UK Politics and the Silicon Valley Bank Fallout

UK Politics and the Silicon Valley Bank Fallout

By Mathew Gilbert, Head of Capstone’s European Practice

March 19, 2023 – Prudential standards in the UK financial services sector have become an unlikely political football as politicians tussle with regulators over the balance between increasing UK competitiveness and managing risk in the financial system.

The debate started with the regulatory requirements for UK life insurers, where the review of Solvency II made a surprise appearance in last year’s Conservative party leadership race. The latest flashpoint has shifted to the banking sector, where a UK government minister has suggested banks could “sue the Bank of England” over new rules that will require them to hold more capital under the pending Basel 3.1 reforms, developed in response to the financial crisis. Andrew Griffith, the city minister, reportedly raised the prospect of legal action against the capital reforms during a discussion with banking executives last month.

The Basel 3.1 standards are a package of proposed international banking standards that would make significant changes to the way banks calculate risk-weighted assets. This is the first major package of international banking standards to be designed by the Bank of England’s (BOE) Prudential Regulation Authority (PRA) since the UK left the EU. The PRA published its Basel 3.1 plans in November 2022, with a consultation running until March 31st.

Although the SVB collapse involved several idiosyncratic risks, we believe recent US events will remind global policymakers about the importance of international banking standards.

Less than a month after Mr. Griffiths comments were reported, an unrelated incident was occurring across the Atlantic, Silicon Valley Bank (SVB) was being shut-down by US regulators. Although the SVB collapse involved several idiosyncratic risks, we believe recent US events will remind global policymakers about the importance of international banking standards.

Silicon Valley Bank Run

SVB was an old fashioned bank run, which stirs up memories of the UK’s Northern Rock bank run – with the now famous pictures of depositors lining up outside branches during the 2007-2008 financial crisis.  The modern day bank run may unfold online and be reported on Twitter as opposed to newspaper images of depositors standing outside of banks, but the fundamental issues are similar.

SVB’s problems began with a liquidity crisis which created a solvency issue. More importantly, we believe the problem was primarily about concentration risk. The US bank’s deposit base was largely uninsured (c.90% at Q422) to sophisticated counterparties (40% of deposits in early-stage technology and life science/health care companies), making them highly susceptible to outflows. Management treated the recent technology and VC related surge in deposits as sticky money and invested it as such.

Many commentators have focused on the impact of higher rates on SVB’s fixed income portfolio and subsequent capital loss, with the potential read-across for other banks with large bond portfolios as a percent of their balance sheet. However, in the case of SVB these losses were only crystallised due to the run on the bank’s deposits forcing a sale of held-to-maturity (HTM) assets. The unrealized losses in the bank’s HTM portfolio increased during 2022 with the rise in interest rates, but we didn’t first learn about this last week. At the end of September 2022, the unrealized loss on the HTM securities ($15.9 billion) was clearly reported in SVB’s financial accounts.

Liquidity Ratios

In response to the global financial crisis of 2007-2008, the Basel Committee agreed to a series of changes to its standards through Basel 3. Many of the standards have already been implemented in the UK and globally, increasing the quantity and quality of capital held by banks and notably, introducing requirements for liquidity. To mitigate liquidity risk, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) were created. These ratios aim for different but complementary goals, LCR is aimed at promoting the short-term resilience of the liquidity risk profile of banks; while the NSFR is to reduce the funding risk over a broader time horizon.

For example, the numerator of the NSFR – “available stable funding” applies a weighting based on the stability of the liability side of the balance sheet, with retail deposits (90-95%) and long term borrowings (100%) favoured over deposits from corporates (50%), financial institution deposits (0%) and short term funding (0%).

Silicon Valley Bank and UK Liquidity Ratios

As has now been well reported in the last week, SVB didn’t have to adhere to Basel 3 liquidity ratios. The bank said in its most recent 10K filing: “Because we are a Category IV organization with less than $250 billion in average total consolidated assets…we currently are not subject to the Federal Reserve’s LCR or NSFR requirements, either on a full or reduced basis.”

The perception of a bank’s liquidity position can change quickly following sudden shifts in market sentiment. Credit Suisse has a solid LCR of 144%, this did not prevent the need for a central bank intervention to calm market nerves last week. However, we believe Basel liquidity ratios have been an important supervisory tool in Europe and also force management to be more accountable to the bank’s owners (the shareholders).

UK Response

With the UK political conversation now firmly focused on the risks of increasing financial regulation on the competitiveness of the economy, we believe lessons can be learned from across the pond. Although we see very limited direct read-across from the failure of SVB to large-cap listed UK Banks, which have less deposit concentration and have little problems attracting retail current accounts – questions will continue to arise for niche and specialist banks. The US has been historically praised for having greater proportionality imbedded in its regulatory framework versus the less flexible UK and EU requirements. The UK is currently creating a new “simpler regime” for smaller banks to address this but the recent events in the US are likely to temper any calls for a lowering of capital or liquidity standards for mid-sized banks.

With the UK political conversation now firmly focused on the risks of increasing financial regulation on the competitiveness of the economy, we believe lessons can be learned from across the pond.

The parts of Basel 3 that remain to be implemented focus not on liquidity but capital and the calculation of risk-weighted assets, the final piece of the reform jigsaw. In the face of political criticism, Andrew Bailey, the BOE governor, has defended the UK’s approach to Basel 3.1, arguing the route the EU is taking is “non-compliant” with the global standards. The US has not yet issued its proposals. In light of renewed concerns about the stability of the global banking system, we believe government ministers may need to reconsider calls for de-regulation.

*On 29th March, Capstone will host a lunch with Phil Evans, Director of Prudential Policy at the Bank of England’s Prudential Regulation Authority (PRA), to discuss the UK’s implementation of Basel 3.1 and the broader outlook for the UK banking sector. Spaces is limited, if you are interested in attending, please contact your sales representative or email RSVP@capstonedc.com

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