What does Silicon Valley Bank’s (SVB) failure tell us about the updates to Basel requirements post the 2007-9 financial crisis?
Basel III requirements were intended to “.. strengthen the regulation, supervision and risk management of the banking sector ..” with the intention that “ .. greater resilience at individual bank level reduces the risk of system-wide shocks.” In doing so the aim was not only to reduce the risk of a repeat of the financial crisis but, should problems arise at one or more banks, that it was not the taxpayers footing the bill.
To achieve these goals key elements of the revised requirements were:
Enhanced capital requirements which increased the levels of capital that banks were required to hold as well as revised eligibility criteria which would ensure that any losses would fall on bondholders and not just shareholders, or governments.
The introduction of new liquidity requirements to improve transparency and the management of liquidity risk.
A new leverage ratio to constrain balance sheet growth without a commensurate increase in capital.
Resolution plans to enable the continuation of bank services whilst a bank facing difficulties was recapitalised or run down in an orderly manner.
Banks were allowed until 1 Jan 2019 to implement these requirements. This date was largely met, albeit with some exemptions as detailed below. The exception is the final tranche of changes issued in December 2017, often referred to as Basel IV, and as Basel 3.1 by the Bank of England, which are still in transition, but they did not include any changes to requirements relating to liquidity or resolution plans.
Despite these changes, which were proven to have enhanced the soundness of the banking system through the Covid-19 crisis, the collapse of SVB has raised concerns. To address these it needs to be understood whether its failure was a case of serious mismanagement, the consequences of a unique operating model, flaws in regulatory requirements, or their implementation, extraordinary circumstances or all of the above? Only time will tell but it is worth looking at how things were supposed to work and what happened, as far as we can say at this point, at SVB.
To comply with the new liquidity requirements banks must calculate a liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR) that are are maintained at > 100% to demonstrate that they have sufficient liquid assets to meet expected cash outflows over a defined period. To achieve this they need to hold larger quantities of liquid assets, mainly government bonds, than was previously the case and have had to make significant investments in systems, resources and controls to improve their management and reporting of liquidity risk.
What the failure of SVB highlights, once again, is the well-known and age-old understanding that banking is built on confidence and that once confidence is lost the rational thing to do is to protect one’s own interests. For SVB depositors this was to take their money out as quickly as possible once concerns became evident.
The immediate cause of SVB’s problems was the need to liquidate bond holdings to meet significant levels of withdrawals. In itself this should not have caused a problem, and indeed was how the revised requirements were supposed to work. The issue was the significant hike in interest rates in preceding months resulted in a sharp fall in the value of the fixed rate bonds sold and a loss of $1.8b. Announcing plans to raise capital to cover these losses failed to address concerns and the regulators acted quickly to shut the bank down and protect all depositors.
The adverse impact of rising interest rates on the value of bond holdings was however not something that banks, or regulators, were unaware of. A question this raises is was this issue exacerbated by flaws in accounting and regulatory requirements or bad luck due to unexpected events? More specifically:
Accounting policy – where bonds are held to maturity changes in their current market values do not need to be marked-to-market and accounted for on a daily basis. This means there is a lack of transparency over the size of potential losses nor a need to increase capital to cover them should they result in losses.
Interest rate risk in the banking book (IRRBB) – whilst banks are required to assess and demonstrate to their supervisors that they hold sufficient capital to absorb possible losses as part of their internal capital adequacy assessment process (ICAAP) this is only done annually.
Unprecedented circumstances – over the period 17 Mar 2022 to 1 Feb 2023 the Fed raised the Fed Funds Rate from the range of 0.25% - 0.50% to 4.50% - 4.75% a total increase of 4.25% for a rate that had been at historic lows for upwards of 10 years. Similar rates rises were made by central banks in other major markets.
Whilst these points apply to all banks, a unique feature of SVBs operating model was a high level of uninsured deposits and a higher-than-average level of holdings of government bonds, many of which were bought when interest rates were much lower. This meant it was more at risk of a run and losses than most banks. Despite the need to submit an ICAAP only annually bank risk management should have been aware of the potential losses on their bond portfolios and the impact that could have if some of them crystallised, which is of course what happened. In practice hedging this risk would have been difficult, and potentially expensive, but raising capital earlier would perhaps have helped. Something that clearly didn’t help was the fact that SVB was one number of “mid-sized” banks that, despite its $200b balance sheet, benefitted from exemptions from some of the requirements on liquidity management and resolution planning set out in the Dodd-Frank Act 2010.
Further details of what happened behind the scenes will emerge in due course but the issue for regulators is, in the short-term, to restore confidence in banks and the banking system. No doubt there will be many twists and turns as events unfold in the coming weeks but, once the dust has settled, regulators will need to determine if any changes are needed to regulatory requirements and/or supervisory practices. Hopefully tweaks rather than wholesale changes and not ones that will result in banks requiring to hold significantly more capital.