The banking industry is rapidly evolving and navigating new challenges. Darden Professor George (Yiorgos) Allayannis, an expert in corporate finance, risk management, financial institutions and international finance, recently hosted a webinar, Navigating Modern Banking Amid Disruption. The discussion focused on recent banking industry events, such as how the Silicon Valley Bank (SVB) collapse highlights the importance of risk management and corporate governance, the impact of rising interest rates on bank profitability, as well as newer issues banks face arising from social media and technology, more broadly. Below we’re highlighting a few key insights from the discussion.
The Demise of Silicon Valley Bank (SVB)
SVB was founded in 1983 and catered to startups, venture capital and private equity firms. By December of 2022, SVB was a top 20 U.S. bank with $211.8B in assets. The loans on SVB’s balance sheet were concentrated in technology and pharmaceuticals, though SVB had seen some changes from 2020-2022 in its assets and liabilities.
These changes included:
- Increase in deposits from $102B to $173.1B
- This was largely due to Venture Capital groups and Private Equity firms raising money, but not investing it due to the tech industry declining
- Increase in assets from $115.5B to $211.8B – almost a 4-fold increase since 2018
- Large increase in agency-backed securities
On March 8, 2023, SVB Financial Group announced that it had commenced a public offering to raise $2.25B in common and preferred shares, and that it had sold $21B of AFS securities, mostly U.S. treasuries, at an after-tax loss of $1.8B, with an average yield of 1.79% and a duration of 3.6 years. Upon this announcement, depositors panicked and withdrew $42 billion in less than 24 hours from SVB, largely driven by twitter postings. Then on March 12, 2023, regulators closed SVB.
So, why did depositors flee SVB?
The announcement was unexpected and showed the gravity of the current situation. A bank equity offering is commonly the least desirable option, and in addition, market conditions were not ideal for an equity offering. The tech sector had been declining for a while and SVB saw a decline in its stock price, return on equity (ROE), and price to book ratio (P/B). Additionally, 93% of SVB deposits were uninsured (were above the threshold of USD 250,000 for individually owned account that FDIC insures) — the average account value was $4 million. Technology (mobile and e-banking) enabled swift withdrawals as social media fueled the depositor panic.
Lessons To Be Learned from the SVB Collapse
Unlike the financial crisis of 2008, SVB’s case was largely an issue of mismanaged interest-rate risk as well as badly managed growth, not one of credit risk. SVB saw a significant increase in deposits, but it struggled to turn them into loans due to a lack of opportunities in its key sectors, pharma and tech. As a result, SVB invested most of the deposits into long-maturity bonds like agency mortgage-backed securities (HTM) yielding a higher interest rate risk because longer maturity, fixed income is impacted more by a rise in interest rates than shorter maturity fixed income securities.
Allayannis identified several lessons that banks should consider going forward:
- Asset-liability management matters: On the asset side, investing in HTM securities presents a significant risk in an environment where interest rates are going up -in the event that banks need to sell these securities for liquidity purposes. On the liability side, banks need to consider that deposits might flee as interest rates increase because depositors could transfer their money to banks that will offer higher interest rates on their money. Banks should understand their deposit “betas” – that is how much of an increase in interest rate is needed to pay depositors so they don’t flee.
- Search for yield entails risk: Investing in longer dated securities increases risk in a rising interest-rate environment and banks need to have a plan and systems in place to manage that risk. In hindsight, SVB could have invested in some shorter-term maturity securities.
- Importance of stress-testing scenarios: SVB’s collapse calls for the need for more stringent stress-testing. Banks below USD 250 billion in assets were excluded from more stringent stress-testing after 2018. Rigorous, well-thought-out stress-testing scenarios can help banks identify threats sooner.
- Uninsured/”non-sticky” deposits: SVB had a high percentage of uninsured deposits. When panic struck about SVB’s viability, it resulted in the withdrawal of $42B in deposits in less than 24 hours. Banks should better evaluate the risk of the deposits they hold at their institute flee as interest-rates rise.
- Cash/assets ratio: Between 2020 and 2022 SVB’s cash-to-assets ratio went down from 15.3% to 6.5%. At the same time, SVB experienced an increase in non-interest expenses, which added to its liquidity problem.
- Loan Diversification: SVB’s business model serving primarily tech and pharma was inherently risky. It highlights the need for banks to diversify loans across sectors (and geographies).
- Federal Reserve’s reaction/Federal Reserve’s role prior to crisis: Despite many warnings to SVB from the Fed, a lot remained unfixed. Going forward, it would be important for the Fed to be stricter in enforcing regulations and identify what would be relevant stress-testing scenarios that should be performed.
- As part of a holistic risk management approach banks must identify vulnerabilities and fix them
- Strengthen risk management and controls: Weak risk management is at the center of a lot of financial crises and banks should take steps to strengthen this area of their organization.
The Future of U.S. Banking
The SVB collapse and the subsequent collapse of Credit Suisse, have left many people wondering what the future of U.S. banking looks like. Allayannis highlighted the following about the state of U.S. banking:
- Moody’s downgrade of mid-size banks: Moody’s recently downgraded mid-size banks while several large banks are under review, giving a negative outlook of the industry. Allayannis also highlighted that banks are faced with pressures on net interest margins, as deposit costs are increasing, while potential losses are lurking from an increasing amount of commercial real estate sitting empty post-pandemic.
- Banking index declines and many banks are currently trading below book
- Mid-size/community banks and the number of banks in the U.S.: The current state of banking has led to conversations about how many banks are needed in the U.S. and whether there will be mergers in the future.
- Bank business model: There are also conversations about the bank business model broadly, and how sustainable it currently is, when interest rates rise.
- Trust/loyalty concerns and the regulatory environment: There are issues of trust with the industry that must be addressed and inevitably changes should be expected on the regulatory side.
If you’d like to watch the full webinar and Q&A discussion, you can access the recording here.
As this webinar highlighted, the banking industry is facing disruption and transformation at a rapidly evolving pace and senior leaders need to be able to effectively guide their organization in this challenging environment. Our Bank Executive Leadership Program combines Darden’s renowned leadership training with strategic and financial expertise to help you navigate risk, manage bank-wide change and understand new models of banking.
