• There are calls for more regulations. However, creating more regulations is not the solution.
• Boards have a role to play and should have the right market expertise and experience to ask the right questions before issues become too big to fix.

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The basic facts of the Silicon Valley Bank failure are well known. On Friday, March 10th, California regulators closed the SVB. It was the largest bank failure since WAMU in 2008. Before being shut down, Silicon Valley Bank had  $212 billion in assets and was the 16th largest federally insured bank in the U.S.  The crisis was triggered by the announcement by SVB on Wednesday that it had sold approximately $21 Bn in Treasury and Agency mortgage backed securities in its AFS (Available For Sale) at a loss of $1.8 Bn, or approximately 8.6%. That led to a focus on the estimated $15 Bn mark-to-market losses in its $91 Bn HTM (Held to maturity) portfolio, which was greater than the approximately $12 Bn of Tangible equity cushion the bank had. SVB tried to raise $2.25 Bn in fresh equity, but abandoned that effort with stock down 60%. That accelerated withdrawals by spooked depositors. On Thursday, depositors tried to withdraw $42 Bn, but only $16 Bn of that was successful (bank had $15 Bn in cash at end of 2022). On Friday, regulators put SVB in FDIC receivership, in an unusual move, in the middle of the day.

A lot has been written about the failure since then. As happens after these type of events, there have been many calls for more and stricter regulations, including reversal of the 2018 bill that lowered the Fed oversight of medium sized banks. The White House has proposed new rules for mid-sized banks requiring that banks with between $100 billion and $250 billion in assets should hold more liquid assets, increase their capital, submit to regular stress tests and write “living wills” that detail how they can be wound down. However, as JPMorgan CEO Jamie Dimon articulated  In his annual letter to shareholders,  we should avoid knee-jerk, whack-a-mole or politically motivated responses that often result in achieving the opposite of what people intended, and instead deeply think through and coordinate complex regulations to accomplish the goals we want, eliminating costly inefficiencies and contradictory policies, and avoid putting rules in place in one part of the framework without appreciating their consequences in combination with other regulations.

Let us look at some facts that have not been talked about as widely.

• The problem was not new or recent. In 3Q 2022, SVB had unrealized losses of $15.9 Bn, with tangible common equity of just $11.5 Bn. At end of 2022, SVB held $212 Bn of assets against $200 Bn of liabilities, an equity cushion of $12 Bn (5.6% of assets). A footnote disclosed the HTM book had $15 Bn of unrealized losses. So even at that point, losses had wiped out the $12 Bn equity cushion.
• SVB offered foreign exchange risk hedging services to its clients that do business internationally, and boasted that it could hedge volatility across more than 90 currencies. While it offered hedging services to clients, somehow, its own portfolio was not hedged.
• SVB actually removed interest rate hedges in 2022. In December 2021, SVB had about $10 billion of interest rate swaps (not nearly enough to hedge all of its assets). The Dec 2022 statements showed close to zero interest rate hedges.
• SVB board seems to have been aware of the issue. According to its filings, the risk committee had seven people, more than any other committee, and it met an unusually high 18 times in 2022. That’s an average of 1.5 times per month and more than twice the seven meetings held in 2021.
• Regulators were aware of the issue. According to Fed Vice Chair of Supervision Michael Barr’s testimony to Congress, in November 2022, Supervisor’s delivered a new MRA to SVB regarding “the inaccuracy of their interest-rate risk modeling” which was “not at all aligned with reality” as “the models suggested they earn more money when they were losing more money.”

SVB is not the only bank with the problem of unrealized losses. Signature Bank was another bank that was closed shortly after SVB. According to the FDIC, there was roughly $620 Bn in unrealized losses in bank portfolios at end of 2022. If the unrealized losses were taken into account, SVB (and some others) would have been considered  insolvent, but despite this $620 Bn hole in banking system, most banks, including SVB were rated as “well-capitalized” banking institutions by the regulators.

This disconnect results from an exemption that allows banks, other than a few very large ones, to exclude Accumulated Other Comprehensive Income (“AOCI”) from their capital ratios. Any unrealized losses (e.g. from rising interest rates) on AFS securities do not impact net income or flow through the profit and loss statement, and are instead recognized in the balance sheet as AOCI. So, for small and medium sized banks, unrealized losses, which are counted in AOCI, do not reduce the capital base and do not impact capital ratios. For very large banks, the AOCI is part of capital adequacy computations.   

This different treatment of AOCI makes the capital ratios for mis and small banks look better, and allows them to operate with lesser amount of capital. It also has another impact. Since the unrealized losses impact capital ratios, larger banks like Citigroup, Bank of America, etc hedge their interest rate risk to avoid volatility in their CET1 and other regulatory ratios. Since smaller banks like SVB do not have an impact on their capital ratios, they have less regulatory incentive for putting hedges in place. If SVB had interest rate hedges, its losses on the treasuries and agency backed securities would have been offset by the gains on the hedges.

The next obvious question is how did we get here and what to do about it?

Bank Regulations

Understandably, bank regulation has been the target of a lot of criticism. A lot of that has focused on the 2018 partial rollback of Dodd-Frank law, and many suggest undoing that as the solution. However, there is more to it.

In the wake of the 2007-2008 financial crisis, the 2010 Dodd-Frank law created stricter regulations for banks with at least $50 billion in assets. These banks were required to undergo an annual Federal Reserve “stress test,” to maintain certain levels of capital (to be able to absorb losses) and liquidity (to be able to quickly meet cash obligations), and to file a “living will” plan for their quick and orderly dissolution if they were to fail. The Stress Test is seen by most as an enormous, mind-numbingly complex task, which focuses on one scenarios, which is not likely to happen, and which may give false sense of security to those who pass it.

With many banks arguing that the increased regulations were needlessly encumbering them, the 2018 rollback got rid of the $50 billion threshold.  Instead, it made the enhanced regulations standard only for banks with at least $250 billion in assets, which included only about a dozen banks at the time. The rollback law did give the Federal Reserve the right to choose to apply the regulations to particular banks with at least $100 billion in assets, and it said that banks that met that $100 billion threshold would still face periodic Fed stress tests. Small and medium-sized banks with less than $250 Bn in assets were no longer required to undergo stress tests.

Experts have expressed mixed views on  how much the rollback mattered in the SVB failure. One thought that SVB might well have been “less exposed to a bank run” under the Dodd-Frank rules from 2010. Another didn’t believe it “would have made any difference in this case” if the threshold had never been raised, as Fed’s severe-stress test, which involves a hypothetical big recession, wouldn’t have captured the current rising-interest-rates scenario that bedeviled SVB on account of its hefty holdings of long-term bonds, and the way the Fed calculates its capital requirement means that calculation wouldn’t have captured the decline in the value of SVB’s bonds.

The 2018 partial rollback was a part of it, but the real seeds of the problem were put in place a decade ago.

In 2012, the rules proposed by US banking regulators  to implement the Basel III standards in the United States required banking organizations to include most AOCI components in their CET 1 capital. However, there was strong opposition from banks of every size, politicians, and others to including AOCI in the capital ratios with the argument that including AOCI would introduce significant volatility in capital ratios resulting from change in interest rates. When the rule was adopted in 2013, only Advanced Approach banks (large banks with $250 Bn or more in assets) were required to follow the BASEL III approach to AOCI. Other banking organizations had a one-time right to opt out. In 2019, the Federal Reserve released tailoring regulations, which allowed Category III banks, of between $250 billion to $700 billion in size, also to exclude AOCI. This allowed a lot more banks (e.g. Capital One, PNC, US Bancorp) to opt out of AOCI. Since SVB was always below $250 Bn threshold, it was never required to include AOCI in its capital ratios based on the 2013 rule.

Path Forward

After the shutting down of SVB and Signature Bank, the Federal Reserve, Treasury, and other regulators acted quickly and appropriately to stop the contagion from spreading to other banks. The quickly announced new Bank Term Funding Program to provide liquidity to depository institutions holding treasuries and agency backed securities, was the right step to contain the problem and stabilize the system. If held to maturity, the securities will pay off at Par and not have losses. However, banks will be earning below market income on those, which will hit their profitability. Cheaper financing helps reduce that impact.

For longer term, are more regulations the answer?

Regulations generally are result of some crisis, and they try to address that experience. When a lot of the current regulations were put in place after the GFC (Global Financial Crisis of 2008), rising rates were not a concern.  Then the concern was more credit risk. Stress scenarios from that experience focused on credit issues, recession, and lower rates. They did not anticipate problems from losses on safe and liquid treasury and agency mortgage backed securities due to a rapid rise in rates.

The financial system is complex. Risks are abundant, and managing those risks requires constant and vigilant scrutiny as the world evolves.  It is difficult to have one-size-fits-all regulations that fit financial institutions of all types and sizes and cover all possible situations. That attempt is sure to lead to overregulation and massive overhead for the regulated companies. No amount of regulation can ever anticipate or prevent people and organizations from making mistakes and getting into trouble, intentionally or not.

If more regulation is not the solution, there has to be some other mechanism that avoids these types of scenarios of losses. That mechanism needs to take into account the specific situation of that organization, and provide governance that would otherwise be asked from more regulations. Boards can and should provide that governance. The Board of Directors is primarily responsible for hiring a competent CEO who can manage the bank in a safe and sound manner while making money for the shareholders, and for providing high-level oversight of corporate activities and performance.  As Noah Barsky says in his Forbes article, at a minimum, boards in all sectors must boldly ask if their risk management approach is real or rhetoric.

However, boards often do not have the appropriate expertise and the required market experience. According to an article, of the 12 people on the SVB board, only one had banking and market experience (Thomas King, a former Barclays investment banking CEO who joined in Sep 2022), and he was not in the Risk Committee. A strong board is one comprised of a mix of expertise, skill sets and networks. It’s not one where the VC assigns their seat to a junior associate who is only a year or two out of business school, with no practical work experience; or one stacked with friends or trusted former work buddies who have your back; or one that rewards the largest check-writing angel with a seat despite a lack of relevant experience. The Board should have a mix of talent that can  be tapped into for any situation.

Investors, C Suite, boards, and regulators, should be looking carefully at the composition of the boards to make sure the board has the expertise needed to ask the right questions so business leaders can address them before they become too large.

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