Week 1: Introduction to risk management and the 2023 banking stress
Why do banks invest in MBS? (Drechsler, Savov, and Schnabl, 2023)
The study “Why Do Banks Invest in MBS?” by Drechsler, Savov, and Schnabl (2023) analyzes the
reasons behind bank investments in mortgage-backed securities (MBS) and the risks associated with
these practices, using Silicon Valley Bank's (SVB) failure as a case study. The authors explore the
core of the banking model, particularly the practice of “maturity transformation,” where banks lend
long-term (e.g., mortgages) and finance themselves with short-term funds (e.g., deposits). This
creates a duration mismatch that exposes banks to interest rate risk, especially when rates rise
sharply.
SVB's collapse in March 2023 is used to illustrate how this risk can become a liability. The bank, like
many others, saw large deposit inflows during the COVID-19 pandemic, driven by flight-to-safety
behavior, government stimulus, and the Federal Reserve’s liquidity-boosting measures. With excess
deposits outpacing loan demand, SVB invested heavily in MBS. However, these fixed-rate assets lost
significant value as interest rates rose rapidly in 2022 and 2023.
A critical element of bank strategy is to hedge interest rate risk using deposits.The concept of
“stickiness” in deposits is a key factor in how banks manage interest rate risk. In this context,
stickiness refers to the tendency of depositors to keep their money in the bank even when interest
rates rise, and more attractive rates may be available elsewhere. Banks rely on this behavior to keep
deposit rates lower than the market rate, especially during periods of monetary tightening by the
Federal Reserve. This stickiness gives banks what economists call “market power” over their deposit
base, allowing them to save significantly on financing costs without losing substantial deposits.
SVB was uniquely vulnerable because nearly 96% of its deposits were uninsured, mostly from tech
startups, making it highly susceptible to a bank run. As these clients began withdrawing funds amid
rising interest rates, SVB was forced to sell its MBS holdings at a loss, resulting in further capital
erosion and sparking a full-fledged bank run. The SVB case demonstrates the importance of
managing interest rate risk effectively, especially for banks with high concentrations of uninsured
deposits. The study underscores that such vulnerabilities, if not carefully managed, can lead to rapid
destabilization, as seen with SVB.
NYU Stern White Paper - Chapter 1: Overview of Recent Banking Stress (Acharya,
Cecche, and Schoenholtz, 2023)
Chapter 1 of SVB and Beyond: The Banking Stress of 2023 provides an in-depth analysis of the
recent stresses on the U.S. banking sector, which culminated in a series of bank runs and failures in
2023. This chapter, authored by Viral V. Acharya, Stephen G. Cecchetti, and Kermit L. Schoenholtz,
identifies several structural weaknesses and regulatory lapses that laid the groundwork for these
banking crises, focusing on the cases of Silicon Valley Bank (SVB), Signature Bank, and other
mid-sized banks. The analysis also outlines the response by regulators and policymakers, along with
the broader implications for banking resilience.
The authors explain that while many factors contributed to these banks’ failures, a core issue was the
inherent fragility of institutions engaged in maturity transformation—funding long-term assets with
short-term liabilities. This approach is risky, as it exposes banks to sudden deposit outflows. The
collapse of SVB, for instance, was a result of this fragility combined with poor interest rate risk
management. SVB's asset portfolio was heavily weighted toward long-term, fixed-rate securities,
which lost substantial value as the Federal Reserve raised interest rates to combat inflation. The risk
was amplified by SVB’s reliance on uninsured deposits for over 90% of its funding. Unlike more stable
“time deposits,” most of SVB’s deposits were volatile and easily withdrawn. As these tech-sector
clients experienced financial strain, they began withdrawing funds, triggering a liquidity crisis at the
,bank. This high exposure to both interest rate risk and a non-sticky depositor base, mostly uninsured
and sector-concentrated, set the stage for a bank run.
In addition to SVB, Signature Bank faced similar issues. Signature had concentrated exposure to the
cryptocurrency sector, and like SVB, most of its deposits were uninsured. This sectoral exposure
heightened both banks' vulnerability when their respective sectors—tech startups for SVB and
cryptocurrency for Signature—faced downturns. Both banks experienced rapid deposit outflows as
their clients scrambled to preserve liquidity amid broader economic tightening.
The chapter also details SVB’s poor asset-liability management practices. By the end of 2022, SVB
had allocated nearly 57% of its assets to fixed-income securities with an average duration of 5.6
years. While the duration of MBS naturally extends with rising rates, SVB’s management actively
allowed this duration to increase and even unwound some interest rate hedges to book immediate
gains, which further exposed the bank to rate increases. At the same time, SVB took no significant
steps to extend the maturity of its liabilities by increasing the proportion of time deposits.
SVB also used accounting loopholes to mask its declining capital base. By designating a significant
portion of its assets as “held-to-maturity” (HTM) under U.S. GAAP, SVB avoided marking them to
market, which allowed the bank to omit unrealized losses from its regulatory capital reports. Although
these losses amounted to billions, they remained off-balance sheet due to the HTM accounting
designation, leading depositors and regulators to underestimate the bank’s vulnerability. The authors
argue that had SVB’s regulatory capital included these unrealized losses, its financial distress would
have been evident as early as 2022.
The chapter also explains the speed and intensity of the bank run. Initially, SVB depositors, mostly
tech-focused and uninsured, did not monitor the bank's health closely. However, once the bank
announced losses on securities sales and a failed attempt to raise capital in early March 2023, panic
ensued. The news spread quickly within SVB’s interconnected client base, resulting in an “electronic
run,” as depositors moved their funds out at an unprecedented speed. On March 10, California
regulators closed SVB, and the FDIC assumed receivership. Signature Bank also experienced $10
billion in outflows, while First Republic Bank saw withdrawals of $25 billion, reflecting the widespread
panic among depositors.
The U.S. government intervened with emergency measures to stabilize the situation, including
invoking the “systemic risk exception” to protect all deposits—both insured and uninsured—at SVB
and Signature Bank. This exception provided an implicit guarantee to other banks’ uninsured
depositors, calming the immediate crisis but also raising concerns about long-term regulatory
implications and potential moral hazard. As the authors suggest, the response may encourage banks
to take on even greater risks in the future, relying on the expectation of government support during
crises.
The chapter concludes that the 2023 banking stress highlights vulnerabilities that persist in the
banking system, despite reforms since the 2008 financial crisis. The key lesson, according to the
authors, is the importance of balancing crisis mitigation with regulatory measures that discourage
excessive risk-taking. The need for ongoing reforms and a better understanding of macroeconomic
and regulatory dynamics will be critical in strengthening banking resilience in the future.
NYU Stern White Paper - Chapter 2: Underlying Macroeconomic Causes of Recent
Banking Stress (Acharya, Cecche, Schoenholtz, and White, 2023)
Chapter 2 of SVB and Beyond: The Banking Stress of 2023, titled "Underlying Macroeconomic
Causes of Recent Banking Stress," explores the macroeconomic landscape that contributed to the
banking crises of 2023, with an emphasis on how pandemic-era policies created conditions that
increased risk-taking among banks. Authored by Viral V. Acharya, Stephen G. Cecchetti, Kermit L.
,Schoenholtz, and Lawrence J. White, the chapter identifies key economic policies and trends that
catalyzed systemic vulnerabilities within midsized banks such as Silicon Valley Bank (SVB) and
Signature Bank.
The chapter begins by highlighting the massive fiscal and monetary stimulus enacted during the
COVID-19 pandemic, which was unprecedented in scope and scale. This stimulus included near-zero
interest rates and extensive asset purchases by the Federal Reserve under Quantitative Easing (QE)
programs. On the fiscal side, the U.S. government injected over $5 trillion into the economy, leading to
the largest peacetime deficit in U.S. history. These policies, intended to stabilize the economy during a
period of severe economic uncertainty, had several unintended consequences that increased banks’
exposure to risk.
The Federal Reserve’s “low-for-long” interest rate policy was a central factor. By keeping rates close
to zero, the Fed created an environment that incentivized banks to increase interest rate risk, as they
sought higher returns through long-term, fixed-rate investments. With short-term rates suppressed,
banks were encouraged to “ride the yield curve” by investing in long-duration assets such as
government securities and mortgage-backed securities (MBS). This strategy was based on the
assumption that rates would remain low for an extended period, as signaled by the Fed's forward
guidance. Banks, therefore, expanded their balance sheets by accumulating these long-duration
assets, which increased their sensitivity to future rate hikes.
In addition to suppressing rates, the Fed’s asset purchase programs under QE expanded reserves
across the banking system, which inadvertently boosted uninsured deposits. As the Fed purchased
securities on a massive scale, reserves in commercial banks grew by approximately $2.5 trillion, and
much of this ended up as uninsured deposits held by banks. These deposits became a liability for
banks when interest rates rose, as they could be withdrawn quickly, heightening liquidity risk. The
chapter notes that banks like SVB saw surging uninsured deposits, which rose substantially between
2019 and 2022. By early 2022, uninsured deposits in the U.S. banking sector had grown from $5.5
trillion to more than $8 trillion, representing an enormous increase in potentially volatile funding.
With the rapid rise in interest rates starting in 2022, this balance-sheet composition exposed banks to
significant stress. The Federal Reserve’s shift to aggressive monetary tightening, prompted by the
highest inflation in four decades, triggered losses on the long-duration assets held by banks. As rates
rose, the market value of these assets declined, generating substantial unrealized losses across the
banking sector. This impact was particularly acute for banks like SVB, which had concentrated
exposure to fixed-income securities. The FDIC estimated that unrealized losses across the banking
sector exceeded $690 billion by the third quarter of 2022, compared to just $85 billion during the
monetary tightening in 2017-2019. This staggering increase in unrealized losses was largely due to
the steep and unexpected rise in interest rates.
The chapter also examines how the Fed’s policy stance impacted the liability side of banks' balance
sheets, specifically by altering the dynamics of deposit behavior. Low rates encouraged depositors to
accept low-yield deposits during the pandemic, but as rates began to climb, depositors increasingly
sought higher returns from alternatives like money market funds. This shift put pressure on banks,
which faced the risk of “deposit flight” as savers moved funds to more attractive interest-bearing
accounts. Smaller banks, which were more reliant on uninsured deposits, were particularly vulnerable
to these outflows, which directly affected their liquidity.
One of the chapter’s key insights is how the Fed’s prolonged low-rate policy affected banks’ risk
assessments and hedging decisions. Many banks, lulled by the Fed's assurances of temporary
inflation, refrained from purchasing interest rate hedges. This reluctance was partly due to
expectations that inflation would subside, as Fed policymakers suggested. As a result, banks took on
interest rate risk without adequate hedging, believing that the low-rate environment would persist. This
, miscalculation left them exposed when the Fed was compelled to pivot to rapid rate hikes in 2022,
resulting in substantial unrealized losses on their portfolios.
The chapter concludes with a comparison of the 2023 banking stress to the Savings and Loan (S&L)
crisis of the 1980s. Similar to the recent episode, the S&L crisis was marked by widespread interest
rate risk, as institutions funded long-term, fixed-rate loans with short-term deposits. When the Federal
Reserve raised rates sharply in the late 1970s and early 1980s to combat inflation, S&Ls faced
devastating losses, as the value of their long-term assets plummeted. This comparison underscores
the enduring vulnerability of banks to interest rate risk and the critical importance of prudent risk
management, particularly in an environment where policy shifts can be swift and severe.
In summary, the chapter argues that the macroeconomic environment fostered by COVID-era policies,
including extended low interest rates, QE, and massive fiscal spending, set the stage for excessive
risk-taking in the banking sector. When inflation surged and forced the Fed to raise rates, these risks
materialized in the form of unrealized losses and liquidity challenges, particularly for banks heavily
reliant on uninsured deposits. The events of 2023 serve as a reminder of the delicate balance
between stabilizing the economy and maintaining financial stability, as well as the need for vigilant risk
management practices across the banking sector.
Lecture slides week 1:
Introduction to financial risk management
Bank balance sheet:
Deposits are the main liabilities. Loans are the main assets
→ Maturity mismatch between assets and liabilities
Increasing role of short-term debt. Increasing focus on trading assets. Low equity ratio (5%-8%).
Bank balance sheet: Types of risk
Credit risk is the risk that counterparties in loan and derivatives transactions will default. Credit risk
can wipe out (parts of) loans and trading assets. Provision for Loan Losses (Nonperforming loans with
90 days delays in payments) can wipe out Equity.
Market risk is the risk relating to the possibility that instruments in the bank’s trading book will decline
in value. It depends on the future movements in market variables.
Liquidity risk is the risk that a bank may be unable to meet short-term financial demands. Can
withdrawals of deposit or a roll-over freeze of short-term debt be absorbed by assets? Related to the
ability to convert assets into cash. Loans and trading assets are often long-term and with limited
marketability.
Basel Committee on Banking Supervision: Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people, and systems or from external events. Pandemic or
geopolitical risks fall into this category
Credit, market, and operational risk can wipe out assets and equity, leading to insolvency.
When is a corporation insolvent?
- When is not able to pay its debt
- Test: Do liabilities exceed assets?
- Test: Can it raise new equity (from private investors)?
As banks have little equity, a 5% loss of assets can lead to insolvency
Capital regulation:
Regulators set minimum levels for the capital a bank is required to keep. Note that the usage of
“keep” may be misleading.
