Anatomy of a bank failure

Source– The post is based on the article “Anatomy of a bank failure” published in the “Business Standard” on 12th May 2023.

Syllabus: GS3- Economy

Relevance- Issues related to banking sector

News– Silicon Valley Bank (SVB) and its holding company, Silicon Valley Bank Financial Group (SVBFG), failed last March. This resulted in the failure of Signature Bank and, First Republic Bank.

How management and board failures were responsible for this crisis?

SVBFG’s assets tripled in size between 2019 and 2021. The technology sector was booming, so lending expanded rapidly.

Any abnormal growth in loans can cause trouble for bank. Management does not have the bandwidth to assess risk properly.

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 take actions. But Boards supports CEOs who show good performance for a few years.

At SVBFG, the board was not even responsive to supervisory warnings. As per FRB report, the board put short-run profits above effective risk management. It treated resolution of supervisory issues as a compliance exercise rather than a critical risk-management issue.

Since July 2022, SVBFG has failed its liquidity stress tests repeatedly. Management Did not necessary actions were not executed until March 2023.

Interest rate risk too was poorly managed. The bank had crossed its interest rate risk limits since 2017.

What are the supervisory failures responsible for this crisis?

There were supervisory failures also. For governance, SVBFG got a “Satisfactory” rating, despite repeated supervisory observations about inadequate oversight.

The bank had large, uninsured deposits, yet managed a “Strong” rating on liquidity. Despite breaching interest rate risk limits repeatedly, it got a “Satisfactory” rating on the item.

How weak regulatory oversight is responsible for this crisis?

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.

The philosophy of “light touch” regulation and supervision is an issue. Multiple regulators and supervisors are another problem.

There is also the “revolving door” syndrome. The regulators join private banks, then jump back to the regulator in a senior capacity. The relationship between regulators and banks is cause of concern.

How can RBI improve the regulatory and supervisory oversight over banks?

The RBI is better in regulatory and supervisory capacity than its counterparts in the West. Its intrusive approach is a better safeguard for banking stability than the light touch regulations. 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.

One independent director may be chosen by institutional investors and another by retail shareholders from a list of names proposed by the Financial Services Institutions Bureau.

Until there are independent directors who are distanced from the promoter and management, it’s unrealistic to expect board oversight to improve.