KPMG’s role in the collapse of SVB, the epicenter of the global banking storm

When KPMG LLP gave Silicon Valley Bank a clean bill of health just 14 days before the lender went under, the Big Four audit firm pointed to potential losses on loans to its customers as one of its so-called critical audit issues. But the audit opinion didn’t mention what really brought the bank down: its unrealized losses on bonds and its ability to sustain them, given its reliance on potentially volatile deposits.

“The auditors didn’t mention the fire in the basement or the box of dynamite on the second floor, but they did mention the peeling paint on the planter,” says Erik Gordon, a business professor at the University of Michigan. “How could they have overlooked interest rate risk?” The current banking crisis is the first litmus test of the system of critical audit issues, a measure designed to help investors decipher hidden risks and uncertainties in financial statements.

Audit regulator Public Company Accounting Oversight Board introduced critical audit issues in 2017 to “bring the audit report to life.” Described as the biggest overhaul of audits in 70 years, the new standard was intended to make audit opinions more useful to investors. So far, however, critical audit issues have failed to shed light on the problems that have led to the collapse of depositor and investor confidence in many small and medium-sized banks.

Auditors are required to record any critical audit issues when approving a public company’s books. Regulators define them as matters that have a significant impact on financial statements and involve “especially difficult, subjective or complex” judgments by auditors.

Silicon Valley Bank’s unrealized losses on its bond portfolio “appear to meet all the criteria to be a potential critical audit matter,” writes Martin Baumann, former chief auditor of the PCAOB, who played a leading role in designing the new measure.

The latest banking crisis has highlighted the risk that some banks took by betting heavily on long-term government bonds, the value of which plummeted last year when the Federal Reserve raised interest rates.

Banks can disguise these losses by classifying their bonds as “held-to-maturity,” or intended never to be sold, allowing them to be held at cost rather than fair value. Last year, the banking sector made greater use of this accounting maneuver as rising rates hit balance sheets hard.

Accounting rules dictate that banks can classify bonds as held-to-maturity only if they have the intent and ability to hold them, rather than having to sell them to meet the demand for withdrawals. For well-capitalized banks, this is probably not a difficult decision to make.

But it is a much more nuanced question for many of the lenders in the eye of the latest banking storm. Unlike larger banks, smaller banks rely heavily on deposits for funding, which can prove volatile in times of stress, calling into question a bank’s ability to hold long-term assets indefinitely.

Silicon Valley Bank’s parent, SVB Financial Group, had $91 billion in held-to-maturity bonds on its balance sheet as of Dec. 31, which, according to a footnote, had a fair value of only $76 billion. That $15 billion loss was large enough to wipe out most of the bank’s total net worth of $16 billion at year-end.

The lender’s total deposits were down from a year earlier, its financial statements showed. In addition, its reported cash flow represented only 8% of total deposits, increasing the risk that it would have to sell long-term assets if a significant number of its depositors left the bank.

This appears to meet all the requirements for the auditor to highlight this issue as a critical audit matter. “The question of whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly complex, it was important to investors, and it’s hard to understand how liquidity was not an issue that was discussed with the audit committee,” opined Baumann, who was also a senior partner at PricewaterhouseCoopers, one of the Big Four audit firms.

“I’m not the bank’s auditor and I don’t know if this should have been included in the auditor’s report,” he added. “But as the lead author of the standard, this is certainly the kind of issue we had in mind when we were talking about critical audit issues.”

Accounting industry representatives rejected suggestions that auditors should have blown the whistle before the crisis. According to Dennis McGowan, vice president of professional practice at the Center for Audit Quality, accounting standards do not require companies to forecast “extremely remote” scenarios in deciding whether they can classify bonds as held-to-maturity.

“Some of what has happened could not have been foreseen. Social media drove withdrawals from a bank, for example,” McGowan argued. “Auditors don’t have a crystal ball to foresee that kind of thing.” KPMG’s audit of Silicon Valley Bank could be tested in court if shareholders decide to include the company in lawsuits that presumably will be filed.

“The lack of a relevant critical audit issue and a going concern are going to come out if it comes to litigation,” says Jack Castonguay, professor of accounting at Hofstra University. He adds that it is difficult to judge KPMG’s audit without seeing the company’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 Federal Reserve spokeswoman cited the regulator’s description of the bank’s failure as “a paradigm case of mismanagement.” She declined to comment on the KPMG audit.

The auditors’ apparent blindness to the interaction of interest rate and liquidity risks is not limited to Silicon Valley Bank . Auditors at nine other U.S. banks most exposed to bond losses also failed to note this problem when they approved financial statements for 2022, according to an analysis by The Wall Street Journal.

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

None of the auditors included a critical audit question related to the bank’ s treatment of bonds. Instead, nine of the 10 reported a critical audit question about estimated losses on loans or other bad debts. That’s the risk that brought down banks in the 2008 financial crisis. Auditors did not report any critical audit issues for one of the banks, according to the analysis.

A PCAOB spokeswoman declined to comment on whether the lack of critical audit issues related to the latest crisis was a reflection of the measure’s effectiveness. “Unfortunately, the critical audit issues have not been as fully utilized as we had hoped,” former regulator Baumann sentenced.

When KPMG LLP gave Silicon Valley Bank a clean bill of health just 14 days before the lender went under, the Big Four audit firm pointed to potential losses on loans to its clients as one of the so-called critical audit issues. But the audit opinion did not mention what really brought the bank down: its unrealized losses on bonds and its ability to sustain them, given its reliance on potentially volatile deposits.

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