Just about two months back, the US banking sector looked to be on the brink of a crisis. SVB Financial had gone bust and so had Signature Bank. Both were not big-bucket Manhattan banks but were fairly powerful in the niche areas they operated in. The Federal Reserve has done a very detailed analysis of where exactly SVB went wrong and what needs to be done to proactively prevent such occurrences in the future. There are 4 broad takeaways that emerge from the Fed report about what went wrong with SVB Financial.
What triggered and exacerbated the SVB crisis
We shall first look at the key points and then understand what the Fed said about each of these points.
Apart from the hard findings, the Fed has also come up with some soft findings on what actually escalated the crisis. According to the Fed, the presence of social media channels and a highly networked depositor base enabled quick exchange of information which actually fanned the flame of the crisis. This networking effect led to a run on deposits, which was much sharper than anticipated. There was also the systemic impact as depositors started painting all mid-sized banks with the same brush. This widened the run on deposits. Finally, it is not the solvency but the concerns or perception of solvency that was the real issue in the SVB Financial case. Hence, that is something that has to be effectively managed.
How the SVB Board failed to manage the risks?
We come to the first of the hard points made by the Fed, which is the lack of adequate risk management by the bank board. For instance, the bank was exposed to dual risks. Firstly, there was the risk of the slowdown in the technology sector which was impacting funding and the liquidity of digital companies, which formed the backbone of its investor base. Secondly, the rising interest rates exacerbated the crisis due to depreciation in bond values. Ideally, the onus was on the board of directors to anticipate such risks and prepare for the same, which was not adequately done.
For example, the bank had failed in its internal liquidity stress tests but the management never disclosed these results to the board nor did the board insist on a detailed examination of the findings. Risk management when it comes to interest rates is substantially neutral and only partially based on view. In the case of SVB, the interest rate risk management was substantially based on views and hardly any neutral approach was taken. The bank effectively assumed that rates would come down and that is where the strategy bombed. Ironically, the board did not insist on granular details on these matters.
Risk complexity growing with size was not appreciated
The company was in the midst of frenetic growth. For instance, between 2019 and 2021, the assets of SVB Financial had grown 3-fold from $71 billion to $211 billion. That should set the alarm bells ringing, but the risk management systems and practices were exactly the way it was managed when SVB was still a small bank. In short, when a bank grows 3-fold in two years, it assumes new risks arising from the complexity of the business. In the case of SVB, no analysis was done about the risk implications of the enhanced asset size and that was a key reason the risks did not get highlighted. It was a classic case where the systems did not grow and mature at the same pace as the assets of the bank were growing.
The above can also be taken as a statement on the rating agencies as none of these rating agencies had highlighted risks to the balance sheet. Also, governance was always a major risk in the case of SVB but was not taken seriously. Its governance had only received a satisfactory rating and that should have again set the board running overtime. No such urgency was shown. Typically, any rapid growth brings with it massive governance issues as liquidity and risk can change rapidly. That is where the lack of adequate governance at the bank became a major issue.
Inertia with respect to acting on the yawning gaps
As the Fed admitted, this is partly a shortfall in the bank and partly in the way it was regulated. For instance, the extant regulations provided SVB a long time and a long rope to meeting higher standards of supervision. That meant a lot of time was lost and during this period the entire crisis got exacerbated. Regulators and board members were not too keen to apply the standards of large banks to mid-sized banks as it would stifle growth in these niche banks. However, that eventually came back to haunt the bank and the regulators. But the biggest issue was inaction by the supervisors.
For instance, in the years 2020, 2021 and 2022, the risk management systems at SVB Financial were held to be deficient. However, the supervisors did little other than highlight these problems. Little was done by way of action, despite the banking falling short on stress tests, liquidity adequacy tests and the ability to handle interest rate risks. The banking regulations in the US have been deliberately supportive of smaller banks and for valid reasons. However, that cannot be a justification for lax supervision, especially when it involves systemic risks. More so, for a bank that has grown 3-fold in a short span of just 2 years. The risks were just ignored.
Growth over risk was a major reason
This has been highlighted by the Federal Reserve report as a key reason for the laxity in supervision of SVB. The regulators had laid a lot of emphasis on tightly regulating the handful of systematically important banks (SIBs), while other banks were not subjected to such stringent standards. In such cases, the boards were expected to fill the gaps, which obviously did not happen in this case. The entire focus was to allow small banks to growth by reducing their regulatory and supervisory liability. The idea was to focus on growth over risk and that is where it backfired.
To sum it up, what are the major takeaways, and was the crisis avoidable? Obviously, it was a man-made crisis, which is the good news. Unlike the systemic global financial crisis of 2008, this was more focused on smaller banks with weak risk management systems. The onus will now be on the Fed to see how it reconciles the twin objectives of growth and risk management, especially with respect to the small sized banks. That will be the billion dollar question.
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