The dominoes are, predictably, beginning to topple. In 2022, there was the crypto-crash, the UK gilt problems which triggered issues for pension funds' liability-driven investing strategies and the still ongoing emerging market debt crisis. The latest chapter in this unwinding, which has some way to go, is the collapse of Silicon Valley Bank ("SVB") in the US.
Underlying these developments is the reversal of a 13-year period of low or zero interest rates and highly accommodative liquidity policies of central banks globally. An economic architecture built around artificially low cost of capital which over-stimulated segments of the economy and encouraged leverage and speculation, on a large scale, was neither sustainable nor costless. The assumption that raising rates and withdrawing monetary stimulus would result in a painless adjustment back to a new normal was naïve in the extreme.
As Charles MacKay wrote in Extraordinary Popular Delusions and the Madness of Crowds: "Nations, like individuals, cannot become desperate gamblers with impunity. Punishment is sure to overtake them sooner or later." Unfortunately, the financial reckoning underway will create winners and losers as well as suffering.
Silicon Valley's Best and the Brightest
On Friday, March 10, 2023, SVB was taken into administration by the Federal Deposit Insurance Corporation ("FDIC") in the US. The Bank, which had around $200 billion in assets, was the second largest US bank failure after Washington Mutual, which collapsed in 2008. Bank failures in the US have been relatively rare in recent years with the last FDIC-insured bank closing in October 2020.
The information available suggests that the collapse resulted from a confluence of events:
SVB invested depositor's funds in highly-rated, long-duration US Treasuries and Federal Agency backed Mortgage Backed Securities ("MBS").
These investments, which are of high credit quality, have lost value due to sharp increases in interest rates leading to unrealised losses estimated at around $15 billion.
Concern about these losses led to a bank run with depositors withdrawing funds, culminating in $42 billion of withdrawals (around a quarter of all deposits) on Thursday 9th March 2023.
The withdrawals left SBV potentially insolvent and incapable of paying its obligations as they come due.
The chronology of the collapse is murky.
There are suggestions that SVB sought to protect their portfolio of interest-rate-sensitive assets by selling around $20 billion of longer-term securities and investing the proceeds in shorter-dated instruments. This realised a loss of $1.8 billion but would have boosted interest earning due to the fact that the yield curve is inverse with short rates offering higher returns.
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Simultaneous to the portfolio restructuring, SVB sought to raise new capital -- $1.25 billion in shares and $500 million in mandatory convertible preferred shares -- to cover the losses on the sales of securities and also strengthen the balance sheet and liquidity. The fund raising was abandoned.
An additional factor was the highly concentrated SBV's customer base that was heavily focused around US West Coast technology and bio-technology start-ups. It is alleged that as SVB's problems intensified after a number of venture capital firms and luminaries advised firms they had invested in to withdraw their deposits from SVB deepening their liquidity problems.
SVB's collapse can be attributed to familiar and avoidable banking risks -- asset-liability mismatches and concentration risk.
All financial intermediation involves maturity transformation. Banks take short-term deposits but invest these funds in longer-term loans or securities. This makes them vulnerable to a rapid loss of deposits which exposes them to the liquidity and price risk of realising assets. Abnormal concentration of depositors or borrowers creates exposure to the withdrawal of funding or default on assets or investments with resulting liquidity or solvency issues.
In SVB's case, both these factors coincided. Broader environmental considerations compounded these problems.
SVB's business model focused on venture capital and start-ups. It acted as the banker of choice for these businesses. Venture capital investors encouraged firms that they invested in to bank with SVB. Funds raised and surplus cash was parked with the Bank allowing investors to keep a close eye on operations. These start-ups frequently also took out credit facilities from SVB a condition of which was that surplus cash had to be deposited with them. In addition, employees frequently also banked with SVB and took out loans. Its success was in no small measure due to the fact that traditional banks were less willing to offer financial services to these nascent companies.
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SVB's business underwent rapid expansion over the last few years as funds flowed into private markets and the volume of venture capital, start-up and early- or late-stage funding grew. The Bank's liabilities appear to be dominated by a small, group of depositors. As at end of 2022, over 80% of the bank's $173 billion in deposits were uninsured being over the FDIC maximum of $250,000.
At the same time, a highly accommodative monetary policy meant that the financial system was awash with liquidity. The problem became larger during the pandemic when lockdowns and supply shortages drove a rapid increase in savings rates adding to the liquidity of the banking system. Between Q4 2019 and the first quarter of 2022, deposits at US banks rose by $5.4 trillion.
Normally, this liquidity would be deployed as loans. However, since the 2008/2009 Great Recession, loan demand has been relatively weak and well below deposit growth. Between Q4 2019 and the first quarter of 2022, only 10-15% of deposits growth at US banks was lent out. Banks had to seek out alternative investments.
During this period, banks invested deposits surplus to loan demand in securities, mostly US government bonds or high-quality MBS (Mortgage Backed Securities). Since the pandemic, banks have increased their holding of over $4 trillion in securities investments by around 50 per cent.
The choice of securities was designed to minimise credit risk. However, with interest rates low, banks took on duration or interest rate risk, and extended the maturity of securities. The higher return on these long-dated securities boosted bank profits.
SVB followed this formula. Its assets rose by around 250% + over three years as rising capital investment in start-ups was deposited at the bank. SVB invested this cash in longer-maturity bonds to generate a higher return. By end 2022, it held around $120 billion in securities.
Beginning in 2022, a change in conditions affected these practices.
Responding to higher inflation, central banks globally led by the US Federal Reserve began to aggressively increase interest rates. At the same time, they commenced QT (quantitative tightening) gradually removing liquidity by decreasing the size of their balance sheets by reducing bond purchases and then allowing existing holdings to run off. The combined effect of these actions was to shift interest rates up across the entire yield curve.
Higher interest rates decreased the market value of these fixed-interest securities. In the case of MBS, the losses were compounded by convexity effects. When interest rates increase, mortgage prepayments decline meaning that the term of the security extends increasing the duration and the losses. SBV had unrealised losses of $15 billion as at end 2022.
However, these mark-to-market paper losses would not be realised unless the securities were to be sold. Unfortunately, the decline in prices coincided with declines in cash inflows into banks and rising withdrawals reflecting lower savings as post-pandemic spending increased and prices rose especially for essential goods and services.
SVB was also affected by the altered environment for venture capital and start-ups. Weakening equity markets led to decreases in Initial Public Offerings ("IPOs") and the end of the boom in Special Purpose Acquisition Corporations ("SPACs") reducing exit opportunities for investors. This reduced new investment in private companies. With limited new funding and a high rate of cash burn, start-ups started to use up their funds drawing on their SVB deposits. As the rate of outflows increased, the Bank's asset liability mismatch became problematic necessitating sales of holding realising the mark-to-market losses eroding their capital base.
The puzzling thing is why SVB did not pursue several avenues available to manage its evolving risks.
Given that the credit quality of its securities was high and they would pay back in full if held to maturity, it would have been open to SVB to use them as collateral to borrow funds, through the repo market or from the central bank, to meet deposit withdrawals. Lender-of-last resort facilities provided by central banks are specifically available to meet these contingencies.
Alternatively, they could have borrowed in the wholesale or interbank market to replace deposits to bridge the cash outflows. There are unsubstantiated allegations that alongside prominent venture capitalists who advised their start-ups to withdraw money, a number of large banks withheld inter-bank loans from SVB and actively sought to convince SVB customers to move their accounts. If true, then the active solicitation of deposits by competitors could have worsened the deposit flight accelerating SVB's problems.
US regulators have been anxious to state the low risk of contagion and the overall strength of the banking system. However, there are several channels of potential contagion both in the real and financial economy.
Firms with deposits at SVB are at risk. Many of these start-ups have no revenue and without access to their cash cannot operate, including paying employees and suppliers. Reports suggest that over 80% of customers' deposits (around $150 billion) may be over the FDIC threshold of $250,000 and therefore uninsured. Given that SVB senior and subordinated bonds are trading at 45% and 12.5% of face value, uninsured depositors may face significant losses in the absence of government intervention or new owners injecting substantial capital into the Bank.
Loss of their funds may force some start-ups into bankruptcy or, in the case of more established operations, to retrench operations. In addition, SVB is the provider of credit facilities to the private capital industry and the withdrawal of this funding would create an investment shortage.
Even those with no relationship to SVB may experience indirect effects. Many external payroll providers use the bank for payments and funds are now trapped. According to legal experts, under Californian law, founders and individual executives can be personally liable for unpaid wages under certain circumstances complicating the situation.
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The collapse of SVB may be widely felt across the technology sector and affect economic activity more broadly.
The financial effects are less predictable. Circle, which operates a crypto-stable coin, has announced that it has $3.3 billion of its reserves with SVB, triggering a fall in the value of its token in the crypto market. However, there is no evidence to date that SVB has interbank and derivative transactions with other market participants, at least of a magnitude, to trigger a major contagion event.
There is concern that the broader issues behind the problems of SVB -- falling customer deposits (projected to decline in the US by up to 5% this year) and losses on holding of securities -- are systemic and pervasive across the banking sector. Estimates suggest that the unrealised losses at FDIC-insured US banks exceed $600 billion as at end 2022. The losses globally are perhaps three to four times that number.
While individual exposures vary significantly, for major systemically important money centre banks, realisation of these mark-to-market losses while significant should not affect solvency. Nevertheless, concern has triggered sharp declines in bank share prices across the world, especially in US regional institutions which have lost between up to 40% of their value.
The working assumption is that these securities will be held to maturity and pay out their face value in full meaning that the losses will never be realised and ultimately disappear. This may prove to be correct but cannot be guaranteed.
Regulators have been quick to state that the financial system is far more resilient than in 2008 due to the strengthening of regulations. While that may be partially true, the case of SVB highlights major loopholes and deficiencies.
One potential problem revealed is in regard to liquidity. After 2008, banks were required to always keep adequate liquid funds to meet depositor obligations. There were two specific rules. The Liquidity Coverage Ratio ("LCR") required banks to hold high-quality liquid assets, cash or short-dated government securities, covering estimated cash over 30 days. The complementary Net Stable Funding Ratio ("NSFR") emphasised higher reliance on more stable or 'sticky' retail deposit rather than wholesale or inter-bank funding.
While the LCR and NSFR regulations mandated by the Bank of International Settlements ("BIS"), popularly known as the Basel rules, were adopted by the US, it did not apply to SVB because it did not meet the threshold of a systemically important bank and relied on corporate deposits rather than short-term wholesale funding.
A second problem relates to the valuation of holdings of long-term securities. SVB followed accounting guidelines that did not require it to mark-to-market its portfolio. This is because the bulk of its holdings were in hold-to-maturity ("HTM") (which are valued at amortised cost) rather than available for sale ("AFS") portfolios (which are valued at market prices). If SVB's portfolio had been properly valued, as at end 2022, its shareholder funds of $16 billion would have been substantially reduced by the $15 billion of unrealised losses.
The rationale for permitting HTM securities to be held at amortised cost rather than current value is unclear. As SVB and previous similar episodes illustrate, transitory losses assume that the holdings do not need to be liquidated to meet, for example, withdrawal of deposits resulting in unrealised losses being realised with an immediate impact on solvency.
SVB also highlights other weaknesses in bank regulation:
The Basel rules are not uniformly applied globally with national regulators adjusting standards for domestic and political purposes reducing their effectiveness.
Existing rules apply more rigorously to large systemically important institutions. In reality, smaller and regionally focused banks face significant concentration risks on both assets and liabilities (although SVB is probably an extreme case) and more limited access to capital. This has implication on their risk.
The advantages of reliance on non-wholesale funding are exaggerated. As SVB and other cases highlight, retail and corporate depositors are likely to be less informed and behave as a herd triggering runs on banks.
Emphasis on holding high-quality government securities to provide emergency short-term liquidity underestimates the price risk, especially at a time when the quality of sovereigns is deteriorating.
The B Word
US regulators have been careful to rule out a bailout aware of public distaste for such actions. However, authorities are moving to implement measures indistinguishable from the dreaded 'B' word:
US Treasury Secretary Janet Yellen has not ruled out safeguarding all uninsured deposits at SVB and presumably any other bank to prevent a run on US financial system. If this is implemented then it would mean that the state would be assuming a contingent liability in the order of $20 trillion being the total of US bank deposits.
The Federal Reserve may ease the terms of banks' access to its discount window, allowing firms to use assets that have lost value to raise cash to avoid the outcome at SVB.
The Fed has also unveiled a new $25 billion facility -- the Bank Term Funding Program ("BTFP") -- to provide loans of up to one year to banks, savings associations, credit unions, and other eligible depository institutions against the security of US Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. Unusually, these assets will be valued at par, not as usual at market value, ignoring the unrealised net losses on these securities.
The UK government is instituting measures designed to keep cash flowing to tech groups. One option is to provide guarantees for banks to offer new loans to companies with money locked in SVB accounts.
These measures are somewhat inconsistent with the stated lack of contained nature of the SVB problem and the adequacy of existing regulations.
Over the last decade and a half, the economic system and financial practices have become geared around low rates, abundant liquidity and the authorities underwriting risk-taking. The collapse of SVB underlines why moving away from this state of affairs was never going to be easy, that is, if it is possible at all.
Satyajit Das is a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His columns have appeared in the Financial Times, Bloomberg,WSJ Marketwatch, The Guardian, The Independent,Nikkei Asia and other publications. (THE NEW INDIAN EXPRESS)