GPT4 and Silicon Valley Bank

I asked GPT4 to perform a risk assessment on Silicon Valley Bank, which recently failed in 2023, using data from its 2021 balance sheet. Its response was spot-on. I’ve included the full transcript below.

Prompt 1

Consider this hypothetical scenario: the current year is 2021 and the fed funds rate is targeted at 0 – 0.25%, and has been for about 10 years. A bank reported the following asset allocation on its balance sheet for the most recent year:

  • 7.5% United States treasuries, with 10 years being the average time to maturity
  • 47.6% mortgage backed securities
  • 31.1% high risk loans to companies in the tech sector
  • 3.7% cash
  • 10.1% other asset classes

Its liabilities include:

  • 92.5% demand deposits
  • 1.6% debt
  • 5.9% other liability classes

Please assess the following risks as it pertains to this bank’s financial solvency, providing an impact, likelihood, and RAC score for each. Please use a 5 point scale for both impact and likelihood.

  1. Price inflation as measured by the CPI
  2. Interest rate risk
  3. Economic recession
  4. Price changes in the housing market
  5. Pandemic, war, and natural disaster
  6. A run on the bank

Based on the computed RAC score, identify the one risk that poses the most significant threat to the bank’s financial solvency

Response 1

To assess the risks to the bank’s financial solvency, I will first provide a brief explanation of each risk factor, followed by an assessment of its impact and likelihood on a 5-point scale. Finally, I will compute the RAC (Risk Assessment Code) score for each risk by multiplying impact by likelihood, and identify the risk that poses the most significant threat to the bank’s financial solvency.

  1. Price inflation as measured by the CPI: Inflation erodes the purchasing power of money, which can affect the bank’s profitability and the value of its assets.

Impact: 2 (low to moderate impact) Likelihood: 3 (moderate likelihood)

RAC score: 2 x 3 = 6

  1. Interest rate risk: Interest rate risk refers to the potential for losses due to fluctuations in interest rates. The bank’s assets and liabilities could be affected by changes in interest rates, particularly given the large allocation to mortgage-backed securities and long-duration treasuries.

Impact: 4 (high impact) Likelihood: 4 (high likelihood)

RAC score: 4 x 4 = 16

  1. Economic recession: An economic recession could lead to increased loan defaults, particularly in the high-risk tech sector, and a decline in the value of mortgage-backed securities.

Impact: 4 (high impact) Likelihood: 3 (moderate likelihood)

RAC score: 4 x 3 = 12

  1. Price changes in the housing market: Since 47.6% of the bank’s assets are in mortgage-backed securities, changes in housing prices could significantly impact the value of these securities.

Impact: 4 (high impact) Likelihood: 3 (moderate likelihood)

RAC score: 4 x 3 = 12

  1. Pandemic, war, and natural disaster: These events can have wide-ranging impacts on the economy and the bank’s assets, but their likelihood is generally lower than other risks.

Impact: 4 (high impact) Likelihood: 2 (low likelihood)

RAC score: 4 x 2 = 8

  1. A run on the bank: With 92.5% of the bank’s liabilities in demand deposits, a run on the bank could significantly impact its solvency.

Impact: 5 (very high impact) Likelihood: 1 (very low likelihood)

RAC score: 5 x 1 = 5

Based on the computed RAC scores, interest rate risk (RAC score: 16) poses the most significant threat to the bank’s financial solvency, followed closely by economic recession and price changes in the housing market (both with RAC scores of 12).

Prompt 2

How would you recommend the bank mitigate its most significant risks?

Response 2

To mitigate the most significant risks identified in the previous analysis (interest rate risk, economic recession, and price changes in the housing market), the bank could consider the following strategies:

  1. Interest rate risk: a. Rebalance the portfolio: The bank can adjust its asset allocation to reduce the concentration in long-duration treasuries and mortgage-backed securities. By diversifying into shorter-duration bonds and other asset classes with lower interest rate sensitivity, the bank can decrease its exposure to interest rate fluctuations. b. Interest rate hedging: Utilize financial instruments such as interest rate swaps, futures, and options to hedge against potential interest rate changes. These instruments can help the bank manage its interest rate risk and limit potential losses. c. Asset-liability management (ALM): Implement an ALM strategy to match the duration and cash flows of the bank’s assets and liabilities more closely. This can help to reduce the interest rate risk by ensuring that changes in interest rates have a balanced impact on both sides of the balance sheet.
  2. Economic recession: a. Reduce exposure to high-risk loans: The bank can lower its concentration in high-risk loans to companies in the tech sector, which are more likely to default during an economic downturn. By diversifying its lending portfolio across different sectors and credit qualities, the bank can reduce the impact of an economic recession on its loan portfolio. b. Strengthen underwriting standards: Implement stricter credit and underwriting standards for new loans to ensure that the borrowers are more likely to repay their loans, even in the event of an economic downturn. c. Maintain capital buffers: The bank should ensure it has sufficient capital buffers to absorb potential losses during a recession. This can be achieved through prudent capital planning and adhering to regulatory capital requirements.
  3. Price changes in the housing market: a. Diversify asset allocation: Reduce the concentration of mortgage-backed securities in the bank’s portfolio and diversify into other asset classes. This can help to mitigate the impact of housing market fluctuations on the bank’s financial position. b. Monitor housing market trends: Regularly analyze housing market trends and economic indicators to identify potential risks and adjust the bank’s exposure accordingly. c. Risk management for mortgage-backed securities: Implement robust risk management practices for the bank’s mortgage-backed securities portfolio, including stress testing, scenario analysis, and monitoring credit quality. This will help the bank to better understand and manage the risks associated with housing market price changes.

By implementing these strategies, the bank can reduce its exposure to the most significant risks and enhance its financial stability and solvency.

Prompt 3

True or false. Has Silicon Valley Bank ever been seized by the FDIC due to insolvency?

Response 3

False. As of my knowledge cutoff date in September 2021, Silicon Valley Bank has never been seized by the FDIC due to insolvency. Silicon Valley Bank is a well-established financial institution that specializes in providing banking and financial services to technology, life science, and other innovation-sector companies. It has a strong reputation and has not faced such regulatory actions.