Silicon Valley Bank: Gross Mismanagement or Government Failure (or Both)?

While we still have much to learn about the inside dealings that led to one of the largest bank failures in U.S. history last week, two things have become abundantly clear, the Silicon Valley Bank (SVB) debacle involved gross mismanagement and negligence by the bank board and senior management, and it was a major failure of government regulators. Here is why.

Let me start by saying that multiple, clear, and serious “red flags” had been present for at least 3 years. Internally, the Board, the CEO, CFO, Chief Risk Officer (CRO), Internal Auditors, etc., and externally from their independent audit firm to the Federal Reserve and FDIC, they were all keenly aware of the bank’s precarious position, in fact, on March 6, FDIC Chairman Martin Gruenberg, stated… ”as a result of the higher interest rates, longer-term maturity assets acquired by banks when interest rates were lower are now worth less than their face values… The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022. “ Thus, the FDIC was well aware of this systemic problem, and specifically the looming SVB failure.

So why did no one act until it was too late? That question may be better answered when we have more time. Today, let’s just briefly examine some of the obvious “red flags” that were present at SVB.

I spent less than an hour reviewing the publicly available 10-K reports from 2018 to 2022 for SVB and then prepared a brief five-year bank Key Performance Indicator (KPI) table (with some visuals/graphs to follow). First, here are some revealing statements (bolded by me for emphasis on key areas) management made below in their 2022 10-K:

• Our interest rate spread may further decline in the future. Any material reduction in our interest rate spread could have a material adverse effect on our business, results of operations or financial condition.
• Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
• We have experienced significant growth during 2021 and into 2022, including deposit growth. If we again experience deposit growth at a similar or greater rate than has occurred in the past, we may need to raise additional equity to support our capital ratios.
• Concentration of risk increases the potential for significant losses, while the establishment of limits to mitigate concentration risk increases the potential for lower revenues and slower growth.
• An ineffective risk management framework could have a material adverse effect on our strategic planning and our ability to mitigate risks and/or losses and could have adverse regulatory consequences.

Thus, it is clear that both regulators and management were quite aware of the highly volatile situation SVB was in – but again no serious mitigating steps were taken by those that could have avoided this fiasco. Why? (again, for another time).

For today, note that I have summarized some of the bank’s most important KPI measures below from their publicly available 10-K’s – this reveals several immediate, clear, and serious red flags obvious to all stakeholders, especially when one compares SVB’s KPI’s to optimal industry benchmarks (based on available industry data and my experience as a former commercial banker) as listed below:

Here are just three areas that should have sounded the alarm…

1. Deposits grew too rapidly (especially short-term, riskier, noninterest-bearing liabilities/deposits) ?to be able to effectively loan out in a diversified and variable interest rate manner (prime plus, etc. not fixed rates) business, commercial real estate, etc. Note the low and declining ROAA levels as a result (right). Also, their very low "Loan to Deposit" ratio compared to the optimal industry benchmark (see KPI table above) was a hugh, waiving red flag for years – clearly, these trends should have raised serious alarms about liquidity, profitability, risk, and capital adequacy.

2. Invested too heavily in Fixed Bonds / HTM Securities. Since all the excess deposits could not be quickly turned into quality loans (which would have increased their spread, NIM, profitability, etc. significantly) their Loan to Deposit ratio had dropped from 53% in 2018 (already way too low. 80% is the target ratio for most banks) to 38% in 2022 – again a major red flag as the excess deposits were then placed in longer-term fixed rate bonds, creating a major duration gap risk (funding long term earning assets, with short-term deposits/liabilities) that were also highly sensitive to interest rate increases (as interest rates increase, bond prices decrease – there is an inverse relationship). Thus, their low-earning, high-risk bond investment portfolio increased in size from less than $15 Billion in 2018 to over $95 Billion in 2022 (a more than 6-fold increase). No appropriate risk mitigation steps were taken. The value of these bonds as interest rates rose fell well below their face value and significant looming losses were imminent.

3. Significant Increase in Expenses (noninterest). There has been a concerning trend of increasing overhead and noninterest expenses (higher than typical industry compensation levels, excess bonuses, funding numerous costly “green” and/or ESG causes, etc.) as evidenced by a worsening “efficiency ratio” which should remain under 50%. This revealing noninterest expense / overhead ratio had worsened each of the last five years to 58.28% in 2022, a negative impact of 29.3% since 2018.

There are a number of other contributing factors in SVB’s demise, and certainly, as we continue to learn more about what took place behind the scenes in this tragic event, this will prove to be a comprehensive business school case study in the future. For now, take a look at some of the numbers and graphs prepared from the summary KPI table above – and you will also clearly see the obvious!

This graph (right) is a helpful visual of the data that demonstrates how much faster deposits grew than loans (in millions) – the widening GAP each year, especially the last 3 years is vast. It has also been reported that over 90% of the deposits were over the $250,000 FDIC insurance limit at SVB, in other words, 90% of SVB’s deposits were not insured – a highly unusual situation that should have also raised great concern and alarms.

Thus, one can clearly see the red flags were not only obvious by just using basic public reports, but they were everywhere! We have not even touched on the other unethical decisions and possible illegal behaviors of management, but the questions I will leave you with today are:

• What can we learn and improve from this debacle?
• Are additional changes needed in the banking industry?
• How can other bank failures be avoided in the future?
• What actions should the federal regulators have taken to avoid this massive failure, and what steps should they now take to strengthen the U.S. banking system?
• Why did the SVB board and management not take the needed actions to prevent this tragic failure, and what steps should other bank boards and managers now take as a result of this enormous fiasco?

Manuel Salazar III, EdD, MBA, CPA/PFS, Associate Dean of the Jessup School of Business and Master of Accountancy (MAcc) Director. Former commercial bank senior financial & accounting officer.

Find additional insights and brief quotes about the SVB failure from several of my colleagues below:

Erin Hill, J.D., LL.M., Associate Professor; Previous Associate Dean, and a former industry Vice President of Finance.

Was more “regulation and oversight by the Fed the answer to the SVB failure? Would comprehensive diversification requirements, limits to the percentage of hedging, higher monitoring and controlling of banks at solvency risk, & holding management and boards more accountable deter another failure like SVB? Does the failure of SVB prove the current banking industry's regulatory system is insufficient? Only time will tell...but one thing is clear, failure to count the cost has caused SVB to be the greatest mockery of 2023."

Kent Meyer, Ph.D., LL.M. J.D., M.B.A., Adjunct Professor, former industry CFO and current professional law corporation President and Owner.

“The Silicon Valley Bank (SVB) debacle is an example of what happens when bank managers are incompetent and [overly] politically [and ESG] motivated… they invested in low interest rate [fixed] bonds which, as a result of [inflation and rising interest rates]… are now worth less than their original purchase price. Additionally, bank executives took large bonuses and sold bank stock just before the failure. The fact that the $250,000 FDIC limit was totally disregarded creates real problems for subsequent failures…”

Richard Yang, M.B.A., J.D., former investment banker, and professor of Finance and International Business.

“The SVB failure has its roots in 2018 when… the threshold for stress tests [were reduced] from $50 billion to $250 billion in assets. This law was under Section 401 of EGRRCPA (Economic Growth, Regulatory Relief, and Consumer Protection Act) which amended Section 165 of the Dodd-Frank Act.

SVB, at the time of its collapse had approximately $200 billion in assets. Banks below $250 billion were no longer subject to these regulations meant to ensure that bank management keep to risk management practices that were diversified and prudent. These forward looking stress tests such as the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test, conducted by the Fed, reviews the bank's capital ratios, and how well it can meet its obligations during difficult economic cycles… had the stress tests' threshold not been raised, the bank's management would have been forced to meet various covenants imposed by Dodd-Frank designed to prevent such a lack in the bank's fiduciary responsibilities…”

Jeffrey Jones, CPA (retired), Adjunct Professor, former Senior Audit Partner with a global firm for nearly four decades, and served as a “Professional Accounting Fellow” in the Office of the Chief Accountant of the U.S. Securities and Exchange Commission (SEC).

“The failure of SVB raises many questions. Although a run on the bank such as this one can’t easily be predicted, it is important that questions as to its underlying root cause be addressed.?Among others, such as the extent and effectiveness of federal regulations,?it causes one to question the effectiveness of the bank’s corporate governance… the signs were there… ultimately resulting in the need to dispose of investments that had fallen in value, management in 2022 largely ceased hedging the inherent interest rate risk associated with long-term government bonds and mortgage securities… [funded by] demand deposits, and the technology industry was suffering a downturn. Was management effectively betting that interest rates would soon start to decline??How effective was the Board’s Finance Committee in overseeing the investment strategy, or the Risk Committee in overseeing management’s hedging decisions??

From an accounting perspective, SVB may have to answer questions as to management’s assertions that they had both the intent and ability to hold to maturity a large part of its bond portfolio, which allowed it to reflect in its balance sheet those assets at original cost rather than recognize the reduction in value as a reduction of income and equity.?All of these matters raise the question - were these just bad business decisions that became clear only in hindsight, or was it negligence or worse on the part of management and the board?”

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Concluding Thoughts from Dr. Salazar: As more and more details are revealed in the future, we will learn much more about the ins and outs of this massive and historic bank catastrophe, but for now we can clearly conclude that the "red flags" were obvious and numerous for all to see - for at least the last three years… and that the SVB’s board and management, along with federal regulators, all failed.

More importantly, may we now begin to consider the key questions I have posed above (along with others), being fully transparent, competent, honest, unbiased, and thorough, so together we can learn, improve, and better master the “art and science” of sound and effective commercial banking practices for the benefit of all stakeholders, and so that, God-willing, we will never see another SVB again! ??

Where no counsel is, the people fall: but in the multitude of counsellors there is safety. Proverbs 11:14

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The Jessup School of Business offers MBA and MSCS programs at its urban campus in Silicon Valley, and offers BSBA, BAcc, MBA, and MAcc programs at its main Rocklin campus near the California State Capitol. Jessup University is a private, non-profit, Christ-centered institution of higher-learning founded in 1939. The business school is regionally accredited by WASC, and professionally accredited, and globally recognized by ACBSP. Learn more here