Compensation Lessons in a Banking Crisis

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Between March 10 and May 1, three regional U.S. banks failed. How were these bank failures similar, or different, than the bank failures of the Great Recession? We already know that there will be more regulatory pressure on banks, but what lessons can these failures teach directors about compensation? First, it is important to compare the Great Recession to the 2023 banking crisis.

Credit Versus Liquidity
The Great Recession was defined by a general deterioration in loan credit quality, incentive compensation that overly focused on loan production and a lack of a risk review process that incorporated the role incentives and compensation governance played.

Contrast that to 2023: Banks have upgraded credit processes and their risk review processes to evaluate the role of incentive compensation under the 2010 regulatory guidance of sound incentive compensation policies. Unfortunately, the banks that failed did not have enough liquidity to cover depositors who desired to move their money.

General Versus Unique
The three failed banks had unique patterns that responded dramatically to the increase in interest rates by the Federal Reserve and complicated each firm’s ability to fulfill depositor withdrawals. Silicon Valley Bank’s bond portfolio was long duration, and First Republic had a material portion of its portfolio tied to long-term residential mortgages. In contrast to the Great Recession, this banking crisis has more to do with business model and treasury management than actions of mortgage or commercial lenders.

Poor Risk Review
This is one area of commonality between the Great Recession and 2023. The Federal Reserve’s postmortem report on Silicon Valley Bank noted that the institution’s risk review processes were lacking. Specifically, the bank’s incentive plans lacked risk measures, and their incentive compensation risk review process was below expectations of a $200 billion bank.

“The incentive compensation arrangements and practices at [Silicon Valley Bank] encouraged excessive risk taking to maximize short-term financial metrics,” wrote the Fed in its postmortem report. This is a responsibility of the board of directors: Examiners review the board’s incentive risk review process as a part of their effectiveness evaluation, as well as a foundational principle of sound incentive compensation policies.

Going Forward
Lessons for the compensation committee must include considerations for what should be in place now versus what committees should be thinking about going forward. The compensation committee should have a robust process in place that examines all incentive compensation programs of the bank in accordance with regulatory guidance.

This process should evaluate each incentive compensation plan according to risk and reward, and monitor how each plan is balanced through risk mitigating measures. In addition, the incentive review process should be governed by a sound overall incentive compensation governance structure.

This structure is anchored by the compensation committee and works with a management incentive compensation oversight committee. It should dictate how plans are approved, how exceptions to plans are made and when the compensation committee is brought in for review and approval. As an example, if a major change is made to a commercial lender incentive compensation plan midyear, what is the process to review and ultimately approve the midyear change? Regulators expect those processes to exist today.

But all crises present new learnings to apply to the future. While there are a number of lessons related to a bank’s business model and treasury management, there are also takeaways for the compensation committee.

Going forward, banks need to move their mindset from credit risk mitigators to overall risk mitigators in incentive compensation. Credit risk metrics are often found within executive incentive plans as a result of the Great Recession. Banks should think how they can incorporate overall risk mitigators, beyond credit risk, and how those mitigators could affect executive incentive plans.

A risk modifier could cover risk issues such as credit, legal, capital, operational, reputational and liquidity risk factors. If all these risks rated “green,” the risk modifier would be at 100%; however, if credit or liquidity turned “yellow” or “red,” this modifier could apply a decrement to the annual incentive plan payout. In this way, a compensation committee can review all pertinent risks going forward and help ensure incentive compensation balances risk and reward.

Community Bankers Emphasize Calmness, Stability Amid Crisis

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You can’t communicate too much during a banking crisis – even when your bank is not the one actually experiencing the crisis.

After regulators shut down SVB Financial Group’s Silicon Valley Bank and Signature Bank two weeks ago, community bankers across the nation began working behind the scenes to field questions from their boards, their clients and their frontline staff. They checked their access to the Federal Reserve’s discount window and sought to reassure customers and directors of their own institution’s liquidity position.

Locality Bank, a de novo bank based in Fort Lauderdale, Florida, still has ample liquidity from its capital raising efforts and simply by virtue of being a new bank. The $116 million Locality, which first opened a little over a year ago, reiterated these points in a letter it sent out to clients the day after Silicon Valley Bank was closed by state regulators, CEO Keith Costello says.

“We don’t have a portfolio of low-interest securities or loans,” the letter reads in part. “We have capital of almost three times the level required to have a well-capitalized rating, and our liquidity ratio at 54.17% at month end of February is one of the strongest in the U.S. Our securities portfolio, because we bought our securities when rates went up, has no appreciable decline in value.”

That letter went a long way toward assuaging customer fears around the ongoing banking crisis, Costello says, adding, “We just got a tremendous response from clients who emailed, who called, who just said, ‘Hey, we love that letter. We feel so much better about everything.’”

Communicating with frontline staff has also been critical, says Julieann Thurlow, CEO of Reading Cooperative Bank in Massachusetts. Not only are those workers spending a lot of time interacting with customers, but they also may have their own questions about how ongoing events impact their livelihoods.

“Not every teller reads The Wall Street Journal,” Thurlow says. “So make sure that you actually communicate with them as well because there was a level of uncertainty … ‘Is the banking community in trouble?’”

Some community bankers also took to social media to get the word out, including Jill Castilla, CEO of $358 million Citizens Bank of Edmond. Since the March 12 failure of Silicon Valley Bank, Castilla has taken to Twitter and LinkedIn to provide a rundown of the crisis and explain how Silicon Valley Bank and Signature differed from a typical community bank.

Even larger banks whose stocks have taken a hit sought to distance themselves from those banks. Phil Green, CEO of Cullen/Frost Bankers in San Antonio, Texas, took to CNBC to discuss the subsidiary Frost Bank’s liquidity position. The $53 billion Frost Bank CEO told “Mad Money” host Jim Cramer that the bank has a low loan-to-deposit ratio and roughly 20% of its deposits are held in highly liquid accounts at the Federal Reserve.

Even though Cullen/Frost Bankers’ stock price has taken a hit this year — down more than 10% since Silicon Valley Bank failed, mirroring the fall in the KBW Nasdaq Bank Index this year — Green expressed confidence in the long term.

“Frost Bank’s deposit base has been very strong,” he said, adding “We’ve seen really no unusual activity.”

While Reading Cooperative already tests its liquidity lines on a quarterly basis, the $796-million bank double-checked its access to the Federal Reserve’s discount window after Silicon Valley Bank failed.

“We could almost refinance the entire bank with our liquidity lines,” she says.

Meanwhile, Costello says that a handful of customers made their accounts joint accounts in order to get coverage from the Federal Deposit Insurance Corp., and he said that Locality also tapped its cash service with IntraFi, a privately held deposit placement firm, for the first time. He also added that Locality’s messaging around the crisis and its own liquidity position and relative stability resonated with non-customers, too.

“You find people that aren’t your clients will call you at times like this, too,” Costello says. “We did actually pick up some business as a result.”

Other community bankers also reported a similar experience picking up new business in the crisis. In a post on LinkedIn, Castilla reported that deposits continued to increase at her bank and “my lobby today is full of happy customers!”

Thurlow says Reading Cooperative picked up a few new larger accounts, although she was also cautious not to characterize that as a “flight to safety.”

“It’s not something that we’re marketing or looking to capitalize on,” she says. “This is a time for calm. We’re not looking to create or exacerbate a problem.”

Will Regulators’ Actions Stem Deposit Runs, Banking Crisis?

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Bank regulators rolled out several tools from their tool kit to try to stem a financial crisis this week, but problems remain. 

The joint announcements followed the Friday closure of Silicon Valley Bank and the surprise Sunday evening closure of Signature Bank. 

Santa Clara, California-based Silicon Valley Bank had $209 billion in assets and $175 billion in deposits at the end of 2022 and went into FDIC receivership on March 10; New York-based Signature Bank had $110 billion in assets and $88.6 billion in deposits at the end of 2022 and went into receivership on March 12. Both banks failed without an acquiring institution and the FDIC has set up bridge banks to facilitate their wind downs.

Bank regulators determined both closures qualified for “systemic risk exemptions” that allowed the Federal Deposit Insurance Corp. to cover all the deposits for the failed banks. Currently, deposit insurance covers up to $250,000; both banks focused mainly on businesses, which carry sizable account balances. About 94% of Silicon Valley’s deposits were uninsured, and 90% of Signature’s deposits were over that threshold, according to a March 14 article from S&P Global Market Intelligence.

The systemic risk exemption means regulators can act without Congressional approval in limited situations to provide insurance to the entire account balance, says Ed Mills, managing director of Washington policy at the investment bank Raymond James. 

The bank regulators also announced a special funding facility, which would help banks ensure they have access to adequate liquidity to meet the demands of their depositors. The facility, called the Bank Term Funding Program or BTFP, will offer wholesale funding loans with a duration of up to one year to eligible depository institutions that can pledge U.S. Treasuries, agency debt and mortgage-backed securities and other qualifying assets as collateral. The combined measures attempt to stymie further deposit runs and solve for the issue that felled Silicon Valley and Signature: a liquidity crunch. 

In a normal operating environment, banks would sell bonds from their available-for-sale securities portfolio to keep up with liquidity demands, whether that’s deposit outflows or additional lending opportunities. Rising rates over the last five quarters means that aggregate unrealized losses in securities portfolios grew to $620 billion at the end of 2022 — losses many banks want to avoid recording. In the case of Silicon Valley, depositors began to pull their money after the bank announced on March 8 it would restructure its $21 billion available-for-sale securities portfolio, booking a $1.8 billion loss and requiring a $2 billion capital raise. 

“The BTFP will be an additional source of liquidity [borrowed] against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress,” the Federal Reserve said in its release on the facility. Importantly, the pledged collateral, such as U.S. Treasurys, will be valued at par. That is the “most beneficial portion” of the program and eliminates the discount many of these securities carry given their lower yields, Mills says. 

The hope is that banks pledge their underwater bonds to increase their liquidity should deposits begin to leave their institution. One concern, then, is that banks hesitate to use it as a sign of weakness, Mills says. But he says, “conversations about impacts to earnings and impacts to reputation are secondary to solvency.”

Former Comptroller of the Currency Gene Ludwig tells Bank Director that he appreciates the steps the regulators took, and of President Joe Biden’s messaging that accompanied Sunday’s actions. 

“I realized that for the regulators, because of the speed and the need to react quickly and over a weekend, there was a lot of wood to chop,” he says. “ It takes time, but I think they reacted with vigor.”

Although he wasn’t at the FDIC, Ludwig’s career touches on the importance of deposit coverage. In addition to serving as comptroller in the 1990s, he founded and later sold IntraFi, a reciprocal deposit network. He encourages banks to at least establish lines to the BTFP, since the application and transfers can take time.

It remains to be seen whether regulator actions will be enough to assuage depositors and the broader public. Banks have reportedly borrowed $11.9 billion from the new facility and another $152.8 billion from the discount window, according to a Bloomberg article published the afternoon of March 16. However, the facilities don’t fully address the problem that most banks are carrying substantial unrealized losses in their bond books — which may only continue to grow if the Federal Open Market Committee continues increasing rates.

“This announcement was about stemming the immediate systemic concerns, but it absolutely did not solve all of the banks’ woes,” Mills says.

It’s also possible that those tailored actions may be insufficient for certain institutions that resemble Silicon Valley Bank or Signature Bank. Clifford Stanford, an Atlanta-based partner of law firm Alston & Bird and a former assistant general counsel at the Federal Reserve Bank of Atlanta, remembers how bank failures and weakness would come in waves of activity during the Great Recession and afterward. 

“There’s a lot of unknowns about who’s got what holes in their balance sheet and who’s sitting on what problems,” he says. “Every board of every bank should be asking their management right now: Do we have this problem? If we do have a risk, how are we hedging it? What sort of options do we have to backstop liquidity? What’s our plan?”