What went wrong for Silicon Valley Bank? Industry expert Clive Corcoran goes through the books to identify what red flags could have been spotted.
The collapse of Silicon Valley Bank in California (SVB) in early March 2023 was a case study in how a large bank – the 16th largest in the US – totally mismanaged interest rate risk.
The bank had a very large portfolio of long duration US guaranteed securities (mainly Treasury bonds) which had been purchased when interest rates were extraordinarily low. As interest rates – on a global basis – have been increasing rapidly, the mark-to-market value of these securities has been dropping precipitously. To take a rather striking example, a US 10-year Treasury note with an annual coupon payment of 0.625% and which was auctioned in August 2020 with a maturity date in mid-2030, has a mark-to-market value in mid-April 2023 of only around 80% of its $100 par value. Many long-term Treasury instruments which were issued during 2020 and 2021 had exceptionally low coupons reflecting historically unprecedented conditions in government bond markets. Some even longer duration issues (for example, 30-year US Treasury bonds) are currently priced closer to 60% of par.
The critical issue for holders of such bonds is whether and how to recognize these mark-to-market write-downs. The accounting treatment regarding this matter is rather complex and hinges on the way that banks, for example, elect to classify these bond exposures. For example, if a bank is holding the 2030 maturity bond just cited in its Trading Book, then it should, for regulatory purposes, be marked to market on a daily basis, and the unrealized loss will directly impact the balance sheet and regulatory capital.
On the other hand, under global accounting rules (IFRS 9), if the bond is designated as held-to-maturity this allows the bank to hold the bond on its balance sheet on an amortized cost basis – the current mark-to-market unrealized loss does not directly impact the balance sheet. The more interesting cases arise in connection with bonds that have been designated as Available for Sale (AFS). The accounting treatment here is more nuanced and varies between a bank’s size and also varies between different jurisdictions. For example, in the United States, the very largest banks (with balance sheets in excess of $700 billion) are required to recognize the full impact of the unrealized losses on AFS securities for regulatory capital purposes. Other US banks have been allowed to show the unrealized loss in the equity section of their balance sheets, under what is known as Accumulated Other Comprehensive Income (AOCI). This AOCI opt out provision, which smaller and medium sized US banks took advantage of, means that any unrealized loss is not a charge against regulatory capital, and only a charge against accounting capital if the mark-to-market loss is realized by selling the security. European banks have not been provided with this opt-out.
Some of the more problematic issues which surround this topic relate to the feasibility of the hold-to-maturity (HTM) designation. There are IFRS rules regarding a bank’s decision to transition away from classifying its holdings, from HTM exposures, to an AFS or Trading book exposures and thereby having to recognize the impairment of its assets. The impairment is not related to credit risk in the case of US Treasury instruments but based purely on the duration issue.
One of the troubling consequences for SVB arose from its failure to hedge the mark-to-market write-downs on its substantial holdings of US Treasury securities. The unrealized losses on these holdings – despite the favourable accounting treatment around the fact that these were mostly HTM exposures – hit the balance sheet with a vengeance when SVB depositors withdrew more than $40 billion in a few hours (itself a remarkable event) and the bank became illiquid and then insolvent.
Just two of the unresolved matters arising from SVB’s demise, relate to the questionable nature of the HTM classification and the status of uninsured deposits. It has been estimated that more than 90% of SVB’s deposits were above the FDIC threshold level for insurance of $250,000 and the policy response to revising this, in the US, has been ambiguous and not adequately resolved.
In some ways, even more serious is an increasingly expressed view regarding the HTM classification. The criticism is that it is a fiction to carry a bond at historic cost based on the idea that if held until the end of its lifetime, it will then redeem at par which suggests that the holder is not subject to any capital loss. To appreciate that this is a pretence, consider the present value of the $100 par/redemption payment for a 10-year bond with a discount rate being applied of 4%. The present value, in other words the purchasing powers 10 years hence, is about $67 in today’s terms. The other problem is, of course, the problem that hit SVB – even if banks are classifying their Treasury holdings as HTM what happens when the bank, in an attempt to remain as a going concern, is forced to sell the holdings and recognize the mark-to-market write-down.
Meet Clive Corcoran
For the opportunity to meet Clive and learn from his 30 years of experience, join the Measuring, Managing & Monitoring Interest Rate Risk taking place in London from the 26-28 June, 2023. The course is CPD-certified and you will receive an IFF exclusive digital badge upon completion of the course. See you in London!
Dates: 26 – 28 June 2023
Venue: 240 Blackfriars, London, SE1 8NW