Since the global financial crisis in 2008, banks have significantly improved risk management practices and increased liquidity. Until a couple of months ago, a sudden failure of a large U.S. bank seemed almost impossible. We will discuss the catastrophic collapse of Silicon Valley Bank diving into the timeline of events, the aftermath, how banks manage risks, and practical lessons for investors. Picture: Large Office Building About Silicon Valley Bank (SVB, Ticker: SIVB)Silicon Valley Bank (SVB) was a California-based financial institution centered on providing customized financial solutions to its diverse range of clients, including innovation companies (technology, life science, healthcare), venture capital firms, private equity firms, non-profit organizations, and wealthy individuals. The bank offered a wide range of financial products and services, such as loans, deposits, cash/treasury management, foreign exchange, merchant banking, investment banking, asset management, and private banking. With over two decades of experience in serving the innovation industry, SVB became one of the industry’s leading banks. Prominent borrowers include industry giants such as Pinterest, Shopify, and CrowdStrike Holdings. SVB also owned multiple subsidiaries and affiliates, including but not limited to SVB Financial Group UK Limited, SVB Capital, SVB Leerink, and SVB Private Bank. As of 2022, the bank had $212 billion in assets and $195 billion in liabilities[1]. How did Silicon Valley Bank Fail?Silicon Valley Bank’s problems started in 2020. As the Coronavirus Pandemic continued, SVB’s deposits grew from $62 billion (2019) to $189 billion (2021)[2]. SVB’s acquisition of Boston Private Bank & Trust in June 2021 contributed $9 billion in deposit growth[3]. SVB invested the majority of their deposits in safer long-term (>10 years remaining term) residential and commercial mortgage-backed securities rather than loans. When the Federal Reserve began raising interest rates to combat inflation in 2022, the value of these long-term assets declined. Additionally, their venture capital clients curtailed deposit inflows because of slowing investment activity while other clients experienced higher operational cash burn that drained SVB’s deposits[4]. By the end of the year, SVB borrowed $13 billion from the Federal Home Loan Bank (FHLB), a government agency, to replenish their cash while high interest rates eroded 10% to 15% of their mortgage-backed securities’ value[5]. In early 2023, deposits continued to drain. SVB’s financial situation was dire possessing a limited quantity of liquid short-term investments that could easily sell for minimal losses[6]. On March 8, 2023, SVB announced they sold $21 billion worth of securities with a tax loss of $1.8 billion and a plan to raise $2.25 billion through a stock offering and a partnership with private equity firm General Atlantic to replenish cash[7]. This news sparked a bank run because of concerns about the bank’s financial stability. The following day, SVB clients en masse withdrew $42 billion in deposits leaving SVB with a negative $958 million cash balance[8]; the bank’s shares fell 60%[9].
Unfortunately, about 90% of SVB’s deposits exceeded the $250,000 limit[11] and clients might lose some of their uninsured deposits. Please see Exhibit 1 to see that SVB’s uninsured share of customer deposits was much higher than those at other regional banks. The public also wondered about the safety of having uninsured deposits at their own banks and began withdrawing their funds. On March 12, 2023, in an about-face to shore up confidence in the banking system, the U.S. government announced that the FDIC will cover SVB deposits over $250,000. Also, the U.S. Federal Reserve allowed banks to borrow money from them[12]. SVB reopened as Silicon Valley Bridge Bank[13] on March 13, 2023, but it took several days to restore normal operations. Thirteen days later, on March 26, 2023, First-Citizens Bank & Trust bought Silicon Valley Bridge Bank. Exhibit 1: SVB’s Uninsured Share of Customer Deposit The Aftermath of SVB’s Failure and the 2023 Banking CrisisSVB’s collapse was the worst bank failure in the United States since Washington Mutual's collapse in 2008. Immediately, SVB’s clients felt the impact as funding sources contracted and financial services disruptions set in. Customers, suppliers, investors, and families of SVB’s clients were also affected. These effects then spread broadly into the innovation, venture capital, and private equity industries. SVB’s failure also raised concerns about the stability of large regional banks with similar exposures to the bond market and the innovation industry. Exhibit 2, shows the collapse of many regional bank stock prices as SVB’s sped towards failure. Exhibit 2: Regional Bank Stocks Collapsing Alongside SVB Source: Bloomberg The public, worried about the safety of their funds, also withdrew their money from banks worldwide. Exhibit 3 shows U.S. bank failures by year and total assets to highlight the scale of SVB’s failure. Exhibit 3: Bank Failures by Year and Total Assets Source: The New York Times SVB was not the first bank to collapse. Silvergate Bank, also known as Silvergate Capital, announced its closure two days earlier on March 8, 2023. The bankruptcy of crypto exchange, FTX, a major client, roiled Silvergate. Clients were concerned about the bank’s stability because of its heavy concentration in the struggling cryptocurrency industry and withdrew their deposits[14]. Although not technically considered a failure, Silvergate was forced to close as clients lost confidence and abandoned the bank. On March 12, 2023, two days after SVB failed, Signature Bank failed. Signature was heavily concentrated in serving the cryptocurrency industry and concerned clients stopped working with the bank and withdrew deposits. Credit Suisse, a Swiss bank with a significant presence in the United States, was the fourth bank to fall. The bank had already struggled with losses, scandals, and management changes for several months. Clients withdrew $110 billion Swiss francs in deposits in Q4 2022. Things took a turn for the worse when its largest shareholder, the Saudi National Bank, said on March 15, 2023 that they couldn’t provide Credit Suisse with anymore financial assistance. This led to a sell-off of Credit Suisse stock to a record low. To prevent a collapse, Credit Suisse borrowed $50 billion Swiss francs ($53.7 billion U.S. Dollars) from the Swiss National Bank. That wasn’t enough. Massive deposit withdrawals continued. The Swiss National Bank and Swiss Government brokered a quick deal with close rival UBS to acquire the bank on March 19, 2023[15]. Another U.S. bank, First Republic Bank, specializing in serving the innovation industry and wealthy clients, suffered a significant blow. A considerable portion of its deposits exceeded the $250,000 FDIC coverage limit as shown in Exhibit 1. Following the failures of SVB and Signature Bank, many customers of First Republic who held uninsured funds became concerned and rushed to withdraw their money. On March 16, 2023, a consortium of eleven banks saved First Republic by depositing $30 billion U.S. dollars into the bank. Unfortunately, the deposits only bought the bank several weeks of reprieve[16]. On May 1, 2023, JPMorgan Chase acquired First Republic Bank, marking the fifth bank collapse in the ongoing banking crisis. The full extent and duration of the 2023 Banking Crisis on the United States’ financial stability and economic growth is still unknown. The Federal Reserve continues to battle inflation with steady increases in interest rates. Broader financial markets, including banks, stocks, bonds, and credit, continue to face increased uncertainty, volatility, and risk aversion. The public continues to be on edge wondering which industries and banks will become the next flash point. Who is to Blame for SVB’s Failure?
SVB’s failure might have been preventable had their regulators and their risk management team identified and mitigated emerging risks quickly. As a result, the bank operated in an unsafe and unsound manner, until it was too late to save it. Banking Industry RisksBanks and Their Role The concept of banking has been around for centuries. Long ago, traders and merchants used temples and palaces as safe places to store their money and valuables. A bank is a financial institution that provides a range of products and services, the most prominent being accepting deposits and lending money. However, banking is risky because banks lend out most of their deposits as loans and keep little of it in reserve. This is called fractional reserve banking. Banks are crucial to the economy because their loans stimulate economic activity and growth. Major Banking RisksBanks face six major risks: Source: Palm Street Consulting LLC Concentration risk, which is the risk of having a large exposure to a single sector or customer type, was SVB’s bane. This is a common risk for all businesses and not unique to banks. SVB had a high concentration in the innovation (technology, life science, healthcare), venture capital, and private equity industries on both sides of their balance sheet. In terms assets, SVB issued loans to their workers and companies, especially early-stage companies that were often unprofitable and risky. On the liability side, SVB received deposits from these workers and companies as well. The Coronavirus Pandemic supercharged these industries’ growth from 2020 to 2021 increasing SVB’s deposit and loan portfolio growth. But growth stalled and reversed in 2022 and 2023. Then SVB’s loan growth slowed and deposits shrank. The second risk, interest rate risk, is when interest rate changes affect the bank's profitability and solvency. In terms of profitability, banks earn the positive difference between interest income (loans, securities, investments) and interest expenses (deposits, debt). A rising interest rate environment reduces a bank’s profit. Banks typically hold long-term fixed-rate assets that don’t produce additional income, while holding short-term variable-rate liabilities that raises interest expense. In terms of solvency, a rising interest rate reduces a bank’s value. It drops the value of long-term fixed-rate assets dramatically and raises the value of short-term variable-rate liabilities modestly. Therefore, a rising interest rate environment could force a bank to raise money to maintain a healthy positive margin between assets and liabilities. Higher interest rates also change borrower and depositor behavior. Borrowers curtail their borrowing and depositors save money. These actions assume that only interest rates change and all banks offer competitive loan and savings interest rates. Liquidity risk, the third risk, is not having enough cash or liquid assets to meet current obligations, such as client withdrawals. SVB had a high liquidity risk because of their dependence on deposits as a primary source of funding. In 2022 and 2023, SVB's clients faced financial difficulties. Borrowers struggled to repay their loans or borrowed more. Depositors withdrew their money to cover expenses or invested in other opportunities. As a result, SVB experienced a liquidity squeeze, meaning that the demand for cash was so great that the bank had to sell assets at a loss or borrow from high-cost sources to access cash quickly. When SVB depositors heard about the liquidity squeeze, they panicked and withdrew $42 billion in two days[17], causing the bank to fail. Maturity mismatch risk, the fourth risk, is when the difference in the remaining contractual term of a bank’s assets and liabilities amplifies interest rate and liquidity risks. Most banks face this risk because they typically hold long-term fixed-rate assets and short-term variable-rate liabilities. As the maturity gap between a bank’s assets and liabilities grows, interest rate changes have an outsized impact on net interest income and net asset value. In terms of liquidity risk, a large maturity gap increases the sudden risk of not having enough cash to pay depositors (money is locked up) or taking substantial losses desperately selling long-term assets. 57% of SVB loan portfolio was invested in short-term variable-rate loans to the venture capital and private equity industries that matched well with their short-term variable-rate deposits[18]. Ultimately, it was the maturity mismatch of the bank’s larger holdings in fixed-rate long-term residential and commercial mortgage-backed securities that sank SVB. The fifth risk, credit risk, is when the bank experiences loan losses from borrowers defaulting on their loans or failing to meet their repayment obligations. Banks assess the creditworthiness of their clients throughout their relationship and reserve loan loss provisions to cover potential losses. Credit risk can also be present in other bank assets like a securities portfolio. For SVB, exposure to the struggling innovation, venture capital, and private equity industries in their loan portfolio was a major contributor in the public view of the bank’s financial stability. The last risk, regulatory risk, is the impact of laws or regulations affecting bank operations or compliance. Typically, larger banks face stricter rules and regulations that increase operational complexity and costs. SVB may have benefited from the 2018 roll-back of Dodd-Frank laws, which increased the threshold for bank comprehensive stress testing from $50 billion to $250 billion in assets[19]. This meant that SVB was exempt from the enhanced supervision and capital requirements for larger banks. Unfortunately, this also meant that SVB may have under prepared for adverse scenarios compared to their bigger peers. Besides the six risks above, other risks include but are not limited to systemic, economic, operational, legal, financial, strategic, reputational, etc. Another risk dimension is a bank’s business model:
A second risk dimension is a bank’s loan portfolio characteristics:
Other bank assets and liabilities, such as bonds, line of credit, deposits, and other funding sources also share many of these loan characteristics. Identifying and measuring risk is a crucial first step for a bank. SVB, a specialized bank, was concentrated in the innovation, venture capital, and private equity industries that supercharged its growth in 2020 to 2021. When these industries contracted in 2022 and 2023, the bank was hurt. On the asset side, the majority of SVB’s holdings were in fixed-rate long-term residential and commercial mortgage-backed securities that declined in value dramatically with rising interest rates. A smaller portion of their assets was held in a loan portfolio invested in the same industries, which became increasingly vulnerable to credit and liquidity risks. Their liabilities were in mismatched short-term variable-rate deposits that maintained their value and quickly increased interest expenses during a rising interest rate environment. Finally, a reduction in regulatory supervision for SVB seemed beneficial, but ironically, it was another broken levee to protect the bank from failure. Ultimately, a changing environment coupled with increasing risk vulnerabilities bested the bank. How Do Banks Absorb Risk?Besides being able to identify, measure, and plan for risks, banks hold capital, which is the positive difference between their assets and liabilities. Capital acts as a buffer that absorbs losses and ensures that banks can meet their obligations to depositors and creditors. Across countries and regions, regulatory capital requirements vary. The most widely adopted standard is the Basel Accord, or Basel, set by the Basel Committee on Banking Supervision (BCBS). It is an international agreement among central bankers and regulators to harmonize banking rules and promote financial stability. The BCBS issued several frameworks for measuring and managing bank risks, known as Basel I, II, III. The current framework for capital adequacy is Basel III, which was implemented after the 2008 Global Financial Crisis. Basel III boosted the quantity and quality of capital reserves compared to Basel I and II. Under Basel, capital is segregated into Tier 1 and Tier 2. Tier 1 capital is primarily shareholder equity plus retained earnings. This forms the bank’s core capital used to cover losses without disrupting the bank's operations. It also reflects the bank's financial strength and reputation because it tallies total shareholder investment and accumulated profits. Tier 2 capital is subordinated debt and general loan-loss reserves. Compared to Tier 1, this supplementary capital is unreliable, illiquid, and difficult to value. Exhibit 4 highlights the capital structure of a financial institution to show that as a bank becomes insolvent, Tier 1 capital is the first to absorb losses followed by Tier 2 capital. Exhibit 4: Tier 1 and Tier 2 Capital Source: VanEck Basel requires banks to hold both Tier 1 and Tier 2 capital as a percentage of their risk-weighted assets (RWA). These are the bank assets adjusted for risk, such as credit, market, and operational risks. In an RWA calculation, the riskiest assets have the largest impact and weight, they will need more capital to offset their risks. Under Basel III, banks must maintain a minimum capital adequacy ratio of 10.5% of RWA funded predominately with Tier 1 capital. This requirement is higher than those for Basel II. Certain banks are also required to meet additional capital buffers: a countercyclical buffer and/or a higher loss absorbency capacity. New to Basel III, banks must also meet leverage and liquidity ratios. Please see Exhibit 5 for two diagrams of Basel III’s expansive requirements and a list of definitions and formulas. The first diagram explains the capital, leverage, and liquidity requirements, while the second diagram is a breakout of only the capital requirements. Exhibit 5: Basel III Requirements Source: Palm Street Consulting LLC Basel implementation varies across countries and regions. For the example, the European Union (EU) adopted the Basel III framework through the EU Capital Requirements Regulation (CRR) and Directive (CRD IV). However, they modified some of Basel III’s capital definitions and the credit risk framework. The CRR and CRD IV also added rules around banking industry governance and auditing[20]. An enhanced or definitive version of the Basel III framework was completed in 2017 with bank adoption starting in January 2023[21]. Many in the banking industry call it Basel 3.1 or Basel IV. The new framework aims to further increase the quality and quantity of bank capital, reduce variability in RWA calculations, enhance transparency and disclosure, and strengthen supervision. Basel is a good framework and adhering to its principles and rules will improve a bank’s survivability. SVB exceeded Basel III’s minimum capital adequacy ratio of 10.5%. Although the bank was not subject to the countercyclical buffer nor the higher loss absorbency capacity, SVB held close to its equivalent in capital. On December 31, 2022, SVB had $18.38 billion in capital (16.2% of RWA), whereas the minimum capital adequacy was $11.93 billion (10.5% of RWA)[22]. The extra capital was not enough to save the bank. Once clients lose trust, few banks can survive a sudden catastrophic bank run. Effective risk management is never as simple as checking boxes, following rules, and reaching a minimum statistic. It must be combined with a robust system for identifying emerging risks and taking decisive action. Risk Management Lessons for Investors Monitoring Risks in the Economy and Banking IndustrySVB's downfall was partly attributed to its failure to foresee and adapt to an evolving economic environment. Investors can anticipate changes in the financial markets by monitoring macroeconomic and industry trends, starting with inflation and the Fed Funds Rate. Inflation’s rapid surge in 2022 and 2023 forced the Federal Reserve to raise the Fed Funds Rate quickly, which impacted other financial market interest rates including U.S. Treasuries, mortgages, and corporate bonds. See Exhibit 6 for a historical chart of the Fed Funds Rate. Higher interest rates eroded the value of long-term bonds that SVB and other banks had purchased during the era of ultra-low, near-zero interest rates in the early stages of the Coronavirus Pandemic. Exhibit 6: Fed Funds Rate Source: Trading Economics Besides watching the Fed Funds Rate, investors can also follow three key banking industry trends: loan performance, asset growth, and loan interest rates. Banking data and statistics can be found in databases and reports compiled by credit rating agencies, central banks, government agencies, industry associations, market data providers, and even directly from banks via their financial statements and investor presentations. Loan performance statistics, such as defaults, past-due, etc., show changes in overall borrower credit quality and economic health. Asset growth statistics break out changes in loan and asset balances into granular detail, for example commercial real estate, consumer credit card, land, business, etc. Loan interest rate trends help investors understand the profitability, market value, and growth expectations of not only the banking industry but also a particular bank's assets and liabilities. Loan interest rates are not as easily observed because much of the information is sourced from private banks in contrast to financial market data, which is sourced from publicly traded assets such as bonds, auto loans, and student loans, etc. Although the financial market and loan interest rates move together, the timing and scale of movements differ across sectors and individual banks. These three trends allow investors to notice struggling asset sectors or even the next credit or concentration risk. Below, you will find a list of data sources investors can use to assess the risks and opportunities in banking and other industries:
Monitoring Risks at Individual BanksMacro-level statistics and insights can help identify many risks but each bank’s risk profile is unique. If the bank is publicly traded, investors must delve into their quarterly (U.S. 10-Q) and annual (U.S. 10-K) financial reports to establish a comprehensive risk profile. Here are a few tips:
Investors in public and private banks can supplement their research by accessing regulatory reports (e.g., FDIC call reports), supervisory ratings (e.g., CAMELS ratings), market data (e.g., credit ratings, bond spreads, stock prices), industry data (e.g., peer comparisons, market share), customer/employee reviews, etc. Information about privately banks is limited. Investors need to be resourceful by seeking other sources, such as executive interviews, industry articles, transaction records, press releases, and lawsuits to ascertain the bank’s performance, culture, and risks. Differences between U.S., Non-U.S., Domestic, and International BanksOne of the key differences between U.S. and non-U.S. banks is their accounting standards. U.S. banks use the U.S. Generally Accepted Accounting Principles (U.S. GAAP), while non-U.S. banks use the International Financial Reporting Standards (IFRS) or their own domestic accounting standards. Most of the world uses U.S. GAAP and IFRS. A detailed comparison between these two major accounting methods is beyond the scope of this article. Examples of some differences[24] include,
U.S. GAAP is rules-based; banks follow a strict set of accounting rules, which makes comparisons between U.S. banks easier. IFRS is principles-based; banks follow accounting principles instead of rules, which allow banks the flexibility to interpret their financial situation and reflect it on their financial reports. This makes comparisons between IFRS banks harder. Comparisons between U.S. and IFRS banks are even harder. The key accounting differences for the banking industry are loan treatment on the balance sheet, interest income, and interest expenses. Second, banks are governed by local, national, and multinational laws and regulations. U.S. domestic banks benefit from a common and stable legal and regulatory framework that provides clear guidance and oversight for their operations than non-U.S. domestic banks. International banks and some non-U.S. domestic banks, for example banks in the European Union, can be subject to several banking minimum standards for capital adequacy, liquidity, leverage, disclosure, supervision, and resolution. Sometimes, conflicting laws and regulations can be a compliance challenge. For example, a British international bank that operates in the European Union has to comply with both British and EU laws and regulations, which may be contradictory. At a minimum, investors should know the bank’s geographic reach and its implications for risk and business operations. If available, investors should carefully review a bank’s financial reports. International banks are exposed to currency risk, which is losses or gains from exchange rate movements. For example, a European bank that has loans in euros and deposits in U.S. dollars. If the euro depreciates against the U.S. dollar, the bank’s asset value drops relative to its liabilities. Hedging, the act of offsetting exchange rate movements through financial arrangements, can reduce currency risk. However, international banks operating primarily in developed countries have less currency risk because their currencies are widely used for international trade and finance. Domestic banks, those that operate in a single country, don’t have significant currency risk. Effective risk management practices are even more important for international banks than it is for domestic banks. The additional layer of various accounting standards, currencies, laws, and regulations provides a greater challenge. The collapse of SVB Bank, a U.S. domestic bank, serves as a cautionary tale for all banks, regardless of their location or regulatory framework. Managing your Investments in the Banking IndustryDespite our best efforts, we might not see the signs of an impending bank or investment collapse. Most diversification advice focuses too narrowly on the concentration risk of a single asset, sector, market, or country using a percentage of total portfolio value threshold. For example, the U.S. Investment Company Act of 1940 mandates that public diversified mutual funds cannot invest over 5% to 25% of their total assets in a single issuer[25]. A static threshold is a primitive risk management practice because it does not consider the additional diversification benefits of mixing assets with different risk profiles and correlations. For example, some large banks may manage interest rate and credit risk better because its risks can be hedged, absorbed through larger capital buffers, or managed with a more experienced team. It may be safer to increase portfolio holdings in these large banks rather than their peers. Another way investors can enhance their portfolio diversification is to limit exposure to the six major banking industry risks. For example, they can cap holdings in banks that have higher than average credit risk using a loan loss reserve to loan balance ratio or liquidity risk using a cash to deposit ratio. Diversification is not always about limiting risk; it can also help investors capture opportunities. When stock prices of specialized banks vulnerable to the innovation and cryptocurrency industries are falling, well-diversified or traditional banks may outperform. In terms of concentration risk alone, investors can enhance their risk mitigation by considering the percentage of total assets invested in a more granular asset or sector breakout. For example, commercial real estate can be divided into property types, such as retail, office, industrial, residential, etc. Even within a property type, investors may further benefit from a deeper breakout by location, tenant, lease terms, etc. Identify unique sub-group risks and consider sub-group correlations with each other and broader asset groups. Diversification is not a panacea. It reduces but does not eliminate all risks, especially systemic or global risks that can be unpredictable and extreme. Many investments are highly correlated during a financial market turmoil, meaning that diversification provides little benefit to the portfolio because these assets prices fall together. Some examples include the 2008 Global Financial Crisis and the Coronavirus Pandemic. Investors need a broad investment plan to tackle these risks. Have a Strong Investing Plan to Counter Systemic and Global RisksSitting above the banking industry portfolio is an investor’s investing plan which outlines their investment goals and strategy. Investors can take the following steps to protect against systemic and global risks:
There is no one-size-fits-all rule for defining or measuring risk. Besides diversifying the banking industry portfolio, investors should review their investing plan to guard against systemic or global risks. By taking these steps, investors can achieve a balance between risk and reward that best suits their needs and goals. How to Invest When the Government Intervenes?Lesson one: Know the governing laws and regulations. This knowledge provides investors with a baseline expectation or status quo of how banks, businesses, and governments function.
Lesson two: Governments can change, bend, or counter existing rules and laws.
Lesson three: Government intervention benefits certain stakeholders over others.
Lesson four: Government intervention may have unintended consequences.
SVB’s failure is one of many U.S. government bailouts in history. In 1998, U.S. hedge fund, Long Term Capital Management (LTCM) almost collapsed. Their investment strategy cratered, while their debt burden increased. Instead of allowing the natural death of LTCM to continue, the Federal Reserve intervened and organized a consortium of financial institutions to purchase the hedge fund for $3.625 billion U.S. dollars. Next, the hedge fund was successfully closed and its assets sold in an orderly manner, protecting the financial markets. The government and participating financial institutions didn’t lose money. LTCM’s investors lost everything. The hedge fund’s bailout leads to the question of whether there are sufficient incentives to deter financial institutions from not only becoming a danger to themselves but also to the financial markets and the public. The 2008 Global Financial Crisis, also known as the Great Recession, demonstrates the government’s commitment to protecting financial markets when financial institutions cannot. The U.S. government bailed out several large financial institutions including the American International Group (AIG), Citigroup (C), and Bank of America (BAC) as they experienced the fallout from the subprime mortgage industry collapse. These institutions were deemed "too big to fail", meaning their failure could cause global financial market disruptions and hurt the public. The bailouts included government purchases of “toxic” or rapidly deteriorating assets, loans to institutions, and purchases of bank preferred shares, which gave the government part ownership and control over some large banks. The bailouts were criticized for creating a moral hazard by rewarding the reckless behavior that held the financial markets and the public hostage. There were several losers. Lehman Brothers and Washington Mutual, two large financial institutions, weren’t rescued; neither were the three hundred plus banks that failed from September 2008 to December 2010[26]. Investors in these failed institutions lost everything. Although financial markets were saved, large financial institutions saved by the government gained market share over their smaller counterparts. This concentration in large financial institutions is bad not only for bank clients and the public who have fewer banking choices, but also for the increased vulnerability of financial markets to their risks. In these examples, the U.S. government prioritized financial market stability, the public, special interests, and specific societal groups. While investors, individuals, and smaller organizations were not protected. Please see Exhibit 7 for our take on the U.S. government’s stakeholder priority and a short diagram on previous crises highlighting which stakeholders benefited from government intervention. Exhibit 7: U.S. Government Intervention: Stakeholder Order of Priority and Beneficiaries Source: Palm Street Consulting LLC With the U.S. government, some stakeholders are better protected than others. Investors should be mindful that every government is different. Learn about a financial institution’s governing laws and rules. Understand how the government intervenes by changing or ignoring established norms and protecting some stakeholders over others. Finally, don’t forget international diversification as another layer of protection against the risk of being at a government’s mercy. ConclusionSVB failed because of a rapidly changing interest rate environment and an exposure to a weak innovation, venture capital, and private equity industries, compounded by the bank and regulator’s inadequate risk management practices. The final nail was the massive deposit withdrawals from panicked borrowers. The continuing 2023 Banking Crisis reminds investors about following macroeconomic and banking industry risks, evaluating a bank’s risk management practices, monitoring for potential government intervention, and having a diversified investment portfolio. Banks are built on risk, but sometimes they fail. Don’t let their failure stop your investing journey. Footnotes [1] Silicon Valley Bank 10-K Annual Report, 2022, pg 95. [2] Silicon Valley Bank 10-K Annual Report, 2019, pg 96; Silicon Valley Bank 10-K Annual Report, 2021, pg 98. [3] https://www.mass.gov/decision/merger-of-boston-private-bank-trust-company-and-silicon-valley-bank [4] Silicon Valley Bank Earnings Presentation 4Q 2022, pg 10, https://s201.q4cdn.com/589201576/files/doc_financials/2022/q4/Q4_2022_IR_Presentation_vFINAL.pdf [5] Silicon Valley Bank 10-K Annual Report, 2022, pg 125, unrealized losses divided by amortized cost [6] Silicon Valley Bank 10-K Annual Report, 2022, pg 64-65; https://www.bloomberg.com/news/articles/2023-03-10/svb-spectacularly-fails-after-unthinkable-heresy-becomes-reality [7] https://www.prnewswire.com/news-releases/svb-financial-group-announces-proposed-offerings-of-common-stock-and-mandatory-convertible-preferred-stock-301766247.html [8] https://fortune.com/2023/03/11/silicon-valley-bank-run-42-billion-attempted-withdrawals-in-one-day/ [9] Yahoo Finance, SIVBQ adjusted close price March 8, 2023 to March 9, 2023. [10] https://www.fdic.gov/news/press-releases/2023/pr23016.html [11] https://www.usnews.com/news/national-news/articles/2023-03-12/feds-step-in-with-emergency-funds-say-all-svb-deposits-to-be-available-monday [12] https://www.npr.org/2023/03/12/1162975615/the-u-s-takes-emergency-measures-to-protect-all-deposits-at-silicon-valley-bank [13] https://www.fdic.gov/news/press-releases/2023/pr23019.html [14] https://www.cnbc.com/2023/03/08/silvergate-shutting-down-operations-and-liquidating-bank.html [15] https://www.swissinfo.ch/eng/business/where-did-it-all-go-wrong-for-credit-suisse-/48269536; https://www.swissinfo.ch/eng/business/credit-suisse-reports-chf60bn-of-client-withdrawals/48457372 [16] https://edition.cnn.com/2023/03/16/investing/first-republic-bank/index.html [17] https://fortune.com/2023/03/11/silicon-valley-bank-run-42-billion-attempted-withdrawals-in-one-day/ [18] Silicon Valley Bank 10-K Annual Report, 2022, pg 73. [19] https://abcnews.go.com/Politics/trump-era-rollback-bank-rules-after-silicon-valley/story?id=97852603 [20] https://en.wikipedia.org/wiki/Capital_Requirements_Regulation_2013; https://economyandfinanceforum.com/2022/08/02/banking-regulations-basel-iii-crd-iv/ [21] https://www.project-syndicate.org/commentary/basel-committee-new-capital-adequacy-rules-by-howard-davies-2017-12 [22] Silicon Valley Bank 10-K Annual Report, 2022, pg 166. [23] Silicon Valley Bank 10-K Annual Report, 2022, pg 65. [24] https://corporatefinanceinstitute.com/resources/accounting/ifrs-vs-us-gaap/; https://www2.deloitte.com/us/en/pages/audit/articles/us-aers-a-comparison-of-ifrs-standards-and-us-gaap-bridging-the-differences.html [25] https://www.sec.gov/files/staff-report-threshold-limits-diversified-funds.pdf, pg 2. [26] https://www.fdic.gov/resources/resolutions/bank-failures/failed-bank-list/ AuthorsDilantha De Silva, Primary Contributor
Adrian Wong, Contributor
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Uncontrollable inflation – or hyperinflation, as economists call it, is one of the worst economic scenarios because it destroys a country’s standard of living. Although inflation might sound easy-to-understand, as investors, it is imperative to not only deepen our understanding of the concept but also its specific economic implications to help us make well-informed, data-driven investment decisions. What Is Inflation?Inflation is an increase in the level of general prices. As prices rise, each dollar buys fewer goods and services, in other words, your purchasing power has declined. This weakening of purchasing power increases the cost of living, slowing economic growth as consumers cut spending. Inflation comes in two forms:
Exhibit 1: An Illustration of Demand-Pull Inflation Source: einvestingforbeginners.com Cost-push inflation occurs when prices of products and services increase sharply because of an uncontrollable uptick in inputs prices caused by issues with production. Some examples are supply chain disruptions, or input/labor shortages. Exhibit 2: An Illustration of Cost-Push Inflation Source: einvestingforbeginners.com Today’s rising inflationary environment is a classic example of two-pronged inflation, demand-pull and cost-push inflation together. Over the last couple of years, demand-pull inflation has pushed prices higher as the government’s money printing and coronavirus pandemic lockdowns resulted in record levels of personal savings in the United States, giving consumers the financial means to spend on discretionary items. Making matters worse, cost-push inflation from supply-chain challenges and labor shortages has resulted in higher inputs costs for many goods and services. How Is Inflation Calculated?The Consumer Price Index (CPI), the most widely used measure of inflation, calculates the percentage change in the price of a basket of 80,000 commonly purchased goods and services each month. Some examples of goods and services tracked include milk, coffee, clothing, furniture, medical expenses, transportation expenses, cost of housing, and others. See Exhibit 3 for recent inflation data and Exhibit 4 for the declining purchasing power of consumer dollars. First, The Bureau of Labor Statistics (BLS) collects spending data from U.S. consumers via the Consumer Expenditures Survey. Next, the BLS determines which goods and services to track and their associated weights based on their necessity for the average consumer. The CPI can help us calculate the inflation rate between two time periods. For example, if you want to calculate the inflation rate from Jan. 2021 to Jan. 2022, collect the CPI values from the Bureau of Labor Statistics Portal for those two months. For Jan. 2021, the CPI value was 261.582, and for Jan. 2022, the CPI value was 281.148. Calculate the inflation rate using the below formula: Inflation rate = (Current period CPI − Prior period CPI)/Prior period CPI *100 (281.148-261.582)/261.582 * 100 = 7.48% Exhibit 3: The U.S Inflation Rate (Jan. 2020 – Dec. 2022) Source: Statista Exhibit 4: Purchasing Power of the Consumer Dollar in U.S. Cities (Jan. 2000 - Dec. 2022) Source: Federal Reserve The Personal Consumption Expenditure (PCE) Index, maintained by the Bureau of Economic Analysis (BEA), is another inflation measure. The BEA differs from the CPI in several areas. First, consumer goods and services prices are sourced from businesses. Second, the PCE Index includes indirect expenses, such as health care premiums, employer-provided insurance, and Medicare. Third, the PCE Index’s item weights are different and more dynamic, helping it to better track price changes in the country. See Exhibit 5 for a comparison between CPI and PCE Index weights. The Federal Reserve favors a stripped-down version of the PCE Index called the Core PCE Index, which excludes food and energy prices, as its best measure of inflation in the United States. Exhibit 5: CPI and PCE Index Weights Comparison Source: www.brookings.edu Most economies are experiencing high inflation in 2022. The annual U.S. inflation rate, as measured by the CPI, has risen from 1.8% in 2019 to a high of 8.5% in 2022, implying that the purchasing power of the U.S. dollar has declined. With consumer prices rising over 8%, a recent Census’ Household Pulse Survey revealed that inflation is affecting spending patterns and consumer psychology. A survey of 51,000 households conducted from September 14 to 26 found that 20% of households had reduced or eliminated spending on basic household necessities, such as medicine or food, to pay an energy bill. However, falling prices, also known as deflation, is more serious. While high inflation can stifle the economy by reducing the purchasing power of consumers and business activity, deflation also causes serious economic damage. During a deflationary period, the value of the dollar rises, giving consumers an incentive to delay purchases for a better deal because they expect prices to fall. As consumers stop spending and hoard money, the monetary supply in the economy contracts and businesses lower prices. This can become a negative feedback loop leading to an economic depression. In addition, deflation raises the real value of debt, which forces consumers and businesses to spend and invest cautiously. Achieving the right level of inflation is critical to encourage business and consumer spending growth. How Does the Government Keep Inflation Down? Inflation, if left unchecked, has the potential to strengthen into hyperinflation, a phenomenon where prices rise uncontrollably. As inflation continues to rise, people react by spending their money instead of saving because they expect the price of goods and services to skyrocket. As a result, demand for goods and services will continue to outpace supply, leading to a vicious upward spiral of higher prices, production costs, and unemployment. A country’s central bank attempts to keep inflation in check through monetary policy, managing the size and growth of money supply. The most common tool to combat inflation is to adopt a contractionary monetary policy stance. The central bank will reduce the money supply within an economy by raising interest rates and selling government bonds, reducing consumer and business spending. In the United States, the Federal Reserve’s job is to achieve stable prices and maximum employment. Following the 2020 health and financial crisis, the Federal Reserve (the Fed) kept interest rates (through the Fed Funds Rate) near zero for over two years and pursued a bond-buying program. Critics claimed this massive expansion in money supply (expansionary monetary policy stance) would cause inflation to spike. The Fed Funds Rate has not been near zero since the 2008 financial crisis. After reaching a trough of zero in May 2020, the inflation rate has steadily climbed, surpassing 7% by February 2022. In March 2022, the Fed began cutting the money supply by raising interest rates and scaling back their bond-buying program. Unfortunately, inflation reached 40-year highs in the second quarter of 2022, which pushed the Fed to accelerate the pace of interest rate hikes. Jerome Powell and his team have raised interest rates seven times in 2022, and have promised to keep rates high to taper economy growth and contain the worst inflation in 40 years. As of December 2022, the Fed Funds Rate was 4.50%. For reference, the highest Fed Funds Rate was 20% in 1980, when the Fed had to induce an economic recession to curb inflation. When Is Inflation Too High? In theory, advanced economies should have no inflation. Modest inflation is beneficial for keeping the economy growing. U.S. policymakers try to keep inflation in a sweet spot between 1% to 2% per year. Many countries have experienced high inflation, but cases of hyperinflation are rare. The informal definition of hyperinflation is a monthly inflation rate exceeding 50%. Zimbabwe is a classic example of a country that has grappled with hyperinflation recently. According to the IMF, Zimbabwe in 2008 experienced one of the worst cases of hyperinflation in global history, with an estimated annual inflation rate reaching 500 billion percent at its peak. The country was forced to abandon its national currency in 2009 to reduce inflation. Another dramatic case of hyperinflation includes Hungary topping the list with a 195% daily inflation in 1946. However, World War I and II had a fair share of countries dealing with high inflation, which is understandable when they were recovering from military and economic destruction. During the American Civil War, the United States came dangerously close to hyperinflation as well, but it never exceeded a 50% monthly inflation rate. What Happens to Stocks and Investments if Inflation is Left Unchecked?High inflation reduces consumer spending, hurting investment returns. However, inflation sensitivity differs by asset class. For fixed-income securities like bonds and treasuries, rising inflation reduces the purchasing power of their current and future interest and principal payments. TIPS, or treasury inflation-protected securities, can help combat inflation. Their principal is indexed to inflation and future interest payments are calculated using the inflation-adjusted principal. In terms of stocks, Fisher (1930) proposed a theory that stock prices should rise in tandem with inflation. However, Lintner (1975), Bodie (1976), and Fama (1981) found a negative relationship between stock price and inflation. While Fama (1981), Geske and Roll (1983), and Kaul (1987) studies show a negative relationship between stock price and expected inflation. The extent to which prices fall or rise during inflation varies by industry and company size. Exhibit 6 shows that stocks, despite inflation’s detrimental impact, have a positive inflation-adjusted long-term performance. This makes sense because companies must out earn inflation to stay in business. Exhibit 6: Inflation-Adjusted Performance of Asset Classes Source: A Wealth of Common Sense; Note: Shaded periods are negative returns. Real assets like commodities and real estate typically are positively correlated with inflation (Exhibit 7). Real estate investment trusts (REITs) – which approximate the performance of real estate investments - and commodities are less sensitive to inflation while gold’s performance has been unpredictable. However, these assets have offered lower total returns than stocks in the long run (Exhibit 6), and real assets also carry liquidation risks, as these investments cannot be cashed easily or effectively. Exhibit 7: Annualized Returns of Different Real Assets During Inflationary Periods Source: Visual Capitalist During Inflationary Times, Do Growth or Value Stocks Outperform and What About Contrarian Investing?There are two primary stock investing strategies: value and growth. Value stocks are shares of companies that have limited growth potential. Instead, they have strong cash flow, which allows them to pay cash dividends. Growth stocks are shares of companies that are expected to grow rapidly. Their stock price reflects potential earnings. Value stocks are more appealing during an inflationary period. Their strong cash flow provides certainty and they frequently trade at low price-to-earnings (P/E) ratios. Investors usually avoid growth stocks when inflation rises because higher input costs weigh on growth companies' cash flow and expected profitability. Most businesses struggle to pass higher costs onto customers and investors lose faith in these companies. It also doesn’t help that growth stocks frequently trade at high P/E ratios. However, not all stocks respond in the same way. Investors should have a long-term view on investment return expectations by holding a diversified portfolio that includes both growth and value stocks. Diversification is crucial to limit losses during an inflationary period. Contrarian investing is an investment strategy in which investors purposefully invest against the market by selling when most investors are buying and buying when most investors are selling, mimicking the strategy of one of the most famous contrarian investors, Warren Buffett. "Be fearful when others are greedy and be greedy when others are fearful." - Warren Buffett With most inflation-protected stocks, such as consumer staples and utilities already trading at elevated valuations, your investment portfolio is likely taking a beating in the current economic climate. Before making any rash decisions, it is critical to assess the market, potential investments, investment objectives, and investment time horizons. Following a contrarian approach and buying inflation-affected stocks/investments may be successful in the long run, but finding a company that is unfairly discounted with the potential for significant long-term returns could feel like finding a needle in the haystack today. Contrarian investors, like value investors, typically look for undervalued stocks, but the latter believes the market responds to positive or negative economic or company-specific events efficiently. Contrarian investors, on the contrary, believe that markets are inefficient. They are ready to hold their investments for a prolonged period to generate alpha returns when the market raises their undervalued stocks to market value. If you are an investor with an extensive investment time horizon, it would be a good idea to look into the beaten-down tech sector to find companies that are unduly punished amid inflationary pressures. Inflation is unlikely to hamper the long-term earnings potential of many of these tech companies, but investors should tread cautiously to avoid value traps, cheap stocks that have a poor prognosis. Takeaway Inflation has been a hot topic and for good reason. People frequently sell their investments and hide their money in cash during inflationary periods because they don’t understand how inflation affects investments. While different asset classes respond differently, leaving your money idle or ignoring your investments may put your savings at risk and deprive you of long-term investment returns. During these difficult economic times, invest for the long term and diversify your portfolio by including stocks, bonds, and real assets. Although diversification cannot guarantee short-term returns, it can limit inflation’s impact on your portfolio, which should create an excellent platform to enjoy lucrative investment returns when inflation normalizes – it always does. AuthorsDilantha De Silva, Primary Contributor
Adrian Wong, Contributor
Welcome to Palm Street Consulting LLC’s The Wall Street Basement investing blog!
We are an investor education company, sharing our knowledge and insights to help investors succeed. Palm Street began operations in 2020 as a financial risk consulting company helping small and medium banks implement a new accounting standard, Current Expected Credit Loss (CECL). As the industry completed CECL implementation, the company transitioned into the investor education business in 2022. Our first article about investing in an inflationary environment will be published soon! In the meantime, please browse our website to learn more about our services or even read some of our old articles about CECL. I was the “CECL guy” at my bank. In 2017, I was searching for the right Current Expected Credit Loss (CECL) vendor. I listed as many vendors as I could find, read countless articles, and attended scores of webinars. That summer, I attended a vendor-hosted full-day CECL seminar to learn about potential methodologies and how to comply with the accounting standard’s finer details. The seminar was an avenue for the vendors to introduce their products and services. Toward the end, they showed their CECL platform capabilities: importing bank data, ease of use, portfolio analytics, reporting capabilities, and the range of calculations available. I usually shunned sales presentations, but my bank needed a vendor and it was a great opportunity to learn more about the accounting standard. I was also a big fan of leaving the office for free coffee and food. Despite everything I learned about CECL from the seminar, I treasured the informal conversations I had with fellow bankers during session breaks more. Like a circle of old friends opening up about their experiences in high school, we voiced our anxieties and stress, ranging from our unfamiliarity with the accounting standard, the limited time and resources for implementation, and the pros and cons of each vendor we considered. Unfortunately, before our conversations concluded, vendor representatives squeezed into our circle. Opportunities to continue the conversations later in the seminar were limited by a busy seminar schedule. After the vendor seminar, I reconnected with many of those bankers at future seminars and we benefited from each other’s experiences. Financial institutions like my bank, who were part of the 2020 wave of CECL implementations, faced the tough task of sifting through countless vendors. New CECL vendors seemed to launch every month. Every vendor marketed their expertise and their ability to provide everything as a one-stop shop. If the standard hasn’t been implemented and audited, how can a person or company be a CECL expert?! Picking a vendor was daunting. Do I need a vendor?Before we talk about selecting a vendor, we must determine if vendors are essential for CECL implementation. According to the Financial Accounting Standards Board (FASB) in 2016, the accounting standard was crafted so that institutions can comply by enhancing their existing methodology. However, that statement makes two critical assumptions about what institutions have:
For the first point, most institutions lack the CECL knowledge to upgrade their existing methodology to be compliant. This reality drives institutions to hire vendors. However, this doesn’t mean institutions can’t form a CECL task force instead to gain the knowledge. Regarding the second assumption, institutions have everyday responsibilities and initiatives that compete for their time and resources. Implementing CECL is a sizable commitment and a major distraction for most financial institutions’ goal of maximizing profitability. This mismatch can lead to lean staff counts and prioritizing more profitable initiatives, which severely constricts an institution’s CECL implementation capacity. These challenges contributed toward the feelings of fear, pressure, and uncertainty for CECL teams at institutions that implemented CECL for 2020 (first wave). CECL vendors compounded the pressure in the industry by driving the grim narrative that financial institutions are behind schedule and institutions underestimate the efforts required. Yet CECL vendors struggled to finish product development and solutions. Fortunately, financial institutions implementing CECL today for 2023 (second wave) will benefit from the industry’s first wave experience. Most first wave institutions have successfully transitioned to CECL on January 1, 2020. Remaining first wave institutions received a reprieve through the CARES Act and the Consolidated Appropriations Act in response to the coronavirus pandemic. These acts impact publicly traded entities* by delaying the standard’s effective date to the earlier date of:
The operational disruption caused by the coronavirus pandemic has also robbed second wave institutions of implementation opportunities. Whether a vendor is needed depends on institutional readiness:
Each institution is unique. The largest institutions may have the organizational resources, but are bogged down by deep layers of management, complex operational processes, and a wide range of financial instruments. On the other side, the smallest institutions may have simple processes and a single loan type, but are marred by a lack of organizational resources and early preparation. Before exploring whether a vendor is essential to the success of your institution’s CECL implementation, we need to understand the different CECL vendor types, how to prepare for implementation, and how to determine your implementation needs. If hiring a vendor is the best approach, the last half of this article will provide a vendor due diligence overview, tips to improve decision making, and a case study on the importance of a thorough due diligence. Vendors TypesIt’s easy to lump all CECL vendors into a homogenous pool. However, there are four vendor types. Service vendors specialize in accounting or consulting services. Product vendors sell models or platforms subscriptions. Let’s explore the four vendor types in greater detail. Accounting vendors are generally medium to large firms that provide services focused on accounting standards, audit, internal controls, financial reporting, and model validation. Many can’t mix audit, implementation, and validation services for a single client because of efforts to limit conflicts of interest. A prospective client will need to hire additional vendors to complete some tasks. Accounting vendors provide client-tailored implementation services that can be expensive. However, they rarely offer CECL product subscriptions, such as software platforms, pre-built models, data, or forecasts. They may build a custom product for your institution or recommend hiring a CECL product vendor to cover some of your needs. Clients who are willing and able can hire these premier CECL vendors with peace of mind. Depending on the solution implemented, your institution may need ongoing support for model/methodology updates at an additional cost. They charge by project or engagement. Examples of these vendors include KPMG, PwC, Deloitte, BDO, RSM, Wolf & Company, Grant Thornton, and Crowe. Consulting vendors are like accounting vendors but with three key differences. First, they don’t provide auditing services. Second, they are smaller, more affordable, and less prestigious. Third, they limit their focus to one or more of the following CECL services: assessing, implementation, documentation, and model validation. A minority of consulting vendors offer subscriptions to software platforms, pre-built models, data, or forecasts. These products can be developed in-house or in a partnership with other CECL vendors. For their efforts, consulting vendors bill clients by project or engagement. However, if product subscriptions are included, you may need to pay a recurring subscription cost and an implementation fee. Depending on their recommendation, your institution may need ongoing support for model/methodology updates for an additional cost. Institutions looking for a lower cost alternative to accounting vendors should consider hiring consulting vendors. However, each consulting vendor is unique in their offerings and capabilities. Extra time is needed to evaluate their suitability for your CECL needs. Examples of consulting vendors include MossAdams, Ardmore Advisors, MountainView Financial Solutions, FI Consulting, and Darling Consulting. Model vendors sell pre-built model and forecast subscriptions. They generally develop their products using proprietary data and calculations. Clients must upload their loans, securities, and credit risk data into a vendor software platform that houses the products. Their platforms likely include a suite of analytical tools, automation functions, reports, and audit features. A platform and product implementation fee (data linkage and user configuration) will typically be charged. A model vendor’s implementation may involve scaling or adjusting model results to your institution, peer institutions, financial instrument, or geographic credit loss experience. This is because vendors usually build their models from broad industry data. Product subscription fees are based on your institution’s portfolio size. However, questions and answers access to technical experts is typically provided to clients at no cost. These vendors often sell independent subscriptions to proprietary databases and custom forecasts/scenarios for clients who may want to build their own models or customize their solutions further. A model vendor’s base subscription fee is typically more expensive than hiring a platform vendor (we will discuss them next). Model vendors own development, maintenance, updates, and documentation for their platforms, models, and forecasts. Clients looking for a premium methodology solution should consider model vendors, who are credit loss modeling and forecasting experts. Institutions are still responsible for implementation, data, controls, and documentation outside the model vendor’s product responsibilities. Model vendors are typically large companies selling CECL products as an add-on to their primary business. However, some of these vendors only focus on specific asset classes. Examples of model vendors are Moody’s Analytics, S&P Global, Trepp, and CoStar Risk Analytics. Platform vendors sell software platform subscriptions that provide data organization, calculation engines, process automation, audit tools, analytics, and reporting capabilities. These vendors may call a CECL platform a solution and its calculation engine a model. A platform is a tool to help build a CECL solution, not a solution in itself. Calculation engines such as PD / LGD, vintage, roll rate, and discounted cash flow can be called models, but they aren’t a solution without the ability to provide a forward-looking life of loan/instrument estimate. A CECL-compliant model typically satisfies the forward-looking component by integrating independent variables (usually economic or industry data) and/or forecasts. Their basic value proposition is to provide clients with the products to implement CECL themselves. Similar to model vendors, they charge a product implementation fee for initial training, data linkage, and user configuration. Their recurring subscription fee is typically based on portfolio size. Consulting services such as methodology design, modeling, validation, and implementation are an extra expense. More recently, platform vendors have offered subscriptions to models, forecasts/scenarios, or proprietary data; however, some have provided publicly available economic or industry data for their clients to use at no additional cost. For clients, they may provide experts to field questions at no cost. These vendors may be more affordable than other CECL vendors, but institutions should be careful to consider not only the platform cost but also additional products and consulting services that may be needed to implement CECL. Examples of these vendors include Abrigo, SS&C Primatics, Wolters Kluwer, and Jack Henry & Associates. In summary, service vendors are more flexible because they are less likely to be anchored by a CECL product. They can be hired for broad functions, such as customized solutions and project management. Or they can perform ad hoc and piecemeal services, such as assessing CECL readiness, vendor selection, economic forecast methodology design, and methodology documentation. An institution should hire a service vendor if they want to retool existing systems and processes, own a customized solution, or need experts to address specific knowledge gaps. Using existing capabilities can reduce implementation time and operational disruptions. During the first wave of CECL implementations, large institutions (>$20 billion in financial assets) who had robust systems, in-house experts, and money were more likely to hire service vendors. Product vendors are better for firms that have rudimentary or no infrastructure. In these cases, it could be prohibitively expensive or time consuming to build from scratch, upgrade, and maintain. Examples of products include models, forecasts, software platforms (data organization, analytics, reports), and data. Institutions must be willing and able to adapt their processes, data, and methodology to utilize the vendor’s product(s). Small and medium institutions without in-house CECL expertise, platforms, models, and forecasts are more likely to hire product vendors. In terms of vendor characteristics, larger CECL vendors are typically more expensive because of their expertise, range of offerings, and abundant organizational resources. However, vendors of all sizes may specialize in certain asset classes, industries, and techniques. Today, the line between service and product vendors has blurred. Many have added services, products, and partnerships with other CECL vendors to offer a comprehensive CECL solution. Regardless of which vendor(s) you hire, your organizational resources, preparation, and commitment are still essential to your implementation completion time and overall success. Identify your resources and needsThe key resource in any CECL effort is your implementation team. Having the right team means having strong cross-functional experts with the time and budget to implement the accounting standard successfully. First, assemble a team with representation from the following areas**:
Identify expertise gaps by considering team member availability (conflicting projects and other responsibilities), skills, and experience. Don’t assume expertise is directly tied to a person’s title, reputation, or years of experience. Make sure each role has a backup because CECL implementation can be arduous and team turnover rate can be high. The executive sponsor helps the team find resources, prioritize the project, and facilitate organizational cooperation. Keep in mind potential gaps in your CECL team and expertise as you consider hiring vendors. Second, select an implementation lead amongst the team who will coordinate in-house experts and departments, make critical decisions, and interface with potential CECL vendors. Leadership skills, subject expertise, CECL knowledge, and availability are essential. The lead will need to obtain CECL knowledge quickly by reading FASB’s CECL rule, attending webinars, and reading literature. Third, a large budget will be helpful but not critical to implementation success. Institutions with the financial means can hire premium vendors and in-house experts to increase implementation success, whereas institutions with limited financial resources might rely solely on a part-time internal implementation team. Regardless of your budget, implementation will always be bottlenecked by the availability of CECL team members who know the organization’s systems, processes, and data. Plan CECL methodology and processesOnce your team is assembled, take an inventory of processes, data, and documentation involved in the current allowance for loan and lease losses (ALLL) methodology and impairment/losses on loans, debt securities, and receivables to prepare for CECL. Please look at the following (not exhaustive list):
Anticipate your CECL needs (not an exhaustive list):
Utilize free CECL resources available from FASB, regulators, journals, and vendors to build your team’s knowledge. Be mindful that each source has their own motivations, agendas, and limitations. After inventorying your current methodology and planning CECL needs, the first step is to narrow down your initial list of suitable methodologies. To be conservative, select methodologies that are close to your existing methodology while considering the complexity added by CECL. For example, if you currently calculate loan losses using a five-bucket risk ratings system, you wouldn’t downgrade to a simpler two-bucket rating system (pass / fail), nor would you upgrade to a quantitative model with a finely tuned non-linear PD / LGD scaling and fifteen loss factors. Second, build a comprehensive CECL data dictionary using your current allowance as a starting point, and then add potential data fields needed for CECL methodologies. The dictionary will be frequently used and helpful for audits. Third, create a flow chart of your methodology highlighting processes, systems, and controls for both incurred loss and CECL. This exercise helps your team and external parties visualize the implementation. Fourth, develop a detailed CECL methodology blueprint weaving in your new data dictionary and flow chart. Identify areas of your current methodology and reports that can be retained, then branch out to other areas that can be enhanced. Fill in new calculations, processes, and reports needed to bridge the gap between the incurred loss and CECL methodologies. Implementation is an iterative process; repeat steps as necessary to re-select or refine your methodology, data dictionary, flow charts, and blueprints. Fifth, complete a project timeline factoring in potential delays. At my bank, we spent six months preparing for CECL before selecting a vendor. We estimated the remaining implementation steps, including parallel testing, would take another 12 to 18 months for a total project timeline of 18 to 24 months. Unfortunately, we grossly underestimated our implementation timeline, and it took us four years to adopt CECL. Do I Need A CECL Vendor? RevisitedAfter planning your CECL methodology, does the prospect of a successful in-house implementation feel achievable, leave a sense of uncertainty, or a mix of both? Vendors can not only provide peace of mind; their job is to shorten the implementation time frame and improve project success rate. Begin noting areas where the team has encountered challenges or gaps in expertise. Use this insight to determine whether a service or product vendor fits your needs. As mentioned previously in the vendor type section, keep an open mind as the line between a service and product vendor has blurred. Even if you decide on an in-house implementation, the situation can change and hiring a vendor may be necessary. The next section will explain the vendor selection process by providing a detailed overview, decision making tips, and a case study. Vendor Due DiligenceA bottom-up approach to vendor due diligence is critical to implementation success. The CECL team, which is deeply involved in the data, calculations, methodology, and reports, will have the operational insight and the knowledge to select the most suitable vendor(s). The executive sponsor and departments supporting implementation efforts can focus on higher-level support and oversight duties, such as allocating resources, clearing obstacles, resolving conflicts, and project monitoring. Be patient; vendor selection takes a few months but its impact lasts years. During my experience implementing a customer reporting platform at an investment firm many years ago, the information technology department hired a product vendor without sufficient input from the users, the client reporting team. Unfortunately, the platform didn’t meet the reporting team’s needs. The firm had to hire two more team members to implement and develop custom workarounds for more than a year before the reporting platform became the originally envisioned solution. The walkthrough below will present steps to help you select the most suitable vendor and avoid potential pitfalls. 1. Make an initial list of vendorsThis is the easiest part of the due diligence. Source vendor names from industry magazines, search engines, conferences, and industry peers. Don’t exclude any vendors at this stage. 2. Review product / service offeringsExpand the list into a document and table comparing vendor offerings, expertise, and characteristics. The aim at this stage is to source basic, readily available information from vendor websites and brochures. In the document, include:
This exercise is not only an efficient way to screen vendors but an example of effective project governance and is essential for due diligence reviews by auditors, model validators, and other reviewers. Next, meet with your team to narrow down the list. Keep in mind that you could need one or more vendors. Document the team’s discussion, decision, and rationale. 3. Speak to potential vendorsContact the remaining vendors on your list to learn more about their products and services. Be proactive and provide details about your portfolio composition and financial instruments to move conversations deeper. Focus your discussions in the following areas: Strengths and weaknessesA vendor has no problem elaborating on their strengths. If asked about weaknesses, they will generally spotlight a few but pare them with strengths, benefits, or workarounds. I had several meetings with a model vendor who only had a CECL model for commercial real estate (CRE) loans, but we also needed models for the rest of our portfolio. Even after I reminded the representative several times, they continued to focus only on their CRE CECL solution and an unrelated bank competitive analysis tool. Their ability to discuss weaknesses or limitations is a good way to ascertain their honesty, evaluate trade-offs, and decide whether they are the right vendor to hire. Implementation / training / ongoing supportMany vendors rush to sign new clients, but it’s important to understand what the vendor means by implementation and what post-implementation support entails. Product vendors are typically only responsible for product setup, customization, and training. Your institution must utilize their products to implement CECL. Service vendors provide deliverables spelled out in a negotiated contract. Make sure the contract clearly describes the deliverables and expectations. For both types of vendors, plan to implement tasks the product or service doesn’t cover with your internal resources or engage another vendor. Ask vendors about post-implementation support. Are training, documentation, and ancillary services included? Do they assist during audits or address potential mistakes or changes after setup or delivery? Experience with similar institutionsVendors tend to spend much of their time selling their benefits, features, and expertise, but neglect to link those with your institution’s needs. Ask the vendor how the vendor’s products and services account for your institution’s size, industry focus, processes, and portfolio. Broaden the conversation and ask how they met the needs of similar clients. This can give you new insights about challenges other firms have faced that your team hasn’t considered and other benefits the vendor forgot to mention. At this stage during my due diligence, I was surprised by two experiences. First, a name brand service vendor was pitching a product solution. We felt uncomfortable that the vendor never mentioned previous clients and when we asked about them, their response was shallow. We crossed them off our list and found out later that despite their stellar reputation, their product was new and untested. Second, a large product vendor presented their IFRS 9 (an international accounting standard similar to CECL adopted in 2018) products and experience, but their clients were large multinational entities. After they shared a slide deck with us, we felt their CECL products were too numerous and complex for our more modest needs. Solution pricingMost vendor representatives won’t be forthcoming on pricing early in the sales process. There are several reasons other than their desire to appear affordable and keep fees confidential. CECL implementation is unique to each institution. Find out what solutions are suitable for your institution and price range. Is there a platform subscription and an implementation fee? Does a base subscription to a platform include external data, report writer, analytics, models, and forecasts? Do the implementation services help build everything I need or will I also need to hire a second vendor? Understanding the scale and scope of products and services needed will allow a vendor to nail down pricing later. Generally, a service vendor’s post-implementation support is limited. It is a separate engagement to hire the vendor again to upgrade the methodology or product they built for your institution. However, with a product vendor, you may enhance your methodology with no additional cost other than the recurring product subscription fee. Consider the possibility of future updates to your CECL methodology from changes in your portfolio composition or mergers and acquisition activity. My institution was a growing multi-state community bank. We thought that if our assets reached a point where our regulators and auditors raised their expectations, we may need to enhance our methodology. Therefore, we considered a product vendor who had a range of products depending on the level of sophistication. Conversations with potential vendors are more insightful than the static information available from their website and brochures. These conversations can also uncover a new perspective regarding your implementation plan or needs. Update your methodology blueprint. Write everything else you learn into your vendor selection documentation. Meet with your team to narrow down your vendor list further. The next step is to put the finalists through a time-consuming, detailed review involving product demonstrations, proof-of-concept exercises, mock project plans, and detailed discussions. 4. Detailed reviewConducting a detailed review will test your patience. Your team needs to be skeptical, alert to minute details, and persistent in finding complete answers. Stay organized by preparing questions prior to vendor meetings and document their responses. A thorough due diligence is your best chance at finding the right vendor(s). For product vendors, ask for a product walkthrough, a trial period, or a proof-of-concept exercise. A vendor should be able to show how their product(s) can implement CECL using your portfolio, data, and approach. For service vendors, use a similar approach. Ask them for a tailored implementation or project plan. Delve into specifics: steps, methodology, processes, rationale support, and project timeline. Make sure their plan and responses reflect understanding and customization toward your institution’s needs and circumstances. Vendors may avoid detailed answers, evade the discussion, or simply introduce you to the methodologies they can handle. Be assertive and ask again. You want a knowledgeable vendor whose expertise can be shown in the products they built or in the services they can provide. The questions below will guide you toward conducting a thorough vendor review. They are split between product and service vendors. The topics and questions are not exhaustive. Product Vendor
Service Vendor
As you are conducting your due diligence, reconsider whether your institution can replicate the processes or products internally using existing resources and capabilities. This exercise will accomplish two goals. First, it will further cement the value your potential vendor can or cannot provide. Second, it will improve implementation success by providing your team with opportunities to better understand your institution’s processes, methodologies, and needs. Don’t forget to ask for client references, speak to other institutions informally about their experiences with the vendor, and read their product/service reviews. Factor in that a long implementation and reliance on your vendor will make you vulnerable to future upselling of products/services, large subscription price increases, and future advisory services to maintain your methodology. 5. Completing Vendor SelectionHave the CECL team carefully review each vendor’s offerings and capabilities. An updated vendor comparison list will be essential. Work with your team’s supporting departments and executives. If possible, have an independent party review your due diligence process and selection. Allow several weeks and multiple rounds of two-way feedback before picking the vendor(s). After selecting a vendor, visualize and map out a rough implementation blueprint and solutions to remaining gaps or unmet needs. When you receive the vendor proposal and contract, don’t hand documents to the legal team without the team’s review and feedback. Be thorough. Work with the legal team to make sure the contract matches your expectations, protects the institution, and is reasonable. Lastly, don’t forget documentation. Archive meeting notes, vendor correspondences, internal emails, documents, and presentations. Provide specific details and steps about your vendor selection process, including selection criteria, vendors considered, questions asked, and the internal approval process. In the next section, I will provide several tips to reduce decision-making biases throughout your vendor due diligence. Improving Decision MakingThe key to improving decisions is to understand that assumptions and biases can be subtle and inconspicuous. Mitigate the dangers through documentation, evidence gathering, discussion, and listening for alternative viewpoints.
The case study below will illustrate many of the decision-making tips highlighted above and the importance of an in-depth vendor due diligence. Due Diligence Case StudyAfter a thorough due diligence, my bank hired a CECL platform vendor. Their platform connected with our loan data and would allow us to calculate both our incurred loss and the upcoming CECL methodologies. This was a major benefit since it allowed us to gain operational efficiencies in our current processes while we prepared for CECL. During the months-long implementation, we discovered several issues. The vendor couldn’t replicate our methodology despite reviewing our documentation and assuring us their platform could during due diligence. Next, we determined their platform can’t replicate or replace our process for calculating our incurred loss methodology. We should have done a better job reviewing our processes and mapping out how the platform can replicate them. By not doing so, we missed the fact that platform calculations can’t be exported and imported into our loan data and reporting system without significant work. Using our existing processes would be easier. We didn’t realize our internal management reports were heavily customized to our needs and that the platform could neither pull in the relevant internal data nor replicate the reports. We were forced to continue calculating our allowance internally just to run our reports. The platform couldn’t replicate our qualitative adjustments and was cumbersome to use. Our current methodology was calculated and maintained using Microsoft Word and Excel. It was easier to use our existing processes rather than invest 10 hours to load them manually into the platform every time the allowance was calculated. In summary, we could not replicate our incurred loss methodology using our vendor platform and wasted time and money trying. Had we focused our efforts on detailing our internal processes and comparing them to the platform’s steps, we would have understood the platform could never replicate our methodology. The vendor platform’s CECL capabilities were a similar story. We knew our vendor didn’t have pre-built models or methodologies that we felt met the forward-looking requirements, and we were prepared to either develop our own models and forecasts or find external help. Several months after implementation, I built a prototype credit loss model on a single loan segment as a feasibility study. The exercise proved that a model was difficult to develop and maintain internally. We reached out to our vendor’s advisory team and were disappointed. Their model building capabilities were limited by platform constraints. Only a small selection of simple methodologies was available, forecasted industry and macroeconomic variables were unavailable, our loan portfolio had few losses to build a robust model, and their level of expertise wasn’t enough to pass auditor scrutiny. The risk management department was in charge of the allowance methodology and calculations. Therefore, both co-leads of the implementation team were from risk management. However, one lead had little experience with the allowance methodology, CECL, and risk analysis. She had a close and trusting relationship developed over decades with our executive sponsor. As co-lead, she had an outsized influence on vendor due diligence. She placed a greater emphasis on a vendor’s audit and compliance capabilities at the expense of the platform’s ability to satisfy other important CECL needs. This undue influence and mismatched expertise were partially responsible for selecting the wrong vendor. We were also enthralled by the numerous platform features and capabilities presented and assumed a vendor platform would be an upgrade compared to our more hands-on processes without explicitly comparing them. We wasted months implementing something we can’t use and even if we could, it would take much longer for the same results. Thankfully, we learned our mistakes from the due diligence and hired a model vendor a year later to replace our platform vendor. We were more careful qualifying our next vendor, more aware of our assumptions and biases, and better prepared with a reorganized CECL team. ConclusionA vendor can have an enormous impact on your CECL implementation efforts and success. Before committing to a vendor, inventory your institution’s needs and capabilities. A vendor is very helpful, but not as essential as your CECL team for a successful implementation. Conduct a thorough due diligence. Be mindful of feedback from team members and potential decision-making biases before making the final decision. Although this article is about selecting a vendor, hiring a CECL expert as an employee or temporary contractor can also be a viable alternative and would utilize many of the same approaches used for effective vendor due diligence. Good luck with your vendor search and implementation. *This excludes public smaller reporting companies who have an effective date of January 2023. **Please see “Five Current Expected Credit Loss (CECL) Implementation Survival Tips” by Adrian Wong published by Palm Street Consulting LLC for more information about domain expertise necessary for CECL Implementation.
I spent close to four years at a mid-sized bank implementing the Current Expected Credit Loss (CECL) accounting standard. It was a great stress reliever to write about my experience with CECL. I hope you find the Five Current Expected Credit Loss (CECL) Implementation Survival Tips PDF article (article download below) informative and helpful. This is the first of many articles to come. Subscribe to our email newsletter at the blog footer to be notified of new articles. Thank you for reading. Please print and share the article with others. You can post comments at the bottom or reach out to me with questions (email button below my bio). Article Download
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Palm Street Consulting LLCWe are the owners behind The Wall Street Basement Blog. Our headquarters is in downtown Boston, Massachusetts. We love investing and sharing our knowledge. Date
July 2023
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