The SVB Collapse: A Wake Up Call for Better Risk Management

Circle, the company behind the USDC stablecoin, acknowledged on Friday to having a $3.3 billion exposure to the now collapsed Silicon Valley Bank (SVB). USDC is one of the most widely used stablecoins with a market share of 44% in February 2023, and it maintains the peg to the US dollar by backing each USDC with a dollar of assets held by US banks and custodians, including SVB. The startup-focused SVB fell amid the biggest banking failure since the 2008 financial crisis, shaking up the markets and leaving billions of dollars' worth of retail, corporate, and investor assets stranded. With a market valuation of more than $200 billion before this event, the California-based corporation was the 16th largest bank in the United States, catering to the financial requirements of technology companies all over the world. But how did this happen?

SVB Financial Group, the parent company of SVB, disclosed on March 8 it had recently sold $21 billion in bonds, resulting in a quarterly loss of $1.8 billion after taxes. Many of those bonds had an average yield of 1.79%, far below the current 10-year treasury yield of around 3.9%. In an effort to bolster its finances, SVB reported at the same time that it was executing a $2.25 billion stock sale. This announcement caused investors to panic, and on Thursday, investors and depositors attempted to withdraw $42 billion from SVB within only 44 hours, virtually leading the bank to fail.

Many have cited Twitter as a key contributing element in this decline, with venture capitalists (VCs) being blamed for spreading mistrust and inciting fear. It is true that with greater communication, SVB might have been able to alleviate some of the anxiety felt. The market was clearly unable to absorb the bank's disclosure of the bond sale loss and enormous fundraising campaign. Claims that everything was "business as usual" quickly backfired, as they sounded all too similar to the events leading up to the 2008 collapse of Lehman Brothers. This was also exacerbated by bad timing, as the statement followed the demise of Silvergate Bank, a prominent financier in the crypto industry, which had already left investors feeling uneasy. There have also been inquiries as to why SVB delayed strengthening its balance sheet until the $1.8 billion loss rather than doing so sooner.

However, the reasons behind SVB's failure go beyond the use of social media and inadequate communication. While these had immediate and noticeable impacts, the real cause of the problem is sustained poor risk management. Every bank or individual is continually exposed to risks, and while some may be tougher to recover from than others, such severe errors might have been avoided through an effective strategy for managing risks. Moral hazard in the bank’s management and mislabeling in accounting have also been mentioned as culprits, but the focus of this commentary is on clear red flags in risk management that should be taken as lessons for the future.

For instance, in the months before to the collapse, the bank reportedly lacked a chief risk officer. Furthermore, although deposits up to US$250,000 are insured by the Federal Deposit Insurance Corporation (FDIC), more than 90% of SVB's client deposits were larger. As a result, this share of SVB’s deposits was not insured, turning it far more susceptible to the risks associated with withdrawals.

Another drawback was the fact that SVB had such an overlapping client base on both lending and depositing. A customer base diversification plan would have been essential to managing risk, especially since the absence of one led to a high concentration of its clients among VCs and failing startups.

Furthermore, SVB had a major investment portfolio relative to its overall assets, with 57% invested (compared to 24% for the typical American bank) and 78% in mortgage-backed securities (as opposed to 30% for Citi or JPM). Banks everywhere have flooded their balance sheets with billions of bonds as a result of LCR legislation, which designed rules to ensure that banks hold a sufficient reserve of high-quality liquid assets (HQLA). While regulation enables this, owning so many bonds on the balance sheet certainly carries risks, particularly interest rate risk. Banks typically hedge the bulk of the interest rate risk since it is costly to hold treasuries if rates increase. Although by December 2021 SVB held $10 billion in interest rate swaps, by December 2022 nearly all of these hedges had been taken down. As the duration of the bank's sizable portfolio remained the same before and after interest rate hedges, this indicated that the firm presently did not hedge interest rate risk at all. Why is this such a big deal? Economically speaking, a portfolio of $100 billion in bonds with a 5-year non-hedged duration represents a loss to the bank of $500 million for every 10 basis points increase in the 5-year interest rate. A loss of $5 billion would result from 100 bps, while a loss of $10 billion would result from 200 bps. This indicates that SVB was exposing its investors and depositors to a tremendous number of risks by failing to implement fundamental risk management procedures.

Moreover, SVB should have anticipated that rising interest rates would have a significant detrimental affect on deposits given that the tech industry grew during the era of record-low interest rates, especially when it started to become clear in early 2022 that tech valuations were declining. The bank should have conducted a thorough scenario study to assess the risk of deposit withdrawal.

Finally, SVB's collapse serves as a reminder of the importance of risk management. The bank's concentration of its client base, failure to hedge interest rate risk, lack of insurance and absence of a chief risk officer contributed to its downfall. To avoid similar events in the future, banks must take a diversified approach to their lending and deposit customers, prioritize risk management, and engage in adequate scenario analysis to assess potential risks.

This should be a wake up call for stablecoin issuers and other crypto protocols that rely on banks to retain value: risk management goes beyond their own practices and must include extensive due diligence on the banks holding their funds.