Bank failure resolution and financial risk management: Silicon Valley Bank, Signature Bank, and First Republic Bank.

Bank failure resolution and financial risk management: Silicon Valley Bank, Signature Bank, and First Republic Bank.

 

What are the main root causes of recent bank failures in the specific cases of Silicon Valley Bank, Signature Bank, and First Republic Bank?

The recent bank failures amount to classic bank runs on short-term debt. Silicon Valley Bank specifically has no sufficient short-term assets to offset short-term liabilities. The resultant bank run reflects both bank capital and liquidity shortages with unusual credit concentration in the high-tech sector. The latest macroprudential stress tests overlook the adverse impact of Federal Reserve interest rate hikes on this credit concentration at Silicon Valley Bank. In addition, these fundamental root causes expose Signature Bank and First Republic Bank to the same financial risks (i.e. capital and liquidity shortfalls, partial macro stress tests, interest rate risks, and credit concentration risks). In combination, these considerations may call for congressional support of a higher deposit insurance coverage threshold above $250,000.

 

This article delves into the policy implications of recent bank failures for the 5 core pillars of bank regulation in America. These 5 core pillars include capital adequacy rules, short-term liquidity controls, leverage limits, macroprudential stress tests, and deposit insurance rules. As the Federal Reserve System sharply tightens financial conditions with interest rate hikes to rein in inflation in recent quarters, several banks from Silicon Valley Bank and Signature Bank to First Republic Bank find it more difficult to raise cash amid a rare and unique episode of deposit outflows. At this stage of the current business cycle, the Federal Reserve System targets a terminal interest rate of 5.25% to 5.50%. Central banks tend to be more successful at separating contradictory price stability and financial stability goals (apart from the FOMC dual mandate). In the midst of recent bank failures, the financial stability problem relates to weak near-term liquidity rather than bank capital solvency. If higher interest rates erode the credit quality of riskier assets (such as commercial real estate loans), central banks may find it harder to separate the monetary policy mandate from asset market stability.

 

What financial sector policies, rules, and regulations should be put in place to protect against the recent bank failures? All U.S. banks with over $100 billion in total assets should be subject to Federal Reserve macro stress tests that include rare but plausible scenarios of interest rate hikes. More stringent bank capital and liquidity requirements are necessary. In addition, simple leverage limits help apply brakes on credit extensions as the real economy recovers from macro economic downturns such as the Global Financial Crisis of 2008-2009 and recent rampant corona virus crisis of 2020-2022. Financial policymakers should further consider providing insurance for all bank deposits above the current threshold of $250,000. The higher deposit insurance coverage threshold would help reduce the risk of future bank runs. However, the higher threshold would inadvertently cause moral hazard in bank credit extensions. This moral hazard problem calls for better supervisory focus on short-term debt management in its various forms.

 

Better bank regulatory tools include higher bank capital solvency and liquidity standards, macroprudential stress tests with interest rate risk, and a higher deposit insurance coverage threshold (above $250,000).

In broad terms, the recent bank failures amount to a classic textbook bank run. A piece of fundamental bank information (cf. mark-to-market losses in Silicon Valley Bank’s asset book) generates uncertainty about its fundamental financial health. This uncertainty causes many depositors to rationally withdraw their money even if the bank may have been solvent (with sufficient equity capital buffers). Silicon Valley Bank might have mishandled short-term debt on the liability side of the balance sheet. Any time a bank quadruples short-term debt within just a few years, this rapid bank credit extension should be an early warning sign to Federal Reserve bank regulators. Rapid bank growth often outstrips the risk management capacities of the same institution. Credit concentration risks come into play too. The top 10 depositors of Silicon Valley Bank own a sum of $13 billion in open deposits with no deposit insurance coverage. In hindsight, Federal Reserve bank regulators should view interest rate hikes and credit concentration risks as red flags in the broader context of both bank capital and liquidity requirements and macroprudential stress tests.

Mid-size U.S. banks with $100 billion to $250 billion in assets are not systemically important financial institutions. Below the $250 billion threshold, these mid-size banks are not subject to the stringent capital, liquidity, and stress test requirements for the mega banks with more than $250 billion in assets (where the latter banks are too big to fail). On the basis of these long prevalent metrics, Silicon Valley Bank’s capital and liquidity coverage ratios might have been reasonably high for near-term business operations. The U.S. financial system would be fundamentally healthier if every bank with over $100 billion in assets had to participate in the Federal Reserve macro stress test every year. This annual macroprudential stress test would include multiple macro financial scenarios to reveal different kinds of vulnerabilities in the U.S. financial system. These vulnerabilities should include interest rate risks and credit concentration risks. Given the important role that bank runs play in each episode of deposit outflows, many economists and regulators cannot agree more with the recent calls to revise bank capital and liquidity requirements for annual macro-prudential stress tests.

We have done a great deal of research on the recent proposal for more robust bank capital adequacy (Admati and Hellwig, 2013; Myerson, 2014; Yeh, 2020). Our theoretical proof and evidence accord with the central thesis that banks become more stable by boosting its equity capital to absorb extreme losses in rare times of severe financial stress. This analysis helps contribute to the ongoing policy debate on total capital adequacy. Monte Carlo simulation helps develop an analytical solution for the default probability adjustment through the macro economic cycle. This work poses a conceptual challenge to the neoclassic normative view that banks should maintain high leverage over time (DeAngelo and Stulz, 2015). In this new light, there are good reasons for financial regulators to impose more stringent leverage limits on systemically important financial institutions as well midsize banks such as Silicon Valley Bank, Signature Bank, and First Republic Bank. In the worst-case macro scenario of rapid interest rate hikes, banks should hold substantially higher common equity capital buffers to safeguard against extreme losses that might arise in rare times of severe financial stress (such as the Global Financial Crisis of 2008-2009 and recent rampant corona virus crisis of 2020-2022).

Should bank capital rules instead rely on simple leverage ratios (common equity-to-assets ratios and tangible capital ratios), the substantial growth in Silicon Valley Bank’s total assets would have been slower because the bank would need to fund every dollar of assets with at least 15% to 25% of common shareholder funds. Focusing more on these simple leverage limits would help create a safer financial system in America.

During the Global Financial Crisis of 2008-2009, some banks had tangible capital of around 3%. Today these banks maintain about 5% to 7% tangible capital ratios. However, too-big-to-fail banks and midsize banks would need at least 15% to 25% tangible capital ratios to safeguard against extreme losses that might arise in rare times of severe financial stress. Recent studies show that adequate common equity capital ratios are in the neighborhood of 15% to 25%. Even if bank capital levels seem to be better, the current common equity capital ratios may or may not suffice to be adequate relative to the risk that the U.S. banking system periodically encounters in due course.

Many bank advocates argue that raising equity capital requirements would slow loan growth. Across the board, however, higher equity capital buffers would promote a safer U.S. banking system. This additional financial stability would ultimately reduce the cost of common equity capital for banks (because these banks would be able to better absorb extreme loan losses as the macro economy moves into a recession). For both mega and midsize banks, these considerations of low and stable costs of capital would help discipline out highly risky bank activities. In combination, these considerations help reduce the likelihood of another severe financial crisis in America.

The conventional wisdom of central bankers is not to apply monetary policy and interest rate levers for better financial stability. One would hope that the FOMC would have considered the adverse impact of interest rate hikes on bank asset portfolios, net interest margins, as well as the ripple effects on non-bank financial institutions (insurers, credit unions, broker-dealers, mutual funds, hedge funds, and other institutional investors). If the FOMC feels that the monetary policy mandate requires front-loading interest rate hikes, the Federal Reserve System needs to use shrewd supervisory oversight to ensure little disruption to bank capital adequacy, liquidity coverage, and financial leverage.

The Federal Reserve System and Treasury may find it easier to separate financial stability concerns from the monetary policy mandate (of better inflation curtailment), especially if the financial stability concerns relate to short-term liquidity issues. It is easier for U.S. regulators to separate bank liquidity concerns from the monetary policy mandate (than bank solvency issues). These regulators often apply new term funds to ease bank liquidity shortages. When the bank has to sell assets at a deep discount in rare times of severe liquidity stress, these short-term liquidity shortages may inadvertently erode bank solvency. Early and substantial balance sheet intervention from U.S. bank regulators can often help sever the link between bank liquidity and solvency. This intervention can further help insulate the broader financial system and real economy from greater risks. It is more challenging for U.S. bank regulators to maintain this mandate separation when bank solvency issues begin to negatively affect the macro economic outlook (even if the real economy remains strong).

In the medium term, we expect the Federal Reserve System to raise the interest rate to the terminal range of 5.25% to 5.50%, even though it is now much less likely for the FOMC to frontload aggressive 50-basis-point interest rate hikes again. In response to the recent bank failures, the Federal Reserve System is likely to continue to offer short-term liquidity through the Bank Term Funding Program (BTFP). This program provides short-term bank debt funds at par against high-quality collateral such as long-term U.S. Treasury bills, notes, and bonds. This liquidity provision can occur alongside high interest rates and low bond prices because there is little concern about the underlying credit quality of U.S. Treasury debt instruments. After all, even if a 30-year U.S. Treasury bond trades well below par, this bond still pays the full face value upon maturity. However, if credit quality begins to deteriorate in riskier assets due to higher interest rates (such as commercial real estate loans), it may become difficult for U.S. policymakers to sustain generous liquidity provision without interest rate decreases. At this later stage, it may be more difficult for the Federal Reserve System to separate the monetary policy mandate from asset market stability concerns.

 

Recent bank stress arises from poor bank management and inadequate capital and liquidity coverage buffers.

Bank management is first and foremost responsible for the recent midsize bank failures of Silicon Valley Bank, Signature Bank, and First Republic Bank. These bank failures result from poor asset risk management and subpar bank capital and liquidity buffers. Frontloading interest rate hikes magnifies the adverse impact of credit concentration risks on asset quality at these midsize banks. For this reason, rare rapid interest rate hikes might be a predictable monetary policy error on the part of the Federal Reserve System.

In the specific case of Silicon Valley Bank, the fear of insolvency arises from the enormous mark-to-market losses, and then this fear leads to liquidity shortages that ultimately trigger the bank failure. Regardless of the chain reaction, the fundamental root cause of bank failure arises from poor bank risk management practices, subpar capital and liquidity levels, and underwater assets. The initial liquidity spiral eventually becomes a bank solvency problem. With similar bank runs, Signature Bank and First Republic Bank follow suit to enter into FDIC receivership.

From a fundamental viewpoint, these bank failures have arisen from the duration mismatch between bank assets and liabilities. Whereas banks hold very long-duration assets (e.g. 30-year residential mortgage loans etc), bank deposits represent the vast majority of short-term bank liabilities and then turn out to be much shorter in duration. This fundamental duration mismatch triggers the liquidity spiral, and this liquidity spiral causes the fear of insolvency in due course. With poor bank risk management practices, high credit concentration risks, low capital and liquidity levels, and underwater assets, these banks eventually become the first to fail in the digital age of social media. Bank runs and deposit withdrawals happen within a relatively short time frame: Silicon Valley Bank lost 25% of its deposits in one morning, and First Republic Bank lost about 60% of its deposits in about 3 days.

Dodd-Frank legislation offers a false sense of security rather than substantive improvements that would have required banks to hold substantially more common equity capital to survive in unforeseen circumstances of severe financial stress. The mega banks and midsize banks both need pre-emptive provisions such as open bank resolution schemes and living wills etc in stark contrast to mere contingency plans and compliance exercises. Dodd-Frank macro-prudential stress tests should specifically include rare but reasonable scenarios of rapid interest rate hikes from the zero lower bound. In these specific scenarios, interest rate risks manifest in the corresponding impairment of bank assets with respect to short-term liabilities. These macro stress tests help detect the early warning signs of bank-specific vulnerabilities in the form of both common equity capital shortfalls and liquidity shortages etc. Future macro financial reforms should focus on simple leverage limits that connect the dots between short-term liabilities and credit value-at-risk measures of equity capital shortfalls.

 

What are the main regulatory responses to the recent bank failures?

The U.S. regulatory responses include an implicit guarantee on all bank deposits, as well as the creation of the Bank Term Funding Program (BTFP). These responses fall short of the blanket guarantee on bank deposits that the U.S. asset market seems to have been seeking in recent times. The FDIC have no legal authority to explicitly grant greater deposit insurance coverage without bipartisan support in Congress. Without a full guarantee, we believe that corporate treasuries are likely to continue shifting bank deposits into either money market funds or larger institutions (Bank of America, JPMorgan Chase, Wells Fargo, and Citigroup). The speed of this migration may or may not moderate in due course.

U.S. systemically important banks may not look vulnerable to the recent interest rate hikes. Since the Global Financial Crisis of 2008-2009, these mega banks have been trying to run core business operations with considerably more capital, liquidity, and supervisory oversight. For these U.S. systemically important banks, the Tier 1 common equity capital ratios stand at 7% to 9%. Regional midsize bank Tier 1 common equity capital ratios hover around 9.5% to 11%. These ratios may fall below 6% if we take into account mark-to-market losses at the regional midsize banks in America. This current situation highlights the importance of both common equity capital and liquidity buffers for most midsize banks other than Silicon Valley Bank, Signature Bank, and First Republic Bank.

In the meantime, U.S. midsize banks are subject to less onerous regulations in equity capital adequacy, liquidity, leverage, and macro stress test resilience. After the recent bank failures, we expect U.S. bank supervisors to strengthen the relevant rules and regulations on regional midsize banks, with a central focus on capital and liquidity for banks with over $100 billion in total assets. In particular, we expect U.S. regulators to impose higher capital and liquidity requirements on these regional midsize banks. Specifically, these midsize banks should not be able to exclude non-interest other income from regulatory capital calculations. In relation to liquidity, these regional midsize banks should be subject to higher minimum requirements for liquidity coverage ratios (LCR) and net stable funding ratios (NSFR).

When we compare and contrast the recent U.S. and European bank failures, there is a rare and common economic thread: the optimal bank resolution requires a mega bank to acquire all the assets and liabilities of the smaller bank in financial distress. In America, JPMorgan Chase acquires First Republic Bank. In Europe, UBS acquires Credit Suisse. The resultant bank recapitalization requires the full write-down of Tier 1 bonds with an implicit government guarantee. We can expect the recent bank failures to affect macro credit supply in the real economy. Most banks seek to tighten credit standards for new loan origination as the recent bank failures reveal vulnerabilities in the financial system. Further, bank capital and liquidity concerns are likely to exacerbate these macro trends.

In America, regional midsize banks with $100 billion to $250 billion in assets hold more than 75% of U.S. commercial real estate loans on their balance sheets (although commercial real estate loans represent only 25% of total bank loans across the U.S. financial system). As the Federal Reserve System frontloads interest rate hikes from early-2022 to mid-2023, the average loan delinquency rate for U.S. commercial real estate loans has already started to deteriorate with more than 55-basis-point increases in commercial office mortgage defaults over the same time frame. If the FOMC continues the current cycle of hawkish interest rate hikes, we expect new loan default cascades in the residential real estate and auto loan asset classes.

Although an implicit government guarantee for deposit insurance can most effectively shore up depositor confidence to avoid future bank runs, the Federal Reserve System, Treasury, and FDIC probably cannot strengthen this implicit guarantee beyond where it stands now. Congress is hence the only plausible source of an explicit government guarantee for deposit insurance above the current threshold of $250,000. In the meantime, however, we see fairly low odds of congressional support of this explicit guarantee. Potential Democratic support for broader deposit insurance coverage might make the House Freedom Caucus’s support unnecessary for banking legislation. House Republic leaders, specifically Speaker McCarthy, might want to avoid conflict within the party ahead of more important debates such as raising the fiscal debt limit by early-June 2023.

Any medium-term deposit insurance reforms that Congress passes would likely include new regulatory changes too. Conditioning broader deposit insurance coverage on new regulatory changes would reduce the odds of passage in Congress. Further, there is no consensus on how much the deposit insurance limit should rise above the current threshold of $250,000. At the moment, the greatest support seems to be around greater deposit insurance coverage for non-interest-bearing transaction accounts in America. These accounts include business accounts for paying employees and suppliers. U.S. non-interest-bearing accounts represent $4.7 trillion in bank deposits, and U.S. transaction accounts represent another $6 trillion in bank deposits. It seems unlikely for both chambers of U.S. Congress to approve complete deposit insurance coverage simply because this radical change would be prohibitively costly. Even during the Global Financial Crisis, the temporary complete deposit insurance stopped short of covering all bank deposits. Any extra deposit insurance coverage above the current threshold of $250,000 would be only incremental. This statistical conservatism would accord with the gradual convergence to best practices in deposit insurance with no or little additional moral hazard. Senate and House are likely to pause before bipartisan support approves any additional deposit insurance coverage. Incrementalism would likely leave out high-net-worth households and small-to-medium enterprises in America. Many of their bank deposits may or may not relate to regional midsize banks with $100 billion to $250 billion in assets. In light of this complex nuance, we expect no dramatic deposit insurance reforms to take place amid the recent bank failures of Silicon Valley Bank, Signature Bank, and First Republic Bank. In time, we expect U.S. bank regulators to focus on raising the minimum requirements for better bank capital support, liquidity control, and financial leverage. Future macro-prudential stress tests should include the rare but reasonable macro scenarios of 50-basis-point interest rate hikes. These macro stress tests should assess the adverse impact of interest rate and credit concentration risks on credit quality and bank asset impairment.

 

This analytic essay cannot constitute any form of financial advice, analyst opinion, recommendation, or endorsement. We refrain from engaging in financial advisory services, and we seek to offer our analytic insights into the latest economic trends, stock market topics, investment memes, personal finance tools, and other self-help inspirations. Our proprietary alpha investment algorithmic system helps enrich our AYA fintech network platform as a new social community for stock market investors: https://ayafintech.network.

We share and circulate these informative posts and essays with hyperlinks through our blogs, podcasts, emails, social media channels, and patent specifications. Our goal is to help promote better financial literacy, inclusion, and freedom of the global general public. While we make a conscious effort to optimize our global reach, this optimization retains our current focus on the American stock market.

This free ebook, AYA Analytica, shares new economic insights, investment memes, and stock portfolio strategies through both blog posts and patent specifications on our AYA fintech network platform. AYA fintech network platform is every investor's social toolkit for profitable investment management. We can help empower stock market investors through technology, education, and social integration.

We hope you enjoy the substantive content of this essay! AYA!

 

Andy Yeh

Chief Financial Architect (CFA) and Financial Risk Manager (FRM)

Brass Ring International Density Enterprise (BRIDE) © 

 

Do you find it difficult to beat the long-term average 11% stock market return?

It took us 20+ years to design a new profitable algorithmic asset investment model and its attendant proprietary software technology with fintech patent protection in 2+ years. AYA fintech network platform serves as everyone's first aid for his or her personal stock investment portfolio. Our proprietary software technology allows each investor to leverage fintech intelligence and information without exorbitant time commitment. Our dynamic conditional alpha analysis boosts the typical win rate from 70% to 90%+.

Our new alpha model empowers members to be a wiser stock market investor with profitable alpha signals! The proprietary quantitative analysis applies the collective wisdom of Warren Buffett, George Soros, Carl Icahn, Mark Cuban, Tony Robbins, and Nobel Laureates in finance such as Robert Engle, Eugene Fama, Lars Hansen, Robert Lucas, Robert Merton, Edward Prescott, Thomas Sargent, William Sharpe, Robert Shiller, and Christopher Sims.

 

Follow our Brass Ring Facebook to learn more about the latest financial news and fantastic stock investment ideas: http://www.facebook.com/brassring2013.

 

Follow AYA Analytica financial health memo (FHM) podcast channel on YouTube: https://www.youtube.com/channel/UCvntmnacYyCmVyQ-c_qjyyQ

 

Free signup for stock signals: https://ayafintech.network  

Mission on profitable signals: https://ayafintech.network/mission.php 

Model technical descriptions: https://ayafintech.network/model.php

Blog on stock alpha signals: https://ayafintech.network/blog.php

Freemium base pricing plans: https://ayafintech.network/freemium.php 

Signup for periodic updates: https://ayafintech.network/signup.php

Login for freemium benefits: https://ayafintech.network/login.php