The recent failure of Silicon Valley Bank (SVB) has raised important questions for the safe and sound operation of other banks in its aftermath. While there are many opinions on what went wrong, it is too early to determine with certainty what mix of factors ultimately resulted in SVB’s failure. The likely suspects include a mix of poor internal risk management practices, weak supervisory oversight, misaligned incentives of banking regulations, and purely a market-driven event.  Over the coming months, reviews and investigations will shed light and provide additional clarity, but we wanted to highlight how different elements likely played a role in SVB’s collapse.

This two-part explores two key factors that likely played material roles in the failure of SVB:

Part 1 will focus on SVB’s failure to establish effective risk management practices.

Part 2 will focus on the role of regulations and supervisory oversight.

SVB Snapshot 2019-2021

SVB had a unique business model that catered to tech startups and venture capital-backed firms.  The beginning of SVB’s demise began in late 2019  and early 2020 with the pandemic acting as an accelerant.

• SVB underwent substantial changes during 2020 and 2021, with deposits increasing from $62.94 billion on December 31, 2019, to $191.43 billion on December 31, 2021, an increase of approximately 200 percent.
• To put this growth into perspective, during the same period all other FDIC commercial banks and savings institutions grew deposits at only 26 percent.

Consumers and businesses benefitted from the monetary and fiscal policies that were enacted in response to the COVID-19 pandemic.  As a result, SVB (like most banks) saw a dramatic rise in deposit inflows.  SVB likely benefitted disproportionally as a result of market activity and the concentrations in its customer base, which included private equity (“PE”) and venture capital (“VC”) firms. Bank business models are often centered on taking short-duration deposits and investing into longer-dated loans or securities. The extreme influx of deposits during a relatively short period left SVB with multiple options.

Loan demand did not follow the same trajectory as the influx in deposits, with the bank increasing loans from $32.84 billion as of December 31, 2019, to $65.85 billion as of December 31, 2021, an increase of approximately $33 billion over the same period where deposits increased approximately $130 billion. Because loan growth remained modest, the bank took the strategy of transforming these deposits into securities. This decision proved to be a material factor in the bank failure that occurred on March 10, 2023.

Risks to SVB

Reviewing publicly disclosed information within SVB’s Call Reports one can observe that the bank’s strategy was targeted at holding longer-duration securities primarily within its held-to-maturity (HTM) portfolio.

• For example, SVB’s HTM portfolio increased from approximately $14.11 billion as of December 31, 2019, to $97.23 billion as of December 31, 2021, or 589 percent, while the bank’s available for sale (AFS) portfolio increased from approximately $13.91 billion to $27.09 billion over the same period.

Now this by itself doesn’t necessarily look concerning, banks need to make a profit and if loan demand is not there then earning a small spread between the cost of deposits and high-quality liquid assets such as U.S. Treasury’s and other U.S. agency-backed Mortgage-Backed Securities (MBS) and Collateralized Mortgage-Backed Securities (CMBS) makes sense. But when you look one layer deeper, there are potential problems with this strategy that requires proactive management and mitigation. Those problems involve duration and interest rate risks.

We’ll start with duration risk. The growth in the HTM investment portfolio was likely driven by long-duration securities. Although the public data does not provide duration metrics segmented by HFS and AFS, the data does provide maturity metrics for SVB’s portfolio as a whole.

• For example, securities with a maturity of five years or more increased from approximately $16.21 billion as of December 31, 2019, to $81.70 billion as of December 31, 2021.
• At this time, the average yield on the bank’s investment portfolio was approximately 1.59 percent. The concentration in long-duration securities paired with the bank’s concentration in non-insured deposits exposed the bank to a multitude of risks, with interest rate risk looming in the shadows.

Since the 2008 financial Crisis, interest rate has been accumulating but historically low rates have prevented them from being realized. Prior to 2022, the Fed Funds rate has remained low and monetary policy by the Federal Reserve rather benign. In the past 12 months, however, quickly rising rates have lit a fuse regarding interest rates as pointed out in January by another Patomak blog.

• For instance, it took close to 2.5 years (i.e., November 2016 to March 2019) for the effective Fed Funds rate to increase from 41 bps to 240 bps during the previous rate hiking cycle.
• Conversely, in the past 12 months the effective fed funds rate has increased from 8 bps to 483 bps, and just like that, lessons forgotten from the past re-emerged.

SVB Risk Management Practices

One of the more interesting facts that have become known is that SVB had operated without a Chief Risk Officer (“CRO”) for approximately eight months following the resignation of the CRO in April 2022. We don’t know how the bank managed this departure internally, but we do know that during the eight months when the bank did not have a designated CRO the effective funds rate increased by approximately 377 bps and represented the bulk of the rate hikes experienced in the past 12 months.

The data above highlights the strategy SVB employed prior to 2022, as the size and composition of the bank’s balance sheet did not materially change post-2021. Thus, senior management should have had time to identify and better manage the risk as the 2022 rate hiking cycle commenced.

Banks are expected to establish effective risk management processes across all functions of the bank, which include capital, liquidity, and interest rate risk. Another example of poor risk management becomes strikingly obvious when you look at the composition of SVB’s deposits.  The deposit growth of approximately $130 billion appears to have flowed directly into money market deposit accounts (MMDA), which represented approximately $111 billion or 85 percent of the deposit inflow. Qualified risk managers should immediately recognize the inherent risk of these deposits, even in a non-rising rate environment, as MMDA are inherently more susceptible to changes in interest rates and have greater flight risk than other deposits.

Now, even in a stable rate environment, investing MMDA liabilities into long-duration fixed-rate investments exposes the bank to heightened liquidity risk (among others), as even a few bps can incentivize depositors to move balances to a competitor that may provide a slightly higher yield.  As of December 31, 2021, SVB had on-hand liquidity (excluding repo, HTM portfolio, and borrowing lines) of approximately $31 billion comprised primarily of AFS securities totaling $27 billion, and the remainder comprised of acceptances and cash/due from banks. That provides coverage of approximately 19 percent of the bank’s highly-rate sensitive MMDA.

Senior management at SVB appears to have made a series of critical errors in sequence with one another. Beginning with the strategic decision to use highly rate-sensitive non-maturity deposits to take unnecessary duration risk in long-dated securities. This strategy was enacted during one of the lowest interest rate periods in recorded history and was further exasperated by holding these long-dated, low-yielding assets in the HTM portfolio and limiting the bank’s ability to pivot if the interest rate environment changed. At an institution as large as SVB, this lack of effective risk management is inexcusable.

Key Takeaways / Conclusion

There are several lessons we can take away and learn from the failure of SVB, which appears to be a direct result of poor risk management practices that led to a liquidity crisis culminating in its collapse.

One of the biggest takeaways is the speed with which information travels and the impact of technology on the financial industry. The internet and social media allow individuals across the globe to interact and share information with little limitations in near real-time. The evolution of the financial industry where an individual can move money in seconds with a few clicks on a cell phone introduces a risk that may have been overlooked and underestimated until now.

• For instance, on March 9, 2023, SVB witnessed approximately $42 billion, or 25 percent of its deposit base, flow out of the bank. All of which occurred in a single day. This wasn’t in response to a situation like COVID in March 2020 or Lehman in September 2008, but rather to information going viral.
• SVB likely conducted periodic stress tests to assess the impact of various events and scenarios on the bank across various time horizons, but these are typically done over increments of a month or quarter and may not address an extreme liquidity event in a 24-hour period that SVB witnessed a few weeks ago.

This event will surely have an impact on how banks manage their liquidity and may very well redefine assumptions used in stress testing. This event and the market events that have followed bring to light an old quote from Paul Tudor Jones that is as relevant today as ever.

“Liquidity is one of those things that never matters until it does.” – Paul Tudor Jones

Put Patomak’s Expertise to Work

Patomak has deep experience in designing and assessing risk management at banks, swap dealers, broker-dealers, digital asset trading platforms, and other financial firms. If you’d like to learn more about how Patomak can partner with you, contact Keith Noreika (knoreika@patomak.com) or Joshua Kuntz (jkuntz@patomak.com).