WHAT HAPPENED WITH SILICON VALLEY BANK?

On March 10, 2023, Silicon Valley Bank (SVB) was declared insolvent and taken over the by the FDIC.  With total assets of $209 billion and total deposits of $175 billion, this was the largest bank to fail since 2008 and the second largest bank failure of all time.  No doubt there will be multiple post-mortems, failed bank reports, and regulators hauled before Congress.  In the meantime, though, I wanted to provide some initial thoughts.

SVB was a state-chartered member of the Federal Reserve System and was regulated by the State of California and the Federal Reserve, with the FDIC acting as backup regulator and insurer.  I’m basing my observations entirely on publicly available information and the insights gained from a career examining banks.

The size of the bank was not the only element that made the FDIC’s takeover significant.  Usually, the preferred path is to find an acquirer for the troubled bank, sometimes with FDIC assistance.  That’s what happened with Washington Mutual, Wachovia, and most other failed banks.  This was a liquidation.  That usually means that the regulators have thrown up their hands and conclude that no one wants to buy the place.  There is essentially no franchise value.

The two most critical elements of a bank’s continued existence are its liquidity and its capital.  Press coverage often conflates the two concepts but they are quite distinct.  Liquidity is the amount of cash or high-quality investments available to meet obligations.  That can include day to day operations or under stress, such as a bank run.  Capital is the bank’s net worth:  its assets (like loans and investments) minus its liabilities (like borrowings and deposits).  Regulators look at capital both relative to total assets (this is known as the leverage ratio) and relative to risk-weighted assets, which assigns a higher weight to riskier assets, with some assets, such as U.S. Treasuries, risk weighted at zero.

I looked at SVB’s Call Report and Uniform Bank Performance Report (UBPR) as of December 31, 2022.  The Call Report contains the bank’s detailed financial statements and the UBPR is an analytical report that looks at trends and key ratios relative to similar banks.  These reports are available on the FFEIC’s public website.  At first glance, some of the numbers look pretty good.  SVB’s risk-based ratios are well over 15%, comfortably above minimum requirements.  Its leverage ratio is just a shade under 8%, also well in excess of requirements.  Net income was also in line with peer banks.

So what was the problem?  A few things.  News reports showed that the bank’s available for sale (AFS) investment portfolio was about $2 billion underwater.  This unrealized loss is recognized in the bank’s GAAP financial statements but gets added back for regulatory capital purposes.  (The very biggest banks aren’t allowed to add this back.)  Selling the AFS investments meant SVB needed to take the earnings and regulatory capital hit.  A $2 billion hit would hurt but wouldn’t necessarily be fatal for a $200 billion bank.

There are two other items that are even bigger red flags.  The first relates to the type of deposits SVB had.  The FDIC insures up to $250,000 in deposits.  Up to that amount, you’re not too concerned if the bank fails.  Some inconvenience but nothing catastrophic.  Above that amount, there’s no guarantee.  You’re just another one of the bank’s creditors.  Deposits above $250K were 97% of SVB’s total deposits with an average balance of more than $4 million.  Even including the insured portion of the large deposits, more than 93% of SVB’s deposit balance was uninsured.  No wonder depositors rushed for the exits at the first sign of trouble.  And rush they did with a staggering $42 billion in deposits leaving the bank.

The other red flag is that SVB had $91.3 billion in held-to-maturity (HTM) securities, up from $16.6 billion two years earlier.  When a bank designates securities as HTM, it is supposed to have the intent and ability to hold them until they mature.  Selling securities out of HTM can have adverse accounting consequences, where selling some securities can taint the entire portfolio.  However, tainting does not apply in certain circumstances, such as a liquidity crunch.  The trouble is that the fair value of these securities was only $76 billion, meaning they were $15 billion underwater.  Selling the HTM securities would wipe out SVB’s capital. 

Designating securities as HTM has been a popular way for banks to try to mitigate the interest rate risk of its securities portfolios.  If rates go up, they don’t need to recognize the decline in value in their regulatory capital or GAAP financial statements.  If a rise in rates turns out to be cyclical rather than part of a longer-term trend, the bank can presumably ride things out until rates go back down.  That approach doesn’t work if the increase in rates persists over a longer period or if the bank needs to sell HTM securities to meet liquidity needs.  Closing your eyes before getting hit may be a natural response but it doesn’t really help.

While having more than $200 billion in assets made SVB the 18^th largest bank in the country, it wasn’t large enough to subject the bank to certain regulatory requirements that may have identified the problem earlier.  The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (EGRRCPA) meant that banks with less than $250 billion in assets would not be subject to the Liquidity Coverage Ratio (LCR) or to annual capital stress tests, known as CCAR for bank holding companies and DFAST for banks.  The bill was pushed through by the Trump Administration and Republicans in Congress but enjoyed bipartisan support, passing the Senate by 67-31.  Regulatory implementation of the legislation was called the Tailoring Rule.

Would subjecting SVB to annual stress tests and LCR identified the problem earlier?  Maybe yes, maybe no.  Stress testing scenarios under CCAR have typically focused on a bank’s exposure to an economic downturn rather than to its interest rate risk.  The 2021 Severely Adverse scenario assumed that short term rates would remain near zero with longer term rates increasing modestly.  The 10-year Treasury Rate was assumed to reach 1.5% (it’s currently at 3.5%).  The 2022 scenarios assume a similar rate paths and the 2023 scenario assumes that rates will decline.  Like generals, regulators sometimes fight the last war. 

The largest banks must run at least one firm-defined scenario.  This was once a requirement of all banks over $50 billion in assets and is still considered an important element of prudent capital planning.  These scenarios should identify the types of scenarios that keep management up at night.  For SVB, that might have included a sharp rise in interest rates followed by a bank run.  However, there’s no guarantee that the bank would have run that type of severe scenario and management could argue that its approach was “conservative” as long as it came out worse that the supervisory scenario. 

SVB had a lot of liquidity risk but it’s not entirely clear to what extent the LCR would have flagged that risk.  LCR looks at whether the bank has sufficient cash and other liquid assets to handle cash outflows during a time of stress.  The numerator considers something called “high quality liquid assets” (HQLA).  The idea behind HQLAs is that they easily and immediately convert to cash with little or no loss of value.  Well, that’s the idea.  The trouble is that HQLA definitions don’t pay a lot of attention to interest rate risk.  HQLAs aren’t all cash and T-bills.  The definition can include longer term government obligations, and (subject to some limitations) mortgage-backed securities, equity securities, and municipal bonds.  The value of these assets can really tank if rates rise sharply.  The FR Y-15 Report for SVB Financial shows that 94% of its AFS portfolio met the HQLA definition, but the portfolio was still about $2 billion underwater.

There’s not enough of publicly available information on the HTM portfolio to see where it shakes out in terms of HQLA.  However, it appears to primarily consist of Fannie Mae and Freddie Mac MBS, which would count as Level 2A HQLA.  That means that you can count 85% of it toward meeting your LCR requirements.

On the denominator side, SVB’s FR Y-15 reports most of the firm’s deposits as short-term wholesale funding.  It’s not clear whether that would also be the case with LCR, particularly if SVB could provide evidence that it had an operational relationship with some of its large depositors to tether them more closely to the bank.  There’s just not enough publicly available to play out this hypothetical.

SVB’s failure may not spur a lot of changes if it remains an isolated event rather than as the start of a contagion.  I have my own wish list.  Capital stress testing provides a good indicator of a bank’s vulnerability, but the current process gets too hung up on getting the exact right scenario.  This can provide a false sense of security for a bank such as SVB, that’s exposed to a scenario different to what the regulators chose.  I also believe that liquidity rules should give more consideration to interest rate risk and take greater account of the interplay between liquidity and capital.  It’s very early days and we still have a lot to learn about SVB’s collapse.