5 Lessons For Credit Unions From Silicon Valley Bank’s Collapse

The crisis is still unfolding, but the latest high-profile bank failure has plenty of takeaways for credit unions around asset management, net worth, communication, and more.
Michael Sacher

The story is still unfolding, but the failure of Silicon Valley Bank (SVB) appears to have resulted from a combination of bad governance, fundamental financial mismanagement, and regulatory failures, too! Having been in the credit union world for nearly five decades, this kind of sounds familiar – think the S&L crisis of the 1980s or the banking crisis that led to the “Great Recession.” From a credit union perspective, look back at all of the claims paid by the National Credit Union Share Insurance Fund for failed credit unions. The common denominator is almost always governance failures combined with financial mismanagement and often significant fraud committed by insiders.

The challenging financial conditions faced by credit unions today present a heightened level of risk that all those charged with governance should carefully consider to ensure that appropriate risk-mitigation measures are in place. Here are five issues related to the SVB failure that should be noted and addressed if appropriate at your credit union.

1) Regulatory Net Worth Vs. An Expanded Net Worth Ratio

As has been widely publicized, prior to its failure, SVB had massive amounts of unrealized losses on its “held to maturity (HTM)” investment portfolio. Such unrealized losses are not charged to earnings (or retained earnings) as long as the institution has the intent and ability to hold those securities until maturity. The drop in value of such securities is simply disclosed on the institution’s financial statements.

At December 31, 2022, SVB disclosed approximately $15 billion in unrealized losses on its HTM portfolio, compared to net worth of approximately $16 billion. In other words, had SVB been forced to write down these unrealized losses or at least account for them in an alternative manner, there would virtually be no equity left in the institution. Further, SVB had unrealized losses of approximately $2.5 billion on its “available for sale (AFS)” investment portfolio. Of this amount, $1.4 billion had been in an unrealized loss position for more than 12 months.

An expanded analysis of net worth (and the related liquidity management impacts) incorporating both the unrealized losses on HTM and AFS securities should have sounded the alarms. How could this have been missed by an experienced management team, by those directors who were charged with governance, by the regulators and even by the auditors – not to mention sophisticated investors who had both deposits in the bank as well as stock ownership?

Another critical question is whether SVB truly had the ability to hold these HTM securities until maturity, especially considering the continued drop in value that began to develop as a result of increasing interest rates in early 2022. This should have prompted SVB to take evasive action to grow earnings and build equity to better manage this extremely risky financial structure. Continuing business as usual should never have been an option. And perhaps the post-mortem analysis will indicate that actual losses on these securities should have been recorded and, therefore, charged to net worth despite the “intent” to hold to maturity. Ironically, the 2022 audit report by KPMG was released on February 24, just two weeks short of the FDIC takeover. Stay tuned on this.

For credit unions, the regulatory net worth ratio excludes the unrealized losses on the AFS portfolio even though those losses have been recorded on the balance sheet. Why is this critical? From a financial structure standpoint, net worth should represent the excess of the book value of assets minus liabilities. All credit unions combined reported a total decline in fair value of their AFS portfolio of approximately 200bp of assets as of December 31, 2022. If this were reflected in the net worth ratio, the average credit union would have reported net worth of 8.9% rather than 10.75%, a difference of 1.85%. And as of year-end 2022, there are roughly 350 credit unions with net worth ratios under 6% (the amount required to be considered adequately capitalized) if these unrealized losses on AFS securities are included in the calculation.

Credit Union Lessons

  • Is consideration given to both the regulatory amount of net worth and an expanded definition of net worth? Since the beginning of 2022, unrealized investment losses for all credit unions combined have reduced net worth by nearly 185bp. For many credit unions, unrealized losses have reduced their true net worth to dangerously low levels. It is critical that those charged with governance understand the difference between these two ratios and implement risk-management procedures to deal with the unfortunate results of investment losses that have developed in this very unusual interest rate cycle.
  • Does your credit union have the ability to hold all AFS and HTM securities to maturity? Or should an impairment loss be recognized based on deteriorating liquidity levels?
  •  SVB’s failure has resulted in a period of extreme anxiety for many consumers. Has your credit union developed a communication plan to clearly articulate the differences between SVB and your credit union’s financial strengths? Doing so could provide a measure of comfort right now.

2) Some Basic Asset/Liability Management (ALM) Issues

It appears SVB grew the liability side of the institution with short-term instruments and invested the proceeds in long-term Treasury and agency securities. Sound familiar? This created a classic mismatch of maturities, with a deadly impact in a rising-rate environment. So as customers began withdrawing their deposit balances late last week, the bank had no significant sources of liquidity and therefore had to start selling HTM investments, thereby turning unrealized losses into realized losses. The realized losses resulted in inadequate levels of regulatory net worth, which led to the FDIC takeover. But as noted above, the true net worth of the organization was already seriously impaired as a result in the decline in investment valuations, but not measured as part of regulatory net worth.

Many credit unions find themselves in exactly the same situation. The result has been massive amounts of borrowing to avoid having to sell the underwater investment securities. Further complicating the process has been the rapid rise in dividend costs, as credit unions have had to aggressively promote share certificates to retain and attract share balances.

Credit Union Lessons

  • Is your credit union’s investment portfolio well diversified, both in terms of investment types as well as investment maturities? The lack of credit risk in the portfolio is not the measure by which interest rate risk should be assessed.
  • Does your credit union have guidelines in place that would deter or prevent the buildup of massive amounts of investments that would have negative impacts in a changing rate environment?
  • Has the credit union considered derivatives to help control or mitigate interest rate risk? It is now being reported that SVB actually had interest rate hedges in effect in 2022, but those hedges had expired and were not renewed. Is this further financial mismanagement?
  • Does your credit union have adequate borrowing agreements in place, and have these agreements been recently reviewed for compliance? Has your credit union recently executed a draw on an existing line of credit to test the operational readiness of the line?

3) Deposit Retention And Growth

One important element of maintaining adequate liquidity is to ensure a vibrant and compelling product menu, especially on the deposit side of the balance sheet in this current economic cycle. I’ve noted the following weaknesses in many credit unions, which can have a very negative impact on liquidity:

  • Lack of competitively priced share products. Does your credit union have competitive rates on deposits at various maturity stages?
  • IRA products lacking competitive pricing. Are your IRA products competitively priced?
  • Large numbers and amounts of uninsured shares. Has your credit union identified members with relatively large deposit balances (say, over $100,000) and ensured those members have competitively priced products so as to alleviate the need for withdrawal to another institution?
  • Failure to proactively approach members with maturing CDs. Does your credit union actively reach out to members with upcoming CD maturities for the purpose of promoting competitively priced products and perhaps offering an early withdrawal without penalty if the proceeds are immediately rolled over to a new CD?
  • Failure to provide MSRs with authority to match rates. Do your MSRs have the OK to match other institutions’ rates in order to avoid a potential withdrawal?

4) Curtailing Loan Growth

With tightening liquidity on the horizon, additional borrowings and/or deposit growth might result in impaired levels of net worth. Although probably a last resort, consideration should be given to slowing loan growth for the purpose of building liquidity.

With the economy expected to move toward a recession in the near future, slowing loan growth may have positive impacts on loan quality and earnings.

Mike Sacher, credit union consultant

5) A Word About Regulators

As with past cycles of financial institution failure, the blame extends to regulators as well as those charged with governance of the various institutions. The regulators are too often silent during the early phase of the crisis, and then go into overreaction mode once the crisis unfolds. To put this into the context of a doctor/patient relationship, this seems analogous to a patient gaining way too much weight over an extended period, then suffering a serious heart attack and being told to not only lose weight, but to have gastric bypass surgery on an emergency basis.

Credit unions have been gaining way too much weight, so to speak, over the past 15 months. It shouldn’t have taken a doctor to point this out. But when the doctor finally made the house call (in the form of regulator exams and call report submissions), the scale didn’t measure total weight or body fat. The scale measured regulatory net worth! GAAP-based net worth ratios combined with impounding the impact of losses on HTM securities into the net worth ratio have become increasingly impaired at many credit unions, just as they did at SVB. But the regulators have continued to focus on regulatory-based net worth rather than giving equal weight to expanded net worth calculations.

Don’t wait for the regulators to tell you to lose weight! Get the proper scales in place to measure your financial fitness and be proactive in getting back in shape.

About Mike Sacher

Mike Sacher has been serving credit unions for over 40 years. He is a retired partner of RSM/McGladrey and O’Rourke Sacher & Moulton, and the former EVP/CFO of Xceed Financial Federal Credit Union. Mike continues to provide consulting services to credit unions.

March 15, 2023

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