Tuesday, 14 March 2023

Silicon Valley Bank – Key Take-aways for Transfer Pricing

With the Silicon Valley Bank (“SVB”) all over the financial news, in the below, we briefly summarize the case and provide you the key take-aways from a transfer pricing perspective on internal banks of multinational groups.

The fall of SVB

SVB primarily serves clients in the technology and life science/healthcare industries as well as the global private equity and venture capital sector. In recent years, an overwhelming amount of money flew to exactly these sectors, resulting in interest-bearing deposits at SVB tripling from 2020 to 2022 (according to its latest annual report). Moreover, start-up companies collect funds on the financial market and will ‘burn’ this money over time as they grow larger and larger. Unlike “normal” businesses, however, start-up companies typically do not require or are able to finance themselves via fixed income/business loans.

Of course, in view of SVB these deposits are liabilities, which the bank uses to turn them into assets such as business loans. However, due to the sheer size of the deposits, SVB could not turn all those deposits in acceptable assets and, thus, bought assets guaranteed by the US government, which seems reasonable (at the time). Nevertheless, as it bought assets with long duration (in a low interest rate environment), now it appears this was clearly an overly risky undertaking as there is a mismatch in duration between its liabilities and assets.

Given the current hike in interest rates, fixed income prices deteriorate. As long as clients did not withdrew their money from the deposit accounts, the balance sheet problem (as the fixed income assets are value at market value) is not an issue as time passes as SVB would still be able to collect the (low) interest rates on its assets.

However, due to the hike in interest rates, in view of SVB’s clients, there are more interesting options to invest rather than deposit money in low interest deposit accounts together with rumors concerning issues at SVB, created a bank run. This causes SVB to sell its assets which makes the balance sheet problem (the temporarily loss on fixed income at market value) a real issue and which wiped out its equity buffer.

Impact on internal banks

While this particular set-up will probably not cause issues with respect to internal banks of multinational corporations, directly, the underlying problem of mismatch between outstanding loans and incoming funds can nevertheless, also in the hands of internal banks cause problems.

Indeed, internal banks might be funded via long-term commitments. This created profits in the past as the interest rate of the historical funding of the internal banks are likely very low, whether its assets (i.e., outstanding loans to subsidiaries) are long or short term, the internal banks typically receive an interest rate higher compared to the interest rates is pays. Refinancing of the funding of the internal banks could turn those profits into losses. While in case its outstanding loan portfolio is rather short term, this loss scenario will also probably exist for a short period of time (refinancing of those loans will result in higher interest rates to be received by the internal banks), in case that its outstanding loan portfolio is rather long term, the loss scenario could be more resistant. Specifically if there is a mismatch between the refinancing moments of the outstanding loan portfolio of the internal bank and its funding.

Obviously, the functional risk profile of the internal bank of a multinational corporation, will determine who will bear those losses. In case the internal bank is characterized as a mere service provider, the entity earns a base remuneration in accordance with its costs and the losses realized will be borne by the entrepreneurial entity of the multinational group. However, in case the internal bank is characterized as an entrepreneur, bearing all or a significant part of the risks, the accrued losses will have to be borne by the internal banks.

If anything, the SVB case comes to show that banking, even without investing in complex financial instruments can (temporarily) be loss-making. This might be contrary to general beliefs (by tax authorities, for instance). It will be paramount to document the functional risk profile of the internal bank as well as its funding and outstanding loan portfolio to explain those losses.

Deposit rates

Another important take-away is the fact that although interest rates in general, in case of SVB on treasury bonds and mortgage-backed securities, started to rise, depositors did not react immediately. However, due to the hike in interest rates, depositors started to act by transferring their money out of their deposit accounts (which only generates a historical low deposit rate – which the banks are reluctantly increasing) to higher interest-receiving instruments.

The big cash-generating entities of the multinational group might be tempted as well to invest (temporarily) (a part of) their (excess) cash in higher interest-receiving instruments (particularly, in case those entities do not transfer the cash out of the deposit accounts, their so-called “options realistically available” should be firmly documented, although this remains a management decision). In turn, this might be an issue in view of the internal banks which are impacted in view of funding (in case internal banks are dependent on those deposits to fund outstanding loans). Dependent on the portfolio structure, it might be time to revisit the deposit rates set by internal banks.

Cash pool

Moreover, in view of cash pool, it will be important to set appropriate interest and deposit rate policies in order to determine the remuneration in view of the cash pool leader, but also – and more importantly - to support why cash-generating entities deposit their cash overnight, in comparison to investing in higher interest-generating instruments.

While intragroup cash pool systems might be a hassle from a transfer pricing perspective, please note that we have tools available which assist you to monitor the cash pool effortlessly and keep control over the system. Please do not hesitate to contact us if you want to know more about these tools, or whether you have any question on the above.

Kenny Van Tulder - Senior Manager