Thursday, 25 April 2024

SVB collapse sets off underwriting-risk alarm

5 min read

By Jayarethanam Pillai

Silicon Valley Bank’s 2023 collapse continues to raise concerns in the echo chambers of the banking sector over slack lending practices and underwriting oversight, prompting a reevaluation of risk management strategies around macroeconomic influences

  • Slack underwriting, lending, financial oversight
  • Credit risk and underwriting concerns in banking
  • Diversifying funding for startups and venture capital firms

Silicon Valley Bank’s (SVB) collapse, the third-largest in US history, revealed a $20 billion impact on Federal Deposit Insurance Corporation’s (FDIC) Deposit Insurance Fund, exposing vulnerabilities in underwriting compliance and financial oversight across the industry.

SVB was a key financial institution in Silicon Valley that provided customised financial services to startups, venture capital firms, and other technology-focused businesses. Its reputation as an early adopter of new technologies allowed it to stay ahead of the curve and better serve its customers. Despite its strengths, its sudden death has left many wondering how the ecosystem will be affected and what the future holds for the banking industry. 

Slack underwriting, lending, financial oversight

The collapse happened for multiple reasons, including a lack of diversification, overextending its loan initiatives, weak macro indicators, and a classic bank run, where many customers withdrew their deposits simultaneously based on fear of the bank’s solvency. What has become clear in hindsight is that banks are failing to undertake strict underwriting compliance, leading to slack lending activities and a clear lack of financial oversight.

Negative consequences of adverse macroeconomic events are not limited to the banking sector. Banks’ underwriting activities play a special role in the economy, and their failure markedly reinforces the adverse developments that may have caused them to fail. Given that banks’ underwriting models are more prone to risk-taking than those of non-financial institutions, and that weak macroeconomic fundamentals simultaneously affect a large number of institutions, it is all the more important to understand macroeconomic influences on risk positions.

Banks perform intermediary functions for the real sector. As economic conditions worsen during stagnation and recession periods, the riskiness of intermediation tends to rise. Underwriting models are vulnerable to adverse selection and ‘moral-hazard behaviour’ of the borrowers.

The impact of exchange-rate fluctuations on bank risk depends on the interplay between currency movements and a bank’s foreign exchange exposure. Domestic currency depreciation can be expected to hurt banks and their underwriting models, whose foreign exchange liabilities substantially exceed their assets denominated in foreign currencies. However, the effect of exchange rate levels on the performance of the banks’ borrowers, has its primary impact on bank profitability, leading banks to attach greater importance to the connection between exchange rate and credit risk than to currency risk.

Credit risk and underwriting concerns in banking

Shifts in terms of trade also affect bank risks by influencing the profitability of its borrowers, thereby also the banks’ credit risk and underwriting activities. A drop in terms of trade occurs when imports become more expensive relative to exports, eroding the purchasing power of a country. Falling terms of trade can be expected to increase a bank’s credit risk.

Interest-rate risks associated with changes in market interest rates constitute a central source of market risk for banks and their underwriting models. A rise in market interest rates, evident from the Fed’s interest activities in 2023 to fight off inflation, whose direct effect is an increase in bank returns for newly-made or variable interest loans, nonetheless bears the danger of increased credit risk.

An increased rate of inflation diminishes real rates of return on bank assets and therefore induces credit rationing. Countries with high inflation will have less access to financial intermediation. Higher rates of inflation lead to a decrease in the quantity of bank assets and thus the quantity of credit risks. Nevertheless, higher inflation can have a negative impact on the earnings of existing borrowers, thereby impairing the quality of previously extended loans.

Coincidentally, during early 2023, the traffic signals were on amber for all of the above key factors, as the US and, to some extent, the global economy, were struggling to come to grips with post-COVID-19 momentum. Despite the warning signs, there was no letting up in the manner in which underwriting was undertaken, coupled with weak oversight on running up debt financing through venture activities.

Diversifying funding for startups and venture capital firms

The collapse of SVB highlights the importance of diversifying funding sources for startups and venture capital firms. Relying too heavily on one financial institution can be risky, as the collapse has shown. In addition, strict financial oversight has to be maintained by banks to ensure sufficient liquidity is maintained at all times, and due diligence on loan portfolios must always be a priority. 

Now, in 2024, it is crucial to glean lessons from the SVB meltdown and past financial crises, maintaining a watchful and prudent eye on domestic and international macro indicators.

 

Jayarethanam Pillai is the Head of Data Science Consulting, Financial Services at Aboitiz Data Innovation. He holds a Ph.D. in Economics and Public Policy from the School of Economics and Government of the Australian National University.



Keywords: Credit Risk, Underwriting, Financial Ecosystem, Diversification, Startups, Venture Capital, Macro Indicators, Exchange Rates, Trade, Interest Rates, Inflation
Institution: Silicon Valley Bank, Aboitiz Data Innovation
Country: US
Region: United States
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