Anatomy of a bank failure

A radical change is necessary in the appointment of independent directors in India in light of the extensive failures in oversight and management of US banks

Silicon Valley Bank (SVB) and its holding company, Silicon Valley Bank Financial Group (SVBFG), failed last March. This resulted in the immediate failure of Signature Bank and, with a lag, of First Republic Bank. More mid-sized banks may follow.

The US Federal Reserve Board (FRB) has been quick to commission and publish a review of the failure of SVB. Even more creditable, the review pulls no punches in apportioning blame. The bank’s management failed. The board of directors failed. The supervisor failed. Regulations turned out to be inadequate. Everything that could go wrong went wrong.

The Fed review should be compulsory reading for bankers, bank boards, regulators and supervisors. The report will help drive home an important point: It is futile to expect “market discipline” by itself to take care of banking stability.

Let us begin with management and board failures. SVBFG’s assets tripled in size between 2019 and 2021. Deposits flowed in. The technology sector was booming, so lending expanded rapidly. Any growth in loans that is way above average loan growth in the sector is a recipe for trouble, a point often lost on managements as well as boards. Management does not have the bandwidth to assess risk properly. Internal controls and systems cannot keep pace with runaway growth. Reliance on volatile wholesale deposits tends to increase.

Managerial incentives are often linked to profits without adjusting for risk. For CEOs, the temptation to quickly grow the loan book is irresistible. The onus is on the board of directors to apply the brakes. Rarely does this happen. Boards tend to be mesmerised by CEOs who show dazzling performance for a few years. They find it hard to tell a performing CEO, “Sorry, this is not on.” 

At SVBFG, the board was not even responsive to supervisory warnings. The FRB report remarks acidly, “Moreover, the board put short-run profits above effective risk management and often treated resolution of supervisory issues as a compliance exercise rather than a critical risk-management issue.” That could be said of many boards.

Starting in July 2022, SVBFG failed its liquidity stress tests repeatedly. Management moved to increase funding capacity, but the necessary actions were not executed until March 2023 when it was too late. Management chose to mask liquidity risks by changing the stress test assumptions.

Interest rate risk too was poorly managed. The bank had breached its interest rate risk limits on and off since 2017. Instead of reducing dependence on short-term deposits, management fiddled with assumptions about the duration of deposits. Hedges on interest rate risk were removed in the interest of boosting short-term profits. Management was massaging earnings by hiding the underlying risks. The Risk Management Committee of the board should have picked up these lapses. It failed to do so, again not a huge surprise.

The supervisors did not cover themselves with glory either. For governance, SVBFG got a “Satisfactory” rating, despite repeated supervisory observations about inadequate oversight. The bank had large, uninsured deposits that were volatile, yet managed a “Strong” rating on liquidity. Despite breaching interest rate risk limits repeatedly, it got a “Satisfactory” rating on the item. Clearly, supervisors in the FRB set-up were hard to displease. Banks in India must pine for such a supervisor; they find the Reserve Bank of India (RBI) almost impossible to please.

What accounts for these supervisory failures? The report says joint oversight by the FRB and the 12 Federal Reserve Banks is a factor. The Board delegates authority to the Reserve Banks, but Bank supervisors look to the FRB for approval before making a rating change. Getting a consensus is time-consuming.

But that was not the only reason. In 2018, heightened supervisory standards were made applicable only to banks with assets of more than $100 billion. Moreover, supervisors were under pressure to reduce the burden on banks and to exercise greater care before reaching conclusions or taking action.

Finally, there were the failures of regulation. The Dodd-Frank Act, passed after the global financial crisis (GFC), provided for stiffer prudential standards for banks above a threshold of $50 billion. In 2018, the Act was amended to raise the threshold to $250 billion. For banks in the range of $100-$250 billion in assets, the Fed was given the discretion as to what standards to apply. When SVBFG reached the threshold of $100 billion, it was subjected to less stringent regulations than would have applied before 2019. Had the dilution in regulations not happened, SVBFG would have been compelled to enhance liquidity and capital before it was too late.

The problem is fundamental. The philosophy of “light touch” regulation and supervision hasn’t quite lost its hold on the US system. Multiple regulators and supervisors are another problem. There is also the “revolving door” syndrome — regulators join private banks, then jump back to the regulator in a senior capacity. The relationship between regulator and banks is too cosy for comfort, which may explain the kindness shown to SVB.

The RBI, as your columnist argued last month, is well ahead of the regulatory and supervisory curve in the West. Its intrusive approach is a better safeguard for banking stability than the light touch elsewhere. However, supervision can only be a third layer of defence against bank instability. Regulations are the primary layer, followed by the board. The RBI must find ways to get bank boards to do a far better job.  

A radical change would be to alter the way independent directors are appointed at banks. At present, the promoter or CEO has the dominant say in the appointment of independent directors (at both private and public sector banks). The RBI may want to insist that, for instance, one independent director be chosen by institutional investors and another by retail shareholders (from a list of names proposed by the Financial Services Institutions Bureau). Until we have independent directors who are distanced from the promoter and management, it’s unrealistic to expect board oversight to improve.

The RBI is hosting a conference for bank directors later this month. Here are two suggestions. One, in the interests of transparency and accountability, the RBI may want to commission a review of the failures at IL&FS and Yes Bank. Two, it may prescribe the FRB’s review of SVB’s failure as one of the “readings” for the conference. It may also include the report of the UK’s Financial Services Authority on the failure of Royal Bank of Scotland during the GFC. At least, bank directors can’t say they weren’t warned.

 ttrammohan28@gmail.com