20 years: Research & banking
In this video, January discusses the collapse of Silicon Valley Bank (SVB), its failed risk management, and dubious asset and liability management practices sealing its demise. She also explores the misguided assumptions behind the structural hedging undertaken by the bank, the bank’s economic value of equity (or EVE) measurements and confusion surrounding its risk exposure. Finally, she highlights the lessons that should be learned from the SVB collapse, emphasising the importance of effective risk management, understanding the deposit base, and not running large open risks in the banking book.
In this video, January discusses the collapse of Silicon Valley Bank (SVB), its failed risk management, and dubious asset and liability management practices sealing its demise. She also explores the misguided assumptions behind the structural hedging undertaken by the bank, the bank’s economic value of equity (or EVE) measurements and confusion surrounding its risk exposure. Finally, she highlights the lessons that should be learned from the SVB collapse, emphasising the importance of effective risk management, understanding the deposit base, and not running large open risks in the banking book.
Silicon Valley Bank's collapse serves as a warning for the financial system, as it highlights the risks of mismanagement and a crisis of confidence. The bank's failed risk management and asset-liability management practices sealed its demise, as it invested the majority of its deposits in long-term, fixed-rate bonds without proper hedging and oversight, leaving it exposed to interest rate risk. The collapse was also driven by sector concentration risk, as most of the bank's depositors were from the tech industry. The lessons to be learned include the importance of effective risk management, understanding the deposit base, and not running large open risks in the banking book.
Key learning objectives:
Understand the causes of the collapse of Silicon Valley Bank, including failed risk management and ALM practices
Outline why investing deposits long-term for a fixed rate isn’t sensible
Outline the key learnings from the SVB collapse
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SVB's risk management and ALM practices were flawed because they invested a majority of the sharp increase in deposits (+$89bn in 2021) in long-term, fixed-rate bonds without proper hedging or oversight, leaving them exposed to interest rate risk.
As interest rates rose sharply, the market value of the bonds dropped substantially, exposing an existential hole in its solvency. SVB lacked adequate liquid assets to cover the quantum of withdrawals as depositors headed for the exits en masse, forcing the bank to realise the very losses that prompted the exodus.
SVB approached its structural hedging by applying a simplistic risk management technique of "structural/margin compression hedging" of non-maturity deposits. This requires a clear demonstration of deposit stability, a clear grasp of concentration risk, and properly forecasting the investment horizon, which are all required for normal ALM practice.
However, SVB lacked the observable trends and past behaviour of its largely VC and cash-strapped tech start-up client base, and it is unclear whether these considerations were made. SVB's misguided assumptions included endorsing this simplistic technique without undertaking basic checks and implicitly assuming deposit stability for an extended period.
The Economic Value of Equity (EVE) measurement published in SVB's 2021 annual report indicated that the bank had a value-at-risk of $5.7bn, which represented 34% of its capital base of $16.6bn in the event of a 200 basis point rate shock. It is unclear how the numbers were computed and whether any behavioural maturity was assigned to non-interest-bearing deposits. The bank entered into swaps to reduce rate risk in March 2021, indicating an awareness of the risk to its EVE and its size. However, SVB did not publish its EVE sensitivities in its 2022 annual report and accounts.
During 2022, total customer deposits declined from $189bn to $173bn. Even more critically, the mix altered: as non-interest-bearing deposits fell from $125bn to just $81bn while interest-bearing deposits increased from $63bn to $92bn. The outflow of over a third of SVB’s non-interest-bearing deposits during 2022 was driven by depositors being more rate sensitive than forecasted, as well as the concentration risk of depositors stemming from the tech sector, many of whom were individual owners and stakeholders in the industry. Additionally, during 2022 as rates increased, recession risk loomed and macro-sentiment shifted, resulting in a decline in equity capital raising for start-ups and a decrease in deposits. The lack of diversification of SVB's depositor base in one sector contributed to this vulnerability.
Key lessons from the SVB collapse:
1. Avoid large open risks in the banking-book for short term gain
2. Ensure competent independent risk management
3. Don't exceed risk appetites without loss-absorbing capacity
4. Unremunerated cash deposits may not stay long-term
5. Properly analyse NMD portfolio before hedging
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