21 March 2023

Opening remarks by Andrea Enria, Chair of the Supervisory Board of the ECB on the failure of Silicon Valley Bank and its implications

The failure of some mid-sized US institutions earlier this month reminds us that specific features of a bank’s business model can make its balance sheet particularly vulnerable to interest rate risk. In extreme cases, this can turn rising interest rates from a boost to profits into an existential threat.

Monitoring the euro area banking sector in the aftermath of the March 2023 US bank failures

..,In this context, the case of Silicon Valley Bank is particularly illuminating. The institution concentrated both its lending activities and its deposit-taking activities among venture capital firms, fintechs and start-ups. More than 80% of its deposit base consisted of uninsured corporate deposits, which tend to be more mobile than other deposit types. Most of the bank’s assets consisted of fixed income securities, which typically lose value when interest rates rise. As deposit outflows started mounting, Silicon Valley Bank liquidated fixed income securities at a loss, further exacerbating the run on its deposits and the strain on its liquidity. This happened in a US regulatory context where mid-sized banks, like Silicon Valley Bank, are exempted from, or treated preferentially under, relevant prudential standards such as liquidity requirements − the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) − and capital requirements; such banks are subject to less frequent stress tests than larger ones and they can be allowed not to reflect in their regulatory capital the unrealised losses on securities held in the balance sheet as “available for sale”.

The episodes under consideration have been contained also by the prompt and forceful intervention of the US authorities, which have (i) committed to protect all uninsured deposits of the banks involved, under what is known as the “systemic risk exception”; and (ii) set up a central bank liquidity facility accepting from banks fixed income securities valued at par.

There is no direct read-across of the US events to euro area significant banks. First and foremost, this is because the banks we supervise do not exhibit the outlier features of extreme interest rate risk and predominant reliance on a concentrated, uninsured deposit base – what might be termed the “SVB business model”. Our banks generally operate with a more diversified customer base. Although uninsured deposits are an important source of funding in the euro area as well, they tend to be more relevant for business models which are well diversified on both the asset side and the liability side, including their depositor base. Importantly, all our banks are subject to LCR and NSFR requirements. Liquidity coverage ratios have only decreased marginally since the monetary policy normalisation process began, and they averaged in excess of 160% towards the end of last year. More than half of the existing buffers of highly liquid assets are made up of cash and central bank reserves, which sensibly mitigates the risk of mark-to-market losses when liquidity needs arise. In fact, recent data indicate that those banks that have experienced some deposit outflows appear to have succeeded in maintaining their levels of excess liquidity. They have done so mostly by issuing debt securities and reducing interbank lending, and only to a minimal extent by liquidating securities. The sector’s overall liquidity resilience also results from the overhaul of the regulatory framework implemented in the aftermath of the global financial crisis and the choice, made by the European Union, to apply the international standards to all the banks operating in its jurisdiction.

We are well aware that the ongoing, fast-paced normalisation of monetary policy conditions is increasing our banks’ exposure to interest rate risk. We started assessing interest rate risk and credit spread risk as early as the second half of 2021, when the first signs of inflationary pressure emerged, and in 2022 we included those risks in our supervisory priorities. Last year, we repeatedly measured the sector’s response to standard 200 basis point shocks to interest rates, highlighting that the net effect on bank profitability and capital is expected to remain positive under baseline macroeconomic scenarios. The boost interest margins give to net interest income has a positive impact on banks’ earnings capacity. The effect of this is expected to outweigh the costs associated with worsening asset quality, as borrowers find it more difficult to pay back their loans. At the same time, we also reviewed the interest rate and credit spread risk management practices of the most exposed banks and instructed them to improve the way they monitor and manage the negative impact that rising rates typically have on their economic value of equity, i.e. the net present value of their balance sheet. When interest rates rise, the economic value of equity falls due, among other factors, to the reduction in value of fixed income securities, including sovereign debt securities. This happens irrespective of whether banks measure the value of such securities at amortised cost or at market prices for reporting purposes. If not appropriately managed and hedged, unrealised losses on securities that banks hold at amortised cost might become a concern, particularly because investors and sophisticated depositors tend to focus on market values when their level of confidence dwindles on the back of changes in fundamentals or even mere rumours....

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