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What are the lessons learned from SVB’s collapse?

Author: ICAEW Insights

Published: 15 Mar 2023

Reuben Wales, ICAEW’s Head of Financial Services, explains how recent interest rate rises played their role in Silicon Valley Bank’s demise.

Over the weekend, US and UK regulators sought to avert a banking crisis through a package of measures designed to deal with the fallout from the collapse of Silicon Valley Bank (SVB). 

The bank’s demise appears to be driven by the terminal combination of a concentrated and flighty corporate deposit base, funding low yielding long-term government bonds. Ultimately, it was a situation that was not sustainable. 

SVB’s plight is a reminder of the apparent fragilities that exist within the financial system – and will continue to run – as we chart a course out of an ultra-low interest rate environment. 

Whereas previous crises were dominated by credit risk, this current dilemma appears to be less to do with recoverability and more to do with the pricing and value of assets and where the maturity of those assets is not appropriately matched to a bank’s liabilities. 

Markets have now reflected that there are no safe assets, especially when leverage is involved. This is certainly the case with government debt. The pace and scale of recent interest rate hikes by central banks has resulted in a remarkable slump in the market value of government bonds; 30-year US Treasuries at their lowest point in 2020 were yielding less than 1% and now trade at more than 3.5%. 

The value of a bond has an inverse relationship to market interest rates for a like for like instrument. If rates go up, the market will discount the value or price of a bond. The opposite is true where rates go down. As a result, there is the potential for a significant decrease in the market value of bonds as rates increase.

A conventional bank’s business model is typically long term with some short-term assets, funded by a mix of short-term deposits, longer-term debt and a sliver of capital. Confidence is normally maintained by holding capital to cover losses and liquid assets to cover any unusual large withdrawals, and by being regulated.

When you get this delicate balance wrong, the business model has a tendency to upend – as was the case with SVB. The bank was ultimately sitting on significant unrealised losses relating to its bond portfolio. While the fair value of these assets was disclosed in the financial statements, they were not reflected directly as a carrying value on the bank’s balance sheet, muddying the true position of the bank should it need to liquidate part of its bond portfolio – which it did.

However, unrealised losses were not the only issue. As the failure of SVB has shown, if a bank has to raise its savings rates to hold on to depositors and those saving rates then exceed the returns being made on the bank’s assets (which might include government bonds), eventually losses will ensue. Irrespective of accounting treatment, the bank may be forced to dispose of those assets (potentially at a loss) and replace them with higher yielding ones. 

Although regulators have done well to intervene quickly, the financial sector now faces a series of risks – some new and not well understood, others well-trodden.

The events over the past week and the repricing of assets as we move to a higher interest rate environment reinforce the importance of getting risk management right. Where management and risk functions are not keeping pace with developments in the real economy, issues can and will be identified late and the implications can be significant.  

 

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