Compliance Confessionals – Banking 101: Recent SVB and other US bank meltdowns

Compliance expert and former Head of Compliance, Sylvia Yarbough, shares secrets and insights from the heart of the compliance team.

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I know all of us Compliance and Risk professionals have been watching the unfolding of the recent banking crisis over the last few months. Those of us that have been around for a while, are really scratching our heads wondering how we got here AGAIN. There are so many articles in the media on recent bank issues with some more accurate than others. We old-timers in the industry have had a great deal of discussion with our peers and colleagues on this topic, so I figured I would take a moment and summarize my assessment and opinion of the situation.

A recap on “March Madness”

We were all so focused on Silicon Valley Bank (SVB) some of us may have missed the other banks with issues:

On March 1, Silvergate Bank, based in San Diego, California (CA) with an asset size of 11.36B (2022), announced it would begin voluntary liquidation proceedings. The company primarily services cryptocurrency users and with the fall of cryptocurrency prices and the bankruptcy of FTX, a Bahamas-based cryptocurrency exchange, Silvergate experienced a 32% decline in its deposits and had heavy losses in its loan portfolio.

On March 10, SVB had a run on the bank that led to its involuntary takeover by Federal Regulators. SVB, formerly based in Santa Clara, (CA) with assets of $209B (2022), business model focused on the venture capital market. SVB has been taken over by First Citizens Bank based in Raleigh, North Carolina (NC) with assets of $109B (2022).

On March 12, Signature Bank, based in New York City, New York State (NY) with assets of 110.4B, was forced to close its doors by the New York Banking Regulators. Signature engaged with the cryptocurrency industry with the crypto business making up about one-third of its deposits. Its customers drew down approximately $10B in deposit balances. In addition, it was under investigation by the Department of Justice for failure to monitor transactions for money laundering proactively. It is under FDIC receivership and is being overtaken by New York Community Bancorp.

On March 16, the First Republic, based in San Francisco, CA with an asset size of 212.6B (2022), received $30B from eleven of the largest US banks to stabilize the bank due to a run-on deposit. First Republic’s business is commercial banking and wealth management services with its focus on high-net-worth individuals.

It was, indeed, a very busy March. However, the question we should all ask is how did we not see this coming and how many more banks are out there that may have similar issues? My peers and I broke down these issues in what we call Banking 101 lessons, which include:

Banking 101

Liquidity Management

Yes, good old fashion liquidity Management would be overseen by the Asset Liability Committee (ALCO). In simple terms, the maturity and returns of the bank’s assets need to align with the bank’s liabilities. With 15 years of low-interest rates and the market volatility of 2022, most banks have resorted to a heavier reliance on Mortgage-Backed Securities, Treasury Bonds/ Bills – what would be normally considered a lower risk with a good return on investments, albeit the majority of which is for very long terms. However, when this makes up your entire investment strategy for the growing liquid (short-term) deposits sitting on your balance sheet, the level of risk is magnified. The Fed’s increase in interest rates each quarter has resulted in significant unrealized losses on some banks’ balance sheets. Those not sufficiently capitalized like our “March Madness” Banks could survive the hit.  A traditional bank’s investment portfolio is much more diversified between long and short-term investment assets as well as a robust loan portfolio.

Diversification Strategy

As with all businesses, banks need to look at their diversification strategy. In the case of the March Madness Banks. We all can see a common theme. These banks had concentration risk in one type of industry or business model. Even worse, it was all cutting-edge industries like Crypto or Venture Capital or high-net-worth clients, unlike traditional banks that typically cover the gambit of industries and customer base.

Capital Management

For almost 15 years after the global economic crisis, banks should have been pushed to ensure that they were well capitalized under various stress scenarios – including interest rate shocks. Yes, we are all aware that in 2018 mid-size banks were no longer required to participate in the regulatory requirement. However, if we learned anything from 2008, it would have been a good business practice to model these scenarios and see how the organization might fare in a rising rate environment. At a minimum, most banks might have started to look at this when the Federal Reserve began raising interest rates to combat inflation. Where were the risk management teams? SVB didn’t even have a Chief Risk Officer for a year before its collapse.

Executive Management

The establishment and growth of these “Boutique” banks have taken off since 2010. Most of these banks are playing to whatever is the hottest growth market at the time. They often have an executive leadership team that is at the start of their careers or have moved up in the ranks at the same bank so they may not have learned some of the traditional banking lessons. There is something to be said to have been in a senior or executive leadership role during a few of the downturns in the banking industry. In the case of the former CEO at SVB, he was promoted through the ranks at SVB and became CEO in 2011 during the upswing, coming out of the “Great Recession”.

Board of Directors

The Board of Directors at these new institutions tend to come from the industry or have connections to the industry that is the bank’s primary focus. In a traditional banking model, you will find a Board of Directors with a variety of backgrounds that bring some breadth to the understanding of various topics, including risk management. In the case of SVB, only one board member had direct investment banking experience.

Customer Loyalty

Traditional banks still harp on building brand and customer loyalty. Some would say that such a thing is not real anymore. However, companies, including banks, still spend a good amount of their marketing dollars on this concept. The assumption of most of these “Boutique” banks is that they are offering unique services that will build long-term relationships with their customers. The reality we have seen play out is proving very different. The deposit holders in each of these bank scenarios had no loyalty. These are private equity firms, tech firms, and crypto companies that are scrambling to grow and can’t afford one misstep, including a banking partner not being fully operational. They will move their funds quickly to avoid a business disaster,

Where are the regulators?

It seems our friendly regulators are also struggling. Most of those who lived through the dark days of Dodd-Frank might have retired and/or been told to stand down with such aggressive regulating. However, 2023 should be a wake-up call – those who forget the past are doomed to repeat it. Yes, this is a different flavor of a banking crisis. Some banks operate in spaces where the regulators are still grappling to understand the risk and, therefore, can’t opine on expectations. Some regulators believe they don’t have the authority to push hard where they see problems. All regulatory agencies need to hold a caucus and figure out how they need to adapt to a more agile framework.

It isn’t about the last law that was passed that needs to be policed.  In its early days, I was involved in Comprehensive Capital Analysis and Review (CCAR), and it was the most awful process. It was more like an exercise to be completed than a tool to leverage. Regulators need to turn these laws into tools, not hurdles that banks can leverage to understand possible risks and develop contingency plans to address them. If that were being done correctly, all banks would have been ready for a fast-rising interest rate environment. It was one of the most frequent economic scenarios years back.  However, it was exercised banks had to complete, file, get a passing grade, and put on a shelf.

Regulators need to become more knowledgeable about changing industries in which these “Boutique” banks are operating. Venture Capital, Tech, Crypto, etc. banks are building entire business models on these industries and most of the regulators understand very little about these industries and the potential risk. If we were to have another recession, chances are SVB would have failed anyway as the venture capital market slowed or dried up completely, so it should have been on the regulators’ radar for a while now.

Another concern is the regulators’ practice of having an active bank CEO sitting on the Federal Reserve Regional Board as in the case of the former SVB CEO. Becker was a Class A director of the San Francisco Federal Reserve Bank Board from 2019 until March 2023. There are pluses to having active CEOs on these regulatory boards. However, how many would now say that his role on the board helped temper down the red flags being raised by the regulatory supervisors? Regulators tend to frown on any perception of improprieties or nepotism in the financial services industry. This may be an opportunity to look inward at this practice.

An outdated FDIC Insurance Program

As to FDIC insurance, over the last 15 years with exceedingly low-interest rates and, until 2022, a booming stock market, consumers have had more money to invest and save. It is true that $250K, the FDIC insurance limit, covers the average consumer. However, on every bank’s regulatory filing, the deposits that are covered and not covered by FDIC insurance are reported. The banks are required to file this information so who on the regulatory side has been paying attention to it, especially as a growing population of banks have an exceedingly disproportioned percentage of uninsured deposits to insured deposits.

Consumers don’t want to lose their money, so when they get the least idea that something may be amidst at their bank, they rush to move their funds around resulting in a run on the bank. These current runs on the bank are caused by the same fears that occurred in 2008 and in 1929 Black Monday, which resulted in the establishment of FDIC. It should not take another bank crisis to step back and look at the FDIC model and establish some additional parameters that may include notifying customers about the risk to their deposits more proactively, an increase of deposit insurance limits, or mandating a cap on individual deposits held in one bank. I am not sure of the answer, but we are all sure that after 50 years, the FDIC program needs to be relooked at under current and future scenarios proactively, not reactively.

One last word on the media

In today’s quick-moving media consumption environment, everything is newsworthy today and disappears tomorrow. Sometimes, I question if the media is reporting the issues or creating the issues. It is often hard to tell. If SVB could have quietly raised capital, they may not have been the mid-month headline. However, businesses these days can’t quietly do anything without it leaking to the media. If banks question their investment in public relations, I would highly suggest they double down on – I hate to say it – good “Spin Doctors.” Often the lack of public understanding of the complexities of running a bank and the regulatory underpinning shoring it up can make or break a bank. The media simplify things into one or two lines that a less astute public does not understand, and the result is panic.

If given the opportunity, could SVB have considered quietly reaching out to the regulators before this situation became public? Similar to the First Republic, they may have been able to get some of the larger banks to bail them out or drive their own liquidation like Silvergate. We have no control over the media. However, some level of control over the message and how the problem is handled and delivered to the media would have had less of an impact. There were some of the “Too Big to Fail” that survived 2008 just because of their ability to manage the spin.

In conclusion, there are many more banks out there at a pivot point based on the next interest rate announcement. It is my general hope that their internal risk management and executive management are working with the regulators and are taking a closer look at shoring up balance sheets. If the interest rate rise isn’t enough of a problem for a bank’s balance sheet, what will happen if we go into a full recession? Truth be told, the “Too Big to Fail” banks have it covered. They have been beaten into submission. However, they make up the top 8 or so of the approximately 4,200 FDIC-insured commercial banks in the United States.

*Note for those of you that are not College Basketball fans, March Madness is a reference to the NCAA college basketball tournaments that begin in March.