In one year, Silicon Valley Bank went from having more than $15 billion of interest rate hedges on its balance sheet to less than $600 million.
In the wake of the Santa Clara, California, bank's failure — which was driven, in part, by its unhedged interest rate risk — some are asking whether regulators should have allowed Silicon Valley to offload those assets at a time when interest rates were on the rise.
"Imagine if, in March 2023, Silicon Valley Bank had $15 billion of its [available-for-sale] portfolio hedged," said Dennis Kelleher, head of the consumer advocacy group Better Markets. "It likely wouldn't fail, there would have been no loss, there would be no crash."
At the end of 2021, the bank was holding $15.26 billion of interest rate swap contracts, according to its year-end financial report. In the first quarter of 2022, it sold $5 billion of swaps along with their related securities and in July it sold another $6 billion of swaps, though it did not specify if the related securities were sold, too.
Kelleher and others say the Federal Reserve, Silicon Valley Bank's primary federal regulator, should have intervened to prevent the bank from selling its hedges, especially considering the central bank's supervisors had been flagging issues related to risk management and corporate governance at the bank since late 2021.
"You are not running a consulting operation. You are running a regulatory operation who can force banks to follow that advice," Rep. Brad Sherman, D-Calif., told Fed Vice Chair for Supervision Michael Barr during
During the hearing, Barr fielded criticism from both sides of the aisle. Rep. Blaine Luetkemeyer, R-Mo., pressed him on why the Fed's actions against Silicon Valley Bank
"That's a question for our review," said Barr, who is leading an internal investigation into the factors that contributed to Silicon Valley Bank's failure. "We don't know, I don't yet know the answer. Could the staff have escalated more? Should they have done more? What were the interactions with the bank? That's all part of the supervisory record that will be in the May 1 report."
A review of Silicon Valley Bank's quarterly earnings reports and analyst calls from the past two years shows that the bank's executives were not treating their substantial exposure to long-dated, low-interest-rate bonds as an existential threat while they were offloading swaps.
After the initial sale in the first quarter of 2022, which would have occurred around the time of the Fed's first interest rate hike, Silicon Valley Bank Chief Financial Officer Daniel Beck cast the move as opportunistic and a chance to access liquidity.
"So, if we think about the hedging strategy and just being able to provide optionality to be able to execute and to gain access to liquidity, that's why we have such a large securities book to begin with," Beck told analysts on April 25.
He added that it would be prudent to keep some protections on its books but that wouldn't prevent the bank executing more sales.
"Keeping some of that protection there really makes sense for us. So, we'll keep an eye on what happens from a rate perspective," he said. "If rates start to move, we may be opportunistic. But no plans right in front of us right now."
Its next move — selling down the remainder of its hedges — came roughly three months later, after the Fed implemented the first of what would be four straight 75-basis-point hikes. During the following earnings call, Beck made no mention of the swap sales but praised the construction of the bank's balance sheet as a source of strength.
"We've got a lot of flexibility with the portfolio. At the same time, we're always considering ways to optimize the balance sheet," he said. "We've got a considerable available-for-sale portfolio, and we've demonstrated that we've been opportunistic with sales like that in the past."
Interest rate swaps are a type of derivative designed to insulate bond portfolios from changes to rates. Typically, one party in the contract pays the other a fixed interest rate while the other, in turn, pays a floating rate. These arrangements typically do not result in additional funding for the institutions, but rather are meant to keep a bank's asset funding in line with its liability costs in a changing rate environment.
In the case of Silicon Valley Bank, it was paying fixed rates and receiving variable ones. The swaps on its balance sheet would have offset at least some of its net interest margin declines. But, instead of collecting those interest payments from the swaps overtime, it opted to sell them at their elevated valuations to crystallize gains. In total, it reported more than $500 million of profits from swap sales in 2022, according to its third quarter earnings presentation.
The move to shed swaps last year amounted to a quick about-face on interest rate management for Silicon Valley Bank. During its first-quarter earnings call in 2021, Beck told analysts the bank was gearing up for a rising rate environment by adding hedges and pledging to cut the average duration on its available-for-sale securities "in half here pretty quickly."
"So in the quarter, we put on close to $10 billion worth of swaps on that available-for-sale portfolio," he said. "And we're going to continue to do more to protect against that, to mitigate the impact of potential further rate movement."
During its final earnings presentation in January of this year, then-CEO Greg Becker said Silicon Valley Bank was caught off guard by the Fed's rapid changes to interest rates. He said the bank was working on addressing issues on the liability side of its balance sheet, where costs for keeping deposits were outpacing the returns coming from its long-dated securities.
"We saw such a rapid increase in rates, which we've never seen before. And that's what kind of made the biggest change, in addition to this kind of construction of the balance sheet. Those two things caused it to be kind of out of historical norm," Becker said. "And it's going to take a little while for us to get back to that place where we can eventually get back to a base level, although a less level of asset sensitivity."
As part of the bank's failure earlier this month, all of the executives were fired.
Silicon Valley Bancshares, the former parent company of the failed bank, did not respond to a request for comment this week.
Interest rate risks were also raised as an issue last fall, Barr said, but he noted that the onus for managing that type of risk is one that falls on all banks.
"Interest rate risk management is a core, bread-and-butter issue in banking," Barr told lawmakers Wednesday. "It's not an esoteric issue, an exotic issue, a complicated issue. It's a straightforward issue and the bank management failed to do that here."
Kelleher said the Fed should have been able to block the derivatives sales under the Volcker Rule provision of the Dodd-Frank Act, which prohibits banks from engaging in certain types of proprietary trading activities. However, he said, changes to the rule implemented under then-Vice Chair Randal Quarles in 2019 and 2020 made it more difficult for the Fed to intervene on these types of transactions.
"People are trying to say this is a failure of supervision. It's not. The San Francisco Fed supervisors were set up to fail by the leadership in Washington, [Fed Chair Jerome] Powell and Randy Quarles, who had spent five years gutting and disempowering supervision," Kelleher said. "Supervision can work and has worked, but it won't work when the senior leadership of the Fed is working overtime to tie their hands, tie the hands of supervisors and gut supervision."
Short of invoking the Volcker Rule, the Fed has several tools for compelling banks to stop certain activities. These include cease-and-desist orders, written agreements, prompt corrective action directives, removal and prohibition orders and orders assessing civil money penalties. It is unclear which — if any — of these options were considered or used against Silicon Valley Bank.
In addition to changing certain regulatory policies, Quarles also oversaw a reworking of oversight practices. Under his leadership, the Fed established more explicit standards for when supervisors can take certain actions, effectively removing some of the broad discretion granted to them under Dodd-Frank. The goal of those changes was to establish more of a formal due process for supervisory actions.
Critics of those changes say they established a light-touch approach to bank examination that allowed the issues that ultimately toppled Silicon Valley Bank to proliferate.
Others say the Quarles era changes had little effect on the Fed's ability to prevent a bank from taking on the types of risks Silicon Valley Bank did. Norbert Michel, director of the Cato Institute's Center for Monetary and Financial Alternatives, said the Fed still has the ability to prevent banks — especially those with outstanding supervisory issues — from engaging in certain activities.
"The question is, why did you let them sell and allow them to have more of an unexposed interest rate risk? It has nothing to do with Volcker," Michel said. "They could have stopped them from doing that, plain and simple."
The episode, Michel said, speaks to the limitations of bank supervision overall. As long as banks are allowed to take risks, he said, the current system requires supervisors to have perfect foresight about which banks and activities will prove to be too risky.
"This is exactly why you don't identify 'too big to fail' banks and why you don't identify overall stability as your goal," Michel said.
