The March 2023 collapse of California’s Silicon Valley Bank (SVB) — the second-largest bank failure in US history — shook the global financial system. In the post-mortem of SVB, several risk (mis)management red flags have emerged. Although its vulnerabilities were not as complex as those that ravaged the US housing market (leading to the global financial crisis and the Great Recession), SVB’s failure is in some ways reminiscent of the 2008 subprime mortgage crisis. In both cases, a huge part of the problem was a failure to recognize the possibility that there was a financial contagion cooking in the financial jungle. Like the beginnings of a pandemic that are not recognized, once the contagion starts to take hold, it is just too late.
Amid the 2008 debacle, I offered some insight into how ineffective risk-mitigation efforts contributed to the financial contagion that spread across the globe. Given this latest banking crisis, it might be useful to revisit some of those ideas because, as Yogi Berra said, it feels like “déjà vu all over again.” This Advisor reintroduces five risk management principles that could prove helpful in future messy situations.
1. Know Your Risks Before You Act
A Charette risk maxim is, “Risk ignorance begets risk arrogance.” Back in 2008, the risks embedded in the subprime mess were not understood — even though some very smart financial and government people thought they were. Not only was there ignorance of the risks in individual financial sectors but across financial sectors. (More about how clueless most in the financial industry were to those risks can be found here.) In the SVB case, risk management was not even a concern, as the chief risk officer position was left vacant for months. As Michael Barr, the Federal Reserve’s vice chair for supervision put it, “SVB’s failure is a textbook case of [risk] mismanagement.”
2. Understand Your Risk Context
This goes along with #1 above. The risk context consists of the objectives you are trying to reach, the assumptions that underpin them, and the constraints that can keep you from reaching the objectives.
A favorite risk maxim of mine is, “Assumptions made are risks assumed.” Assumptions that are unexamined are problems waiting restlessly to happen. If nothing else, the 2008 financial crisis exposed how poorly — if at all — the assumptions underpinning the financial markets were examined and how important assumption analysis is to successfully managing risk. I tell my clients if they can’t do anything else, at least do this type of analysis.
In the SVB situation, the assumption that interest rates would remain at virtually zero forever was never reexamined, even as the rate of inflation and subsequent interest rates were hiked up rapidly by the Federal Reserve.
Examining constraints is also critical since they are (perceived) barriers to action. I have found it interesting — again from a professional, not personal, risk management viewpoint at least — to see how the moral hazard constraint argument that formerly was used by US government officials as an excuse not to intervene in financial markets went by the wayside. It is always remarkable to see how supposedly hard constraints are ditched overboard in a crisis.
3. Define Completely Your Criteria for Success
In 2008, there was raging debate over whether the US government’s encouragement to banks to lend to low-income citizens caused the subprime implosion. From the data I saw, it did not help, but it was far from certain that this lending by itself was the root of the problem. The government wanted home ownership for this segment of society for a whole host of reasons: home ownership creates individual capital wealth; it helps creates social stability; it helps lower crime; and so on. All these are fine governmental and societal objectives.
Banks and mortgage companies did not object to the government’s encouragement because subprime lending was a source of very profitable fees. Unfortunately, the success criteria for both the government and the lenders together were not defined — nor was what it meant to be unsuccessful. As a result, each went on to maximize their individual success criteria, to the detriment of the other — and everyone else directly and indirectly involved, unfortunately.
A better definition of success by both government and lenders might have at least highlighted what “not successful” would have meant — and served to underline what the real risks were. Another Charette maxim is that, “If you don't know what constitutes success, you sure as heck can’t identify the risks that can keep you from achieving it.”
SVB was seen as the bank of Silicon Valley venture capitalists and start-ups, and its banking lending policies were as speculative. High risk may create high rewards, but only if you understand your risks in the first place.
4. Understand the Behaviors That Motivate Success
“Greed, greed, greed; politics, politics, politics,” explains everything that happened in 2008, according to a Wall Street friend of mine. I think he was probably right.
Success in all financial centers of the world was (and still is) measured in stock options and bonuses tied to maximizing short-term financial “performance.” If success is measured in that way, expect personal behavior to be maximized to pursue it. Success in politics is to be reelected — usually every two years or so. The tried-and-true method for getting reelected is to make sweeping promises and then to “deliver the goods” to your voters. The subprime mortgage market was where both financial and political behaviors — even though they were for entirely different reasons — intersected, aligned, and then became mutually and destructively supportive of one another.
The SVB collapse has similarly been blamed on “the greed and avarice that has long been present in Silicon Valley [that] has come home to roost,” by many financial analysts, with still others blaming greed combined with “hubris” and “recklessness.” But the bank was also lauded for its commitment to green energy start-ups and pledging billions for cleantech investments, a political goal of the Biden administration. SVB management thought it was bulletproof.
Another Charette maxim is, “Beware intersecting organizational behaviors that create (negative) force multiplier effects.”
5. Understand the Root Causes of Risk
The three root causes of risk are: lack of information, lack of control, and lack of time — in that hierarchical order. Without time, you better have control. Without time and control, you better have information. Without information, you are wandering about the wilderness. Right now, given the lack of information that still exists on how much risk exposure exists in the banks and elsewhere, we are still deep in the financial wilderness. There are an estimated 200 banks that have similar risk exposure as SVB, but no one really knows for sure.
A corollary to this principle is to understand whether your root causes of risk are tightly or loosely correlated. Another problem that 2008’s financial crisis exposed is that many risks that were thought to be uncorrelated were in fact correlated. In SVB’s case, the rise in interest rates was directly correlated with SVB’s lending and investment portfolio, but apparently the connection was totally overlooked by management and by government banking officials.
Furthermore, like behavior force multipliers, highly correlated risks can be extremely dangerous when they create (unknown) negative feedback loops in the system. When this happens, a financial contagion can take hold. These risk feedback loops — and it isn’t a single loop but cross-connected loops — are a major reason why government financial risk-mitigation strategies had such a tough time gaining traction. Taking action to mitigate risk in part of the loop can cause risk to increase in other parts of the loop(s). You have to attack many segments making up the loop simultaneously, which is not easy or inexpensive to do.
Now with the government’s guarantee of all SVB’s deposits, the banking depositor risk equation has been turned on its head. There is little to prevent future risky banking activities since the government has now turned into risk manager of first, instead of last, resort. This change will almost guarantee more and large bank failures in the future unless banking oversight gets a whole lot better.
A Charette’s maxim to remember here is, “Beware risks bringing uninvited friends.”