The sudden failure of Silicon Valley Bank shocked the financial services world. How can a 40-year-old bank—the 16^th largest in the nation—collapse and be taken over by the FDIC in a matter of days? But in hindsight, the warning signs were there for those who knew where to look.

The immediate cause of the collapse was obvious; it was an old-school run on the bank. Alarmed by reported liquidity issues at the bank, SVB’s depositors, which consisted largely of tech stalwarts and startups, along with the venture capitalists who funded their dreams, withdrew $42 billion in deposits—a quarter of the bank’s total—in a single day. Within two days, the bank was insolvent, and the FDIC stepped in to take control of the institution and guarantee all remaining deposits, even those above the $250,000 FDIC insurance maximum.

But SVB’s issues were long simmering. A series of poor management decisions and a broad lack of risk management controls eventually resulted in a cascading crisis.

A Business Built on Risk, and Trust

At its core, banking is a business built on risk.

Financial institutions earn interest on the money they lend to individuals and businesses. The rates they charge are considered fair compensation for the amount of risk they take on in the deal.

On the other side of the balance sheet, banks pay out (a relatively low rate of) interest on deposits, which they then invest in higher-performing vehicles like Treasury bonds, allowing them to earn a modest profit margin.

The key to success and growth lies in an institution’s ability to balance the added risk with what they can earn on these assets, to make a profit.

Banking is also a business built on trust.

Nothing is more critical to a financial institution’s success than the covenant of trust it has with its customers. The depositor must believe that their money is safer within the bank vault than it is sitting at home under the mattress. Without trust, there is nothing preventing any bank from failing, because they are only required to have 10% of their deposit base held in reserves at any time. Banks are literally a house of cards, held up by little more than a promise (and $250,000 of FDIC insurance guarantees).

But when a bank takes on too much risk, that trust can begin to crumble. That’s when the house begins to tremble, and eventually fall. And that’s exactly what happened to SVB.

A Perfect Storm

The Silicon Valley cautionary tale contained an unusual confluence of unforeseen events and poor management decisions, but it serves as warning for all financial institutions.

The story begins with SVB’s unusual business model and client base, which consists largely of large tech companies, wealthy investors and venture capital firms. For this reason, an unusually high percentage of its deposit base (estimated at 90%) consisted of uninsured deposits—accounts with more than the FDIC insured level of $250,000 per depositor.

In addition, in early 2022, SVB decided to take a gamble on investing in long-term government bonds, which had higher rates than short-term bonds at the time. Unfortunately, management did not foresee the steady rise in interest rates throughout 2022, which put downward pressure on the valuation of these long-term bonds. Moreover, SVB elected to account for these bonds as “hold to maturity” on their balance sheet, which meant that it did not have to disclose their declining market values to regulators, masking rapidly accelerating paper losses.

In 2023, as rates continued to rise, the tech firms that constituted SVB’s core clientele began to struggle, and drew down on their deposits. To avoid a liquidity crisis, SVB was forced to sell off its long term investments at a loss to provide the cash for these withdrawals. Eventually, SVB couldn’t hide its precarious state any longer, and a wider pool of depositors rapidly withdrew their deposits in fear that the bank was going to collapse, and they would lose all their funds on deposit at the bank.

“Let’s be clear, risk in business is not an inherently bad thing,” says Damion McIntosh, an expert in financial institution regulation and a senior lecturer in finance at Auburn University. “But untethered risk-taking is extremely dangerous, especially for a bank. When banks take risks without a formal and effective risk management framework in place that is also closely tied to a strong governance framework, that’s a recipe for disaster. It appears that’s exactly what’s happened here.”

McIntosh identifies five specific areas of risk that SVB missed, including:

• Funding risk;
• Mismatched risk;
• Interest rate risk;
• Funding liquidity risk; and
• Market liquidity risk

That’s a lot of missteps for one institution, but there are several takeaways from this sad story that we can all learn from.

Risk Management Requires Constant Effort

The typical community financial institution must maintain ongoing vigilance over a wide variety of risks.

Within lending operations, banks must assess and manage credit risk at the borrower level, collateral risk on secured loans, as well as interest rate, term and concentration risks at the portfolio level. The well-known “5 Cs of lending,” coupled with a prudent risk rating system and regular loan review processes provide a good starting point for assessing and mitigating risk within a lending portfolio. In addition, lenders should utilize a respected outside consulting firm for collateral valuations and environmental reviews, to protect their interests in the real estate collateral securing their loans.

Banking institutions must also assess interest rate risk within their investment portfolio, and ensure duration on the investment side properly lines up with their deposits. As we witnessed from the SVB fiasco, banks must ensure they have adequate liquidity to maintain trust, and handle a reasonable level of withdrawals from depositors.

All institutions should maintain sound asset and liability management processes and oversight to manage all the above risks effectively and ensure full compliance with regulatory requirements.

Risk is an unavoidable element of modern banking, and is the engine that drives profitability. But it must be managed properly to ensure success and sustainability over the long term. If you need help in planning or implementing your comprehensive risk management program, reach out to ORMS, your outsourced risk management experts.