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December 21, 2023

US banking crisis: Building resilience in the face of rising challenges

 

 

Mayur Patil

Associate Director
Credit and Lending Solutions
CRISIL Global Research & Risk Solutions

Mayur Agrekar
Lead Analyst
Credit and Lending Solutions
CRISIL Global Research & Risk Solutions

 

 

The collapse of Silicon Valley Bank (SVB) in March 2023 swiftly impacted other regionally concentrated mid-sized banks, prompting more runs, such as those witnessed at Signature Bank and First Republic Bank.

 

The collapse of SVB was triggered by a substantial mark-to-market loss from a securities-portfolio sale, a failed capital-raising attempt, and subsequent negative rating actions, leading to loss of confidence and significant withdrawal of uninsured deposits. SVB and Signature Bank witnessed the highest one-day withdrawal rates of 20% of pre-run deposits, compared with 2% during the failure of Washington Mutual (WaMu) in 2008 - the largest failure of an insured depository institution by inflation-adjusted total assets.

 

The rapid and substantial withdrawals of deposits raised concerns about the resilience of U.S. banks, with a large concentration of uninsured deposits and notable declines in the fair values of fixed-rate assets in a rising-rate environment, prompting decisive actions by the U.S. Federal Reserve (Fed) and other agencies.

 

Swift regulatory response

 

While the systemic liquidity crisis subsided due to robust regulatory interventions, the remarkable speed of the runs on SVB and Signature Bank - fuelled by electronic withdrawals and social media communication - distinguished them from the past banking crises, underscoring the imperative for enhanced regulatory measures. The U.S. banking crisis this year also spotlighted vulnerabilities in the regulatory framework, particularly in addressing significant asset/liability mismatches, deposit concentration/outflow risks, and regulatory oversights, especially among regionally focused small-to-mid-sized and community banks. These institutions, which enjoy comparatively less stringent regulation than their larger counterparts, faced the consequences of lower resilience and heightened susceptibility to abrupt shocks. In response, the U.S. regulators were swift in taking actions to fortify the banking system through tighter supervision, refining the regulatory framework and bolstering compliance standards across the sector. Apart from other regulatory and supervisory announcements, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) came up with supervisory announcements and consultation papers, specifically focused on mid-sized and regional banks.

 

 

In September 2023, the OCC released the bank supervision operating plan for 2024, facilitating the development of supervisory strategies based on the bank size, complexity, and risk profile. The plan focuses on:

 

  • Asset and liability management, especially with respect to management of interest-rate and liquidity risks.
  • Credit risk, concentrating on underwriting practices and risk management systems. 
These supervisory priorities aim to ensure that banks have robust stress testing and contingency plans, continuously assess concentration risk, and maintain accuracy in risk rating while monitoring high-risk portfolios. Besides, the OCC will also examine the banks’ IT infrastructure and operational resilience to ensure strong IT controls. These strategic priorities are collectively aimed at enhancing the banks' risk management, compliance, and the preparedness to navigate evolving challenges effectively.

 

Additionally, in October 2023, the FDIC came out with a consultation paper aiming to closely align the corporate governance and risk management practices of the relatively smaller US banks with total consolidated assets of $10.0bn or more, with that of the larger banks in the country (as per the FDIC, 57 regional banks will fall under this requirement). The proposed guidelines elaborate on the roles and responsibilities of the Board to enhance the structure and risk-management frameworks of banks. Moreover, the guideline proposes each bank to design a risk-management program, which clearly identifies its risk profile and demarcates its risk appetite. This involves:

 

  • Development of comprehensive risk management framework covering credit, concentration, interest rate, liquidity, operational, strategic, and legal risks.
  • Quarterly review to identify existing and emerging risks and risk appetite limits.
  • Implementing ‘three lines of defense’ model for monitoring and reporting on risk compliance.
  • Identifying breaches of risk limits, concentration risk, and violations of law or regulations.
Apart from the above, the guidelines encompass strengthening the governance framework, involving constitution and composition of the Boards, duties of the boards, formation of different committees, and independent judgement by the Board members.

 

 

Regulatory developments in the right direction

 

These proposed regulations and supervisory priorities collectively aim to enhance risk governance and monitoring practices at banks to better withstand the ongoing economic challenges. They also focus on strengthening compliance across the banking system, irrespective of size. Accordingly, regulators have increased their scrutiny of supervised institutions.

 

Notably, in November 2023, regulators took enforcement actions against three banks (asset size of less than $10bn): Vast Bank, National Association (Tulsa, Oklahoma), Heritage Bank, National Association (Spicer, Minnesota), and United Fidelity Bank, FSB (Evansville, Indiana) for gaps in credit underwriting, credit review, credit monitoring, liquidity management, interest-rate risk  management, and governance - highlighting the regulators’ focus on ensuring sound risk-management practices, even at the community banks.

 

External challenges warrant close monitoring and governance

 

In addition to the regulatory headwinds, the banking system is also facing rising credit risks from higher-for-longer interest rates and the expectations of a slower economic growth. On top of this, the emerging strain in commercial real estate (CRE) has been a credit concern for U.S. banks, driven in large part by structural changes in the patterns of office utilization and tighter lending standards.  The risk is especially prominent for small and mid-sized US banks, which are more CRE-concentrated and are significantly lending more to late-cycle CRE than their larger counterparts.

 

Implementation a challenge?

 

While most large banks, in lieu of their extensive risk-management frameworks, are well equipped to handle the enhanced regulatory requirements, small and community banks remain on the radar. These small-sized banks, which until now were not subject to stringent regulatory reporting, are required to develop extensive data reporting and risk-monitoring systems as well as governance frameworks that will help monitor risks on an ongoing basis. This imposes a substantial financial and regulatory burden on the affected banks, which will require onboarding-specific skillsets to meet the enhanced regulatory demand.

 

However, limited financial flexibility and the potential challenges of recruiting skilled personnel, particularly for banks situated outside the major metropolitan areas, will necessitate a reliance on external consultants. These experts can assist in establishing robust risk frameworks and streamlined processes to address the evolving regulatory landscape as well as save costs, which would have been higher had the bank onboarded skilled personnel to run transformation programmes.

 

With more banks coming under the regulatory radar, how they adapt to the new regulatory asks in a stipulated timeframe bears watching.