Friday, Mar 17, 2023
TC Insights - Supervisory Lessons from the Failure of Silicon Valley Bank
This is the first in a series of Toronto Centre Insights drawing out some lessons for financial supervisors from the failure of Silicon Valley Bank (SVB)[1]. Download the document above to see all lessons. Other TC Insights can be found in the News section of our website.
Many of these lessons are applicable to supervisors of all types of financial institutions, not just banks.
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us ….”
Charles Dickens, Tale of Two Cities
Lesson 1 – Understand the Business
To understand the risks to supervisory objectives from a financial institution, supervisors need to understand its business, on both sides of the balance sheet.
For SVB, this included three key elements:
- Lending to the technology-based start-up sector. This was inherently risky business, because of high rates of failure among start-ups; the early-stage nature of the lending; the inability of start-ups to provide security against loans, for example in the form of property or other physical assets; and lending that was intended to be repaid from the proceeds of forthcoming capital raising.
- Deposits from cash-rich technology companies, start-ups and venture capital companies, which were concentrated in the sense of being deposits from similar types of company that were likely to behave similarly in response to shocks.
- A substantial holding of fixed-income securities, mostly mortgage-backed securities, giving rise to both market and credit risk.
Lesson 2 – Dangers of Rapid Growth
Not all financial institutions that grow rapidly subsequently fail. Nor have all failed financial institutions previously exhibited rapid growth. But it is nevertheless the case that many failed financial institutions did grow rapidly ahead of their failure. So supervisors should treat rapid growth as a warning sign of higher risk.
For many financial institutions, the main problem with rapid growth is that it is driven by taking on risky business – lending and insurance that is under-priced or that other providers have turned down; moving into riskier products and new markets; building up large exposures to single or connected customers; and investing in risky securities. Any rapid increase in assets has then to be funded, which for banks has often led to an over-reliance on short-term wholesale market funding.
For SVB, rapid growth took a slightly different form. Yes, during 2021 (the year of SVB’s most rapid growth) its loans increased by nearly 50%, from $45 billion to $66 billion. But the main driver of overall balance sheet growth was deposits, which increased by 86% from $102 billion to $189 billion. The largest increase on the asset side was in investment securities, which increased by 160%, from $49 billion to $128 billion. Overall, SVB’s balance sheet grew by 83% in 2021, from $116 billion to $211 billion.
Another major problem with rapid growth is that all too often, the growth in business runs ahead of a financial institution’s ability to identify, understand, manage, and control the risks it is building up. Governance, risk management, policies and controls, IT systems and data management, staff numbers, and experience and expertise all tend to lag behind the rapid growth. The increase in inherent risks is then combined with an inadequate control environment, which is a toxic and dangerous mix.
There is insufficient information in the public domain to reach a judgement on the quality of governance and controls at SVB, but reports that its Chief Risk Officer departed in April 2022 and was not replaced until January 2023 are not encouraging.
[1] This series of TC Insights is written by Clive Briault, Chair, Toronto Centre Banking Advisory Board.
For more information, please contact:
Judy Shin
Communications Lead, Toronto Centre
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