Since the collapse of Silicon Valley Bank (SVB) in March 2023, financial analysts have been performing a thorough autopsy. What caused SVB to fail? While many factors led to its downfall, a U.S. regulator told a Senate panel that SVB had a “terrible” track record when it came to risk management.
That’s an important lesson for any company, especially those that operate in the financial sector. What kinds of risks are associated with the banking industry? The following is a summary of the most common types of bank risk, along with strategies for managing them.
Liquidity Risk
Liquidity risk refers to a bank’s lack of liquid funds (i.e., cash), which renders it unable to meet its financial obligations. Banks must earn money to ensure that they have the cash to meet these obligations, including customer demands. If enough investors request a withdrawal of their money at one time, it can create liquidity issues for the bank.
The primary cause of SVB’s collapse was liquidity risk. SVB had invested in U.S. Treasury bonds when interest rates were low but failed to institute liquidity contingency plans to assess their resilience to potential shocks.
How to Screen for Liquidity Risk
Controllers and CFOs should do their due diligence to screen banks and assess their ability to meet financial obligations. Unfortunately, SVB wasn’t large enough to meet liquidity coverage ratio (LCR) reporting requirements, but other financial institutions use this calculation to ensure that they remain fiscally solvent.
The good news is that the FDIC insures deposits. The bad news is that they only cover up to $250,000. Even small to midsize businesses may have more money than is ordinarily backed by this cap. How can companies work to overcome the $250,000 FDIC limit?
One option is to open multiple accounts at multiple institutions where each account is covered by the same limit. Or you might consider the Certificate of Deposit Account Registry Service (CDARS), a banking network that lets you save millions of dollars in a certificate of deposit (CD).
Credit Risk
Banks provide consumers and business owners with various loan types, including personal loans, auto loans, mortgages, small business loans, and more. But that presents the possibility that borrowers will fail to repay the loan or make consistent, on-time payments.
This is known as “credit risk,” and it’s the most common type of risk facing the banking industry.
Screening for Credit Risk
Lenders manage credit risk in several ways, including:
- Rigorous screening process for loan applicants
- Interest rates that reflect a borrower’s credit risk
- Collateral for secured loans
- Personal guarantees for certain types of business loans
Credit risk primarily affects the lending institution, but controllers and CFOs should still be aware of a bank’s strategies for managing these risks, as it reflects a broader system of financial management.
Operational Risk
Operational risk is perhaps the broadest category of banking risk. Operational risk denotes mismanagement of the bank or the assets it holds.
Operational risk may overlap with liquidity risk, though it usually refers to management and leadership practices within the institution or fraud that disrupts the bank’s normal operations.
How to Screen for Operational Risk
Controllers and CFOs should closely examine a bank’s leadership structure and security protocols. This data can provide insight into the bank’s stability and how well it can be trusted.
For instance, if a banking institution has a history of data breaches or massive shifts in leadership, you may want to delay a relationship with that institution until its reputation improves.
Market Risk
Market risk refers to losses from financial investments due to unfavorable movements in the price of an asset. For instance, if a bank purchases shares of a stock and the price declines, the bank suffers from market risk.
SVB experienced something similar, though it would more accurately be termed “interest rate risk,” which occurs when interest rates change rapidly in a short period.
SVB had invested in U.S. Treasury bonds when rates were at their lowest. However, when banking customers began making withdrawals, SVB was forced to sell these bonds before their maturity date, thus incurring a loss.
How to Manage Market Risk
Part of SVB’s problem was that they invested more than half of their assets in these securities. Every investor knows the importance of diversification, which is why controllers and CFOs should make it a point to investigate a bank’s investments carefully.
A bank that sinks its money into one asset class may pose a considerable market risk and therefore be a poor financial partner. Conversely, a bank that relies on bonds, stocks, and tangible assets may be a stable choice.
Too Big to Fail?
Silicon Valley Bank will perhaps remain a case study in what not to do for the banking industry. But does that mean businesses should pivot to larger banks that boast of being “too big to fail”? Not necessarily.
The screening methods listed above can help you evaluate banking partners, and by spreading your money across multiple banking systems, business owners can manage their investments even if they exceed the normal $250,000 FDIC insurance limit.
