The year is is 2017 and I find myself in conversation with a senior colleague at  Credit Suisse. He has retired after 35 years at the Bank and it had been a year since I left the firm. Since both oth of us previously worked at the investment research division at the firm, the chat expands to sharing perspectives on the financial markets—given  that the US Fed is looking at raising interest rates that year and the next.

At some point in the conversation, he makes a point that is so original that it could have only been made by someone who has had an extended microscopic view of how investing and risk management work in real settings.

“Shailesh, as the Fed raises rates over the next few years, the big problem I see is that we have gone through an entire generation (almost) since we saw an extended rate hike. The last time the central bank started raising rates was in 2004. In the following thirteen years, all we have seen is the central bank come and rescue the markets at the slightest signs of distress.

The  problem is that most of the people in charge of billion dollar portfolios today were freshers then. They might have read it in books, but didn’t really grasp how rising interest rates can quickly eat through any gains you may have made in your portfolios.

At a physiological level, risk is about fear. Until you have felt an interest rate hike in your bones, or have spent sleepless nights wondering if your bank or fund will survive, no amount of mathematical modeling can overcome complacency and greed. Today, it is likely that most investment managers are sitting like Dodo birds in front of gun-bearing hunters, when it comes to rising interest rates—they haven’t seen one and don’t know what to do about it.

The bank that failed

Last Friday, America’s 16th largest bank, Silicon Valley Bank, failed. That morning, it was declared illiquid and insolvent by the California State government and placed in the receivership of the Federal Deposit Insurance Commission (FDIC). Since then, a lot of worthy commentary has flooded the social media on what this could mean for the banking institutions in the US, given that at $ $209 billion, it was the second largest bank failure just behind Washington Mutual in 2008. , its impacts on the start-up ecosystem since it was the bank of choice—as as a depositor and lender to VC funds and startups respectively. My two cents, here would be my assessment of what risks the bank had been ignoring for over a year and what could regulators learn from this episode.

A bank’s life - living on the edge of time

Let us just briefly touch upon the basic business of a bank, before jumping into the specifics that led to the fall of the Silicon Valley Bank. All banks are essentially engaged in a maturity transformation business for money. For the economy to grow, someone has to take the risk for what comes tomorrow and loan funds to businesses and people long-term. Banks are created to do that. One way of doing so would be to fully finance all the funds—but in that case, few people would be encouraged to set up a bank. Because that would mean such people either not having enough funds to lend or not having a large enough risk appetite to bear the losses if all the lenders default.

So, the idea, since medieval ages, has been to pool the savings of a large number of smaller savers and lend them out. In return, these savers get a rate of interest for locking in funds with the bank. Mind you, barring holders of fixed deposits, the funds of these savers are parked at will - they can ask for their funds back at any time.

Moreover, since banks become good at handling savings from corporates as well as individuals - they also offer other related services to them that would impose a burden if done on a standalone basis. They take custody of these surplus funds and invest them in the markets, they handle the collection and distribution of funds to vendors, suppliers and employees among other things.

However, at all times - such banks bear a maturity risk. That is—your assets are locked in investment products or loans which are long-term when it comes to maturing whereas your liabilities, such as deposits, can be withdrawn at will. Therefore, each time the external conditions change-like interest rates rising, clients defaulting or geopolitical and economic risks emerging on the scene—banks have to recalibrate short-term plans to ensure that depositors with them are compensated enough for taking those risks. They do so either by increasing the deposit rates when interest rates are rising or entering into derivative contracts to protect them from adverse risks or raising equity (more of their own funds) in the market or actively churning portfolios by investing in financial instruments.

Raising equity or increasing deposit rates are considered the more extreme options, because the former depends on the market conditions and latter is tough to reverse once taken.

 More often than not, it is by investing the cash gained through deposits in the financial markets that banks manage the maturity risk and keep their depositors happy. And it is where the problems that brought down the Silicon Valley Bank begin.

How and why banks invest deposits?

Between 2019 and 2022, supported by the unprecedented fiscal and monetary easing by the Fed, the volume of new deposits coming into banks in the country rose by nearly 1.7 times. For banks in the Silicon Valley serving mainly as the bankers to startups, the pace of growth in deposits was much faster—this nearly tripled for the Silicon Valley Bank.

Regionally, as firms were raising equity on eye-wateringly attractive valuations and as tech profits soared, taking debt as a way to finance your company became a less preferable option for valley-based startups. As of last year, loan demand remained exceptionally weak in the region, and even nationwide, with just 10%-20% of the volume of new deposit growth being channeled to new loans. What would one do then, with the new deposits, to ensure that depositors got at least some return on their funds with a bank. Invest them in the financial markets.

To ensure that all banks adhere to the same standards of reporting, the Fed requires them to declare upfront what they intend to do, in a way, with the securities they have purchased in the financial markets. They are classified into two categories - Held to Maturity (HTM) or Available for Sale (AFS).

When a bank classifies a certain portion of its portfolio of investments as HTM during a period, it is considered that it will hold them until they finally redeem themselves and return the invested capital. In such cases, the value of such securities, on the balance sheet, is considered to be the value at which it is purchased. For example, if a bank purchases $1 billion worth of US treasury bonds and classifies it as HTM in Q1 2023, the value of those bonds will remain at $1 billion at the end of the quarter, regardless of where the current market prices of such bonds are as of 31st March 2023.

On the other hand, AFS is sa fairer description of the value of assets with the bank. When a bank declares a part of its portfolio as AFS, it needs to report the actual traded or third party valued price of the investments at the end of each period. This is called “marking to market” and at the end of each quarter it has to value its AFS portfolio and report any gain or loss to its investors. Just like in the previous example, if the bank purchased a portfolio of bonds worth $1 billion and classified it as AFS and finds out that the market price of those bonds is $1.3 billion at the end of the quarter, it will mark $300 million as an unrealized gain in its financial statements.

Banks are free to decide whether they want to mark their portfolios as AFS or HTM, in whichever proportion they like. However, there is a rule followed globally by all banks that once you sell even a single bond from your HTM portfolio, it is considered as AFS and then has to be accordingly marked to market, with the bank taking the profit or loss on its financial statements.

Naturally then, when interest rates are low, markets are doing well and the general sentiment about economic growth is positive—one is likely to see financial asset prices rise and hence the greater temptation for banks to allocate a larger share of their portfolio to AFS as it flatters the bottomline. This is exactly what happened in 2020, following the exceptional global monetary stimulus, which saw banks mark up to 75% of their investment portfolio as AFS (pre-2020 share varied between 45%-50%).

However, as early last year the expectations around interest rates as well as economic growth in the US began to shift in an adverse direction. Other things being equal, bonds, which make up a huge part of bank investment portfolios, begin to fall in prices when interest rate expectations rise and recession risks increase. From having booked $39 billion in unrealized gains in their AFS portfolios through 2020, banks in the US were sitting on $31 billion in unrealized losses by early 2022.

Different banks reacted to this situation differently. JP Morgan was one of the most proactive, aggressively recognizing losses on its AFS portfolios, taking its weight down to almost 30% and even going ahead deciding to sit on cash deposits. Morgan Stanley, Citi and HSBC also followed suit through 2022.

Most of the larger banks decided to sell significant sections of their AFS portfolio as well and recoup cash, as they were expecting interest rates to rise further and the value of their portfolios to be hit even harder. The mantra, across the traditional banking space, for the past year or so has been to increase the participation in really short-term securities market - lending to banks facing a transient shortage of cash on a overnight or weekly basis, parking their funds with the Fed to earn a higher interest rate or buying extremely short-term government bills (1-3 month tenor).

And perhaps whereas the entire industry moved in a different direction following the change in interest rate expectations, Silicon Valley Bank was perhaps caught on the wrong foot.

A commercial bank with the traits of a high-risk VC Fund

Historically SVB has always been a high beta bank. That is, it has always acted as a banker to firms in industries that are at the frontier of hockey stick kind of growth. Founded in 1983, the bank was an instrumental player in lending to the real estate sector over the decade, which saw the rapid growth of corporate and residential housing across Northern California. As the region emerged as a center for indigenous winery, it also moved into financing vineyards. But the problem with high beta companies is that they do better than average when the times are good but also fall sharply when things go south.

 Incidentally, this is not the first time as well when the bank has landed in trouble because of its bias for getting into high-risk endeavors without significant protection.

It happened once in 1992, when the real estate sector suffered during a short recession due to the oil price shock brought upon by Iraq’s invasion of Kuwait. SVB saw a big write-off on its real estate loan portfolio, was recapitalized and then went on to aggressively lend Internet 1.0 superstars like Cisco Systems through the mid to late 1990s. Its fortunes once again fell sharply through the dot com bubble bust, rising once again in the early aughts and then receiving a small bailout of $325 million from the US Government in 2009 under the TARP program.

It is then surprising that the rapid growth of such a bank through the 2010s, which was known for aggressive culture and its exposure to highly risky industries, received no additional oversight from the Fed.

Managing a deposit glut

If anything, such concerns should have been paramount in the last three years, when its customers - the Silicon Valley startups and VC funds became flush with cash. As we have noted earlier, between Q4 2019 and Q1 2022, the bank's deposit balances rose from approximately $ 60 billion to $ 198 billion. This compares to a global compounded annual growth rate (CAGR) of the same entity by 37% over the same period. What’s more, unlike your neighborhood bank, SVB mostly had corporate clients which rarely lock their funds in fixed deposits. Much of its deposit base was highly susceptible to a sudden withdrawal as it comprised mainly of non-interest-bearing demand deposits.

The question to ask then becomes—if the bank was not obliged to pay any contracted interest rate on any of its deposits, why did it have to even build a portfolio— it could have just kept it in cash? The answer—you still have your equity holders to answer to. You can either turn away the depositors and not expand your balance sheet, possibly injuring a business relationship or you could take them and figure out how to invest it.

Investing here is a keyword, because the demand for loans, in a region where most of your customers are sitting on cash, is poor.

The basic reasoning the bank followed, to deal with this glut in deposits was sound - to meet the short-term redemption needs from savers, park a part of the portfolio in short-term AFS, and to get high returns for your equity holders, invest a part of the portfolio in HTM, but in slightly riskier and higher yielding securities. In fact, as of Q1 2022, just 22% of its portfolio was marked HTM, an approach even more conservative than JP Morgan.

Mortgage backed securities, a blast from the past

The trouble lay in what HTM securities the bank had invested in - Mortgage Backed Securities. (MBS). People who were working in financial markets in the late 2000s, know how terribly afraid one should be when investing in these assets - these were the original weapons of mass destruction of the Global Financial Crisis of 2008-09.

MBS is secured against mortgages - house, commercial buildings or large consumer purchases. When interest rates rise, the probability that some of these mortgage holders will default on their payments rises - causing the value of MBS to fall. This is what happened through the last year, even as SVB continued to remain invested in such assets, targeting an overall return of 1.7%-2% on its portfolio.

The challenge in a strained market is - even if you don’t factor in all the risks inherent in your business on an accounting basis, someone else is doing so. Even as SVB kept almost 79% of its investment portfolio in HTM, its customers were calculating how much it would actually lose if the portfolio were to be marked as AFS (it was down 17% on market value basis by Q3 2022). By end September 2022, the bank’s portfolio was down overall by $ 18.4 billion ($ 15.9 on HTM side and $ 2.5 bn on AFS side). This was scary - the bank’s shareholders only had $ 11.8 billion in common equity to cover these losses if all of its portfolio had to be liquidated.

The problem was magnified by an increasing interest rate environment, where their customers found it tougher to raise capital and easier to fund themselves out of their own deposits. Ergo the bank started to see a number of its customers ask for it to release deposits. In the 11 months between March 2022 and February 2023, the bank’s deposit base fell by $33 billion.

In order to manage the deposit outflows, the bank decided to sell some of its AFS portfolio. Investment banks advising it calculated that such a sale would entail a $1.8 billion in loss after tax. Given the bank’s equity position was already shaky due to the potential unrecognized losses sitting on its balance sheet, it was advised to raise capital from shareholders.

Silvergate lit the tinderbox

At the end of February 2023, everyone in financial markets knew these things about SVB - it had potentially more losses to offload on its balance sheet, it would make a loss in Q1 and it was looking to raise equity capital. The catalyst came on March 8th, when another rising bank from the valley, catering to crypto currency exchanges called Silvergate failed. What was a concern turned to panic and SVB saw the first bank run on an American bank in 15 years.

The typical feature of this bank run was that it was happening during an age where digital banking had widely been adopted as a feature of finance operations across global corporations. One didn’t have to queue up outside bank branches or send pay orders that would take a few days to process, giving the bank bosses some time to calm the nerves. Panic spread fast. VC Firms instructed their portfolio companies to move their funds out of the bank within 24 hours of Silvergate’s failure, notably an order to withdraw $ 42 billion coming on 9th March. The breakdown of IT systems handling fund outflows further spread the concerns that the savers funds would become illiquid.

In a sense, the VCs were justified in their approach. The US Government, through its Federal Deposit Insurance Commission, provides full deposit insurance for deposit accounts up to a level $ 250K. Any more, and the depositors need to bear the losses. As of end 2022, just $21 billion out of its $173 billion in deposits was insured by FDIC or any other private insurer.

As I write this, the Treasury Department, FDIC and the US Fed have quickly come to the rescue of SVB’s depositors. Considering that Monday happens to be a salary day for a number of its corporate clients, who would have been unable to pay their salaries due if the deposit services were suspended, and hence would have had to furlough/layoff employees, urgent recovery measures were perhaps necessary.

The US government has pulled off a systemic-risk exception, which comes from the Depression Era. In the 1930s too, the crisis had been exacerbated not by large banks failing, but through the contagion effects of failures of a large number of small banks across the country, which put a number of MSMEs out of business. As a result, even the uninsured deposits of the bank will be insured and the depositors made whole.

Second, in return for offering a full insurance of the deposits, the government will increase the bank assessment rates - a kind of insurance premium that banks pay to the FDIC to insure their deposits in normal times. These rates are likely to be kept elevated for an extended period of time, even as a new management team takes over.

Third, given the poor corporate governance on display from both the shareholders and the bank’s senior management, it is likely that the company will be sold off to new bank holding companies. We have already seen this for the UK subsidiary of the SVB, which was purchased by HSBC.

Every crisis is different

In hindsight, it is important to ask what the bank could have done differently? And how can the regulations change to prevent such failures from happening?

An easy conclusion is that the bank failed to manage its maturity risk and was cavalier with its allocation towards AFS. That doesn’t seem to be true. To be fair, SVB’s practices, in the new environment of rising rates and an unmanageable deposit growth weren’t anything out of place. As we have discussed earlier, even large banks did something similar. The blind spot was chasing yields through investments in MBS just at the time they were getting riskier. For the year ended 2022, of the $91.3 billion in assets in its HTM portfolio, almost $72 billion (~79%) was parked in these assets, which are extremely susceptible to high interest rates.

By some calculations, the overall duration of its portfolio was between 5.5-6 years, and each increase in market interest rates by 0.01% meant that the bank was losing $70-$80 million in value. Unless it could have hedged these risks through interest rate and credit derivatives, which it did not.  It did not help at all that during the period Q2 2022 to Q1 2023, when global financial market risk rose sharply - the bank did not have a Chief Risk Officer.

The lack of succession planning and of someone experienced at the helm just at the time when risk management becomes the most important thing that the bank ought to do also tells something about the aggressive growth-at-any-costs culture of the bank, as compared to that of more conservative houses.

The second thing references back to the point I made at the beginning—it is not just professionals, but also regulators who have made safeguards to prevent the odds of the last series of bank failures from happening. But that doesn’t prevent a new problem leading to a bank failure. American regulations for banks are built for preventing another collapse happening if the credit risk rises. They do precious little to manage Interest rate risk. Banks are required to report stress tests for all scenarios of credit risk, but none very robust analysis on what happens to portfolios if the interest rates rise. As the adage goes, what gets measured, gets optimized.

This is not the case with European and Indian banks though. There, the banks are required to hold a portfolio of High Quality Liquid Assets (HQLAs) such as short-term government debt, which can be liquidated over a month. This Liquidity Coverage Ratio is subject to a number of stress tests and banks are required to keep funds that cover at least 100% of the projected outflows in the worst-case liquidity stress. In America, only the top 15 Systemically important banks are subject to these requirements—SVB was the 16th largest.

Indeed, one of the key reasons there wasn't bank run on Credit Suisse (which is in even worse financial condition than SVB) was because it was pushed by regulators to keep a solid LCR to prevent a bank run and a bailout by the Swiss government.

Third, there wasn’t enough customer diversification at the bank anyways. It had branded itself as a bank for startups and did precious little to reach out to traditional companies, MSMEs or firms in legacy sectors like commodities and consumer staples which actually do well in a rising interest rate environment.

As with its troubles in the 1990s, or early 2000s, having a relatively uniform customer base meant that its own business beta was also pretty high. A little bit of diversification - not enforced from above but realized from within, could have definitely helped here. An instructive story here is that of Continental Illinois Bank, which failed in 1984. As with SVB, this bank had an overreliance on corporate deposits from firms focused in the Midwest.

Fourth, creating guard rails to manage interest rate risk is still a problem that has precedent solutions across the world. There are many new evolving risks which don’t have a clear workflow, in case they end up bringing down the financial system. In a related news, one of the largest customers of SVB was the crypto startup Circle, which had $3.3 billion in deposits at the bank. Circle also issues $ Coin, which is one of the largest stablecoins. A stablecoin is a token that promises to pay $1 for a fixed equivalent amount of the token - kind of like a peg to the $. Last weekend, $ Coin broke its peg essentially indicating that holders of its token wouldn’t be able to redeem a dollar for the pegged number of tokens. While this has not yet led to a rout in the crypto space, it is by no means certain that a future event wouldn’t lead to one. Stablecoin funds today are one of the largest players in global money markets, and concerns have been repeatedly raised that a failure of any of them could lead to a liquidity squeeze, much like it happened after the collapse of the Reserve Primary Fund in 2008. Regulating Stablecoin funds tightly or asking banks to hold higher protection (equity) against deposits from firms/ banks/ financial institutions exposed to crypto could be one of the tangential lessons to learn from this crisis.

And finally, it doesn’t augur well if your senior —including the CEO —is found to be selling the company stock just as the risks of its failure are rising. While we talk so much about ESG these days in the investing community, in most cases our worship of this concept hardly ever extends to G (Corporate Governance) part of the abbreviation. A CEO who cycles while his firm shatters, a company which declares bonuses days before its spectacular dissolution. If that doesn’t tell you about the pathologies of tech capitalism what else will?

Shailesh Jha lives in Shanghai, where he is pursuing an MBA at the China Europe International Business School. He worked with Credit Suisse's private banking and asset management division, where he worked on long-term thematic investment ideas with the Credit Suisse Research Institute, and was promoted as the assistant to the Chief Asia Economist in Singapore.

Disclaimer: This story has been updated to reflect a change in the cover image.