SVB: LESSONS TO BE LEARNT

Rick Bookstaber, co-founder of Fabric, a risk technology firm and former head of risk management at the University of California, Bridgewater, Salomon Brothers and Morgan Stanley, writing in the?Financial Times, notes:

“With the benefit of hindsight, there is hardly a risk management failure … that can’t be explained in a few paragraphs, however complex and opaque it might seem.??And it always comes down to a few points: too much risk, too little diversification, and playing fast and loose with the rules.”

SVB was no different.??It was playing fast and loose with?"other people's money" (OPM), a term which refers to the funds that banks and other financial institutions lend out to borrowers.??In this context, the bank is lending depositors’ money which must be repaid with interest.

When banks lend OPM, they are taking on the risk that borrowers may not repay, which can lead to financial losses for the bank and its stakeholders. At the same time, banks also have the potential to generate significant profits by using OPM to make loans and investments that yield higher returns than the interest paid to depositors.

Gillian Tett writing in the?Financial Times?notes:

“During the past decade banks enjoyed abundant cheap funding because their customers left their money in low-yielding bank accounts due to a lack of better alternatives. The banks then made profits by extending loans at slightly higher rates and buying long duration assets such as treasuries.”

RISKS

CREDIT:?In SVB’s case, the risk of not being repaid was very low since they had invested/lent the OPM to the US government in the form of gilt-edged securities—long-term US Government Treasury Bonds.

INTEREST RATE:?However, these long-dated fixed rate Treasury Bonds were subject to interest rate risk, and as interest rates rose, SVB incurred mark to market or?unrealised losses when these bonds were accounted for using their current market value.??SVB should have hedged this risk using interest rate swaps, but this would have reduced its net interest earnings.??They chose short-term profitability over long-term stability and paid the price,?a recipe for disaster, and the chickens came home to roost as the Fed raised interest rates to combat inflation.

CONCENTRATION:?SVB’s depositors, the majority of which were start-ups, were concentrated in Silicon Valley and the very volatile technology sector—one region and one industry.??They were also primarily companies, as opposed to individuals and many had accounts that were well over the US$250,000 guaranteed by the Federal Deposit Insurance Corporation (FDIC).

I assume that SVB knew their customers.??But did they communicate with those customers???Did they understand how closely connected those customers were to each other???As Bookstaber notes, “… although not part of the usual risk discussion, SVB clients all had pretty much one degree of separation, sharing the same central nodes. To wit: Peter Thiel’s Founders Fund and other high-profile venture capital firms?advised their companies to pull money from the bank. It’s like having all of your power lines on one master switch.”

I am also not sure that SVB’s customers knew the bank.??I believe that SVB failed to communicate that they were aware of the liquidity risks and were in the process of raising funds to meet all obligations.??I also believe that the situation was compounded by social media, in this case Twitter, and the speed with which depositors can move money electronically today.

LIQUIDITY:?These deposits were also primarily in the form of short-term checking, savings and money market accounts.??Therefore, as cash-strapped depositors, faced with a down-turn in the tech industry and a reduction in funding from venture capitalists, began withdrawing their deposits, SVB had to sell their Treasury bonds at deep discounts crystallizing their losses.??They also found themselves on the back foot scrambling to raise funding in the middle of a crisis.

REMEDIES

REGULATORY OVERSIGHT?refers to the rules, laws, and regulations put in place by government agencies to ensure the safety and soundness of the banking system to protect consumers, maintain financial stability, and prevent fraud and abuse in the banking industry.

In most countries, banking is regulated by a central bank or a regulatory agency that is responsible for overseeing the banking system. These agencies set rules and regulations that govern the operation of banks and financial institutions, and they also monitor and enforce compliance with these rules.??Unfortunately, SVB was not subject to the level of oversight required of the biggest banks because of?regulatory changes passed in 2018, and implemented by the US Federal Reserve in 2019, which some believe weakened the system.

As?Martin Wolf?notes:

“The failure of Silicon Valley Bank shows there are holes in the US regulatory dike. That is no accident. It is what lobbyists called for: get rid of onerous regulations, they cried, and we will deliver miracles of growth. In the case of this bank, what stands out is its reliance on uninsured deposits and its bet on supposedly safe long-duration bonds. At the end of 2022, it had?$151.6bn in uninsured domestic deposits?against about $20bn in insured deposits. It also had substantial unrealised losses on its bond portfolio, as interest rates rose. Put these two things together and a run became likely: rats will always abandon sinking financial ships.”

Part of the remediation, to ensure that this does not happen again, should be ensuring that all banks and financial institutions with over US$50 billion in assets are subject to the same level of regulatory scrutiny.??Regulatory oversight is critical to maintaining a stable and trustworthy banking system that serves the needs of consumers and businesses while also safeguarding the broader economy.

STRESS TESTS?are a tool used by banks and financial regulators to assess the resilience of a financial institution's balance sheet and overall financial health under adverse economic scenarios.??During a stress test, a bank's financial condition is subjected to hypothetical scenarios that could have a significant impact on its ability to meet its financial obligations, such as a severe economic downturn, a sudden drop in asset prices, or a spike in unemployment. These scenarios are designed to be severe enough to test the bank's ability to withstand economic shocks and continue operating under adverse conditions.

Stress tests are typically conducted annually or on a regular basis by regulatory bodies, such as the US Federal Reserve, the European Central Bank, or our own Trinidad and Tobago Central Bank. The results of the stress tests are used to assess the bank's capital adequacy, liquidity, and risk management practices, and to identify any vulnerabilities or weaknesses that need to be addressed. This information can be used to determine if the bank needs to take any corrective actions to improve its financial health or if regulatory intervention is necessary.

I believe that in addition to the usual capital adequacy and liquidity risks, concentration and reputational risks must now be considered and the speed with which social media can impact a bank’s operations must now be factored into any stress scenario.

CONTINGENCY FUNDING PLANS (CFP)?must?be an essential component of a bank's overall risk management strategy.??After identifying and assessing what could go wrong and the likelihood of various risks, a bank should identify various funding sources to ensure it has sufficient liquidity to meet its obligations during a crisis. These funding sources may include short-term and long-term funding, lines of credit, and access to the central bank's discount window.??Its contingency plans should include clear communication strategies, such as notifying regulators, investors, and customers, as well as a plan for managing the bank's liquidity position.

Overall, a robust CFP is essential for a bank to manage its financial risks and ensure that it has the resources it needs to weather unexpected events. A well-designed CFP can help a bank maintain its financial stability and protect its reputation, even in the face of challenging circumstances.

KYC ("Know Your Customer")?is the process that banks and other financial institutions use to verify the identity of their customers and assess their potential risks to ensure that their funds are not sourced from criminal or terrorist activity. KYC is an important part of anti-money laundering (AML) and counter-terrorism financing (CTF) regulations, and it is mandatory for banks to follow these regulations.

In this case, I believe that SVB would have been well served by really knowing their customers and ensuring that those customers understood their business model, so that they would have retained confidence that the institution could meet its obligations when they fell due.

SVB’s demise was the result of lax regulation compounded by the perfect storm of mismatched funding, a concentration of depositors in an industry in crisis and the power of social media to galvanise action in record time.??It may have been the first, but it will not be the last.??Therefore, bank leadership and regulators must prepare, yet again, for another new normal.

Next week we will look at banking in the Caribbean and whether we should be concerned.??Have a disciplined week as you work to build your financial freedom.??If you find this advice helpful, please share with your friends and colleagues.??As usual, I look forward to your questions and comments.??Be safe.??Take good care, and if you can, help someone in need.

Cheers, Nigel

Nigel Romano, Partner, Moore Trinidad & Tobago, Chartered Accountants