TL; DR: Feds on SVB and deposit guarantee reform | Miller Nash LLP

The Federal Reserve recently released a massive 118-page review of the bankruptcy of Silicon Valley Bank (SVB), and three days later the FDIC released a 75-page report outlining several ideas for reforming our deposit insurance system. We know you’re busy, so we’ve read these 192 pages for you. Here is the TL; DR version of these posts, along with a few takeaways:

First, the Federal Reserve Review of Silicon Valley Bank.

The Fed’s review highlighted several errors in governance, management and regulatory oversight. These mistakes, combined with SVB’s unique business model, rapid growth (it grew from $71 billion to over $211 billion from 2019 to 2021), and changes in technology created the perfect storm for the bank’s fatal deposit drain. On March 9, the bank had $40 billion in outgoing deposits and expected another $100 billion the next day — the bank was shut down by state regulators before that happened. Although Silicon Valley Bank was unique, there are some lessons to be learned from this failure:

  • Senior management and the board must learn and grow. SVB’s failure to adapt to its growth became a serious problem as its business model became more complex and subject to increased regulatory requirements. The Federal Reserve noted that the bank’s senior management and board members did not have the necessary experience to effectively assess and manage the risks of a financial institution of more than $200 billion, and that lack of experience played a major role in the bank’s failure. Simply put, senior management failed to provide adequate information to the Board and the Board failed to hold senior management accountable. For example, senior management finally provided relevant information to the Board outlining the bank’s liquidity problems in November 2022, just five months before the bank’s failure.
  • Compensation should drive long-term success. The Federal Reserve has argued that compensation at SVB is largely based on short-term financial performance without consideration of risk management metrics, and this has become a problem over time. In addition, the bank’s liquidity and interest rate risk assessments lacked long-term considerations – short-term profits took precedence over long-term risk management. This strong focus on short-term results encouraged excessive risk-taking and prevented the Bank from properly assessing and managing these long-term risks. Much to the chagrin of outsiders, several SVB executives even received cash bonuses on March 10, 2023, which was (coincidentally enough) the same day the bank went bankrupt.
  • Technology has changed the speed of banking. The Fed’s review highlighted the “highly connected” customer base at SVB and their ability to quickly move their funds as reasons for the speed and severity of the bank’s withdrawals. Social media fueled the hysteria, and technology allowed near-instant withdrawals. As noted above, the bank lost $40 billion in deposits in one day. To help put this into perspective, during the 2008 financial crisis, Wachovia lost $10 billion in eight days and WaMu lost $19 billion in sixteen days.
  • Supervisory issues are more than a compliance exercise. The Fed’s review discussed several instances in which SVB’s senior management and board focused on simply resolving supervisory issues rather than focusing on the risks these requirements were intended to address. In addition, the bank’s risk management systems failed to keep pace with its growth, leading to serious weaknesses in its ability to properly manage liquidity and interest rate risk in a rising interest rate environment.
  • Expect increased regulation. Importantly, the Fed also acknowledged that SVB’s failure was due (at least in part) to inadequate regulatory oversight, including unsupported regulatory ratings and a recent culture that facilitated continued operating practices for banks. For example, SVB received satisfactory and strong ratings during its inspections from 2017 to 2021, although the bank’s condition deteriorated. Michael Barr, the Fed’s vice chairman for supervision, has already signaled upcoming changes to capital requirements, stress tests, interest rate and liquidity oversight, oversight of “new activities” (such as those involving fintech or cryptocurrencies), and the overall nature and speed of regulatory oversight and remedial action.

Second, the FDIC’s Report on Deposit Insurance Reform.

After the run against Silicon Valley Bank (and others that followed), the FDIC issued a report outlining several ideas for reforming our deposit insurance system to promote financial stability and further reduce the risk of such runs. The FDIC report discusses three options, including limited, unlimited, and targeted coverage. Spoiler alert: The FDIC likes “targeted” coverage.

  • Limited coverage. The limited coverage would maintain the current structure while considering an increase to the $250,000 limit. While this approach may benefit small and medium-sized businesses, the FDIC recognizes that this approach would not be sufficient to cover many of the most large uninsured deposits. For example, unless this approach involved a huge increase in the insurance limit, this approach probably would not have prevented the Silicon Valley Bank run, as the average deposit amount at the bank reportedly exceeded $4 million. This limited coverage approach, even with an increase to the $250,000 limit, is unlikely to reduce the risk of a run at a financial institution with a high concentration of uninsured deposits.
  • Unlimited coverage. Unlimited coverage would provide unlimited insurance coverage. Although this approach will essentially eliminate the risk of deposit accumulation, the FDIC recognizes that this approach has several drawbacks. For example, this approach would encourage risk-taking by banks, creating so-called “moral hazard” and could have a significant impact on other asset markets (e.g, where deposits serve as a proxy for these asset markets). As might be expected, this approach would also require a significant increase in the Deposit Guarantee Fund, which would lead to much higher bank valuations. In fact, the FDIC suggested that unlimited coverage would likely require as much as an 80% increase in Deposit Guarantee Fund.
  • Target coverage. The FDIC likes its identified third option, the idea of ​​target coverage — coverage that would significantly increase insurance for certain categories of business checking accounts (e.g, transaction accounts used by businesses to pay their expenses, employees, etc.). In fact, the FDIC already has some experience with this type of targeted coverage approach. For example, you may recall the Transaction Account Guarantee Program (TAG) during the 2008 financial crisis, which provided unlimited coverage for certain types of transaction accounts for institutions that chose to participate, but the TAG program ended in 2012. Even and with a targeted coverage approach, the FDIC recognizes that it would be difficult to define the specific types of business checking accounts that deserve increased coverage, and that banks and depositors may try to game the system to circumvent coverage. Additionally, this increased coverage for business current accounts will also include higher bank ratings to match the increase in the Deposit Guarantee Fund as well. Overall, the FDIC believes that targeted coverage would be the best way to increase financial stability without extending the safety net wider, but there is work to be done on how this option will be implemented.

There you go – you’re all caught up (for now)! Expect more as we are likely to see increased regulatory oversight and costs for financial institutions of all sizes.

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