Why almost everyone failed to predict Silicon Valley Bank's collapse

CNN New York --

Few people outside of the tech industry knew of Silicon Valley Bank two weeks ago. It was a mid-sized California lender. The rapid implosion of Silicon Valley Bank would shake the foundations of the global financial system.

Then, Friday morning, March 10, after clients drew $42 million in a matter of hours, federal and state regulators intervened to save what little of SVB.

Silicon Valley Bank was a household name in the hours that followed, but not in the way its founders would have hoped. It was the second-largest US bank failure, behind Washington Mutual in 2008.

As regulators and analysts began to comb through the debris, several red flags were raised. Surprisingly, SVB's vulnerabilities weren't very complicated. This was not 2008, when obscure products in the middle of a complex Wall Street derivatives market proved to be worthless, and ended up ruining the US housing market.

SVB's autopsy revealed clear signs of corporate mismanagement. This, when combined with customer panic, proved to be a serious flaw.

Why didn't anyone anticipate SVB's fall? This is likely to be the central question that lawmakers will ask next week at Capitol Hill's back-to-back House-Senate hearings about the bank's collapse.

For now, the unsatisfying truth is that nobody knows, or at least not anyone who is willing to tell it loudly. It is clear that SVB's failures are not due to any single person, system or asset. Instead, they are a result of a multitude of missed warning bells.

There are many red flags

SVB was founded in 1983 and became a symbol of status among wealthy Bay Area individuals and businesses. It was a financial institution that served a global community of venture capitalists, who are known for their extraordinary wealth and their willingness to take on risk. SVB was an elite club. To embrace the unique Silicon Valley ethos of boldness, growth, and disruption.

SVB's assets almost quadrupled between 2018 and 2021, much like the start-up clients it attracted. With $209 billion in assets, it was the 16th largest bank in the country by 2022. This should have been enough to raise alarm bells.

Red flag No. 1: Breakneck growth

There are red flags everywhere when banks grow rapidly, says Dennis M. Kelleher CEO of Better Markets. This is because banks' compliance systems and management capacity are not always up to the mark.

According to the Wall Street Journal, and the New York Times, the Federal Reserve had warned SVB about its inadequate risk-management system in 2019 - four years prior to the bank's collapse. It is not known if the Fed, SVB’s primary federal regulator, responded to that warning. The central bank is currently reviewing its supervision of SVB.

Fed Chairman Jerome Powell stated that his only interest was to identify the root causes of the problems. "We will find out, then we'll assess what policies are needed to prevent it from happening again," Powell said.

2: Hot money

According to Wedbush Securities data, 97% of SVB's deposits are uninsured.

Kairong Xiao from Columbia Business School said that US banks typically finance 30% of their balances with uninsured deposits. He said that SVB's was "a crazy amount."

Crazy because you can withdraw your money quickly if you suspect that the bank is in trouble.

SVB's excessive reliance on these deposits led to its instability. The panic spread quickly after a few of the bank's close-knit clients started to worry about its viability.

Red flag No.

Silicon Valley Bank was well-known for its support of young start-ups in tech. SVB was there to support these start-ups as they grew. SVB also managed the personal wealth and capital of these founders. Their fortunes were often tied to equity in their businesses, so they were often short on cash.

It was geographically concentrated. Kelleher stated that it was concentrated in an industry segment, which was very sensitive to interest rates. "Those three red flags should have prompted the bank's directors and officers to take corrective actions," Kelleher said.

Red flag No. 4: Risk management 101

Even if one had only looked at Silicon Valley Bank's financial situation a month ago, they would not have been alarmed.

John Sedunov, professor at Villanova University, said that 'the bank would have appeared to be healthy, if they look at their capital situation, liquidity ratios...they'd've been fine. "Those traditional big-picture items, the top stories...they should have been fine.

Sedunov stated that the ticking time bombs were one layer deeper in the construction of bank's liabilities and portfolio.

Silicon Valley Bank had a remarkable 55 percent of its customers' long-dated Treasuries deposits. These bonds are generally extremely safe assets and SVB wasn't the only one to load up on bonds during an era of near zero interest rates.

However, the market value of these bonds decreases as interest rates rise.

A bank will typically hedge its interest rate risk by using financial instruments called Swaps. This means that it exchanges a fixed rate for a floating interest rate over a time period to reduce its exposure to rising rates.

SVB seems to have no hedges on its bond portfolio.

Sedunov stated, "Frankly managing your interest rate risk exposure -- this is one of the first things I teach an undergraduate bank class,". It's the stuff of textbooks.

Red flag No. 5: The missing CRO

The Fed has increased interest rates at an unprecedented rate in modern times over the past year. Silicon Valley Bank operated for the majority of the year with a huge vacancy in its corporate leadership: a chief risks officer.

Art Wilmarth, a George Washington University professor of law and expert on financial regulation, said that 'not having a Chief Risk Officer is kind of like having a Chief Operating Officer or a Chief Auditing Officer'. Every bank with this size must have a risk management board. The CRO is the number one person who reports to that committee. The CRO is the No. 1 person that reports to this committee.

Wilmarth stated that it was a'surprising' for a chief risk officers to be absent for eight consecutive months like SVB's.

The theory is that a CRO could have identified the extreme risk of the bank’s long-dated bonds dwindling in value, which together with the large deposit risk, would warrant a course correction.

Even without a CRO there is no excuse for SVB to not have any apparent hedges in its bond portfolio.

CNN spoke with several experts who said that it was likely that SVB employees knew of the risks, but ignored them. The bank was capitalized. It was profitable. It was profitable.

Sedunov stated, "I'm certain someone saw it, and I'm sure somebody let it slip." "Because, again," Sedunov said, "Because if you're in compliance a lot of big-picture stuff, maybe they figured, well they can survive something... What's the likelihood that your withdrawals will total $40 billion all at once?