Risky Business: What Attorneys Need To Know About the Recent Bank Failures

The dominant business news story of the first half of 2023 has been the failures of three large regional banks: Silicon Valley Bank, based in Palo Alto; Signature Bank, based in New York; and First Republic Bank, based in San Francisco. First Republic was taken over by JPMorgan Chase, with assistance from the Federal Deposit Insurance Corporation; Silicon Valley and Signature have been closed by the FDIC, which acts as receiver of most failed banks in addition to insuring their deposits. The Silicon Valley and First Republic failures were the second and third largest in history; only the failure of Washington Mutual during the global financial crisis in 2008 was larger.

The common denominators in all three of this year’s failures were the rapid increase in interest rates resulting from the Federal Reserve’s inflation-fighting policy; each bank’s overreliance on one industry or sector, particularly high tech; and rapid growth that was not properly managed. But the more fundamental reason is the age-old inherent flaw in the banking system as a whole: what bankers call “maturity mismatch.” Most if not all commercial banks derive the bulk of their funding from demand deposits – checking accounts. Because bank deposits are insured by the FDIC up to the insurance limit, currently $250,000 per account, the ability to take such deposits is the primary reason for obtaining a bank charter in the first instance. In normal times, demand deposits are a low-cost and reliable source of funding.

The problem is that demand deposits, by definition, are withdrawable “on demand” – any time at the depositor’s initiative. But the primary assets in which most banks invest – commercial loans and mortgages – are longer-term in nature. One thinks of the scene in the classic movie “It’s a Wonderful Life” in which Jimmy Stewart, as the head of a local building and loan association, reminds his depositors that their money isn’t at the building and loan’s office sitting in a safe: “It’s in Joe’s house, right next to yours, and Mrs. Macklin’s and the Kennedys, and a hundred others.”

And for banks that rely on high net worth and business depositors, a large proportion of these deposits may exceed the $250,000 insurance limit. Silicon Valley Bank styled itself and waxed prosperous as the go-to bank for the large high-tech firms based in the eponymous San Francisco Peninsula region; an estimated 97% of its total deposits exceeded the insurance limit. In the case of First Republic, about two-thirds of its total deposits were uninsured at the end of 2022. Even a bank that appears to be soundly capitalized can quickly find itself in trouble if depositors decide to withdraw large amounts of those deposits. That’s what happened: large customers started withdrawing deposits because they were having trouble obtaining financing as interest rates rose. With loan demand down, Silicon Valley Bank had invested those funds in longer-term government bonds to obtain better yields. As the Federal Reserve rapidly raised interest rates to fight inflation, these longer-term bonds declined in value, so, to meet deposit outflows, Silicon Valley was forced to sell these bonds at a loss. As word spread, more and more large depositors drew down their balances – a classic death spiral. And once Silicon Valley failed, depositors quickly moved to withdraw their uninsured funds from other struggling regionals, including First Republic. Its uninsured deposits, some two-thirds of the total, dropped from about $120 billion to about $20 billion, even as its insured deposits held steady or increased somewhat.

The Federal Reserve, as regulator of Silicon Valley and its parent holding company, has released a preliminary report pointing at the bank’s inadequate risk management and criticizing its executive compensation schemes for being overly based on performance while neglecting risk management and governance concerns. The FDIC, as primary federal regulator of Signature Bank, has released an internal report citing “poor management” and, not surprisingly, the pursuit of rapid, unrestrained growth without developing risk management practices adequate to the bank’s size and complexity. The New York and California regulators are also conducting reviews and will be weighing in on the deficiencies that led to these failures.

In the interim, and predictably, some politicians have pointed the finger at the “deregulation” resulting from legislation in 2018 that relieved smaller banks from some of the more extreme strictures of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in the wake of the global financial crisis of 2008–2009.[1] It is true that Silicon Valley and other regionals successfully lobbied to raise the threshold for certain stress tests from $100 billion to $250 billion in total assets and thus avoided the need to conduct these tests, one of which was designed to identify potential exposure to interest rate increases, but it also appears that the Federal Reserve, in examining the bank, had all the tools it needed to identify the problem and take corrective action. The Federal Reserve Bank of San Francisco did indeed identify many of the bank’s risk exposures and issued a series of corrective notices known as “matters requiring attention” and “matters requiring immediate attention.” The reasons for the bank’s apparent failure to address these are currently under regulatory and congressional scrutiny.

One reason for the enactment of Dodd-Frank was to address the so-called “too big to fail” scenario. Smaller banks had long protested, with some justification, that they were hampered in competing for deposits exceeding the insurance limit because of the perception that while a smaller bank could and would fail if it got in trouble, the regulators simply would not allow a larger bank to fail due to the impact on the banking system as a whole. That is exactly what happened here; to prevent “systemic contagion” the FDIC in effect has guaranteed all the deposits, and the banking industry will collectively be assessed additional premiums to bring the FDIC’s Deposit Insurance Fund back up to the mandated percentage of total deposits. Contrary to misinformed statements in the press, “the taxpayer” will not pay for these failures; they are covered by the FDIC’s Deposit Insurance Fund, which is funded by premiums paid by all insured banks based on their total deposits. This fund is backed by the full faith and credit of the United States in the event of a shortfall, but this provision has never been invoked in a commercial bank failure (it was invoked, however, in the 1980s to bail out failed thrift institutions under a separate insurance fund, since merged into the Deposit Insurance Fund).

For attorneys who advise sizable businesses, this is yet another matter that should be on your radar. Corporations have other options for investing their liquid funds, and there are deposit broker services that place a company’s excess deposits with other banks to obtain maximum FDIC insurance coverage, although this generally applies to large certificates of deposit, which are not withdrawable on demand. Under FDIC rules it is also possible to open multiple deposit accounts with the same bank and have each insured up to $250,000, based on their beneficiaries. But the problem is that a company’s working capital accounts will need to hold sufficient funds to cover predicable outflows, such as for payroll and to pay suppliers. While the FDIC’s commitment to pay all the deposits of the failing banks has raised the specter that the too-big-to-fail rule is back in effect, de facto if not de jure, companies and their attorneys should not assume that this will be the case going forward. While it is not the attorney’s function to oversee the client’s finance and treasury function, he or she should be satisfied that, at the least, management and the board of directors are aware of this risk and taking appropriate measures to mitigate it.

David L. Glass, editor-in-chief of the NY Business Law Journal, is special counsel at Hinman, Howard & Kattell and is a senior advisor for the Macquarie Group. The above article is excerpted from “HeadNotes” from NY Business Law Journal (2023, v. 27, no.1). For more information about the NYSBA Business Law Section, please go to NYSBA.ORG/BUSINESS.

[1] See David Glass, Banking Regulation: The Pendulum Swings Back [Slowly], NY Bus. Law J., 2018, vol. 22, no. 1 at 9.