Silicon Valley Bank - If You Own Bonds, are your ALM Practices Bullet Proof?

Written by Cecile Lotter - Engagement Professional

Although most South Africans should be mildly affected at worst by the Silicon Valley Bank (SVB) collapse (we have enough to deal with already!) it always pays to reflect on what went wrong in such a crisis.?How can a repeat be prevented in future and what lessons are to be learnt?

As with most disasters, the collapse of SVB was not caused by a single event, but rather a combination of factors, namely, (i) poor management decisions; (ii) ?adverse market developments; ?and (iii) the absence of proper regulation to prevent the inevitable end result.?We have seen this show before and will again when these three elements combine.?

The role of a Chief Risk Officer (CRO) is an important one.?In fact, the Basel Committee on Banking Supervision’s Basel III framework includes a requirement for banks to appoint a CRO.?Yet SVB did not have a CRO for the better part of 2022 – a critical time given market conditions and tech sector upheavals.?No captain of the risk management ship to ensure sound risk management practices and communicating the impact of management decisions on the risk profile of the bank.?One can only speculate that this left senior management to their own devices to make decisions based on profitability alone, and without the voice of risk management reason whispering caution.

Fingers have been pointed at the US Fed and their monetary policy decisions.?Did the aggressive hiking cycle by the Fed contribute to the collapse??Absolutely, but of more concern is that the interest rate hikes should not have caught anyone by surprise.?After a decade of cheap money followed by increases in inflation, every portfolio manager in the world would have known that interest rate hikes were on the cards.?The managers and risk managers at SVB should have included a range of interest rate stress scenarios in their planning and hedged any exposure that they did not have appetite for.??If they used a VaR sensitivity metric, this should have been calibrated properly to a range of interest rate movements and not just the benign shifts of recent years.?The proper implementation of sound Asset-Liability Management (ALM) practices would have ensured a much better duration match than what SVB was running, preventing cash being locked up in long dated and high duration bonds.?These bonds that SVB were invested in were sound and liquid instruments.?For the most part, they were Treasuries and government-backed bonds which would tick all the boxes from a credit perspective.?But if bonds are not held to maturity there is a significant mark-to-market (MtM) element to their price that needs to be taken into account.?During times where interest rates move aggressively, these are not low risk instruments.?The MtM losses on the bonds held by SBV were so significant, that by the end of September 2022 SVB was technically insolvent.?Yes, they were unrealised losses as the bonds were still held on the balance sheet but once deposit outflows started gaining traction, SVB had no choice but to liquidate a large part of their bond portfolio and crystallise the losses.

This brings us to the last and most important element in the SVB perfect storm – the lack of adequate regulation.?After the global financial crisis in 2008, significant resources were poured into more effective regulation of our global banking system.?This has been largely effective – the disclosure requirements under Basel III for banks are extensive and cover a range of risks and stresses.?However, in 2018 a bill was passed by US Congress which significantly lowered risk management requirements for banks with assets below $250bn.?This meant that SVB was not subject to the same regulatory scrutiny and stresses as many of the larger banks.?The regulatory framework is a safety net that would have: (i) ensured the appointment of a CRO; and (ii) required the proper interest rate risk management practices and disclosures.??As this safety net was not in place, SVB was allowed to conduct their risk management in a way that was not in line with global best practice standards.?

So far it appears that any contagion has been prevented, despite news headlines indicating depositors moving their cash to the larger banks (where proper disclosure and regulation is required).?Credit Suisse appears to be struggling as a result of poor performance, rather than risk managers dropping the ball.?Many banks will be releasing financials over this time of the year and they can be assured that the numbers will be scrutinised, particularly the sections on market risk.?

The SVB collapse serves as a useful reminder to banking treasury desks to ensure their Asset-Liability Management practices are bulletproof. It is important to understand what the stress scenarios prescribed by regulation can tell us, and whether these stresses fully capture the risks to a bank or business. ?If there is no requirement to disclose these results, then some more surprises might be lurking under the hood...