Bank failures' ripple effects

May 29, 2023 10:00 AM

One of the irrefutable laws of physics is that for every reaction, there is an equal and opposite reaction. That same principle could easily be applied to the banking sector. Every time there is a blip, a crisis, a string of failures, key stakeholders rush to analyze, pick apart, determine what happened and why and how to contain the damage.

Take this story's artwork. It features a picture of depositors crowded outside the American Union Bank in New York after the institution failed on June 30, 1931. During the Great Depression, roughly 9,000 banks failed. In response, the Federal Deposit Insurance Corp. was created and deposit insurance has been offered since 1934 to shore up Americans' trust in the banking system.

That image is juxtapositioned against a picture of depositors lined up outside of Silicon Valley Bank a few days after the Santa Clara, California-based bank failed. A second large regional, Signature Bank, was also taken over by regulators in March. That was followed by First Republic's collapse in early May.

The industry is just starting to grapple with the fallout from this most recent crisis, and executives should brace for far-reaching consequences. Given the events earlier this year, the American Banker staff has made 10 predictions about how the banking sector will be permanently altered.

Silicon Valley Bank headquarters in Santa Clara.

Chief risk officers will get their moment in the sun

The collapse of Silicon Valley Bank put a spotlight on one particular executive-level job that's become increasingly standard in the industry since the financial crisis — the chief risk officer, whose main function is to provide oversight of risk management on an enterprise-wide level.

At Silicon Valley Bank, the role went unfilled for eight months, during which time the bank and its parent company, SVB Financial Group, grappled with mounting risks such as rising interest rates, insufficient liquidity and the ongoing impacts of a slowdown in the venture capital marketplace. According to SVB's proxy statement filed on March 3 — seven days before the bank failed — former CRO Laura Izurieta agreed to step down from her job in late April 2022 and move into a non-executive, transition-related role that would last for five months.

The company did not disclose the reason for Izurieta's departure, but it did say conversations about exiting the role began in early 2022. Her replacement, Kim Olson, who came from Tokyo's Sumitomo Mitsui Banking Corp., wasn't hired until late December 2022, less than three months before regulators closed Silicon Valley Bank, citing inadequate liquidity and insolvency.

Going forward, it's safe to say there will be plenty of attention paid to the role of chief risk officer, especially if a bank goes months without one. The market will force banks to pay more attention to risks they're taking, and with that scrutiny will come more interest in making sure someone is watching overall risk, said Christine Chung, a law professor at Albany Law School and a former branch chief of the enforcement division of the Securities and Exchange Commission.

Banks may face added pressure to show they have the right chief risk officer in place, she said.

"I think there will be renewed attention on … having a chief risk officer who understands the core business drivers of risk," Chung said. "There are best practices that are industry neutral, but there's also a level of sophistication of the business your company is conducting around risk."

The heightened scrutiny might also play out in the form of additional succession planning, said Damion McIntosh, a trained bank regulator and senior lecturer in finance at Auburn University. While banks normally have succession plans for CEOs and chief financial officers, it isn't as common to have a No. 2 in waiting for the heads of risk, audit and compliance, McIntosh said. That's in part because such jobs aren't considered revenue-generating roles, he argues. He predicts that will soon change.

"I expect there will be more value placed on the role in and of itself, the information that comes from that function and the scope of the work that risk management does," McIntosh said.

At least one regional bank has recently laid out its succession plan for the chief risk officer job. Citizens Financial Group in Providence, Rhode Island, said in early April that Richard Stein, who has been the chief credit officer at Fifth Third Bancorp, will become chief risk officer following the retirement of Malcolm Griggs, Citizens' current chief risk officer, in the first quarter of 2024. — Allissa Kline

The regulatory hammer will drop

Coming into 2023, the Federal Reserve seemed poised to increase capital requirements and impose tighter regulation on large regional banks. After the failures of Silicon Valley Bank and Signature Bank in March, those changes are all but guaranteed.

Fed Vice Chair for Supervision Michael Barr said as much when he testified in front of the Senate Banking Committee on March 28.

"It's important for us to strengthen capital and liquidity rules," Barr said. "We're working on strengthening them as part of our Basel III reforms and our holistic review of capital, and I think we need to move forward with that."

Since joining the Fed as its chief regulator last summer, Barr has touted the need for a holistic review of capital, one which looks at each of the Fed's various standards — including the minimum Tier 1 equity requirement, stress capital buffers and the surcharge for global systemically important banks, or GSIBs — as well as their cumulative impact to determine if the banking system is sufficiently capitalized.

Barr had hinted that banks could stand to maintain higher capital levels, but he tended to couch that stance by saying he would wait for the results of the review. His congressional testimony was his first explicit statement that an upward revision was in order.

During that hearing, Barr also endorsed a long-term debt requirement for banks with between $100 billion and $250 billion of assets. The Fed and FDIC had floated such a requirement last fall in an advanced notice of proposed rulemaking on potential resolution requirements for non-GSIBs. In prepared remarks, Barr also noted that further changes could be made to the Fed's stress testing program. This year's stress test includes multiple scenarios for the first time. He said broadening the scope of the test to capture "a wider range of risk" and "channels for contagion" is appropriate.

The recent bank crisis has added fuel to the fire for ongoing regulatory reforms. It has also renewed a debate about the implementation of past legislation. Specifically, the Fed's response to the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act has come under the microscope.

At the time, the Fed used the discretion granted under the bill to apply less regulatory scrutiny to banks with between $100 billion and $250 billion of assets. Regulators and lawmakers agree that same discretion could allow the Fed to stiffen standards for banks in that range. Barr has said the Fed won't put forth new proposals until after it completes its review of the factors that contributed to Silicon Valley's failure. But he is open to making changes both to regulations and supervisory practices.

"The Fed has broad authority to change the rules it uses for different approaches to supervision of firms," Barr told lawmakers. "Under the rules that were put in place in 2019, [Silicon Valley Bank] was bucketed by a set of categories. I think that it is important to revisit those, as I have been doing since arriving at the Federal Reserve in July." — Kyle Campbell

Not all of the Federal Home Loan Banks will survive

As the banking industry consolidates further due to fallout from the liquidity crisis, some experts suggest that the 11 regional Federal Home Loan banks should be downsized as well.

In March and early April, the Home Loan Bank System issued roughly $430 billion in debt to support its members' demands for cash advances. The liquidity backstop could be the undoing of many other banks that may be technically insolvent due to underwater securities portfolios or have other underlying problems.

The two banks that failed in March — Silicon Valley Bank and Signature Bank — and Silvergate Bank, which voluntarily closed, each tapped the Home Loan Bank System for billions of dollars.

Because each regional Home Loan bank operates independently, some critics suggest the banks may not be collectively identifying problems among their members and hewing to safety and soundness concerns. Critics argue that the system has become unwieldy.

Ryan Donovan, president and CEO of the Council of Home Loan Banks, a trade group that represents the system, said it was "premature to speculate on what the FHFA might do."

"The regional nature of the FHLBanks was shown to be highly effective both in the most recent market disruptions as well as in meeting member needs throughout the history of the system," Donovan said.

The Home Loan Bank System, created by Congress during the Depression to provide funding to savings and loans, was modeled on the Federal Reserve banks. The 11 regional banks lend money to their roughly 6,500 members in the form of secured loans, known as advances.

The system's Office of Finance issues bonds that carry an implied government guarantee but critics argue that taxpayers are not getting as good of a return on their investment compared with the banks' members. The system is "very much a creature of the politics and geography of 1932," said Edward Golding, executive director of the MIT Golub Center for Finance and Policy, senior lecturer, and former member of the Federal Home Loan Bank Board, a predecessor to the current system.

Sandra Thompson, head of the Federal Housing Finance Agency, which regulates the Home Loan banks, has authority under the Bank Act to merge or consolidate the Home Loan banks. Given the attention the Home Loan Bank system has recently garnered, it may be hard for Thompson to resist the urge to restructure the government-sponsored enterprise. Last year Thompson launched the first major review of the system in 90 years. Consolidation would be a major step toward far-reaching reforms.

"There needs to be consolidation," said Stephen Cross, an advisor at Alvarez & Marsal and former deputy FHFA director, during a panel in March.

Golding, who also spoke on the panel, said, "If you were to start with a blank sheet of paper you probably would not have 12 or 11 banks." The FHFA is expected to take a more active role in providing both market and mission discipline by focusing on the banks' boards. These boards are stacked with directors who are both shareholders and customers of each bank. Some experts think at least half of each board should be independent.

"Institutionally, all of these types of quasi-public institutions do better with more voices in control," said Michael Hanson, CEO of Massachusetts Credit Union Share Insurance Corp. Hanson said he thinks 60% of each banks' board should be independent as a "counterweight" to the banks' members.

The banks have said they are open to the FHFA's review but are lobbying heavily for no changes to their business model of providing liquidity to members. Others see the system differently.

"The purpose of facilitating a robust housing market is the primary purpose of the FHLB system," Hanson said.

To that end, the FHFA is expected to issue a report soon with suggestions for both regulatory and legislative changes. — Kate Berry

Diversify, and then diversify some more

Silicon Valley Bank spent years carving a niche for itself as the bank for the innovation industry.

By providing financing and other services that catered to both venture capital firms and the startups they fund, it cemented a place for itself within the technology, life sciences and healthcare ecosystem. It claimed to be "fundamentally different from other banks" due to its fundraising expertise, its ability to connect startups to investors and its deep bench of advisors. And it wasn't unusual to hear executives often repeat that about half of all U.S. venture capital-backed tech and life sciences companies were Silicon Valley Bank clients.

But, in the wake of the bank's failure, being so heavily concentrated in one or two areas is likely to generate heightened scrutiny at other banks that are also deep into certain sectors, some say. There could be pressure to diversify not only business lines, but funding sources, especially given the fact that more than 90% of Silicon Valley Bank's deposits were uninsured.

"Going forward, diversification will be more important to banks and potentially to how regulators evaluate the banking sector," said Terry McEvoy, an analyst at Stephens Research. "Regulators, ratings agencies and investors will all take a closer look at the lack of diversification at certain institutions, and there may be consequences for having outsize exposure to one segment."

That doesn't necessarily mean there is no longer a place for banks with a niche focus and strategy that sets them apart from others, said Al Dominick, a partner at Cornerstone Advisors. Investors still expect banks to figure out how to separate themselves from the pack.

But it could mean there's a change in the way banks communicate their specialties, both internally among colleagues and externally to clients and other stakeholders, he said.

"If you can show a clear plan, then banking a specific industry may still prove very attractive and realistic," Dominick said. "But it ties back into being able to articulate the risks you run by doing so."

Even for banks that think they have a good handle on their business model going forward, the March crisis is forcing them as well to reevaluate how they are operating, Dominick said.

"There's a healthy realization that you could have done strategic planning six months ago and feel good about your three-year plan, and most likely [those banks too] are revisiting it today to see if it has to change," he said. "It goes back to the risk mindset that we can't be on the defensive all the time and we can't anticipate every black swan moment, so are we being realistic about what's in front of us?" — Allissa Kline

Deposit insurance will never be looked at the same way again

In the wake of the collapse of Silicon Valley Bank and Signature Bank, regulators established a systemic risk exception to bailout uninsured deposits at the failed institutions.

The move was meant to provide short-term market stability and stop panic from spreading to other institutions. But the move may have signaled to the industry that banks deemed too-important-to-fail can assume all of their deposits are insured if they run into trouble.

During a Brookings Institution panel debating whether the recent crisis merits lifting the deposit insurance ceiling, Prasad Krishnamurthy, a UC Berkeley law professor, said that rescuing depositors beyond the insurance limits highlights how regulators will pull out all the stops to prevent systemic contagion.

"Whether we like it or not, so-called uninsured deposits are actually insured in fact," Krishnamurthy said. "[Regulators] are always going to err on the side of insuring deposits when there's stress on the banking system because they're afraid that depositors will just exit the banking system en masse and go and buy government bonds for safety."

To prevent this assumption and the potential moral hazard that could come with it, Krishnamurthy and other panelists argued that rules surrounding uninsured deposits needed to be changed. One change would be limiting the uninsured deposits a bank could hold, said Patricia McCoy, a law professor at Boston College.

"You could have a very simple ratio of uninsured deposits to assets, for instance, and have a numeric cap," she said. "The median level of uninsured deposits to assets in the banking system is around 40%, so that tells me the cap would be somewhere in that region," McCoy added. "One advantage this would have is it would force some deposits out of the four big banks and back into community banks. That would be a good thing in many respects."

Another solution would be varying deposit insurance limits for different types of accounts, said Thomas Philippon, professor of finance at New York University.

"Small businesses need to find a way to treat their deposits in a bank differently. This could be a higher level of the deposit insurance, say 2 million or something," Philippon said. "I think that's what's going to happen, 200k for your average family, and 2 million for your typical [small and mid-sized enterprise], and that's one option."

Whatever regulators ultimately do, it is clear their decision to temporarily disregard deposit insurance limits may not be reversible. — Ebrima Sanneh

Banks must be ready to justify anything perceived as “woke”

Silicon Valley has long been criticized for its white-dominant "bro" culture, which is why it took many by surprise to hear Silicon Valley Bank accused on social media of being too "woke" after its crash.

In fact, the bank wasn't particularly focused on any singular political causes, and instead, a few of its diversity, equity and inclusion gestures became flashpoints.

The takeaway is that failure can invite scrutiny of any policy, so banks must be ready to justify even inclusivity initiatives. One trigger for critics of Silicon Valley Bank's political agenda was a Wall Street Journal column that appeared days after regulators took control of the bank. The column, written by Andy Kessler, suggested that the company "may have been distracted by diversity demands." The backlash didn't subside even when further research revealed that SVB wasn't overly invested in controversial political causes.

Additionally, Sen. Josh Hawley, R-Mo., deemed that Silicon Valley Bank was "too woke to fail" after federal regulators pledged that they would cover all deposits, even those over the insurance limit of $250,000. The same step was taken for the depositors at Signature.

And there were memes on social media suggesting SVB had contributed tens of millions to Black Lives Matter, another claim that was subsequently debunked. SVB had a handful of relationships with diversity-focused professional groups, including the Black Venture Capital Consortium, which works to increase the number of Black venture capitalists; BLCK VC, a nonprofit geared toward helping Black investors; and Blavity, a tech company for Black millennials.

But SVB's workforce wasn't notably diverse. The bank's U.S. employee base was fairly stereotypical of Silicon Valley. Just over half of employees were white men with about two-thirds of senior leadership positions held by men. Only 6% of its U.S. employees were Black.

The New York Post also harped on SVB's hire of lesbian Jay Erspah as the bank's U.K.-based head of financial risk management for Europe, the Middle East and Asia as evidence of an obsession with inclusiveness. But Erspah — a soft-spoken native of Mauritius who described herself as a "minority of minorities" there and in Silicon Valley for being a gay woman of color — wasn't directly managing the core risk areas for the bank.

SVB had actually filled the long-vacant role of chief risk officer in December 2022 by hiring Olson, a white woman, from Sumitomo Mitsui Banking.

Still, this ugly and very public fallout is likely to give other executives pause before implementing goals and other initiatives tied to DEI. This will lead to bankers being prepared to provide the transparency and details necessary to ensure that any decisions and initiatives can stand up to any type of unexpected scrutiny in the face of today's polarized political environment. — Kate Fitzgerald

Credit unions will strengthen liquidity monitoring procedures

Credit unions will double down on efforts to monitor liquidity in the wake of the bank runs on Silicon Valley Bank and Signature Bank.

The National Credit Union Administration is highlighting this risk and has listed liquidity as one of the top three concerns facing credit unions in its 2023 supervisory priorities. (The other top two concerns were interest rates and credit.)

Todd Harper, chairman of the NCUA, has tried to address these concerns by emphasizing the availability of the agency's Central Liquidity Facility, which is a source of funds owned by member credit unions to help backstop lending activity, and other federal alternatives as sources of funding. He has also noted that more than 91% of member share deposits across the system are insured. "Recent events provide a good reminder of the dangers of concentration risk and the need for effective risk-management policies and practices in the areas of capital, interest rate risk, liquidity risk and credit risk," Harper said during the agency's monthly board meeting on March 16.

To mitigate these concerns, some executives are taking multiple approaches to avoid being swept up in the current crisis. Kim Reedy, president and CEO of the $3.3 billion-asset OneAZ Credit Union in Phoenix, said his institution is in the process of building and rolling out the capability for daily reporting of liquidity risk as an additional component of its internal monitoring processes.

"We always want to make sure that we are 100% confident in the ability to provide the deposits and cash needs of our membership, anytime," Reedy said, estimating that only 12% to 14% of member deposits are uninsured.

Reedy plans to use the analysis with OneAZ's Asset and Liability Management Committee, which is tasked with overseeing the risk management of a credit union's balance sheet and drafting financially sound business plans based on the results.

Other institutions, like Kinecta Federal Credit Union in Manhattan Beach, California, believe they had strong liquidity monitoring procedures in place even before the bank failures in March. Management at the $6.7 billion-asset Kinecta estimates that about 5% of its member deposits are uninsured.

"We do our modeling at the account level, so with every single loan and every single deposit, we forecast how those are going to perform in terms of cash coming in and requirements for cash. … We then 'shock' those forecasts by testing what would happen if rates went up 300 basis points tomorrow or what would happen if the yield curve became further inverted and try to figure out what kind of event breaks the credit union," said Keith A Sultemeier, president and CEO of Kinecta FCU.

The industry should expect more credit unions to follow OneAZ and Kinecta by completing much more detailed analyses of their balance sheets. — Frank Gargano

Deposit swapping services will remain popular

Call them balance sheet management or deposit placement companies. The services that help banks insure deposits that exceed the current insurance limit of $250,000 from a single customer have been popping with new business.

Some of the interest in services from IntraFi, R&T Deposit Solutions and others, which parcel out balances in $250,000 chunks among a network of banks — either as a one-way or reciprocal arrangement — is a predictable reaction to the hubbub surrounding SVB's failure, given that that institution held so many uninsured deposits.

Federal regulators eventually said all of the deposits at Silicon Valley and Signature Bank would be covered but it was made clear this step wouldn't always be taken. The appeal of these deposit swapping firms is likely to stick since the public is currently spooked and hungry for a sense of security.

"If you're a business customer, you will go to your bank and say, 'Can you give me an option so I can tell my management that we have 100% deposit insurance coverage?'" said Leo D'Acierno, senior advisor at Simon-Kucher & Partners, a global consulting firm. "[The crisis] is causing this issue to move from something that used to be primarily of concern to the management of small banks to where substantial depositors are looking at their relationships with their bank and saying, 'I need to ask questions.'"

Businesses are prime candidates for extended FDIC insurance, but so are high-net worth individuals and people in special or temporary circumstances — say, older individuals who have shifted most of their investments to cash, or someone who recently sold a home in an expensive real estate market.

Deposit placement or swapping is particularly appealing to small banks, where volatile or rapid growth in deposits could stress their balance sheets. They may want to remove excess deposits to temper their growth, or, conversely, acquire deposits to fund loans. Sending money into a deposit network can also generate fee income.

Meanwhile, neobanks, such as Brex and Mercury, are advertising millions of dollars in elevated coverage through these sweep programs, as well as storing balances above that in relatively risk-free money market funds.

"This is a fintech flipping the script, because the bank argument has historically been, we're safe and stable and federally regulated," said D'Acierno. "The bottom line is, everybody is going to be doing it." — Miriam Cross

Banks will have to do more to combat synthetic identity fraud

Fraud attempts spiked in the immediate wake of the banking crisis, renewing the attention leaders paid to a particularly difficult form of fraud — synthetic identities.

Synthetic identity fraud involves the creation of a new identity using bits of real information. For example, a fraudster who gets their hands on the Social Security number of someone younger than 18 could use that number alongside a fake name, date of birth, address and phone number to apply for credit or a depository account, thereby synthesizing an identity.

Synthetic identity fraud attempts roughly doubled in the days after Signature Bank and Silicon Valley Bank collapsed, according to Socure, an identity-verification company. The company analyzed the riskiest 1% of applications it processed, which came from its more than 1,500 customers, including banks, state and local governments, sports betting platforms, and other companies that process applications to verify user identities.

The spike in synthetic identity fraud attempts specifically affected applications for depository accounts at small-business banking and investment banking clients. This spike in synthetic identity fraud against banks was accompanied by a spike in third-party identity fraud, which is where a fraudster steals someone's identifying information and uses it to apply for financial products.

Payment companies, fintechs, merchants, processors and data providers for years have also explored ways to create one central digital identity system in the U.S. that could potentially end synthetic ID fraud, but no proposed solution has yet met all the parties' goals.

One system that has helped reduce the level of synthetic identity fraud is the Electronic Consent Based Social Security Number Verification (eCBSV) Service, operated by the Social Security Administration. The service, which became available to all financial institutions in February 2022, provides a digital portal for verifying that the name, date of birth and SSN that an applicant submits matches the Social Security Administration's records.

The banking crisis served as a reminder, however, that eCBSV has not been a silver bullet against synthetic identity fraud. Financial institutions that have not yet integrated the system into their fraud prevention workflows must consider doing so, or look to alternative data sources to verify that applicants with thin or no credit histories are not just synthetic identities. — Carter Pape

Pay for failed bank execs will take a hit

While President Joe Biden is calling for a range of changes to bank regulation after the recent bank failures, few have as many paths to completion as the executive compensation rule. Biden asked regulators and Congress to consider how to more stringently punish the executives of failed banks, including the possibility of clawing back compensation for those whose actions led to the collapse of the institution.

There's some momentum in Congress to amend the Federal Deposit Insurance Act, directly giving more power to the FDIC, including a bipartisan bill co-sponsored by Democratic Sens. Elizabeth Warren of Massachusetts and Catherine Cortez Masto of Nevada, alongside Republican Sen. Mike Braun of Idaho and Hawley, which would require that federal regulators claw back all or part of the compensation received by a failed bank executive in the five-year period preceding the failure.

There's also a more direct route: finalizing an unfinished part of the Dodd-Frank Act, which would grant the FDIC some of those powers. This was meant to be completed in 2011, but despite a 2016 rule being proposed, attrition and turnover at the top of the agencies has meant it hasn't been a priority.

Experts expect the relevant agencies to pick back up the rulemaking after bipartisan anger has erupted over the way the executives of Silicon Valley Bank, in particular, were able to take in significant compensation despite their management of the bank. — Claire William