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- Risk Management Lessons for Directors and Officers from Recent Bank Failures
The first half of 2023 has seen three bank failures, Silicon Valley Bank, Signature Bank and First Republic Bank. In 2008–the last time multiple FDIC-insured banks failed–the collapse of the economy and massive bank reform followed. In this episode of Pensions, Benefits & Investments Briefings, Yuliya Oryol and Patrick Richard discuss risk management lessons for directors and officers to be drawn from these recent events. Were the challenges facing these banks unique, or are the risks more prevalent?
Transcript: Risk Management Lessons for Directors and Officers from Recent Bank Failures
0:00:00.7 Yuliya Oryol: Transcript: Today, we will be discussing the lessons learned from the recent bank failures, should the directors and officers of the regional banks have seen it incoming? What are the implications for the risk management of your business?
0:00:22.8 Speaker 2: Welcome to Pensions, Benefits & Investments Briefings, Nossaman's podcast exploring the legal issues impacting governmental, private and non-profit pension systems and their boards.
0:00:44.6 YO: Welcome to another episode in Nossaman's Pensions, Benefits & Investments Briefings. My name is Yuliya Oryol. I'm a partner at Nossaman and co-chair of the firm's pensions, benefits & investments group. I focus my legal practice primarily on representing public pension plans and other institutional investors nationally and internationally in connection with public and private market investments, including alternative investments and related regulatory work.
0:01:15.2 YO: I am joined today by Patrick Richard, also a partner at Nossaman and co-chair of the firm's corporate group. Patrick has more than three decades of experience as a commercial trial lawyer. He has significant trial experience, successfully representing publicly traded companies, individuals, government agencies as both defendants and plaintiffs.
0:01:36.0 YO: He has been lead counsel in over two dozen successful civil complex arbitrations, jury and bench trials. Patrick has particular experience representing the FDIC in complex business transactions and corporate governance litigation related to breach of fiduciary duties and business-toward actions. He has also worked on numerous governmental investigations related to financial fraud.
0:02:03.3 YO: As background, in March 2023, three regional banks, Silvergate Bank, Signature Bank and Silicon Valley Bank failed. First, Silvergate Bank and Signature Bank had massive exposure to cryptocurrency, and their problems were triggered as a result of turbulence caused by the collapse of cryptocurrency exchange FTX.
0:02:23.4 YO: Next came Silicon Valley Bank. This highly successful regional bank in Silicon Valley had decided to shift its bond portfolio to longer maturity rate bonds. And subsequently, its bond portfolio greatly decreased in value due to the many interest rate hikes imposed by the Federal Reserve. Ultimately, Silicon Valley Bank failed as a result of a bank run by its depositors who became concerned about the bank's liquidity, which was triggered after the bank sold its treasury bond portfolio at a significant loss.
0:03:00.0 YO: The vast majority of the depositors who withdrew their funds from Silicon Valley Bank were technology companies, portfolio companies, the venture capital firms and private equity firms, and wealthy individuals, many of whom were in the high-tech industry and whose account balances exceeded the 250,000 insured by the FDIC. To most everyone's surprise, the Federal Reserve decided to take extraordinary measures in order to prevent global contagion in the financial markets and prevent further panic if the bank collapsed.
0:03:32.3 YO: Despite the extraordinary move by the Fed officials to backstop billions of dollars in uninsured funds, Silicon Valley Bank was eventually shut down in March 2023 by the California Department of Financial Protection and Innovation.
0:03:42.1 YO: Finally, more recently and still spooked by the run on Silicon Valley Bank, depositors started withdrawing their money from First Republic Bank. First Republic had focused on high-net-worth individuals whose deposits were mostly uninsured since they exceeded the 250,000 FDIC limit. Despite the initial 30 billion capital infusion from a group of major banks, First Republic Bank was not able to regain confidence from its depositors and stockholders. On April 29th, the FDIC closed the bank and sold it to JPMorgan Chase.
0:04:16.9 YO: Patrick, there is so much here that we could talk about today, but let's start with risk management. What are the lessons learned from these recent bank failures for directors and officers?
0:04:27.6 Patrick Richard: Well, thank you, Yuliya. And, yes, while there are any number of takeaways from these recent events, I see it as a tension between sales and growth on the one hand and prudent risk management on the other. Based on my experience, our experience litigating bank failure cases, I really don't think there's anything new here. These are known risks. Growth, high concentration on the balance sheet, et cetera, these have all happened before. That's why I call them known risks. So, the first lesson, if you're an officer or director, especially of a bank, is you need to understand and satisfy yourself that your bank has a strong, experienced risk manager and risk management culture.
0:05:17.6 YO: Risk management culture, what do you mean by that?
0:05:21.6 PR: Sure. As anyone who's been involved in a bank or any other business, there are many risks that face your enterprise: Operational risks, competitive risks, economic risks, specific market risks for acceptance of your company's products. There's financial risks, running out of capital, whether you're a start-up or the risk of a run on the bank or simply your costs of capital increase beyond what you can handle. There are regulatory risks, litigation risks, among others.
0:05:57.1 PR: But even though risk management is challenging, these types of risks, these types of risks are well-known. So whether the precise risk will overtake your bank or business, that can't be predicted precisely any more than turning points in the economy can be predicted. But the risks are there. They're known. The risk that I think is an overarching thematic risk that's helpful and particular for directors who are not making management decisions and they're not necessarily down in the weeds on a lot of these other risks, they can understand and remember that growth, rapid growth beyond your peers, that is a red flag. That is a risk to your bank or business.
0:06:45.9 YO: That's interesting because it seems to me that business growth should be seen as a positive and yet you also talk about risk. Why is it a risk?
0:06:54.9 PR: If you look at any of the postmortems on failed banks going back to this crisis or the SNL crisis decades ago, the risk of growth is a risk for two reasons. If it's rapid growth on your balance sheet, there's two things that should be looked at closely. One, rapid growth can mean that your growth outpaces your risk management. Then you see this with banks where the number of credit officers, for example, doesn't keep up with the number of new account officers, loan officers, and production. So it's simply, sometimes growth means that your risk management infrastructure is not keeping up.
0:07:44.1 PR: The other risk of rapid growth... And again, if you're growing two, three times others in your space or your peer group, look at the concentration on your balance sheet. Are you achieving rapid growth through an increase in a certain class of risk, whether it's questionable loans, looser underwriting, a high concentration in a certain geographic area, high concentration of cryptocurrency, or investing in what you might think was perfectly safe, long-term notes, treasury notes, when you have short-term liabilities like bank deposits. So those two things outpacing your risk management infrastructure or achieving growth through higher concentration, which, of course, is a well-known risk.
0:08:32.5 YO: But banks cannot avoid risk, can they? I mean, what in particular is the role of a board member than particularly an outside board member and risk?
0:08:43.3 PR: Sure. And I heard this a lot when I would be talking to or cross-examining former CEOs and board members, members of the bank's loan committee who would sit back and say, "Well, all lending involves risk" as though that was a sufficient explanation. Who knew? We couldn't predict it. We were just unlucky.
0:09:06.8 PR: And the flip side is, while it's true you have to take risk in order to be successful, you absolutely have to identify and manage the risks unique to your enterprise. So for the outside board member, that means, first, educating yourself on what is your role. There's actually a lot of literature from the FDIC and other regulators on guidance for board members, including outside board members. You need to inform yourself. You need to be active. You need to ask the tough questions. It basically means you need to bring a healthy skepticism to management.
0:09:43.1 PR: So in this case, again, it comes back to the main lesson learned. If you're the outside board member, you need to understand your enterprise's risk management culture and the leadership of your risk management team. Silicon Valley Bank, for example, really had no chief risk officer at the time of its failure.
0:10:00.0 YO: Wow. I didn't realize that was the case. But you're talking about banks. And are these risks then unique to banks and other financial institutions?
0:10:12.1 PR: They're unique in this sense, Yuliya. Banks, unlike other businesses, are required to be operated in a safe and sound manner because they're accepting insured deposits from the FDIC. Banks are not supposed to take on the same level of risk as a startup company or high tech company or other businesses. On the other hand, every business, wherever it is in its business cycle, faces enterprise risk management.
0:10:43.0 PR: And so I would say the common theme, the common risk is, what are you incentivizing? Who's getting bonuses and for what? If you follow that, that's an important part of prudent risk management. So, for example, in the abstract, you could say, well, gee, how could opening new bank accounts pose a risk to a bank? Well, if you're giving a bonus to people just for opening new bank accounts, you better audit that program to see if those are all bonafide new accounts, or you can end up with a problem like Wells Fargo had. So follow the money, see what it is you're incentivizing folks to do. And that's a major role for not just the managers, but the outside board member to understand, what are we incentivizing?
0:11:33.9 YO: The directors and officers you're talking about were fiduciaries, and they had fiduciary duties. Can you talk a little bit about that and explain the type of fiduciary duties directors and officers in the financial institutions are expected to have?
0:11:49.9 PR: Sure. And I think there's really two aspects to this. One, I think all directors generally understand that fiduciary duty means you have to put the interest of the bank ahead of your own, right? You have to avoid self-dealing. You have a fiduciary duty of loyalty. But you also have a fiduciary duty of competence, to be informed, to be an active independent director. That's your oversight role. That's your fiduciary duty.
0:12:20.9 PR: Not showing up to meetings or not asking questions or not informing yourself, many would argue, especially if it's a postmortem of a failed bank, you fell out on your job. You did not fulfill your important role. You had a job to do. You had a fiduciary duty.
0:12:39.2 YO: Finally, based on your experience in trying cases for the FDIC, what are some of the red flags directors and officers should be aware of regardless of the industry?
0:12:49.7 PR: Sure. One would be if... Like, there's a host of regulatory and reporting and requirements faced by publicly traded companies, banks, and other regulated businesses. But that's not the end of risk management. That's the beginning of risk management. You as a director need to understand the dominant culture of your enterprise. Is it a dominant sales culture, growth, growth, growth, sales, sales, sales? What is the risk management culture?
0:13:21.8 PR: It needs to be top down. Is the chief credit officer or chief risk manager engaged? Does management listen to them? Does the board listen to them? There's tendency to downplay risks. And the role of the outside board member is to bring that broader perspective. It's not enough to say, well, we've been around 40 years like Silicon Valley Bank or 140 years. Bear Stearns, Lehman Brothers those institutions had been around a long time.
0:13:51.0 PR: It comes back to known risks. The economy is cyclical. There are ups and downs. And you need to bring that perspective to your risk management. Learn from these recent events. As Warren Buffet has said, "It's good to learn from your own mistakes, but it's better to learn from someone else's mistakes." So that would be my overarching takeaway from these recent events.
0:14:17.5 YO: Thank you so much, Patrick. This conversation and your insights have been extremely informative and instructive. And thank you to our listeners for joining us on this episode of Pensions, Benefits and Investments Briefings. For additional information on this topic and other pension issues, please visit our website at nossaman.com. And don't forget to subscribe to Pensions, Benefits, and Investments Briefings wherever you listen to podcasts so you don't miss another episode. Until next time.
0:14:51.6 Speaker 2: Pensions, Benefits & Investments Briefings is presented by Nossaman LLP and cannot be copied or re-broadcast without consent. Content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only. It is not intended as legal advice and does not create the attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.