After the 2008 global financial crisis, bank failures have become common. Since then, central banks have swung into action to strengthen the regulatory mechanism and tightened regulations. In spite of these, the Silicon Valley Bank (SVB), the 16th largest in the US, with an asset size of USD 212 billion, failed last week.
SVB is a Nasdaq listed bank headquartered in Santa Clara, servicing the world’s tech startups. Its client included several VCs and startup companies in technology and healthcare sectors.
The bank claimed to have a strong capital position with more than the Regulator prescribed (10.5 per cent) capital adequacy ratio of 15.5 per cent. As per its January 2023 disclosure, it had a highly liquid balance sheet with multiple levers to manage liquidity position. Their client’s funds’ growth remained under pressure even then. It had 62 per cent of assets in cash and fixed income securities; 92 per cent of fixed income portfolio in US treasuries and securities issued by government sponsored enterprises. 35 per cent of assets in loan book of which only 3 per cent (early stage start up) had the chance of becoming problematic when conditions turned sour. With such strong fundamentals, how did the bank collapse? What went wrong?
How did the bank then collapse?
It appears to have had poor risk management framework. To begin with, the bank was catering to venture capital and startup companies only, with little retail participation. The concentration risk was evident when 35,000+ startup companies were its customers (borrowers too). These clients parked their temporary surpluses for less than a year as deposits with this bank. Next, contrary to Indian banking system, SVB was having about USD 95 billion, nearly half its assets, invested in long dated US Government Treasury bonds. This also contributed to the concentration of its asset profile.
Thirdly, this asset preference itself had an attached market risk arising from interest rate hikes. These were not floating rate investments, unlike loans and advances. But fixed deposits where interest rate or coupon remains fixed for the term of the deposit. When interest rate was aggressively raised by the Federal Reserve, in a short span of time, the bank’s bond portfolio took a huge hit, as bond price, moves inversely with interest rate movement. It showed a massive MTM loss of USD 16 billion, while its entire capital (around USD 15.5 billion) was fully eroded.
Rising interest rate and a trim from VCs
There was another contributory factor. In the last one year, the VCs advised the startups to cut losses, improve operational efficiencies and raise money through capital markets. Plainly, the VCs wanted an early exit from these companies, in the background of raising interest rates, as the access to cheap money was not possible. This forced startup companies, for whom SVB was the exclusive banker, to withdraw their deposits for payroll and other day-to day operational expenses.
Once several corporate depositors rushed to withdraw their money, the bank had to liquidate its readily encashable assets and pay them off. Although enough liquid securities were there to encash, there was an asset-liability mismatch. On account of several rate hikes by the Federal Reserve, bond price was heading southwards already. Short term interest rate was ruling higher than the longer maturity interest rate. (i.e., inverted yield curve). These bonds could be encashed only at substantial loss and this formed the crux of the problem. It was only partly due to ‘borrowing short, and lending long’ but more because of sudden spike in interest rates in the economy leading to a liquidity crunch.
Immediate need to augment capital
At this juncture, when the bank sold USD 21 billion worth government bonds in the market, it suffered a loss of roughly USD 1.8 billion. There was need to immediately augment the capital. The bank then tried to raise capital of about USD 2.25 billion which did not materialise. Seems familiar with the Adani’s agony, right? So, in effect, the SVB could not honour the demands of its startup customers’ withdrawal and capital needs.
Two other developments compounded the problem – the promoter himself had sold the bank shares just few days prior to the default; secondly, a prominent VC advised its startup clients to move their funds from the bank. That was the last straw on the camel’s back. Depositors and the market, smelt the rat. The bank ultimately had to be shut down.
Accident waiting to happen
The Federal Deposit Insurance Corporation (FDIC), swiftly took over the bank and assured the insured depositors (up to the maximum insured amount of USD 250,000 per depositor). But the average deposit size in the bank ran into millions of USD, hence FDICs measure seemed inadequate. The Receiver of FDIC said the uninsured depositors would also get an early dividend over the next week, from the sale of SVB’s assets. Subsequently, US treasury secretary had promised funding, to meet all the deposit demands in the bank.
Stark reality of losing deposits, in a once considered, five-star bank by the Forbes magazine, spread the ‘contagion-fear’ theory and spooked the bank stocks across the world. Indian markets were no exception. SVB’s stock had tumbled in Nasdaq by 60 per cent. Failure of few more regional banks in the US only added fuel to the already raging fire. How SVB and Federal Reserve did not see the oncoming accident, is a surprise to many who closely watch the developments.
Inadequate risk management
There was apparently no risk management system in the bank to mitigate concentration risk and handle the asset liability mismatch in short term. There were no serious steps taken in the last few months to specifically manage the market risk caused by increased interest rates. There seem to be no Federal Reserve inspections or audits, as we have in India. No one seemed to have noticed this meltdown. More worrisome is the fact that the accident was actually caused by the Federal Reserve’s action. While fighting inflation is its goal, can it justify sacrificing few banks while achieving its objectives? Is it not Fed’s another objective to preserve banking and financial stability? These are questions that US banking regulator must ponder.
Can this happen in India?
For one, we have a strong and pro-active Reserve Bank of India, which will not allow this type of debacles. It is evident from the way the Global Trust bank, Lakshmi Vilas Bank and Yes bank mess was handled earlier on. RBI ensured that there is no contagion flowing from these failures. We also had the rich experience of handling of Satyam computers fiasco by the government.
Secondly, we have the system of reserves being kept by banks with the RBI and in government securities to fall back on. Apart from this, a deposit insurance up to Rs 5 lakh per depositor per bank is mandated. There is the comfort of the RBI being always available as the lender of last resort to the banks here. Few years back, when there was almost a run on the ICICI bank, RBI ensured adequate funds were available to the bank, so the depositors could be fully paid.
Thirdly, it is amazing to note the level of confidence and trust the Indian public have on the banking system. Despite being operationally inefficient in the past, with large pile of NPAs and offering poor customer service, PSU banks continued to garner public deposits, that too low-cost CASA deposits. This is a testimony to this unflinching trust. PSU banks have more than 75 per cent of total banking business in India. Better managed private sector banks do fare well both in market share and customer trust.
Fourthly, the concentration risk faced by SVB cannot arise in India, as our banks have a bigger chunk of their assets in loans and advances. Investments come only second in size. Bank boards have been asked to fix industry, individual borrower and group exposure limits, to curtail concentration risk in loans. SBI’s exposure to Adani group was as less as 1 per cent of its loans due to this.
Fifthly, supervisory system by the RBI through off site and on-site inspections is done regularly. Almost all banks annually have asset quality reviews and statutory and other audits periodically. These ensure that the risks in the banks are under control. ‘Too big to fail’ banks are more closely monitored and that does not mean the other banks are left scot-free. A recent case in point is that CUB, a smaller bank as compared to SBI/HDFC/ICICI banks, was penalised by RBI on larger divergence in its asset classification vis a vis RBI’s assessment.
Finally, with the experience gained after the south Asian financial crisis and the global financial crisis of 2008, RBI has laid stress on financial stability. . The asset quality reviews by RBI are a redeeming feature which ensures that banks’ assets are safe. Income recognition, asset classification and provisioning norms as well as the risk based supervision by RBI is the bedrock of guaranteeing the health of banking system in India. Periodic preventive health check-up is better than curing the disease, if and when it strikes. SVB type failure, well-nigh, is impossible in India.
