Silicon Valley Bank - an accident waiting to happen

In summary, SVB was a very risky bank in terms of 

1. client & business mix
2. liquidity management
3. interest rate risk management
4. governance.

Was SVB a typical bank?

SVB was far from a typical bank since it had a focus on being the bank at the heart of the venture capital ecosystem. Most of its banking business was being made with start-up companies mainly in the tech and bio-tech sectors. As a result, its customer mix was very concentrated, and the lack of diversification was compounded by its specific clients being early-stage companies which are particularly vulnerable in a world with costlier and less access to money. Hence, we already have the first red flag associated with SVB.

When their start-up clients raise funding, they deposit the cash at SVB, and then draw it down as they burn cash in their business. The chart below illustrates that providing loans to its clients was only a small part of their business model. The main part of its business was to store its clients' funds as deposits (as long as its clients didn't need their cash). This resulted in an unusually low loan to deposit ratio around 40-50%. As a comparison, the median loan to deposit ratio for large US banks is around 80% and around 100% for large European banks. In other words, large US and European banks have much more balanced business profiles.

Loan to Deposits (%)

The chart below illustrates the extreme growth in deposits at SVB during 2020 and 2021 as a result of abundant funding being available for its clients. The annual deposit growth at SVB peaked at 85%! in 2021 compared to 13% for large US banks and only 6% for European banks. The chart also illustrates what happened with deposits at SVB in the last 12 months. As funding for their tech start-up client base dried up, the clients continued to face cash burn (start-up clients are inherently cash flow negative).

Deposit Growth (YoY, %)

Large deposit growth is typically a warning sign when analyzing banks, since it can lead to bad business decisions. If client loan demand is not there a bank may then choose to deploy the deposit inflows in security investments (which might add liquidity, credit and/or interest rate risks). Hence, we have a second red flag associated with SVB.

This is exactly what played out at SVB. With limited demand for loans from its clients, SVB decided to increase its bond investment portfolio to earn additional interest income, illustrated in the chart below. This was another warning sign associated with SVB.

Deposits, Cash, Bond Portfolio (USD, bn)

Such portfolio must be liquid and consist of high-quality bonds to be able to quickly sell bonds at a minimal cost to meet any deposit outflows. It is normal bank treasury praxis to either invest in floating rate notes (to reduce interest rate risk), short duration Treasury bills (30-90 days), and/or to hedge the interest rate risk in its bond portfolio through interest rate swaps for any longer maturities.

With limited amounts held in cash, the deposit outflows forced the bank to sell part of its bond holdings. This is normal practice in the sense that a bank bond portfolio being liquid and of high quality is there to be used to provide liquidity when needed.

However, what is not normal practice is that SVB had acted as if the deposits would remain for several years, since most of the purchased bonds (mortgage backed and US Treasury bonds) were in longer maturities paying fixed interest (5.6-year portfolio duration). Since such a high duration translates into considerable interest rate risk appropriate interest rate hedging is needed. However, it seems SVB applied a minimal level of interest rate hedging ($550m on the $120bn bond portfolio and as late as in October 2022). Hence, the lack of interest rate risk management was a third red flag associated with SVB.

Bond Portfolio (USD, bn)

In terms of profit and loss impact a bank can choose to book a bond either as Available for Sale (profit and loss reflected in capital changes) or Held to Maturity (amortized at cost over the life of the bond and no reflection of profit and loss in capital). SVB decided to not hedge the majority of interest rate risk but rather book the vast majority of its bond portfolio as held to maturity (chart above). This means that any bond losses (from higher interest rates) will only be accounted for if a bond is sold from this portfolio before its maturity.

The large size of the SVB's bond portfolio booked as Held to Maturity is evident compared to larger well-regulated banks in the US and Europe (chart below). We regard this as poor liquidity risk management and a fourth red flag associated with SVB.

Held to Maturity / Total Assets

Why did SVB collapse?

When the clients needed their cash, held as deposits at SVB, the bank sold $21bn of its «Available for Sale portfolio» resulting in a $1.8bn realized loss (8.6% loss). With the vast majority of depositors being corporate clients (98% of its total loan book, with retail loans only accounting for a mere 2%) most would not be protected by the deposit guarantee (limit at $250'000). This in turn alarmed the venture capital sponsors who advised their portfolio companies to withdraw their funds and limit their exposure to SVB. This in turn exacerbated the problem. SVB tried to raise capital but failed and were taken over by the California state regulator.

What is the read across to large US and European banks?

We see limited read across to large US and European banks. It is for us clear that SVB was a very risky bank and a complete outlier in most dimensions. It had a risky client and business mix (looking more like a monoliner), very poor liquidity management and absence of standard bank treasury practice in terms of interest risk management. In addition, operating without a Chief Risk Officer for the last 12 months speaks for weak governance. These are major flaws we don't see at the largest US and European banks.

We expect a heightened focus on other specialist regional US banks. We also expect a greater focus from banks to start to increase the still very low bank deposit rates to reduce the risk of deposit flight. Particularly in the US these still pale in comparison with the sharply increased short-term rates available from Treasuries and money market funds. Normally when interest rates increase deposit migration is observed i.e. clients don't withdraw deposits but rather move from non-interest paying deposits to interest rate bearing deposits within the same bank. While higher interest rates on deposits will reduce earnings, this will have a greater impact on smaller regional US banks than large and solid US and European banks in our view.

One thing that strikes us is that European banks are in different situation and should be less affected by this problem than US banks in our view.

1. Deposit growth has been much more muted in Europe compared to the spike seen at US banks.
2. European banks have been more conservative thank US banks since European banks haven't increased their bond holdings but have rather increased the amount of cash held on balance sheet by more than €2tn since pre-Covid (from €2tn to €4tn).