Home Banking Ex-ante Autopsy of a Failed Bank Using Public Information

Ex-ante Autopsy of a Failed Bank Using Public Information

by internationalbanker

By William C. Handorf, Ph.D.,Professor of Finance, Banking and Real Estate, George Washington University’s School of Business

  

 

 

 

Panics and failures have long been part of the US banking sector. These problems are typically associated with recessions, high unemployment or elevated interest rates caused by restrictive monetary policy. Poor asset/liability management—including high-risk lending, excessively quick asset growth unaccompanied by capital, undue interest-rate repricing gaps or asset/liability duration mismatches—and inadequate attention to maintaining sufficient liquidity and standby sources of funds render banks especially prone to hostile national or regional economies. Ultimately, failure can be traced to ineffective risk management and a lack of due care by management and the board of directors. Occasionally, fraud contributes to a bank’s difficulties.

Bank failure

In this article, we examine public information (regulatory filings and reports submitted to the U.S. Securities and Exchange Commission [SEC]) about Silicon Valley Bank (SVB) before (ex-ante) it was placed in receivership. Three large US regional banks, including SVB, suffered massive liquidity problems in early 2023 when the market recognized their large accumulated other comprehensive income (AOCI) losses relative to bank earnings and capital. SVB had purchased long-term Treasury and mortgage-backed securities during the low-rate pandemic period and later incurred large market value losses when the securities were marked-to-market. The central bank belatedly removed the pandemic’s accommodative monetary policy to focus on non-transitory inflation.

Unforeseen withdrawals of core and non-core deposits occur quickly if recent lending or investing losses impair a bank’s earnings and/or capital. Confidence is fragile, especially with the proliferation of social media, and requires management and the board of directors to ensure all risks are identified, measured, monitored and controlled. Congress and bank supervisors invariably respond to banking crises by calling hearings, enacting new restrictive laws and regulations and creating a new regulatory agency.1North Carolina Banking Institute (NCBI): “An Examination of the Factors Influencing the Enactment of Banking Legislation and Regulation: Evidence from Fifty Years of Banking Laws and Twenty-Five Years of Regulation,” William C. Handorf, Reggie O’Shields and Andrew Richardson, March 1, 2020, UNC School of Law, Volume 24, Issue 1, Pages 93-114. The laws impose incremental costs and asset/liability constraints.

The Federal Reserve Act of 1913 created the United States’ existing central bank. The Banking Act of 1933 established the Federal Deposit Insurance Corporation (FDIC) and gave the new agency the authority to provide limited federal deposit insurance to qualified deposit institutions. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) to liquidate and manage insolvent thrifts. Congress reacted to 2008’s Great Recession and panic with policy initiatives comparable to earlier US banking crises. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) created the Consumer Financial Protection Bureau (CFPB) and required banks, especially those deemed to be systemically important or “too big to fail” (TBTF), to increase funding by equity capital, direct more attention to maintaining adequate levels of liquidity, enhance risk-management processes and develop a “living will”.

But despite these new laws and more restrictive regulations, banks continue to fail.

The economy

Bank failures coincide with an adverse economy.2A Monetary History of the United States: 1867-1960, Milton Friedman and Anna Jacobson Swartz, 1963, Princeton University Press, National Bureau of Economic Research Publications, Pages 1-860. ,3The American Economic Review: “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” Ben S. Bernanke, June 1983, Volume 73, Number 3, Pages 257-276. Economic historian Charles Kindleberger claimed that bank failures are part of the business cycle and result from myopic foresight by bankers.4Manias, Panics, and Crashes: A History of Financial Crises, Charles P. Kindleberger, 1978, Basic Books, New York, Pages 1-318. Table 1 illustrates year-end economic and financial metrics relevant to SVB. The yield curve, illustrated by the difference between ten-year and two-year U.S. Treasury rates, was relatively flat going into the pandemic. The yield curve steepened quickly, given the accommodative monetary policy adopted by the Federal Reserve System (the Fed). The upward-sloping yield curve tempted some banks, including SVB, to invest in longer-term securities. These investments later plummeted in value and created large AOCI losses. Any bank comparable to SVB that is liability-sensitive (i.e., has long-term assets funded by short-term liabilities) also witnessed net interest income (NII) pressures as interest rates surged. Prices increased dramatically and were not transitory, as was initially projected by the Federal Open Market Committee (FOMC). Unsurprisingly, economic output declined in 2020 as unemployment surged, reaching 14.8 percent in April. Many banks with large exposures to credit risks suffer during economic recessions, but SVB invested heavily in fixed-income securities. Interest rate risk (IRR) is not new to financial institutions. The thrift industry imploded during the 1980s due, in part, to the high interest rates adopted by the Federal Reserve to control inflation. The savings institutions had long-term, low-rate mortgages funded by short-term, high-rate deposits.

Asset/liability management

Once a bank’s difficulties become well known to regulatory supervisors and the interbank market, liquidity issues proliferate. If a rapidly deteriorating bank, similar to SVB, has little high-quality collateral available for pledging, large uninsured deposits placed by commercial firms for payroll or working capital and/or an unusually large proportion of investments categorized as “held-to-maturity”, liquidity pressures worsen. Weak banks lacking unencumbered, high-quality assets cannot borrow funds in the interbank market. Douglas Diamond and Philip Dybvig wrote that the mission of the banking industry is conducive to precipitating banking panics. “Banks create liquidity risk for themselves as they provide liquidity to customers in the form of loan commitments and mismatched terms of longer-term assets funded by shorter term liabilities.”5Journal of Political Economy: “Bank Runs, Deposit Insurance, and Liquidity,” Douglas W. Diamond and Philip H. Dybvig, June 1983, Volume 91, Issue 3, Pages 401-419. The FDIC noted that the typical characteristics of the 489 banks that failed between 2008 and 2013 included “heightened concentrations of ADC [real estate acquisition, development and construction] lending, rapid asset growth, reliance on funding other than stable core deposits and relatively lower capital-to-assets ratios”.6Federal Deposit Insurance Corporation (FDIC): “Crisis and Response: An FDIC History, 2008-2013,” last updated June 12, 2023.

Table 2 briefly illustrates various financial ratios from SVB’s call report and compares the bank to the peer group ($100 billion or higher, except for 2018) compiled by the Federal Financial Institutions Examination Council (FFIEC). The ratios measure capital adequacy, asset quality, management, earnings, liquidity and sensitivity; this rating system is generally known as CAMELS. The analysis is not exhaustive but illustrative of what would have been known in early 2023.

  • Tier 1 leverage capital (i.e., equity minus goodwill) to assets declined from more than 8 percent (fifth percentile of peer banks) in 2018 to less than 6.5 percent (sixth percentile) by 2020, as asset growth outstripped capital creation. The acquisition of Boston Private in 2021 created more than $200 million of goodwill, placing additional pressure on Tier 1 capital. Total year-end assets increased by almost 40 percent per year between 2018 and 2022, while capital lagged with a compound annual growth rate (CAGR) of 35.5 percent.
  • Asset quality is invariably the bane of most commercial banks. Net loan losses compared to total loans were manageable at SVB and did not exceed 0.25 percent in any year chronicled. Its allowance for loan losses was always less than 1 percent throughout the period but was in line with its peers.
  • Given a large investment portfolio, the bank could maintain effective operating efficiency (low non-interest expenses compared to the sum of net interest income and non-interest income). It is much cheaper to purchase $10 billion of investment securities relative to originating and monitoring a similar amount of commercial loans. Regulatory costs increase once assets exceed $100 billion.
  • The bank’s profitability, measured by its return on assets, slipped from 1.71 percent in 2018 (87th percentile) to 0.79 percent (16th percentile) in 2021 as net interest income declined once the central bank responded to inflation. Net loans declined from 49.98 percent of the portfolio in 2018 to 31.57 percent in 2021.
  • The bank’s net non-core funding dependence (i.e., non-core funds minus short-term securities, all divided by long-term assets) turned positive in value in 2021. The bank’s quick growth relied on non-core funds, such as federal funds purchased, large commercial deposits and Federal Home Loan Banks (FHLB) advances. SVB also pledged high-quality collateral to obtain the cash. Almost 50 percent of this large investment portfolio was pledged as of 2022.
  • The one-year repricing gap derived from the call report was negative, as short-term and variable-rate liabilities exceeded assets with the same tenor. The gap was unusually high, increasing from negative-24 percent in 2018 to more than minus-52 percent by 2021. Interest-rate exposure of this magnitude was reminiscent of the thrift industry decades earlier. The unrealized depreciation of investment securities soared to 89 percent of Tier 1 leverage (third percentile) in 2022. The Form 10-K submitted to the SEC for 2022 showed net income adjusted for unrealized holding losses equaled a loss of almost $300 million versus the gain of $1.6 billion reported. Interest rate risk (IRR) exposure set the stage for a deposit run.
  • The equity market had already provided an early warning of an impending disaster when SVB’s stock price plummeted by more than 66 percent in the calendar year 2022. Moody’s Investors Service (Moody’s Ratings) had placed the bank under a negative outlook, but it affirmed an upper-medium grade A3 rating until March 8, 2023, when it was reduced to Baa1 for senior, unsecured debt. Rating agencies often lag behind the market.
  • The bank’s Big Four accounting firm released SVB’s 2022 audit report on February 14, 2023, and provided an unqualified opinion. The auditor believed the bank was a “going concern” and a viable entity. The critical audit matter (CAM) focused on the adequacy of the allowance for loan losses rather than interest-rate or liquidity risks.

Where was the chief risk officer?

Management

Ultimately, banks fail because their boards of directors are unable to establish viable business plans to be implemented by qualified management. Ineffective bank directors have been identified as a primary cause of bank failure.7American Banker/BankThink: “Banks Should Reject More Board Candidates,” Richard Parsons, October 19, 2012. Failing banks do not heed early-warning signs or “red flags” indicative of impending financial distress. As of the end of 2022, 11 members of SVB’s 14-person board were independent of management. The independent directors were well educated, and most had received academic degrees from prestigious universities. The board was continually refreshed, given that four directors had been appointed since 2020. Common to many boards, almost all directors were older (60s and 70s) and experienced in finance, accounting, IT (information technology), banking, fixed-income management and venture capital (VC). Affiliations included well-known firms such as Ernst & Young (EY), Citibank, Barclays, Accenture, McKinsey & Company and T. Rowe Price. Those with banking experience were all relatively new to the board. The majority of the board’s independent directors had experienced the Great Recession, and one was the under secretary of the Treasury responsible for implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The board was well educated, diverse and experienced.

Unfortunately, the bank had no chief risk officer (CRO) for almost a year prior to its failure. The board is responsible for establishing policies, monitoring risks and evaluating management. Most banks of SVB’s size disclose the duration of assets relative to liabilities and the resulting economic value of equity. The key interest rate risk metric was omitted from the SEC Form 10-K report released early in 2023. It is impossible to assess from public information what other systems or reports were unavailable to the board as disaster loomed without the guidance of a CRO. Quick asset growth invariably pressures internal controls and reporting systems, and some executives cannot manage the increased complexity. Without a key member of the executive management, how can a board monitor the risks of a large financial institution that expanded very quickly with a non-traditional bank business plan? The board must have access to reliable reports, explanatory models, heat maps and a qualified CRO to assess risks.

Summary

Public data provides information to identify red flags indicative of distress. SVB’s growth was very quick and not supported by capital. Silicon Valley provided a high-tech community with many new firms, IPOs (initial public offerings) and venture capital (VC) activity, allowing firms to raise cash. The bank tried to increase yields by investing in longer-term securities funded by non-core funds. Interest-rate and liquidity risks soared to unsafe levels that were clearly visible once the central bank changed focus from responding to the pandemic to controlling rampant inflation. Inexplicably, the institution was without a CRO for one year before being placed in receivership.

Why are banks unable to learn from the many documented episodes of prior crises? Failures can be traced to executives and directors failing to exercise their responsibilities and their inability to comprehend the complexities of their businesses. Award-winning work in the field of social psychology by Amos Tversky and Daniel Kahneman suggests that recall and memory are important to judgment.8Cognitive Psychology: “Availability: A heuristic for judging frequency and probability,” Amos Tversky and Daniel Kahneman, September 1973, Volume 5, Issue 2, Pages 207-232. If an event is easier to retrieve from memory, it can be applied more quickly when the board develops a strategy. The bank, the auditor, the rating agency and the missing CRO should all have studied more closely the thrift industry’s demise decades earlier and realized interest rates tend to revert to a mean.

 

References

1 North Carolina Banking Institute (NCBI): “An Examination of the Factors Influencing the Enactment of Banking Legislation and Regulation: Evidence from Fifty Years of Banking Laws and Twenty-Five Years of Regulation,” William C. Handorf, Reggie OShields and Andrew Richardson, March 1, 2020, UNC School of Law, Volume 24, Issue 1, Pages 93-114.

2 A Monetary History of the United States: 1867-1960, Milton Friedman and Anna Jacobson Swartz, 1963, Princeton University Press, National Bureau of Economic Research Publications, Pages 1-860.

3 The American Economic Review: “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” Ben S. Bernanke, June 1983, Volume 73, Number 3, Pages 257-276.

4 Manias, Panics, and Crashes: A History of Financial Crises, Charles P. Kindleberger, 1978, Basic Books, New York, Pages 1-318.

5 Journal of Political Economy: “Bank Runs, Deposit Insurance, and Liquidity,” Douglas W. Diamond and Philip H. Dybvig, June 1983, Volume 91, Issue 3, Pages 401-419. (

6 Federal Deposit Insurance Corporation (FDIC): “Crisis and Response: An FDIC History, 2008-2013,” last updated June 12, 2023.

7 American Banker/BankThink: “Banks Should Reject More Board Candidates,” Richard Parsons, October 19, 2012.

8 Cognitive Psychology: “Availability: A heuristic for judging frequency and probability,” Amos Tversky and Daniel Kahneman, September 1973, Volume 5, Issue 2, Pages 207-232.

 

 

ABOUT THE AUTHOR
William C. Handorf, Ph.D., is a Professor of Finance, Banking and Real Estate at the George Washington University School of Business. Over the course of his almost 60 years in the banking industry and 50 years as an academic, he recently completed his 17-year term as a Director, Vice-Chair and Committee Chair of a SEC-registered bank in Atlanta, Georgia. Earlier, he served as a Director and Chair of the Federal Reserve Bank of Richmond’s Baltimore branch.

 

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