In light of the closure of Silicon Valley Bank (SVB), and the stability of the banking system generally, there have been several questions raised as to what led to its demise. While there’s plenty to analyse to make a good case study and learn from, in this article I would like to address the governance of a bank from the Board, through to C-suite and all across management.
My focus is going to be on the summary of events outlined in “Here’s how the second-biggest bank collapse in U.S. history happened in just 48 hours” (Son H. et al, CNBC, 10 March 2023). Where some points are speculative at the time of writing this, they are taken as is for learning and analytical purposes only, with governance questions being drawn from my own experience and point of view.
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Audience
For all those working in or consulting for a bank, as well as the Board and financial regulators.
What happened?
- SVB announces >$1b loss taken from its sale of bonds and the subsequent need to raise money;
- Depositors make a run on the bank by withdrawing $42b in deposits; and
- SVB suffers from a lack of liquidity and closes shop.
Banking background
So firstly, a quick retail banking overview. The bank takes deposits from customers, i.e. your transaction/checking, savings, term/certificates of deposits, its liabilities, offering you an interest rate and lends those funds out in the form of loans, its assets, to other customers at a higher rate. The difference between the interest income and the interest expense, often called the Net Interest Margin or NIM, is how the bank profits. Different investments or loan types attract varying interest rates, which impacts the bottom line. An easy way to see the differential is like this. The bars going up are the interest rates received and the ones going down are the interest rates paid.
As we can see, the way to increase profits would be to accept deposits at the lowest rate possible and lend funds at the highest rate possible. Problem? Loans are usually taken out over longer terms and the funds you place in a bank are often at call, or available to you immediately should you need.
The importance of liquidity
This mismatch that we see needs to be managed stringently when it comes to monitoring the liquidity of the bank, i.e. a measure of the ability for the bank to convert those assets into cash that you can then withdraw.
This mismatch needs to be managed stringently when it comes to monitoring the liquidity of the bank.
When customers start withdrawing their funds on a large scale, often termed a bank run or a run on funds, and you don’t have enough liquid assets to convert and meet those obligations, you effectively end up with a bank collapse.
Think about the assets an individual might have – say some savings, shares, a piece of jewellery, a car and maybe property. If that person now needs emergency funds, perhaps for the next day, where would they source it from? Savings, which is already cash, and the shares are probably the easiest to liquidate while the car and property would not be easy to sell in a day, i.e. are illiquid.
The same logic applies to banks. Excess funds are often invested with other financial institutions much the same way individual customers do, but with products such as notice saver accounts, term deposits (TD) or negotiable certificates of deposits (NCD). While they are all cash, even cash can have different grades of liquidity. For example, an overnight 11am account (you can call your funds in the day and receive them by 11 o’clock the next morning) and NCDs with good quality ratings are much more liquid than a notice saver, breaking a TD, or NCDs with lower quality ratings. These are what financial regulators term High Quality Liquid Assets (HQLA) and minimum holdings are mandated for banks.
Now that we have a basic grasp of liquidity, how do we manage the mismatch risk between those customer deposits and the loans we made out to others? Looking at the facts of SVB closely, what questions should we ask different business units in a bank in order to effectively govern its operations?
Governance Questions
Q1) CEO to CFO via ALCO: How are we monitoring that we have enough liquid assets to fund customer withdrawals when needed?
The inability of the bank to meet its financial obligations as they become due is the liquidity risk. To manage this, treasury often calculates and monitors the bank’s Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The former is a measure of the HQLA we mentioned above that is available to cover short-term funding obligations during times of stress, usually cash outflows over the next 30 calendar days. The second considers funding over a 365-day span as an indicator of funding stress that could arise in the future. While regulators often mandate certain percentages for these ratios, they are something that should be tabled at the Assets and Liabilities Committee (ALCO) for review and discussion as to whether current levels are sufficient and commensurate with the size and nature of the bank in order to continue operations.
With loans and deposits, the finance team often looks at repricing. To govern this, it is a good idea to consider bucketing based on when fixed loans and term deposits are going to mature/reprice. While this is an indicator of where there is a maturity mismatch and resulting interest rate sensitivity, it should also be used to show when maturing deposits might be withdrawn, impacting liquidity.
Q2) Board to CEO and CFO: If LCR is not a regulatory requirement for us, do we still use it to monitor our liquidity? If not, what other metrics does management use to gain comfort about the stability of the bank?
SVB stated in their 2022 annual report that they are not subject to the Federal Reserve’s LCR or NSFR requirements.
Banks should declare their regulatory requirements with liquidity monitoring. If they fall under thresholds and are not required to calculate LCR, it may be prudent to still do so for internal management reporting. While this may be deemed too much for simpler and less complex banks, good governance prescribes that alternative ratios and metrics be monitored at the management ALCO and Board levels. Note that some regulators prescribe Minimum Liquidity Holdings (MLH) to be reported as an alternative.
When we saw those large withdrawals from SVB, banks can learn from this event and see how ratios/metrics can be an indicator of further liquidity issues.
Q3) CEO to CFO and Treasurer: If customers withdraw more funds than we anticipated, how do we raise more funds?
Okay, here is where a funding plan is good practice. There will be times where customers withdraw more than we anticipate. Treasury reporting showing HQLA available for conversion and a gap analysis on maturity of deposits are just some of the things to monitor regularly.
We saw SVB look to liquidate its bond holdings for about $21b, which were done at a huge loss due to a sharp rise in interest rates per “Goldman Sachs bought the SVB bonds whose $1.8 billion loss set off the startup lender’s meltdown” (Tayeb Z. Markets Insider, 15 March 2023). When asking where the bank can raise more funds from, always reconsider those options in the light of changing interest rates.
SVB actually called this risk out as “…increases in interest rates have resulted, and may continue to result in, decreases in the fair value of our AFS fixed income investment portfolio and increases in the pricing frequency and proportion of interest-bearing deposits…” (Annual Report 2022, pg. 22).
Q4) Board and CEO to CFO and Treasurer: Noted on Q3. What else have we got?
With increasing Board responsibilities, they should consider all forms of raising funds. What other assets can be liquidated? Are there any areas of expenditure reduction? Some might be slower techniques than others.
Q5) CRO to Board, CEO and CFO: Noted on Q3 and Q4. If that gets sapped up too, the bank should ideally place additional mechanisms in place. What else have we got?
Have you ever played monopoly? You bought as much as you could, landed on your opponent’s property with a hotel on it and you didn’t have enough cash. What did you do? You would call this person, right?
Your property is mortgaged and you cannot collect rent on them until you release them, but you get some cash in hand upfront. Pass Go a few times so you have some funds, release the mortgage and then you keep going as usual.
Same analogy for banks. Consider having in place a Committed Liquidity Facility (CLF) with your Reserve Bank, where you can undertake a repo or repurchase obligation against a pool of AAA-rated mortgages. That way if things go really bad during a bank run, you can quickly turn on the tap for funds against your mortgage assets, where the Reserve Bank can inject liquidity and reverse it down the track when things stabilise – kind of like a cushion effect.
Q6) CRO to Board and then to CEO: Knowing how critical liquidity is to the operations of the bank, how comfortable are we with our risk appetites on liquidity?
Boards and Board Risk Committees – always revisit your Risk Appetite Statement. Regulators may set minimum requirements for liquidity, but as Directors ultimately responsible for liquidity risk, at what levels are you comfortable? Are your RAG segments appropriately spanned with a buffer to allow sufficient time for remedial action to be taken before you breach limits?
Q7) Between CFO, COO, CRO and CISO: What are the assumptions and results of our liquidity stress-testing?
One of my personal favourites – stress-testing. Check and question the assumptions from wider stakeholders. It is normal to consider operational factors for stress but what about the digital age we are in now? Have you considered a shock scenario, where one cyber incident or a cluster of events to the wider banking industry can send customers to withdraw in panic?
Back in the old days it was always based on people lining up outside branches to access their money.
What about now? Given faster payment transactions and the speed of withdrawal that can be made online, how quickly can your liquidity levels tank? It’s a good idea to use one worst-case scenario to see the monetary value that needs to be withdrawn before you breach any hard limits.
Q8) CFO to CIO and CISO: These were the results of our liquidity stress-testing as per Q7. Can our tech infrastructure handle such high volumes of banking activity at the same time? Is this security risk around a denial of service from non-malicious activity being considered and what can you advise?
Based on the digital point in Q7, it’s a good idea to stress the load on your networks and test your load balancing capability. Could you handle such high volumes or would it crash your core banking system, sending further panic, which in turn would create more panic and even more withdrawals?
From a cyber security perspective, we always consider malicious attack vectors such as a denial of service (DoS). Is this non-malicious DoS also considered in the security risk profile?
Q9) COO to CFO: What’s the imbalance like between our loans and deposits? Then revisit Q6 again.
At the beginning, we talked about the nature of a bank – offer interest on deposits and lend the funds out at higher rates. But will these always match one-to-one?
At 31 December 2022, SVB had about $74b in loans and $173b in deposits per their balance sheet (Annual Report 2022 per 10-K submission to SEC, pg. 95). In this case you have excess funds, where you now need to consider other investments that yield higher than the interest you have to pay but still have enough in the short-term to meet customer withdrawals, i.e. not have too little liquidity.
Too much liquidity can hurt too. I recall a client, a member-owned financial institution, that had its sole customer base as the employees of a nearby refinery. When the refinery closed, employees were paid out large sums that they used to pay off mortgages or push into term deposits. Assets plummeted and liquidity soared, meaning the NIM got squeezed and started biting into the capital (lesson for another time).
On the flip side, if the loans are greater than deposits, you have to look to other wholesale funding to plug the gap. Now you may be exposed to interest rate risks and forex risks.
Either way, given the risks resulting from the mismatch, revisit your RAS as per Q6 and challenge its appropriateness in the given economic environment.
Q10) COO to Marketing: What communications plan do we have in place to manage the flow-on effect of more customers blindly withdrawing funds and running because others are doing the same?
It’s a vicious cycle – panic, some withdraw because there may be an issue, so others withdraw too, leading to more panic and the spiral continues.
This is where your Marketing team’s comms plan comes into play. To stop the knock-on effect, what messaging and templates do you have ready to use to communicate to your customers and instil confidence?
This is where your Marketing team’s comms plan comes into play. To stop the knock-on effect, what messaging and templates do you have ready to use to communicate to your customers and instil confidence?
Q11) Between CFO, COO, Actuary and Data Scientist: What is the frequency of breaks in long-term deposits and how would these change during times of panic?
Consider this. You factor in your funding from customers having taken out long-dated term deposits, say maturing in five years. Due to unforeseen circumstances where a customer needs their funds, they pay a small fee to break their term deposit early. In times of panic, is it likely that they would pay a small fee to break in larger waves?
This is where your actuaries and data scientists come into play. Look at historical breaks and forecast probabilities around early breaks. During a bank run, more deposits could be a flight risk regardless of fees or penalty interest rates.
Q12) CRO to COO and CFO: When providing loans, we always check for credit risk concentrations. What about liquidity concentrations on the receipt side? Now revisit stress tests in Q7 again.
Banks often look at risk concentrations when lending out and have set LVR caps on dense high-rise areas or low liquid markets such as mining towns.
On the liquidity side, regulators have limits in place on how much counterparty risk you can take, i.e. where you are placing your investments.
However, have you considered the concentration risk of your customers providing those deposits? Like that refinery example in Q9 above, was SVB a niche in respect to where its customers mostly came from? While they state that 7-9% of deposits came from Asia (Annual Report 2022, Pg. 80), what about segments? For all banks, are your deposits majority wholesale from businesses or specific to a certain industry or perhaps start-up companies?
Now go back to Q7 and factor this into your stress-testing.
Q13) Internal and External Auditor to bank: In light of Q1-12, are these processes and activities in line with policy?
Based on Q1-12 above, it is practical for banks to have policies and procedures surrounding these regulatory requirements and funding activities. Undertake regular audits of these against policy and critically assess suitability during times of changing interest rates at your next Board Audit Committee.
Q14) Regulator and external consultants to bank: Show us the interactions from Q1-12. What actions have you taken accordingly?
As part of regulatory oversight or consulting engagements, it is important to get a grasp of Q1-12 above and engage with the bank you are supervising to determine the strength of its financial risk management.
Q15) Regulator reflection: With supervision across all the banks, how resilient is the nation’s banking sector to times of panic withdrawal? What measures should we introduce to reduce the likelihood of a knock-on liquidity effect to the wider banking sector?
In the current environment, we are seeing panic leads to irrational decision-making. If banks individually are strong in terms of capital and liquidity, how is the wider sector as a whole across the nation placed to deal with knock-on effects from other banks? What regulatory measures do we need to take to reduce contagion risk?
Final Thoughts
The banking sector plays a vital role in the industry. However, running a bank carries a great deal of risk with it, a key one being liquidity risk. Wearing multiple hats across the whole spectrum of the business, as well as a view of the Regulator, helps the Board, CEO and senior leaders effectively govern the liquidity and hence viability of a bank. The above questions are from my own personal experience and thoughts for the banking industry going forward. I hope these prove to be useful conversation starters at your next Board meeting. What other questions do you ask to govern liquidity?
