On March 12, the US Department of the Treasury, Federal Reserve Board (FRB), and Federal Deposit Insurance Corporation (FDIC) announced measures to protect all deposits under an emergency lending program and for the FDIC to complete the resolutions for Silicon Valley Bank (SVB) and Signature Bank. These actions were taken in consultation with President Biden and ordered using the ‘systemic risk’ exception. In a speech at the White House, the President stated that he would do “whatever is needed” to ensure the banking system remains strong. Consequently, regulatory changes are expected, and bank management needs to be asking the right questions to be prepared.
The President stated there will be a “full accounting of what happened and why those responsible can be held accountable”. Subsequently, the Federal Reserve announced that the Vice Chair for Supervision, Michael S. Barr, will immediately review the supervision and regulation of SVB and publish a report on the failure by May 1, 2023.
A complete account and analysis of the banks’ failure are expected from other government bodies, including the US Securities and Exchange Commission (SEC), US Department of Justice (DOJ), Treasury’s Financial Stability Oversight Council (FSOC), the US Congress, the California Department of Financial Protection and Innovation (DFPI), the New York Department of Financial Services (NYDFS) and the United Kingdom’s (UK’s) Financial Conduct Authority (FCA).
While bank failures are uncommon, the recent events around SVB, Signature Bank, and Silvergate Bank are expected to put pressure on banking institutions to examine and rationalize their corporate governance and their risk measuring and monitoring systems, as well as undertake overall stress testing of their capital levels, complexity, and business models. It is a reminder of the vital importance of an effective risk management program to maintaining the safe and sound operations of the bank.
While most banks do not face similar liquidity risks to the three failed institutions, we anticipate additional supervisory expectations and rulemakings, as well as increased scrutiny over how banks are managing against seven risks to the banking system.
1. Balance Sheet Management
Banks who sought higher returns and purchased longer-term investments saw the value of those investments decline in a rising rate environment. These securities were often high-quality and government-backed debt instruments. Importantly, these instruments were not subject to risk-based capital reserve requirements (e.g., minimum regulatory capital requirements).
Although these instruments can be used to quickly generate liquidity when needed during a stress event, they are also sensitive to swings in interest rates. As a result, banks should immediately evaluate their liquidity monitoring and stress testing scenarios. Actions and considerations could include:
2. Customer Base
Banks often compete by focusing on specific customer groups or industry sectors. This focus can be a competitive strength, but can also create concentration risk. Concentrations are risky because the exposure tends to move in the same direction. Banks need to understand the concentrations they have and develop strategies to manage them.
Banks need to understand the operating and financial environment of their customers and liquidity risks arising from customers’ business model(s) (e.g., cryptoassets, stablecoin-related reserves, etc.). They need to evaluate the risks to their financial position and deposit base, counterparty risks from customers’ funding sources and business model(s), and risks related to the geographies where the bank and customers operate. Concentrations by customer type will also be a focal point.
3. Faster Payments
Since the 2008 financial crisis, payment technologies have increased access and accelerated the speed of payments. The rapid outflows and velocity at which customer withdrawals can occur (e.g., Zelle, Real-Time Payments) can result in a near immediate run on the bank. In response, banks must adjust their liquidity plans accordingly.
This includes assumptions about the number of cash sources available to the bank and at what cost. The liquidity risk framework should include the process for tapping each liquidity source and the timing of each. Liquidity stress tests should be performed to confirm assumptions.
Early warning triggers for potential deposit outflows should be put in place and monitored with appropriate frequency.
Poor communication, externally and internally, by the Board, senior management, and key stakeholders can cause regulators, customers, investors, and the public to lose confidence in a bank’s financial position. Banks need to carefully consider the timing of communications, the messaging, distribution channels, the people and audiences involved, and feedback loops.
Banks will also need to contend with social media echo chambers where views and narratives are shaped and disseminated at speed and at scale by the press, social media influencers, customers, short sellers, and competitors. They should revisit the crisis management playbook to include a deposit run and liquidity crisis, and include in the playbook any early warning triggers from stakeholders who are not customers.
5. Interest Rate Risk Management
Banks will need to continue to monitor the Federal Open Market Committee (FOMC). The FOMC has operated in a clear and transparent manner in promoting its views on how it plans to conduct monetary policy. In addition, the FOMC has communicated the path and timing for reducing the size of their balance sheet and its determinations for the forward-looking federal funds rate.
Chair Powell has indicated that the FOMC is prepared to continue its pace of rate hikes based on the data. While the recent bank failures may cause the FOMC to temporarily pause the pace of rate hikes to assess the economic risks, banks should continue to anticipate an increase to the target range for the federal funds rate in 2023.
With the expectation the FOMC will continue near-term rate increases, banks will need to continue to monitor and manage for their asset-liability mismatches, loan books tied to riskier assets, securities financing, digital-asset related deposit management, and manage their liquidity stress testing and management framework. While the recent bank failures may cause the FOMC to temporarily pause the pace of rate hikes to assess the economic risks, banks should continue to anticipate an increase to the target range for the federal funds rate in 2023.
6. Management and Personnel
In Washington, DC, there is a saying that “personnel is policy”. Banks must ensure they hire and retain qualified personnel in the bank’s critical risk management and operational areas (e.g., risk management, communications, finance). They must ensure there are no critical coverage gaps in key positions and that there is appropriate expertise for the bank’s risk profile. The Board must ask vital questions about the robustness of the bank’s personnel strategy and practices.
Investments in risk and compliance talent are key, as the desired resource profile has shifted from ‘assessment/check the box’ towards expertise with analytics and data modelling, quantitative techniques, next generation risk, and compliance tools/surveillance systems.
Regulators will also scrutinize executive compensation and clawback provisions, as well as the timing of any payments.
7. Deposit Data Considerations
Banks will also need to consider their deposit data under FDIC 12 CRF Part 370. It is crucial for Covered Institutions (CI) with more than two million deposit accounts to maintain the complete and accurate client information that is needed by the FDIC to determine deposit insurance coverage in a timely manner with respect to each deposit account.
Banks must reconcile and remediate existing data gaps and take the appropriate steps to ensure complete and accurate record keeping at the point of client onboarding/account origination. Further, efforts to better understand current deposit-level concentrations may be important to minimize liquidity risk and enable account diversification.
As we consider lessons learned to date from the current situation and examine whether the actions taken by the Biden Administration can isolate these impacts, banks should strike a meaningful balance between generating profits and navigating regulatory complexity.
Banks will be subject to increased supervision and examination attention on enterprise resilience, including more stringent regulations to identify and close financial and market vulnerabilities that pose unacceptable customer and market impact.
Efforts by the Board, senior management, and a bank’s risk management functions typically focus on expectations around identifying, quantifying, escalating, measuring, and monitoring operational risks, including emerging risks, reliance on third parties, and inter-company affiliates.
Banks should consider lessons from recent events to ensure they are asking the right questions:
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