– By Dr Vinay Kumar Singh
The Silicon Valley Bank (SVB) with assets of USD 200 billion was closed on Mar 10, 2023. The poor risk management practices and the governance ineptitude of the SVB board have been widely written about as the factors responsible for its fall. Banks operate in an environment tightly regulated by the policies of the government and the central bank. Any story about SVB’s failure is incomplete without mentioning the role of monetary policy actions, the misplaced confidence in the reduced importance of liquidity adequacy norms, and the indulgent approach of the regulatory supervisors towards SVB’s shortcomings. This article analyzes these aspects in the context of the developments post the ‘Great Recession’ of 2007-09- a period when the world financial system faced one of its biggest crises.
The Dodd-Frank (DF) Act passed in 2010 in response to the near collapse of the financial system had enhanced prudential regulations for banks with greater than USD 50 billion in assets. In the decade before the crisis, the cumulative ‘loans to deposit ratio’ of US banks had been consistently above 80 per cent. Starting 2009, it started sliding and was down to 63 per cent by 2019. Banks were choosing to invest higher amounts in bonds instead of lending to households and businesses. Opponents of the DF Act claimed that the regulations demanding higher capital requirements had contributed to this reduction in flow of credit. The clamor for relaxing these regulations culminated in the passage of EGRRCPA (Economic Growth, Regulatory Relief, and Consumer Protection Act) 2018. It increased the threshold for applicability of the DF Act to USD 100 billion. In Oct 2019, the Federal Reserve Board tailored the regulatory framework to the size of the bank. It estimated ‘that the changes will result in 0.6% decrease in required capital and a reduction of 2 per cent of required liquid assets.’ Cumulatively, these actions reduced the supervisory oversight and capital and liquidity requirements for banks like SVB and allowed them to take higher risks.
The COVID crisis in 2019 led to a steep downturn in the economy and heightened business uncertainty. The normal flow of funds in the economy was disrupted and ‘staying in cash’ became the preferred choice. To ensure credit availability and spur economic activity, the Fed cut its target for the federal funds rate, the rate banks pay to borrow from each other overnight, by a total of 1.5 percentage points in March 2020. The Fed also announced its intentions to buy securities worth USD 700 billion as ‘quantitative easing’ to further enhance the available liquidity. These steps followed the announcement by FOMC (Federal Open Market Committee) in Jan 2019 of its intention to ‘conduct monetary policy in ample reserves regime.’ Under this regime, monetary policy goals are sought to be achieved solely through changes in interest rates- tweaks in liquidity reserve requirements are deemed to be ineffective. Consequently, reserve requirement- the fraction of deposits which banks should keep in ‘cash-like’ assets- was reduced from 10 per cent to 0 per cent effective Mar 2020. Further, the banks were encouraged to ‘use their capital and liquidity buffers’ to lend more. With these steps, the Fed effectively took over the role of liquidity management from the banks. Unfortunately, the policy consensus about the efficacy of the mechanisms in the ample liquidity regime was belied in the case of SVB.
The dilution of liquidity adequacy norms influenced the ratings given to SVB in regulatory audits. The report ‘Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank’ released in April 2023 is severe in its censure of the lack of rigor in these audits. Despite serious gaps, its liquidity management practices were consistently rated strong. Being a small bank with assets of only USD 71 billion in 2019, SVB had a ‘Strong-1’ liquidity rating.
A period of high liquidity and low interest rates gave rise to a boom in the venture capital (VC) investments. VCs as well as their investee companies constituted a dominant proportion of SVB’s customers. The bank grew rapidly – its deposits tripled from 2019 to 2021, the loan book doubled, and its investment portfolio shot up by 4.5 times. More stringent regulatory norms became applicable as SVB crossed the threshold of USD 100 billion in assets in 2020. SVB was subjected to internal liquidity stress tests every quarter and failed them repeatedly. Regulatory supervisors noted that it did not have contingency funding plans in place. Even though a review by the regulator in 2021 identified foundational issues in liquidity risk management, it was not reflected in the comments on liquidity adequacy. As late as Aug 2022, supervisors assessed that SVB’s ‘actual and post-stress liquidity positions reflect a sufficient buffer’. Instead of taking steps to reduce the liquidity risk, the SVB management tweaked its modelling assumptions to project a rosier picture of the liquidity position. Supervisors were aware of this but remained sanguine about it.
It is difficult to predict if stricter regulations for liquidity reserves could have prevented the collapse of SVB. But as the report argues ‘it would likely have bolstered the resilience of Silicon Valley Bank’ and stricter audit ratings would have highlighted the risks earlier. The downgrading of the importance of liquidity adequacy norms, the benign assessment in risks in regulatory audits, aggressive monetary policy actions, and the lack of risk management abilities of the SVB management formed an explosive mix. The increase of interest rates by the Fed to control inflation and the resultant losses in the investment portfolio of SVB lit the fuse and led to the collapse of the bank. Undeniably, the primary responsibility of the failure of SVB lies with its management and board. But a fair share of the blame must be attributed to the policy makers and regulatory supervisors too.
(Dr Vinay Kumar Singh is the SRO Head at Microfinance Institutions Network.)
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