Silicon Valley Bank Collapse – Should we worry about European Banks?
The collapse of Silicon Valley Bank (SVB) end of last week sent shock waves over the global financial system. Bank stocks in the US and Europe lost between 10% and 20% within a few days. In this article, we discuss whether investors and clients should be worried about European Banks or not.
We share the view of most industry experts that SVB is a special case. The bank invested a large part of its roughly $200bn balance sheet in long-term assets and funded it predominately with short-term sight deposits. As of December 31, 2022, SVB held $73bn of loans (35% of balance sheet) and $120bn of investment securities (55% of balance sheet), mainly consisting of US treasuries, municipal bonds, agency-issued mortgage-backed securities (MBS) with long maturities. A surprisingly high amount (80%) of SVB’s securities portfolios had contractual maturities of over ten years. By contrast, the $166bn non-maturity deposits used to fund these investments were mostly of very short-term nature and could be withdrawn by clients any time.
The sharp increase in US treasury yields following the tightening of US monetary policy caused a material decline in the market value of SVB’s fixed-income securities portfolio. On the $26bn of the securities investments treated as Available for Sale (AVS), SVB incurred unrealized losses of $2.5bn (as of December 31, 2022) which were recognized in other comprehensive income and hence are included in the bank’s shareholders’ equity. Remarkably, the loss was though not considered in SVB’s regulatory capital since the firm made use of an opt-out election. $91bn of fixed-income securities underwent Held to Maturity (HTM) treatment. These positions were carried at amortized cost ($91bn), despite an incurred $15bn fair value decline to $76bn (as of December 31, 2022). This means that the $16bn of shareholders equity reported on December 31, 2022, was fully eroded by the unrealized losses and the 12.05% CET1 ratio/8.1% Tier 1 leverage ratio were from an economic viewpoint unsubstantiated, albeit technically correct.
Not surprisingly, SVB’s balance sheet situation increasingly concerned customers. Within only one day, clients withdrew $42bn (1/4 of total deposits), according to media reports. In other to avoid a bank run, the Federal Reserve had to step in and guarantee all client deposits, even those in excess of the $250k amount covered by the Federal Deposit Insurance Corporation (FDIC).
SVB’s case is unique in several aspects.
- First, the enormous maturity mismatch is unprecedented and reflects gross negligence by the bank’s Asset and Liability Management Committee (ALCO), as well as a serious lack of supervision by the firm’s Board of Directors and the responsible regulators. While rising interest rates were expected to have a positive impact on the Bank’s Net Interest Income (NII), economic value sensitivities pointed to a material interest rate risk. In their annual report 2021, SVP disclosed that a 200bps parallel up shift in market interest rates would result in a $5.7bn decline in the bank’s Economic Value of Equity (EVE). This means that the bank deliberately accepted the risk that such a reasonably possible event could wipe-out almost half of the bank’s CET1 capital.
- The Basel III Liquidity Coverage Ratio (LCR) applies in the US only to the full extent for banks with assets above $250bn. SVB was with a balance sheet of $212bn (as of December 31, 2022) below this threshold. It only needs to comply to a modified less stringent LCR requirement, applicable for banks with assets between $50bn-$250bn. The Basel III Net Stable Funding Ratio (NSFR) requirement is in the US in the final implementation phase. The final rules are effective since July 1, 2021. Holding companies will be required to publicly disclose their NSFR levels semi-annually, beginning in 2023. The less fast and consequent implementation of the Basel III standards may partly explain why SVB’s large maturity mismatch did not receive sufficient regulatory attention.
- The massive deposit withdrawals at SVB were likely accelerated by SVB’s special client base, which is concentrated in tech entrepreneurs, start-up companies and venture capitalists. These customers are similar to each other and frequently placed amounts in excess of the $250k FDIC guarantee threshold with SVB. It is well known that bank clients which multiple-million deposit balances react much faster to uncertainties on a bank’s financial standing than average retail customers.
Orbit36 believes that market concerns about similar situations in the European banking sector could be overdone. We regard it as unlikely that a bank regulated in the European Union, Switzerland or the United Kingdom could operate with an unhedged IRRBB exposure in the magnitude of SVB’s exposure. For instance, the Swiss banking regulator FINMA considers banks which would lose under one of their six standard interest rate stress scenarios (e.g., a + 150 bps parallel shock) more than 15% of their Tier 1 capital as outlier institutions for which they can mandate measures such as additional capital requirements or exposure reductions.
Liquidity and funding frameworks (e.g., LCR, NSFR) are a well-established concept in Europe and apply to most banks. In addition, large domestic banks are often subject to detailed risk disclosure requirements even if they are not considered systemically relevant. This means that European banks are forced to fund a higher portion of their balance sheet long-term and they must hold significant liquidity reserves in securities which can be easily and immediately converted into cash at little or no loss of value. The stringent definitions of so-called High Quality Liquid Assets (HQLA) which can be used to meet LCR requirements preclude securities with longer maturities.
While SVB is in our view unlikely to happen in Europe, Orbit36 remains concerned on the systemic risks which can result from the increased use of short-term deposits as main funding source. As we discussed in an earlier article in 2022 (see https://www.orbit36.com/three-hidden-risks-below-the-waterline-bank-boards-should-be-aware-of/), banks could potentially underestimate their interest rate exposure if their assumptions on the duration of client deposits may turn out to be too optimistic. The negative rate environment forced some banks to materially prolong the time horizon under which client deposits need to be repriced. This causes some vulnerabilities in an environment with quickly rising interest rates.
Please contact Orbit36 if you want to discuss the implications of the recent events on your bank.