Two Key Lessons From the Banking Crisis

Two Key Lessons From the Banking Crisis

By Chris Mamula  March 20, 2023

Investing & Taxes, Uncategorized

The failure of Silicon Valley Bank (SVB) and the general health of banks has been all over the news recently. There are many fascinating aspects of this story. One is parsing out the roles different parties and policies played in the bank’s failure. Another is the short and long-term implications as to how this crisis is being dealt with.

While interesting at policy and societal levels, these issues are out of our control and generally irrelevant from a personal planning perspective. However, there is one aspect of this story that every reader of this blog planning for or navigating their retirement should be paying close attention to: risk management.

How did SVB’s poor risk management lead to its failure and set off the ensuing cascade of events? Are you making similar mistakes in your own retirement portfolios and plans, setting yourself up for catastrophic outcomes.

Volatility and Liquidity Risk

Too often, the terms volatility and risk are used interchangeably when discussing investments. This is incorrect. Volatility is only one investment risk.

During your accumulation phase, volatility actually works to your advantage when asset prices drop. Most successful investors develop a systematic way of deploying their money as they get it.

A common example is dollar cost averaging the same amount of money each pay period into retirement accounts. When asset prices drop, the same amount of dollars buy you more shares of the same asset than they did the prior cycle.

As you approach retirement, and especially once you are in it, the opposite is true. Volatility becomes a massive risk. A dramatic drop in asset prices when you need to sell those assets means you will need to sell more to produce the same amount of income.

This brings us to liquidity risk. This is the risk that you will be unable to meet your short-term obligations when you need to do so. An investment may lack liquidity because you can’t access your money or because the value of the asset has dropped in the short term due to volatility.

SVB could not meet customers’ rapid withdrawal demands and became insolvent in a day. In the case of individual retirees, if you have to sell too many assets too quickly, especially early in retirement, you will deplete your portfolio to the point where it can not recover.

This is basic risk management 101. Yet those charged with managing risk for the 16th largest bank in the nation fell victim to it. We should all be humble enough to recognize our own potential risk management blind spots. Let’s learn from this risk management failure.

Duration Mismatch

Why was SVB in a position to be vulnerable to a bank run? SVB was a bank that catered to venture capitalists and start-up companies. When times were good, they had an abundance of deposits.

Part of the reason times were so good for this bank was because interest rates were so low. This spurred record levels of investment in the start-ups and left those companies flush with cash to deposit.

As every bank does, SVB was looking for ways to make money off of these deposits. In a low interest rate environment, the bank bought U.S. government treasuries with intermediate to long durations to try to squeeze a little extra yield out of their investments.

These are extremely safe investments IF you can hold them to maturity. This wasn’t a repeat of the subprime mortgage induced banking crisis. SVB wasn’t using customer deposits to buy Bitcoin or other highly speculative investments out of extreme greed.

Under anything but outlier conditions, SVB would have gotten away with their poor risk management. However, these were not normal circumstances. Interest rates increased rapidly. This led to a considerable loss in the value of bonds with longer durations.

Despite the paper losses, SVB would have still been OK if they could have held onto these assets until they matured and could be redeemed for full face value. However, they were not able to do so.

Depositors caught wind of SVB’s precarious situation. They started withdrawing their money. They then told others who quickly followed suit. This created a bank run.

In a single day SVB customers made $42 billion of withdrawals. SVB couldn’t meet demands and was out of business the next day.

Lesson 1: Limit Volatility Risk and Maintain Liquidity

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https://www.caniretireyet.com/retirement-risk-management-bank-lessons/