This May, First Republic Bank became the second-biggest bank failure in US history. The Fed’s rapid interest rate hikes in 2022 hit mortgage assets and government securities hard. They also significantly reduced venture capitalist demands in the tech sector, which played a major role in the closure of Silicon Valley Bank (SVB), the first of 3 banks to fail this year. While SVB only accounted for 0.2% of US commercial banking assets at its closure, the aftershock of its collapse is already being felt across the financial services sector and beyond - with Signature Bank customers withdrawing more than $10 billion in deposits and First Republic Bank recently being taken over by JPMorgan.
Examining why the recent bank failures occurred, and its impact throughout the financial world, offers the industry an opportunity to ask critical questions to help leaders avoid similar pitfalls, navigate today's aftershock, and develop strategies for future success and stability.
How can banks address consumer confidence to safeguard against future crises?
Restoring consumer trust is crucial in the aftermath of any crisis. Confidence in the banking sector is essential for maintaining financial stability and ensuring the smooth functioning of the economy. Banks can restore trust by implementing transparent, data-backed communication strategies that inform customers and regulators of their position and risk exposure.
An effective crisis management strategy allows you to assess your position quickly, reducing the time it takes to communicate with stakeholders and safeguarding your organization’s reputation and bottom line.
How can business, regulatory, risk, and compliance leaders prepare for what is most likely a reversal of former regulatory rollbacks and increased regulatory pressure?
First, it’s important to examine why this collapse occurred. Was it regulation rollbacks, risk mismanagement, sharp interest rate rises – or a combination of all three? The Federal Deposit Insurance Corporation (FDIC), the US Treasury, and the Federal Reserve (Fed) quickly swooped in, announcing measures to protect depositors at failed banks and support the banking system. While protecting the consumer and reestablishing confidence in our banking system was paramount, it will come at a cost for institutions.
The current administration is calling for a reversal of Dodd-Frank rollbacks to bring back annual “stress test” requirements for banks with at least $50bn in assets. We recommend that banks (business and risk practitioners) get proactive by setting expectations and preparing to conduct these tests starting now.
Your customers want to hear about indicators of your bank's stability, such as stringent risk management practices and adherence to regulatory guidelines, not risks without proper management, whether that means leaders hiding or not wanting to disclose important details, disagreements over specific risks, or failing to fill critical risk leadership positions. A bank with robust risk management practices is less likely to face challenges like the ones that led to the SBV’s downfall. For example, SVB didn’t have a Chief Risk Officer (CRO) for some of 2022, a situation now being examined by the Federal Reserve. As a result, it’s a good idea to prepare for enhanced regulatory scrutiny of all your risk and regulatory practices.
We expect regulators to step up their enforcement of enhanced risk management standards and to increase oversight of financial institutions. Now is a great time to proactively assess and enhance your risk management practices and ensure regulatory compliance. Transparent communication about your efforts will likely have a favorable effect on consumer confidence. In addition, vigilance, continuous risk management, and regulation improvement are essential for preventing future crises. Banks and regulators should work together to identify and address potential risks, maintain financial stability, and ensure the financial sector's resilience.
How can banks assess their operations to understand their current position better, mitigate exposure, and adapt to change?
Banking has traditionally been considered one of the most risk-averse industries when it comes to organizational cultures and values. However, recent decades have brought more innovative operating models and talent strategies that favor aggressive growth, especially within niche spaces. Often coupled with employee incentive plans favoring riskier and potentially more profitable growth, this adaptation may have left some banks vulnerable.
To solve this, banks may need to reassess their cultural tenants (values, talent strategies, incentive structures, and organizational design principles) to understand and mitigate unintended blind spots in their operations. In the future, innovative practices should be carefully evaluated prior to adoption. Though innovation is a net positive for most organizations, it’s equally essential to pressure-test new approaches (especially those adapted from the tech space) against your organizational culture, operations principles, and existing values to ensure an appropriate fit.
What opportunities exist to strengthen customer acquisition and retention in a volatile market?
With consumers feeling more cautious about their financial decisions, banks must emphasize retention and attract new business by developing strategies to improve customer experience and build trust.
In addition to offering competitive interest rates, consider differentiating your bank through technology. The right tech investments can give you a better understanding of your customers through data analytics and more convenient, personalized services.
What other areas should banks consider evaluating?
Banks should take a look at their entire ecosystem – buyers, vendors, etc. – to identify areas of potential weakness and opportunities to strengthen partnerships. Over the past decade, the financial services industry has been impacted by several significant disruptions, including decreased margins and increased customer churn that squeezed budgets to improve antiquated and inefficient tech stacks. These influences conspired to give rise to Fintech players that focused on unbundling the technical infrastructure and providing narrow solutions that could be implemented around the core at incremental costs. While gains were made, two negative results stand out:
- Today’s CTO is managing many more vendors than in the past. Since many of those vendors were primary customers of the former SVB, their reliability and long-term health need to be reviewed with fresh eyes.
- The technical architecture complexity of typical banks has increased many-fold. This introduced “weakest-link” exposure to potential failure points and unforeseen impacts. To respond, accelerate progress toward building an infrastructure based on MACH (micro-services, API-based, cloud-first, headless) principles. Beyond simple in-source and out-source decisions, moving towards MACH requires retaining technical competencies in-house, even for smaller and mid-sized banks.
Potential Contagion Effects
Transmission channels for contagion
Contagion effects can spread in many ways, including direct exposure to distressed assets, counterparty risk, or changes in market sentiment. These effects can impact other financial institutions, leading to a broader crisis.
Economic indicators and market reactions
Following the SVB crisis, economic indicators, like stock prices and credit spreads, reflected increased uncertainty and risk aversion. This can negatively affect other banks, making raising capital and increasing borrowing costs more challenging.
Mitigating the risks
Banks need to maintain diversified investment portfolios, adequate capital buffers, and strong risk management practices to mitigate contagion risks. In addition, they should proactively monitor and manage exposure to potentially distressed assets and counterparties.
The Bottom Line
Between the end of 2019 and the first quarter of 2022, SVB’s deposit balances more than tripled. As the go-to bank for the rapidly growing tech industry, it did business with nearly half of all US venture capital-backed start-up companies that went public in 2022 and operated as one of the top 20 American commercial banks with $209 billion in total assets. While technically, their failure can be pinned to a liquidity crisis, further examination points to risk management and operational strategy failure.
Exploring this stunning collapse and its resulting effects can help banks reevaluate their business strategy and take swift action to reduce exposure, improve customer acquisition and retention, and adapt to ongoing regulatory change.