September 27, 2023
In reports issued by the Federal Reserve Bank on Silicon Valley Bank (SVB) and the FDIC on First Republic Bank (FRB), the Fed and the FDIC noted that the inability of SVB and FRB to fully understand and/or appreciate the impact of their depositor risk and volatility was a contributing factor in their failures.
Depository Institutions are already accustomed to performing due diligence on new and existing customers. That Due Diligence includes collecting and analyzing information for Know Your Customer/Business (KYC/KYB), Bank Secrecy Act/Anti-Money Laundering (BSA/AML), and Office of Foreign Asset Control/Specially Designated National (OFAC/SDN) purposes. In each of the above cases, the institutions and regulators are looking to mitigate the risk that a customer will use the resources of the financial institution for illicit purposes and thereby expose the institution to potential civil and criminal liability and reputational damage.
On the lending side, depository institutions are well-versed in deploying credit rating tools and methodologies. Banks and Credit Unions use FICO, Equifax, and other tools for consumer credit scores and Experian and D&B for business credit scores. Institutions also use internal and external (e.g., Moody’s RiskCalc) models and methodologies to determine a borrower’s probability of default and the institution’s expected loss in the event of that default, commonly known as risk rating the borrower and the facility.
Even though institutions may categorize depositors into broad risk categories based on the deposit product type or other factors, it is rare that financial institutions currently rate risks for individual depositors.
As deposits are the primary source of funds for depository institutions to earn income, it is important that institutions recognize that there are other risks associated with taking deposits. The degree of volatility in a depositor's balances may expose the institution to interest rate and liquidity risks. The ability to accurately assess deposit volatility when used in conjunction with interest rate sensitivity analysis can provide valuable insights to guide the institution’s asset and liability management decisions. Better management of these decisions consequently affects the institution’s income statement and balance sheet.
The best way to assess depositor volatility is to individually “risk rate” each depositor through a quantitative methodology that considers key risk factors to generate a risk rating and score. Like lending related risk models, the selection of the deposit related risk factors and the weight assigned to each factor needs to be based on industry expertise and analysis and requires updating as depositor behaviors and regulatory actions dictate. Artificial Intelligence tools should be deployed to fine-tune the models. Timely alerts and notifications of risk rating, risk factor ratings, and key value changes should happen daily as data is updated in the institution’s core systems.
By individually risk rating each depositor, institutions can see what risk factors are driving deposit volatility and determine which depositors or groups of depositors and their respective balances are likely to pose greater liquidity and interest rate risk to the institution.
It is also important to note that a quantitative risk rating process would not necessarily require an institution to collect more information from a depositor. Institutions could likely use data that they already collect from a digitized Account Opening/Due Diligence process.
A side benefit to individually risk rating depositors is that institutions can consolidate the individual depositor risk ratings into their respective relationship groups to better balance risk/reward in relationship-based pricing decisions. Institutions can also benefit from leveraging the robust data sets that individual ratings provide to look at other factors such as depositor industry classifications, to proactively manage risk, to better understand depositor behaviors, and to cross-sell other products.
U.S. Banks are currently sitting on $558 billion in unrealized losses from their invested deposits. Most banks with unrealized losses have borrowed from the Fed, the Federal Home Loan Banks, or elsewhere at rates higher than they are earning on those investments. They are doing so to shore up their liquidity in lieu of liquidating those investments and realizing losses. For some, they have no choice but to hold on to the investments until they mature or hope that interest rates will moderate. Some banks will be holding those investments for a long time (ten years or longer), and “hope” is not a strategy.
Given the Federal Reserve Bank’s and FDIC’s willingness to admit missed opportunities in its oversight around this area with SVB and FRB, it is likely that the Federal Reserve Bank and FDIC will be taking a much closer look at how institutions are assessing deposit volatility and managing their interest rate and liquidity risks going forward.
