During the week of March 6, 2023, several financial institutions began to strain under the cost pressure exerted by an increase in short-term interest rates. Apparently having underestimated the negative impact on its balance sheets, Silvergate Bank announced plans to wind down and self-liquidate one day before a run on deposits began at SVB. SVB was closed by the California Department of Financial Protection and Innovation (DFPI) on March 10, 2023, and Signature Bank was closed by the New York Department of Financial Services (NYDFS) two days later on March 12, 2023. The deposits at these banks, which catered to venture capital firms and their portfolio, were heavily weighted towards deposits that were large and mostly uninsured, highly concentrated, and, it turns out, remarkably quick to run.

The U.S. government’s response was to backstop only these deposits and send a clear message that it was neither a “bailout” by taxpayers nor a measure that would be universally available to all financial institutions, lest it have the unintended consequence of rewarding risky behavior. On March 12, 2023, the Secretary of the U.S. Treasury invoked the systemic risk exception, which authorized the Federal Deposit Insurance Corporation (FDIC) to guarantee both insured and uninsured deposits of SVB and Signature Bank. Reasoning that failure to guarantee the uninsured deposits likely would result in more bank runs and negatively affect the broader economy, the Board of Governors of the Federal Reserve System (FRB) then created the Bank Term Funding Program, which provides eligible banks with the ability to receive a one-year loan from regional Reserve Banks. As of April 19, 2023, outstanding advances under the program were approximately $74 billion.

Notwithstanding those measures, the bank closures were not over. On May 1, 2023, the California DFPI closed San Francisco-based First Republic Bank and the FDIC was appointed Receiver. In a highly competitive bidding process, JPMorgan Chase, N.A. (JPMC) acquired under a purchase and assumption agreement, a substantial majority of First Republic’s assets and assumed certain liabilities, including all deposit liabilities. All depositors of First Republic Bank are now depositors of JPMC and lost no deposits whether insured or uninsured. That said, deposits above the FDIC deposit threshold remain uninsured at JPMC.

NYDFS and FDIC: Signature Bank reports

On April 28, 2023, the FDIC and the NYDFS each released their respective reports on their supervision of Signature Bank.

The NYDFS and FDIC identified that, in 2018, Signature Bank had begun to expand its business model to include the private equity and digital assets sectors. Signature Bank experienced rapid and tremendous deposit growth in those sectors, leading the vast majority of its deposit relationships to be large, thus increasing concentration and liquidity risks. As interest rates began to rise and deposits began to contract due to volatility in the digital assets market, Signature Bank experienced deposit outflows. The contagion effects of Silvergate Bank’s self-liquidation on March 8, 2023 and the failure of SVB on March 10, 2023 of course contributed to Signature Bank’s failure, but the NYDFS identified Signature Bank’s management as the ultimate root cause. According to the NYDFS, Signature Bank’s management and board of directors sought rapid growth without building out risk management practices and controls commensurate with the complexity and risk associated with Signature Bank’s increased size.

Additionally, Signature’s inadequate response to FDIC and NYDFS examiner concerns and recommendations delayed appropriate action. The FDIC and NYDFS reportedly had identified issues relating to liquidity risk management at Signature Bank in Reports of Examination in 2018 and 2019 and had highlighted the concerns as matters requiring board attention or a supervisory recommendation. The FDIC also downgraded Signature Bank’s liquidity rating at the conclusion of the 2019 examination cycle. In September 2022, Signature Bank stated that it was implementing reforms that management believed would resolve liquidity concerns, but the FDIC was drafting a Supervisory Letter stating that Signature had failed to adequately address such concerns.

The weekend of March 10, 2023 introduced unfavorable conditions with the failure of SVB and Signature Bank as depositors rapidly withdrew funds. The NYDFS, in its report, identified various improvements to make in its bank supervisory process in response to these events.

FRB and DFPI: SVB reports

On April 28, 2023, the FRB released a report regarding its supervision and regulation of SVB as well as redacted versions of select supervisory materials issued to SVB in recent years. On May 8, 2023, the DFPI followed with a report on its own review of DFPI’s oversight and regulation of SVB based on a comprehensive review of circumstances including confidential supervisory information about SVB. The FRB and DFPI examined the various factors that contributed to the failure of SVB and reviewed their respective involvement with SVB’s ultimate failure.

The FRB explored its role as the primary federal regulator of both SVB and its holding company. The report found four key factors that contributed to SVB’s failure: (1) SVB’s board of directors and management failed to manage risks; (2) FRB exam staff did not appreciate SVB’s vulnerabilities as it grew rapidly in size and complexity; (3) when vulnerabilities were identified, examiners did not take prompt and sufficient action to ensure SVB remedied problems timely; and (4) the FRB’s shifting supervisory policy after the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), which resulted in reduced standards, increased complexity, and a less assertive supervisory approach response to banks of SVB’s size.

The FRB report identified that the Board of Directors of SVB did not receive adequate information from management about the risks to SVB. SVB had failed its own internal liquidity stress tests and focused on short-term profits. In response, SVB altered its approach to measuring and documenting risks instead of addressing those underlying risks.

FRB examiners also did not respond quickly to deficiencies in SVB’s governance, liquidity, and interest rate risk management. They continued giving high marks to SVB even as SVB’s conditions deteriorated. Additionally, the transition period for SVB to meet higher regulation standards for big banks remained prolonged and the new supervisory team needed significantly more time to make initial assessments. The end effect was that SVB was in a more vulnerable position than even its examiners or Board of Directors may have understood. 

Along similar lines, the DFPI found that (1) SVB was slow to remediate deficiencies identified by regulators and, in turn, regulators’ observations did not adequately or quickly resolve SVB’s problems, (2) SVB’s rapid growth was not appropriately accounted for in risk assessments, (3) SVB’s concentration and level of uninsured deposits contributed to the run on SVB, and (4) digital banking technology and social media escalated the run on SVB, in both volume and speed. DFPI concurrently identified subsequent steps for itself in its role as supervisor, including further coordination with federal regulators, review of its internal staffing process, increased monitoring and examination regarding uninsured deposits, and requiring banks to consider how to manage risks posed by technology-enabled activities.

GAO: Banking crisis report

The United States Government Accountability Office (GAO) also released a report on April 28, 2023. The GAO similarly found that risky business strategies with weak liquidity and risk management contributed to the ultimate failures of SVB and Signature Bank. Both banks’ rapid growth indicated a degree of risk as the banks came to rely on large concentrated deposits in their growth. Inadequate risk management in the face of rising interest rates and exposure to the digital assets industry ultimately led to the bank failures.

The GAO reminds the public that in 2011, it urged federal regulators to consider adding noncapital triggers to their framework for prompt corrective action to provide more advance warning of deteriorating bank conditions in escalating supervisory concerns. These noncapital triggers have not been added, and GAO considers this a missed opportunity.

Implications of these Events and Reports Going Forward for Financial Institutions:

1. Financial Sector M&A Considerations:

The consistent messages of these reports and the warning signals they send to financial institutions ought to be carefully considered when engaging in due diligence of other financial institutions in connection with M&A opportunities, particularly considering the potential focus on these issues by regulators throughout the regulatory approval process. Among other things, the potential acquirer should:

• Ensure that any proposed acquisition considers “compliance by design” as part of its post-merger integration strategy. If product lines are integrated more quickly than the acquiring institution’s compliance functions, rapid growth by acquisition can be become a textbook case of compliance failing to keep up with product growth;

• Perform independent stress testing and evaluation of long-term, low-interest assets or, at the very least, review the target institution’s analyses of those metrics;

• Review carefully the deposit concentration and liquidity risk management of the target institution;

• Review how or whether the target institution:

  • is focused on short-term profits and protection from potential rate decreases;

  • has a consistent interest rate hedging strategy or has had a recent change in strategy; or

  • historically has responded in the face of interest rate or other risk, including whether it moved the goal posts by altering its risk-management assumptions to minimize how these risks appear or whether it has done root-cause analysis to identify and address the underlying risks;

• Review, to the extent possible taking into account of restrictions on sharing of confidential supervisory information, the number and nature of open supervisory actions the target institution has, both on the safety and soundness and compliance sides;

• Not place too much reliance on the lack of public regulatory enforcement actions for the target, because this does not mean that there are not issues – it could mean that there are supervisory actions that are nonpublic and confidential, or possibly that regulators are understaffed or may be engaging in “grade inflation” when it comes to supervision; and

• Anticipate the value of commercial real estate portfolios

  • Many warning signs are present for financial institutions with significant investments tied to commercial real estate, which make up around a quarter of an average bank’s assets.

  • Rising interests rates mean falling property values that will leave commercial properties underwater and susceptible to default, especially to the extent that they are not producing sufficient rental revenue.

2. Litigation Ramifications:

In the aftermath of these bank closures, there is the possibility for litigation by shareholders and regulators regarding compensation of executives and Board members at these institutions and whether governance exercised by the Board was sufficient. Banking and publicly-traded institutions should take note regarding risks associated with rapidly-changing market conditions and whether management and the Board are sufficiently prepared and informed to govern in a way that will get the benefit of the business judgment rule.

The recent reports made by U.S. state and federal regulators do recognize the exogenous forces that put extraordinary pressure on these banks and could be used to defend against claims of mismanagement at the banks. For instance, the FRB’s report regarding SVB criticized SVB’s FRB examiners as addled by confirmation bias:

“Overall, the supervisory approach at Silicon Valley Bank was too deliberative and focused on the continued accumulation of supporting evidence in a consensus-driven environment. Further, the rating assigned to Silicon Valley Bank as a smaller firm set the default view of the bank as a well-managed firm when a new supervisory team was assigned in 2021 after the firm’s rapid growth. This made downgrades more difficult in practice.”

Boards of Directors should continue to keep written records of their risk management oversight activities and other oversight functions with respect to all aspects of an institution’s business, particularly material changes in strategy, depositor or asset concentrations, and evolving economic environmental factors.

3. Time for Stricter Regulation?

Given the FRB report mentions its shifting supervisory policy after the EGRRCPA, banks that had formerly seen a less stringent approach to stress testing should expect regulatory change or at least additional attention from regulators. 

Regulators may also seek the ability to cite noncapital triggers as alternative bases for taking corrective or other action, which would afford them a great deal more discretion to disregard financial evidence and focus on facts such as depositor characteristics, regional location or branching, and the bank’s strategic plan when considering whether to impose stricter requirements on a bank in order to reduce risk.

4. Scapegoating Crypto?:

A question on which these reports revealed little, if any, consensus is whether and to what extent deposit or other relationships with digital asset and crypto-adjacent industry players may have contributed to these institutions’ collapses. SVB, Silvergate Bank, and Signature Bank all provided banking services to cryptocurrency firms in the form of holding the deposits of, or making loans to, crypto industry companies. Each bank’s level of involvement with crypto firms varied.

The FDIC’s report mentioned that Signature Bank had some lack of understanding of the risk of association and reliance on the digital asset industry for deposits. Yet, the NYDFS report suggested that the role of digital assets in Signature Bank’s failure had more to do with its reputation as a crypto bank and its association with SVB rather than crypto-related risks specifically. In fact, crypto-related deposits accounted for only 18% of Signature’s deposit base. Subsequent statements by NYDFS Superintendent, Adrienne Harris, flatly denied that the decision to close Signature was animated by preference for or against digital assets or crypto. Nevertheless, it may be telling that the Signature Bank assets sold by the FDIC to Flagstar did not include its crypto or crypto-adjacent depositors and those deposits were returned to depositors. While banking regulators previously clarified that banks were “neither prohibited nor discouraged” from banking crypto, banks may be reticent to bank the industry. As with deposit concentrations in any other sector, crypto-adjacent deposits merit enhanced monitoring and testing by banks, investors, and potential deal counterparties.

How can we help?

The recent bank failures have created a plethora of legal implications and potential risks for the financial sector and other industries. Led by our U.S. and UK teams, our global, multi-practice Distressed Bank Task Force provides guidance to those affected by recent incidents and other issues that will arise in connection with them. Have a question? For help navigating the legal implications relating to banks in distress, please visit our Distressed Bank Topic Center for timely, helpful resources; email our Task Force team directly; or reach out to your existing Hogan Lovell’s contact with any questions or concerns.

Authored by Liz Boison, Sara Lenet, Nathan Truong,  and Deb Staudinger.