The Three Rs of Regulatory Response to Recent Bank Failures

I was a teenager in Uzbekistan when the Soviet Union collapsed. I recall panic and uncertainty. Empty store shelves. Shortages of basic necessities. Most vividly, I remember my grandmother’s tears when she realized her life savings had been wiped out by currency devaluation. While my parents ensured she had everything she needed, the loss of financial independence weighed heavily on her for the rest of her life.

Decades later, living in the United States, it’s easy to take for granted the strength of the dollar and the safety and soundness of the U.S. financial system. Working on the SAS financial regulatory team, I have a unique perspective and deep appreciation for the complex and sophisticated work that financial regulators do every day to ensure the public can have confidence in our banks.

When the news of Silicon Valley Bank’s potential demise broke, depositors faced significant risk that they would lose access to their accounts and, much worse, their uninsured funds. More than 85% of SVB’s deposits were uninsured.

Elena Shtern of SAS: New risks in an “always on” world.

This brought back memories of my grandmother. I thought of employers suddenly unable to pay employees – and of employees, in turn, unable to pay for necessities like housing, food, and childcare. Fortunately, the Federal Deposit Insurance Corp., Federal Reserve and U.S. Treasury acted promptly to ease market fears and reassure the public that the U.S. financial system is indeed safe and sound.

Lessons Learned

Much has been written about the collapse of SVB and those that followed. Analysts, journalists, regulators and lawmakers will continue to analyze the details and sequence of events that led to these failures. In the case of SVB, it’s clear that its management, inadequate risk management practices and poor governance deserve much blame. But the culpability is broader. As JPMorgan Chase CEO Jamie Dimon noted in his recent letter to shareholders, “This wasn’t the finest hour for many players.” That includes auditors and bank regulators.

Like many involved in the financial services industry, I followed the demise of SVB with rapt interest, delving into unfolding news coverage, dissecting the postmortem analyses, and debating insights with colleagues with deep expertise in risk management and finance. Wearing my analytical hat and putting myself in the shoes of bank executives and regulators, I see three areas that require regulatory attention. Let’s call them the three Rs of regulatory response to recent bank failures:

1. Revisiting existing assumptions.
2. Recognizing fundamental shifts in consumers’ behavior and incorporating them into regulatory and supervisory frameworks.
3. Revamping technology infrastructure.

Revisiting Assumptions

The banking industry’s relative calm since the Great Recession of 2008 has understandably fueled a degree of complacency around risk management fundamentals. Financial services organizations must now revisit the common assumptions that increase their liquidity risk in today’s volatile economic market. Paramount among them:

• Deposits. Regulators must ask themselves, are deposits as stable and sticky as previously believed, especially in a rising interest rate environment? Changes in deposit behavior can significantly impact banks’ stability. Regulators should model deposit behavior using different deposit betas and also analyze how deposit behavior would change under varying deposit insurance thresholds. For example, they could examine the impact of increasing the current insurance threshold of $250,000 to $500,000, or even of providing full insurance coverage. A recent FDIC report suggested options for deposit insurance reform that include increasing insurance for business accounts.
• Treasury securities. While Treasury securities are generally considered safe and liquid, macroeconomic changes can cause swings in their valuation and make them a less suitable investment. Discussions are already underway whether the current accounting of held-to-maturity (HTM) securities should be revisited to better reflect risks associated with such assets. Similarly, some argue that the capital requirements for U.S. Treasury securities should be raised. Both topics will require careful analysis by regulators given their far-reaching implications on the financial system and broader economy.
• Stress testing. Stress testing is a critical tool used by banks and regulators to assess the resilience of banks under several macroeconomic scenarios. Regulators must incorporate scenarios with higher interest rates and, per Dimon’s recent shareholder letter, create scenarios that are “a less academic, more collaborative reflection of possible risks that a bank faces.”

Fundamental Shifts in Behavior

Our “always on,” digitally connected world has created new risks for banks that must be addressed. Most especially:

• Information velocity. The speed at which information spreads through digital channels is unprecedented and can significantly impact a company’s reputation and financial stability in near real time. In SVB’s case, tweets from a few influential venture capitalists triggered a mass exodus of deposits – a staggering $42 billion on March 9. Regulators can leverage natural language processing (NLP), a form of artificial intelligence (AI), to develop a sentiment model to measure attitudes and emotions of posts on social media and other communication channels and translate them into sentiment scores. Sentiment scores can provide regulators with critical public opinion insights and potentially help them identify and mitigate issues before they snowball into bigger problems.
• 24-hour banking. The prevalence of 24-hour banking and the ease of moving funds through apps and websites have become the new norm. In the lead-up to SVB’s collapse, customers were able to move their funds electronically without the hassle of visiting physical branches during limited business hours or facing long lines as in bank runs from decades ago. While the ease and convenience of such digital transacting is a boon to customers, it clearly contributed to the remarkable speed of SVB’s deposit flight. With digitalization of financial services expected to further accelerate, regulators must analyze the effects of digital banking on financial conditions and the overall health of financial services.

Technology Infrastructure

The modernization of technology infrastructure is an area of utmost importance for regulators and financial institutions alike. As SAS’s Donald van Deventer recently noted for GARP Risk Intelligence, banks must do more stress testing and scenario analysis, enabled by advanced analytics technology. He wrote, “As recently as a few years ago, stress testing and scenario analysis capabilities faced the limitations of the number of hours in a day. But recent advances, especially in the velocity of calculation and the self-learning capabilities of AI and machine learning in the cloud, make more exhaustive analysis possible.”

Financial institutions must “simulate, simulate, simulate to a minimum 10-year time horizon,” he advised. The same can be said for regulators in quantity, frequency, and trajectory. And, like financial firms, bank regulators must continue to modernize their technology stack by investing in robust and scalable data and analytics infrastructure to stay agile and proactive in predicting and identifying emerging risks in the financial system.

A Path Forward

In testimony to Congress, Federal Reserve Vice Chair for Supervision Michael Barr acknowledged that the events of March 2023 have indicated a shift in the banking landscape.

Barr noted that regulators will be “analyzing what recent events have taught us about banking, customer behavior, social media, concentrated and novel business models, rapid growth, deposit runs, interest rate risk, and other factors” – and, moreover, what changes to regulation and supervision are needed to maintain the safety and soundness of the financial system. 

In April, the Federal Reserve Board completed an internal investigation and shared the findings and initial recommendations with the public. While the task of shoring up the banking sector’s trepidatious risk landscape is complex and challenging, given the sophistication of the modern financial system, I have confidence in U.S. regulators’ ability to navigate the challenges ahead.

With the right insights and interventions, regulators will help steady the industry, as they have in years past with support of financial firms and the industry’s supporting players. Together, with the benefits of the latest technology, we can pave a path to a more stable and secure global financial system.

Elena Shtern is Customer Advisory Lead for Federal Financial Regulatory Agencies at SAS. She helps financial regulators identify opportunities to improve operations using data analytics in critical areas such as supervision and regulatory compliance, data-driven policy and research, risk management, surveillance, and fraud detection. By aligning their missions and objectives with the right enabling technologies and capabilities, agencies can achieve better outcomes and optimize performance. The views expressed in this article are her own.