SVB Bank Tremors One Year Later (1): Key “Realizations”

Analyzing the failures of SVB and other banks in early 2023 yields lessons and premonitions of further strategic, management, and policy challenges to come involving unrealized losses.

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How time flies. It’s hard to believe that it’s been a full year since a run on deposits at Silicon Valley Bank set off a series of events leading to its failure and a brief —though hardly resolved— banking crisis. Last week, we explored what Texas has done —and what remains to be done— to keep another 2021-style Deep Freeze from happening. This week’s Gray Rhino Wrangler explores the aftermath of the 2023 banking crisis triggered by the collapse of Silicon Valley Bank.

What went wrong? What lessons have decision makers learned that might prevent similar crises from unfolding? And –most importantly—will the fixes put in place in haste in 2023 hold for the future?

These questions are about more than just the banks that failed in 2023. The answers touch on the entire banking system, the lifeblood of the economy. Regional banks and the flow of finance to businesses and consumers play a central role in economic growth and stability.

In the Previous Episode…

First, a recap: As you’ll recall, SVB –whose investors and clients were largely venture capital funds and the start-up companies in their portfolios-- failed in early March 2023 after depositors withdrew their money en masse.

That forced the troubled institution to sell US government bonds that it had intended to “hold to maturity,” a category that regulations and accounting standards allowed it to count at full face value when reporting its capital ratio and to keep the losses out of its reported income. Once the bank sold those securities, those same rules forced it to “realize” losses which in turn left it fatally undercapitalized. (Many thanks for bearing with me: To those of you for whom these terms are new for delving into what might seem esoteric but in reality affects us all; and to those of you who are finance veterans as I do my best to make sure that this complex topic is widely accessible and understandable.)

SVB’s failure triggered similar crises at Signature, and First Republic banks, which were heavily invested in speculative crypto-currency funds (Another bank, Silvergate, failed a few days before SVB). The tremors spread across the Atlantic to Credit Suisse, which was relatively quickly absorbed by rival UBS.

The crisis abated after timely interventions by federal policy makers (more below). Markets let out a sigh of relief after a few months of jitters.

The Unrealized Losses Challenge

But the problems that led to the bank failures in Spring 2023 have not disappeared. Banks and policy makers have yet to find a solution to the challenge of how to handle unrealized losses ; that is, assets that have fallen in value but whose fallen value does not affect reported income.

For banks and investors, unrealized —for now but not for long— losses in commercial real estate are the “hold-to-maturity” securities of 2023. This is an even more challenging issue than it was for highly liquid Treasury bonds, because it’s much harder to estimate the value of property losses.

I have many, many thoughts on this issue –too many, as I have discovered, to fit into today’s post. So this week will be a “two-fer”: A second installment is on the way with deeper thoughts on policy and strategic gray rhino risks related to unrealized losses. These involve many trade-offs. Are we making the right trades? I am not so sure. Are there better approaches? I look forward to a dialogue.

In the meantime, today these are the questions at hand: How did the feds, the markets, ratings agencies, other banks, and depositors respond to the last spring’s banking tremors? And what does the episode suggest for the future?

Lessons Learned

Why did banks fail in spring 2023? Post-mortems pointed to several issues , many of which (but not all) were present across all of the failed institutions:

• “A textbook case of mismanagement” (The US Fed on SVB )
• Rapid growth and loan and funding concentrations
• Boards and management failed to manage glaringly obvious risks
• Supervisors did not appreciate the extent of bank vulnerabilities
• Bank supervisors failed to act robustly enough when they did appreciate vulnerabilities
• Over-reliance on uninsured deposits and depositor loyalty
• Failure to adequately hedge interest rate risk
• Large gap between actual value of unrealized assets and the higher values on the books
• The vacant chief risk officer position at SBV for eight months out of the year ahead of the failure
• Misreading of customers’ cash needs as other funding sources dried up
• Changes in supervisory standards, including a 2018 rollback of tighter regulations , which made it harder to prevent the crisis
• Board governance issues including lack of oversight and holding management accountable
• Social media has accelerated the viral information spread that leads to bank runs
• Risk governance not keeping pace with as the bank tripled in size in just a few years
• Failure of capital requirements to appropriately measure the ability of banks to absorb losses.

Responses

The bank failures triggered quick responses by policy makers, investors, depositors, and regulators. Financial authorities were right to act quickly to minimize contagion. But choices that make sense for getting out of a crisis can have unintended consequences that create other problems in the future.

Policy Makers and Regulators

• The Federal Deposit Insurance Corporation invoked the rarely used systemic risk exception provision that allowed it to raise the usual $250,000 legal ceiling on deposit insurance in order to be able to cover all of the deposits of the businesses with money at the ailing banks.
• The Fed imposed a special assessment , falling most heavily on larger banks , intended to refill its insurance fund after the hit it took during the spring banking crisis.
• The Fed created a special Bank Term Funding Program allowing banks to borrow against their government securities holdings at face value even if their market value was much lower. Critics contended that the program was essentially giving banks cheap money. That program expires March 11 . (More on this in Part Two of this piece.)
• The FDIC sold the bulk of the assets of SVB (to New York Community Bank); Signature Bank, and First Republic (by JPMorgan Chase). Still, it estimated losses from those interventions at $18.7 billion for the first two and another $15.6 billion for First Republic. (Two smaller bank failures at the end of 2023 cost an additional, paltry by comparison, $69 million.)
• The Fed has created a new supervisory group focused on new activities that are not yet well understood (fintech and crypto, for example).
• The Federal Reserve invited comment on a new, tighter set of regulations intended to make bank runs less likely. The rules were already in the works before the banking crisis, but the timing aligned. Dubbed Basel III after the Swiss hometown of the Bank for International Settlements which created them, the rules were developed in 2009 by 28 central banks in response to the Great Financial Crisis but have been phased in very slowly. The rules would require banks to set aside more capital reserves and to account for (ie “mark to market”) additional losses or gains on securities. More on this in the next installment.

Depositors

• During the depths of the crisis, depositors moved money from regional banks to bigger banks , though the outflows slowed as the situation stabilized and many smaller banks raised deposit rates.
• Taking advantage of higher rates while likely re-evaluating the relative risk of bank deposits versus money market funds, depositors moved nearly a trillion dollars from banks to money market funds, according to recent figures from the Kansas City Federal Reserve.

Markets and Ratings Agencies

• Investors sold bank shares during the spring crisis but bought them back up after the crisis abated, ending the year little changed from the beginning.
• Investors are paying more attention to unrealized losses on bank balance sheets -from both government securities held as reserves and from troubled commercial real estate.
• Moody’s downgraded ten small regional banks and put 17 other banks on review in August 2023.
• Over the course of 2023, Standard & Poors downgraded nine banks and lowered outlooks on five others (though they raised the outlook for four other banks).
• Fitch describes the 2024 outlook for banks as “deteriorating .” In Summer 2023, it downgraded its sector assessment and warned that downgrades could be in the works. The agency’s downgrade of US sovereign debt in August 2023 did not help matters. It remains concerned about the impact of commercial real estate market troubles on bank balance sheets.

I’ve already written longer than I intended to but I have lots more to say on these subjects, how well the responses of different actors are working, and what needs to be done to improve them.

Up Next...

Stay tuned for more on:

• The looming commercial real estate unrealized losses gray rhino and renewed concerns over bank stability;
• The debate over Basel III and how much capital banks are required to hold;
• Unintended consequences (and potential new problems created by) various policy responses;
• Positive and negative externalities in banking.

I also believe that Silicon Valley Bank and the immediate aftermath were merely Phase One of a bigger set of banking tremors.

Stay tuned for the next installment coming very soon.