We have seen three significant bank failures in March, including the second and third largest in US history. Let’s hope April is a better month for banks. The timing of these failures coming so close together was not a coincidence. These events were remarkable in their timing and location, which I will address later.
Let me start by saying that the root cause of the failure of Silicon Valley Bank (SVB) rests with its management and board of directors. As a former federal regulator with two US Treasury regulatory agencies, we used a rating system to evaluate all the major components of a bank’s operations.
I will not go into great detail on the system except to say that the management component—known as the CAMELS—was a critical aspect of any examination. The component factors are as follows: C—capital adequacy; A—asset quality; M—quality of management; E—quality of earnings; L—adequate liquidity; and S—market risk sensitivity.
During my international career involving banking supervision at 16 central banks, I have taught a course on the CAMELS system to approximately 2,000 examiners. I would ask the students which components were the most important in each class. Regardless of the country, most of them indicate that the amount of capital is the most critical factor in rating a bank.
We had many good discussions and debates on this topic; however, I always advocated that the M component was the most important. Even a well-capitalized bank will only survive with competent management.
I wish I had the example of Sam Bankman Fried and FTX when I was teaching these classes. Without prudent management and oversight, the bank would not survive long term as their poor decisions would eventually catch up and cause problems.
So, going back to SVB, let’s start with what has been reported. It appears SVB had more money than it knew how to invest prudently—I will get into that later.
However, let’s look at Banking 101. What is the business of commercial banking? In straightforward terms, the bank buys money from the general public and then sells it to other members of the general public.
If things go well, the bank should profit from the costs of buying money (a liability on their balance sheet) and then the price of selling the money (an asset on their balance sheet). Again, this is just banking 101.
When banks get into trouble, the issues usually concern credit quality. The bank suffers a loss when borrowers do not repay their loans. SVB’s demise was not a loan problem. Their loan portfolio was significantly smaller than their security portfolio, which is unusual for most banks. SVB’s issues involved the maturities of their government securities and the liabilities used to buy them.
Banks must keep enough of these deposits (liabilities) in cash because the depositors can demand their money at any time – even a long-term CD can be redeemed. As noted, SVB bought significant government securities when its deposit base increased significantly. When the Fed started raising interest rates, the market value of these securities fell. This is not a problem when you hold them to maturity, but it is a problem when you need to sell them (at a discount) to return deposits to their owners.
I am skipping some of the complexities, but the scenario noted above only works because most depositors usually leave their money in the bank. It also helps to have a loyal and diversified depositor base spread out over a large geographic area.
The scenario described above is commonly noted as interest rate and maturity risk. This is familiar ground for bankers or bank regulators. A mismatch between long-term loans and short-term deposits primarily drove the savings and loan crisis of the 1980s. Again, this concept is not new; most bankers I know are keenly aware of this trap.
To continue with this thought, I recently found an article from a reputable investment firm that the Federal Reserve Bank of San Francisco issued six warnings to the board of SVB that it was vulnerable to asset/liability issues, including liquidity management.
The article also stated that SVB was rated deficient in governance (the M component of the CAMELS system) and internal controls. As noted in a New York Times article earlier this month, SVB’s management team did nothing to address these deficiencies.
One of the biggest red flags for SVB should have been the volume of deposits—most of which were uninsured. SVB’s balance sheet as of year-end 2022 revealed that the bank had $74 billion in loans, $120 billion in securities, and $173 billion in deposits.
The largest asset on a typical bank’s balance sheet is its loan portfolio, which is typically 70 -75 percent of the bank’s deposit base. However, SVB’s security portfolio was almost twice the size of the bank’s loan portfolio.
Banks generally buy securities as a secondary source of liquidity to have adequate funds when depositors request their money. This reveals (to me) that the bank had more money than opportunities to invest as loans in the communities in which it operated.
I feel compelled to note that government securities are deemed to have lower credit risk than loans, but they are not zero risk either.
Nothing new concerning mismanaging interest rates and SVB’s failures is new in the above-noted scenario. So, what is the teachable moment in all this? Perhaps the lesson is that regulatory warnings are only sufficient if the bank’s management takes concrete steps to address the deficiencies.
In hindsight, the regulators could and should have been more forceful in their dealings with the SVB board. However, nothing that I have seen about this failure relieves SVB’s board and senior management of their responsibility for this bank failure.
The bank’s management is always – and should be – the first line of defense in protecting depositors’ money. SVB failed miserably at this, and if I were a board member or a senior manager, I would have trouble sleeping. The bank’s external auditors – KPMG – will also be in the line of fire. You can bet the auditors also have sleepless nights.
It is frustrating to see that most of the red flags regarding this failure were ignored. It must be mentioned that these three bank failures took place in the most liberal states in our great country. To illustrate the complexities of this, what would have been the decision to ensure all depositors if the bank’s clientele were in the oil patch of West Texas or a farming community in Iowa? This deserves our attention since most of SVB’s deposits come from a relatively small group of venture capital firms and their owners.
The federal regulators decided to insure all deposits over a weekend; however, I was under the impression that only Congress could raise the limits for deposit coverage. I assume the Fed and the Treasury used emergency powers to help avoid systemic risk to the financial system. After all, our banking system only works on faith and trust.
To reiterate, when a bank fails, it is primarily because of incompetence, gross negligence, or some type of wrongdoing on the part of management. Nonetheless, depositors keeping millions of dollars in the same bank is not logical – I do not care where you live or work. And by the way, I was only asking these questions to a friend!
