Staying focused on the fundamentals of risk management and being vigilant about their consistent application and execution is crucial to effective risk management. Mike Russo, our resident finance and risk solution expert, is sharing his view on the recent bank collapses. During his extensive career, as a bank regulator and CFO, he has witnessed numerous occasions where banks overlooked fundamental risk management practices and basic internal controls that resulted in significant financial losses.
What can we learn from these bank runs and subsequent failures of Silicon Valley Bank and Signature Bank? In the case of SVB, the downfall was a result of a lack of sound risk management practices and a confluence of events:
· Concentration in volatile sectors
· Poor balance sheet management
· Inadequate risk management practices
· Lack of risk oversight by the board and risk team
Don’t ignore industry concentration risk
While many reasons have been offered for the demise of Silicon Valley (SVB) and Signature Bank, one obvious culprit is concentration risk. Bankers always have had to be cautious to guard against, “putting all their eggs in one basket.” SVB’s customer base was mainly VC funds and tech and life-science companies. Most of its deposits and loans were concentrated in these sectors.
Moreover, banking exclusively with SVB was often a precondition imposed on borrowers’ needing access to credit. With funding harder to access in a high-interest-rate environment, tech firms began to withdraw their deposits at a rapid rate. The Fed raised its benchmark interest rate from near zero to almost 5% over the last 12 months. The majority of SVB depositors were uninsured, well-informed, and sensitive to high rates.
SVB didn’t anticipate the extent and speed by which its depositors would withdraw money from the bank upon hearing that SVB was shedding cash at a rate that required them to raise capital. Subsequently, SVB probably never expected it could experience a run of USD 42 billion in a single day – about one-quarter of all deposits at the bank. 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.
Signature provided banking services to real estate companies, law firms, and cryptocurrency companies – the latter held significant deposit balances at the bank. So, as the SVB situation became public, the crypto industry grew increasingly concerned about the financial stability of the bank and started withdrawing their deposits from Signature, causing regulators to ultimately shutter the bank.
Poor balance sheet management
A bank’s asset/liability mix is absolutely a topic that bank executives, bank directors, regulators and shareholders need to consider carefully on a consistent and dynamic basis. In its regulatory filings, SVB indicated that it conducted regular and sophisticated market risk analysis and interest rate risk hedging activity. However, this does not seem to have been the case. The bank saw a huge surge in its deposits during the pandemic and it invested a large chunk of them in long-term, fixed-income Treasury Bonds and other fixed-income securities. From the beginning of 2020 to the end of 2021, SVB saw a deposit growth of nearly 206%. This massive inflow of cash compelled SVB’s management to invest in long-term, low-yielding, fixed-income Treasury Bonds in an effort to generate a return on all that cash.
The problem with treasury bonds
SVB had about 55% of its assets invested in fixed-income securities while the industry average is about 24%. As of the end of 2022, SVB was sitting on $16 billion in unrealized losses on its investment portfolio. From a credit risk perspective, the bank stood on solid ground. However, the market value of its bonds was declining. These losses could remain unrealized, provided the bonds could be held to maturity (measured at amortized cost), but once sold the losses had to be realized.
The problem is long-term bonds, while yielding more than short-term instruments, are more sensitive to rising interest rates. Silicon Valley Bank took on a significant amount of so-called duration risk. Duration is a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon, and call features. All of these many factors are calculated into one number that measures how sensitive a bond’s value may be to interest rate changes.
Hiking interest rates meant decline in long-term value
Since the Federal Reserve aggressively hiked rates (zero to almost 5% over the last year) to beat back inflation, the market value of long-term bonds declined sharply. SVB’s balance sheet was squeezed on both the asset and liability sides. The bank’s customers were withdrawing their deposits beyond what it could satisfy with its cash reserves, and to meet its obligations, the bank decided to sell $21 billion of its securities portfolio at a loss of $1.8 billion. The resulting drain on equity capital led the bank to try to raise over 2 billion in new capital. The announcement panicked VC investors and the degree and pace of withdrawals accelerated creating a huge run on the bank.
Excessive duration risk
Excessive duration risk was a significant factor in SVB’s downfall. Duration risk is a form of interest rate risk that SVB could have managed. In fact, they only hedged a very small part of the interest rate risk. It seems the bank made a big bet on interest rates staying low and the miscalculation was a significant factor in the bank’s demise. An experienced leadership team and board could have moved to reduce the duration risk in the bank’s investment portfolio. Clearly, the bank’s risk modeling didn’t anticipate the combination of interest rate and liquidity risk shocks it would face. Moreover, it seems apparent now that SVB’s liquidity and risk management practices were deficient.
Signature had similar pressures with deposit growth of 165% from the beginning of 2020 to end of 2021. In the case of Signature, about 88% of the bank’s deposits were business deposits as of December 31, 2022. During 2022, deposits declined by $17.54 billion (16.5%) to $88.59 billion due largely to a decline in digital asset banking deposits which decreased by $12.39 billion.
Poor risk oversight
While most organizations understand the value and necessity of risk oversight, bank boards face a pressure that is unique to most other industries. The worst-case scenario in failing to monitor or mitigate risk is always devasting as we have seen in the case of SVB and Signature Bank. So, compounding SVB’s problems was an apparent lack of risk management experience oversight by the board and the risk team. SVB had a risk committee charter covering all the components of a sound risk management program. So clearly, there was a disconnect between the documentation in the charter and their actions.
Taking risks is a core activity for banks. Therefore, we should expect the board and risk team to pay close attention to the level and types of risks that a bank need to navigate.
Provisions of Dodd-Frank were rolled back by virtue of a 2018 law that softened bank regulations in ways that contributed to Silicon Valley and Signature’s failure. Pushed by the Trump administration with bipartisan support in Congress, it removed the requirement that banks with assets under $250bn submit to stress testing and reduced the amount of cash they had to keep on their balance sheets to protect against shock. This allowed small and mid-sized banks – such as Silicon Valley Bank (and Signature Bank) – to invest more of their deposits. In October 2019, the Fed voted to effectively reduce the capital those banks had to hold in reserve.
Not unexpectedly, we are seeing calls for more stringent bank regulation from certain politicians and industry observers. House Republicans have said adequate safeguards were in place to prevent the run on SVB and signature. They blame lax regulators and monetary policy for the problem.
I anticipate the scope of regulation will continue to expand and would look for expansion of the breadth and depth of regulation. Especially, as it relates to capital adequacy, reserves, and liquidity risk management.
The failure of SVB and Signature is a vivid reminder that an inadequate understanding and management of liquidity and interest rate risk – and their ultimate impact on the balance sheet – can have devastating ramifications. Thus, banks must look to create infrastructures and risk cultures that enable the level of transparency and analysis required today. As regulators and the financial services industry investigate the causes of SVB and Signature’s rapid demise, we are reminded that liquidity issues can appear out of nowhere, snowball out of control, and do grave damage to a bank’s capital position.
The current financial market turbulence underscores the importance of getting the fundamentals of sound risk management right and being ever vigilant about their consistent application, execution, and improvement. Banks should review their capabilities with regard to governance and control, risk identification and measurement and liquidity risk management on a regular basis – in good times and bad.
Mike Russo has over 35 years of experience in financial services. In addition to his current position at SAP Fioneer, his experience includes stints as Manager of the International Department at Barclays Bank of New York, 14 years as CFO for Nordbanken’s Bank’s, and as a senior regulator with the Federal Reserve Bank where he was responsible for the supervision of large commercial banking organizations in the United States. Reach out to him on LinkedIn or at [email protected]!