Poor Risk Management at the Silicon Valley Bank
The entire world is still trying to grapple with the failure of the Silicon Valley Bank. The impact has been felt across the United States economy and even across the entire world. It is obvious that since the impact has been significant, a lot of time will be spent trying to analyze if this financial disaster could have been avoided in the first place.
Up until now, only an elementary analysis of the risk management mechanism at the Silicon Valley Bank has been done. However, even this elementary analysis reveals gaping holes in the risk management practices at Silicon Valley Bank. Some of these mistakes have been made by the bank itself. However, questions also arise about why did the regulators allow the bank to continue their operations unabated.
Some of the important issues related to risk management at Silicon Valley Bank are as follows:
- Flying Under the Radar: First and foremost, it is important to understand how Silicon Valley Bank was able to fly under the radar i.e. how it was able to continue its operations without facing significant interference from the banking regulators in the United States.
- High Concentration of Risks: The Silicon Valley Bank was funding its liabilities mostly with demand deposits. The bank was taking in a lot of funds from startups and venture capital firms which are a closely-knit circle.
Hence, there was always a risk that the demand deposits could be called up by a small group of individuals at very short notice. This meant that there was a concentration of risk on the liabilities side of the balance sheet of the Silicon Valley Bank. The case was not very different when it came to the asset side either.
The Silicon Valley Bank made most of its loans to startups in the tech sector. As a result, the risk profile of all its loans was also similar. Hence, there was a large concentration of risks on the asset side as well.
- Unhedged Exposure: The Silicon Valley Bank had created its portfolio in such a way that most of its money was invested in the treasury bills issued by the United States government. The US treasury bills are one of the safest investments in the world. This means that the Silicon Valley Bank could have been assured that it would receive the nominal value promised by the United States government. However, the real value of the bonds could change with the fluctuation in interest rates.
The US treasury bills which have a long duration are particularly sensitive to interest rate changes. Hence, when the Fed raised interest rates steeply, the value of these bonds also fell rapidly.
The problem was that Silicon Valley Bank did not hedge its exposure to these interest rates. This is strange because if any bank has such a large position in a single asset class, then they are supposed to hedge so that a catastrophic downfall can be avoided. This is a basic risk management tool that even the smallest of financial institutions are expected to follow. However, they were not followed at Silicon Valley Bank.
- No Chief Risk Officer: Silicon Valley Bank was not focusing on its risk management. This is evident from the personnel management decisions taken by the bank. For example, the bank was functioning without a chief risk officer for a long period of time preceding this crisis.
It is the task of risk management exposure to ensure that risks are not concentrated and not hedged. Since the Silicon Valley Bank did not have any chief risk officer, it is likely that some of the tasks which were supposed to be performed by this officer remained unattended.
- No Stress Test: Stress testing is another method that is generally prescribed by central banks to individual banks so that the quality of their portfolio can be tested. However, it seems like Silicon Valley Bank did not conduct any stress tests.
Had it conducted the stress tests when the interest rates first started rising, it would have seen a huge asset-liability mismatch in the event of a steep rise in the interest rates. This would have prompted the Silicon Valley Bank to take pre-emptive measures and avoid this massive crash.
After the banking system failure in 2008, the Dodd-Frank Act was specifically created with the intention of enabling better risk management at such banks. However, in 2018, this act was amended and the provisions of this act were applicable only to banks that had more than $250 billion in assets.
It needs to be understood that this limit was revised from $50 billion to $250 billion. As a result, a large number of banks that were earlier facing scrutiny from banking regulators were exempt from such regulation.
It needs to be noted that Silicon Valley Bank had assets of close to $220 billion. As a result, it was very close to the regulatory limit. The Silicon Valley Bank was the 16th largest bank in the United States and yet the provisions of the Dodd-Frank Act did not apply to it.
It is said that Silicon Valley Bank was amongst the banks which lobbied American regulators to provide them exemption from regulation. It is absurd that the bank which was claiming to be too small to be regulated is now being considered too big to fail!
The fact of the matter is that Silicon Valley Bank made some elementary mistakes when it came to risk management. Also, the United States regulators should have had a system in place to prevent any bank from indulging in such risky behavior.
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