Facing into the Banking Jitters: 8 pragmatic steps for all companies.
Much has been written about the demise of Silicon Valley Bank (SVB) over the last week – some of it confusing and misleading, even to an informed observer. The subsequent rescue of Credit Suisse has created further jitters in the banking sector. This article provides a pragmatic analysis and thoughts on learnings.
Scare-mongering driving irrational decisions is in no-one’s best interests and perhaps means we fail to learn the real lessons. This article is written in the language of a non-banker, for which we make no apologies, in order to inform and create a debate about what lessons should be learnt.
Before starting, lets also remember that at the centre of this are many employees of these banks, in the UK and overseas, who have always acted appropriately and now find themselves in a position of uncertainty with reputational risk to mitigate – we support and empathise with those individuals.
The banking sector in the UK has been proven to be resilient in its response to this kind of event. Over the weekend following the announcement of SVB’s demise in the US there was a process of “resolution” that has been well designed since the financial crisis and which operated as intended such that a larger bank (HSBC in this case) stepped in to ensure that customers of SVB in the UK did not suffer harm. HSBC has the resources and scale to absorb any short-term losses. This is not dissimilar to the actions of the large energy suppliers who have absorbed the customers of more than 60 small energy suppliers in the UK that have failed in recent years.
The failure of SVB was a strategic one with poor top-down decision making and failure to consider the risk of economic uncertainty and changes in interest rates adequately, particularly given the higher-risk profile of its customer base. The inevitable investigation will determine who and what was responsible for this – although history tells us culture will play a significant role. However, this failure does not evidence a systematic issue across the sector as a whole.
As a non-banker, we should consider the business model of banking. The bank takes in deposits creating an obligation to repay the customer when they want their money, often with interest. The bank must use that cash to cover the interest on the deposits, cover all operational costs and provide a suitable return to its investors. Using the cash means investing it. The lowest risk way is to put it in another bank account, often with central banks such as the Bank of England, guaranteeing a level of interest and meaning the cash is available when the customer needs it. But the interest will be low and may not cover core costs. So, the bank must either invest in much higher risk equity or lend the money at a higher rate of interest (often some combination of both).
When a bank lends cash, it is generally over a fixed period during which the cash is not accessible and there is a risk that there could be default with the borrower not making repayments. A rate of interest is established to reflect the risk. If it is “safer” lending in terms of the risk of default, the periods when the cash is tied up will be longer and interest received lower. Banks must balance profitability in relation to interest on their assets (investments) compared to their liabilities to customers, with the timing of cashflows to return cash when the customer wants – and importantly for SVB in the context of their business model.
SVB’s business model centred on providing banking facilities to new technology companies that have been rapidly growing and are often financed through venture capital funds. These companies have complex structures, often require significant capital in the early stages and take risks that most of us find mind boggling! Some succeed and some will fail. For this reason, these companies may find banks will not provide them with facilities as when they struggle they need cash quickly. Banks, particularly new or smaller banks, are seeking to have relatively stable customer deposits.
In recent months heightened geopolitical and macro-economic risk has created nervousness across many sectors, not least the technology sector. At the same time interest rates have been rising – by historical levels only to relatively manageable levels for most companies (and banks) of 4% to 5%. This means there are stronger potential returns for investors in low risk accounts earning safe interest and greater unease about pouring more money into higher risk companies. At present venture capital backed start-ups are not able to access new funding so they are drawing on the cash in the bank rapidly. This was a predictable risk event for SVB, even if the underlying causes of risk may have been less so.
At the same time, SVB had placed the cash it received from customers into fixed term bonds where they would not benefit from rising interest rates. The cash was inaccessible when customers started to want to draw on it. They faced a crisis because they had failed to recognise the risks in the business model and match the risks in their assets with those in their liabilities. There has been commentary about the fact that SVB’s Chief Risk Officer departed in April 2022 and a permanent replacement only introduced in December. The specific circumstances of this are unlikely to be made public, but this indicates that there were probably debates and disagreements internally about the risk profile.
As noted above, the banking sector as a whole in the UK stepped in. HSBC has the scale to absorb both the assets and liabilities and take any short-term shortfall. In the longer term it will access the assets. SVB is a classic case of a business running short of cash.
Within the same fortnight the news of Credit Suisse financial reporting and accounting weaknesses became public. For the banking sector the timing was unfortunate when there were already jitters about the business models and strategies. In this case we may well find there are similarities in the root cause of the issues – a culture of not considering or investing sufficiently in understanding risk and the associated controls. However, the issues themselves relate specifically to the accounting and disclosure of non-cash items in the Cash Flow Statement. This is important to analysts and investors but does not change the underlying business model.
In the immediate aftermath of these events we believe there are lessons for all companies that are not about scare-mongering but sensible risk management by leadership teams having the courage and humility to recognise where their weaknesses and blind spots may be. These are our BRAVE recommendations:
- The banking sector is not the problem. Poor decision-making with an individual company caused this failure. Think carefully about all your counterparties and their risks as part of your risk assessment process – even the ones you thought would not fail.
- Think carefully also about your culture and decision processes. Are you listening to the right voices? Do you have a Chief Risk Officer with the skills, capabilities and accountability for providing early warning of emerging risk – whether or not they carry this title somebody needs to play devil’s advocate and be listened to as the voice of caution.
- It is an old adage, but cash is king. SVB has failed primarily because it could not match the timing of liquidation of assets with liabilities.
- Scenario planning and stress testing are critical to identify the combination of risk outcomes that could be catastrophic – you might not be able to predict the specific risk that will create the determinantal risk outcome, but if you know where your greatest points of potential failure are you can create early warning indicators.
- Take the time to understand your insurance and hedging arrangements. If you don’t understand them, educate yourself. In this instance (as with the energy suppliers that have failed) there were hedging instruments available that might have balanced the cashflow and interest rate imbalances between assets and liabilities. These are not fool proof but might have created time for other actions to be taken. For other businesses look carefully at your insurance policies and at contractual terms with third parties.
- If you are a small business that is carefully managing cash and where inability to access cash for a period of time would be detrimental, be aware of the protections that exist for balances up to £85,000 in the UK in any individual bank – create a portfolio.
- If you are a company that is finding it harder to obtain banking facilities because you have more complex funding arrangements or for other reasons (as many legitimate companies do), be aware that a bank that will offer you facilities will also be taking risks with many other customers. That is their business model. And it’s a higher risk business model than other banks. Be more vigilant to any warning signs of problems and read the publicly available information about their profitability, liquidity and asset base.
- When problems arise for any company failure is caused as much by the inability to take the right actions to secure the reputation and confidence of the organisation. Business continuity and resilience plans must be tested regularly, ideally through a war game style scenario. There must be a clear view of the business-critical services that need protecting and the plans to do so. Companies must have embedded internal assurance mechanisms to know that the core processes and systems underpinning those services are operating (or when they are not). Communication planning in a world of social media and 24-hour access is critical, as is monitoring how this is playing out. The ability to respond quickly might just create the time you need to implement actions that could save the organisation.
At BRAVE we are passionate about business accountability and ensure the right governance exists within companies to be resilient and successful.
There are pragmatic and commercially astute steps all companies can take.
Please talk to us if this resonates with you.