Financial implications of the collapse of Silicon Valley Bank
Washington this week came to grips with the implications of the sudden collapse of Silicon Valley Bank (SVB) and the regulatory response to it.
Last Friday, federal regulators closed SVB and placed it in receivership. SVB had over $200 billion in assets and became the second-biggest bank failure in US history in terms of assets. Over the weekend, federal regulators also closed another bank, Signature Bank (it became the third largest bank failure in history). They also took emergency steps to make whole all depositors in SVB and Signature Bank. Finally, they set up a facility to provide banks with dedicated funding (for up to one year) for their holdings of high-quality, liquid assets.
SVB was a unique bank. Its banking activities were concentrated in the technology and venture capital industries.
It had grown rapidly through deposits from technology companies flush with cash during the pandemic. The vast majority of its deposit funding was from uninsured deposits ($152 billion out of $173 billion of total deposits at the end last year). SVB made a fateful decision to heavily invest the proceeds of that funding in long-term assets. That subjected it to significant interest rate risk. By the end of last year, unrealized losses on its securities holdings exceeded its Tier 1 capital. As SVB began to experience withdrawals last year and earlier this year, it needed to sell some of these securities at a loss. When it tried to raise additional capital last week amidst the backdrop of those losses, the withdrawals only accelerated, leading to its closure on Friday.
The Federal Reserve earlier this week announced that Vice Chair for Supervision Michael Barr will be leading a review of the supervision and regulation of SVB. The review is scheduled to be publicly released by May 1. In the meantime, there will be hearings in Congress to probe what happened and what needs to be done in response.
The following issues will be a big part of the post-mortem on SVB and the policy debate moving forward:
Risk management and supervisory failures: The problems at SVB seem to have risk management and supervisory failures at their root. The bank had a vulnerable funding profile and held large portfolios of long-term debt securities. This created substantial duration mismatch between its assets and liabilities. It seems to have done little to hedge the associated interest rate risk. As mentioned, by the end of last year, unrealized losses on its securities holdings exceeded its Tier 1 capital, which is a core measure of a bank’s strength by regulators. A big part of the Fed’s probe and Congressional hearings will be looking at the processes and circumstances that led SVB and its supervisors to miss or discount this key risk.
Deposit coverage: FDIC deposit insurance coverage is capped at $250,000 ($500,000 for joint accounts). SVB was a huge outlier in the extent to which the composition of its deposits was uninsured. However, uninsured deposits (e.g. from business accounts) are a significant part of many banks’ deposit funding. In the weeks and months ahead, there will be significant discussion in Congress and with the regulators about the need to raise the current limit and, if so, by how much. As noted, as an emergency step, regulators made the decision to guarantee the deposits of all uninsured depositors at SVB and Signature Bank. One possible consideration will be covering all deposits. That likely would mean much higher deposit insurance assessments on banks. Both Congress and regulators will consider both the costs and benefits of wider deposit insurance coverage. A change to the deposit insurance limit would require a change in law by Congress.
Treatment of unrealized gains and losses on banks’ securities holdings: SVB held total investment securities of over $120 billion at the end of last year. About $26 billion was categorized as available for sale (AFS) and $91 billion was categorized as held to maturity (HTM), with the remaining balance reflecting nonmarketable securities. Unrealized gains and losses are reflected in the accounting value of 007AFS securities, but not that of HTM securities. Furthermore, applicable regulatory rules allowed SVB to not count its accumulated losses on AFS securities in its regulatory capital. There will be debate about both the accounting and regulatory treatment of unrealized gains and losses on banks’ securities holdings. Whatever the specific treatment of these securities holdings, it’s worth noting that the unrealized losses on both AFS and HTM securities were disclosed in SVB’s financial statements. At the end of last year, it had $17.7 billion of unrealized losses on its securities holdings ($2.5 billion on its AFS securities and $15.2 billion on HTM securities). That combined amount actually exceeded the amount of Tier 1 capital ($17.5 billion at the end of last year).
Cross-Selling: One key question is why did so many of these businesses have such large transaction account balances with a bank of this risk profile. There have been reports that SVB had exclusivity agreements whereby it required customers to have banking accounts with SVB as a condition of getting financing. Regulators and Congress will probe the nature of these agreements, including whether any constituted legal wrongdoing.
Monetary Policy: When Fed Chairman Jerome Powell appeared before Congressional committees last week, he was criticized by some Democrats for what they saw as an overly hawkish stance on monetary policy. They emphasized the potential negative impact of interest rate increases on employment numbers. As noted, SVB was on the wrong side of the Federal Reserve’s interest rate movements with its long-dated securities holdings. The situation with SVB and other banks gives Fed critics further ammunition. Senate Banking Committee Chairman Sherrod Brown (D-OH) said recently that he hoped that the Fed would pause its interest rate increases. The Fed will have its Federal Open Market Committee meeting next week to discuss another potential interest rate hike.
Social Media: Lawmakers and regulators also will delve into the role of social media in potentially fueling runs at SVB and Signature Bank.
Debt Limit “X Date”: Since the Fed’s backstop program to fund bank debt holdings is capitalized with funds from the Treasury, this could have implications for the X date (the effective date when the government runs out of room to maneuver with extraordinary measures and can no longer meet all of its obligations). Depending on how much the facility is used, this could move up the X date and therefore accelerate the fight in Congress on raising the debt ceiling.
“Bailout”: Some Republicans have criticized the Biden administration and regulators for bailing out SVB’s (and Signature’s) uninsured depositors. Some Republicans also have expressed concern and frustration with the inability or unwillingness of the FDIC to auction SVB to another bank based upon the bids it had received (the FDIC plans on making another try at an auction at a later date). On the other hand, many Republican lawmakers have largely reacted positively to regulators’ swift actions to help ensure confidence in the banking sector. Regulators have made clear that any losses to the Deposit Insurance Fund (should they materialize) would be recovered through a special assessment on banks.
ESG: Some Republicans have argued that SVB was overly focused on environmental, social and governance (ESG) programs and initiatives.
Regulatory Relief: Perhaps the biggest issue is what role (if any) regulatory relief provided in 2018/2019 by Congress and the regulators played in SVB’s collapse. Some progressive Democrats like Senator Elizabeth Warren (D-MA) have been trumpeting this argument. In 2018, Congress passed regulatory relief legislation that raised the asset threshold at which bank holding companies would be subject to heightened regulatory requirements and that directed the Federal Reserve to tailor regulatory requirements based upon the risk profile of banking entities. The banking industry has argued that the management of interest rate risk is addressed primarily through supervision rather than standardized regulatory requirements. They add that the application of a regulatory requirement like the liquidity coverage ratio, which requires banks to hold high-quality liquid assets for potential outflows, would not have changed anything since SVB had plenty of high-quality liquid assets. From a political lens, any legislative effort to overturn the 2018 law is a non-starter in the Republican House. Furthermore, the 2018 regulatory relief effort was a bipartisan undertaking (e.g. 17 Democrats supported the bill in the Senate). While tailoring isn’t likely to get a wholesale overhaul, the Fed, pending its aforementioned review, may look to make some adjustments to the types of regulatory requirements that apply to certain classes of banks. As we noted last week, this whole situation occurs as the Fed is conducting a holistic review of existing capital requirements and as regulators are working on finalizing efforts on a major proposed update of capital rules. The timeline of those efforts inevitably will be pushed back pending the aforementioned review.