April 13, 2024

Corporate Nex Hub

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Credit Strategy – Knowledge Hub

6 min read

The risks of the prolonged pandemic crisis of the last three years and the armed conflict between Russia and Ukraine for over a year have devastated many parts of the global economy.

 

The heightened inflation caused by emergency economic measures has led to a rise in policy interest rates and falling yields in bonds. This has exacerbated risks of erosion in the value of investment portfolios built by banks and financial entities during pandemic times when interest rates were ultra-low. 

 

The enormity of the liquidity risks inherent in investment portfolios led to the fall of even some prominent banks in the US. Silicon Valley Bank (SVB), Signature Bank and First Republic had to be closed down, while Silvergate Capital Bank sought voluntary liquidation.  

 

The collateral damage caused by the US banking crisis eroded investor wealth amid seismic volatility of stock markets across the globe.

The crisis also stretched to Europe where UBS Group AG had to take over Credit Suisse Bank. In the following sections, we look at how liquidity risks, if not managed well, can lead to the collapse of banks.  

 

Liquidty risk turns toxic for SVB
SVB, the 16th largest bank in the US, focused on serving start-ups, tech giants, and high net worth individuals. When interest rates were at a low ebb, start-ups were receiving more investments.

 

As a result, targeting start-ups and tech companies produced a massive increase in SVB’s deposit base from $62bn in December 2019 to $189bn by the end of December 2021, taking the total asset size of the bank to $212bn. 

 

While deposits were rising, SVB was not able to lend due to low demand for credit during the pandemic. The inability to deploy resources in loan assets prompted SVB to park deposits in its investment portfolio at low interest rates. 

 

Whether such concentration of resources in the securities market at low interest rates was envisaged by the investment and Asset/Liability Management (ALM) policies of the bank is debatable. ALM and liquidity risk management are the two constituent disciplines of balance sheet management.  

 

Liquidity risk is managed by using a structured framework designed to capture the behaviour of the residual maturity period of assets and liabilities of the bank to measure liquidity gaps in different time buckets. Such liquidity data enables the Asset and Liability Committee (ALCO) of the bank to plan the optimisation of resources.

In the melee of high deposit inflows during the pandemic times, SVB invested $80bn in mortgage backed securities (MBS) with greater than 10-year duration and a weighted-average yield of 1.56%.

In order to manage the yields and mark-to-market (MTM) losses, the bank chose to designate a higher proportion as Held to Maturity (HTM) instruments rather than Available for Sale (AFS) securities, something which banks across the globe opt for as normal risk management practice. Instruments held under HTM are not subject to MTM.

The tipping point of SVB’s liquidity crisis
In the post-pandemic times, the economy started to revive and inflation began to climb to a new high. The central banks in major parts of the globe started to increase interest rates, absorb excess liquidity, and tighten liquidity windows beginning in 2022 to fight raging inflation.  

 

Just as central banks were mounting efforts for policy normalisation after the pandemic, the new crisis of the Russia-Ukraine war, sanctions imposed on Russia, and other geopolitical risks exacerbated financial sector risks.

As a result of a shift in the macroeconomic setting, the deposit inflows at SVB slowed down. Customers earning low interest rates on deposits placed during the pandemic times suddenly found multiple avenues for better deployment.

Higher interest rates elsewhere and liquidity needs prompted them to withdraw their deposits from banks. In these changed liquidity conditions, SVB experienced a high volume of withdrawals. As a result, SVB had to manage heightened liquidity risk which reached a tipping point. 

 

The normal strategies to tackle liquidity risks cannot work when mismatches far exceed the bank’s ability to manage them. When a bank’s liquidity risk appetite is built for normal times, coping with stressful times calls for extraordinary measures.  

 

To cope with its unsustainable mismatch situation, SVB decided to sell part of its AFS portfolio and raise capital. 

 

SVB initially sold part of its investment portfolio at a loss in order to garner $21bn to shore up its liquidity. Then, on March 9, Silvergate Capital’s voluntary insolvency announcement made it impossible for SVB to tap the equity market and the run on the bank became inevitable. 

When more depositors started withdrawing their money in a matter of hours, many through online transfers, the bank had to start selling more of its assets at losses to fund depositors’ withdrawals. This was the tipping point of liquidity risks that pushed SVB to sell investments in the secondary market at a loss of $2bn, leading ultimately to its collapse.

Regulators and supervisors need to introspect: 
lessons from these bank failures The US Federal Reserve Board conducted a review of the supervision and regulation of SVB and identified certain key reasons for its failure: 

  1. The Bank’s board of directors and management failed to manage their risks;
  2. Federal Reserve supervisors did not fully appreciate the extent of the vulnerabilities as SVB grew in size and complexity;
  3. When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that SVB fixed those problems quickly enough; and
  4. The Board’s tailoring approach in response to the Economic Growth Regulatory Relief, and Consumer Protection Act and a shift in stance of supervisory policy impeded effective supervision by reducing standards, increasing organisational complexity, and promoting a less assertive supervisory approach.

Risk management policies are typically designed to cope with usual business risks. While accepting new deposits during the easy money regime, SVB could have (but didn’t) anticipate post-Covid trends and challenges in the financial sector – rising interest rates, falling yields, and expensive liquidity. 

 

If SVB had anticipated the post-Covid challenges, it could have altered the course of its liquidity risk management strategies to ring-fence the organisation and prevent its failure. Risk appetite should always be well-conditioned to meet changing business dimensions.

Flexibility and application of vision and dexterity in managing liquidity risk can be the differentiating factor in times of stress. 

 

Lessons from these bank failures

The US Federal Reserve Board conducted a review of the supervision and regulation of SVB and identified certain key reasons for its failure: 

 

An effective risk management program has a dual proactive role – setting appropriate risk appetite by making room for stressful times, and envisioning future risks and building resilience. 

 

The epicenter of accumulated balance sheet risks in SVB were the gaps in liability management and the inability to forecast future liquidity and cash flows. The resultant risks simply swept away SVB and unleashed fragility in many others as collateral damage.

The plunge in the share price of a major European bank – Credit Suisse – was part of the collateral damage of SVB’s collapse. Credit Suisse was the 17th largest systemically important European bank.

 

Thus, the lack of preparedness of regulated entities is an ongoing threat to the financial stability critical for economic revival from the pandemic. 

 

Taking a cue from the regulatory guidelines to strengthen risk management capabilities is essential to fighting the current spate of geopolitical and global financial risks. In a globalised world, it is difficult to stay decoupled from each other.  

 

Articulating risk management checkpoints from time to time and testing the bank’s resilience are vital for organisational growth. While banks may not be able to control spillover risks from macroeconomic developments, they do have control over their own liquidity and balance sheet composition in the near term. 

Internal risk tolerances have to be more conservative than regulatory norms. Surviving with moderate profits is better than optimising income during stress-free times in the mistaken belief that it is a perpetual opportunity.

 

PRMIA membership sets professionals apart, identifying them as active in the growth and promotion of the risk profession and demonstrating leadership by helping fellow risk practitioners develop best practices for their employees and community. Become a leader by joining PRMIA and providing your expertise. Join today at www.prmia.org.

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