Tuesday, Mar 21, 2023
TC Insights - Supervisory Lessons from the Failure of Silicon Valley Bank
This is the fourth lesson 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.
“With inflation well above the FOMC’s longer-run objective and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”
Board of Governors of the Federal Reserve System. Monetary Policy Report, February 2022.
Lesson 4 – Market Risk
When interest rates increase, the value of fixed income securities falls. Holding fixed income securities therefore carries market risk, even if the credit risk is small (as, for example, with government bonds). As SVB illustrates, this market risk needs to be properly factored into risk management.
SVB had to do something with the very high amount of customer deposits that flooded into the bank, especially during 2021. Its loans increased from $45 billion to $66 billion. But the biggest increase on the asset side of its balance sheet was in investment securities, which increased from $49 billion to $128 billion, representing 61% of total assets at the end of 2021, mostly in the form of mortgage-backed securities. This was at a time when interest rates were very low.
If a bank holds a $100 fixed income security to maturity, then – credit risk aside – it should be able to redeem the security for $100 at maturity. But if it is forced to sell the security before maturity it will be worth less than $100 if interest rates have increased since it was purchased. SVB was able to elect whether to treat its fixed income securities as “held to maturity” (in which case they sit on the balance sheet at cost) or “available for sale” (in which case they are marked to market and increases in interest rates result in immediately realised losses). At end-2021 SVB had allocated $98 billion of securities as “held to maturity” and $27 billion as “available for sale”.
As US interest rates increased during 2022 (the Fed began increasing its rates in March 2022, for the first time since 2018), SVB incurred unrealised losses of $2.5 billion on its “available for sale” portfolio. That was manageable for a bank with equity of $16.6 billion (at end 2021) and profits of around $3 billion a year.
But meanwhile the unrealised losses on the “held to maturity” portfolio increased from $1.3 billion to $15.2 billion during 2022, which if realised would have almost exactly wiped out the bank’s equity (which had declined slightly to $16.3 billion by the end of 2022).
Now here comes the big problem for SVB. The withdrawal of customer deposits that began in 2022 and accelerated early in 2023 could not be offset by raising replacement deposits from other sources, such as wholesale markets or the Federal Home Loan Fund, without paying such a high cost for replacement deposits that this would have destroyed the profitability and viability of SVB – especially when such a large proportion of its assets were held as fixed income securities that were earning a low rate of interest.
And under accounting standards, if SVB sold a single security out of its “held to maturity” portfolio it would have to revalue the entire portfolio on a mark-to-market basis, which would wipe out its equity.
So in the face of continuing deposit withdrawals – themselves no doubt accentuated by the unrealised losses on fixed income securities mounting up at SVB – and with the failure of a proposed capital raising by SVB, the game was up. In effect, the market risk crystallised and the bank failed.
[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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