Key Takeaways from Bank Failure Reports

As previewed in our client update from April 26, 2023, three government agencies released reports reviewing the failures of SVB Financial Group (“SVBFG”) and Signature Bank (“SBNY”) on Friday.  Specifically:

• the Federal Reserve Board (“FRB”) released a report on the failure of SVBFG and Silicon Valley Bank (“SVB”) led by Vice Chair for Supervision Michael Barr (the “FRB Report”);
• the Federal Deposit Insurance Corporation (“FDIC”) released its internal review evaluating its supervision of Signature Bank (“SBNY”) conducted at the request of FDIC Chairman Martin Gruenberg (the “FDIC Report”); and
• the United States Government Accountability Office (“GAO”) released a report reviewing agency actions related to these failures (GAO-23-106736) (the “GAO Report” and, together with the FRB Report and FDIC Report, the “Reports”).

We note that the New York State Department of Financial Services also released a report on the failure of SBNY on April 28.  The California Department of Financial Protection and Innovation is expected to release a report on the SVB failure later this month.  While this post focuses on the FRB, FDIC and GAO Reports, we expect to discuss the state regulators’ reports and JPMorgan Chase’s purchase of First Republic Bank on May 1, 2023 in upcoming posts.

The Reports provide a detailed summary of the events and analysis, and include confidential supervisory information in the form of examination records, communications with examiners and supervisory analyses.  In this post, we outline key takeaways from the Reports that focus on the potential implications for banking organizations, including what the industry may expect in terms of supervisory posture and areas of heightened focus, impacts to growth strategies and regulatory reform.  We first list the key takeaways and then discuss each of them further below.

Top Takeaways for Banking Organizations

Near-Term Supervisory Implications

1. Going forward, supervisors may issue supervisory findings more quickly and escalate un-remediated supervisory concerns (into enforcement actions or ratings downgrades) more readily.
2. As a matter of best practice and in light of likely enhanced supervisory scrutiny, banking organizations may wish to assess their governance, including by reviewing the robustness of board reporting and ensuring that board and senior management respond to supervisory criticism in a manner that evidences a commitment to proactive remediation and risk management.
3. The FRB Report’s focus on incentive compensation previews a holistic review of bank executive compensation practices, including whether there is sufficient incorporation of risk considerations.
4. Bank examiners may scrutinize interest rate risk and liquidity risk management practices more closely, and, more generally, banks’ approaches to revising stress test assumptions and risk limits and tolerances.

Near- and Medium-Term Strategic Considerations

5. To confirm operational readiness and demonstrate to supervisors a proactive approach to managing risks, banking organizations may consider revisiting contingency funding plans and other liquidity risk related playbooks, conducting gap analyses and conducting tabletop exercises.
6. A banking organization may be expected to proactively demonstrate to supervisors, by showing rather than telling, that it: (i) has built robust systems and controls, (ii) has hired qualified staff and (iii) will comply with additional supervisory expectations and regulatory obligations as it grows. Developing and operationalizing growth-related compliance plans would maximize the organization’s chances of success on its regulatory applications, and may even increase regulatory receptivity to a bank deal.

Longer-Term Regulatory Implications

7. The FRB Report previews the FRB’s plans to revisit its tailoring framework, including by referring to specific liquidity, capital and stress testing rules that “should be modified or re-evaluated.” The FRB Report also signals pending proposals on a holistic review of capital, Basel III endgame, use of multiple scenarios in stress testing and long-term debt for resolution purposes.
8. The Reports explore the possibility of imposing increased capital or liquidity requirements, or limitations on incentive compensation and capital distributions, following supervisory findings or ratings downgrades.

Near-Term Supervisory Implications

1. Increasing the “Speed of Supervision.” The Reports all discuss deficiencies in the speed at which supervisory actions could have been escalated:
   • FRB Report: “slower action by supervisory staff and a reluctance to escalate issues” and “an approach that emphasized consensus and the continued accumulation of evidence even as SVBFG deteriorated.”
   • FDIC Report: “FDIC could have escalated supervisory actions sooner,” particularly “when bank management is not responsive.”
   • GAO Report: “GAO has longstanding concerns with escalation of supervisory concerns”

Takeaway:  Going forward, supervisors may issue supervisory findings more quickly and escalate un-remediated supervisory concerns (into enforcement actions or ratings downgrades) more readily.

2. Doubling Down on Governance. The Reports emphasize the central role that corporate governance played in the failures.
   • The FRB Report faults SVB’s full board for not requiring management to provide it with adequate information regarding SVB’s risks. For example, SVB’s board did not receive important negative information in a timely manner related to SVB’s liquidity position “despite deteriorating conditions.”  The Report further stated that the board “did not hold management accountable for effectively managing the firm’s risks.”
   • The FRB Report also faults the board and management for underappreciating that the supervisory criticisms were identifying critical risk management issues and instead “often treated resolution of supervisory issues as a compliance exercise.” The FDIC report raises similar concerns with respect to the SBNY executives, noting that “SBNY executives were sometimes disengaged from the examination process and were generally dismissive of examination findings.”  The FRB Report states that SVB’s “management was only addressing issues in response to supervisory findings rather than being proactively focused on safe and sound operation of the firm.”

Takeaway:  As a matter of best practice and in light of likely enhanced supervisory scrutiny, banking organizations may wish to assess their governance, including by reviewing the robustness of board reporting and ensuring that board and senior management respond to supervisory criticism in a manner that evidences a commitment to proactive remediation and risk management.

3. Pressure on Executive Compensation. The FRB Report concluded that SVBFG’s incentive compensation decisions were primarily based on its financial performance, with “insufficient linkage to risk management and control factors.”  The Report goes on to indicate that “[o]versight of incentives for bank managers should also be improved” and that the FRB is considering setting tougher minimum standards for incentive compensation programs.
   • Relatedly, in a White House Fact Sheet published on March 17, 2023, President Biden called on Congress to expand the FDIC’s authority to claw back compensation from executives at failed banks, strengthen the FDIC’s authority to bar executives from holding jobs in the banking industry when their banks enter receivership and expand the FDIC’s authority to bring fines against executives of failed banks.

Takeaway:  The FRB Report’s focus on incentive compensation previews a holistic review of bank executive compensation practices.  Banking organizations may wish to proactively review their executive compensation policies, including whether these policies appropriately incorporate risk metrics.

4. Focus on Risk Management. The Reports noted significant deficiencies in liquidity risk management practices at both banks.  The FRB Report cited “foundational weaknesses” in SVB’s liquidity risk management, including in its liquidity position, internal liquidity stress testing and contingency funding plans, while the FDIC Report noted “overreliance on uninsured deposits without implementing fundamental liquidity risk management practices and controls.”  Finally, the GAO report highlighted liquidity and other risk management failures at both banks.
   • Both the FRB and FDIC Reports signal that supervisors will increase their focus on uninsured deposits and deposit concentrations. The FRB Report noted that reliance on asset liquidity to evaluate liquidity risk led to an “underappreciation of the inherent risks” of high levels of concentrated, uninsured deposits, while the FDIC Report noted the risks associated with a “significant volume of uninsured deposits and the concentration of deposits in a few key accounts.”
   • In addition to increased supervisory scrutiny on risk management processes, the Reports also suggest that supervisors may focus on identifying the underlying risks faced by the organizations they supervise.
   • Further, banking organizations may consider the processes they have in place for modifying existing model risk models. The Reports noted that SBNY dealt with a breach of internal limits on digital asset-related deposits by raising the limits while SVB switched to an internal liquidity stress testing model with less conservative assumptions, which masked certain liquidity risks.

Takeaway:  Bank examiners may scrutinize interest rate risk and liquidity risk management practices more closely, and, more generally, banks’ approaches to revising stress test assumptions and risk limits and tolerances.  As such, banks may consider evaluating whether their risk management practices, particularly interest rate risk and liquidity risk management practices, are at or exceed industry benchmarks.

Near- and Medium-Term Strategic Considerations

5. Enhancing Operational Readiness. Each of the Reports cited a lack of “preparedness” as contributing to the respective failures.  The FRB Report noted SVBFG’s “inadequate preparedness to access contingent funding sources likely contributed to the failure.”  Similarly, FDIC Report noted a “lack of preparation [that] prevented SBNY management from a timely understanding of the bank’s true liquidity position in a time of stress and left it unable to meet very large withdrawal requests.”
   • Banking organizations may consider reviewing their operational readiness to execute on contingency funding plans. The FRB Report revealed that SVBFG had repeatedly failed its internal liquidity stress testing, including with respect to its ability to monetize liquidity buffers.  Although both SVB and its supervisors characterized these deficiencies as merely “operational,” the FRB Report suggests that these very operational deficiencies contributed to its failure.

Takeaway:  To confirm operational readiness and demonstrate to supervisors a proactive approach to managing risks, banking organizations may consider revisiting contingency funding plans and other liquidity risk related playbooks, conducting gap analyses and conducting tabletop exercises.  These exercises may identify gaps in operational readiness and demonstrate to supervisors a willingness to be proactive about managing risks.

6. Implications for Growth. The Reports document rapid growth at SVB and SBNY, respectively.  One of the core findings of the FRB Report in particular is that supervisors “did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.”  The FRB Report indicates that in approving SVBFG’s merger with Boston Private Financial Holdings, Inc., FRB staff did not assess the bank’s readiness to move into the LFBO portfolio or the planned supervisory strategy.  The Report goes on to suggest that supervisors implement an “explicit supervisory plan for firms transitioning between portfolios.”
   • As the differential burden of enhanced prudential standards among firms in different categories decreases, the comparative benefits of bank and non-bank M&A, including economies of scale and diversification, increase. In this regard, strategic growth through M&A may address many of the diversification issues highlighted in the Reports as contributing to the respective failures.  More generally, as has historically been the case following banking crises, regulators may reconsider their current negative view towards bank consolidation activity.

Takeaway:  A banking organization may be expected to proactively demonstrate to supervisors, by showing rather than telling, that it: (i) has built robust systems and controls, (ii) has hired qualified staff and (iii) will comply with additional supervisory expectations and regulatory obligations as it grows.  Developing and operationalizing growth-related compliance plans would maximize the organization’s chances of success on its regulatory applications, and may even increase regulatory receptivity to a bank deal. 

Longer-Term Regulatory Implications

7. Pending Regulatory Reform. The FRB Report cites the FRB’s response to the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”) passed in 2018 as a having played a key factor in the SVB failure.  It links the delay in supervisory escalation to a shift in stance of supervisory policy following adoption of EGRRCPA and mentions reevaluating certain rules the FRB adopted in response to EGRRCPA.
   • The FRB Report lists certain rules that the FRB indicates “should be modified or re-evaluated,” including those identified in our prior update.
     • With respect to liquidity risk, this includes technical calibration changes, e.g., re-evaluation of “the stability of uninsured deposits and the treatment of held to maturity securities in [the FRB’s] standardized liquidity rules [i.e., the liquidity coverage ratio (“LCR”) and the net stable funding ratio (“NSFR”)] and in a firm’s internal liquidity stress tests,” as well as scoping changes to apply “standardized liquidity requirements to a broader set of firms.”
     • With respect to regulatory capital and capital stress testing, this includes removing the accumulated other comprehensive income (“AOCI”) opt-out for a broader range of firms and revisiting prior reduction in coverage and timeliness of stress testing. Although the FRB Report noted that under the pre-EGRRCPA framework SVB would have been subject to the advanced approaches capital rules and the supplementary leverage ratio, the Report stops short at recommending that these be applied to similar firms.
     • The FRB Report also mentions a need to evaluate how the FRB supervises and regulates bank’s management of interest rate risk. Currently, consistent with the Basel Committee on Banking Supervision framework, the FRB’s regulatory framework does not include quantitative interest rate risk regulation.
     • In each case, the FRB Report notes that any adjustments to rules would go through normal notice and comment rulemaking and have appropriate transition rules, and thus would not be effective for “several years.”
   • The FRB Report cites a number of regulations we previously highlighted, to which SVB would have been subject to prior to EGRRCPA. The Report notes that application of these rules may have bolstered its resilience, but stops short at recommending revisions to the scope of these rules.
   • The FRB remains focused on not just proximate causes of the recent bank failures, but also measures that could improve “resilience.” Although the FRB Report does not directly link capital or solvency to the SVB failure (the Report indicates that the “proximately cause of SVB’s failure was a liquidity run,” but that the “underlying issues was concern about its solvency”), the FRB repeatedly cites the need for “strong bank capital.”  On this topic, the FRB highlights work “in progress,” including “the holistic review of our capital framework; implementation of the Basel III endgame rules; the use of multiple scenarios in stress testing; and a long-term debt rule.”  Importantly, the FRB Report indicates that the FRB will seek comment on these proposals “soon” and that further revisions to the enhanced prudential standards framework “will follow later.”

Takeaway:  The FRB Report previews the FRB’s plans to revisit its tailoring framework, including by referring to specific liquidity, capital and stress testing rules that “should be modified or re-evaluated.”  The FRB Report also signaled pending proposals on a holistic review of capital, Basel III endgame, use of multiple scenarios in stress testing and long-term debt.

8. Mandatory Supervisory Triggers. As mentioned above, each of the Reports highlights the need for more rapid supervisory response to identified deficiencies at supervised institutions.  In this regard, the FRB Report notes that the FRB “generally does not require additional capital or liquidity beyond regulatory requirements for a firm with inadequate capital planning, liquidity risk management or governance and controls” and that “[w]e need to change that in appropriate cases.”  Similarly, the GAO Report notes that it recommended in 2011 that regulators consider adding noncapital triggers to their framework for prompt corrective action “to help give more advanced warning of deteriorating conditions.”
   • As an example, the FRB Report notes that “limits on capital distributions or incentive compensation could be appropriate and effective in some cases.” Currently, only breaches of certain capital buffers trigger these types of limitations.

Takeaway:  The Reports explore the possibility of imposing increased capital or liquidity requirements, or limitations on incentive compensation and capital distributions, following supervisory findings or ratings downgrades.

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