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SVB: Early lessons for all financial institutions from Silicon Valley Bank’s failure

Dave Koch
March 13, 2023
Read Time: 0 min

Stress testing & deposit strategies in the spotlight

The failure of Silicon Valley Bank offers other financial institutions the chance to reassess their approaches to and management of interest rate risk, liquidity risk, and credit risk. 

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Historic collapse

SVB is different from other financial institutions

The FDIC closure and assumption of Silicon Valley Bank (SVB) – the largest bank failure since 2008 – is a stark reminder that when a crisis occurs, it can spread as fast as a wildfire in dry fields with a strong wind.

While details of the root cause of failure will come to light in the coming weeks, we do know that one major issue was the loss of depositors in a short period of time. Much attention has been placed on the sale of the securities portfolio at a loss and if that move itself was causal. I’d say not likely the cause, but for sure it was a warning flag that things were not right in this institution.

Not having any knowledge of the bank’s actual practices or internal discussions, I am relegated to supposition. But we do know that this bank had a unique business practice.

Banks in rural America are not going to have the same kind of lending activities, or depositor relationships as this bank seemingly had. Lending to startup companies with a plan to go public is not itself a problem. But what we are not aware of is how leveraged these loans were and how the economic conditions that dried up the IPO market have impacted loan performance. I’d love to know what kind of stress testing was being done on these loans. Was the loan repayment plan based on the IPO? Did the stress test consider the impact of not going public on the bank’s position?


Finding vulnerabilities

Stress testing's importance reinforced

While this bank had unique loans that most community financial institutions won’t be dealing with, it does raise the question of appropriate stress tests. Financial institutions have been hounded over and over to run stress tests on every part of the business ever since the Great Recession. I liken the design of the stress tests to the video game Angry Birds. The goal of the game is to shoot different bird types at structures to topple them and capture points, but finding the right spot to topple the structure is key to winning. Finding the connection that makes all points of the structure vulnerable is key.

Similarly, a stress test needs to be aimed at the single point of failure that could bring down the business line. Looking back to the Great Recession, I recall the banks that made Jumbo Alt-A mortgages that woke up one morning to the realization that their one conduit to sell these loans (Countrywide Mortgage) was now gone, and they were then stuck holding loans that ballooned the total assets of the bank. Boy, did that impact capital ratios.

For SVB, many of their customers didn’t need loans. In addition, the bank had money pouring in as a result of being associated with the startup tech industry. As more and more money came in from their customers, the levels of concentration risk rose.

Deposit studies

Lessons on concentration risks, deposit stability

Concern over the stability of funds should always be a major discussion point at financial institutions as they consider deposit strategies. Listing services to insure funds can also help bring more stability to retaining funds beyond that offered solely by the interest rates paid.

We often talk about how the role of a good deposit study is not just to understand the way to manage non-maturity balances in an ALM model but rather to better understand the overall concentration risks within the deposit base and offer guidance to the liquidity plans for managing or replacing large funding blocks. Do you get that from your deposit analysis? How are you designing stress tests for liquidity?

With lots of cash and lending not a central asset to generate earnings, Silicon Valley Bank needed to find a way to generate earnings. And while liquidity risk most certainly had a major role in the closure, given deposit runoff, there has been a great deal of discussion over the sale of the investment portfolio to meet liquidity needs. Enter interest rate risk.

Clearly, every bank or credit union that has purchased securities prior to the Fed raising rates has been feeling the effect of unrealized losses on those decisions. Hindsight is always 20-20, so let’s not go back and focus on the decision to buy bonds. Not many folks forecasted a Fed rate rise like the one we have seen to date. If we knew then what we know now, we’d make a lot of different decisions. But the interest rate risk hit this bank in the decline in the securities portfolio. It tanked the value of the “liquid investments” and put pressure on their tangible equity capital.

I am always amazed when I discuss with a banker how they are so dead set against making long-term, fixed-rate loans to customers for fear of interest rate risk. But then I watch the institution invest in securities with longer durations than many of the loans they could have made and think that they didn’t take on any interest rate risk. Well, we know now that is simply not the case.

Reviewing the call reports for SVB through Q4 2022, I see a bank that began increasing security positions after Q3 2021. The mix was balanced between Treasury bonds, mortgage-backed securities, and municipal bonds –  nothing overly complicated, based on call report reviews. But the move was likely an extension of duration in order to pick up yields since there was no incentive inside the 2 to 3 year window as seen in the Treasury Yield Curve below.

chart showing yields of US Treasuries in discussion of SVB lessons

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Anyone looking for yield in Q4 2021 would be drawn to the 5 to 7 year window of maturity. As we know, longer term equals higher price volatility. And like many banks, SVB encountered this in their portfolio, seeing a major decline in value when funds were needed.

Avoiding contagion

What financial institutions can do now

So the early returns indicate that SVB had issues surrounding liquidity that stemmed from presumably a less-than-stable depositor base that saw opportunities to increase returns in the new rate environment that outpaced the ability of SVB to meet demands. The resulting sale of securities created real losses on capital levels and likely restricted access to other funding options. The unknown in this is the role if any that the credit conditions played on loans that are not typical across community banking institutions.

The question is really if this is a precursor to a “crisis” and what other financial institutions should do to make sure they aren’t swept up in the aftermath. Keep reading for actions to take now.

Here are five steps financial institutions can take from the lessons of SVB's failure:

  1. Reassess your approach to stress testing of each area individually, and then how well you combine these into realistic but painful scenarios.

  2. Understand the nature of your funding and the rate sensitivity, particularly in high-balance relationships. Liquidity remains the one risk that is hard to fix once broken. Liquidity makes the banking wheels go around.

  3. Be mindful of the exposures to other risks: credit risk in a continued Fed tightening posture, or interest rate risk when the Fed begins to ease, for example.

  4. Decide when to insure against risks, even though the best of times may have passed us already. Insurance may be more expensive now but may be needed to cover the catastrophic losses that are possible.

  5. Make sure you are working with others who can help you identify big-picture risks and opportunities.

  6. Reassess your approach to stress testing of each area individually, and then how well you combine these into realistic but painful scenarios.

We know one thing is for certain, the regulators will be making this event a focus of upcoming exams.

Stay tuned for more analysis and discussion from Abrigo’s advisory team on the impact of these events and what it means for you and your institution in the coming months.

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About the Author

Dave Koch

Director, Advisory Services
Since 1989, Dave has delivered educational programs on Asset/Liability Management and pricing topics to Federal Regulatory Agencies, national and state industry trade groups, Federal Home Loan Banks, and Corporate Credit Unions nationwide.

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