SVB failure brings into sharp focus the importance of asset and liability committees

• FDIC and other regulators take action to calm depositors
• Increased scrutiny of the asset and liability committee (ALCO)
• Why its role is critical to the financial strength of a bank

The collapse of Silicon Valley Bank (SVB) and the financial turmoil that followed in both the United States (US) and global markets have again reminded investors and bank executives of the critical importance of managing funding and liquidity.

There will inevitably be an increased focus from investors, ratings agencies and regulators on the oversight and management of liquidity risks at all banks, particularly small and medium-sized ones.

The famous saying from ancient Roman times to “beware the ides of March” is a warning to watch out for betrayal or misfortune. Misfortune struck the US banking system and its regulators in March this year.

FDIC and other regulators take action to calm depositors

After unprecedented deposit withdrawals from 8 to 9 March totalling $42 billion in one 24-hour period, SVB was taken over by the US Federal Deposit and Insurance Company (FDIC). In the days following, bank runs continued at several smaller US banks, including First Republic Bank and Signature Bank.

These events forced the US Treasury, The Federal Reserve and FDIC to announce a range of measures to restore confidence in smaller regional banks in the US. Uncertainty continues with the viability of many of these banks continuing to be questioned, and the share prices have been falling. Contagion then spread globally with Credit Suisse forced by Swiss authorities to merge with its rival, UBS.

The root cause of the collapse of SVB appears to be the losses in its US treasury bond portfolio and the inability to meet the withdrawals as depositors came to understand the scale of the unrealised losses.

As of 31 December 2022, SVB held $120.1 billion in liquid assets. This comprised $26.1 billion in available-for-sale (AFS) securities and $91.3 billion in held-to-maturity securities. They were all predominantly long-dated US Treasuries.

During 2021 and 2022, the value of these went down as the US Federal Reserve started raising interest rates. The announcement by SVB on 8 March 2023 of realised losses of $1.8 billion on the sale of $21.1 billion of AFS securities (less than a quarter of its total bond portfolio) triggered the crisis. The announcement crystallised concerns in the minds of many investors and depositors about the solvency and financial viability of SVB.

Increased scrutiny on asset and liability committees

In the coming months and years, we will learn what created these issues and how SVB was managing (or mismanaging) its financial risks.

Numerous questions about what happened at SVB remain unanswered. What was the basis of the investment strategy implemented? What discussions took place about hedging the interest rate risk in the bond portfolio? How regularly were the risks reviewed by SVB’s board and management, including its ALCO? Questions will also be asked about the role of the various regulators supervising SVB.

Behind the scenes, all around the world, regulators will be quietly and discreetly reviewing the oversight of funding and liquidity in the banks they supervise. In a release on 23 March 2023 following the collapse of SVB, the Basel Committee on Banking Supervision (Basel Committee) stated that in the face of rising interest rates, “Banks and supervisors must therefore be vigilant to the evolving outlook to ensure that the global banking system is resilient.”

Mark Lawrence, managing director of Mark Lawrence Group and a former chief risk officer of ANZ Banking Group stated: “We are currently seeing a significant change to the nature of bank liquidity risks and the range of potential response options in times of stress, including dramatically shorter windows for effective action by bank executives and intervention by supervisors.

“Consequently, what might have been an acceptable liquidity risk profile five years ago may no longer be acceptable today, due to heightened depositor flight risk.”

Mark Lawrence,

Managing Director of Mark Lawrence Group and former Chief Risk Officer of ANZ Banking Group

No doubt there will also be more focus on prudential reviews going forward on the role and effectiveness of every institution’s management-level ALCO. Banks in all jurisdictions should have a look at the operation and effectiveness of their ALCO, looking at its composition, the frequency of its meetings, its agendas, papers presented, and effectiveness.

Bill Coen, former secretary general of the Basel Committee and now a non-executive director of China Construction Bank told The Asian Banker: “The prudential oversight process for banks emphasises the examination of those well-known factors that contribute to bank stress and even failure, such as asset quality.

“The oversight process is equally sensitive to the proximate cause of failure, which is almost always inadequate liquidity or mismanagement of funding. The regulatory process, therefore, rightfully focuses on the quality of liquidity risk management and the performance of the ALCO.”

Non-executive Director,

China Construction Bank and former Secretary General of the Basel Committee

ALCO’s role is critical to the financial strength of a bank

In its practice guide, Guidelines on Risk Management Practices—Liquidity Risk, The Monetary Authority of Singapore (MAS) stresses that “an institution should establish and regularly review funding strategies and policies and processes for the ongoing measurement and monitoring of funding requirements and the effective management of funding risk”.

ALCO functions as an oversight body, a decision-making body, and a risk management committee. It oversees and makes decisions on the key capital management, funding, and liquidity strategies at a bank. An ALCO should ensure that both assets and liabilities are aligned with the bank’s strategic objectives, risk appetite, and regulatory requirements.

ALCO members usually comprise the chief executive officer, chief financial officer, chief risk officer, key business executives, and the senior treasury and relevant risk management managers.

The Basel Committee’s key guidance on liquidity management is its publication Sound Practices for Managing Liquidity in Banking Organisations (BCBS144), published in September 2008. BSBC144 outlines 17 principles for managing liquidity. It highlights both the importance of sound liquidity risk management at every institution and the systemic implications of a failure, stating: “Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial markets developments have increased the complexity of liquidity risk and its management.”

The key areas of focus for ALCO are:

Establishing the bank’s strategic objectives:  One of the primary roles of an ALCO is to set the bank’s strategic objectives in asset and liability management. This will usually include determining the target balance sheet structure, defining the risk appetite, and agreeing on the appropriate risk management strategies.

Monitoring market risk: ALCOs are responsible for monitoring the market risks that the bank faces. This will include tracking interest rate risk, foreign exchange risk and liquidity risk. The ALCO needs to ensure that the reporting of these market risks, including scenarios, is independently reviewed and reported.

Managing liquidity risk: As we have seen with SVB, managing liquidity risk is critical. It is an essential responsibility of an ALCO. In simple terms, the committee is responsible for ensuring that the bank has sufficient liquidity to meet its obligations and maintain its ongoing operations. It needs to monitor the bank’s liquidity position, including its cash flows, and develop contingency plans to address any potential liquidity shortfalls. In times of crisis, this can be a daily or even hourly activity.

Managing interest rate risk: Again, as we have seen with SVB, managing interest rate risk is critical to the financial viability of a bank. Liquid asset portfolios can be highly sensitive to interest rate movements. In addition, ALCO must ensure there is oversight of strategies to manage any interest rate risk that arises from the mismatch between the duration and pricing of the bank’s assets and liabilities.

Asset management: An ALCO is responsible for assessing and approving the allocation of the bank’s assets. This includes reviewing the business strategies and plans for growing the bank’s loan book and also the allocation of other investments. The ALCO is charged with ensuring alignment with the approved lending and investment risk appetite.

Funding and liability management: An ALCO also oversees the management of the bank’s liabilities. This includes reviewing the proposed short-, medium- and long-term funding plans put forward by the treasury department. In addition, an ALCO plays a critical role in monitoring market conditions in both retail and wholesale funding markets. It is imperative that an ALCO alerts the board to material changes in the external market and recommends strategies to mitigate and manage risks. The ALCO will also be responsible for managing the bank’s capital structure and ensuring that it meets regulatory requirements.

Board and committee reporting:  The operation of ALCOs will usually be delegated from either the board or a board subcommittee. The ALCO Charter will usually detail its role in reporting to the board on the bank’s capital, funding and liquidity, and risk exposures. ALCOs will often sign off on these reports—covering funding and liquidity, detailed risk portfolio reports, capital adequacy, market conditions and management strategies.

In summary, the role an ALCO plays goes to the heart of a bank’s financial stability and long-term viability, through the sound management and oversight of its assets and liabilities.

According to Lawrence: “An effective response to the current developments will likely involve substantial changes to the way many banks assess and manage their liquidity risk profiles in times of stress.

“In particular, all banks will need to review and adapt their liquidity risk management strategies and processes in the short to medium term to reflect the new reality. Working through these changes will provide significant challenges to bank ALCOs and boards, and to supervisors and policymakers in the official sector.”

As noted, we will soon understand more about what went wrong at SVB. In the meantime, it will be important to seek reassurance on the workings of the ALCO at each institution and ensure liquidity management practices adapt to the volatile and evolving landscape the bank operates in today. Regulators and banks can all learn from bank failures and market events.