Silicon Valley Bank had red flags, but no one noticed

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Silicon Valley Bank — Not many people were aware of the existence of Silicon Valley Bank beyond the tech industry two weeks ago.

However, the bank’s failure created a domino effect that put its name on everyone’s radar while shaking the foundation of the global financial system.

On March 10, state and federal regulators stepped in to salvage what was left of Silicon Valley Bank after clients withdrew $42 billion a day earlier.

The bank’s collapse embedded its name in history as the second-largest bank failure in the United States’ history following the Washington Mutual failure in 2008.

Digging through the rubble

Following the collapse, analysts and regulators started going through the rubble, finding several red flags.

The bank’s vulnerabilities weren’t as complicated as believed.

Going through what happened to Silicon Valley Bank, there were signs of basic corporate mismanagement that, when paired with customer panic, created an existential flaw.

Next week, the world will understand how people failed to see SVB’s red flags over the questions at Capital Hill and hearings at House and Senate hearings breaking down the bank’s downfall.

For now, there is no definitive answer – if there is, no one is willing to explain – but it’s clear that Silicon Valley Bank’s collapse is down to a series of missed warnings rather than a single person, system, or asset.

Red flags

Silicon Valley Bank was founded in 1983 as a financial institution and status symbol for lucrative Bay Area businesses and individuals.

The bank catered to venture capitalists whose wealth allowed them to take risks.

SVB was something of an elite club where members were known for their hunger for boldness, growth, and disruption.

Between 2018 and 2021, Silicon Valley Bank grew aggressively as assets nearly quadrupled.

By the end of 2022, the bank was the United States’ 16th largest bank, holding $209 billion in assets – a feat that shouldn’t have gone unnoticed.

Growth

Dennis M. Kelleher, the CEO of Better Markets, noted that when banks grow at an alarming rate, there are red flags everywhere.

His words suggest that the bank’s management capacity and compliance systems rarely grow at the same pace as the rest of the business.

According to reports from the Wall Street Journal and the New York Times, the Federal Reserve warned SVB about its insufficient risk-management systems in 2019.

It’s unclear if the Fed, the bank’s primary federal regulator, took action upon the warning.

The central bank is currently reviewing its SVB oversight.

During a news conference last Wednesday, Federal Reserve Chairman Jerome Powell offered some insight on what the central bank was doing.

“My only interest is that we identify what went wrong here,” he said.

“We will find that, and then make an assessment of what are the right policies to put in place so it doesn’t happen again.”

Read also: Silicon Valley Bank blame game commences

Uninsured deposits

According to Wedbush Securities, 97% of Silicon Valley Bank’s deposits were uninsured.

Kairong Xiao, a Columbia Business School professor, said that US banks typically finance 30% of their balance sheets with uninsured deposits.

However, SVB had a “crazy amount.”

Individuals or businesses with plenty of uninsured money in an institution can quickly remove their money if they suspect the bank is in trouble.

Silicon Valley Bank’s over-reliance on the deposits made it unstable.

When members of its social-media-engaged community of clients started worrying about SVB’s viability, it triggered mass panic.

Clientele

Silicon Valley Bank is renowned for its partnerships with young start-ups that other banks turn away.

When the start-ups gain traction, the bank grows with them.

SVB also managed the start-ups’ founders’ personal wealth as they were often light on cash with their fortunes tied to their companies’ equity.

“It was geographically concentrated,” said Kelleher. “It was industry-segment concentrated, and that industry segment was extremely sensitive to interest rates.”

“Those three red flags alone should have caused the bank’s officers and directors to take corrective action.”

Risk management

For casual observers, Silicon Valley Bank’s financial position in February wouldn’t have been anything noteworthy.

“The bank would’ve appeared healthy,” said Villanova University finance professor John Sedunov.

“If you look at their capital position, their liquidity ratios… they would’ve been fine.”

“Those traditional big-picture things, the front page items… They should have been fine.”

However, Sedunov noted that the problems were deeper under the bank’s portfolio and its liabilities.

SVB held 55% of its customers’ deposits in long-dated Treasuries, which are typically safe assets.

The bank wasn’t alone in loading up on bonds in a time where near-zero interest rates were prevalent.

Banks typically hedge their interest rate risk with financial instruments called swaps, trading a fixed interest rate for a floating rate for some time to minimize exposure to rising rates.

Silicon Valley Bank seemed to have zero hedges on its bond portfolio.

“Frankly, managing your interest rate risk exposure – that’s one of the first things that I teach an undergraduate banking class,” said Sedunov.

“It’s textbook stuff.”

The lost CRO

In 2022, the Fed boosted interest rates at an unprecedented pace, and for most of the year, Silicon Valley Bank operated with a big hole in its corporate leadership team: the chief risk officer.

Art Wilmarth of the George Washington University and an expert on financial regulation highlighted the CRO’s importance.

“Not having a chief risk officer is sort of like not having a chief operating officer or a chief auditing officer,” he said.

“Every bank of that size is required to have a risk management committee. And the CRO is the No. 1 person who reports to that committee.”

It was astonishing that SVB’s CRO was absent for most of 2022.

A CRO might have been able to recognize the outsize risk of the bonds’ dwindling value, which could have led to a course correction.

However, without one, there’s little excuse for SVB’s lack of hedges on its bond portfolio.

Experts said it’s likely people in the bank were aware of the risk and let them slide due to the bank’s capital and profitability.

“I’m sure someone saw, and I’m sure that somebody let it slide,” said Sedunov.

“Because again, if you’re in compliance with a lot of the big-picture things, perhaps they figured, well, they can survive something.”

“What’s the likelihood that you’re gonna have $40 billion in withdrawals all at one time?”