Three lessons for risk managers and regulators from SVB’s collapse
The spectacular collapse of Silicon Valley Bank (SVB) has reverberated throughout the US financial markets and beyond. While the fallout continues to be assessed, there are already some valuable lessons to be drawn for risk managers and regulators argues Evgueni Ivantsov, chairman of the European Risk Management Council.
Focus on business model and business strategy
Initial analysis pointed to a fundamental mistake of SVB’s management, caused by a significant duration gap between long-term assets and short-term liabilities that had not been properly hedged for interest rate risk. However, a closer examination suggests that this error was a consequence of the bank’s business strategy. SVB had substantially transformed its business model in response to the pandemic. While interest rates dropped to historic lows, SVB capitalised on the boom in tech start-ups which became cash-rich.
The bank capitalised on the opportunity and repositioned itself as an investment firm, pumping interest-free deposits into securities investments. Loans as a percentage of SVB’s total assets dropped from 47% to 31% over the first two pandemic years, while security investments soared from 39% to 59%. The bank’s net income surged by 56%, and its assets trebled in just two years, propelling SVB from 37th to 13th place among US largest banks.
Given this aggressive investment strategy, it is not surprising interest rate risk management seems to have taken a back seat, given that it would have conflicted with the bank’s growth strategy. Rapid asset growth is typically a sign of either a magic formula or a risky strategy, with the latter being the more likely explanation. This is the first lesson for risk managers and regulators from SVB’s case: risk managers need to scrutinise any changes in strategy even if a new strategy looks smart. On the other hand, regulatory supervision oversight should include a robust approach to examine a business model change or an ‘out of the ordinary’ business expansion. A fast change of a bank’s business model and a balance sheet transformation should be treated by regulators as a big red flag.
Liquidity risk reassessment
SVB’s failure highlights the importance of revisiting the issue of liquidity risk. This is the second lesson to be learned. Specifically, two key aspects require reassessment: the issue of hidden deposit concentration and the assumption regarding deposit stickiness.
Despite the fact that SVB’s depositors represented a broad group of individuals and organisations, many of them belonged to a tight community of tech entrepreneurs, venture capitalists, and start-ups. This created a hidden concentration risk that was further amplified by the mobility and connectivity of the group. It made possible it for them to exercise simultaneous deposit withdrawal which drastically increased liquidity risk.
Furthermore, the power of digital technology has undermined the stickiness of deposits in recent years. Today, a depositor can move millions of dollars from one bank to another in mere seconds at the touch of a smartphone. The proliferation of social media has made bank runs more likely and more vigorous due to the rapid spread of information. The power of digital technology was demonstrated by a run on SVB when depositors withdrew $42bn from the bank on 9 March alone with an extraordinary rate of $1m per second. Even a seemingly healthy bank cannot sustain such a massive bank run.
Therefore, all new liquidity risk drivers revealed by SVB’s case should be reflected in liquidity regulatory requirements and banking liquidity risk models and stress-testing.
Adding backstops from a bank run
The third lesson concerns the robustness of deposit guarantee schemes (DGS) as a backstop to prevent bank runs. SVB’s case highlights serious weaknesses in the current state of the DGS in the US as SVB had a significant percentage of uninsured deposits (94%), a key factor in the bank run that occurred. While the US government’s decision to guarantee all deposits in US banks can be justified as a temporary and emergency measure to prevent the panic from spreading further, it created a moral hazard by passing deposit insurance costs onto all banks and, ultimately, all taxpayers.
The fundamental architecture of the DGS in the US, which provides a guarantee for deposits up to a certain threshold (e.g. $250,000), is too blunt and fails to reflect the new drivers that contribute to liquidity risk. As a result, regulators must introduce additional backstops. One of the options could be a multi-threshold approach, with a requirement for banks with deposit concentrations considerably above the guaranteed threshold to cover deposits up to a higher threshold to ensure that more deposits are guaranteed. Such banks will face higher insurance costs which will represent a price for deposit concentration risk, thereby creating an economic incentive to diversify their deposit base and reduce liquidity risk. These measures should make future bank runs less likely and create stability in the banking system.
The three lessons above are just a small part of a long list of lessons from SVB’s collapse. The bank failure has exposed many faultlines in key areas, from accounting standards and capital regulation to corporate governance and early warning signal tools. It is imperative for risk managers, regulators, and policy-makers to thoroughly examine all identified weaknesses and undertake corrective measures to ensure the long-term stability of the banking system.
Dr Evgueni Ivantsov, a UK-based banker and risk management expert, is chairman of the European Risk Management Council.
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