Daniel Davies is a managing director at Frontline Analysts, the author of Lying for Money, and co-author of The Brompton.
If you think back to the Great Financial Crisis, one of the big things you’ll remember is that for the first time in living memory, major banks were subject to liquidity runs.
Banks like Northern Rock, HBOS and Dexia had gone too far out on a limb, funding long-dated assets out of short-term liabilities, and either requiring massive central bank bailouts or flaming out themselves. You might also remember that in the aftermath of that crisis, regulators assured us all that the rules had been changed to prevent that sort of thing.
So what’s happened with Silicon Valley Bank (and Silvergate) then? You’re going to laugh.
To a certain extent, of course, borrowing short to lend long is what banks are for. So the rules that were passed as part of the Third Basel Accords (“Basel III”) were never meant to outlaw the practice entirely, just put reasonable limits on it and say “come on folks, be sensible”. There were two dimensions of being sensible that were meant to be enforced, with two corresponding ratios. (Regulators think in ratios).
First is the “Liquidity Coverage Ratio”, which is meant to measure emergency funding capacity. In simple terms, it’s the ratio of the amount of “High Quality Liquid Assets” you have available, compared to a rough-and-ready estimate of the cash outflows you might experience over 30 days if your wholesale funding dried up and some (but not all) of your retail and corporate deposits ran. The ratio is meant to be above 100 per cent; it corresponds broadly to a thirty day “survival horizon”.
The second is the “Net Stable Funding Ratio” — also meant to be above 100 per cent in a good bank — which measures structural funding liquidity. It’s basically a ratio of the two sides of your balance sheet, after each side is adjusted for liquidity risk.
Assets are assigned weightings according to how easy they are to turn into cash. That means short-term Treasury bills get 100-per-cent weightings, while longer-dated corporate bonds get 50-per-cent weightings and loans get zero. Liabilities get weightings according to the likelihood that someone will want cash back immediately. So overnight repo is weighted at 100 per cent and retail deposits are 90 per cent. “Hot money” wealth management and corporate deposits only get a 50-per-cent weighting, and long-term bonds/deposits are zero. If the ratio of the first number to the second is above 100%, then broadly speaking, your long term and illiquid assets are matched by an equivalent amount of long-term and stable liabilities.
All of this sounds pretty sensible. So why didn’t this regulation prevent SVB from . . .
Oh.
That’s from SVB’s most recent 10-K. When the Fed implemented Basel III in October 2020, they took advantage of the fact that strictly speaking, the Basel Accords are only internationally agreed to apply to “large, internationally active” banks. While most jurisdictions apply the Basel rules to their entire banking system anyway, the US has a strong and powerful community bank lobby, and US community banks are usually quite aggressive in their use of the borrow-short/lend-long business model.
So the Fed adopted a rule under which only the very largest international banks were subject to the full Basel NSFR requirements (several of those large banks are actually holding companies for foreign institutions). It adopted a second tier, under which the ratio only had to be 85%, and a third tier where it was calibrated to 70%. And even then, the majority of US banks are not required to follow the NSFR or LCR standards at all.
Despite being the 16th largest bank in the US by balance-sheet size, SVB was apparently not subject to the “no more Dexias, no more HBOSes” regulation. The reason, as implied in the 10-K disclosure above, seems to be that a bank is only required to follow the NSFR and LCR rules if they have a certain amount of “short term wholesale funding”, and SVB’s liability side was dominated by deposits from corporate customers.
Of course, as we’re seeing now, the fact that a risk isn’t covered by a regulatory ratio doesn’t mean it doesn’t exist.
Although they grumbled and moaned back in the 2010s (NSFR compliance in particular was a big drag on European bank profitability), the European and UK banks basically managed to become compliant with the funding rules, which in many ways just codify sensible treasury management practices.
The fact that large domestic banks in the US are apparently allowed to run such sizable funding mismatches (and indeed, to hang around with massive unrealised losses on hold-to-maturity securities portfolios, which is perhaps a regulatory bedtime story for another day) is likely to be a source of embarrassment to the US authorities next time they visit the big Swiss tower.
