Three Key Takeaways from Silicon Valley & Signature Bank
What banks can do to reduce credit risk in a volatile economy
OakNorthMarch 16, 2023
The failures of both Silicon Valley Bank (“SVB”) and Signature Bank have already been well discussed and analyzed – a concentration of deposits in one industry (SVB: tech; Signature: real estate) and a mismatched balance sheet in a rising rate environment. Essentially, as interest rates rose the banks needed to reprice their deposits but were hampered by asset yields that were largely fixed (HTM MBS portfolio for SVB, and multifamily/CRE for Signature). This inability to attract new deposits, coupled with an outflow of capital to cash-starved businesses, led to an old-fashioned bank run that created an acute liquidity crisis they could not weather.
It was nothing to do with sub-prime loans, asset bubbles, and credit rating tranches. Instead, there’s a new set of buzzwords behind this crash: available-for-sale securities; deposit insurance; and AOCI.
So, it’s not 2008 all over again, just uniquely over-concentrated banks that didn’t see or were unable to plan for a liquidity crisis many would say they should have anticipated. Though this may seem like isolated incidents for the two coastal banks, there are key insights that any bank can apply to improve its position and better prepare to mitigate risk in advance. Let’s look at three significant takeaways.
1. Avoid concentrations where possible; manage them closely where necessary
It is a fundamental tenet of finance that concentration amplifies risk, while diversification diminishes it. Most regional banks do an excellent job of diversifying their lending portfolio, but a certain degree of concentration is unavoidable and, in some ways, beneficial to the business.
There are two primary reasons why most banks develop a concentration in deposits: regionality and reputation. For example, by virtue of its location, SVB was the go-to bank for tech companies and VCs. Similarly, Signature Bank was the largest CRE lender in NYC by volume of loans. But both also developed industry expertise around serving the complete banking needs of their customers, which attracted more business.
It’s important to note that what ended as a liquidity crisis could have quickly become a credit crisis. With better balance sheet management practices in place, both banks could have managed the steady outflow of deposits. But a steady outflow of deposits, with no commensurate investments in business, is an early warning indicator of industry health, and it’s likely they would have soon found themselves wrestling with their credit concentration risk in tech and CRE.
Every bank will develop some level of concentration based on location, expertise, and reputation. However, well-diversified portfolios means regional and community banks have smaller, more numerous pockets of credit concentration risk to manage. Credit risk managers need to think carefully about how they measure and manage these pockets of risk.
2. Take a forward-looking view
In retrospect, the causes of SVB’s liquidity crisis seem obvious (and parallels can be drawn to Signature Bank and its exposure to NYC CRE). Their tech startup and venture capital customer base raised considerable funding during the lengthy low-interest rate environment, driving the rapid growth in SVB’s deposit base from $63bn at March 31, 2020 to $200bn at March 31, 2022. At the same time, SVB made a bet that interest rates would remain lower for longer by investing in long-dated mortgage-backed securities.
A forward-looking view of risk by SVB could (or should) have included evaluating the impact of higher interest rates – across asset prices, their customers’ financial profiles and cashflows, and deposit pricing behavior. Having a better understanding of the potential consequences of rapidly rising interest rates could have helped SVB manage its balance sheet more effectively.
Credit risk managers should proactively consider the impact of macro-economic conditions on borrower business models and performance. A diversified credit portfolio will see different impacts across the range of industries. Taking a forward-looking view of industry impacts on borrower performance will help credit risk managers identify borrower needs and changing risk profiles and manage them proactively.
3. Test your loan book frequently, to a granular level
To better anticipate and prepare for potential risks, credit risk managers should regularly run detailed, industry-specific scenarios. This practice will help identify potential vulnerabilities and allow for proactive risk management.
To effectively run granular scenarios, banks should consider factors such as industry dynamics, domestic and global economic conditions, regulatory changes, and unexpected events such as natural disasters or political shifts. Regularly updating models and assumptions as new information becomes available is crucial for maintaining the relevance and accuracy of the analysis, ultimately allowing credit risk managers to safeguard their credit portfolio in an evolving and uncertain environment.
As we sit in mid-March 2023, the economy and the banking sector are in a precarious position, with multiple macro-economic factors shifting rapidly — bringing both risk and benefit to different industries. Understanding those industry risks and benefits, how they impact your portfolio, and how they drive your early action will make scenario analysis a core piece of your risk management strategy, not just a regulatory exercise.
By keeping these key takeaways in mind, credit risk managers can better protect their institutions from the risks associated with both liquidity crises and credit events – and hopefully avoid some of the challenges that ultimately led to the demise of Signature Bank and SVB.