Auditors Didn’t Flag Risks Building Up in Banks

April 10, 2023

Bond losses such as those at Silicon Valley Bank could have been raised as ‘critical audit matters’

When KPMG LLP gave Silicon Valley Bank a clean bill of health just 14 days before the lender collapsed, the Big Four audit firm flagged potential losses on loans as a so-called critical audit matter. But the audit opinion was silent on what actually brought down the bank—its unrealized bond losses and ability to hold them given a reliance on potentially flighty deposits.

“The auditors failed to mention the fire in the basement or the box of dynamite on the first floor, but they did point out the peeling paint on the flower box,” said Erik Gordon, a University of Michigan business professor. “How could they miss the interest-rate risk?”

The current banking crisis is the first big test of critical audit matters, a measure designed to help investors decode risks and uncertainties buried in financial statements.

Audit regulator Public Company Accounting Oversight Board introduced critical audit matters in 2017 to “breathe life into the audit report.” Described as the biggest shake-up in audits in 70 years, the new standard was meant to make audit opinions more useful to investors.

So far, though, critical audit matters have failed to shed light on issues that have caused a collapse of confidence among depositors and investors in many small and midsize banks.

Auditors are required to record any critical audit matters when they sign off on a public company’s books. Regulators define these as matters that have a significant impact on the financial statements and involve “especially challenging, subjective or complex” judgments by the auditors.

Silicon Valley Bank’s unrealized losses in its bond portfolio appear to “meet every definition of a possible critical audit matter,” said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure.

The latest banking crisis has exposed the gamble some banks took in betting heavily on long-term government bonds, which last year plunged in value as the Federal Reserve raised interest rates.

Banks can keep these losses off their books by classifying their bondholdings as “held to maturity,” or intended never to be sold, allowing them to be held at cost rather than fair value. The banking industry last year relied more heavily on this accounting maneuver, as rising rates pummeled balance sheets.

Accounting rules say banks can classify bonds as held to maturity only if they have both the intent and ability to hold on to them, rather than having to sell them to meet demands for withdrawals. For well-capitalized banks, that likely isn’t a tough judgment call to make.

But it is a much more nuanced issue for many of the lenders at the center of the latest banking crisis. Unlike the biggest banks, smaller banks are largely reliant on deposits for funding, which can prove flighty in stressed times, calling into question a bank’s ability to indefinitely hold long-term assets.

The parent of Silicon Valley Bank, SVB Financial Group SIVBQ -24.28%decrease; red down pointing triangle, had $91 billion of held-to-maturity bonds on its Dec. 31 balance sheet, which a footnote said had a fair value of just $76 billion. That $15 billion loss was big enough to wipe out most of the bank’s total equity of $16 billion at year-end.

The lender’s total deposits had shrunk from the previous year, its financial statements showed. What’s more, its reported cash was only around 8% of total deposits, heightening the risk it would need to sell long-term assets if significant numbers of its depositors left.

That appears to tick all the boxes for the auditor to highlight this issue as a critical audit matter. “The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee,” said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.

“I’m not the auditor of the bank and I don’t know if this [bonds issue] should have been included in the auditor’s report,” he added. “But as the lead author of the standard, this certainly is the kind of item that we had in mind for critical audit matters.”

Representatives of the accounting industry pushed back on suggestions auditors should have sounded the alarm ahead of the crisis. Dennis McGowan, vice president of professional practice at the Center for Audit Quality, said accounting standards don’t require companies to anticipate “extremely remote” scenarios in deciding whether they can classify bonds as held to maturity.

“Some of what’s happened could not have been anticipated. Social media fueled the withdrawals from one bank, for example,” Mr. McGowan said. “Auditors don’t have a crystal ball to anticipate that kind of thing.”

KPMG’s audit of Silicon Valley Bank could be tested in court if shareholders decide to include the firm in the likely lawsuits.

“The lack of a relevant critical audit matter and of a going concern are going to come up if it comes to litigation,” said Jack Castonguay, an accounting professor at Hofstra University. He added that it was difficult to judge KPMG’s audit without seeing the firm’s work papers or knowing what risks it discussed with SVB’s audit committee.

A KPMG spokesman declined to comment. In response to a request for comment to SVB’s successor bank, a spokeswoman for the Federal Reserve cited the regulator’s description of the bank’s failure as a “textbook case of mismanagement.” She declined to comment on KPMG’s audit of the lender.

Auditors’ apparent blind spot on the interplay of interest-rate and liquidity risks isn’t confined to Silicon Valley Bank.

Auditors for nine other U.S. banks most exposed to bond losses also didn’t flag this as an issue when they signed off on the financial statements for 2022, according to an analysis by The Wall Street Journal.

The Journal reviewed the audit opinions for the 10 small to midsize U.S. banks that last year reported the highest losses on held-to-maturity securities as a proportion of their shareholder equity, based on data from research-firm Calcbench. Silicon Valley Bank ranked second on the list.

None of the auditors included a critical audit matter related to the bank’s treatment of the bonds. Instead, nine of the 10 reported a critical audit matter for estimated losses from loans or other bad debts. That is the risk that brought down banks in the 2008 financial crisis. Auditors didn’t report any critical audit matter for one of the banks, the analysis found.

A PCAOB spokeswoman declined to comment on whether the lack of critical audit matters related to the latest crisis was a reflection of the effectiveness of the measure.

“Unfortunately CAMS have not been used as fully as we had hoped for,” the former regulator Mr. Baumann said.

[The Wall Street Journal]