Markets are still digesting the fallout from the failure of Silicon Valley Bank, the second largest bank failure in US history and the biggest collapse since the 2008 financial crisis, which was quickly followed by the collapse of New York’s Signature Bank, when suddenly what seemed to be just a problem of mid-sized American banks caused a domino effect on Europe’s apparently strong banking system.
Five days after regulators and the Federal Deposit Insurance Corporation shut down Santa Clara-based Silicon Valley Bank (SVB) and later New York’s Signature Bank, Switzerland’s Credit Suisse hit a snag with its shares down 30 percent. The Swiss central bank had to provide the troubled investment bank with a $54 billion bailout to shore up liquidity after a Saudi investor said it would not provide the financial institution with further funding.
Many will wonder if this is just a Credit Suisse problem or a hangover from the events that had occurred with the collapse of the 16th largest US commercial bank.
But the collapse of SVB should cause concern for the financial services industry in assessing the effectiveness of their risk management frameworks.
The events of 2023 raise questions about the health of the wider financial system, given that over the past 10 to 15 years, the world has become addicted to free money. Everyone, including the banks, took advantage of it. But now with the rapid rise in interest rates, comes the expected fall. whoever managed properly will not manage to get out unscathed or with minimal losses, but others will work hard to succeed.
Relaxed Regulatory Framework
As the FED began to tighten policy, some of the world’s largest and most profitable growth companies became very sensitive to interest rate hikes. As SVB discovered to its detriment, longer-term bonds are more susceptible to interest rate risk. In the days before its collapse, the bank had launched a capital increase to plug a $2 billion hole in its balance sheet caused by a significant loss the bank had on long-term U.S. Treasuries, which lost much of their value when interest rates rose. The bank had not engaged in hedging procedures for the whole or the greater part of the value of this portfolio (unprotected against an interest rate reversal of the market).
Hedging has a cost that limits the profits made on a bond portfolio, to the point of yielding a minimal profit. For this reason, SVB did not proceed with this hedging procedure. However, it should have done so for 70% of its bond portfolio in order to limit losses by causing uninterrupted continuation of its activities.
A 1% increase in the interest rates on eight- or nine-year US government securities caused an 8% or 9% drop in the value of these securities. You have to hedge that risk, which SVB apparently didn’t do as we mentioned above.
If SVB’s long-term bonds, held by its asset management arm, had been subjected to multidimensional stress tests imposed on US money market funds, which require them to undergo stress tests on their portfolios in three dimensions ( increases or decreases in interest rates, credit spreads and liquidity) the banks would have discovered there was a problem. Certainly, but this was not the only problem at SVB.
European banks
European banks may have a much larger liquidity cushion and be more heavily regulated than their US counterparts. But the Funding Program created by US regulators in response to the collapse of SVB and Signature Bank was quite clever.
This program is changing the dynamics of fixed income trading. Until this weekend, when you bought US Treasuries, you had to hold them to maturity. They may drop in value, but at maturity you will get the face value back.
The problem for SVB was that they needed the liquidity now, not in 10 years when the bond matured. But now the US government says you can borrow against bonds that are rated at par, which completely changes the risk and reward in bond trading.
There is no longer interest rate risk in holding US government debt for banks considered systemically important.
We learned a lot from the global financial crash (GFC) — multidimensional stress testing, but not everyone does it. Let’s hope SVB is in the 0.1% of banks that fail spectacularly, but it’s a reminder that good risk management practices are security. If you don’t have strong risk management processes in place, no one is going to help you when times get tough.
The US authorities are to be commended for the swift resolution of the crisis. But SVB was a big bank, with more than $200 billion in assets.
The EU’s strong regulatory and supervisory framework is more stringent than that of the US and governs a much larger number of banks by size, compared to the more devolved situation in the US where banking regulation is shared between federal and state agencies, where smaller banks are heavily regulated less.
A crucial difference between the European and American systems is that European bank bonds are smaller. All EU banks are subject to minimum liquidity coverage ratio requirements and have strong central bank cash holdings totaling 16% of assets, which means European banks are less likely to resort to selling securities and carry-out to any damages.
High levels of uninsured deposits
One of the aspects that emerged from the collapse of SVB and Signature Bank is the high levels of uninsured deposits that both banks maintained.
SVP ranked second among banks with more than $50 billion in assets, with 93.9% of its total domestic deposits uninsured, while Signature Bank ranked fourth.
Huge deposits accumulated during the Covid-19 pandemic, but for the thousands of technology companies (including fintechs) served by SVB, which made up more than half of its deposits.
Depending on the branch of business in which it operates, businesses choose specialized financial institutions that better understand their needs and how they operate and do not usually choose traditional commercial banks. A technology-driven startup, such as those operating in Silicon Valley, needs financial institutions that recognize that these businesses require a high degree of liquidity and working capital to operate. The fact that the majority of Silicon Valley start-ups chose SVB for their cooperation is not a strategic mistake on their part. Having accounts and deposits in different banks can reduce the risk of losing all deposits, but you do not achieve dynamic service when your business needs it.
The mistake has nothing to do with the choice of businesses to cooperate with a specialized bank. It was SVB’s fault that it had many uninsured deposits as a result of its business model.
Its main product was business debt – lending money to start-ups in exchange for certain rights and the exclusivity of banking relationships. It was one of the few banks that lent money to start-ups. It allowed start-ups to get unrestricted funding, which is very attractive for any start-up.
