- Legislative responses to recent banking industry failures could include reinstating various rules that formerly applied to banks with more than $100 billion in assets.
- There are a variety of measures which bank depositors may pursue to remediate the risk of exposure in a bank failure.
- Bank management would be advised to consider measures to address the uncertainties arising from the current economic climate.
The first quarter of 2023 was the most tumultuous for the banking industry since the outbreak of the pandemic in early 2020.
On Friday, March 10, 2023, the Federal Deposit Insurance Corporation (FDIC) was appointed receiver of Silicon Valley Bank (SVB) in California. SVB was the 15th largest bank in the United States with approximately $210 billion in assets. It claimed to have banking relationships with nearly half of the venture-backed technology and life sciences companies in the United States.
On March 12, 2023, regulators closed Signature Bank (SB), appointing the FDIC as receiver. SB, based in New York, focused on middle market companies, but was especially known for catering to law firms, real estate market participants and cryptocurrency companies. SB, at year-end 2022, had total assets of approximately $110 billion. It has been reported that approximately 30% of SB's deposits were attributable to its cryptocurrency business.
The SVB and SB failures were the second and third largest bank failures in U.S. history (after the failure of Washington Mutual in 2008).
Both the SVB and SB failures resulted from a classic "run on the bank" scenario with large amounts of uninsured deposits being withdrawn in an extremely short period of time, coupled with substantial losses in the banks' investment securities portfolio arising from the sustained period of inflation and the Federal Reserve's program of increased interest rates as it has sought to quell inflation. By one estimate, as a result of the Federal Reserve's aggressive stance on interest rate increases, the banking industry had some $620 billion in unrealized losses in the securities portfolio at the end of 2022.
Also on March 12, 2023, the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System and the FDIC jointly approved actions enabling the FDIC to complete its resolutions of the two failed banks on a basis that they would "make whole" all depositors of the failed banks (both insured and uninsured). The Federal Reserve also announced on the same day the creation of a Bank Term Funding Program (BTFP) to provide liquidity to eligible financial institutions in the U.S. (essentially those banks in satisfactory condition who are eligible to make short-term borrowings from the Reserve Banks; see 12 CFR Section 201.4(a)). The Federal Reserve, under the BTFP, is giving a 100% advance rate on eligible collateral. In other words, the collateral will be valued at par and not marked to market. As of April 2023, it is estimated that borrowings by banks under the BTFP have exceeded $64 billion. In addition, banks had borrowed some $88 billion from the Federal Reserve discount window.
Losses to the FDIC Deposit Insurance Fund (the DIF) from the two bank failures have been estimated at over $22 billion.
In the weeks following their failure, portions of the business and operations of the two failed banks were absorbed by other banks in transactions assisted by the government.
This paper comments on: the outlook for the U.S. banking sector in the aftermath of these bank failures; possible regulatory and legislative responses to the current situation; and lessons learned for customers and management of U.S. banks, including possible approaches to dealing with the liability and asset mismatch challenges facing the U.S. banking sector.
Outlook For the U.S. Banking Sector
As of this writing, the U.S. government's response to the SVB and SB failures appears to have calmed financial markets. Nevertheless, in March 2023, following the SVB and SB failures and related events, Moody's Investors Service downgraded its view of the entire U.S. banking system to negative from stable. Moody's cited a "rapidly deteriorating operating environment" despite regulators' efforts to support the industry. Moody's also warned that it either was downgrading or placing on review for downgrade seven individual institutions. Moody's stated: "Banks with substantial unrealized securities losses and with nonretail and uninsured U.S. depositors may still be more sensitive to depositor competition or ultimate flight, with adverse effects on funding, liquidity, earnings and capital."
In the immediate aftermath of the SVB and SB failures, according to data published by the Federal Reserve, smaller U.S. banks lost nearly $200 billion in deposits in the week ending March 15, 2023. More recent data from the Federal Reserve showed that customer deposits at smaller banks appear to have stabilized, totaling $5.39 trillion in the week ending March 22, almost matching the $5.38 trillion in the prior week. Deposit outflows from the banking system as a whole, however, have continued. The Wall Street Journal reported that, as of April 5, 2023, some $2.2 trillion was lodged in the Federal Reserve's reverse repurchase, or repo, facility. It also reported that bank deposits had dropped $363 billion, to $17.3 trillion, since the beginning of March 2023, with assets in money market funds increasing $304 billion to a record $5.2 trillion. Some 40% of money market fund assets are invested in the Federal Reserve's reverse repo facility.
Nonetheless, the seeds of continuing challenges to the banking sector may well have been sown by recent events. In the past, challenges to the banking sector only became crises over a period of years. For example, from 1980 to 1994, approximately 3,000 financial institutions in the United States were closed or taken over (mostly smaller banks and many savings and loan institutions).
As compared with prior crises where the quality of bank loan assets was the main problem, the current environment focuses on the mismatch between the duration of the investment securities portfolio and the liability side of the balance sheet.
Another source of potential volatility for banks is the growing prevalence of smartphone banking applications and social media. While online banking has been available for quite a few years, the share of bank customers who use internet or mobile banking has increased from 52% in 2017 to about 66% in 2021, according to the FDIC. In the case of SVB, it has been widely reported that the deposit flight was spurred by commentary on social media and online communications within the tight-knit Silicon Valley technology and venture capital community. It should also be noted that later in 2023 the Federal Reserve is expected to roll out its new FedNow Service which is described as a new around the clock service through which businesses and individuals can send and receive instant payments in real time. This service might increase the risks for banks experiencing liquidity pressures.
What are the implications of these developments for the banking industry as a whole? The following are possibilities:
- FDIC insurance premiums are likely to increase for the banking industry as a whole, to replenish the DIF after the losses resulting from SVB and SB. The Secretary of the Treasury has avowed that U.S. taxpayers will not bear these costs. (However, as discussed below, the White House position is that community banks should not bear the costs of the recent failures.)
- Will securities portfolio accounting and regulatory treatment be changed? In the worst case, bank securities portfolio accounting will be changed to 100% "available for sale" (AFS) accounting which would force banks to shorten their securities book and likely reduce their yields on investment securities. As an alternative, it is possible that all deposits beyond the level of FDIC insurance would be required to match the securities portfolio accounted for on an AFS basis. This would also reduce yields on investments but not as much as the worst-case scenario where AFS accounting applies to the entire securities portfolio. Presumably, insured deposits still could be matched by securities accounted for on the held-to-maturity basis. Any change in the accounting rules would likely need to be phased in over a considerable period of time.
- Bank regulators likely will require enhanced stress testing for a much wider range of banks, not only the global systemically important banks. Enhanced and expanded stress tests will likely focus on deposit analysis and may include deposit customer behavior analysis, predicting the deposit flow against interest rate movements based on depositor history. Bank regulators will likely examine banks' securities portfolios to ascertain whether they match the deposit characteristics.
- Will regulators also be more focused on placing restrictions on lending to avoid another serious mistake? If so, this also will be a challenge to bank profitability.
- Will the adoption of current expected credit loss (CECL) accounting for the loan loss reserve be revisited? Of course, a major shift in accounting for loan losses occurred in the last few years with the adoption of CECL accounting (requiring an analysis of expected "lifetime losses" in the loan portfolio as opposed to currently incurred losses).
As a "bottom line" conclusion, these challenges to the industry may well result in much less tolerance for risk on the asset side of the balance sheet, as well as greatly increased scrutiny on the liability side; the implication is clearly for pressure on overall profitability of the U.S. banking system.
Possible Legislative or Regulatory Responses
It is too early to be certain about the range of responses by the U.S. Congress or the bank regulators to the current challenges faced by the banking industry. But a number of possible responses are already emerging.
On March 30, 2023, the White House issued a "Fact Sheet" on the crisis suggesting a number of actions, including: reinstating various rules that formerly applied to banks with more than $100 billion in assets, namely enhanced liquidity requirements and stress testing, annual supervisory capital stress tests, "living wills" for the resolution of the bank in a failure, increased capital levels and expanding long-term debt requirements for a broader range of banks. The White House paper did state that community banks should not have to pay increased FDIC insurance premiums. Another subject mentioned was the completion of the executive compensation rule for bank executives authorized under Section 956 of the Dodd-Frank Act (to prohibit incentive compensation arrangements that encourage inappropriate risk-taking at covered financial institutions). The White House Fact Sheet in a number of places lays blame for the failures on the previous administration, although the 2018 legislation referred to was passed by Congress on a bi-partisan basis. Senator Tim Scott, the leading Republican on the Senate Banking Committee, stated: "Here are the real facts. The bank executives at these banks failed to manage their risk, the regulators failed to supervise these banks, and the Biden administration failed to stop its reckless spending and curb inflation. The regulators had the tools to supervise these banks, but they were asleep at the wheel."
On March 18, 2023, an organization called the Mid-Size Bank Coalition of America sent a letter to the federal bank regulators arguing that a temporary suspension of the FDIC deposit insurance limit is necessary to "halt the exodus of deposits from smaller banks." Whether the political will to do so can be mustered is unclear (legislation would be required).
Another alternative to the deposit insurance limit would be to institute, by legislation, an increase in the coverage level to, say, $1,000,000 for some period. This would appear to quell concerns about the deposits of most small- and medium-sized businesses.
Former FDIC chairman William Isaac observed that, rather than affording coverage to all the uninsured deposits at SVB and SB, the FDIC could have returned to its 1982 approach (called the modified deposit payoff) under which the FDIC would pay uninsured depositors the full insured amount of $250,000 and would issue receivership certificates for 80% of the uninsured funds, which was the approximate amount historically recovered from failed bank receiverships. The certificates could be tendered to the Federal Reserve Banks for cash. If the FDIC ultimately recovered more than 80%, it would remit the extra funds to the large depositors. The government's announcement of the closure of SVB did mention the issue of receivership certificates to uninsured depositors, but the amount was unspecified and the issue became moot when full coverage was afforded.
Others have suggested that enhanced "claw back" rules on bank executive compensation should be adopted with respect to banks that fail—e.g., clawing back bonuses, etc., if the bank fails within two years.
Lessons Learned—Bank Customers
The SVB and SB failures exposed many customers of both banks to potentially severe losses on the uninsured portion of their deposits. As discussed above, the federal government, determining that a systemic risk was presented by the two bank failures, determined to make whole not only the insured deposits, but the uninsured deposits as well. However, the uncertainty generated by the two bank failures has brought into sharp focus the need for bank customers with substantial deposits to manage the risk of bank failure. There are a variety of measures which bank depositors may pursue to remediate the risk of exposure in a bank failure (the Secretary of the Treasury having made clear that not all bank failures will result in full protection for the uninsured depositors). These measures include the following:
- Diversification of Bank Accounts at Multiple Institutions. Of course, for some depositors, e.g., individuals and small- to medium-sized businesses, it may be feasible to diversify the customer's banking relationships so that all deposits are within the $250,000 insurance coverage at each bank. There are practical difficulties with that strategy, of course, since the management of multiple accounts and the fees associated with them can be burdensome. For major corporate customers, of course, this strategy is likely impracticable.
- CDARS. Some years ago, Promontory Financial Group developed the Certificate of Deposit Account Registry System (CDARS), which essentially breaks up a customer's uninsured deposits into smaller increments and places those deposits with a number of banks, with the result being that all funds are covered by FDIC insurance. The service is now provided by a company known as the IntraFi Network LLC of Arlington, Virginia, which claims membership of over 1/3 of the banks and thrifts in the U.S. This service is in widespread use in the U.S. banking industry.
- Sweep Accounts. Sweep accounts are basically of two kinds: (a) "external" sweep accounts; and (b) "internal" sweep accounts. They are called sweep accounts because funds in the customer's ordinary bank account or accounts are, by agreement with the bank, "swept" (usually at daily close) from the bank account to either (a) investments in money market mutual funds (or similar investment vehicles) in the case of an "external" sweep account; or (b) another type of account within the bank (e.g., a Eurodollar account at a foreign branch of the bank) in the case of an "internal" sweep account. Money market mutual funds, of course, are investment companies which invest principally in U.S. Treasury securities and other obligations of the federal government. The FDIC has generally taken the position that customer funds at a failed bank that were swept into a money market mutual fund before the bank failure remain the assets of the customer and are not part of the FDIC receivership estate. This is consistent with the fact that, when the sweep recurs, the deposit totals of the bank are reduced by the amount of the sweep. In other words, both the deposit liability and the associated cash are removed from the bank's balance sheet and are now represented by the investment in securities, which are owned by the customer. As to "internal" sweep accounts, the regulations of the FDIC treat them as creating a general unsecured creditor's claim, which is not a deposit in a receivership. (See 12 CFR Section 360.6(d)(3)(i).) This has two negative features: (a) the provisions of law giving bank depositors certain "preferences" in a bank failure do not apply if the obligation is not a deposit; and (b) general unsecured creditors in bank failures usually fare very poorly in terms of their recovery.
Under most external sweep arrangements, the bank acts as agent of the customer relative to the mutual fund and the customer cannot practically deal directly with the mutual fund. Recovery of funds from the money market mutual fund, of course, is subject to its continuing solvency and liquidity. To ascertain a customer's rights in respect to sweep accounts, careful review of the underlying account documentation is critical.
- Repos. As described above, another investment vehicle which reduces the amount of ordinary bank deposits would be to enter into overnight repurchase agreements, or repos, with creditworthy counterparties.
- Multiple Accounts for Affiliated Groups. Under the FDIC's regulations, multiple accounts by a given customer (or individual) are normally aggregated for purposes of determining the coverage of the FDIC insurance. However, the FDIC regulations do provide that bank accounts of separate legal entities within an affiliated group (e.g., corporations, partnerships, etc.) can qualify for separate FDIC insurance coverage if each entity in the group is formed and operated for a principal purpose other than obtaining additional FDIC insurance coverage. It would be advisable for customers relying on this approach to document within their own records the separate purpose of each entity and to exchange correspondence with the bank on that subject so that the separate purpose is reflected on the account records of the bank (which are determinative for FDIC insurance purposes). (See 12 CFR Section 330.11(a).)
- Borrowing. The FDIC has recognized that, in a bank receivership, a depositor who is also a borrower from the bank may have rights of set-off between the loan and the deposit obligation. Careful observance of the loan terms is important in such a circumstance.
- Too Big to Fail. The federal government's coverage of the uninsured depositors at SVB and SB, based on a perceived systemic risk, clearly indicates that, at some point, while a bank may not be too big to fail, it may well have its uninsured deposits covered by the FDIC. Understandably, the federal government's representatives have been vague about how large a bank needs to be for it to pose a systemic risk. How much of a concern this will ultimately prove to be across the banking industry remains to be determined. As discussed above, there has been migration of deposits to the larger banks and out of the banking system.
- Cash Flow Contingency Plan. Businesses would be advised to maintain a cash flow contingency plan in the event their financial institution fails. They may also be advised to inquire of their service providers, such as payroll processing companies, as to the soundness of their banking institutions.
- Customer Notices. Many businesses provide for their customers to pay for goods and services directly to an account at their bank (commonly referred to as a "lockbox"). If a business depositor's bank were to fail, it would be advisable for the business to immediately give notice to the business's own customers directing them to remit their payments to a different bank. While funds arriving after the bank's closure should not be part of the receivership estate, there could be administrative and practical difficulties in segregating and accessing such funds.
Lessons Learned—Banking Industry
The Federal Reserve's most recent interest rate increase of only 25 basis points suggests that the Federal Reserve believes that inflationary pressures are easing. Whether this comes to pass in the remainder of 2023 and beyond remains to be seen. Bank management and boards of directors would be advised to consider a variety of measures to address the uncertainties arising from the current economic climate. Measures which might be considered include the following:
- Medium-Term Bank Note Program. Banks may wish to consider lengthening the duration of their liabilities by initiating a medium-term bank note program. Many billions of dollars of medium-term bank notes have been issued in recent decades. Typically, the maturities range from one to three years or longer in some cases. National banks have a particularly attractive regulatory path for the issuance of such notes. Under the regulations of the Comptroller of the Currency, investment-grade bank notes can be offered to accredited investors without prior regulatory review and approval, subject to certain conditions. (See 12 CFR Section 16.6.) State-chartered banks may also be able to issue such notes, subject to compliance with applicable state law. Of course, the current interest rate climate and general concerns about the health of the banking industry will increase pricing and may adversely affect availability of this funding vehicle for some banks.
- Limit on Uninsured Deposits. At SVB, it was reported that uninsured deposits constituted some 96% of the bank's deposits. Bank management and boards of directors may wish to consider instituting prudential limits on uninsured deposits as a percentage of total deposits.
- Hedging. Of course, for a price, interest rate hedges to protect the value of the investment portfolio can be acquired. Fixed to floating rate interest rate swaps will help protect the value of the investment securities portfolio in a rising rate environment (giving up current earnings to some degree as the price of the hedge). Caps, collars and other hedging products are widely available in the market.
- SEC Filings. For publicly held banks and bank holding companies, the quarterly report on Form 10-Q for the first quarter of 2023 will present a platform for clearly delineating management's strategy for dealing with interest rate risk and liquidity issues. Investors and analysts will surely be giving careful attention to these risks in earnings conference calls and as they review the quarterly reports of the banking industry.
- Stress Tests. While regulatory requirements for stress tests in the liquidity area may well be forthcoming, management and boards of directors of banks would be advised to consider instituting liquidity stress tests on a reasonably frequent basis irrespective of the regulatory requirements. Expert advice on the interest rate outlook for purposes of stress testing analysis should be considered. Interest rate and liquidity stress tests in the past generally have not dealt expressly with a "run on the bank" scenario. Consideration should be given to doing so in the current environment.
- Deposit Predictive Models. There are a variety of companies making available sophisticated predictive models regarding depositor behavior in various scenarios. Consideration should be given to instituting regular use of such models. One such model is made available by the Darling Consulting Group through their proprietary Deposits360° deposit analysis solution.
- Other External Liquidity Sources. Banks would be advised to be in close touch with their Federal Home Loan Bank and their Federal Reserve Bank to optimize their access to emergency liquidity if the need should arise. Press reports indicated that SVB was trying to increase its borrowing capacity from its Federal Home Loan Bank but was unable to do so before the regulators closed the bank. Of course, liquidity arrangements with other banks are possible. And if the bank is a subsidiary of a significant holding company with its own resources, a formal line of credit or other borrowing arrangement for the holding company to provide funding to the bank may be in order.
It can be expected that the banking sector will continue to see challenges and changes during the balance of 2023. Bank customers, management and boards will need to exercise continued vigilance as matters evolve.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.