Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank

Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank

After completing this reading, you should be able to:

  • Describe the events leading up to the failure of Silicon Valley Bank.
  • Describe shortfalls and deficiencies in the Federal Reserve’s supervisory oversight of Silicon Valley Bank during the period that the bank transitioned from the Fed’s Regional Banking Organization (RBO) portfolio to its Large and Foreign Banking Organization (LFBO) portfolio.
  • Identify Silicon Valley Bank’s specific risk issues which led to and accelerated its failure including deposit concentration, type of deposits, held-to-maturity securities, available-for-sale securities, the bank’s contingent funding plan and capacity, and its capital raising efforts.
  • Identify and describe the failures and shortfalls of Silicon Valley Bank in the areas of governance and risk management including those related to the CRO position and the bank’s internal audit function.
  • Identify the scope of Silicon Valley Bank’s liquidity risk management deficiencies and shortfalls, including its modeling and stress testing of its 30-day liquidity buffer, as well as the actions that management and regulators considered to address these specific liquidity issues.
  • Describe the deficiencies in Silicon Valley Bank’s interest rate risk management process, including its modelling process, and explain how proper use of metrics such as net interest income (NII) at risk and economic value of equity (EVE) could have improved its management of interest rate risk.

Events Leading Up to the Failure of Silicon Valley Bank

Silicon Valley Bank, a significant entity in the banking industry, specialized in providing financial services predominantly to companies in the technology and life sciences sectors. By March 2023, SVB had grown into a large bank holding company, boasting approximately $212 billion in total assets. This growth was primarily fueled by rapid deposit inflows during a boom in the venture capital and technology sectors, particularly in a period marked by exceptionally low interest rates. SVB’s business model and operational approach were pivotal in understanding the events that led to its eventual failure.

Overview of Silicon Valley Bank’s Vulnerabilities and Mismanagement

  • Inadequate risk management: SVB’s board and senior management failed to manage their risks adequately. The bank’s vulnerabilities included widespread managerial weaknesses, a highly concentrated business model, and reliance on uninsured deposits. This poor risk management left SVB highly exposed to rising interest rates and a slowing technology sector in 2022 and early 2023​​.
  • Rapid Growth Without Enhanced Supervision: Between 2019 and 2021, SVB’s assets grew from $71 billion to over $211 billion. Despite this rapid expansion, the bank did not come under heightened supervisory or regulatory scrutiny. This lack of oversight meant that SVB remained well-rated even as significant risks to its safety and soundness emerged​​.
  • Governance and risk management issues: SVB was consistently rated satisfactory in governance from 2017 through 2021, despite repeated observations of weaknesses in risk management. The full board of directors did not receive adequate information about risks and did not hold management accountable, leading to ineffective oversight of risks inherent in SVB’s business model​​.
  • Ineffective interest rate risk management: SVB’s interest rate risk management was flawed, as identified in several exams, but not adequately addressed. This deficiency became critical when interest rates rose, and the technology sector slowed down. SVB’s management focused more on short-term profits, ignoring long-term stability, further aggravating the risks​​.

The Final Days Leading to Failure

  • Balance sheet restructuring and bank run: On March 8, 2023, SVB announced a balance sheet restructuring plan. However, this announcement triggered a massive bank run, with over $40 billion withdrawn on March 9 and an additional $100 billion expected to be withdrawn the next day, leading to the bank’s closure on March 10​​.
  • Deposit inflows and outflows: SVB’s rapid growth was driven by deposit inflows from the booming venture capital and technology sectors. However, as interest rates began to rise in 2022, the bank faced significant deposit outflows and unrealized losses on its long-term securities investments​​.
  • Liquidity risk management weaknesses: SVB demonstrated foundational weaknesses in its liquidity risk management. The bank repeatedly failed its internal liquidity stress tests and failed to take rapid and comprehensive actions to increase funding capacity. Misleading stress testing assumptions further masked the liquidity risks​​.
  • Operational weaknesses in crisis management: During its final days, SVB’s inability to effectively manage a crisis became evident. The bank had not prepared adequately for borrowing under emergency conditions, which could have facilitated a more orderly resolution​​.

In conclusion, the collapse of Silicon Valley Bank resulted from a combination of poor risk management, inadequate regulatory oversight, and operational failures in a rapidly changing financial environment. This series of events underscores the importance of robust risk management and regulatory vigilance in the banking sector.

Shortfalls and Deficiencies in Federal Reserve’s Supervisory Oversight of Silicon Valley Bank (SVB)

SVB’s rapid asset growth from $71 billion to over $211 billion between 2019 and 2021 necessitated its transition from the Regional Banking Organization (RBO) portfolio to the Large and Foreign Banking Organization (LFBO) portfolio within the Federal Reserve supervisory structure in February 2021. This shift meant SVB was now subject to a higher supervisory and regulatory standards​​.

Key Shortfalls and Deficiencies in Supervision

  • Delays in enforcement actions: The Federal Reserve took over seven months to develop an informal enforcement action (Memorandum of Understanding) to address underlying risks at SVB. This delay was critical as SVB failed before the MOU was delivered​​.
  • Inadequate experience and transition planning: Examiners from the RBO portfolio, generally accustomed to community/regional bank supervision, lacked experience with governance and risk management practices of larger, more complex institutions like SVB. The transition to the LFBO portfolio lacked a defined plan and process, leading to a “cliff effect” in supervisory approaches and regulatory standards. This contributed to delays in assessments during a time when SVB’s financial condition was deteriorating​​.
  • Underestimation of risks and slow response: The Federal Reserve did not fully appreciate the seriousness of SVB’s governance, liquidity, and interest rate risk management deficiencies. Supervisors also failed to recognize the vulnerabilities as SVB grew in size and complexity and were slow to act on concerns, missing opportunities for early intervention or timely remediation​​.
  • Liquidity risk oversight: SVB was subject to limited-scope liquidity reviews, which were inadequate given its significant asset growth and unique business model. Despite fundamental weaknesses in risk management and evidence of a deteriorating position, liquidity ratings remained satisfactory, reflecting a failure to appreciate the extent of liquidity risks​​.
  • Policy and supervisory approach impacts: The Board’s tailoring approach in response to the Economic Growth Regulatory Relief and Consumer Protection Act (EGRRCPA) led to reduced standards, increased complexity, and a less assertive supervisory approach. These changes in regulatory and supervisory policies contributed to ineffective supervision of SVB​​.
  • Resource allocation and staffing issues: Resources for SVB supervision may have been insufficient, reflecting reallocation to address other demands like cybersecurity or fintech. The staffing for examinations, particularly while SVB was in the RBO portfolio, was not adequately geared towards the bank’s increasing complexity and unique risks​​.
  • Overlooking foundational problems: During SVB’s rapid growth in the RBO portfolio, Federal Reserve oversight did not resolve foundational problems or implement stronger oversight despite recognizing gradual increases in liquidity and market risks​​.

Silicon Valley Bank’s Specific Risk Issues Leading to Its Failure

Between 2019 and 2021, the bank experienced rapid growth, tripling in size due to rapid deposit inflows during a period of low interest rates. However, this expansion also came with increasing vulnerabilities, particularly in governance, liquidity, and interest rate risk management​​.

Specific Risk Issues

  1. Deposit concentration and type: SVBFG’s customer base was heavily concentrated in venture capital (VC)-backed technology and life sciences companies. More than half of SVBFG’s deposits at year-end 2022 were from these sectors. The concentration in large uninsured deposits in non-maturity accounts from VC-backed and private equity clients linked SVBFG’s funding growth directly to VC deal activity, making it vulnerable to sector-specific downturns​​.
  2. Held-to-Maturity (HTM) securities: A significant portion of SVBFG’s assets consisted of unencumbered investment securities, with an increasing proportion designated as HTM by 2021. This allocation to longer-term maturities became problematic as interest rates began to rise, leading to deposit outflows and unrealized losses in the HTM portfolio​​.
  3. Available-for-Sale (AFS) securities: SVBFG also experienced unrealized losses in its AFS portfolios, exacerbating its financial challenges. The bank’s tech-focused business model made it an outlier in terms of the growth and composition of its balance sheet, particularly with its securities portfolio being more than double that of its large banking organization (LBO) peer group​​.
  4. Contingent funding plan and capacity: SVBFG’s weaknesses in preparedness for a contingent liquidity event contributed to its inability to access contingent funding sources in a time of need. The bank had already incurred significant net client outflows by 2022, prompting the activation of certain aspects of its contingency funding plan. However, the bank could not monetize its investment securities immediately, revealing shortcomings in its liquidity buffer and contingency planning​​.
  5. Capital raising efforts: In response to increasing financial stress, SVBFG attempted to restructure its balance sheet, which included the sale of certain securities and plans to raise capital. However, these efforts were insufficient and untimely, as the bank faced rapid deposit outflows and pressure on its liquidity and earnings​​.

Failures and Shortfalls of Silicon Valley Bank in Governance and Risk Management

Governance and Risk Management Framework

Silicon Valley Bank Financial Group (SVBFG) faced significant challenges in its governance and risk management, primarily due to its inability to keep pace with rapid growth and evolving business model risks. The board of directors and senior management failed to effectively oversee the risks inherent in SVBFG’s business model and balance sheet strategies. This inadequacy was partly attributed to a governance and risk management framework that did not evolve in tandem with the bank’s growth​​.

Board Oversight and Accountability

A critical shortfall in SVBFG’s governance was the board of directors’ insufficient oversight and accountability of management. The board did not receive adequate information about the bank’s risks, particularly regarding liquidity issues, until late in the crisis. This lack of effective communication led to the board’s failure to hold management accountable for these risks. Additionally, the board prioritized short-term profits over effective risk management, often treating supervisory issues as mere compliance exercises rather than critical risk management concerns. This approach was evident in the structure of the compensation packages for senior management, which were tied to short-term earnings and equity returns without incorporating risk metrics, thus incentivizing managers to focus on short-term profit over sound risk management​​.

Liquidity Risk Management

SVBFG demonstrated foundational weaknesses in its liquidity risk management, including its liquidity position and ability to manage risks through internal liquidity stress tests (ILST), limits, and contingency funding plans (CFP). From July 2022, when SVBFG first became subject to enhanced prudential standards, it repeatedly failed its own ILST. Although management responded by increasing funding capacity, these actions were not rapidly undertaken or fully executed. Moreover, management adopted less conservative stress testing assumptions, which masked some of the liquidity risks. This was particularly problematic given SVBFG’s highly concentrated deposit base, which was assumed to be more stable than it actually was​​.

Interest Rate Risk Management

SVBFG also failed to adequately assess and manage interest rate risk (IRR) in its rapidly growing securities portfolio. The sharp rise in interest rates and the slowdown in the technology sector in 2022 and 2023 significantly impacted SVBFG. The bank’s net interest income and the value of its long-dated securities declined, leading to pressure on earnings and potential losses. SVBFG management was focused on short-term profit impacts, which led to limited visibility into vulnerabilities due to the board-set internal risk appetite metrics. The bank had breached its long-term IRR limits since 2017 due to a structural mismatch between long-duration securities and short-duration deposits. Instead of addressing this risk, SVBFG made counterintuitive modeling assumptions about the duration of deposits and removed interest rate hedges that could have protected against rising rates. Ultimately, management’s actions prioritized maintaining short-term profits over managing underlying balance sheet risks​​.

Liquidity Risk Management Deficiencies

Silicon Valley Bank (SVB) experienced significant deficiencies in its liquidity risk management, which were central to its eventual failure. These deficiencies spanned various aspects, including internal liquidity stress testing, modeling of its 30-day liquidity buffer, and the actions taken by management and regulators to address these issues.

Internal Liquidity Stress Tests (ILST) Shortfalls

  • ILST implementation: SVBFG developed and implemented an updated ILST in response to the 2021 Liquidity Examination Material Risk Identification Actions (MRAs). However, the implementation highlighted weaknesses in the bank’s liquidity risk profile.
  • 30-day liquidity buffer deficiency: As of July 2022, SVBFG was required to maintain a 30-day liquidity buffer based on ILST results, as per Regulation YY EPS. The reports revealed a significant deficit in the balance of highly liquid assets, which management and supervisors termed an “operational shortfall.”

Management Responses to Liquidity Challenges

  • Addressing liquidity pressures: Management undertook actions in the fourth quarter of 2022 to mitigate liquidity pressures. This included increasing FHLB advances, enhancing repurchase agreement capacity, and incorporating new stress assumptions to lower liquidity requirements.
  • Changes to ILST assumptions: Significant changes were made to the ILST assumptions in October 2022, effectively reducing the modeled liquidity shortfall. This was achieved by updating methodologies for unfunded lending commitments and intraday liquidity, specifically at the 30-day horizon​​.

Board’s Involvement and Accountability

  • Inadequate board oversight: The full board of directors at SVB did not receive sufficient information from management about the bank’s liquidity risks until November 2022. This delay in communication impeded the board’s ability to hold management accountable for effectively managing the bank’s liquidity risks​​.

Supervisory Oversight and Regulatory Considerations

  • Supervisory weaknesses: Limited-scope approaches to liquidity risk management reviews at SVBFG and a lack of broader supervisory assessments contributed to missed opportunities for more critical evaluations. As a result, SVBFG’s size and risk profile significantly outpaced its liquidity risk management practices, rendering it unprepared for EPS requirements​​.
  • Regulatory standards and expectations: SVBFG’s liquidity risk management practices were fundamentally flawed across multiple standards, including board and senior management oversight, establishment of liquidity risk tolerances, ILSTs, and contingency funding plans (CFPs), as outlined in SR letter 10-6 and Regulation YY EPS​​.

Modeling and Stress Testing Shortcomings

  • Inadequate sensitivity testing: SVBFG exhibited limited sensitivity testing and lacked an adequate secondary function to review and challenge decisions and model assumptions. This shortfall was evident in their interest rate risk policy and manifested in the lack of specified scenarios, analysis methods, sensitivity analysis, and back-testing requirements​​.
  • Unrealistic assumptions: The approach to assessing risk in deposits for ILST did not appropriately consider key risk attributes, impacting the reliability of SVBFG’s liquidity buffer. The static measures used did not reflect correlations or stress outcomes, and the bank faced multiple CFP deficiencies, including a lack of assessing potential funding sources and needs during stress​​.

Management’s Inadequate Response to ILST Failures

  • Delayed and ineffective actions: Management’s response to SVBFG repeatedly failing its own ILST included increasing funding capacity and using less conservative stress testing assumptions. However, these actions were not rapidly undertaken or fully executed, particularly problematic given the bank’s highly concentrated deposit base. The less conservative assumptions masked some liquidity risks, failing to adequately assess and manage the interest rate risk in its growing securities portfolio​​.

Overview of Deficiencies in Interest Rate Risk Management

Silicon Valley Bank Group (SVBFG) exhibited fundamental weaknesses in its approach to managing interest rate risk (IRR). These deficiencies were primarily due to a focus on short-term metrics, inadequate risk measurement methods, and poor governance and control mechanisms.

Focus on Net Interest Income (NII)

  • Short-term view: SVBFG’s management focused on the short-term view of IRR through the NII metric. This approach ignored potential longer-term negative impacts on earnings, which could have been highlighted by the Economic Value of Equity (EVE) metric. Such a focus led to a lack of consideration for idiosyncratic risks and the unique impact of rate increases on SVBFG’s customer base​​​​.
  • Risk Appetite Statement Limitations: The bank’s Risk Appetite Statement (RAS), set by the board, included only the NII metric, not the EVE metric. This narrow focus resulted in a limited perspective on interest rate risk and its potential impact on the bank’s long-term financial health​​.

Weaknesses in Interest Rate Risk Policy

  • Inadequate policy guidelines: The interest rate risk policy at SVBFG did not specify necessary scenarios for risk management, such as how assumptions should be analyzed or how to conduct sensitivity analysis. There was also no clear guideline on how limits were set and calibrated, nor were there ongoing reporting requirements for threshold breaches. This lack of detail in the policy contributed to insufficient risk management practices​​.

Mismanagement of EVE Metric

  • EVE breaches: Internal reports indicated that SVBFG was in violation of its internal policy limits for EVE at risk, demonstrating a failure to manage the long-term impacts of interest rate changes effectively​​.
  • Mismatch of durations: A mismatch in the durations of assets and liabilities on the balance sheet caused the EVE metric to worsen and breach SVBFG’s limits. This mismatch was exacerbated by management’s decision to shift from non-interest-bearing to more costly interest-bearing deposits and wholesale borrowings​​.

Modeling and Assumptions Deficiencies

  • Counterintuitive Modeling Assumptions: SVBFG made poorly supported changes in assumptions, particularly regarding the duration of deposits. These changes were unsubstantiated and based on rapid increases in rates and the uniqueness of SVBFG’s client base. Such assumptions reduced the apparent mismatch of durations between assets and liabilities but did not genuinely mitigate the underlying risk​​.

Impact of Short-Term Profit Focus

  • Removal of interest rate hedges: In pursuit of short-term profits, SVBFG removed interest rate hedges designed to protect NII in rising rate scenarios. This strategy extended the duration of the securities portfolio, worsening the EVE metric and increasing the bank’s exposure to interest rate risk​​.

How Proper Use of Metrics Could Have Improved Management

Utilizing NII at Risk and EVE Metrics Effectively

  • Balanced approach: A more balanced approach incorporating both NII at risk and EVE would have provided a comprehensive view of the bank’s interest rate risk exposure. NII at risk would help in understanding the short-term impacts of interest rate changes on earnings, while EVE would offer insights into the longer-term effects on the bank’s economic value.
  • Scenario analysis and sensitivity testing: Incorporating a range of scenarios and sensitivity tests in both NII and EVE metrics could have allowed SVBFG to better understand and prepare for various interest rate environments. This would have enabled the bank to identify and mitigate potential risks proactively.

Enhanced Governance and Control

  • Board involvement: Regular and detailed reporting of both NII at risk and EVE metrics to the board would have facilitated better oversight and strategic decision-making. The board’s awareness of these metrics would have been crucial in ensuring a robust interest rate risk management framework.

Practice Question

Which factor best illustrates a shortcoming in the Federal Reserve’s supervision of SVB during its transition from the RBO to LFBO portfolio?

  1. The Federal Reserve’s prompt identification and rectification of SVB’s risk management issues during the transition.
  2. Examiners from the RBO portfolio, who were less experienced with large, complex institutions, supervised SVB, leading to underappreciation of its risks.
  3. The Federal Reserve’s focus on international expansion risks of SVB, which diverted attention from its domestic operational challenges.
  4. The imposition of overly strict international cybersecurity standards by the Federal Reserve, which were irrelevant to SVB’s business model.

The correct answer is B.

During SVB’s transition from the RBO to the LFBO portfolio, it was overseen by examiners who generally came from the community/regional bank pool and may have lacked experience with the governance and risk-management practices of larger, more complex institutions like SVB. This contributed to the underappreciation of SVB’s risks as it grew in size and complexity​​.

A is incorrect because there was no prompt identification and rectification of SVB’s risk management issues by the Federal Reserve during the transition. Instead, there were delays in enforcement actions and a lack of adequate supervision tailored to SVB’s growing size and complexity.

C is incorrect as there was no specific focus by the Federal Reserve on the international expansion risks of SVB. The main supervisory shortcomings were related to the transition process and the lack of experience of examiners with larger and more complex institutions like SVB.

D is incorrect because there is no evidence that the Federal Reserve imposed overly strict international cybersecurity standards on SVB. The issues in supervisory oversight were more related to the transition process and the examiners’ experience, rather than specific standards like cybersecurity.

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