Would European regulation have helped the American Silicon Valley Bank?

After the financial crisis, European banking sector regulation has increased at an almost overwhelming rate. To a large extent, the regulatory objectives have been justified, and much good has been accomplished. On 10 March, the crisis preparedness of EU banks became a hot topic after the US-based Silicon Valley Bank (SVB) collapsed and was seized by the authorities. The European sector has taken many measures to prepare against potential problems in individual banks. In this article, I will examine how and why the SVB’s case did not uncover any real shortcomings or gaps in European regulation.

Headquartered in Silicon Valley, California, SVB was a commercial bank which mainly catered to venture-backed tech startups. It collected deposits and also provided some lending. This lending enabled a business to make investments even before it drew down capital from its investors. Due to the Fed’s loose monetary policy and the federal government’s relief programs, SVB’s customers acquired an exceptional amount of investments. This, in turn, caused a flow of deposits that was perhaps too great for the bank’s capacity to expand its loan origination operations, so the bank had to invest the deposits into fairly conservative and safe instruments, such as government bonds.

In 2022, the Fed’s key interest rate hikes reduced the value of these fixed-rate investments and caused unrealised losses on SVB’s portfolio. At the same time, SVB’s customers began to withdraw their deposits at a faster rate than SVB had new deposits coming in, forcing the bank to start selling its investments at a loss. At this point, the unrealised losses had unfortunately grown so large that the capital investors who advised the depositor businesses saw it best to recommend that their clients withdraw their deposits from the bank.

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Depositors panicked and rushed to withdraw their money.
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The bank run drained the bank’s liquid assets, forcing bank authorities to step in. The federal government promised to protect the deposits for their full amount, also where they exceeded the normal limits of deposit guarantee. Although the bank auditor had found SVB in “sound financial condition” prior to 9 March, the bank collapsed in less than 48 hours.

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How would the crisis have been resolved in Finland
under the current regulation and supervision regime?
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The crisis resilience of EU banks is regularly submitted to stress testing by banking authorities. A reverse stress test, which starts with the failure of a bank, could well have revealed SVB’s weaknesses before they escalated.

EU regulation also obligates the bank auditor and the supervisory authority to exchange information. Depending on who spotted it first, either the supervisor or the auditor would probably have brought the matter to the other’s attention. Stress tests and audits could thus have brought the bank’s weaknesses to light and prevented the problems from catching everyone by surprise. Whether the supervisor and auditor were fully unprepared for difficulties is impossible to say. What may have come as a surprise was that a third party would start to stir up panic – as the capital investors did in this case.

But what triggered this panic that eventually led to the bank’s collapse?

Discerning eyes were perhaps drawn to the bank’s balance sheet, which indicated that its investments included some $15 billion in unrealised losses. If the bank is forced to sell the investments, these losses are recognised in the bank’s own funds. As it happens, this amount was nearly equal to the bank’s capital buffer. Losing this capital would cause the bank to fail. The capital investors and the bank’s customers probably deemed it best to withdraw their funds before the bank collapsed. This caused an acute liquidity crisis.

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Losses became realised as the bank’s liquidity plummeted,
and it had to liquidate its investments.
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Would the sale of investments have been necessary in Finland? Here the level of liquidity and interest rate risks are strictly supervised and regulated by the supervisory authorities. It is currently unclear why SVB did not sufficiently acknowledge or prepare against the interest rate risk.

Finnish banks typically seek adequate maturities in their funding. This largely prevents the particular kinds of massive bank runs as the one encountered in SVB. Another helpful factor is that the deposits held by Finns typically fall in the scope of the deposit guarantee scheme, which mitigates the appeal of large-scale withdrawals: the funds are already protected. Lastly, all Finnish banks have recovery plans which can be activated to support their recovery from a crisis. Combined, these mechanisms would have given a Finnish bank more time to acquire liquid assets and thus avoid the compulsory sale of investments.

In Finland, SVB would have been included in the scope of the crisis resolution mechanism. If the bank’s recovery plan was found insufficient, a resolution plan prepared in advance would have been put into action. The resolution plan would have determined the appropriate line of action for prompt restructuring of the bank if it seemed failing or likely to fail. Once the bank had been put under resolution, its losses would have been covered from its own funds and the bank would have been recapitalised with recapitalisation capital (i.e. MREL instruments).

In the end, what brought SVB down was the panic that spread among its customers, who feared the bank would need to sell all of its investments and suffer losses that would erase practically all of its own funds. This scenario is highly unlikely in the Finnish regulatory environment, so there would have been no need to panic or make a run on deposits.

If despite all safeguards panic did ensue, the authorities would have put their predetermined resolution plans into action and seized the bank. This would usually be done right before the weekend, during which the bank would be restructured and then reopened for business again on Monday. The success of these measures would be bolstered by the recapitalisation capital that the bank had accumulated in its balance sheet. If need be, the EU Single Resolution Fund would have offered its support in the process. Taxpayer money would not have been needed, probably not even the deposit guarantee fund. Regular customers might not even have been aware of the situation. This is the way EU regulation has been designed.

In conclusion, the regulation and supervision that Finnish banks are subject to should have worked in several ways to prevent the widespread panic. At least based on this case there is no need to amend our existing banking regulation.