The failures of Silicon Valley Bank and First Republic Bank were not just attributable to rising interest rates or to reduced regulatory oversight, but rather the inability of those institutions to accurately assess their deposit volatility. Because of that inability, SVB and FRB were required to take strategic actions to meet their deposit outflow, the disclosure of which led investors and depositors to lose confidence, leading to further, accelerating deposit outflows.
While financial institutions do look at their deposit volatility, it is most often done in broad categories rather than at the granular (depositor) level. In addition, the tools used by regulators to assess whether an institution has adequate liquidity and stable funding sources are measured broadly.
What I propose is that regulators adopt a more granular depositor rating methodology, much like the rating systems used to assign a borrower's probability of default, except that a depositor risk rating would evaluate the volatility risk of a depositor's funds. Such a "depositor volatility rating" would be quantitative, based on specified risk factors and weightings, with limited subjective criteria.
A depositor volatility rating would be assigned at account opening by the institution and updated periodically, including on the occurrence of one or more designated trigger events. Data routinely gathered by institutions during the account opening and "know your customer" (KYC) processes would be used to derive the depositor volatility rating. Existing depositors could be rated en masse from depositor information already available to banks. Smaller, less complex institutions could implement a standardized (simplified) rating methodology, while larger institutions could implement a more advanced depositor rating system.
The Federal Reserve Board governor also called for the Fed to commission an independent investigation into the failure of Silicon Valley Bank.
Financial institutions could then use the depositor volatility rating information in their asset and liability management decisions. Deposits with higher volatility would be allocated to investments or lending facilities with shorter maturities and lower interest rate risk profiles, while more stable deposits could be invested in longer term loans and securities. Note the distinction between stable deposits and contractual deposit maturities in assessing volatility. For example, a checking account with an average collected balance of $500,000 over a ten-year period could be deemed more stable than a $500,000 three-year certificate of deposit from a newer customer.
Regulators could compare an institution's depositor volatility rating and its respective assets against its liabilities. This would allow them to see if the bank has over-invested in less liquid securities or made loans using highly volatile deposits that subject it to higher than acceptable liquidity and/or interest rate risks. Regulators could then require the bank to take corrective actions before investors and depositors lose confidence and a deposit run ensues.
The speed with which SVB and FRB collapsed and concerns around the vulnerability of other institutions has already raised renewed and heightened attention around deposit stability and assets and liability management. We should expect that regulators, bank boards and management, investors and large depositors will now be taking a closer look at what a bank is doing to assess the stability of its deposit base and how well it is managing the associated risks. Because in the end, if depositors don't believe their money is safe at an institution, how fast it's growing or how profitable it is doesn't matter.
