What is an Asset-Liability Mismatch?

Mar 12, 2023

Silicon Valley Bank's failure is the second largest bank failure in U.S. history, Washington Mutual being the largest in 2008.

The catastrophe was not driven by credit problems but mismatch of assets and liabilities.

What is an Asset-Liability Mismatch?

The asset-liability mismatch is when the bank has to pay a short-term liability for which it is undergoing a long-term asset.

Let’s try that again.

The Balance Sheet has Assets and Liabilities.

Loans are on the assets side of the Balance Sheet. They provide a future economic benefit.

The liabilities side of the Balance Sheet will include sources of funds, such as bank deposits. This is what the bank/company owes others.

The asset-liability mismatch takes place when the tenure of maturing loans (assets) does not match the tenure of the sources of funds (liabilities). Consequently, the assets and liabilities are incorrectly matched.

The asset-liability mismatch is examined by way of GAP analysis. A positive gap indicates that the bank has more assets than liabilities. A negative gap indicates bank has more liabilities than assets.

What happened to SVB?

SVB was a major lender to early-stage startup technology and healthcare companies.

A liquidity boom provided a major impetus to venture capital activity. SVB enjoyed a massive inflow of deposits from 2020 onwards (massive indicating billions and billions of dollars; $198 billion on March 31, 2022, from $74 billion in June 2020.)

This money was invested in low credit risk securities, such as bonds, but had a notable interest rate risk. As Barrons explained, SVB’s mistake was investing in longer-term mortgage securities with more than 10 years to maturity, rather than shorter-maturity Treasuries or mortgage issues maturing in less than five years. This led to an asset/liability mismatch.

As the Federal Reserve increased interest rates to combat inflation, these bond prices began to fall (Bond prices and interest rates move in opposite directions). SVB was now faced with falling prices of its fixed income securities. Then began in outflow of money as individuals were looking at higher yield opportunities.

SVB’s parent company, SVB Financial Group, said it would undertake a $2.25 billion stock sale after selling $21 billion of securities from its portfolio at a nearly $2 billion loss. Investors panicked. The share price plunged. Trading of the stock was halted. The regulator shut down the bank.

Morningstar’s view on SVB, by equity strategist Eric Compton

Aside from crypto-related meltdowns, this is one of the first banks we’ve seen that has really suffered a liquidity crunch, which has forced it to restructure the balance sheet and realize losses on its securities portfolios.

SVB scores materially worse than any bank we cover on liquidity and unrealized-loss metrics. This makes us think that SVB could be facing a unique liquidity crunch that does not have to feed through the entire system; however, it does highlight that these risks are now more elevated. It also highlights that it can be very difficult to predict how funding pressure can change in any given quarter and when these risks can materialize.

Banks bought mortgage-backed securities and Treasuries before interest rates started to rise. As interest rates have risen, the prices of these securities went down. Banks are holding a number of securities which technically have losses on them but as yet are unrealized.

The securities pose limited credit risk because Treasuries and government-backed MBS carry the explicit or implicit backing of the government. However, if a bank is forced to sell them at a loss, those losses will then flow through the balance sheet and start to erode equity. This presents a liquidity problem, especially if deposits start to leave the banks, which they are. Deposit outflows put more and more pressure on the banks to sell off existing assets. This risk has been lurking beneath the surface but just materialized in a big way for SVB. This is why bank stocks are selling off in response to this news.

Liquidity issues are an evolving risk worth watching.

A look at the past: India

In the past, the Reserve Bank of India has shown concern about this issue, and it was mentioned in the Financial Stability Report, 2010.

Specifically with the rapid growth observed in banks’ lending to the infrastructure sector which are long-term in nature, coupled with dependence of the banking system on deposits raises, which were short-term in nature. Do note, this was post the Global Financial Crisis of 2008.

An asset-liability mismatch led to the downfall of IL&FS, and PMC Bank.

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