At this point last year, did anyone think we were a little over a month away from a Silicon Valley Bank (SVB) failure?
Sure, there was NMD runoff as SVB’s start-up company clients burned through cash, given issues with their access to equities markets. This wasn’t a surprise, as it had been the focus of press release calls in 2022.
While concerning for earnings, nothing terminal seemed imminent. Credit quality and capital were strong. Sure, profitability faced some headwinds as margins declined quarter over quarter, predominantly due to the deposit declines associated with the start-ups.
However, in February/March 2023, SVB management focused on the bank’s extensive investment portfolio. As with many other banks, the bulk of these investments were purchased in the early part of the 2022-2023 rising rate cycle, which yielded well below what could be obtained on the market in March 2023.
Their concerns were further exacerbated by the fact that a large part of this portfolio was carried as Available for Sale, highlighting the unrealized loss as it dragged down overall equity-to-asset ratios. This then led to SVB management (with the presumed blessing of investment bankers) to embark on a strategy to sell a large portion of these underwater securities at a loss and invest the proceeds into higher yields, all while hoping the investment community would cover the loss on the trade via a new capital raise given the improved earnings forecast.
As we now know, the investor community balked, as well as many large depositors, who, having lost confidence in management, decided to pull their deposits. This triggered an historic level of deposit outflows over the course of the next several days, ultimately sealing the bank’s fate.
News outlets, in print and on TV, primarily blamed the failure on the low market value of the bank’s investments (rather than liquidity contingency lines being inadequate). Even Warren Buffet made comments centering on fair value (and the low-yielding securities) being the blame and impetus for this failure.
The point of this article is not to re-hash the demise of SVB, but rather to build an argument for how methodologies applied in the economic value of equity computations (EVE) provide more comprehensive information than current standards for financial statement disclosures. Perhaps it is time for the disclosure standards to be revisited?
From the Editor
"It's not worth the paper it's printed on." ...Or is it?
In the wake of the Great Financial Crisis of 2008, a number of financial institutions were newly required / asked to calculate their Economic Value of Equity (EVE). While this wasn’t exactly a new calculation (its antecedent, TB 13a, was born of the Thrift Crisis of the 80s), many banks that had previously not calculated a discounted cashflow valuation of their balance sheet began to.
Presumably, the logic was that this “theoretical liquidation value” could provide insight into the worth of the organization in the event a future crisis emerged.
From the outset, opinions on the efficacy of this calculation varied greatly. Some folks argued that “it wasn’t worth the paper it is printed on,” while others maintained that it was the primary scoping tool utilized by their examiners and therefore needed to be managed accordingly.
At its best, EVE can give a glimpse (albeit incomplete) of the longer-term risk inherent in an institution’s balance sheet. At its worst, it can inaccurately portray a risk that isn’t reflective of a “going concern” and require remedial actions (which generally erode earnings).
In this month’s Bulletin, DCG Managing Director Bob Lallo presents a compelling use case for the EVE.
He argues how methodologies applied in the EVE computations provide a more comprehensive look into an institution than the current standards for fair value disclosures.
Specifically, he contends that ASC 825 disclosures should at least give some consideration to the value of the core deposit franchise as well as a summary of the critical assumptions embedded within.
Wherever your opinion might reside on this hotly debated calculation, we can all agree with Bob’s contention that Core Deposits are the lifeblood of any financial institution. Hopefully, your institution’s EVE is within policy limits, but if not, perhaps Bob’s insight will help contextualize the calculation.
Vinny Clevenger, Managing Director
What Is a Bank's Fair Value?
With the SVB failure, the financial markets turned their attention to other larger institutions with high levels of uninsured deposits and highly distressed asset market values. The fair value concerns were not just an issue for those AFS portfolios; it extended to the fixed rate loans in bank portfolios as well as those investment securities classified as Held to Maturity (or Hide to Maturity as some call it as the securities are carried at book, not market value). The market values of these assets are not as prominent in the financials as the mark on AFS but are included in disclosures in financial filings. These disclosures were not new. The requirement to footnote these values came with the advent of Statement of Financial Accounting Standards 107 (now known as ASC 825), which has been in effect for over 30 years.
ASC 825 guidance focuses almost entirely on asset values, as disclosing the potential value of non-maturity deposits is explicitly excluded. It specifies that non-maturity deposits be stated at the value that could be withdrawn on the reporting date, thus book value. While this was done in part as a matter of expediency (cost and time), it eliminates the most valuable part of a bank franchise: the value of its core deposits. It allows for the exclusion of those values and perhaps fuels the financial media and markets' focus solely on the fair value of assets.
In the wake of the SVB failure, it was becoming clear that the emerging calculus for determining potential solvency issues was the fair value of assets less the book value of liabilities (most bank funding is non term, and market values are not determined for the most part under ASC 825). In providing no consideration to the value of the core deposit franchise, most banks had a fair value lower than book value or even negative book values.
Combine this view with a potentially high level of uninsured deposits, and you suddenly have several banks in the gunsights of the under-informed public and a new environment of fear and uncertainty. Accordingly, several other large regional banks, who were otherwise relatively healthy, found themselves on a dubious list of potential “next in line” future problems.
EVE Is Better than Current Disclosures
A few key issues caused the ultimate failure of SVB, and while the fair value of assets was a contributing factor, it was not a primary factor.
Yet the markets did and continue to focus on fair values. The issue is that financial statement disclosures remain flawed because they miss the value of core deposit franchises. Banks have a tool that encompasses the fair value of non-maturity deposits: the Economic Value of Equity, an all-but-required element of interest rate risk management.
This computation, born out of interest rate risk concerns during the Thrift Crisis of the 1980s, takes a discounted cash flow value of the financial institution in the current interest environment at the measurement date (a proxy for current market value) and then runs that balance sheet through other rate shock scenarios to determine the impact of interest rates on the economic value of the bank’s equity.
This computation treats the bank as a non-going concern as discounted cash flows go to cash and are not reinvested/redeployed. Core deposit studies are typically run to support the lifing (decay rate) of the NMDs, which is crucial assumption in determining the value of these deposits without maturity dates.
In essence, the EVE produces a liquidation-based estimate of the bank that is more comprehensive than the current financial disclosure requirements. While the quality of assumptions is critical to determining the fair value of these NMDs, their inclusion highlights a key factor in the disclosure for the financial investor or the less experienced banking public.
We should note that during 2023 while focusing on the distressed market value of assets, many banks saw the estimated fair value of equity in the EVE computation rise to almost 2x book value! This is a far cry from the perceived insolvency in the minds of many depositors who fled their financial institutions based on fair value concerns in 2023. The stability of these funding sources allows banks to make a positive spread on assets even with depressed market values. Core deposits are the lifeblood of a bank.
Three EVE Myths
While EVE is more comprehensive than the current ASC 825 disclosure requirements, it still has critical limitations in its application. These limitations primarily boil down to three key myths that are often mistakenly believed by bankers and regulators when using EVE for valuation and interest rate risk purposes.
Myth 1: EVE Is a Good Predictor of Capital Loss. The EVE computation looks at the change in the liquidation value of a bank in various predetermined rate shock environments (in 100bp increments up and down). A bank that has assets longer than the duration of its liabilities will show a reduction in the dollar amount of economic value of equity (compared to the base, zero shock computation) in the rising rate post-shock computations. That would suggest that the bank would lose capital in a rising rate environment. This is false, as the EVE computation is a non-going concern valuation. In the zero shock (current rates), it may be closer to a potential liquidation valuation, as the losses demonstrated in the EVE will only be realized should those assets and liabilities be disposed of directly at that time in that rate environment. Otherwise, capital loss only happens through operating losses and credit losses.
Myth 2: EVE Is an Adequate Indicator of Short-Term Interest Rate Risk. Once again, the EVE computation uses discounted cash flows for all of a bank’s assets and liabilities and determines a value using the yield curve for discount rates. So, in a positively-sloped yield curve, the longer-term rates receive a higher discount rate, and thus, the longest cash flows have the most significant dollar impact on the current valuation. That mismatch won't likely impact the next year or two of earnings. Additionally, NII simulations treat the institution as a going concern. The reinvestment/redirection of cash proceeds (and the mismatch of cash flows off of assets and liabilities) are critical in determining profitability and the impact of stress on such profitability. Thus, actual net interest income simulations over 2- and 5-year timeframes, like those being done in most ALMs today, are a far better measurement tool for short-term interest rate risk.
Myth 3: EVE Offers Predictive Power for Net Worth. This is also false. As stated earlier, EVE is more of an estimate of the current liquidation value of a franchise. Consider how the market values publicly traded banks. Most bank stocks trade at a multiple of earnings. Why is that? The value of a going concern is not just its liquidation value, but also the added value of the projected earnings stream over a given period. While there may be increases or decreases in that liquidation value for interest rate changes and perhaps even changes to the multiplier applied to earnings by the stock investors, it is not nearly comprehensive enough to be considered an adequate predictor. Again, the liquidation value does not equate to the fair value of the franchise.
So, EVE is not a fair value or interest rate risk panacea. There are inherent flaws like almost anything else. But as a tool where we understand its benefits in the context of its flaws, it can be pretty valuable and certainly more comprehensive than today’s financial statement disclosures.
Is EVE a Solution to the ASC 825 dilemma?
EVE can be a helpful tool when adequately understood – the right tool for the right job. It is a decent fair value summary and does provide a better comprehensive picture than what is currently used for fair market value in financial statements and filings. One of the more significant concerns in using EVE for some financial statement disclosure or supplemental information is that what EVE is and isn’t is already so broadly misunderstood that the risk may not be worth the potential benefit.
Perhaps it is time, if not to use the EVE in financial statement disclosure, then at least adjust the ASC 825 disclosures to include a valuation of core deposits and a summary of critical assumptions behind the valuation. Formal core deposit studies are the norm rather than the exception. Ignoring the value is becoming more dangerous in the current environment. The risks to the industry, where depositors and investors can react to information, comprehensive or not, with lightning speed, are pretty high.
For more insights from Darling Consulting Group, click here.
ABOUT THE AUTHOR
Bob Lallo is a Managing Director at Darling Consulting Group. He has an extensive 35-year background in community banking. Prior to joining DCG, he served as executive vice president and CFO of a publically traded savings bank, as well as several years as an audit manager at a worldwide public accounting firm.
Bob is a graduate of Boston College with B.A. degrees in accounting and finance.
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