About the author: Jeff Hulett is a banking and bank risk consulting professional. Jeff is a behavioral economist and a decision scientist. Jeff is an executive with the Definitive Companies. Definitive helps people and organizations make the best decisions using time-tested and patented technology. Our solutions are developed from the research-informed behavioral sciences and decision sciences. Jeff holds advanced degrees in finance, mathematics, and economics. Jeff previously held leadership positions with KPMG, IBM, Citibank, and Wells Fargo. Jeff and his family live in the Washington D.C. area.
Table of contents:
The SVB failure and the breakaway challenge
Did SVB try to put a "square peg in a round hole?"
The banking industry and board impact - asking the right questions
Conclusion
Resources
Appendix
SVB's failure, a place to start
The systemic risk paradox
Notes
1. The SVB failure and the breakaway challenge
Banks, like people and other businesses, are social animals. They tend to herd and act together. Professional biking offers a helpful analogy. The peloton, French for 'platoon,' is the herd. They have a symbiotic relationship. Even while competing, bikers draft off each other to save energy. The objective of a bike race is to win! So a winning biker's strategy includes NOT being a loyal member of the energy-saving peloton. A pack of several riders will eventually break away. Other riders from the peloton often join them. Sometimes the peloton may even catch the breakaway riders.
In 2023, Silicon Valley Bank ("SVB") failed. Banking tradition, experience, and habit teach an important lesson. It would be short-sighted to believe SVB acted alone. They are likely part of the breakaway pack from the peloton -- in a failed attempt to win. The Economist [i] made an on-point observation about the specific risk that led to SVB's downfall:
"America's capital rules do not require most banks to account for the falling price of bonds they plan to hold until they mature."
This is commonly understood by the industry. As such, there are likely other banks that followed SVB's competitive lead, especially since their balance sheet management approach appears to have been tolerated by the regulators. To be clear, just because the regulator does not prescribe every risk a bank should manage, does NOT relieve the bank's responsibility to manage all their unprescribed risks.
On March 12, 2023, the primary Federal Bank regulators issued a market-calming joint statement. These regulators are the OCC, the Federal Reserve, and the FDIC. The joint statement is an attempt to stem the tide. The regulators are trying to head off any deposit draining "rush to the door" momentum that may spill over into otherwise healthy banks. As suggested in our biking analogy - the joint statement has an unsaid quality as well - the breakaway pack may be bigger.
As a way of learning what actually happened, it would be instructive to understand:
SVB’s historical Asset-Liability Management ("ALM") actions. (These are activities, often executed under the direction of the bank Treasurer, to manage the bank's balance sheet)
The structure, minutes, and historical actions from the SVB Asset-Liability Committee ("ALCO"). (The bank has a senior executive ALCO or similar that governs the bank's ALM operations)
The SVB examination summaries and regulatory actions from their regulators’ historical safety and soundness exams. (The bank regulators, like those mentioned in the joint statement, are compelled to regularly examine and oversee the banks in their scope.)
The truth is, these documents will likely NOT be made public any time soon. The public release of documents like this may not serve the immediate "stability of the U.S. banking system" objective. However, there is also a sense that regulators and society at large have an opportunity to learn more from recent banking history.
There is also a “known or should have known” dilemma. From the outside, the SVB failure has the classic “should have known better” from all of the above when it comes to time-tested bank balance sheet management.
Bernadette Kogler is the CEO of RiskSpan. She leads a successful loans and structured products risk analytics company. Ms. Kogler recently asked a great question - "Don't you think this (SVB) failure is more like the S&L crisis and mismatched deposits than 2008, which was a credit crisis." The answer is "Yes and No."
Jeff's response: I was a Managing Director for a large risk consulting firm. During the hay days of the crisis, we had a long-term contract with the FDIC. My teams helped the FDIC oversee the FDIC's bank failure and resolution program.
We saw the same themes play out consistently -- How the bank managed credit (or "uses") were often the solvency-challenging catalyst, but how the bank managed its interest rate risk and funding (or "sources") were usually the difference between surviving the crisis or going under.
During the financial crisis, there were hundreds of bank failures. Congress compels the FDIC to perform a post-mortem on bank failures. This healthy exercise highlights the very important “what we learned” from the failure. Given we are only a decade or so past the financial crisis, perhaps the biggest SVB failure learning thus far is “Memories are short!” Next, is common banking guidance provided by the regulators:
Here is an FDIC example of regulatory guidance for bank balance sheet management.
- and -
Here is the Federal Reserve's summary of the CAMELS bank regulatory assessment rating framework.
The point is - This is not new stuff.
2. Did SVB try to put a "square peg in a round hole?"
SVB bank management and especially their ALCO had the lion's share of the responsibility for the failure. They had their hands directly on the steering wheel -- and they put the car in the ditch. Sure... we can try to blame the road maintenance crew (The Fed) or the police enforcing road laws (the regulators) but there are thousands of other drivers (other banks) able to keep their cars on the road!
There were so many similar bank failures or near-failure examples from the financial crisis. Key learning from the financial crisis included the interest rate risk created from duration mismatched balance sheets. Simply, over-reliance on short-funded uses matched with long-funded sources spells trouble. Stress on uses reveals deficiencies in the duration matching architecture of the sources. Next, we summarize the broader perspective on the cyclical impacts related to bank funding sources and uses. See the appendix called "SVB's failure, a place to start" for the unique challenges faced by SVB.
The business cycle view of bank funding sources and uses
Banking, like many systems, is complex and dynamic. When trouble occurs, it is easier to focus on the most obvious cause. The reality is, under stress, complex systems tend to become chaotic. They sometimes act in ways seeming obvious in the rear-view mirror but are very challenging to anticipate at the time a decision needs to be made. Next are observations from direct experience with bank failures. In the resource section, we suggest Definitive as a decision platform to assist in making the best decisions.
It is not so much about the funding uses ...
Once you get past the sensational crypto, Peter Thiel-start-up details, the fundamental reasons for the SVB failure are not new. In other words, there will inevitably be some "creative" uses of funds that fall under the category of "seemed like a good idea at the time." That is why the regulatory-informed bank governance tradition provides for strong operating disciplines like credit loss reserves, policies, and stout information resources. The economy and banking environment are cyclical. Economic stress WILL eventually occur.
In the stressed part of the economic cycle, it is less about those past "creative" uses -- whether suspect loans made during the financial crisis or start-up funding on point for SVB -- that ship has sailed.
... It is more about the funding sources
In a stressed economic environment, the difference between survival and failure is more about the ALM discipline driving how the funding sources are managed. Robust ALM, ALCO, and regulatory oversight enable funding source management to act as a control to guide funding uses. As an essential bank guiding principle, properly architected sources of funds enable appropriate downstream uses of funds. This is why getting source management right is so critical. Stressed environments reveal which banks got source management right. Stressed environment bank failure revelations reflect Warren Buffett's timeless observation:
“Only when the tide goes out do you learn who has been swimming naked.”
The post-financial crisis banking system has less tolerance for systemic risk
To be clear, the degree to which SVB'a actions play into overall banking systemic risk is not yet known. SVB may ultimately prove to have little impact on the broader banking industry's systemic risk. Or they may be a Washinton Mutual ("WaMu")-like harbinger as in the financial crisis. Time will tell. Tolerance for systemic risk is different. Following the financial crisis, the banking regulatory environment dramatically changed. Bank regulators, via several legal actions like The Dodd-Frank Act, CCAR and related stress testing, and a host of new financial crisis-era laws and regulations, made significant systemic risk-impacting changes. They rolled back the allowable banking activities impacting systemic risk. Please see the appendix section called "The systemic risk paradox." We address systemic risk challenges in the context of the reduced-scope banking industry since the financial crisis. We also show that if SVB had a mortgage business including owned MSRs, they may still be in business today! The appendix suggests an unintended consequence of strict financial crisis era laws includes disincentives for banks to be in the mortgage business. The MSR natural hedge has evaporated for banks... that natural hedge may have saved SVB.
It appears SVB leadership did not get the less-tolerance-for-systemic-risk memo. SVB's actions appear to be inconsistent with the reduced systemic risk-related regulatory intent, especially regarding how they managed their capital. Research from JPMorgan Chase demonstrates SVB may have led the breakaway pack, but other riders are showing an impact from the stressed economic cycle. The follow-on question becomes:
Was SVB trying to fit a venture funding round peg into a banking square hole?
Making suspect, mismatched interest rate bets is certainly a valid "round peg" concern. Thank goodness, the vast majority of “square hole” banks do not do this. At least we hope! The size of the breakaway pack will soon reveal itself. Also, it is possible, there are many more riders in the peloton managing their bank balance sheet consistent with SVB.
3. The banking industry, board, and regulatory impact - asking the right questions
Banking industry impact: Situations such as the SVB failure cause a ripple effect through all bank leadership. The impact causes bank leaders to hold one of three beliefs, supported by one of three questions:
I know we have a great story to tell. How do we gather the information to tell the story our regulator is sure to ask?
I hope we have a good story to tell. How do we confirm the story and work on any challenges before our regulator asks?
I know we DO NOT have a good story to tell. How do we best come clean in a way that helps communicate with our regulator and creates positive momentum for remediation?
These 3 questions are usually presented as a waterfall. It is human nature to start at the top of the waterfall. Most want to believe they are done at rosy question 1. Most reach question 2. Some more challenged banks descend down the waterfall to question 3. "Groupthink" commonly causes biased and ineffective group decision-making [ii] Bank leaders need to determine how far down the waterfall they must travel. Groupthink causes decision biases causing delayed or inaccurate waterfall decisions. A few banks are able to credibly stop at question 1. Most cannot -- Groupthink causes delays or a failure to achieve alignment between belief and reality. This misalignment will likely be exposed by regulators. In most cases, early identification reduces the time and costs to resolve any challenge. In a timely headline article from The Economist [i], it is suggested:
"Regulators everywhere must also build a regime that recognises the risks from rising interest rates. A bank with unrealised losses will be at greater risk of failure during a crisis than one without such losses. Yet this disparity is not reflected in capital requirements."
As such, it is inevitable your regulator will be asking lots of "nowhere to hide" questions.
Board of Directors impact: The banks' boards of directors present a different challenge. Today, the vast majority of board members do not have extensive banking experience. This reality suggests: "Board members do not always know the best strategic questions to ask."
Chris Repetto leads Promontory, IBM Consulting's financial services client organization. Mr. Repetto recently commented:
"Regulators expect bank boards to take an active and insightful role in governing bank operations. It is critical that Bank boards have the frameworks and capabilities to ask risk-informed questions of their institutions and to effectively communicate with regulators.”
The board challenge is only increased by the following 'Catch-22' reality:
The board must act independently of bank leadership to properly govern.
The most experienced bankers the board members personally know likely work for the same bank!
As such, the board would benefit by engaging with independent third parties that bring decades of relevant banking industry experience and proven decision process experience.
Bank regulatory impact: Groupthink and decision challenges are not limited to banks and their boards. The Federal Reserve, SVB's primary regulator, published the "Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley." In it, Vice Chair for Supervision Barr mentioned:
"In the interviews for this report, staff repeatedly mentioned changes in expectations and practices, including pressure to reduce burden on firms, meet a higher burden of proof for a supervisory conclusion, and demonstrate due process when considering supervisory actions. There was no formal or specific policy that required this, but staff felt a shift in culture and expectations from internal discussions and observed behavior that changed how supervision was executed."
- Michael S Barr, Vice Chair for Supervision, The Federal Reserve System, emphasis added
The underlined text points to the tell-tale signs of groupthink. In terms of regulatory strategy, the impact of groupthink leads to an effective procyclical regulatory supervision approach. In effect, "pressure to reduce burden on firms" reduces regulatory oversight during this time of economic expansion. Procyclical regulatory strategy was called out as a key driver of the financial crisis starting in 2008. [iii]
The procyclicality of U.S. financial regulation was a key driver of the housing bubble in the mid-2000s and the massive credit crunch that followed.
Decision processes designed to overcome groupthink will:
Explicitly enable a countercyclical regulatory strategy or, at least,
Provide confidence the chosen regulatory strategy is not impacted by groupthink.
4. Conclusion
For SVB a key learning is that the traditional bank structure and regulatory expectations make start-up venture funding in a bank a very risky proposition. Or, at least, in the way SVB attempted to fund it. For other banks, the management of their sources and uses will present unique challenges. In a higher-stress economic environment, one thing is for sure, your regulator will come a-knockin'.
5. Resources
Please see our article: Process Not Perfection - The foundation for better decisions. How boards and executive teams make the best decisions by focusing on the decision process.
Definitive Pro: This is an enterprise-level, cloud-based group decision-making platform. Confidence is certainly important in corporate or other professional environments. Most major decisions are done in teams. Group dynamics play a critical role in driving confidence-enabled outcomes for those making the decisions and those responsible for implementing the decisions.
Definitive Pro provides a well-structured and configurable choice architecture. This includes integrating and weighing key criteria, overlaying judgment, integrating objective business case and risk information, then providing a means to prioritize and optimize decision recommendations. There are virtually an endless number of uses, just like there are almost an endless number of important decisions. The most popular use cases include M&A, Supplier Risk Management, Technology and strategic portfolio management, and Capital planning.
6. Appendix
a. SVB's failure - A place to start
Next is an analysis of the unique challenges leading to SVB's failure. This analysis is built from public information, reporting provided since the bank failed, and the author's experience and intuition. Much more will be revealed over time. Consider this analysis a starting point. The unique uses of bank funding are addressed. However, the responsibility to provide properly matched funding sources is no different than all other banks.
On the bank uses side of the balance sheet - There are differences between held to maturity ("HTM") and available for sale ("AFS") accounting when it comes to uses like securities or loans. By rule, the bank must decide when the security or loan is booked whether to designate it as HTM or AFS. This is critical. It is challenging to change after the fact without taking a large impairment. There is a volume of accounting rules governing the HTM and AFS nuances. [iv]
Based on an intuitive understanding of accounting rules, the HTM portfolio is not generally required to be marked to market. That means securities or loan values can go up or down with the market. However, the intrinsic value as found in the bank's financial statements is based on the income produced by the stated yield of the bond or loan. Conceptually, a bank can "ride out" bond price fluctuations if its securities or loans are booked as HTM. It also helps if the bank holds Residential Mortgage Backed Securities. "RMBS" present no credit risk as they are backed by Fannie Mae, Freddie Mac, and the U.S. government. In the post-financial crisis world, RMBS is the Fed's go-to security to implement quantitative easing. "QE" is how the Fed manages the money supply and interest rates at the long end of the yield curve. This monetary policy tool has been used in lower-rate environments since the financial crisis.
According to early SVB reports following the failure, even though their securities book was mostly HTM and no credit risk RMBS, it still bit them because of the duration mismatch. The deposits (sources) repriced whereas the bond yields (uses) did not. Thus, SVB became upside-down. (Variable deposit costs moved higher than the fixed bond yields) To stay solvent, a bank must maintain a minimum level of capital. (known as Tier 1 Capital) The negative impact of being upside-down caused SVB to sell securities to replace the capital bled through their P&L. They were not able to sell enough to overcome the capital losses and the lack of capital caused them to fail.
On the bank sources side of the balance sheet - According to early reports, SVB does have VERY UNIQUE funding uses impacting demand deposit source behavior. Their demand deposits were primarily being used for client startup funding and sourced from venture capital and similar companies for those startups. In most other banks, demand deposit balances are very stable. Largely, most bank commercial clients are mature companies having stable, everyday cash needs that require cash in the bank. While typical demand deposits technically have very short durations, they tend to behave like a long-funded source. Startups are different. They have very fast cash burn rates because they are in an intense business build mode. Unless new startup companies are added, the demand deposit balances will drop fast. SVB had VERY different demand deposit source behavior than most other banks. When rates rose, the door to new start-up-based deposit sources was closed, existing deposits ran off much faster than expected, and the speed at which their bond portfolio became upside down accelerated. Perhaps this unusual demand deposit behavior is why the regulators didn’t seem to catch it! The environment was like a perfect storm.
There were many similar source-based banking challenge examples during the financial crisis. For example, E*Trade Bank, now part of Morgan Stanley, was a whisper away from failing in 2009. They bet the long end of the yield curve with short deposits swept from their broker-dealer's cash accounts. Please note, in the run-up to the crisis, E*Trade's primary bank regulator was the now-defunct Office of Thrift Supervision ("OTS"). The OTS had a reputation as a more permissive regulator. After the financial crisis, E*Trade's regulator changed from the OTS to the national bank regulator, the Office of the Comptroller of the Currency ("OCC"). The OCC has a well-earned reputation as a more strict bank regulator.
b. The Systemic Risk Paradox
Earlier, we discussed the 2 methods of booking securities and loans for accounting purposes - HTM or AFS. We provided an example of how the lower-risk HTM accounting approach still created challenges for SVB.
AFS is a different animal and creates more exposure to market volatility because AFS securities and loans are regularly marked to market.
An AFS example is Mortgage Servicing Rights (“MSRs”). A mortgage is split into 2 pieces, the RMBS which we discussed earlier, and the MSR. Both are tradeable securities.
Think of the RMBS as the deep-pocket investor that owns your mortgage and receives the payment.
Think of the MSR as owned by the company that services your mortgage and collects your payments on behalf of the investor.
Importantly, the RMBS owner and the MSR owner are usually NOT the same company.
MSRs are held as AFS by the mortgage servicer. Mortgage servicers buy and sell MSRs all the time. So holding them as AFS makes sense. MSR values are extremely volatile and must be marked to market quarterly. It creates a challenge for the mortgage servicer’s CFO team. MSRs are notoriously difficult to manage and hedge. They often create significant volatility in the mortgage servicer’s earnings. As interest rates go down, MSR values go down. Conversely, as interest rates move up, MSR values move up. Before the financial crisis, banks held loans, RMBS, and MSRs. When rates go up, the MSRs acted as a natural head against the margin compression. Now that banks have mostly retreated from the mortgage servicing business, that natural hedge has evaporated.
It is interesting how the regulatory environment has evolved since the financial crisis. Today’s post-financial crisis environment creates incentives for non-bank mortgage servicing companies to own the MSRs. As a group average, non-banks are significantly lower capitalized than their bank cousins. It is a head-scratcher that our financial system creates incentives to transfer risk from higher capitalized, higher earnings quality banks to lower capitalized, lower earnings quality non-banks. Also, those riskier MSRs could help banks hedge against today's rapidly increasing rate environment. Instead of managing systemic risk in total, it seems we may be creating more total systemic risk by redefining banking more narrowly. Metaphorically, all we have done is move money (higher risk AFS) from one pocket (bank) to another (non-bank), but the new pocket (non-bank) is more likely to have holes! (less capital/potential for more systemic risk impact)
This financial system's reality may sow the seeds for the next crisis!
For a more in-depth discussion of systemic risk and the impact of principles- vs. prescriptive-based regulation, please see our article:
7. Notes
[i] Leaders editors, What’s wrong with the banks, The Economist, 2023
[ii] The initial confidence for bank personnel to believe "I know we have a great story to tell" narrative in the organizational setting results from naturally occurring optimism bias. Optimism bias causes someone to believe that they themselves are less likely to experience a negative event. Optimism bias is one of the many cognitive biases impacting individual decision-making. This becomes compounded by organizational groupthink. Groupthink may impact group decision-making. Groupthink is a psychological phenomenon that occurs within a group of people in which the desire for harmony or conformity in the group results in an irrational or dysfunctional decision-making outcome.
This is like a double whammy, where individual optimism bias gets leveraged in the groupthink context. Like a bias on a bias. This is a good reason to have independent facilitation confirming the "I know we have a great story to tell" narrative.
Prentice, OPTIMISM BIAS: THE DARK SIDE OF LOOKING AT THE BRIGHT SIDE, University of Texas, McCombs School of Business, 2022
Sharot, The optimism bias, Current Biology, VOL 21, ISSUE 23, 2011
[iii] Kress, Turk, Rethinking Countercyclical Financial Regulation, Georgia Law Review 495, 2022
Masur, Posner, Should Regulation Be Countercyclical? 34 Yale Journal on Regulation
857, 2017
[iv] See the google search "accounting rules afs and htm." There are over 600,00 entries. I suggest a source from an accounting firm or the SEC.
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