What Recent Bank Failures Can Teach Bank Leaders
What Recent Bank Failures Can Teach Bank Leaders
The recent failures of Silvergate, Silicon Valley Bank (SVB), and Signature Bank highlighted the dangers of banks trapped between significant withdrawals by depositors and an overreliance on assets with declining fair values to meet the liquidity needs for repaying the depositors. Bank leaders concerned with preventing similar issues can focus on balance sheet and liquidity management, internal controls, risk management, financial reporting, and communication with clients.
What Led to the Failures?
These banks failed as rising interest rates led to the devaluing of low interest available-for-sale securities with long-dated maturities, which exacerbated their liquidity crunch. For example, more than 90% of SVB’s assets that could be sold to meet liquidity needs were parked in these assets. These banks had accumulated many of these investments in a period of increasing deposits made by tech startups during a near-zero interest rate environment. When the interest rates rose and tech startups began withdrawing money due to a cooling in venture capital funding, the banks struggled to meet the liquidity requirements and were forced to sell their treasury bonds at a substantial loss.
Below, we distill the key lessons that bank leaders can take away from these failures.
Balance Sheet and Liquidity Management
The importance of strong balance sheet and liquidity management cannot be overemphasized. Interdependencies of all assets and liabilities should be properly evaluated, understood, and assessed each period, and the strategy should be shifted in accordance with changes in the risk environment, funding liabilities, and other microeconomic and macroeconomic factors. Some of the best practices a bank should consider include the following:
Have a healthy asset mix. An asset mix refers to the composition of assets on the balance sheet and should match up with funding and liquidity needs. An astute combination of short-term, medium-term, and long-term assets needs to be developed to address liquidity needs, provide a recurring stream of income, manage the downside of rate hikes, and capture the potential upside in a declining rate scenario. In determining the right mix, one should consider the duration of an investment and its income-yielding properties (i.e., fixed or variable), liquidity needs, the maturity profile of the liabilities backing up those assets, expectations of the microeconomic and macroeconomic environment, and the buffer required for a stressed economic situation.
Examine asset/liability sensitivity. A bank is asset sensitive if its assets reprice faster than its liabilities. In a rising interest rate scenario, a bank should often be asset sensitive since interest rate resets are typically advantageous to an asset-sensitive bank. However, asset sensitivity may bring on some undesired results after rates have peaked. Since the asset-liability mix may not be easily changed, an asset-sensitive bank’s earnings may be negatively impacted once rates start to decline. A bank should perform an interest rate risk analysis regularly to determine the impact of a sudden and/or gradual change in the interest rates and create guardrails to mitigate the bank’s exposure to an existential crisis.
Implement proper hedging. Hedging allows a bank to offset the risk associated with an underlying asset, liability, or transaction by entering into a risk-offsetting contract. Hedging protects a bank against unanticipated financial swings. An ideal interest rate risk manager envisions a variety of different interest rate scenarios and creates a strategy that can weather both slow growth/decline as well as more intense periods of expansion/contraction. Various hedging techniques may be used to combat the losses due to an increase in interest rates; for example, a pay fixed-receive variable would help offsetting losses on the fixed-rate securities. A well-thought-out hedging strategy based on the expectation of factors impacting the underlying instruments or transactions may not only be economically beneficial for a bank but may also help it navigate economic downturns or the loss of value in some of its assets.
Comprehensive Internal Controls
Governance and internal controls play a crucial role in monitoring risks that can destroy substantial value if unchecked. Management should consider the following best practices:
Assess the enterprise risk management (ERM) framework. This examination should evaluate the comprehensiveness of the framework and capture key risk areas highlighted by the recent crisis. Bank-run scenarios should also be modeled to ensure proper business continuity and resiliency testing.
Assess enterprise risk and controls. This assessment should include the following:
- Identifying concentration risk: Does the bank have significant exposure to concentration risk due to an overreliance on specific assets / liability categories?
- Rebalancing the asset and liability equation: Does the bank appropriately perform stress testing by modeling asset and liability maturity/repricing duration considerations? Do these tests include “shock” scenarios of sharp hikes/declines in interest rates and rapid deposit/withdrawal/liquidation events?
- Tracking changes in key business metrics: Does the bank track rapid change of key performance metrics and identify underlying causes and impacts? Are risks of rapid changes in key performance metrics assessed over different time horizons?
Assess the strength of the risk management function. Banks should ensure the risk management function has strong leadership, typically including a dedicated chief risk officer. The function should be staffed with sufficient experienced resources to perform all the requisite monitoring/testing. Smaller banks may consider outsourcing this function to obtain the right level of expertise.
Financial Reporting Considerations
Banks should ensure that appropriate accounting and reporting are considered, disclosures are thorough and accurate, and judgmental accounting considerations are adequately supported, as there will likely be more scrutiny by investors, regulators, and external auditors around these areas. Several best practices include the following:
Perform a going-concern analysis. Banks should evaluate if there is substantial doubt about an entity’s ability to continue as a going concern. Disclosures in the financial statements are required if conditions give rise to substantial doubt about an entity’s ability to continue as a going concern.
Challenge judgmental accounting policies. This especially includes those that could have a material impact on the financial statements to ensure they align with the relevant accounting standards as well as the expectations of the external auditor and those charged with governance. Specifically, consider policies around hedging and the classification of available-for-sale and held-to-maturity securities. Changes in accounting policies should be disclosed in the financial statements.
Evaluate subsequent events through the report issuance date. Banks should also include required disclosures about events that occur after a company’s year-end period but before the release of the financial statements. The financial statements are adjusted for events with pre-existing conditions that existed on the balance sheet date.
Communication With Customers and Investors
Communicating with customers and investors is a key factor in demonstrating that a bank is prepared to weather a negative economic scenario. Several best practices can aid in this communication.
Highlight the Federal Deposit Insurance Corporation’s (FDIC) protection of deposits. While customers may be concerned over the potential loss of their money, reiterating the security of their funds due to FDIC insurance can provide significant value.
Describe the risk management procedures that are in place to protect your institution and depositors. Banks should focus on their risk management procedures, balance sheet composition, and liquidity position. Banks can highlight the assessment of their deposits vs. loans, the diversification of depositors and assets, policies against lending money backed by illiquid securities, as well as the liquidity, value, and composition of held-to-maturity securities.
Ashley Ross and Antonio de Quesada also contributed to this article.