Wednesday, Mar 22, 2023
TC Insights - Supervisory Lessons from the Failure of Silicon Valley Bank
These are the fifth and sixth 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.
“Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management.”
Basel Committee Principles for sound stress testing practices and supervision, May 2009.
Lesson 5 – Stress Testing
Stress testing is a valuable tool for financial institutions. They should run a range of stress tests, covering a range of scenarios, taking account of feedback loops and market-wide stresses. They should then act upon the results.
The SVB example illustrates the need for a financial institution and its supervisors to carefully consider the stress tests that it should run, taking into account the specific risks it faces.
First, at the most basic level, it would be natural to assume that SVB stress-tested the credit risks inherent in its loan portfolio, the risks of deposit withdrawals, and the potential impact of rising interest rates on its holdings of fixed-income securities.
What would be a “severe but plausible” stress test here? For deposit withdrawals the Liquidity Coverage Ratio might be a natural starting point, because it is in effect a stress test that asks what happens if a bank loses 5% of its retail deposits in the next 30 days, plus all of its wholesale deposits that mature in the same period. However, the 5% figure for retail deposits is based on assumptions that these deposits are highly diversified and are covered by deposit insurance. If neither of these assumptions holds – as was the case for SVB’s customer deposit base – then a much higher figure than 5% should be used (in the UK in 2007 Northern Rock was at one point suffering the withdrawal of more than 5% of its retail deposits each day, not each month!).
And what about interest rates? Arguably, central banks had been behind the curve in tightening monetary policy before 2022, waiting for inflation to take off rather than raising interest rates in advance of that. Market participants and analysts had been warning for some time of the possibility of much higher interest rates. Financial institutions should therefore have been conducting interest rate sensitivity analysis and stress tests on their holdings of fixed-income securities, and indeed on their non-interest-bearing deposits.
Second, and most importantly, “one-dimensional” stress tests considering a single shock in isolation often do not indicate significant problems. That was certainly true ahead of the Global Financial Crisis. Even without the benefit of hindsight, a severe but plausible “combined” stress test could have included high levels of deposit withdrawals; a consequent need to sell fixed-income securities to meet these withdrawals; and this coinciding with a period of higher interest, so selling these assets would immediately generate large realised losses (because of the fall in the price of these assets since they were first purchased). Such a combination of stresses was entirely predictable, not least because – as happened with SVB – the realised and unrealised losses on the fixed-income securities portfolio was itself one factor that contributed to the high level of deposit withdrawals.
Financial institutions need to consider such multi-dimensional stress tests and to be agile in changing their stress tests to test the sort of prospective risks (deposit withdrawals at a time of higher interest rates in this case) that might arise, as opposed to either (a) just running the same old stress tests over and over again, or (b) just running the tests prescribed by a supervisor/central bank, which may not pick up the specific risks facing an individual financial institution.
Lesson 6 – Recovery Planning
There has been a much greater emphasis on recovery planning by financial institutions since the Global Financial Crisis. To some extent this is closely linked to stress testing, since a starting point for recovery planning is to consider the adverse shocks that a financial institution might be exposed to, and then to consider what recovery actions could be taken to restore the institution’s financial position.
For SVB, one element of any recovery plan should have been its possible recovery actions in the event of the withdrawal of customer deposits. Would it have been credible to rely on a recovery action based on replacing those deposits by wholesale funding, or by offering higher deposit rates to attract alternative funding? Possibly, in some circumstances, although this would have threatened the profitability of the bank. But this recovery action would not have been so credible if the deposit withdrawals occurred at a time of market-wide funding stress (as occurred to a very severe extent back in 2008), or when the bank was vulnerable to the impact of increasing interest rates on its holdings of fixed income securities.
So, as with stress testing, the arts of risk management and supervision require thinking through a combination of plausible but severe inter-linked potential shocks, specific to an individual financial institution.
[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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