Wells Fargo and Bank of America value small deposits when managing liquidity risks. (They may not like the operating costs and administrative attention sometimes required to maintain them.) History shows retail depositors are much less likely to run-off or run away if it appears a bank is in rapid decline.
Of course, retail depositors are comforted by deposit insurance (the FDIC in the U.S., up to $250,000). And many consumers have administrative inertia when it comes to making large withdrawals and closing accounts--the time and expense involved in withdrawing all banking services from one bank and searching for another institution.
Regulators examine historical run-offs based on past stress scenarios and observe empirically how classes of depositors behave during those periods. The Financial Crisis of 2008-09 is a best example. During this period when many were doubting the survival of the U.S. financial system, run-offs from retail depositors were insubstantial compared to massive run-offs from corporate and financial-institution depositors, many of which are have exposures far above FDIC guarantees.
New Basel III and U.S. Dodd-Frank rules attempted to address these scenarios and penalize banks with substantial non-retail deposit bases. But those same rules were lightened years later and weren't applicable to Silicon Valley Bank.
Even with the awareness or knowledge that non-retail deposits would be unpredictable and whimsical, the bank doubled-down on its concentration of large deposits from the corporate motors that run Silicon Valley: technology companies, venture-capital firms, tech entrepreneurs and venture-capital partners.
The story has been rehashed, re-told and reviewed non-stop about the "death spiral" that occurred when the bank began to sell investments it never intended and planned to sell at losses that began to approach billions. A "death spiral" starts when such an incestuous financial world (usually institutions that provide funding to other institutions) shares tales about the probable demise of a bank (or broker/dealer or hedge fund). That the demise may be, in fact, imminent is not as important as no lender wants to be caught with losses when there was an opportunity to get out.
The sudden, unplanned run-offs force the bank to sell assets at losses to accommodate withdrawals. More withdrawals lead to further withdrawals and asset sales at a loss to meet payouts.
For this bank, the circle of tech-company and venture-capital deposits pass the word among themselves until the bank ultimately becomes illiquid while sliding toward insolvency. The FDIC intervenes, the spiraling stops, but the game ends for the bank.
The best-run banks would have prepared for such scenarios, even if the probability of occurrence is remote or near zero. Those banks have elaborate contingency plans and conduct stress scenarios that outline steps to take when depositors start to behave in such fashion. Such a contingency plan would ordinarily have been requested and reviewed by regulators.
Silicon Valley likely had such a plan, if only because regulators would have requested to review it. The plan likely made pertinent assumptions about unexpected run-offs, but might have confidently assumed that the tech industry will embrace and support it during periods of stress. The bank might, too, have conducted stress tests covering the scenario that occurred (rising interest rates, devalued bonds, realized bond losses resulting from selling bonds it had not intended to do so).
Could the bank have hedged against the losses that accumulated in the investment portfolio? It could have, but market risk managers there (if they had such) expected never to be forced to sell this portion of the securities portfolio. The investments were classified as "held to maturity" (by accounting and regulatory standards). If bonds issued by the U.S. Government or Federal agencies are indeed held to maturity, we ordinarily presume there is no market or credit risk. There would be no losses at maturity date.
SVB could have still hedged against losses, if they were in what they thought was a worst-case scenario where they would be forced the sell the securities. Those hedges might include such products as interest-rate hedges (using such products as interest-rate swaps, Treasury futures, interest-rate swaptions, or deferred swaps). If properly constructed, such trades would offset the losses from being forced to sell long-term investments.
Silicon Valley may have considered such hedges, but may have thought it didn't need to do so or didn't want to go through the administrative chores of managing the hedges or meeting ongoing requirements (fees, costs, margins, collateral, etc.) while maintaining hedges.
When a U.S. bank and the FDIC intervenes, as it did with Silicon Valley, pundits and media observers exclaim how the Government has "bailed out" depositors or how taxpayers saved depositors and lenders to the bank. In practice, the FDIC is a Government organization and is an important regulator (standing alongside the OCC, the Federal Reserve and state examiners, but it effectively is an insurance company. Banks pay premiums for the privilege of having depositors "bailed out" when they falter.
Long ago, the FDIC charged banks based on deposit levels. The percentage fee would change from year to year. The FDIC, at the beginning of the year, would announce whether fund resources were rising or sagging and levy fees based on such resources. In some years, if the FDIC felt it was fully funded, the fee would go to zero. Whatever the fee was, banks sometimes found ways to pass that cost to customers--even large corporates with deposits > $100,000 (at that time). They do that quietly and sometimes embed it in other fees. Some large depositors would try to negotiate that away.
Eventually the FDIC changed to a risk-based assessment. It charged the fee based on the riskiness of the assets of the bank; hence, all banks don't pay the same rate.
Nonetheless, when the FDIC has determined that a bank is failing, it first tries to liquidate net assets of the bank before it taps into its own fund. Often it can do that successfully. Equity shareholders ("loss-absorption" capital is how regulators regard the capital base) get wiped out, but debt-holders and depositors have some meaningful recovery.
We all know now that in the Silicon Valley case, the FDIC intervened quickly in the way it does so conventionally. But after a few days, it decided to guarantee not only deposits below $250, 000, but deposits above that mark, as well. That might have sparked much of the banter of a Government bailout.
It took this step to stabilize financial markets and the global financial system and minimize the contagion that seemed to spark run-offs at other similar banks around the country and the world during that week.
After Silicon Valley imploded, markets panicked and wondered which bank could be next. Markets presume (sometimes rationally, often times irrationally) that factors that led to Silicon Valley's demise will also lead to failure elsewhere. In just days, there were rumblings that swamped First Republic Bank and Charles Schwab in the U.S. and
Credit Suisse and
Deutsche Bank abroad.
Credit Suisse had already been labelled a troubled bank, not because of liquidity-risk mismanagement, but because of embarrassments and stumbles in its investment bank (including losses related to exposures to
Archegos, the failed hedge fund). Yet asset losses of any kind can certainly lead to liquidity and funding challenges, as we observed with Silicon Valley Bank.
UBS, days later, bought out Credit Suisse (at the urging of Swiss regulators) at a bargain-basement price, which reminded many of the swift sale of Bear Stearns to JPMorgan Chase in 2008 (at the urging of the U.S. Treasury).
Over the past few weeks, regulators have mapped out and resolved what will happen at Silicon Valley. After its announcement to guarantee all deposits, the FDIC began the work-out of the bank's net assets. An East Coast financial institution agreed to purchase large amounts of the balance sheet, which includes much of the loan portfolio and depositors who remain. Shareholder value is erased, while the FDIC reduces the likelihood that it would need to tap its own funds to make depositors hold. Other assets are up for sale, too.
Before this type of resolution was unveiled, those with large, uninsured deposits had begun to speculate whether they could sell their stakes to distress investors eyeing a trading opportunity if there is still a possibility of recovery at a failed borrower.
Hence, an existing lender or depositor with more than $250,000 of SVB exposure might be willing to sell that exposure to a third party at a discount. The buyer, of course, will assess how much recovery the FDIC could achieve as it goes through resolution. (Would the FDIC permit such transactions or sales?) A corporate depositor with, say, $2 million in SVB deposits would consider selling that deposit to a third party at, say, 25% discount. The third party might deduce that the ultimate loss is, say, 10%, instead of 25%. These potential transactions disappeared when the FDIC announced it would guarantee all deposits.
In the end, in just a matter of three or four months, a brand-name bank that had carved out a special niche among technology companies and venture capitalists and that had exhibited astonishing growth in recent years has already been relegated to the finance history books, one of the prominent cases of failed liquidity risk and funding mismanagement. It joins the chapter that describes the mishaps and demise of Bear Stearns, Lehman Brothers, Long Term Capital and Washington Mutual.
Tracy Williams
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