It has been almost a year since the industry was shaken by three of the five largest bank failures in US history. As regulatory agencies and supervisors continue their response, we highlight what banks should expect and the steps they should take to prepare for prolonged and more intense scrutiny.
It has been nearly one year since the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank. Swift and effective actions taken by both the private and public sectors prevented the fallout of those bank failures from spreading further. Meanwhile markets have moved on, with the focus now on the Federal Reserve (FRB) in anticipation of interest rate cuts later this year. Regulators continue to scrutinize current practices and banks are looking to apply the lessons learned.
One key observation following last year’s events is that idiosyncratic weaknesses can rapidly become systemic, even if the banks initially involved are not systemically important. A combination of factors – digital banking, tech-savvy clients, and social networks – has fundamentally altered the speed and scope of bank runs. The old adage that we are “only as strong as the weakest link” proved to be largely true, and banks would do well to keep this in mind.
Below we look more closely at the supervisory reaction to the events of 2023 and the actions to take in response.
THE REGULATORY & SUPERVISORY RESPONSE
In the wake of the Silicon Valley Bank and Signature Bank failures, the Department of the Treasury invoked the systemic risk exception to protect all their depositors and removed each bank’s senior management.1 In a separate action, the Federal Reserve created the Bank Term Funding Program that allowed banks to borrow against the par value of eligible securities, thereby avoiding firesale monetization.2 These actions, among others, eventually calmed markets and reduced further contagion, but not before First Republic Bank was put into receivership and then sold to JP Morgan.3
The FRB conducted a review of the Silicon Valley Bank failure and published the results in April 2023. Much of the review was focused on potential changes to bank regulation and supervisory practices.4 The FDIC published similar post-mortems on the failures of Signature Bank and First Republic Bank in April and September 2023, respectively.5,6 In July 2023, the agencies updated their guidance on liquidity risks and contingency planning.7 Aside from a heightened focus on operational preparedness (which we address below), the updated guidance mostly reiterated practices and expectations articulated in 2010’s ‘Interagency Policy Statement on Funding and Liquidity Risk Management’, or SR 10-6 as it’s commonly known.
The Basel III Endgame proposal from July 2023 will unwind the exemption for large regional banks (Category III and IV) that allowed unrealized losses on securities portfolio held-for-sale, recognized in equity through AOCI, to not count against regulatory capital capacity. In a separate but related proposal, these same banks will need to issue long-term debt as a source of stable funding to enhance financial stability and mitigate potential run risk.
Supervisors conducted examinations on liquidity and interest rate risk practices during the second half of 2023. On the liquidity front, this included assessing intraday liquidity management, liquidity stress test assumptions, and contingency funding plans. The examination agenda for 2024 will continue to focus on these liquidity themes, in addition to depositor behavior and its impact on liquidity positions and risk management practices. In its November 2023 Supervision and Regulation report, the FRB also highlighted that it had started continuous monitoring for a small number of firms with elevated funding risk profiles.8
The heightened focus on liquidity positions and risk management practices has already resulted in increased supervisory findings, and we expect that trend to continue into 2024. The first figure below shows the increase in Federal Reserve findings from their local bottom in 2021, while the second figure shows the portion of findings for liquidity risk management and positions.
Figure 1: Outstanding Number of Supervisory Findings, Large Financial Institutions
Source: FRB Supervision and Regulation Report, November 2023
Figure 2: Outstanding Supervisory Findings, by Category, Large Financial Institutions
Source: FRB Supervision and Regulation Report, November 2023
Additional regulatory changes are likely and would be subject to standard rulemaking processes. These changes may include technical changes, such as more granular depositor segmentation and faster outflow assumptions for uninsured deposits in the Liquidity Coverage Ratio (LCR), or perhaps a buffer that would be expected to be used in times of stress. However, more significant changes to keep pace with structural changes in technology and consumer behavior as well as the significant, recent growth in uninsured deposits are likely.
For example, new requirements to pre-position collateral at the Federal Reserve discount window (in excess of ‘runnable’ liabilities) was suggested in a recent G30 report.9 Acting OCC Comptroller Michael Hsu suggested a similar idea in the form of a new, 5-day targeted liquidity requirement to cover ultra short-term flows.10 The Bank Policy Institute has suggested a related approach in the form of a fee based committed liquidity facility at the Federal Reserve.11 These suggestions imply that liquidity transformation provided by the Federal Reserve could play a formal role in future requirements. Some industry participants and observers have advocated for this treatment, either as a substitute or complement to the current philosophical approach of stockpiling liquid assets.
Finally, there has also been much debate about the path forward for deposit insurance, which is another critical aspect of preventing future runs. Ideas range from keeping the status quo through to fully insuring system-wide deposits.12 However, any change to deposit insurance will require congressional action.
It is important to remember that global quantitative liquidity requirements are significantly newer and less well-researched than those for bank capital. Last year’s bank failures have prompted a significant amount of new research on bank liquidity and its systemic implications, as recent calls for academic papers by the Wharton Initiative on Financial Policy and Regulation13 and the Office of the Comptroller of the Currency demonstrate.14 These papers will undoubtedly cover the events of the past year, but they will also need to consider additional, significant change coming to the deposit and payments landscape. These changes include the increase of banking-as-a-service and reciprocal deposits, 24/7/365 payments, tokenization of bank deposits, and the potential of a central bank digital currency.
While future bank liquidity requirements are at present unknown, the message from supervisors is clear. Bank executives must ensure their firms are abiding by the guidance set forth in SR 10-6, as appropriate to the size and complexity of their institutions. In addition, they should pay special attention to operational preparedness and capability to execute contingency funding plans. The figure below depicts the key themes of this guidance at a high level.15
Figure 3: Key Themes of SR 10-6
Source: Interagency Policy Statement on Funding and Liquidity Risk Management, March 2010, Revised August 2023
REQUIRED ACTIONS
Since March 2023, banks have been under pressure from the markets and subsequently from supervisors and policymakers. Some firms have begun to integrate lessons learned from the 2023 bank failures, but there is more to do to keep pace with heightened expectations. We expect further supervisory scrutiny throughout 2024 and into 2025. Below are key actions that banks should consider.
Prepare Operationally
Liquidity events are highly stressful for people, processes, and underlying systems. It is imperative that banks are operationally equipped, and that this preparedness is assessed on a regular basis. Banks should ensure that they execute relevant legal documentation, set up communication lines, and establish operational pipes. They should consider simulation exercises to test operational preparedness. This is similar to exercises that certain banks conduct for closing out a large derivative/funding counterparty. If securities liquidation is part of the plan, banks should make sure they have the capability to rapidly execute block trades.
Update Contingency Funding Plans
Given today’s interest rate environment, contingency funding plans (CFP) may need updating to overcome business model limitations. CFPs should ensure the ability to monetize assets during the window of time available to meet outflows. If plans include discount window access, banks should consider to what extent pre-positioning collateral with the FRB would make those plans more tractable. Finally, crisis management plans should prepare external communications regarding the bank’s liquidity and depositor profile to stem ‘guilt by association’, which is commonly used to reference deposit flight spreading from one firm to another due to perceived similarities or lack of information on deposit base characteristics.
Diversify Funding Sources
Banks should review and expand BAU and contingency funding, as needed, so they can continue to fund in highly stressed environments. They should assess the quantity and quality of bilateral funding providers, and consider funding through tri-party relationships, if not in place. Funding sources should appropriately consider capital markets issuance, Federal Home Loan (FHLB) advances, and FRB-provided liquidity through both the discount window and Standing Repo Facility (SRF). If not an SRF member, banks should consider joining (as of October 2023, 10 members representing approximately half of US banking assets were members).16
Challenge Stress Testing Assumptions
Banks should review assumptions within internal liquidity stress tests to ensure they remain appropriate in light of last year’s bank failures. Review areas include outflow assumptions on uninsured deposits, including the quantum and pace of the outflows, adjusting for depositor concentrations where appropriate. Banks should do a read across to other ‘runnable’ liabilities to see if outflow assumptions remain appropriate. Banks may also reconsider alternative sources of funding such as the discount window.
Tighten Intraday Liquidity Risk Management Processes
For firms with material payment, clearing, and/or settlement activities, the FRB has highlighted intraday liquidity risk management as a supervisory focus area for 2024. Since intraday flows for large, active institutions can be highly complex, banks should review their practices to operationally mobilize collateral and curtail credit, if necessary. Payment capacity planning should consider unexpectedly high payment requirements and an established hierarchy of payment priorities.
Uplift Reporting to Management & Board of Directors
Regular, insightful reporting is a critical component of the risk management process. Given the weaknesses highlighted in the Silicon Valley Bank saga, this may be a good time to revisit the quality of liquidity reporting and see how it compares with supervisory expectations and other core risks, such as credit risk.
Regional Banks
As with Basel III Endgame, super-regional and regional banks (Category III & IV) are disproportionately affected by the increased focus on liquidity management practices. This is understandable given the nature of last year’s bank failures, the lessons learned, and relative strength of US G-SIBs (global systemically important banks). Category III and IV banks should expect continued, intense focus from supervisors. In addition, they will have to adapt to likely regulatory change, including additional compliance with stricter liquidity and long-term debt requirements.
FINAL THOUGHTS
The 2023 bank failures occurred at a lightning pace unimaginable only a few years ago. Advances in technology and customer connectivity have fundamentally changed how banks manage liquidity. Policymakers, regulators, and supervisors are focused on preventing a similar episode from happening again in the near term. Over time, significant change to liquidity risk management requirements and practices will be necessary. For now, bank managers must update their liquidity risk management processes to reflect lessons learned and to ensure they stand up to heightened scrutiny.
REFERENCES
1 https://www.fdic.gov/news/press-releases/2023/pr23017.html
2 https://www.federalreserve.gov/newsevents/pressreleases/monetary20230312a.htm
3 https://www.fdic.gov/news/press-releases/2023/pr23073a.pdf
4 https://www.federalreserve.gov/publications/review-of-the-federal-reserves-supervision-and-regulation-of-silicon-valley-bank.htm
5 https://www.fdic.gov/news/press-releases/2023/pr23033a.pdf
6 https://www.fdic.gov/news/press-releases/2023/pr23073a.pdf
7 https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230728a.htm
8 https://www.federalreserve.gov/publications/files/202311-supervision-and-regulation-report.pdf
9 https://group30.org/publications/detail/5264
10 https://www.occ.gov/news-issuances/speeches/2024/pub-speech-2024-4.pdf
11 https://bpi.com/clf-notes-what-is-a-committed-liquidity-facility/
12 https://www.fdic.gov/analysis/options-deposit-insurance-reforms/report/options-deposit-insurance-reform-full.pdf
13 https://wifpr.wharton.upenn.edu/wharton-liquidity-conference/2023-conference/call-for-papers/
14 https://www.occ.gov/news-issuances/news-releases/2023/nr-occ-2023-131.html
15 https://www.federalreserve.gov/boarddocs/srletters/2010/sr1006.htm
16 https://www.federalreserve.gov/newsevents/speech/files/barr20231116a.pdf
