Financial Institutions and Banking

Learn From Past Mistakes

 “Postmortems” on failed institutions are instructive for community banks

In the aftermath of three notable bank failures in 2023, federal banking regulators issued comprehensive reports detailing the underlying causes of those failures. These postmortems are must-reads for banks of all sizes because they point out management shortcomings that led to the bank failures — as well as regulators’ plans to become more proactive in addressing bank risks. Here are some highlights of the three reports.

  1. Silicon Valley Bank

According to the Federal Reserve (Fed) report, Silicon Valley Bank (SVB) was “a textbook case” of bank mismanagement. Its senior leadership failed to manage basic interest rate and liquidity risk, which led to a run by depositors. The causes of SVB’s failure were tied to 1) its business model, which was highly concentrated in early-stage and start-up technology companies and relied heavily on uninsured deposits, and 2) its failure to sufficiently address interest rate and liquidity risk. These factors left SVB “acutely exposed to the specific combination of rising interest rates and slowing activity in the technology sector that materialized in 2022 and early 2023,” observed the Fed. Also, SVB had accumulated substantial unrealized losses on available-for-sale (AFS) securities.

In addition to the fact that SVB’s directors didn’t receive adequate risk-related information from management, SVB:

  • Didn’t hold management accountable for effective risk management,
  • Failed its own internal liquidity stress tests and had no workable plan to access liquidity in times of stress, and
  • Managed interest rate risk with a focus on short-term profits, rather than on managing long-term risks and the risk of rising rates.

The Fed also took some of the blame, noting that supervisors didn’t fully appreciate the extent of SVB’s vulnerabilities as it grew rapidly in size and complexity. Thus, it failed to take sufficient steps to ensure that SVB addressed those problems quickly.

  1. Signature Bank

According to the Federal Deposit Insurance Corporation (FDIC) postmortem, the primary cause of Signature Bank’s failure was “illiquidity precipitated by contagion effects in the wake of” deposit runs that led to the failure of SVB and the self-liquidation of Silvergate Bank. The FDIC noted other causes of Signature Bank’s failure included its:

  • Pursuit of “rapid, unrestrained growth” without developing risk management practices and controls appropriate for its size and complexity,
  • Failure to prioritize good corporate governance and heed FDIC examiner concerns,
  • Overreliance on uninsured deposits to fund its rapid growth, without implementing fundamental liquidity risk management practices and controls, and
  • Failure to understand the risks associated with reliance on cryptocurrency deposits.

Like the Fed, the FDIC accepted some responsibility for Signature Bank’s failure, noting that it “could have escalated supervisory actions sooner,” its “examination work products could have been timelier,” and it could have communicated more effectively with the bank’s board and management.

  1. First Republic Bank

According to the FDIC, First Republic Bank failed primarily because of “a loss of market and depositor confidence” in the wake of the SVB and Signature Bank failures, resulting in a bank run. Notably, the FDIC found that First Republic Bank was well run, responsive to supervisory feedback, and implemented appropriate infrastructure, controls and risk management processes as it grew. Nevertheless, specific attributes of its business model and management strategies made it vulnerable to interest rate changes and the contagion effects of previous bank failures, including:

  • Rapid growth,
  • Loan and funding concentrations,
  • Overreliance on uninsured deposits and depositor loyalty, and
  • Failure to sufficiently mitigate interest rate risk.

Again, the FDIC examined its own possible role in First Republic Bank’s failure. Although it was unclear whether earlier supervisory action would have made a difference, the report noted that “meaningful action to mitigate interest rate risk and address funding concentrations would have made the bank more resilient and less vulnerable.”

Stay tuned

To help avoid future bank failures, regulators are considering several changes, including rethinking stress testing requirements; imposing additional capital or liquidity requirements on banks with inadequate capital planning, liquidity risk management, or governance and controls; incorporating unrealized losses and gains into regulatory capital rules; and encouraging banks to avoid concentrations on both sides of the balance sheet.

The extent to which these changes will trickle down to community banks is uncertain. But expect greater regulatory scrutiny in the future, particularly with respect to capital, liquidity risk and interest rate risk.

Sidebar: Role of social media in liquidity risk

An interesting takeaway from the regulators’ postmortems (see main article) is the role that social media, together with banking technology, plays in liquidity risk. In its postmortem on Silicon Valley Bank (SVB), the Federal Reserve (Fed) commented that “social media enabled depositors to instantly spread concerns about a bank run, and technology enabled immediate withdrawals of funding.”

On March 8, 2023, for example, SVB announced a balance sheet restructuring, including a sale of certain securities and an intention to raise capital. The next day, SVB experienced deposit outflows totaling over $40 billion, as uninsured depositors, interpreting the announcement as a signal of financial distress, began withdrawing their funds “in a coordinated manner with unprecedented speed.” According to the Fed, the run appeared to be fueled by social media and the bank’s concentrated network of venture capital investors and technology firms.

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