I was dumbfounded by what appeared to be a complete failure of the most basic interest rate and liquidity management by a bank that had done so many other things apparently so well. SVB was envied by many competitors hoping to emulate in some small way the overwhelming success it had enjoyed (through several business cycles) with venture debt, technology startups and their venture capital investors. For days after the event, I kept asking myself if this was a case of hindsight bias(i.e.hindsight is always 20/20) or if this was really as obvious as it appeared.
With the publication of the report by the Federal Reserve Bank I believe that we can now speak with confidence. To quote the Vice Chairmanʼs opening comments in his accompanying note: “Silicon Valley Bank (SVB) failed because of a textbook case of mismanagement by the bank. Its senior leadership failed to manage basic interest rate and liquidity risk.
Its board of directors failed to oversee senior leadership and hold them accountable. And Federal Reserve supervisors failed to take forceful enough action, as detailed in the report.” Members of Management were singularly focused on short-term profitability to the exclusion of anything remotely related to risk management and were financially incentivized by the board to wear blinders. “Compensation packages of senior management through 2022 were tied to short-term earnings and equity returns and did not include risk metrics.” When the bank failed internal stress tests, management “made counterintuitive modeling assumptions about the duration of deposits to address the limit breach rather than managing the actual risk.” During the same period of rising interest rates “SVB management took steps to maintain short-term profits rather than effectively manage the underlying balance sheet risks.” This included removing hedges that would have protected the bankʼs equity from rising rates.
The board seems to have had little appreciation of what was happening at the bank in terms of risk management. Interest rate risk, duration risk and liquidity risk are all inherent parts of banking. Each is an inevitable outcome of the role that banks play—taking typically short-term deposits and lending them to credit-worthy businesses and individuals for significantly longer terms.
But because of these unavoidable risks, risk management needs to play a central role—on par with profitability and shareholder returns—in the day-to-day operations, management, and oversight of the bank. In one highly important respect SVB was brought down by events that were probably not foreseeable. The speed at which deposits exited the bank--$40 billion on a single Thursday, with the expectation that Friday would see another $100 billion withdrawn—was staggering.
As the Fed points out, “[T]his deposit outflow was remarkable in terms of scale and scope and represented roughly 85 percent of the bankʼs deposit base. By comparison, estimates suggest that the failure of Wachovia in 2008 included about $10 billion in outflows over 8 days, while the failure of Washington Mutual in 2008 included $19 billion over 16 days.” The unprecedented speed of this run-on deposits was brought about by “coordinated” (the Fedʼs term) actions among SVBʼs client roster of VC firms and their portfolio companies, fueled by social media and enabled by online banking. For those who spend time thinking seriously about financial stability, this will and should be the source of many sleepless nights.
In some respects, that SVB was brought down by this is exceedingly ironic. Venture lending, the core of SVBʼs business, is the ultimate “relationship banking.” Lending is not based upon traditional credit considerations. On that basis no business could be completed.
Rather, venture debt lenders rely principally on their relationships with the venture capital investors who breathe life into technology and other start-up enterprises. The most important part of a venture lenderʼs due diligence is the call to the backers of the company. Will they stand behind this venture?
Will additional capital be available, if necessary? And yet, when SVB was in dire need of support from the ecosystem they had helped to build, it was not there. Finally, as the Federal Reserve Report clearly identifies, bank regulators failed to do their jobs.
At the time of SVBʼs failure there were “31 open supervisory findings…, about triple the number observed at peer firms. The supervisory findings … included core areas, such as governance and risk management, liquidity, interest rate risk management, and technology.” The reasons for the host of regulatory failures are complex, beyond my area of expertise and will challenge the Fed and other government regulatory bodies (who are undoubtedly plagued by similar failures) for a very long time. One thing, however, is for certain.
The regulators who fell short in executing their duties were not acting out of financial self-interest. Unlike SVBʼs management they were not rewarded with cash bonuses and option grants for putting the bank at risk. There will undoubtedly be a lot of public discussion going forward about whether the changes to the regulatory rules brought about by the Economic Growth, Regulatory Relief, and Consumer Protection Act contributed to the collapse of SVB.
Vice Chairman Barr concludes that it led to “a shift in the stance of supervisory policy [that] impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.” On the other hand, the report states that“[w]hile higher supervisory and regulatory requirements may not have prevented the firmʼs failure, they would likely have bolstered the resilience of Silicon Valley Bank.” (Emphasis mine). In other words, the regulatory framework in place should have been sufficient, if executed properly, to avoid this disastrous outcome. While neither I nor any company I have been associated with has had a banking relationship with SVB, I have many friends who worked there.
On one occasion I negotiated (unsuccessfully) a venture debt term sheet with the bank. The people I encountered were smart, dedicated, and resourceful and were motivated to do the right and prudent thing. I suppose this is reflected in the fact that the bankʼs failure did not emanate from its loan portfolio.
The bankʼs senior management and board failed to do the right thing and the consequences were disastrous for the bank and our nationʼs banking system. I want to end with a huge shout out to my former colleagues at Bank Leumi USA. Though a tiny bank by comparison to SVB (under $10 billion in assets) the bank had extraordinary professionals from top to bottom and in the context here had exceptionally talented individuals in the roles of CEO, CFO, Head of Risk Management, Head of Internal Audit and Head of Legal, supported by equally talented mid-level and junior bankers.
The individuals with whom I shared board responsibilities were first-class in every respect. I am extremely proud to have been associated with such an institution.