By: JayaKrishna Nanduri and Ashwath Ram

Over the past few months, two major banks failed on either side of the Atlantic Ocean – Silicon Valley Bank (SVB) and Credit Suisse (CS). The two crises did not happen over a day or a week but resulted from several missteps. It almost felt like the ominous signs of 2008 were upon us, but the collapse of the two banks was not due to systemic failures.

While SVB failed due to Asset-Liability Mismanagement (ALM), CS’s failure of risk controls led to its downfall. Credit Suisse is a perfect example of what we considered a too-big-to-fail bank, which was supposed to have all the necessary risk systems in place and collapsed because of a failure to curb banking wrongdoings and over-risky bets.

Cases like SVB will occur if a financial institution or bank does not retain adequate liquidity. Excessive increases on either the assets or liability side should be monitored with proper regulations in place to avoid a mismatch.

Cases like CS will occur if proper risk control management, installed to protect the banks from crumbling, is not properly scrutinized and enforced. There should be various levels of risk checkpoints that need to be constantly monitored and updated.

Recap of events that unfolded at SVB

1. During the pandemic, people stopped spending money, which led to deflation; US Fed reduced the interest rates to near-zero and encouraged banks to borrow cash at a 0.08% interest rate to increase cash circulation. While Bank of America gave 0.96% and the industry average was 1.17%, SVB gave depositors 2.33% interest.

2. Because borrowing interest rates were at an all-time low, Venture Capitalists (VCs) and Private Equity (PE) investors raised a lot of money and backed new startups in Silicon Valley, expecting big profits. Tech Startups like Circle, Roku, and Roblox, who had obtained large funding from VCs and PE firms but had no immediate expansion plans, were sitting with large cash in hand. They all deposited it in SVB, and its deposits grew to USD 180 billion in 2022.
3. SVB placed a significant portion of its depositors’ money in mortgage-backed securities, also known as held-to-maturity instruments, which means you may be penalized if you liquidate or sell them before maturity.
4. What SVB did not expect was the Russia-Ukraine war that cascaded into high inflation in the Western countries, rising to 9.1%. As a result, to control inflation, the central bank sought to drain cash out of the system, and increased interest rates from 0.08% to 4.5%, in six months.
5. To control inflation, Fed stopped purchasing Treasuries or Mortgage Backed Securities (MBS) from commercial banks as that would circulate more cash into the economy. SVB, which had a large pile of MBS and treasury bonds, suffered an unrealized loss of USD 1.8 billion.
6. Then, no venture capitalist or private equity firm funded tech startups due to the repercussions of the big tech fallout and the market’s high-interest rates. Because no investment was received by tech startups in 2022, they opted to withdraw their money from SVB.
7. When clients with interest-bearing deposits began withdrawing funds, SVB had no alternative but to sell their bonds portfolio and realize their loss of USD 1.8 billion. Every news outlet publicized this story, causing panic among investors over the bank’s future and liquidity position. So, the non-interest-bearing depositors also started withdrawing the money.
8. Moody’s reduced SVB’s credit rating from A+ to C when it discovered the losses. As a cover-up plan, SVB’s CEO met with Goldman Sachs to explore a new public offering to raise USD 2.25 billion, and then brought this model to Moody’s to request an upgrade.
9. But it was too late; social media significantly spread the fear, and the SVB share price dropped 60% in a day! 97% of SVB deposits were uninsured. This caused more panic among the customers to withdraw their money as early as possible.
10. The government and Federal Deposit Insurance Corporation (FDIC) jumped in and took over SVB as the depositors queued up in front of the bank, ensured them that their deposits were safe, and transited all the assets and liabilities of SVB to First Citizen Bank.

Recap of events that unfolded at CS

1. There have been multiple leadership changes in CS during the last decade. Every leader sought to make CS profitable and made risky bets and bad business calls.
2. A corporate espionage episode tarnished its reputation in the market despite having nothing to do with its operations.
3. The problems began to run deep and started in the form of Archegos Capital bankruptcy, with whom they agreed to a total return swap deal worth USD 5.5 billion. Additionally, when the deal with Greensill Capital, a supply chain financing company, broke down, CS lost USD 2.5 billion by funding Greensill customers.
4. The final blow for CS came from SVB’s collapse, where depositors followed the same process of withdrawing money from the embattled vendor. It did not have enough investments to liquidate and honor the withdrawals, so it agreed to sell the company to UBS for USD 3.3 billion.

In addition to the above two major banks, we have witnessed the downfall of other major regional banks in the United States of America – Signature Bank and the most recent one being First Republic Bank. Similar to SVB, First Republic Bank too collected a lot of despoits by taking advantage of pandemic low interest rates, made a lot of mortgages. When inflation hit, their business model looked precarious, set for a major crisis since the assets on their balance sheet started losing a lot of value. Eventually on Apr 24th, First Republic Bank was taken over by JP Morgan.

Why couldn’t regulators identify the risks at SVB or CS?

The origin of SVB’s failure can be traced back to the lack of foresight on the part of the US Federal Government when it decided to reverse the bank regulations enacted post the 2008 financial crisis. Post-2008, banks with more than USD 50B deposits were mandated to conduct stress testing and report the results to regulators. Stress testing is a significant investment in risk systems. The government raised this threshold to USD 250 billion from USD 50 billion, implying that if the bank has less than USD 250 billion in deposits, it is not required to conduct stress testing.

Stress testing basically is designed to detect an impending financial disaster. As SVB deposits were under USD 250 billion, it never performed stress testing on its investments and any risk measures which could identify the economic disaster.

CS’s lack of enforcement of the regulatory controls to curb the risky bets was due to their leaders’ pursuit to generate more profit. There was a lack of risk control management by the internal teams including management and oversight.

Key focus areas for banks, regulators, and service providers moving forward

Here’s what regulators are likely to focus on:

• Regulators are planning to aggressively use RegTech, which can pull data/information from the banks, removing the need for reports whenever they want without notifying the markets to avoid unnecessary panic, making the financial information exchange faster, agile, and devoid of human interference.
• Regulators need to reinstate stress test threshold limits back to USD 50 billion and conduct enhanced stress tests for multiple scenarios to uncover a variety of channels of contagion.
• From investors’ protection perspective, they are creating a new lending facility to serve victims of embattled lenders and trying to create shelter institutions to transit embattled banks to high liquidity banks smoothly.
• Overhauling the regulatory bodies’ tech-infra to monitor liquidity crises, depository crises, the flow of funds, etc., in real-time and adopt a more proactive approach than a reactive one.
• Focus on financial instruments which have not been Marked-to-Market (MTM), since MTM can help give a more accurate figure of the present value of an asset/security under the market conditions and not book value, and analyze the entire dependency chain associated with these securities.

Areas that banks need to focus on:

• The primary area where banks need to focus on is their asset liabilities management applications and understand the gaps. Asset liability management is not a one-off sub-domain of banking operations and needs top priority in monitoring with an agile balance sheet management.
• Internally set up a regulatory and compliance team that provides real-time oversight and invests in a robust banking governance framework.
• SVB collapse has largely been attributed to its concentrated customer base of tech startups. Hence banks need to revisit their customer demographics regularly and mitigate their risk appropriately. They also need to diversify risks in terms of products and their offerings.
• Even if regulators do not impose stress tests, banks should do independent stress testing to foresee any cracks or gaps in their operational structures.
• Develop a strategy to control narratives and real-time feedback on customer and stakeholder sentiments. This becomes imperative in an era where information travels almost instantly through social media, leaving less time to filter the facts from the noise.

Opportunities for tech service providers like LTIMindtree to capitalize on:

• Help banks resolve issues with respect to data siloes by building a single, comprehensive view of risk across the organization.
• Adopt a strategy to follow the ripple effect of the bank failures and focus on opportunities provided by banks which need a course-correction across risk, compliance, operations, and marketing strategies in response to newer regulatory changes.
• Strengthen/leverage partnerships with fintechs and tech-vendors/partners to develop a more solution-oriented approach (rather than resource-dependent) to plug possible gaps that may arise due to industry headwinds.
• Enable banks to be prepared for the hyper-connected world via real-time integration of information across internal and external data sources.
• Build operational resilience by improving scenario analysis capabilities with co-relation of various risk types (credit, market, liquidity etc.)
• Leverage new technologies by enhancing market-sensing predictive capabilities with AI/ML and quantum computing capabilities. For example, JP Morgan is investing in quantum computing to resolve its optimization problems especially in portfolio and ALM risk management.

LTIMindtree’s Governance, Risk and Compliance (GRC) in banking is one of the largest practices driving large-scale transformation through AI/ML-driven next-gen digital, data solutions and proprietary platforms. Check out how we can help ensure your banking operations is healthy: https://www.ltimindtree.com/industries/banking-financial-services/.

REFERENCES:

1. https://www.gartner.com/en/newsroom/press-releases/2023-03-16-gartner-survey-shows-28-percent-of-cfos-plan-to-diversify-deposits-across-more-banks-after-recent-failures
2. https://www.everestgrp.com/https-www-everestgrp-com-banking-industry-svb-aftermath-how-will-the-bank-failures-impact-the-technology-services-industry-blog-html.html
3. https://www.brookings.edu/opinions/svbs-collapse-exposes-the-feds-massive-failure-to-see-the-banks-warning-signs/
4. https://www.nytimes.com/interactive/2023/03/18/business/why-people-are-worried-about-banks.html?smid=tw-nytimes&smtyp=cur
5. https://www.weforum.org/agenda/2023/03/banking-crisis-regulation-technology-regtech-financial-turmoil
6. https://www.linkedin.com/pulse/smartest-guys-room-werent-so-smart-supreme-irony-svb-secs-greenberg/
7. https://www.ft.com/content/c50e9cdf-c444-4b23-92ad-5e2779d35adf
8. https://www.bloomberg.com/opinion/articles/2022-02-22/i-quit-as-fdic-innovation-chief-because-of-regulators-technophobia#xj4y7vzkg?leadSource=uverify%20wall
9. https://fortune.com/2023/03/21/feds-stress-tests-failed-to-stop-banking-crisis/
10. https://www.whitehouse.gov/briefing-room/statements-releases/2023/03/30/fact-sheet-president-biden-urges-regulators-to-reverse-trump-administration-weakening-of-common-sense-safeguards-and-supervision-for-large-regional-banks/