Financial institutions are highly leveraged businesses, making solid financial management imperative.
As credit unions sort out the lessons learned from the failures of Silicon Valley Bank and Signature Bank, they need to keep a firm hold on the chemistry of their business models. Importantly, loans need to be granted to creditworthy borrowers, and concentration and systemic risk need to be identified and closely managed.
To put things into perspective, the Federal Deposit Insurance Corporation’s fund currently has $126 billion. The deposit base of Silicon Valley Bank totals $175 billion. Signature Bank’s deposit base is about $90 billion. The government has said that depositors will be made whole, even for deposits above $250,000. But I heard President Biden say recently that the equity holders in these two banks will not be bailed out, and the management teams of SVB and Signature Bank will all be fired.
The failures of Silicon Valley Bank and Signature Bank are rooted in six risk management elements that are so critical to all financial institutions, including credit unions. These are credit risk, concentration risk, interest rate risk, liquidity risk, leverage risk and reputation risk.
All six elements of risk for financial institutions must be linked to the unique nature of each institution’s balance sheet. A well-capitalized bank or credit union has 7% or more in equity capital. The recent blended average for FIs that are deemed to meet the well-capitalized definition is around 10%. That means for every dollar of capital that is funding the asset base on the balance sheet, 10 cents of the dollar is equity and 90 cents is debt.
If you do the math and calculate the debt/equity ratio, you get $9/$1. For every dollar of equity capital, financial institutions have nine dollars of debt capital. Next, consider the term structure of the debt capital and what it costs to obtain. Deposits in their various forms make up most of the debt capital pool, and they are all due on demand. Deposits held in certificates pay out a higher interest rate return in exchange for a time commitment by the depositor. These deposits are still repayable on demand, however, subject to an adjustment for any interest earned that can be forfeited due to the request for the payout.
If a small business walked into a financial institution looking for access to capital and presented a balance sheet with a debt-to-equity ratio of $9/$1, with all the debt due on demand, they would get laughed out of the building. To say the least, the FI business model is “highly leveraged.” It follows that one of the reasons the FDIC and NCUA offer deposit insurance is to support having a predictable and stable deposit base.
The choices for an asset mix in the financial institution world must take into consideration the funding structure. The good news about the deposit base is that it is a relatively cheap pool of capital. Over the last 10 years, the average cost of funding provided by deposits for most all banks and credit unions has been less than 100 basis points. FIs place this funding pool in a mix of investments and loans and live off the net interest rate margins generated. So long as the economic environment is relatively stable, the returns on equity generated from the profitability of the business model can be significant, given the leveraged condition that is enabled.
Let’s consider each of the six elements of risk faced by financial institutions in the context of the recent bank failures.
Credit risk speaks to the lending function. Typically, 60% to 70% of the overall asset mix is made up by loans. Loans are made based on the execution of an underwriting analysis process that vets the creditworthiness of the prospective borrower. The lender must accurately identify and quantify the primary source of repayment for the loan. This capacity to pay is linked to a definition of cash flow that makes sense given the borrower. Typically, there is also consideration given to backup plans for repayment in the event the primary source of repayment does not work out as planned.
Secondary sources of repayment are typically represented by the pledge of specific tangible assets owned/controlled by the borrower that will serve as collateral for the loan. These assets must be valued, and the critical issues of physical location, possession and conversion to cash must be vetted to determine the viability of the collateral as a loan repayment source.
Tertiary sources of repayment can also be considered. In most cases, this represents some form of guaranty provided by the borrower(s). The credit risk issue here is the need to have a viable game plan for converting a promise to repay into a tangible source of repayment.
In CUES’ School of Business Lending, we preach that the focus of good credit processes needs to be on the viability of the primary source of repayment. We tell the participants to link to this basic message, “If the cash don’t flow, the loan don’t go.”
The goal is to get repaid in the normal course of business as agreed. Good credit administration is all about managing the related collection process and is rooted in properly structured documentation that supports the lender’s rights and enables the collection process to move to secondary and tertiary sources of repayment when needed.
When you consider credit risk associated with start-up or early business lifecycle stage operations, such as with the clientele of Silicon Valley Bank and Signature Bank, it is difficult to justify traditional loans. Many of these businesses are trying to convert business services ideas or new products or services into viable going concerns. They are not yet producing operating profits or levels of internal operating cash flow that would justify loan repayment capabilities.
Much of the funding provided to these businesses comes from personal ownership or private equity investments, venture capital and bridge loans. Most of this capital is provided in a very high-risk environment and is linked to the ability to obtain equity in the business, which may be ultimately tradeable in the public capital markets. I had a venture capital fund many years ago that provided funding injections to businesses in the form of private placements and bridge loans. We would take huge risks if we could see a significant return potential. In our case, if we could not see a 40% return or more, we would decline to participate.
Financial institution lenders that make loans to businesses with start-up profiles don’t get to participate in the equity upside. They get prime rate to prime + 2-3%. Taking venture capital-level risks for a lender’s return is a very scary business.
Another critical element of risk management is the need to identify concentration risk. You are looking for any concentrations in the loan portfolio that could represent systemic risk exposure—businesses engaged in the same industry, in a common physical location, aggregate loans to the same borrower, and loans in dollars size as a percentage of the loan portfolio.
Many tech firms are generating or planning to generate services or products using some sort of intellectual property that they have developed or are in the process of developing. Many take significant amounts of time to develop these services and products. The costs associated with their development activities are paid for from deposit accounts set up at a financial institution that were funded by early-stage capital injections. You often hear the term “burn rate” with these firms because they are tapping these funds to pay for research and development costs and the creation/transition of the infrastructure into a viable going concern. There is no cash flow being produced by the business to pay for these expenses.
Even established tech companies with big cash reserves ran into business reality in the last year. Microsoft, Apple, Amazon, Google, Meta, SalesForce, Intel and HP all announced they were cutting overhead expenses to shore up profitability and reduce their speculative burn rates. Fiscal responsibility is at a premium. Most of them experienced significant hits to their stock values, and they have laid off a lot of high-wage-earning tech staff members that are now tapping their deposit accounts to support their lifestyles while they scramble for new jobs.
Interest Rate Risk
Investments purchased and loans made carry related interest rates. The yield on investments and loans links to the level of interest involved. Investments typically represent the second-largest asset pool on a financial institution’s balance sheet. Most of these investments are in some sort of government securities, and the rates tie to the term structure of the investments.
One of the challenges with these investments comes in a rising interest rate environment. We saw the Fed Funds rate stay literally under 100 basis points for a decade. Then we faced the pandemic and now the post-pandemic economy and suddenly, inflation of consequence started to be visible across the full spectrum of the economy locally, nationally and internationally. The Federal Reserve immediately reacted to this situation by raising Fed Fund rates with the goal of getting the rates of inflation back to around a 2% annual rate.
In a matter of six months, the Fed Funds rate has increased by 450 basis points, and the expectation is that it will continue to rise in 2023. The problem with rising interest rates for any investment or loan that is set at a fixed rate is that it affects their face value. If there ever is a need to sell these assets to generate liquidity, their face value will go down because the value will be adjusted to yield a current market rate.
Now the fun begins. A basic financial accounting principle is the cost principle. It states that assets should be recorded on the balance sheet at cost. Another key financial accounting principle is the conservatism principle. It states that assets should be recorded on the balance Sheet at the lower of cost or market value. The objective is to be conservative and not overstate the value of the assets on the balance sheet.
Long-term investments like government bonds are typically purchased set at a specific interest rate. If interest rates rise above this rate, the sale of the bond would adjust the face value to reflect a yield consistent with the current level of interest rates tied to similar-term structure investments. When rates rise by 450 basis points in six months, the discounts off face value that would be generated if the bonds had to be sold to meet liquidity needs would be significant.
Rapidly rising interest rate environments, such as the one we’re currently in, are very challenging. They put a squeeze on net interest rate margins because the costs of funding typically adjust up faster than the yield on assets. A 50 basis-point net interest margin squeeze on a $200 million loan portfolio represents $1 million reduction in profits without considering any other performance factors.
The fundamental accounting rule is the balance sheet must balance. If you take an asset stated at $1 million on your balance sheet and sell it for $750,000, there is a loss of $250,000. That loss must be recognized on the funding side of the balance sheet to keep the balance sheet in balance. The loss is reduced from the equity to accomplish this requirement. If you are highly leveraged, it does not take long before equity is exhausted.
Liquidity risk reflects the challenges associated with selling assets from a financial institution’s balance sheet. How readily available are secondary markets for investments and loans? What impacts on asset value will be faced if the need to sell these assets is immediate? If they sell for something less than face value, how is this loss recognized?
Secondary markets for loans are problematic. If they have below-market interest rates and any repayment volatility, the discounts faced can be huge. Here again, the balance sheet has to balance. Every dollar of stated value lost in the sale conversion has to be taken out of equity. If you are leveraged $9/$1, how long will it take before the equity is wiped out, and the regulators are forced to take over the institution?
When is liquidity a big concern? When the depositors ask for their money back. Remember, it is repayable on demand.
At the end of the day, the financial institution business model is highly leveraged. Any kind of systemic shock to the structure can collapse it in a very short time. That is one of the reasons why financial institutions are so highly regulated.
Last, but not least is reputation risk. It does not take much time in the public capital markets to create potential chaos. If the customers and members no longer trust that the financial institution can serve their needs and protect their deposits, they will make a run on the institution.
The insurance funds will be tapped, and it will take time to restore confidence. Most of these institutions never survive in name and are merged into other FIs. If any fraud was committed, board members and management staff members could face criminal and civil liability exposure. The regulators could bar them from ever working in a financial institution again.
The asset/liability management challenge in a FI is relentless. One of the critical components of the CAMELS Rating system used by the regulators is Asset Quality. Loans must be granted to creditworthy borrowers and investments must be made with yield, a strong understanding of the interest rate environment and the viability of secondary markets, if and when liquidity needs arise.