Recent bank failures reveal the importance of risk management

The sudden collapse of Silicon Valley Bank (SVB) once again highlights the importance of effective risk management.

Commercial banks typically operate with a large maturity (duration, to be more precise) and liquidity mismatch between their assets and liabilities — i.e., they invest in longer-term loans and securities, financed by short-term deposits. This structure exposes these institutions to considerable interest rate risk.

The good news, however, is that hedging this type of risk is easy, through various derivative instruments such as interest rate swaps, which SVB failed to use effectively. Most importantly, though, SVB appears to have failed on the core principle of operating a commercial bank with such duration and liquidity mismatch: diversification.

More specifically, it failed to diversify risks not only on the asset side, by investing a large fraction of its assets in longer-term bonds during a rising-interest rate environment, but also on the liability side, where it relied heavily on depositors who are connected in Silicon Valley and who started a collective run. This led to an even larger concern about a more pervasive commercial bank run across the industry. (Doug Diamond, the 2022 Nobel Laureate in Economics, provides more information on bank runs on his podcast, Capitalisn't). Additionally, SVB appears to not have had proper enterprise risk management governance and processes in place as evidenced through the tone at the top with having no chief risk officer (CRO) for almost the entire past year.

Two days after the collapse of the SVB, another large bank, Signature Bank, was closed by the New York regulators. This closure was another example of lack of diversification (in addition to possible money laundering by private clients, as we learned later), too much focus on lending linked to crypto companies, and a sudden run of $10 billion in deposits by private clients mainly in the New York area, as triggered by the failure of the Silvergate Bank (due to its crypto exposure) earlier same week.

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SVB and Signature Bank marked the second- and third-largest bank failures, respectively, in U.S. history and the largest since the 2008 Financial Crisis. These collapses have shaken markets and stirred uncertainty into the banking industry. Bank closures create large costs for the Federal Deposit Insurance Corporation (FDIC), which will cover uninsured as well as insured deposits in this case. Hearings have been scheduled by the U.S. Congress. The Department of Justice (DOJ), Securities and Exchange Commission (SEC) and Federal Reserve are also among others involved with reviews and investigations into these bank failures.

A few interesting highlights from risk-research at Fisher College of Business:

• As the Risk Institute’s Academic Director and Professor of Finance Isil Erel and her coauthors observed in the loan level data they constructed for their academic publication entitled, “Why Do Firms Borrow Directly from Nonbanks?” SVB was not a typical regional commercial bank. It was located in Silicon Valley and lent extensively like an unregulated nonbank lender would do — to risky, unprofitable medium-sized firms.
• In her research paper "Financial Expertise of The Board, Risk Taking, and Performance: Evidence from Bank Holding Companies," the Risk Institute Advisory Board Member Bernadette A. Minton and her coauthors point to the importance of financial expertise on the boards of banks, which SVB was lacking.
• Additional insights are provided by René Stulz, a research fellow at the Risk Institute, in his paper, “Risk Management, Governance, Culture, and Risk Taking in Banks.”

As speculation continues regarding the root causes of what happened, how it happened and why these events have happened, there is a much more pressing need and priority for organizations to look ahead at how they will react and what decisions and actions will be taken in response. Risk is not inherently bad or something that should always be avoided. It should, however, serve as a guiding principle or beacon. For example, and in light of recent events, there are risk-related questions and considerations that organizations in any industry can reflect on, such as:

• Related to current events, what is our total risk exposure?
• How concentrated is our risk and/or is our risk adequately diversified?
• Is there a CRO in place, and if so, are CRO roles, responsibilities and significance to the organization clearly defined and communicated?
• Do we have proper enterprise risk management governance and processes in place, and do we have the ability to continuously monitor and adapt as needed?
• Are we resilient, and are we trusted?

At the Risk Institute, we continuously emphasize the importance of enterprise risk management (ERM) and the strategic role of the board governance in ERM. We serve as the convener of leading academicians and practitioners specializing on risk management and recently hosted our annual conference, which focused on the theme of “Creating Value: The Evolving Meaning of Enterprise Resiliency.”

We look forward to further connecting with organizations interested in strengthening their ERM and will continue to advance the conversation about risk!

Isil Erel
Professor of Finance,
David A. Rismiller Chair in Finance,
Academic Director, The Risk Institute

Noah Jellison
Executive Director, The Risk Institute