A Commentary on the Silicon Valley Bank Debacle

Undertaken in response to the recent rash of banking failures, the analysis presented in this paper is intended to serve as a cautionary tale for auditors, highlighting possible reasons why a potential audit failure at Silicon Valley Bank (SVB) occurred. Although a significant decline in held-to-maturity (HTM) investments appears on the balance sheet, neither the regulators nor the external auditor KPMG provided any information that would have alerted the public as to the misalignment of SVB’s investments in long-term debt securities with on-demand deposits, which led to its bankruptcy. Ostensibly, the auditor and SVB management discussed the proper valuation and disclosure regarding HTM and available-for-sale (AFS) securities; however, the nature of SVB clientele, coupled with the interest rate projections, should have prompted explicit risk factor disclosures in SVB’s financial statements regarding their effects.¹

Considering the circumstances outlined in this paper, a going concern decision² and/or the inclusion of a critical audit matter (CAM) in SVB’s 2022 audit report was arguably warranted. According to Martin Baumann, the leading contributor in writing the applicable PCAOB auditing standard, the circumstances and events that brought about SVB’s collapse appear to meet all the requirements of a CAM,³ including a complex, challenging, or subjective matter, material to investors, that was surely discussed with the audit committee⁴ (Eaglesham 2023). Furthermore, the manner in which current litigants are citing incomplete disclosures to bolster their arguments against bank auditors might be cause for them to reexamine their reporting tendencies within the industry. According to a Wall Street Journal report (Eaglesham 2023), none of the auditors for midsize banks with the highest rates of losses on HTM securities (SVB was ranked second) provided a CAM regarding their treatment; however, 90 percent of them did include a CAM regarding loan losses, which is the most prevalent, and usually only, CAM provided by bank auditors (Simpson and Owens 2020).

With its home base in Santa Clara, CA, SVB provided banking services to nearly 50 percent of all venture capital companies and start-up companies around the globe. SVB’s deposits tripled in size during and after the pandemic, prompting the bank to buy shares of long-term Treasury bonds with fixed interest rates and mortgage bonds (which have low interest rates but typically low risk) instead of investing in other technology firms (Zahn 2023). Treasury securities are considered safe investments, but not if interest rates rapidly rise because the value of the Treasury securities falls dramatically.

SVB’s troubles began in earnest when the Federal Reserve forecasted a series of federal funds rate hikes in May of 2021 (a timeline depicting SVB’s collapse is presented in Figure 1). The first rate increase since 2018 was enacted in March of 2022, and, from a base of 0.25 percent, six successive rate hikes culminated in a 4.50 percent federal funds rate at the end of 2022, with more increases on the horizon for 2023 (Tepper 2023). These events posed a significant risk to SVB, as any material decline in the interest rate spread (rates charged on loans minus rates paid on deposits) could adversely affect the bank’s stability by impairing its ability to fund operations. According to Davidson (2023), the rapidly rising interest rates caused an inverted yield curve resulting in net margins being squeezed and a massive decline in the value of bonds.

In its 2021 10-K report, SVB heralded an exceptional year with a net income of $1.8 billion. The balance sheet reported that 66.2 percent of its total assets were in cash and marketable securities. Importantly, SVB failed to document any risk assessment of the likelihood of federal interest rate increases and the subsequent effects on the bank’s financial condition. The internal control certification mandated by the Sarbanes-Oxley Act of 2002 was signed by Greg Becker, President and Chief Executive Officer (CEO), and Daniel Beck, Chief Financial Officer (CFO), stating that the financial statements were true and not misleading, there were no significant deficiencies or material weaknesses in the design or operational internal control over financial reporting, and there was no disclosure of any fraud signifying material weaknesses to KPMG.⁵

With inflationary pressures abounding in the market during 2022, SVB’s financial position began to crumble. In its 2022 10-K report, filed on February 24, 2023, management noted that market volatility and fundraising difficulties impacted balance sheet growth and investment valuations; nevertheless, SVB presented a positive spin on its condition⁶ even though pre-tax income decreased by 20 percent and total investment securities decreased by $7.905 billion (the balance sheet indicated a decrease of $1.152 billion in AFS securities and $6.874 billion in HTM securities, offset by an increase of $0.121 billion in other securities). Although the financial statements make no mention of the possible impact of rising interest rate effects on AFS and HTM securities in Item 1 A: Risk Factors, this section includes only the following language regarding market and liquidity risks, which may have a bearing on investments:

• Instability and adverse developments in national or global financial markets and overall economic conditions…may materially affect our business, financial condition, and results of operations.

• Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

These statements are arguably rather generic and could be applicable in any fiscal year, especially compared with the verbose and detailed disclosure that was provided by a similarly positioned institution, First Republic Bank, in its 2022 annual report (see Exhibit 2). For both the 2021 and 2022 fiscal year, KPMG stated that the financial statements were presented fairly in conformity with U.S. generally accepted accounting principles (GAAP), and effective internal controls were maintained over financial reporting. A no going concern opinion was proffered, and the only CAM discussed by KPMG was the allowance for credit losses for loans and unfunded loan commitments for certain portfolio segments evaluated on a collective basis (see Exhibit 3).

On March 8, 2023, SVB sold $21 billion of its AFS security holdings at an after-tax loss of $1.8 billion. Then, after trading hours, SVB announced in a press release that it would raise $1.75 billion by selling $1.25 billion of its common stock and $500 million of its convertible preferred stock. In a letter to SVB’s customers, CEO Greg Becker said the bank enjoyed the “financial position to weather sustained market pressure,” but noted that deposits were lower than forecasted in February (Giang and Dang 2023). Moody’s downgraded SVB’s bond rating and dropped its outlook of the bank from stable to negative.

These events prompted concerns about the bank’s stability. Simultaneously, the inflationary environment exacerbated financial difficulties as the technology companies began to withdraw money from their deposit accounts to fund growth. As the Federal Reserve kept raising interest rates, borrowing became costlier, further accelerating the pace of withdrawals, culminating in a run on the bank (Rugaber and Sweet 2023).

SVB’s stock price fell by 60 percent on March 9th and continued to fall during the night (Gura 2023). Trading of SVB’s shares was stopped the next morning. On a conference call on March 9th, Becker told the bank’s depositors to stay calm because the bank had ample liquidity (Murray 2023). On March 10th, the California Department of Financial Protection and Innovation (CDFPI) shut down SVB and put it into receivership. The Federal Deposit Insurance Corporation (FDIC) created a bridge bank to oversee the deposits with the promise that insured deposits would be available on the 13th; however, most of SVB’s depositors had large accounts well in excess of the $250,000 limit for federal deposit insurance protection.

Ultimately, federal regulators announced that all deposited funds would be fully recovered whether insured or not. This decision was made to avoid a loss of confidence in the banking system. Mere days following the collapse of SVB, the Department of Justice (DOJ) and the SEC opened investigations, apparently ongoing, into possible infractions of federal securities laws (Mattingly 2023). According to Neukam (2023), although charges may not eventually be filed, the DOJ’s act of opening an investigation suggests that it at least suspects that criminal activity may have been committed.

On April 28, 2023, Michael Barr, the current Federal Reserve Vice Chair for Supervision, concluded that the federal government was partly to blame for not taking forceful enough action as concerns mounted.⁷ In the Federal Reserve Bank’s Report on the Supervision and Regulation of SVB (Barr 2023), the failure was described as a textbook case of mismanagement. The report blames the bank’s board of directors and management for failing to effectively manage risks regarding interest rates and liquidity (Peregrine 2023).

The FDIC took responsibility for insufficient supervision of the banking industry. Reasons cited included staffing shortages and communication delays (Rodini 2023). According to the report, in October 2022, the CDFPI found deficiencies in SVB’s internal audit function, fueled by material weaknesses in risk assessment procedures. Furthermore, in November 2022, the Federal Reserve considered removing SVB CEO Greg Becker from the board of the Federal Reserve Bank of San Francisco (San Francisco Fed), reducing SVB’s interest rate risk rating and downgrading the bank’s CAMEL⁸ ratings but refrained from doing so because of concerns that such actions would send a negative signal to the market (Gandel and Smith 2023). Finally, on November 15, 2022, the San Francisco Fed, in conjunction with the CDFPI, issued a letter to Becker, noting that SVB’s internal interest rate risk simulations were not reliable and called into question the effectiveness of the bank’s risk management practices.⁹

According to Cohn (2023), spokespersons for KPMG commented that audits are based on evidence available only up to the date of the opinion, and that the auditor cannot be held responsible for unanticipated events.¹⁰ Moreover, KPMG CEO Paul Knopp stood by the audit reports issued for SVB, claiming that the auditor followed professional standards. Not surprisingly, such a statement received a flurry of pushback. For instance, McKenna (2023) notes that pending litigation is based on the accounting firm’s failure to include a going concern emphasis and/or any CAMs in SVB’s audit reports related to the effects of rising interest rates.

Prior research reveals that auditors are generally reluctant to issue a going concern opinion for banks even when warranted (e.g., Masli, Porter, and Scholz 2018). Based on data from the 2008 banking crisis, Albrecht, Glendening, Kim, and Pereira (2020) note that Big 4 auditors were particularly hesitant to issue a going concern opinion to banking clients due to the interconnectivity of the banking system and the risk of a domino effect befalling the industry. Moreover, McKenna (2023) insinuates that auditors may view the going concern opinion as a “self-fulfilling prophecy” and are therefore extremely reticent to provide one. Even more compelling, McKenna’s sources suggest that, in the aftermath of the 2008 banking crisis, an investigation revealed that Big 4 auditors did not report any going concern issues because they were informed, confidentially, that governments (both in the United States and abroad) would bail out the banks.

Unveiling any clues as to the auditor mindset regarding CAM usage is difficult. First, the applicable standard has only been in effect since as early as 2019. Second, a substantial portion of research, usually dedicated to examining the complex interplay between the auditor’s usage of CAMs and their effects on potential litigation risk, was anticipatory (Brasel, Doxey, Grenier, and Reffett 2016; Gimbar, Hansen, and Ozlanski 2016; Doxey et al. 2017; Vinson, Robertson, and Cockrell 2018). More recent research finds that auditors do not seem to try to preempt scrutiny by reporting CAMs in the presence of higher litigation risk; however, auditors do include CAMs in conjunction with lower reporting quality and auditor conservatism (Elshafie 2023). Even scarcer is research on CAM usage within the U.S. banking sector.¹¹

According to Maksymov et al. (2019), the majority of litigation brought against audit firms ends in a settlement; consequently, many legal issues remain unobserved by the public at large. This strategy mitigates the risky outcome inherent in a jury trial, allows each side the ability to frame the outcome as a win, and limits both expenses and negative press coverage. In their summary of the researchers’ findings, De Meyst, Lowe, Peecher, Pickerd, and Reffett (2021) point out that attorneys are wary of suing Big 4 auditors because they do not appear phased by lawsuits adversely affecting their reputations and are notoriously uncooperative within the litigation process.

Notwithstanding these impediments, legal actions are in process. On March 13, 2023, Chandra Vanipenta, individually and on behalf of all others in such a situation, filed a complaint for violation of the federal securities laws against SVB Financial Group, Greg W. Becker (CEO), and Daniel Beck (CFO). Covering the period from SVB’s 2021 10-Q report issuance to the 2022 10-K report issuance, the plaintiffs claim that there was no disclosure of the risk that future rate hikes signaled by the Federal Reserve Bank would have on the company’s business and there were no material changes to the risk factors stated in previous SEC filings. The report contained certifications by Becker and Beck attesting to the accuracy of financial reporting, no material changes to internal control, and no necessary fraud disclosure (Chandra Vanipenta v. SVB Financial Group et al. 2023).

Subsequently, on April 7, 2023, a lawsuit was filed by City of Hialeah Employees’ Retirement System on behalf of themselves and all others similarly situated against SVB’s chief executives and other bank directors and officers, KPMG, and the bank’s underwriters, including Goldman Sachs, Bank of America, and Morgan Stanley. This lawsuit claims that the defendants “misrepresented the strength of the company’s balance sheet, liquidity, and position in the market.” Also, the defendants understated and concealed the magnitude of the risks to the bank of the Federal Reserve Bank deciding to raise the federal funds rate, which would negatively affect the value of the bank’s securities portfolio (City of Hialeah Employees’ Retirement System et al. v. Greg W. Becker et al. 2023). As related to KPMG in particular, the complaint contains the following (City of Hialeah Employees’ Retirement System et al. v. Greg W. Becker et al. 2023, 24):

The litigants provide support for such a position by citing a Washington Post report claiming that SVB executives were aware of the bank’s precarious risk exposure as early as 2020. Specifically, the report mentions that SVB executives disregarded their own internal risk modeling metrics and purposefully engaged in unsound investment strategies to continue to demonstrate substantial growth. Moreover, the executives are accused of altering the model’s assumptions “so that it would incorrectly predict that rising interest rates would have little impact on SVB” (City of Hialeah Employees’ Retirement System et al. v. Greg W. Becker et al. 2023). The plaintiffs also point to evidence that the San Francisco Fed had given SVB six citations throughout 2021 regarding a dearth of on-hand cash in the face of possible losses due to rising interest rates.

A confluence of factors surrounds KPMG’s arguably inappropriate handling of the SVB 2022 fiscal year audit. First, this paper presents compelling evidence that a material weakness may have existed regarding SVB’s risk management practices that the auditor should have addressed (i.e., ineffective governance oversight, misguided interest rate risk modeling, and inappropriate investment strategies). Second, critiques from regulators (i.e., repeated citations from the San Francisco Fed and the CDFPI) should have spurred the auditor to insist on more descriptive risk disclosures from its client. Third, evidence suggests that SVB was already undercapitalized, and the inevitable pressures of significant interest rate increases coupled with substantial investments in AFS and HTM securities and booming deposit demand would most likely sink the firm—as argued by litigants, these conditions may have supported a going concern opinion. Fourth, despite ostensibly meeting all of the criteria within the applicable auditing standard, the auditor provided no CAM mentioning the bankruptcy-inducing liquidity risks in its audit report.

The situation in which KPMG now finds itself may have implications for other bank audits.¹² Unique aspects of the banking industry, including seemingly strict and precise accounting and governmental regulation (from the Federal Reserve and the FDIC, among others) may contribute to Big 4 auditors’ predisposition to withhold both going concern opinions and certain types of CAMs from their audit report. In addition, the “too big to fail” precedent established by governmental entities within the banking sector may further compound auditor disclosure reluctance (as suggested by McKenna 2023). Perhaps the Big 4 auditors should be more concerned that plaintiffs’ scrutinization of CAMs, or lack thereof, may be gaining momentum within the realm of audit litigation (e.g., A. Grossman, S. Grossman, and Crumbley 2023). Auditors may wish to rethink their approach to banking sector audits, as staying silent may ironically precipitate a loss of confidence in the financial information they seek to verify.