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2023 Banking Crisis: What Next?
Friday, March 24, 2023

The Silicon Valley Bank (“SVB”) closure was the largest bank failure since the 2008 financial crisis—and second largest in U.S. history.  While the banking industry, federal banking agencies and the market at-large continue to react to the fallout and look to determine the root causes, the industry is likely to see a number of potential changes in the shadow of this recent crisis.  Below are some thoughts on the potential consequences of the SVB failure.   

Rolling Back Deregulation and Increasing Regulatory Scrutiny of Mid-Tier and Regional Banks

After the financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law in 2010, which provides that banks deemed “systemically important” are required to have higher liquidity, perform stress testing, and produce a “living will” to provide for orderly dissolution of assets.  Eight years later, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “EGRRCP Act”) amended the Dodd-Frank Act by raising the minimum total asset thresholds required before banks were subjected to the strictest oversight—which include annual stress testing and enhanced capital requirements. Specifically, the minimum asset threshold was increased from $50 billion in assets to $250 billion, and the threshold for subjecting banks to enhanced capital requirements increased from $10 billion to $100 billion.  The Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Office of the Comptroller of  the Currency still retained broad authority to supervise and regulate all banks, including “mid-tier” and “regional” banks—those with between $100 billion and $250 billion of assets, through the use of their traditional supervisory tools.

To ensure mid-tier banks can respond to deposit demands and maintain sufficient liquidity, the federal banking agencies have the tools necessary to reestablish those aspects of the Dodd-Frank Act that they deem necessary, including as revised under the EGRRCP Act.  Nonetheless, as has frequently been the case following a banking crisis in the past, Congress may bestow upon the bank regulators additional tools by which the regulators can enhance their supervision of the banking system.  To add to the complexity of potential regulatory changes, Federal Reserve Vice Chair for Supervision Michael Barr recently announced that the Federal Reserve was conducting a “holistic capital review” of its capital requirements, including implementation of the Basel Committee’s Pillar 2 standard.  Moreover, even the industry itself is calling for changes regarding FDIC insurance coverage.  Without an increase in FDIC insurance coverage limits, some speculate that the number of banks will continue to shrink until the only banks remaining are ones that are too big to fail.

Deposit Insurance Reimagined – Deposit Concentrations Likely to Be Addressed

Lack of depository insurance didn’t cause the collapse, but enhanced insurance coverage regulations could prevent a future panic and fallout. Leading up to the SVB shutdown, more than90% of SVB’s deposits were uninsured. FDIC insurance covers deposit accounts aggregating $250,000 or less.  As a result, this leaves most business accounts uninsured. Moving forward, there are several different approaches regulators could take to insure more small business accounts. Potential approaches include:

  • The FDIC could increase the $250,000 threshold for FDIC coverage.  Is it reasonable to expect the CFO of a small business to understand the financial health of the local bank?  Apparently, even trained bank examiners were unable to do this in the case of SVB.  Doesn’t this simply force small businesses to bank at the too big to fail institutions, ultimately leading to a banking system of only too big to fail banks?

  • Regulators could require all businesses to obtain private deposit insurance on all deposits held with banks. But it may be difficult to calculate coverage. In contrast to a natural person, whose insurance coverage needs might be measured based on an average annual income estimate, businesses are different and could theoretically be measured by a number of different factors.  Private deposit insurance would amount to insuring the success of the underlying business, something that insurance underwriters are loathe to do.

  • Regulators could place limits on deposit concentrations (i.e., the percentage of a bank’s accounts that are uninsured versus insured).

  • Finally, there are varying opinions on how much deposit insurance banks should be required to obtain.  Legislation could require that insurance provide an explicit guarantee for all deposits, which would increase deposit premium assessments on all banks. But an issue that remains is how much of an increase in insurance assessments the banking industry can actually afford.

Increased Emphasis on Asset-Liability Committee (ALCO) Management

As the narrative has been portrayed, SVB invested a large portion of deposits into longer duration Treasury bonds and mortgage-backed securities that promised enhanced returns when interest rates were low.  However, when the Federal Reserve continued to raise interest rates in an attempt to combat an increase in inflation, the value of these investments depreciated significantly. At the same time, as interest rates increased, technology and venture-backed companies, a concentration of SVB’s customer base, experienced a decrease in capital funding, and as a result, began to withdraw more of their deposits to meet expenses. Accordingly, SVB was forced to meet this funding demand through liquidation of its some of its investment portfolio, which ultimately depleted the bank’s capital, caused a liquidity crunch and forced the federal banking agencies to intervene. 

SVB accepted short-term deposits from clients but mismatched them with these longer-term, fixed-rate assets.  When interest rates rose, the value of long-term assets fell.  Upon sale, these long-term assets incurred the unrealized losses built-in to SVP’s held-to maturity securities portfolio.  It is likely the federal banking agencies will determine that ALCO mismanagement was the direct cause of SVB’s inability to satisfy deposit demands as without incurring significant losses.  As a consequence, it is likely the federal banking agencies will more closely monitor banks’ ALCO strategies, focusing on tenor-matching (having asset tenor match deposit tenor) and liquidity pool depth (requiring diversification of sources of funding).  Duration risk will be monitored more closely.

Interestingly, as others in the industry have pointed out, unlike credit risk and liquidity risk, interest rate risk is not susceptible to being reduced to a formula due to a number of unknowns.  For that reason, interest rate risk has never been subject to a regulatory formula.  Nor is that risk captured in risk-based capital.  Government securities, even those that are well under water, have a zero risk weighting. 

Increased Public Disclosures for Public Bank Holding Companies

While the industry continues to evaluate the circumstances surrounding SVB’s failure, there is no question how the regulatory agencies, including the Securities and Exchange Commission, will view the matter.  SVB’s failure has highlighted a number of inherent risks embedded in the banking industry as a whole and potential issues within the banking industry’s risk management practices (e.g., depreciated securities portfolio, ALCO management, and deposit concentrations, etc.).  For public bank holding companies, these matters are likely to require enhanced disclosures in publicly filed documents, including with respect to large deposit outflows and levels of uninsured deposits.  In addition, public companies that hold significant amounts of cash in bank deposit accounts may need to make disclosures to address their own potential FDIC uninsured deposit exposure risk.

Increased Governmental Intervention in the Next Receivership 

While regulators continue attempts to ward off a financial crisis, questions still remain. For one, what will the government response be in the event of another failed bank? Will federal regulators have to intervene to guarantee both insured and uninsured deposits?  Practically, will the FDIC have to cover uninsured deposits of community banks? 

Recently the Secretary of the U.S. Department of Treasury stated that the “systemically important” exception under the Dodd-Frank Act, which was utilized by the federal regulators to guarantee the uninsured deposits of SVB, would not be used to cover all uninsured deposits in the event of a community bank failure.  Later comments, however, modified that statement by indicating that the United States could move to protect all bank deposits if they see a risk of a banking run in the system.  While the federal banking agencies may be viewing the statutory limitations for deposit insurance, one thing seems certain: regional banks now join the growing list of institutions that are now considered “too big to fail.”  This in turn only places more pressure on community banks.  This crisis demonstrates that the playing field is not level.

Enhanced Scrutiny of Directors/Officers of Failed Banks and Their Compensation/ Equity Sales

Typically directors and officers of banks placed into receivership are faced with the prospect of lawsuits and civil actions brought by the federal banking agencies for perceived gross negligence or a breach of fiduciary duties.  It is well understood that the federal banking agencies’ strategy has and continues to be obtaining value from a failed bank’s directors and officers insurance policies.  This trend is likely to continue.  However, the Biden Administration has recently called upon Congress to toughen penalties on the directors and officers of banks placed into receivership and identified the following areas for enhanced regulatory action:  (i) the claw-back of insiders’ compensation and proceeds from equity sales; (ii) higher civil penalties; and (iii) potential automatic banking industry bans. 

Federal Home Loan Bank (“FHLB”) System

Congress created the FHLB system during the Great Depression to promote home ownership and to provide liquidity to banks, thrifts, credit unions and insurance companies.  The FHLB system provides such funding to its member banks through secured loans, called “advances.”  The FHLB system is currently being criticized by members of the Biden Administration for shifting away from its original home ownership purpose.  For instance, Silvergate Bank borrowed heavily from the FHLB system and primarily used advances to support lending to its clients in the crypto currency industry.  Silvergate Bank received $4.3 billion from the FHLB in 2022, and SVB and other banks in crisis had significant advances from the San Francisco and New York FHLBs.  Due to FHLB’s super-lien priority, it has priority over the FDIC in a failed bank scenario and, in such a circumstance, the FHLB system shifts any lending losses to the FDIC’s deposit insurance fund.  The FHLB system is being portrayed as having financed significant risk taking, contrary to its “original purpose,” and the FDIC’s deposit insurance fund is bearing the loss.  Given the circumstances, we imagine there will be increased discussion about the mission of the FHLB system.

Regardless of the changes and reforms to be proposed and eventually enacted as a result of recent events, it is likely that the federal banking agencies will seek to dramatically alter how banks are supervised without congressional approval.  Insolvencies that threaten the financial stability of the country are likely to bring about more regulation, and bring it about quickly, even if Congress takes no immediate action.  As such, banks may expect a number of changes due to the failure of SVB. 

Kelly Miller also contributed to this article.

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