ICAEW: New risks revealed in the traditional banking model

May 24, 2023

Recent events highlight that there may be new risks at play in the dynamics and the speed with which banks can fail.

Two features of today’s modern world have been brought into sharp relief by the recent banking sector collapses, including that of Silicon Valley Bank (SVB).

First is the sheer quantity and diversity of information available to people, and the ease and speed with which it can be disseminated across a greater variety of platforms. Move aside newspapers; today the proliferation of websites, social media channels and messaging platforms including Twitter, WhatsApp and Instagram allow information to be consumed 24 hours a day, in real time, by a broader spectrum of people.

The quality of information varies from accurate reporting of risk and analysis of events at one end to soundbites, rumours and sensational scaremongering at the other. Some information may not have been checked for accuracy and completeness, and the media at play open the door to stories being echoed, amplified and distorted across different outlets. Use of digital media also limits the ability to contain or clarify rapidly developing and evolving stories.

The second feature is that new technology such as internet banking has increased the speed and ease of money transfers, which today can be enacted from any device with internet access – without the need to visit a branch or even be in the same country.

There are many positives to this evolution: better and faster information should enable people and businesses to make more informed decisions, while new technology allows for quicker decisions and actions. At the same time, suppressing awareness of real risks is not appropriate market behaviour. However, sifting through the noise, chatter and huge volumes of information to successfully draw out appropriate and informed conclusions presents a significant challenge.

These two features might also increase the inherent riskiness of the maturity mismatch that banks engage in and increase the likelihood of bank failure. The speed and ease with which information is disseminated could also increase the likelihood of contagion from one bank to another. From an accounting perspective this means there is a potential increase in the inherent risk that a bank is not a going concern.

Maturity mismatch is a well-known risk and one that banks manage through a variety of means, not least stress testing and holding capital and liquidity resources. Fortunately for banks, customer behaviour is often sticky and a substantial number will leave their money untouched for long periods.

But that can change, for example when interest rates rise, and customers shift from zero or low-yielding to higher-paying accounts – potentially at a different bank. Comparison websites and best-buy tables are readily accessible and internet banking has certainly streamlined the process of changing banks. In the case of SVB, depositors initially withdrew funds to compensate for the slowdown or withdrawal of venture capital funding, a consequence of the rising rate environment.

Underlying confidence that it is safe to leave your money with a bank is another assumption underpinning the maturity mismatch business model. That confidence may more quickly evaporate with the emergence of information that reveals real risks or creates false concerns.

SVB is a case in point; the bank failed after it announced a balance sheet restructuring and losses on its available-for-sale (AFS) securities, which were taken as signs of financial distress and a trigger for further rapid deposit withdrawals. That its depositors were sharing their concerns on social media only served to accelerate the withdrawals and hasten its demise.

Similarly, time was up for Credit Suisse after news spread that its largest shareholder had declined to provide further support. The clarification that this was due to regulatory reasons failed to calm market jitters, as it was ignored or came too late; similarly, the offer of support from the Swiss government came too late or was seen as insufficient.

As information and rumours circulate, you don’t need the visual stimulus of a queue of people on Moorgate for a run to take place. And facilitated by internet banking, a run may then develop much more rapidly than in the past as people rush to withdraw funds. Attention may then quickly be diverted to others, as we saw in the US. First Republic lost around $100bn of deposits over a couple of weeks following the failure of SVB, prompting concerns over the level of uninsured deposits at other US banks and resulting in a ‘flight to quality’.

The circulation of poor-quality information is of particular concerns as there may be little opportunity to contain or clarify it. Widespread use of secure messaging allows stories to develop with little overall transparency to the authorities. Consequently, regulatory announcements designed to bring calm to the markets may not reach all the persons affected, may struggle to be heard above the clamour, or may simply be too late.

Lessons and implications
Events are still unfolding in the US, but the Federal Reserve Board’s review of the failure of SVB has already highlighted specific underlying features of the failed bank and its regulatory environments.

It is not clear how globally widespread the effects of SVB’s demise will be, not least due to significant differences between the accounting and regulatory frameworks in the US and other jurisdictions. However, we have already seen an increased focus on banks’ internal control frameworks and the management of interest rate risk and liquidity; and management and auditors are asking more questions to assess the appropriateness of the going concern assumptions.

The experience of the past few months has also highlighted the need for some introspection across the banking sector, both in the UK and around the world:

1. Remedial actions by banks or authorities need to be quick, decisive and robust to manage, resolve or quash any risks before they escalate. The challenge is how quick action needs to be and what constitutes ‘sufficient’ action to control a rapidly escalating narrative.
2. The US and UK authorities are considering expanding the coverage of their depositor protection schemes to capture currently uninsured deposits. In the UK the question is whether to raise the limit of coverage above £85,000 – what should the limit be to avoid introducing significant moral hazard into the system? In an age when deposits can be moved so quickly, this also may not affect a depositor’s confidence in the bank as their preference might be to take control and withdraw their funds, rather than wait for the potential uncertainty of a claim on a deposit protection scheme.
3. Are further disclosures required about the forward risks faced by a bank and the speed and shortened time horizons over which events can move in today’s environment? We accept this is a challenge as more disclosure brings its own risk of information overload and a ‘wood for the trees’ situation.
4. Has the potential risk of failure due to the increased inherent risks with banks’ business models increased to the point that the current going concern concept is outdated and inappropriate for banks? For example, the 12-month look forward might no longer have any meaning if there is too much uncertainty about failure in that period.
5. What should the auditor’s responsibility be if the degree of uncertainty about default is such that a meaningful level of assurance can no longer be provided that a bank is a going concern for the look-forward period?

It has been said that the seeds of the next crisis are sown in the responses to the previous crisis. We should therefore not be too hasty in drawing conclusions and jumping to action. The irony of that conclusion in an article about the increased speed of today’s modern world and the risks it brings is not lost on us.

[Author: ICAEW Insights]