Three Things Banks Aren’t Doing to Avoid Collapse

The overnight collapse of industry darling Silicon Valley Bank (SVB) sent shudders through the financial services industry. For many, SVB’s implosion was reminiscent of events that triggered the Great Recession of 2008. But longer-term industry veterans will recall an earlier crisis that bears a much closer resemblance to SVB’s demise.

From 1986 to 1995, 1,043 banks collapsed — 32% of all U.S. savings and loan institutions. The reason they failed was identical to the current situation: a combination of government spending and money printing created inflation. The prime rate hit 21%. In the face of soaring interest rates, banks’ assets suddenly plummeted in value — not enough to liquidate should depositors flee en masse.

Being first out the door became a common strategy among depositors of the day. As everyone knows, last ones out are typically left holding the bag.

History repeating

If this all sounds vaguely like current events, that’s because it is. The vast majority of SVB’s deposits were institutional and rooted in a single vertical, technology—a tried-and-true model that almost always spells trouble. SVB boasted 37,000 clients with deposits over the $250,000 deposit insurance cap, averaging $4 million per account.

What’s notable about SVB was the velocity of the failure. SVB had shifted most of its holdings from short-term Treasury bills to longer-maturing bonds, inflating its apparent profitability but exposing it to danger from interest rate hikes. When inflation drove up interest rates, squeezing the bank’s ability to meet customer demands, SVB tried to raise capital through a share offering.

Sensing potential solvency issues, PayPal co-founder Peter Thiel’s venture capital firm Founders Fund began advising portfolio companies to pull out of SVB. Then, the Internet took over. Social media posts and chat rooms spread the panic like wildfire, and the instant accessibility of online banking sealed the SVB’s fate.

According to California banking regulators, depositors attempted to withdraw $42 billion on March 9, about 20% of the bank’s deposits. SVB, named among America’s Best Banks by Forbes on Valentine’s Day, was in ruin a month later—rendered insolvent in the span of just 48 hours. For perspective, the 2008 collapse of Washington Mutual Bank, the largest bank failure in U.S. history, took eight months.

What banks aren’t doing

The same acceleration in technology that made possible the flash bank run that spelled SVB’s doom powers solutions to help avoid another SVB. This is thanks to the Three Vs of Data: volume, velocity and variety. Those themes resonate when we look at what banks aren’t doing to safeguard against failure.

1. Banks aren’t prioritizing good governance and risk management best practices.

First and foremost, SVB’s collapse was the result of poor governance. Whereas in the past regulators would look at policies, procedures and systems when assessing risk management, recently, compliance has been about adhering to a formula, and the bar is set very low. Too many financial institutions are taking a lowest common denominator approach, merely ticking boxes on that minimal regulatory standard—a standard notably eased in 2018.

Much is being made of the loosening of stipulations in the Dodd-Frank Act—enacted, ironically, to prevent another 2008-style crash. The changes of five years ago moved the regulatory cap on some of the most strenuous regulatory oversight of regional banks from $50 billion to $250 billion in deposits. This rendered SVB exempt from the comprehensive annual stress testing required of larger financial firms.

It’s easy to blame deregulation, but in the end, the buck stops with the Board of Directors. Stringent stress testing would have been prudent regardless of regulatory thresholds. SVB went without a chief risk officer (CRO) through most of 2022, naming a new CRO in early January. SVB’s risk committee, which met seven times in 2021, convened 18 times in 2022. It seems the board understood, at least in part, the threat posed by interest rate hikes and the widening gap between the bank’s assets and liabilities. And yet, it failed to act in time.

2. Banks aren’t running enough simulations, in quantity, frequency or trajectory.

Weeks into March as I write this, many banks are still looking at their month-end data from February. That’s incredible when we consider the industry’s accelerating digitalization and the risk technology capabilities that exist on the market today.

The only way to keep default risk within acceptable levels is through robust Monte Carlo simulation—not 3 scenarios, not 10, not 50, but as many as the bank’s infrastructure will allow, done in quarterly steps out 10 years, or 40 quarters. To pick a small number, say they’re doing 200 scenarios at each time step.

Importantly, many risk managers are not taking the final, most critical step: counting failure scenarios (where the assets are worth less than the liabilities) and dividing by the total number of scenarios as they stretch forward across multiple periods. That calculation is the bank’s default probability.

The key to survival, particularly in today’s climate, is to be able to identify problems and react early. If the risk team is seeing a horribly high probability of defaults, the bank should consider issuing common stock now, not later.

3. Regulators, and thus banks, aren’t looking beyond credit risk.

Industry and regulatory focus on credit risk above all else has not been useful in predicting default. While the emphasis on credit risk evolved from past financial crises, the failure of SVB proves that banks need to mind a more complex interplay of risks.

Interest rate risk is an area of particular concern. As I noted in a recent blog post, bankers relying on one-factor interest rate models are seriously at risk in the current environment. Valuations are wrong, capital adequacy calculations are wrong, hedges are wrong, and the correlation of rates, oil prices, and commercial real estate is completely ignored.

Financial institutions must take stock of their liquidity and deposit balance risks considering rising interest rates. Without multi-factor and multi-period interest rate modeling, banks don’t have a sophisticated understanding of the risk of depositor flight. Further, because solvent banks have no experience in the deposit outflows that occur more voluminously as a bank teeters toward default, it’s critical for firms to study data from failed banks to understand and gauge such.

Lessons learned

While these deficiencies don’t universally apply to all financial institutions, there are risk lessons in them for every firm — and plenty of risk professionals clamoring for guidance. A poll question posed at recent webinar by GARP and SAS revealed a startling finding about banks’ preparedness and resiliency. Among the 572 attendees who responded, half indicated that their organization lacks adequate risk infrastructure.

While there aren’t any quick and easy fixes in risk management, the banking pros dissecting SVB’s epic crash for lessons learned already know the moral of the story: Banks need to be vigilant, resilient, and intelligent when it comes to managing their balance sheets.

Modern day asset liability management capabilities allow deposits and cashflows to be confidently managed, not monthly or weekly but daily, bringing risk and finance numbers together into a single view and shared across the organization. When a respected bank like SVB can collapse in 48 hours, settling for less seems irresponsible.

Author: Don van Deventer, Managing Director of Risk Research and Quantitative Solutions at SAS