Silicon Valley Bank (SVB) was a commercial bank in California that failed on March 10, 2023. To date (at the time of writing on March 28, 2023), it was the 16th largest bank in the USA by deposits and assets and the 2nd most significant US bank failure. SVB was a tech-focused lender which faced a bank run of $42bn on March 9, 2023. Ultimately, this caused the regulator to take possession of SVB, citing insolvency. It took less than two days for their stock to crash to 0.
Early warning signs
The early signs of possible issues at SVB were in the form of a diminishing deposit base. The company’s quarterly filings show that from Q2 2021 onwards, SVB had declining inflows, and throughout 2022 this turned into gradual outflows.
The underlying reason for this reduction in client deposits is likely the tech slowdown of 2022 and its impact on the client base that SVB had chosen as its primary source of deposits. This slowdown starkly contrasted with the previous year when the post-pandemic boom meant SVB’s deposits more than doubled off the back of Venture capitalist (VC) investment. Such volatility in deposits could easily have been an early warning sign.
SVB’s deposits were used to fund a hold-to-maturity (HTM) portfolio of US Treasuries – a standard holding for banks required to hold liquid, safe assets as regulatory buffers. This investment portfolio wasn’t necessary to be fairly valued as interest rates fluctuate. The bonds were being held for their lifetime, meaning they would revert to par value at maturity.
External, macroeconomic reasons have significantly contributed to the bank’s collapse – the main driver being the rising interest rate environment. Following a historically long period of low-interest rates and monetary easing, central banks have witnessed a spike in inflation, requiring them to raise rates aggressively – with the Federal Reserve in the US leading the way.
As bond prices decrease when interest rates increase, SVB’s HTM portfolio, which consisted of bonds that were bought mainly during the low-interest rate environment of the last 15yrs, was susceptible to a significant decrease in value that wasn’t required to be realized as a loss unless the bonds were liquidated.
A second driver has been the highly volatile markets experienced over the past three years. COVID-19, the Ukraine-Russia conflict, and its impact on commodity markets and the rising interest rate environment have caused significant economic uncertainty, meaning that many of the smaller companies that SVB had as clients were experiencing unforeseen challenges in their own businesses. The result for SVB was an unstable client base providing deposits to the bank.
Asset and Liability Management
Reports estimate that 1/3 of the deposits SVB accumulated during the pandemic era were with early-stage companies; this concentration risk of depositors in a tightly linked set of businesses and the inherent risks associated with early-stage companies, particularly in a volatile economic situation naturally exposed them to a deposit base with higher churn rates than average.
This concentration risk also exposed SVB to groups of individuals that were closely connected through corporate networks, which caused a panic situation as information spread quickly through this network and eventually caused the bank run and deposit outflows. These deposit outflows created a significant liability for the bank to meet in a few days.
On the asset side of the liquidity management equation, SVB held a concentrated portfolio of fixed-rate bonds exposed to interest rate rises, meaning that the assets held against these liabilities were equally susceptible to a market shock.
This combination of outflows causing increased liabilities to the bank and the sharp reduction in the value of assets over the prior months meant that SVB was eventually unable to fulfill its obligations.
Lessons learned for the sell-side and the buy-side.
SVB’s situation could have been avoided with a better understanding of the behavior of their business under different market conditions. Having a clear view of the changes in their assets and liabilities, and hence the liquidity of their business, under stress scenarios would have provided management with better visibility on business risks and enabled them to act sooner to prevent collapse.
While this is an example of a liquidity management failure within a bank, the lessons are equally valid for buyside firms. Where banks look at deposit outflows, a buyside firm will model their fund redemption profiles. Where banks hold a mix of liquid and non-liquid assets to match their potential liabilities, funds are invested in pools of assets that vary significantly in liquidity to generate returns for their investors.
Both the sell- and buy-side should learn from this episode that they require tools to accurately reflect the liquidity profile of their business under stressed market conditions.
These tools should provide management with the ability to first understand their liability profile by:
– Modelling all potential outflows, whether redemption/deposit based or otherwise.
– Understanding, modeling, and stressing their liabilities. These may be from outflows or other sources such as margin calls, increased business costs, or contractual commitments.
– Modelling concentration risk and the behavior of concentrated risks under stress
But equally importantly, understand their asset profile, which is a less well-practiced area in liquidity management, by:
– Understanding, modeling, and stressing their assets under the same conditions as they stressed their liabilities
– Stressing the liquidity of your assets – both the liquidation value and time required to liquidate.
– Modelling correlations between your assets to have a diversified asset base
– Highlighting which scenarios create higher liabilities and devalue your assets simultaneously.
While there will always be unexpected events that cause market shocks, with the right tools in place, market shocks don’t need to be business-critical events, and scenarios such as those experienced in the SVB collapse can be mitigated.
Given the significant volatility of the last three years and a macroeconomic environment that continues to surprise with unexpected market shocks, Treasury and Liquidity managers must be prepared for even their seemingly safe assets and conservative liability assumptions to be tested for resilience, as SVB discovered.