Learning from Bank Failures

What happens after the banks failures with regulation?

That is something that bankers all over the world are thinking about. After the recent bankruptcies in the USA, it naturally occurs to us that the rules for asset and liability management will probably be tightened: interest rate risk management in the banking book (#IRRBB) and liquidity ratios #LCR and #NSFR. In connection with the Credit Suisse bankruptcy, there is more talk of tighter control of illegal practices and of corporate governance.

In order to be able to make the best possible estimates of the future development of banking regulation, it is worthwhile to make a brief #analysis of recent bank failures. We at Bearning have included the bank failures during the global financial crisis in 2008 (Lehman Brother and WaMu), and of course the latest bank failures in the spring of 2023 (Silvergate, SVB, Signature, Credit Suisse and FRB). We are analyzing these bank failures in relation to risk management and current regulation also in our workshop on "Bank risks and failures".

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Lehman Brothers (15.09.2008)

• Lehman Brothers was a global financial company that operated as an investment bank until its collapse in September 2008.
• It was founded in 1850 and had a long history as a respected financial institution. It was involved in investment banking, analysis, investment portfolio management and other financial services. Lehman Brothers gradually expanded its operations worldwide and actively traded ABS/MBS (asset-backed securities) and complex financial derivatives.
• Exposure to subprime mortgages: These mortgages were made to clients with lower creditworthiness. When the U.S. housing market began to deteriorate in 2007, the number of subprime mortgage defaults increased significantly, causing the value of these securities to decline significantly.
• Excessive use of leverage and risky practices: Lehman Brothers had a high level of leverage, meaning that it borrowed large sums of money on the financial market to finance its investments. In addition, Lehman Brothers engaged in risky practices, such as repurchasing short-term loans on the assumption that it could continually roll over these debts. When confidence fell, lenders stopped lending to the bank, which worsened its liquidity.
• Lack of capital and liquidity: As the value of its assets declined, so did its capital, and the bank struggled to meet its short-term obligations. Attempts to raise capital by selling assets or attracting an external investor were unsuccessful. The loss of market confidence led to a rapid withdrawal of funds by clients.
• Failure of government intervention: Unlike other troubled financial institutions during the crisis (such as Bear Stearns), Lehman Brothers did not receive a government bailout. The U.S. government chose not to provide Lehman Brothers with assistance, in part because of legal constraints and concerns about moral hazard. Without support, Lehman Brothers was unable to cope with the pressure and went into bankruptcy on 15 September 2008.
• The collapse of Lehman Brothers had serious consequences for the global financial system: a credit freeze, further crashes and an economic recession. The vulnerability of the financial system and systemic risk were exposed. The need for reforms and stricter regulation as a result of this crisis was inevitable.

Lehman Brothers faced several fines and regulatory actions before its bankruptcy:

• Securities and Exchange Commission (SEC, 2001) fine: 250k. 250 USD for violation of rules regarding the independence of analysts.
• Fine in 2003: NYSE fined Lehman Brothers $1.58 million for various violations, including inadequate supervision and recordkeeping deficiencies.
• NASD fine, 2005 (National Association of Securities Dealers, now FINRA): $750k. USD 750 for failure to supervise and violation of anti-money laundering rules.
• Settlement (agreement) with the New York Attorney General (2007): Lehman Brothers, along with other major investment banks, entered into a settlement with the New York State Attorney General's Office in which it agreed to pay fines totaling $7.4 million. The settlement was related to conflicts of interest in their analyses.
• Settlement with the Securities and Exchange Commission (SEC, 2007): agreement with the SEC and other regulators to pay $29 million in penalties. The settlement related to allegations of improper accounting and financial disclosure.

Even after the bankruptcy, collusion emerged:

Lehman Brothers' use of controversial Repo 105 transactions led to legal action. A Repo 105 trade is an accounting maneuver that Lehman Brothers used to temporarily remove assets from its balance sheet, thereby reducing its reported level of leverage. For example, in 2010, the Securities and Exchange Commission (SEC) filed a lawsuit against Lehman Brothers executives accusing them of misleading investors and using accounting tricks, including Repo 105 transactions, to hide the company's true financial condition. These allegations proved to be well-founded as the bank's auditor (EY) and other financial institutions (e.g. Citi) later agreed to pay fines for the use of Repo 105 in the tens of millions of USD.

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Washington Mutual (26.09.2008)

• Washington Mutual Inc. (WaMu) went bankrupt on September 26, 2008. It was the largest bankruptcy in U.S. history, with $307 billion in assets.
• The bank was in the subprime mortgage business, making subprime loans to clients who could not afford them. The bank also engaged in fraudulent practices, such as offering loans with minimum payments that did not cover the monthly interest on the loan, and adding unpaid interest on the loans as principal debt, putting clients deeper in debt.
• The bank expanded too quickly, opening many branches in different locations, some of which turned out to be unsuitable.
• The bank lost more than 95% of its value in the year before its bankruptcy.
• The bank got into financial trouble after customers withdrew $9 billion from the bank fearing that its exposure to subprime mortgages would destroy it.

As is evident from a comparison of the Dec 2007 and Jun 2008 balance sheets, WaMu did not experience any significant deposit withdrawals, and shareholders have even increased their capital. Nevertheless, the authorities at the bank ordered a forced receivership and sold it to JP Morgan.

The bank's collapse was therefore primarily due to systemic risk. This is a completely different case from Lehman Brothers. If the subprime mortgage bubble had not occurred, this bank would probably have survived. The Basel III regulatory package then focused precisely on systemic risk.

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Silvergate Bank (8.3.2023)

• Silvergate Bank was a California bank founded in 1988. The bank began providing services to cryptocurrency users in 2016 and conducted an IPO in 2019.
• In November 2022, concerns were raised about Silvergate's health following the drop in cryptocurrency prices and the FTX bankruptcy.
• Silvergate reported losses of $1 billion for the fourth quarter as depositors withdrew more than $8 billion from their deposits.
• In March 2023, Silvergate announced its intention to cease operations and voluntarily liquidate the bank in accordance with the relevant regulatory processes. The bank announced a full refund of all deposits
• The closure of the bank was preceded by a decision to wind down the Silvergate Exchange Network (SEN). The platform allowed users to transfer funds between investors and crypto exchanges around the clock, unlike traditional bank transfers which often took several days to settle.
• Silvergate originally also dealt with mortgages, but announced in December 2022 that it would cease this activity.

In the balance sheet we can observe a certain decline in deposits, a reduction in capital, but most of all a huge share of bonds on the asset side. It can be assumed that the duration of this portfolio has been quite long. It is therefore interesting to see what the interest income from the balance sheet structure looked like and, if so, the mark-to-market revaluation (economic value of equity - EVE). These data are easy to find in the report:

So the bank's management already knew in autumn 2022 that a +200Bps shock would mean a loss of -19.54%! This management voluntarily decided to ignore this interest rate risk (highlighted). This is a complete failure of ALCO!!!

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Silicon Valley Bank (10.3.2023)

• Silicon Valley Bank was a commercial bank headquartered in Santa Clara, California, founded in 1983. It provided diversified financial services to companies in the technology, life sciences, and wine industries.
• The bank was closely linked to the technology ecosystem, providing banking services to nearly half of all U.S. technology and life sciences companies, which were primarily funded by venture capital ("start-ups").
• SVB was the lead bank for more than 2,500 venture capital firms. The bank also managed the personal assets of many technology executives.
• SVB's bankruptcy came 2 days after its emergency actions (selling part of its bond portfolio) shocked Wall Street and depositors. SVB's bankruptcy became a hallmark of this banking crisis. SVB was not the first (see Silvergate use case above), however, it was a huge bank.

When we look at the balance sheet, we see an unusual structure - too many bonds (with a long duration), fewer credits and liabilities mainly from deposits (as it turned out, mostly uninsured). The structure of the balance sheet is similar to Silvergate, there is a huge interest rate risk (IRR). If we wanted to make a very rough good guess, with a bond portfolio of approx. 120 billion USD and a duration of 10 years, the revaluation loss (i.e. EVE) at a +200Bps rise in rates would be approx. 24 billion (120 x 0.02 x 10). The bank's capital was just over 16 billion. Of course, this calculation ignores the liability side and other factors, such as convexity effect etc.. Nevertheless, it is clear to any banker who has at least a minimum of ALM know-how that such an interest rate risk position is simply too large.

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Signature Bank (12.3.2023)

• Signature Bank was a New York-based financial institution founded in 2001. The bank had 40 branches in the states of New York, Connecticut, and California. It served corporate clients (SME), their owners and senior executives.
• The bank offered a wide range of corporate and personal banking products and services, as well as investment, brokerage, trust and insurance products and services, and private equity.
• Signature Bank failed and was closed by regulators due to its inability to meet its obligations. This was due to a combination of factors including poor management, over-reliance on uninsured deposits and the impact of the "contagion" caused by the failure of SVB and Silvergate.
• The New York State Department of Financial Services (DFS) found that the bank's management engaged in unsafe and unsound practices that contributed to its failure.

Signature had a better balance sheet structure than SVB and Silvergate. Yet it went bankrupt. Regulators see the reason for the bankruptcy in the bank's mismanagement.

What the regulators faulted Signature Bank's management for:

• Rapid, unconstrained growth without adequate risk management practices and controls appropriate to the institution's size, complexity, and risk profile.
• Ignoring FDIC supervisory concerns ("red flags"), FDIC recommendations were not applied in a timely manner.
• However, the Bank relied too heavily on uninsured deposits, which represented 90% of total deposits as of year-end 2022. The bank used these deposits as a major source of funding for rapid asset growth, but did not have sound liquidity risk management practices.
• Weak risk management practices and controls, particularly in relation to the bank's exposure to the cryptocurrency industry.
• The bank also failed to provide reliable and consistent data when the number of requests for liability withdrawals increased over the weekend. This caused a significant crisis and ultimately the closure of the bank.

Similarly to the WaMu collapse, we can conclude with Signature that although they did not have the same problems as SVB or Silvergate (fatal failure in ALM management, huge IRR positions), they paid for the systemic risk and the current fears of depositors with uninsured deposits.

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Credit Suisse (19.3.2023)

The case of Credit Suisse in Switzerland is different.

• The bank has received numerous fines in recent years, has been accused of money laundering and collusion, had a bad reputation, and reported high losses in 2022. Total sum of fines since 2000 achieved over 11 billion USD!
• Credit Suisse's largest shareholder (Saudi National Bank) has ruled out investing further capital, causing Credit Suisse shares to fall by up to 31% in spring 2023.
• The bank has borrowed up to EUR 50 billion from the central bank. This makes Credit Suisse the first major bank to receive such an intervention since the global financial crisis in 2008.
• Just before the bank's collapse, credit-default swaps (CDS) on the bank's debt soared, rendering the market illiquid. This suggested that the markets were pricing in a bankruptcy declaration. Credit Suisse's CDS covered a net face value of about USD 2 billion of debt.
• Credit Suisse shares ended at 1.697 Swiss francs, down almost 98% from the stock's all-time high in April 2007.

The reasons for the collapse of this bank lie mainly in poor corporate governance. Unfair practices, frauds, investor protection violations, toxic securities abuses, AML deficiencies, etc. have caused a long-term decline in reputation and too large losses. The bank's shareholders further refused to participate in these practices and the bank collapsed.

First Republic Bank (01.05.2023)

The failure of First Republic Bank (FRB) was another significant event in the banking sector. Key factors and events that contributed to the bank's failure:

• In March 2023, FRB came under intense criticism and experienced a significant decline in its stock price. In particular, FRB's problems were related to the previous failures of SVB, Silvergate, and Signature Bank.
• FRB had an affluent clientele and its depositors' balances were well in excess of the $250,000 deposit insurance limit, which meant that most of these deposits were not covered by the FDIC.
• A consortium of 11 of the largest U.S. banks provided FRB with liquidity totaling $30 billion in uninsured deposits (as part of a government-sponsored arrangement)
• FRB's CDS rose significantly, investors were concerned about the bank's solvency.
• Regulators took over First Republic Bank on April 28, 2023 and sold a substantial portion of its assets to JP Morgan Chase, which meant another major bank failure.

The structure of the FRB's balance sheet was still standard in December 2022: most of the assets in credits, a reasonable volume of bonds, the funding is mostly from deposits. In January 2023, FRB reported good results, e.g. Tier 1 leverage ratio was 8.51%, Revenues were $5.9 billion, up 16.5%, Net interest income was $4.8 billion, up 17.5%.

So what drove the bank to bankruptcy?

Similar to WaMu, we can talk about systemic risk - failures and collapse of other banks lead to loss of confidence and liquidity withdrawals. Depositors with uninsured deposits decided to withdraw their deposits within a short period of time, and at the end of March we see a 70 billion drop in deposits in the bank. Such a run on the bank is hard to bear.

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Comparison of US and EU

Before we come to conclusions, let's compare the application of banking regulation in the US and the EU, as most of the failed banks in spring 2023 are from the US.

These facts suggest that while leverage is more closely monitored in the US and the threshold for insured deposits is set higher, the regulation of interest rate risk and liquidity is much weaker than in the EU.

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Conclusion:

After the failure of the big banks, regulation is likely to be tightened. The primary reasons for bankruptcies that emerge from our analysis are as follows:‍

1. #IRR: poor Interest Rate Risk and ALM Management (Silvergate, SVB)

2. #Corporate Governance: Lack of know-how of bank managers, moral failures, such as frauds, violation of rules, etc. (Lehman Brothers, SVB, Credit Suisse)

3. #Regulation: illogical easing of regulatory rules for ALM area (IRR, LQR) in the USA (Silvergate, SVB, Signature)

4. #Systemic #Risk: bubbles often lead to problems of the whole (banking) system. If some banks fail, it often has a secondary effect on others (WaMu, FRB)

5. #Liquidity: A run on a bank is often very fast and unmanageable. Neither liquid assets nor a good liquidity ratio helps. It must therefore be prevented.

Bank regulation can be expected to tighten in these areas, especially in those where it is relatively simple - IRR, corporate governance, maybe liquidity. We at proMatrix Capical will be happy to help you exactly in these areas. Bearning is Bank Learning. For more than 16 years we have been educating bankers and consulting with top bank managers, especially in the areas of ALM, financial markets, market risk and regulation. Please do not hesitate to contact us.