Liquidity Management: Insights from March’s financial turmoil and 3 Key Lessons for Private Markets firms

Background

On March 9th, Silicon Valley Bank (SVB), the 16th largest bank in America, experienced a major institutional failure, the largest since the 2008 financial crisis. The bank’s main customers, startups, were facing a more challenging climate and sought to draw down on their facilities, causing SVB to liquidate holdings of long term US mortgage-backed securities at a loss to meet the demand for cash. This raised concerns that the bank would not be able to fulfil its commitments, leading to a swift but fatal run on the bank and forcing regulators to step in and take control. SVB’s failure occurred just after Silvergate Capital’s bank liquidation announcement and two days before regulators took over Signature Bank.

While these may seem like US-centric incidents, the paralysing fear of banking failure extends far beyond the shores of the US and highlights the prevalence of institutional risk, even for archaic, government-backed institutions. Credit Suisse was already facing profitability issues and reputational damage due to its involvement with collapsed financial services firm Greensill and hedge fund Archegos. The emergence of weaknesses in US regional banks led investors to scrutinise Credit Suisse further. The news of “material weaknesses” in its financial reporting and the refusal of its biggest shareholder, Saudi National Bank, to provide additional capital added to its troubles. Although rescued by UBS – the ripples of such a stalwart financial institution going into crisis have been felt across both public and private markets.

This recent trouble in the banking sector has effectively created the most challenging period for the banking system since the global financial crisis of 2008, against a backdrop of rising interest rates and slowing growth. For private markets this means liquidity management has never been more important.

The Importance of Liquidity Management

Liquidity management is a critical task for banks and financial institutions, but it’s not always clear how to measure liquidity and determine if you are in danger of running out of cash. There are several tools that can be used to manage this risk, including ratios like the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). These ratios are a measure of the amount of cash that a bank has available to meet its short-term obligations.

Liquidity refers to the ability of an institution to meet its obligations as they come due and can be measured in several ways: by looking at ratios such as current ratio, quick ratio, and acid test ratio; by analysing daily transaction activity or by comparing accounts payable versus accounts receivable balances on hand at any given time (also known as liquidity forecasting).

A call for greater regulatory reform

Financial regulators have the goal to protect the interests of the investor to allow markets to function and to promote transparency within the industry. The fall of the banks in March could have most likely be avoided with appropriate regulation in place, and regulators will be feeling the pressure to address these issues – it is likely we will see increased scrutiny around policies and procedures in the coming years as regulators look to mitigate a recurrence of the events leading up to the collapse of SVB.

In a single day, depositors at SVB bank withdrew $42 billion, highlighting the speed at which money and fear can spread in the digital age. Policymakers will need to grapple with finding ways to curb methods that allow money to move so quickly, and preventing the mass spread of information through social media platforms which will naturally be difficult to regulate. Any reform should focus on increasing the stringency of the LCR requirements, improving transparency of banks’ liquidity risk management, and strengthening supervisory framework to monitor and enforce compliance.

Risk Management and Supervision

While there were several contributing factors leading to SVB’s collapse, there are 3 primary factors that can help us learn from SVB’s mistakes:

• Portfolio allocation

Around 80% of all assets on SVB’s balance sheet were consolidated in long-term government backed securities labelled HTM (hold to maturity) meaning that any fluctuations in asset market value were not considered during PnL reporting. The idea with HTM assets is not to sell them, but instead generate interest yield over time. With SVB choosing to focus on NII (net interest income) in the long term, they did not take steps to adjust their balance of AfS (available for sale) securities which could have adequately capitalized them in the event of a short-term cash bleed.

• Rates and Liquidity risk

The sharp increase in interest rates throughout 2022 led to huge unrealized losses in the bank’s portfolio of long-term securities which went largely unreported, totalling a whopping $15bn (almost the entirety of SVB’s market cap of $16bn at the time). The bank also reported virtually no interest rate hedges on its bond portfolio at the end of 2022 which played a part in the bank’s insolvency. It is essential for banks to develop and implement effective hedging strategies to manage interest rate risk and protect their balance sheets from adverse market conditions in the short and long term. This requires a sound understanding of the nature and magnitude of interest rate risk and implementation of hedging strategies consistent with risk management objectives and risk appetite.

• Stress-testing

There seems to have been a distinct lack of stress-testing at SVB which may have contributed to their collapse. In this case, no doomsday modelling or scenario planning was carried out around the potential speed of expected withdrawals. The need for this kind of modelling may be unique to a customer deposit-led institution, but it highlights the importance of planning for worst-case scenarios across all types of financial institutions.

What does this mean for private markets?

The collapse of Silicon Valley Bank and Credit Suisse shines a glaring spotlight on the importance of Treasury as a core function and serves as a stark reminder of some key lessons:

The importance of diversifying banking relationships

Treasurers who wish to tempt fate may feel strongly about the ease of managing one or two key banking relationships under the illusions of standard operating procedures and scalability of processing over time, but at what cost? The age-old adage ‘Don’t put all your eggs in one basket’ comes to mind. The risk of systemic failure is far less than the risk of failure for a single bank, and financial institutions that rely heavily on a single bank put themselves at risk of severe financial consequences in the event of that bank’s failure.

Diversifying banking relationships can mitigate this risk by spreading deposits across multiple banks and reducing concentration risk. This not only ensures continued access to liquidity and credit but also fosters competition among banks, allowing institutions to negotiate better pricing and terms. By diversifying banking relationships, institutions can also benefit from a broader range of products and services that can meet their evolving needs.

Additionally, working with multiple banks enables institutions to better manage their relationships by holding each bank accountable and mitigating the impact of a single bank’s shortcomings. Overall, diversifying banking relationships can help institutions manage risks, enhance bargaining power, and access a wider range of products and services, ultimately leading to greater financial resilience and stability.

The importance of proper liquidity management

Proper liquidity management should be front of mind for financial institutions, as shortages of cash or insufficient access to funding sources over time can lead to financial instability, reputational damage, and in the case of SVB, insolvency.

Private market firms can learn from this experience and implement effective liquidity management practices to safeguard against potential liquidity crises while ensuring they are meeting their funding obligations appropriately. These practices can include developing robust risk management frameworks, stress testing, scenario analysis and contingency planning, which are all important ways for firms to enhance their financial stability and safeguard against institutional risk. Ultimately, proper liquidity management is essential for ensuring the long-term viability and success of an institution.

The importance of real-time liquidity planning

To navigate a complex financial environment and mitigate risk against rate changes, inflationary pressures, and adapt quickly to changing market conditions in real time, financial institutions should seek to leverage technology. A comprehensive treasury management system (TMS) can ensure efficient cash and risk management and provide greater flexibility, insight, and efficiency in the way a firm operates. By adopting such a system, institutions can benefit from improved cash visibility, greater control over cash movements, streamlined payment processing, and enhanced risk mitigation capabilities such as hedging and stress testing.

Treasury management technology also provides real-time analytics and reporting, enabling institutions to make agile but informed financial decisions and thus optimize their treasury operations. In an increasingly competitive market, treasury management technology can give institutions a strategic edge by improving their financial performance and has a secondary benefit of lowering operating costs in the long term. The need for robust and reliable treasury management technology is evident, and institutions that invest in TMS solutions will be better equipped to navigate the challenges of the modern financial landscape.