Silicon Valley Bank, Signature Bank, and Silvergate Bank: Responding to Market Disruption with a Stronger Compliance Program
Eight interest rate hikes take the tide out every time
Since March 2022 the Federal Reserve (the "Fed") has raised interest rates eight times, taking the federal funds rate up from nearly zero to a target of 4.5% to 4.75%. These increases brought the pace of inflation down, but price indexes continue to show inflation that is well above the Federal Reserve’s 2% target. The Fed has signaled that more increases are coming, with key questions being how many, how much, and when?
The rapid rise in interest rates has brought down the price of fixed income securities, including for highly rated instruments where the risk to principal is effectively zero. For example, as of March 10th, 2023 the S&P U.S. Government Bond Index was down 6.4% over the past 12 months.
Both Silvergate Bank and Silicon Valley Bank saw significant decreases in deposits in late 2022 and early 2023, forcing the sale of debt instruments that had declined in value due to the higher interest rate environment. As instruments that had been expected to be held to maturity were sold for losses, both banks experienced rapid degradation of investor capital.
Little by little, then all at once
Interest rate increases and banking withdrawals, and the subsequent losses from forced sales of fixed income securities, have been taking place for many months. In just the past week capital losses came to a head for Silvergate Bank, Silicon Valley Bank, and Signature Bank.
Silvergate and Signature were the two best known conduits in the U.S. for fiat money to enter and leave the cryptocurrency ecosystem. On Wednesday, March 8th Silvergate announced that it would wind down operations and liquidate its investments, and on Sunday, March 12th the New York State Department of Financial Services shuttered Signature. Decreases in cryptocurrency prices had driven withdrawals from both banks. Pairing leverage with unexpected correlations invariably causes trouble, and for Silvergate and Signature that trouble came from a volatile depositor base and a 425bp increase in interest rates.
Silicon Valley Bank is bigger than Silvergate and Signature combined, and its wind down will likely prove more complicated. For context, Silicon Valley Bank reported $209 billion in consolidated assets as of December 31, 2022, compared to $110 billion for Signature and $11 billion for Silvergate. Silicon Valley Bank was well known as a lender in the venture capital space, and its loan portfolio faces significant investment risk. On Sunday, March 12th the Treasury, Federal Reserve, and FDIC announced that Silicon Valley Bank would be wound down in a manner that protects all depositors. The wind down and protection of depositors for Signature was announced in the same press release.
The stakes are high
Dynamic market conditions can make it difficult to translate facts into insights, and to translate those insights into action. When new information is coming at a mile a minute, it can be difficult to decide where to focus first, but the decisions that compliance professionals make this week will have important implications for their firms, the clients that they serve, and the capital markets generally. U.S. Securities and Exchange Commission (SEC) Chair Gensler drove the importance of compliance home in a statement issued on Sunday, March 12th.
"In times of increased volatility and uncertainty, we at the SEC are particularly focused on monitoring for market stability and identifying and prosecuting any form of misconduct that might threaten investors, capital formation, or the markets more broadly. Without speaking to any individual entity or person, we will investigate and bring enforcement actions if we find violations of the federal securities laws."
Six focus areas
We recommend compliance professionals begin by evaluating how the following key focus areas (detailed below) relate to their firm.
- Investment Risk Management
- Counterparty Risk Management
- Implications for Venture Capital and Private Markets
- Implications for UK-based Financial Institutions
- Implications for Cryptocurrency Investors
1. Investment Risk Management
Risk models may become less useful during periods of market instability, particularly if assumptions about prevailing market conditions become less accurate over time. Changes in interest rates, market volatility, and liquidity may make assumptions that are built into risk models less appropriate, and the models’ sensitivity to those assumptions may not be apparent in the outputs.
Silvergate and Signature both demonstrate the need to pair investment risk management with investor risk management. Concentration from a single investor, or from a group of investors that exhibit highly correlated behavior, can have important implications for a firm’s investment risk appetite.
What can you do about investment risk management?
We suggest that compliance professionals consider four key sets of questions:
- Modeling: Work with risk management professionals to understand the assumptions that are built into your firm’s investment risk management models. Do those assumptions remain valid? How does the firm monitor for changes that might make those assumptions invalid? How does the firm measure and report on the model’s sensitivity to assumptions, including changes in sensitivity over time.
- Reporting & disclosure: How well do senior executives, investment professionals and investors understand the firm’s risk management framework? Are reports to senior executives and investment professionals comprehensive, clear, and current? Do disclosures to investors remain complete and accurate?
- Governance: Are lines of authority and responsibility around investment risk management clear and well-understood across all relevant stakeholders? Are there interpersonal dynamics or processes that will make decision-making more challenging at times when quick decision-making is most important? What can you do now to facilitate good decision-making during a period of potential future disruption?
- Liquidity: How well does the liquidity of your firm’s investment strategy match the liquidity of your capital base? Can hedge funds use gates and side pockets if needed? If a private equity investor missed a capital call, what would be the implications? Could the availability of leverage change unexpectedly, and what would be the implications if it did?
Silicon Valley Bank, Signature, and Silvergate all faced challenges that were made more difficult because certain assets were held at cost even as market values declined. Investment losses can bring heightened regulatory scrutiny, and a greater risk of litigation from investors, both of which are applied with the benefit of hindsight. Compliance professionals can help to protect their firms by ensuring that valuation policies and procedures are well-designed, fully disclosed, and executed consistently.
What can you do about valuation?
We suggest that compliance professionals review their firm's valuation practices, following the four steps below:
- Process and documentation: Review your firm’s valuation policies and procedures. Are they appropriate, particularly for any assets with valuation that requires subjective judgment? Do compliance and/or risk management professionals play an appropriate role in the valuation control environment? Test whether the application of the policies and procedures is consistently documented, including the retention of data inputs and workpapers needed to substantiate historical valuation decisions.
- Reflect current market conditions: Ensure that you understand any instances in which your firm is ascribing values that might not reflect current market conditions. This could include assets that are held at cost, assets that are fair valued, assets that are marked-to-model, particularly models with subjective inputs, and highly volatile derivative contracts.
- Disclosure: Assess whether the firm’s disclosures to clients and investors is complete and accurate.
- Robustness: Assess whether material changes in market dynamics could pose material challenges for the administration of the firm’s valuation policies and procedures, or make disclosures to investors inaccurate or incomplete.
3. Counterparty Risk Management
Depositors and investors are understandably concerned about the risk of contagion among U.S. banks following the FDIC’s decision to put Silicon Valley Bank and Signature Bank into receivership. The failure of these banks raises questions about the safety and availability of cash kept at these and other banks, as well as securities held in custody by bank-affiliated broker-dealers.
The Treasury, FDIC, and Federal Reserve have committed to backstopping all deposits at Silicon Valley Bank and Signature Bank, likely to send a signal to depositors that there is no need to move funds away from regional banks, even in accounts that exceed the traditional $250,000 FDIC insurance limit.
Potential disruptions to bank-affiliated broker-dealers raise more complex challenges for investment managers, as even temporary delays in the ability to trade or move securities could have significant negative implications. Bank-affiliated broker-dealers are statutorily required to maintain separate capital accounts, operations and executive teams. Notably, SVB Securities LLC illustrated this dynamic in its press release on March 11, 2023:
Since its acquisition in January 2019 by SVB Financial Group, the parent of Silicon Valley Bank, SVB Securities has maintained its financial and operational independence and has operated largely autonomously as a standalone subsidiary. The firm has a strong client base and solid financial position, with a healthy balance sheet, significant excess net regulatory capital, and no outstanding debt….. SVB Securities’ CEO Jeff Leerink said, “We understand that the receivership of Silicon Valley Bank has caused concern among our clients and stakeholders. We want to assure you that SVB Securities is financially stable and will continue to operate as usual…”
What can you do about counterparty risk?
Compliance professionals can help their firms take an appropriately cautious posture that reduces exposure to the potential failure of a counterparty.
- Identify and address single points of failure: Talk with traders about whether there are any counterparties where a disruption would be particularly problematic. Evaluate whether pooled vehicles have relationships with multiple custodians to hold cash and securities. For separately managed accounts with a single custodian, evaluate the soundness of each such custodian, and assess how difficult or disruptive it would be to transfer assets to a new custodian if the need arose.
- Systematically review counterparty-affiliate relationships: For custodians and key trading counterparties that have affiliates, evaluate the risks that those affiliates could pose. Broker-dealers with banking or other affiliations will be publishing guidance about their independence. Counterparties have strong incentives to represent that they are fully insulated from their affiliates, and it is up to compliance professionals to help their firms bring an appropriately critical lens to assess these claims. Compliance professionals should prioritize based on the importance of their custodians and trading counterparties, focusing most intensely and quickly on the most important counterparties.
4. Implications for Venture Capital and Broader Private Markets
The Federal Reserve, Treasury, and FDIC have committed to fully backstop all depositors in Silicon Valley Bank, significantly reducing the potential short-term damage that would be caused by corporate depositors suffering losses on deposits or experiencing even temporary limitations to their access of needed funds. Even though deposits are fully backstopped, the failure of Silicon Valley Bank could create some challenges for the timely completion of 2022 audits.
The longer-term implications of the failure of Silicon Valley Bank may be more significant. Silicon Valley Bank was a leader in providing venture capital financing, bringing both funding and experience to this segment of the market. Venture capital firms frequently benefitted from the investment research, valuation guidance, and connections that were made or facilitated by Silicon Valley Bank. Other banks operate in the same space as Silicon Valley Bank, but the loss of this key market participant may make venture capital investing more challenging and more expensive.
As the FDIC takes control of Silicon Valley Bank, the federal government will likely work to sell the bank’s loan portfolio. Market transactions in this higher interest rate environment could depress valuations.
What can you do in the Venture Capital and Private Markets space?
Compliance professionals who work for firms that are active in the venture capital or private markets space should consider the following:
- Talk to your auditor: Initiate a conversation with your auditor right away if your firm or its portfolio companies have exposure to Silicon Valley Bank. Fund-of-funds managers with a venture capital focus might have indirect exposure. For firms that have direct or indirect exposure to Silicon Valley Bank some disruption of 2022 audits is likely, but can be managed with proactive communication and collaboration with your auditor.
- Be careful about custody: If you must move client assets to a new custodian, be careful to avoid co-mingling. Account transfers should be done in ways that keep client assets segregated and fully accounted for. Reconciliation processes deserve special attention, and several sets of eyes when changing custodial relationships.
- Be prepared for new valuation inputs: Disposition of Silicon Valley Bank’s loan portfolio may create valuation datapoints that impact your firm’s valuation process. Start thinking now about how those datapoints will be captured and interpreted, and consider whether your firm’s written valuation policies and procedures are well positioned for the months and years to come.
5. Implications for UK-based Financial Institutions
On March 13th HSBC stepped in to acquire Silicon Valley Bank’s UK arm, which had served approximately 3,300 clients. Like in the U.S., Silicon Valley Bank’s UK operations focused on the start-up and venture capital segments. The sharp rise in interest rates has caused concern in the banking sector in the UK. However, early indications are that the immediate crisis in the UK has been averted, with praise given to the UK government for a quick response.
What can you do in the UK?
Given the newness of the relationship between HSBC and Silicon Valley Bank’s UK arm, compliance professionals should assess whether their firm faces material single-point-of-failure risks. If such risks exist, compliance professionals should help their firms monitor HSBC’s ability to provide support and evaluate opportunities to establish relationships with other service providers.
6. Implications for Cryptocurrency Investors
Stablecoins have historically played a key role in facilitating cryptocurrency investment activity, but stablecoin issuers appear to be subject to the same interest rate risks that created losses for Silicon Valley Bank, Signature, and Silvergate; token issuers that invest deposits in long-dated fixed income – even high quality long-dated fixed income – will see mark-to-market losses as interest rates rise.
Silvergate and Signature were two primary conduits in the U.S. for money to come into and out of the cryptocurrency ecosystem. With both conduits gone in less than one week, cryptocurrency exchanges and investors will likely look for other avenues to support capital flows. The elimination of two key fiat ramps may increase short-term volatility in this historically volatile sector.
More broadly, financial regulators are keenly focused on cryptocurrency. In an op-ed article published on March 9th SEC Chair Gary Gensler stated:
"Crypto entrepreneurs might claim, in their own marketing materials, that they’re transparent and regulated. But make no mistake: Very few, if any, are actually registered with the SEC and fully compliant with the federal securities laws.
As chair of the Securities and Exchange Commission, I have one goal with regard to the crypto markets: to ensure that investors and the markets receive all the protections that they would in any other securities market.
Crypto intermediaries should structure their businesses to comply with our laws governing securities exchanges, broker-dealers, and clearinghouses; they could put into place rulebooks that protect against fraud and manipulation. Crypto security issuers should file registration statements and make the required disclosures.
Of course, another tool in our toolbox is rooting out noncompliance through investigations and enforcement actions…. Crypto firms should do their work within the bounds of the law, or they shouldn’t do it at all."
Also on March 9th, the New York Attorney General filed suit against Kucoin for allegedly operating an unregistered broker-dealer. The suit is notable, in part, because it takes the position that ETH, the native token on the Ethereum blockchain, is a security. The Kucoin suit represents the first time that a regulator has taken the position in court that ETH is a security, but it is broadly consistent with the message from Chairman Gensler that many cryptocurrencies are securities, and that issuers and exchanges are subject to the Federal Securities Laws.
What can you do if you have exposure to cryptocurrency?
Compliance professionals whose firms have exposure to cryptocurrency should review how the failures of Silvergate and Signature may impact their firm’s ability to exchange cryptocurrency for fiat currency. Firms would be well served by presuming that cryptocurrencies are securities, and acting accordingly. Investment advisers with client assets in stablecoins should evaluate whether there is transparency around any collateral backing the coins, as well as the extent to which that collateral may be subject to mark-to-market losses because of rising interest rates.
The past week delivered significant and abrupt changes to the capital markets, including Silicon Valley Bank taking the ignominious title of being the second largest bank failure in U.S. history. Over the weekend the Federal Reserve, the Treasury, and the FDIC have taken steps to protect depositors and prevent contagion that could impact other regional banks. While those steps appear to have been effective in the near-term, the higher interest rate environment has the potential to create other challenging market dynamics. Compliance professionals should look at policies, procedures, risk management systems, organizational dynamics, and disclosures now – periods of disruption are when compliance programs are most important. With the tide going out, now is a great time to make sure that you have your bathing suit!
How we help
Compliance teams need continuous support and knowledge sharing to navigate market disruption and ensure it does not affect their firm's compliance program.
We help our clients manage regulatory compliance through our consulting, outsourcing, and technology solutions. Our services and solutions include standard and customized compliance packages and a variety of business advisory, technology, and training solutions for financial service firms.
Contact us if you have further questions about how the recent bank collapses can affect your firm, or how ACA can help you meet the challenges the collapses cause.