The Collapse of Silicon Valley Bank: An FRM Perspective
Thursday, March 16, 2023
By Paul Cheselka
When the second largest banking failure in U.S. history occurs virtually overnight, people want an explanation of what went wrong. Was the collapse of Silicon Valley Bank (SVB) primarily due to a once-in-a-generation bank run that was virtually impossible to predict, or was it possibly preventable?
SVB — then the 16th largest bank in the U.S. based on asset size — fell quickly. The announcement of the bank’s intended equity and preferred stock offering coupled with its disclosure of a USD 1.8 billion loss was made on March 8, 2023. Just two days later the Federal Deposit Insurance Corporation (FDIC) was appointed as SVB's receiver.
SVB’s demise was the result of not following the proven tenets of risk management. Specifically, it did not adhere to a framework of prudent liquidity risk management, proper company and risk management governance standards, and the operational risk management standards for addressing solvency, stress testing, liquidity, and compliance as set forth under the Basel rules.
The curriculum of the Global Association of Risk Professionals’ (GARP) FRM® Certification Program is dedicated to prudent financial risk management. It covers in detail the discipline of liquidity risk management, a major underlying reason for SVB’s downfall. This section — titled Liquidity and Treasury Risk Measurement and Management — provides employees of financial institutions with the framework to identify, address, and navigate the types of risks faced by SVB.
Additional FRM domains covering liquidity risk include Operational Risk and Resilience, Financial Markets and Products, and Foundations of Risk Management. A robust knowledge of all these areas is necessary to be an effective risk manager and for a company to have a viable and industry standard risk management function.
Here is the relevant liquidity risk knowledge crucial to any risk manager and risk function. All of these relate to the SVB collapse and are contained within the FRM Liquidity Risk Management domain:
Liquidity risk principles and metrics
Liquidity portfolio management
Cash-flow modeling, liquidity stress testing and reporting
Contingency funding plan
Balance sheet management
The reasons for the collapse of SVB are clear and include the following key factors and unaddressed risks.
1. Deposit Concentration
The bank serviced almost exclusively the venture capital (VC) industry and was the leading bank with the largest exposure to this customer niche. In return for the bank providing funding and other services to its VC community, SVB requested that its customers place funds raised with the bank. As the VC industry grew and its customers raised additional investor funding, they also placed this cash on deposit with the bank. As a result, the bank’s deposits were highly concentrated within a very narrow depositor base. As we will show, this set the stage for a depositor run on the bank.
FRM Coverage: The FRM liquidity risk knowledge point of cash-flow modeling, liquidity stress testing and reporting addresses this concept. A central principle of liquidity management is funding diversity. Within the FRM learning objective, compare and interpret different types of liquidity risk reports, is a discussion of the Large Deposit Concentration Report. This report identifies large depositors by either a deposit threshold amount or as a percentage of total bank liabilities. Had SVB prepared and reviewed this specific report the bank would have clearly identified that its deposits were highly concentrated and could pose a future funding risk should they be withdrawn rapidly under a stressed condition.
2. Liquidity Portfolio Management and Balance Sheet Management
Through its banking activities SVB engaged in maturity transformation as a standard course in its banking business. Maturity transformation is effected when banks borrow short-term to provide longer-term financing to their customers. The spread between the interest that banks pay and the interest they earn is the net interest margin.
This funding and investment posture will create a mismatch between the duration (or risk sensitivity) of a bank’s assets and the duration of its liabilities. In the case of SVB this mismatch became extreme.
As described previously, SVB experienced a dramatic increase in deposits from its venture capital customers as they raised investor funds. But it did not have enough customer loan opportunities to redeploy all these excess deposits and made the decision to invest in U.S. government long-term Treasury securities and U.S. guaranteed mortgage-backed securities (MBS). At the time of purchase, these securities had very low coupons due to the interest rate environment and therefore were of longer duration (more interest rate sensitive) compared to higher coupon bonds of identical maturity or bonds of shorter maturity with similar coupons.
The duration of these U.S. Treasuries and MBS was significantly greater than the duration of the bank’s deposits, which could be withdrawn at any time. This problem was amplified by the fact that SVB’s deposits included many individual accounts considerably larger than typical retail bank deposits and were highly concentrated in the technology start-up sector. Based on these characteristics, the duration gap – the difference between the duration of assets and the duration of liabilities – of SVB was large. This meant that the effect of interest changes on the value of the bank’s net worth would be significant.
To compound this situation, SVB was not reasonably hedged from interest rate risk, failing to pursue an active hedging strategy for its holdings of Treasuries and MBS. So it was especially vulnerable when the Federal Reserve rapidly increased interest rates over the last year to fight inflation. Had interest rate hedges been put in place, as interest rates rose the bank would not have suffered the level of losses it was forced to recognize when it sold its available-for-sale securities to cover deposit withdrawals.
SVB’s decision not to hedge proved catastrophic and eventually forced the bank to recognize an after-tax USD 1.8 billion loss on the sale of USD 21 billion of securities.
FRM Coverage: Hedging is covered in the FRM Part l curriculum of the Financial Markets and Products domain and is fully addressed in the knowledge points: structure, mechanics, and valuation of forwards, futures, swaps, and options; hedging with derivatives; and interest rates and measures of interest rate sensitivity. The FRM knowledge points of liquidity portfolio management and balance sheet management address these above concepts. In addition, these topics are further described in two FRM learning objectives: summarize the asset-liability management process at a fractional reserve bank, including the process of liquidity transformation and describe duration gap management and apply this strategy to protect a bank’s net worth.
3. Depositor Run on the Bank
SVB was under stress before the bank suffered an eventual run by its depositors, but its severity was masked by its designating the majority of its bond holdings as “hold-to-maturity” on its balance sheet.
In 2022, the potential problems with the duration mismatch at SVB began to be realized. COVID restrictions loosened globally, inflation rose rapidly, and central banks worldwide raised interest rates. SVB depositors began to make sizable withdrawals to fund their current operations, develop new business initiatives, and seek higher earnings potential than they were receiving from existing non- or low-interest accounts. Simultaneously, higher interest rates hurt the value of the long duration Treasuries and MBS securities the bank had purchased with excess deposits over the previous two years. As interest rates rose the value of their fixed income securities went down, a basic concept of finance.
To meet the growing deposit withdrawal requests by early March 2023, the bank was forced to reduce its available-for-sale assets – selling USD 21 billion of securities at a loss of USD 1.8 billion after-tax. On March 8, 2023, SVB disclosed that it would require additional funding, which heightened depositor anxiety. Additional public comments from bank management intended to calm fears triggered a full run on the bank. By the end of the day, SVB had over USD 40 billion in deposit withdrawal requests. The bank failed on March 10, 2023 when the FDIC placed it into receivership and took possession of its assets.
FRM Coverage:The liquidity and treasury risk management section of the FRM was added after the global financial crisis of 2007-2009 to specifically address the critical role liquidity plays in financial risk management. Developed in conjunction with skilled practitioners, it reflects best practices and prudent regulatory guidance.
The FRM knowledge point of liquidity risk principles and metrics addresses this concept. Within the FRM learning objective, evaluate Basel lll liquidity risk ratios and BIS principles for sound liquidity risk management, the liquidity coverage ratio (LCR) is highlighted. While SVB was not required to report its LCR value, it could have used the principles of sound liquidity risk management to assess both its access to high-quality liquid assets and potential drivers of large cash outflows. Had SVB been actively reviewing and challenging its liquidity position, it could have had time to correct its strategy and devise alternatives.
The FRM knowledge point of cash-flow modeling, liquidity stress testing and reporting includes a review of liquidity stress testing and scenario development. Liquidity stress test scenarios can be hypothetical and are based on a forward-looking view in which the financial institution would experience severe liquidity stress. SVB should have undertaken additional liquidity stress tests incorporating scenarios such as a run on the bank by its depositors, a rapid increase in interest rates, and a case combining both.
The FRM knowledge point of stress testing banks found within the FRM Operational Risk Management domain and the learning objective of provide examples of legislative and regulatory reforms that were introduced after the 2007-2009 financial crisisaddresses these above concepts. This material discusses operational risk stress tests known as Federal Reserve Comprehensive Capital Analysis and Review (CCAR) and Comprehensive Liquidity Analysis and Review (CLAR), which assess bank stress tests to ensure that bank liquidity buffers are maintained.
Previous financial disasters are also covered in the knowledge point of funding models and the learning objective ofidentify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks. The FRM Part I curriculum in the Foundations of Risk Management domain also discusses financial disasters under the learning from financial disasters knowledge point and the learning objective of analyze the key factors that led to and derive the lessons learned from case studies involving funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock.
GARP’s FRM Certification Program provides the foundational understanding and risk management tools necessary to identify and fully address through specific actions the developing liquidity risks experienced by SVB. Had the bank adhered to and employed a risk management discipline and adopted a liquidity risk management framework as spelled out in the FRM curriculum, it might still be operating today.