Liquidity Risk (Mis)Management: The Failure of Silicon Valley Bank and the Liability-Driven Investment Episode in UK Gilt Markets

Silicon Valley Bank (SVB) failed in March 2023.  Three prominent economists affiliated with the Golub Center discussed their ideas of what happened and what’s next immediately following SVB’s demise. Now former Golub Senior Fellow, Laura Kodres, discusses the similarities between what happened with British pension funds in autumn 2022 and SVB in a new article, Liquidity Risk (Mis)Management: The Failure of Silicon Valley Bank and the Liability-Driven Investment Episode in UK Gilt Markets.

May 2, 2023 | by Laura E. Kodres ^[1]

Two incidents roiled financial markets within six months of each other, both in countries with highly developed financial markets, well-respected central banks, and knowledgeable supervisors and regulators. What’s the story? How could these occur?

While a rise in government yields was the trigger, both incidents reinforce the importance of solid liquidity risk management. Liquidity risk comes in multiple guises—two of which are the focus of this piece—and, unfortunately, when it becomes systemic central banks feel obligated to intervene.

What happened (exactly) during these incidents?

In September 2022, the UK government put out a new fiscal plan that was poorly received by financial market participants, causing long-term gilt market yields to skyrocket and bond prices to plummet. The dramatically lower prices hit all those who had posted collateral in long-term gilts for either repurchase agreements (repos) or for other (mostly OTC) derivative positions. Counterparties (mostly banks) to these repo and derivative positions instantly asked for more cash or collateral to hold onto these positions and threatened to sell the existing collateral if they did not receive it. The prospect of fire sales in one of the most liquid global government markets forced the Bank of England to react by re-activating its Asset Purchase Facility, extending it to include inflation-linked gilts, and initiating another facility (the Temporary Expanded Collateral Repo Facility, the TECRF) to provide repo financing against gilts and corporate bonds so as to provide the cash liquidity needed by the UK defined benefit pension schemes. Using repos and derivatives to hedge long-term interest rate risk and inflation risks comes with liquidity risks that were not well-anticipated by bank counterparties, pension scheme advisors, and the pension fund trustees.

In early March 2023, Silicon Valley Bank (SVB) attempted to raise new capital to shore up its balance sheet following the crystallization of a loss from the sale of some of their long-term bonds. This brought to light their relatively heavy investment in long-term US Treasuries and Agencies, which were now clearly under water given the rise in US yields. Alerted about SVB’s weakness, clients of the bank attempted to withdraw their deposits. This precipitated a run on the bank, as reportedly more than 90 percent of its depositors’ accounts exceeded the per depositor insurance limit of $250,000. The extreme maturity mismatch between the holdings of long-term bonds and a short-term, unstable, deposit funding base was left unhedged by the bank’s management and it is unclear whether they performed an in-house solvency or liquidity stress test. Bank supervisors (apparently) failed to influence the bank’s poor risk management practices in light of its large maturity mismatches. The Fed acted quickly into provide liquidity support for all banks with a new facility (the Bank Term Funding Program, or BTFP) for fear of a contagious spread of bank runs due to a widespread re-examination of the unrealized losses on long-term bond portfolios of other banks.   

Both incidents occurred against the backdrop of a rapid rise in interest rates related to their respective central banks’ attempts to bring inflation rates back to their targets. Some commentators have pointed fingers at the Fed and Bank of England, suggesting their policies were implemented too quickly and without due regard for financial stability. But the deeper issue is that of risk management by regulated financial institutions. Both incidents showed how inattention to good risk management practices can cause perceptions (or the reality) of solvency risks to quickly morph into extreme liquidity events. A lesson that should have been learned at least during the Global Financial Crisis if not before.

What were the risk management failings?

In the UK, defined benefit pension schemes have been moving into Liability-Driven Investment (LDI) strategies on advice from a set of financial institution advisors (some of whom are not within the perimeter of regulation). These LDI strategies are, at their most basic level, meant to match the risk sensitivity of the value of liabilities owed to future pension retirees with the those of the assets on which they depend. This can be done by matching cash flows of fixed-income assets with those of the liabilities or by using derivatives to hedge various risks. However, because UK pension schemes had been underfunded for the duration of the low-interest rate environment, some of these strategies entailed not merely matching cash flows or hedging risks, but leveraging up with repos, based on their massive holdings of long-dated gilts, to invest in higher-returning assets. Repo collateral is mark-to-market and requires constant liquidity management. Other LDI strategies using long-dated interest rate and inflation swaps, which were likely risk reducing, also involved careful liquidity management of cash and collateral for initial (and variation) margin requirements.[1] During the time frame in which collateral and margin calls were required, pension schemes were “solvent” in the sense that they had sufficient gilts to post or supply, but they were not operationally set up to move them in short order. Ultimately, there was no need for panic, but heightened volatility in gilt markets, the counterparties’ insistence on the satisfaction of collateral calls, and the potential for consequent fire sales led to emergency liquidity support by the Bank of England. The LDI advisors and their repo and derivative counterparties did not properly anticipate their liquidity hedging needs and their ability to refresh the liquidity buffers in a timely manner.[2]

In the United States, the situation of SVB bank was one of heightened bank insolvency risks leading to illiquidity. It may be that the bank was already insolvent, since at the time of the deposit run, regulators were attempting to find a buyer. Handled differently, a run (and its knock-on effects) could probably have been avoided. Still, it is unclear why the bank’s management waited so long before attempting to raise new capital, even though (admittedly) that capital would have been expensive. At least they could have saved the bank’s “reputational” capital (its “charter value”). Or why they didn’t hedge the long-term interest rate risks of the portfolio using derivatives since policy rate increases were signaled many months before and rates had been rising for quite some time. If executed early, a hedge would have cost a fraction of the value of the bond portfolio. Or why they didn’t attempt to balance their flighty deposits with more stable funding earlier.[3] In addition to the credit risk of its borrowers, well-run banks spend significant resources to manage their maturity and liquidity mismatches between assets and liabilities as these are the fundamental risks of any bank. Indeed, stress tests of these risks (without being required by supervisors), and adjusting to the results, is a normal component of good risk management. SVB’s management did not properly anticipate how its inattention to managing (and potentially hedging) interest rate risk could affect its solvency and hence its liquidity.

Bottom lines

The risk management practices of UK bank counterparties, pension scheme advisors and the pension scheme trustees, and that of senior management of the Silicon Valley Bank were simply not up to snuff. Both needed to pay closer attention the basics of maturity and liquidity mismatches and, given their vast holdings of fixed-rate debt securities, their largest market risk —interest rates. There can be significant associated liquidity risks of hedging (in the UK pension scheme case) or not hedging (in the SVB case) that require constant and consistent attention.

Although individual financial institutions are responsible for their own risk management, they are not tasked with anticipating their impact on others—systemic risk. There are equally disturbing questions about why supervisors and regulators did not see these two events coming. In the UK, while many of the pension scheme advisors are not within the perimeter of regulation, their bank counterparties are. And while SVB was not among the largest, systemically important US banks and subject to heightened supervision and additional capital and liquidity standards, it was still under the watchful eye of several bank supervisory agencies. The knock-on effects of concentration risks, the interaction between solvency and liquidity risk, and the interconnections (both actual and perceived) across banks and non-banks is explicitly part of systemic risk management—the purview of central banks, regulators and supervisors. Lastly, there is an (age-old) question about how quickly, how often, for which institutions, and how much of the central bank’s balance sheet should be used to provide liquidity support in cases similar to these two recent episodes.

[1] Initial margin is a small proportion of the value of the contract and as meant to provide a “performance bond” to assure the counterparty that their client is serious about maintaining a position. Variation margin is paid (or received) frequently (often daily) based on the losses (or profits) of the position through time.

[2] For further explanation of the risks and potential policy solutions see Kodres (2023), "Too Many Cooks, Not Enough Risk Management: Gilt Market Dysfunction and Liability-Driven Investment (LDI).”

[3] Apparently, SBV had plans, along with the sale of bonds and simultaneous raising of more capital, to lengthen the maturity of its funding structure.