Wednesday, Mar 22, 2023
TC Insights - Supervisory Lessons from the Failure of Silicon Valley Bank
This is the seventh lesson for financial supervisors from the failure of Silicon Valley Bank (SVB)[1]. Download the document above to see all lessons. Other TC Insights can be found in the News section of our website.
Many of these lessons are applicable to supervisors of all types of financial institutions, not just banks.
“In preparing for battle I have always found that plans are useless, but planning is indispensable.”
Attributed to Dwight D. Eisenhower
Lesson 7 – Crisis Preparedness
The failure of SVB is yet another example of why it is so important to prepare for crises. Failures of financial institutions happen, and they can have painful consequences.
No doubt there will be many lessons from the failure of SVB for crisis preparedness and crisis management. Three of them are discussed here.
First, it is important for the relevant authorities to decide in advance the possible options for dealing with the failure of each financial institution. A massive – and potentially very costly for taxpayers – inconsistency arises if the authorities decide in advance that a financial institution is not systemically important, or that it can simply be placed into some form of liquidation or administration if it fails (with its uninsured creditors, be they depositors, insurance policy holders or investors, eventually being paid whatever is available from the eventual sale of assets) but then the authorities intervene when it does fail by providing government support, in the form of guarantees, capital injections, asset purchases, or whatever.
If you are going to treat a financial institution as being of systemic importance at its death, then you should do the same during its life. This reads across to all sectors – if governments are going to step in to protect policyholders and investors in some insurers and securities firms, then supervisors should impose tougher requirements up-front on the relevant financial institutions.
In the case of SVB, if the uninsured depositors were deemed worthy (for example because they were predominantly from a “strategic sector”) of protection through a government guarantee when the bank failed, or if a government guarantee was necessary to preserve financial stability, then the logic must be that the bank should have been designated as being of systemic importance in advance, and subject to additional measures designed both to limit the probability of failure and to enable an orderly resolution if a failure nevertheless occurred.
These measures for systemically important financial institutions typically include additional capital requirements; higher expected standards of governance and risk management; more intensive and intrusive supervision; and recovery and resolution planning.
Within resolution planning, this includes a requirement to hold sufficient “loss-absorbing capacity” (in the form of equity and subordinated debt) in advance of any failure, so that holders of equity and subordinated debt can be wiped out to absorb losses, and if necessary the subordinated debt can be converted into new equity to recapitalise a failing financial institution. Resolution authorities typically require this loss-absorbing capacity to be at least twice as large as the equity and subordinated debt held by SVB before it failed.
Second, be careful what you wish for. Following the Global Financial Crisis, in the United States the Dodd-Frank Act essentially designated banks with more than $50 billion in assets to be systemically important, and therefore to be subject to the additional requirements noted above. But this was subsequently watered down, and the threshold was raised to $250 billion. Which happened to be just above the largest amount that SVB’s assets ever reached.
Third, a government guarantee of deposits is good news for depositors. But if this is extended to all banks it creates a moral hazard – it enables an unscrupulous bank to raise limitless deposits just by paying slightly more than the market rate for deposits. The bank can then lend the money to its friends, family, political connections, and related companies. When the bank fails someone else (taxpayers or the surviving banks) bears the costs. And whenever governments bail out failing firms, the profits are privatized while the losses are socialized.
As Diamond and Dybvig (remember them from Lesson 3) showed 40 years ago, the more protection you give the more you have to regulate/supervise as a quid pro quo. But ultimately that becomes overly costly and inefficient. This just means that – as we have seen both before and after the Global Financial Crisis – the authorities continue to struggle to find the optimal mix of deposit insurance and regulation/supervision.
The SVB failure highlights the critical need for supervisory authorities to focus on crisis preparedness and crisis management. Planning, and running crisis simulation exercises, will reveal important lessons about what actions need to be taken both before and during a crisis.
More guidance for supervisors can be found in our Toronto Centre Notes, including those on:
Supervising Corporate Governance: Pushing the Boundaries
Resolution: Implications for Supervisors
Designing and Implementing a Systemic Financial Crisis Management Simulation
Lessons for Supervisory Authorities from Crisis Simulation Exercises
[1] This series of TC Insights is written by Clive Briault, Chair, Toronto Centre Banking Advisory Board.
For more information, please contact:
Judy Shin
Communications Lead, Toronto Centre
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