Silicon Valley Bank crisis: the accounting game
Thoughts around the SVB, Silvergate and Signature Bank crisis:
First of all, SVB is a US bank. As a bank, two relevant features need to be addressed: the banking license, which allows banks to take deposits from deposit holders and fractional ownership regulation, which allow banks to maintain a minimum reserve ratio, enabling maturity transformation by investing the funds raised in different asset-side operations (loans, mortgages, among others).
As banks’ performance can affect financial stability, they are subjected to a very strict regulation held by regulatory and supervisory authorities to ensure that capital and liquidity reserves can protect deposit holders from the different risks that banks assume, as well as other obligations (compliance, customer protection).
In the case of SVB, a 200 Bn size bank, very verticalized in the VC tech sector, the maturity transformation was primarily driven by the holding of deposits from startups and high net worth individuals (with deposits larger than FDIC insured 250k USD), and invested in Treasury Bonds.
Accounting rationale:
From an accounting perspective, fixed-income instruments can be classified in two categories called HTM (Held To Maturity) or AFS (Available For Sale). IFRS 9, accounting standard that regulates financial instruments, defines both as:
- HTM: only if two conditions are met:
- 1) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows; and
- 2) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
- In this category, assets are valued at amortized cost, meaning that the instruments are registered by the acquisition price, and don’t need to be marked-to-marketed through an impairment test until the sale. If they are not sold, the result (gain or loss) is not registered in P&L.
- AFS: for the sake of simplicity, it can be assumed that those instruments that do not meet previous requirements need to be classified in this category. In this case, assets are valued at fair value, so volatility is captured in P&L.
Regulatory consequences:
In the current situation, all the liquidity generated by VCs and startups was deposited in SVB, which invested those deposits in Treasury Bonds. In order to avoid volatility, the assets were classified as HTM.
- Interest rates: the continuous increase due to inflation led to unrealised losses in Treasury bonds acquired by SVB, because the existing Treasury bonds could be sold in the secondary market to acquire new Treasury bonds that were issued with a higher IRR. Therefore, impairment tests, that are performed in the AFS assets on a continuous basis to reflect correct pricing, were not performed in the HTM assets.
- Solvency: SVB solvency ratio was hidden, since the P&L in case of potential T-Bonds sale would impact CET1 ratio, leading to a own funds level below the regulatory triggers (banks are usually required 4.5% CET Pillar 1 + add-on Pillar 2 + other requirements, such as capital buffers and TLAC in some cases, leading to 20% CET1 requirements in some cases).
- Liquidity: additionally, the liquidity requirements from startups, which were not accessing the same funding support in the last quarters, led to deposit withdrawals. This effect, along with the non-coverage from FDIC for HNWI, accelerated the bank run, generating a negative pressure on the LCR (Liquidity Coverage Ratio, which measures the HQLA level that a bank holds in a stress-period for the following 30 days).
The liquidity measures, primarily selling T-Bonds portfolio, could not be activated without recognizing all the losses that the HTM portfolio contained, leading to a solvency crisis. So either SVB assumed a liquidity crisis, due to outflows (corporate and retail deposit holders) that would generate a HQLA reduction — cash as L1 level asset is taken out of the bank or L2A T-Bonds need to perform the impairment test — , or SVB assumes, as it has happened, a solvency crisis due to T-Bonds sale.
In this case, the resolution regulation should have been able to ensure that all the losses generated by the SVB were covered by SVB and the rest of the banking sector themselves, through bail-in mechanisms, but due to policy considerations — too big to fail, systemic risk, presumably — bailout mechanism are put in place by Federal Reserve.
Conclusions:
Even though the SVB crisis has affected crypto through USDC depeg, what we can learn from it is that this is NOT a crypto crisis, nor has been articulated by a web3 actor, but through an accounting mechanism that hasn’t been correclty supervised by the banking supervisory authorities.
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