Is Relationship Banking Too Risky?

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Before they failed, Silicon Valley Bank, Signature Bank and First Republic Bank were highly profitable and well known for using a relationship banking approach to attract and retain customers. But their failures demonstrate that this approach can create serious risks for an institution in an environment where technology makes it easier for customers to move money.

Peter Serene, a managing director at bank data firm Curinos, says the risks that stem from relationship banking are layered.

“Relationship banking was not the problem. The problem was the concentration,” he says. “[T]he banks that failed were very concentrated. Relationship banking is still good but you can’t be single threaded on a particular segment.”

Broadly defined, relationship banking is an approach where bankers establish long-duration affiliations with their customers, often paired with high customer service. The hope is that this closeness means customers will bring their lending, payments and deposit accounts to the bank and may be less sensitive to price.

“From the bank’s perspective, you have a pretty stable deposit base and stable, repeat customers who come back to you. It’s an opportunity to cross sell and upsell new products and offerings as the customer’s needs change throughout their life cycle,” says Elena Shtern, customer advisory lead for financial regulatory territory at SAS.

Shtern points out that relationship banking was a “big differentiator” for the three banks that failed this spring. Silicon Valley Bank served the innovation economy and First Republic Bank catered to the wealthy. Signature Bank focused on New York real estate firms; its approach paid off until 2023, given its no. 10 tie in Bank Director’s RankingBanking based on 2022 results for institutions with more than $50 billion in assets.

But relationship banking at Signature led to large deposit accounts, according to the Federal Deposit Insurance Corp.’s postmortem report. Uninsured deposit accounts totaled 90% of total deposits: around 60 clients had balances above $250 million and another 290 clients had balances above $50 million. The FDIC wrote that examiners flagged the potential volatility of an uninsured deposit concentration. Management responded that they “believed the deposit base was considerably stable” but the FDIC said those assumptions weren’t well documented or substantiated.

Relationship banking also couldn’t assuage customer concerns about bank solvency — and digital banking technology has made it easier for funds to move. Serene says the large accounts, which were often non-operational corporate funds, “moved faster than models predicted” they would in a stressed liquidity environment. He points out that under the liquidity coverage ratio rules, these types of accounts have an assumed runoff of 40% over 30 days.

“In the case of the banks that failed, the numbers were more like 40% of [those] deposits left in 30 hours. There’s some real rethinking about behaviors,” he says. “Evolution in technology has made a difference.”

But technology doesn’t have to undermine a relationship banking approach. Sioux Center, Iowa-based American State Bank is building and strengthening relationships with customers and their children through its partnership with The Postage, a fintech that helps families organize their finances far ahead of transitions such as a move into care facilities or death, create wills and leave memories and messages for each other.

Tamra Van Kalsbeek, the bank’s digital banking officer, sees The Postage as a way the bank cares for its customers, while gathering deposits and connecting with different family members. It also allows the bank to attract business without competing on price. She says the bank’s “spirit club” of customers aged 55 and older were “really receptive” to the product. It has been a way for the customer or the bank to start a conversation with an executor of an estate or will.

Going forward, institutions that use a relationship banking approach may want to closely examine naturally occurring concentrations and diversify their customers and the types of accounts they have, Shtern says. Diversification among clients can increase bank stability, since it offsets the negative impact one group of customers might have. Martin Zorn, managing director, risk research and quantitative solutions at SAS Institute, adds that directors should ensure that executives are addressing concentration risks through close monitoring, hedges and increased liquidity. Boards should also press management on the inputs and assumptions that populate risk management models, ensure that they understand the answers and hold management accountable to addressing these risks.

“How do you manage your models? What is that governance around the model management? How do you stress test, back test or validate your models?” Zorn says. “Depending on your strategy, you may not be able to avoid concentration. There’s nothing wrong with taking more risk if you have the appropriate mitigants in place.”

Governance issues like these will be covered during Bank Director’s Bank Board Training Forum in Nashville Sept. 11-12, 2023.

Bank Failures Reveal Stress Testing Gaps

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Within days of Silicon Valley Bank’s failure on March 10, Democratic lawmakers quickly pointed out that the bank’s holding company, $212 billion SVB Financial Group, and $110 billion Signature Bank, which failed days later, weren’t subject to regular stress tests mandated for the largest banks under the Dodd-Frank Act. The requirement for mid-sized banks, between $50 billion and $250 billion in assets, had been rolled back in 2018.  

But the stress test scenarios developed by the Federal Reserve largely focused on adverse impacts on credit and declining interest rates. In contrast, SVB’s failure had its roots in a rising rate environment that led to an unprecedented deposit run; the Fed’s Vice Chair for Supervision, Michael Barr, testified on March 28 that customers were set to withdraw $142 billion in deposits over two days — roughly 82% of the bank’s total deposits.  

“When we think of stress testing, the key word is stress,” says Brandon Koeser, senior manager and financial services industry senior analyst at RSM US. “When you think of true stress and how that impacts the organization as a whole, it can be credit — but it should also hit liquidity, it should hit capital, and then look at earnings and profitability.” 

Internal stress testing is a regular practice for community banks, according to Bank Director’s 2023 Risk Survey. More than three-quarters of executives and directors say their institution conducts an annual stress test. This can be a valuable exercise that helps boards and leadership teams understand the impact of adverse events on their organization. 

Members of the Bank Services Program can access the complete results to all Bank Director surveys, by asset size and other attributes.

“Banks have enough resources, even small banks, to do some simple stress testing and put pen to paper,” says Patrick Hanchey, a Dallas-based partner at Alston & Bird. The results should be shared with the board, with the discussion reflected in the meeting minutes. “You can take small steps to show that you’ve been thoughtful,” he says. “That’s all the stress test is — thinking about, ‘What if x happens? What do we do, and how does it affect us?’”

Banks should build scenarios that consider account types and depositor behavior, says Sean Statz, a senior manager at Baker Tilly. “We’ve been doing data analytics on the loan portfolio forever,” he says. “Data analytics around the deposit portfolio is going to be a big focus to better understand what [the] portfolio is made up of [and] what could happen [so banks can] start applying some assumptions.” It’s easier to forecast behavior around assets, due to set terms around investments, borrowings and loans. Industry-level assumptions around deposit activity can help fill in some gaps.

The recent bank failures spotlight a key area of risk: deposit concentrations within particular sectors or industries. While much has been made of uninsured deposits, Hanchey cautions that these aren’t necessarily bad if they’re managed safely and soundly. Deposits from municipalities, for example, can be quite stable. Decision-makers should understand how those deposits are concentrated.

Hanchey adds that regulators within the Texas Department of Banking acted quickly to compare levels of uninsured deposits to the availability of other funding sources in a crunch, such as lines of credit from the Federal Home Loan Banks or correspondent banks. “Stress testing your FHLB advance capabilities, lines of credit from your correspondent banking relationships, access to the Fed [discount] window, all those traditional sources of liquidity that have always been important,” says Hanchey. “It’s a new focus on the interplay between those sources of liquidity and [a bank’s] ability to cover uninsured deposits.”

Scenarios should take multiple factors — credit, interest rates, liquidity — into account, helping decision-makers build a narrative that they can use to discuss and assess the impact on the organization, says Joe Sergienko, a client relationship executive at Treliant. They can then come up with a playbook for each scenario — essentially a decision tree that examines how leadership could react in different situations. “No scenario is going to play out exactly the way you forecast,” he says, “but it gives you [a] road map to say, ‘Here’s how we should manage our bank or our process through this.’”

And executives and boards should prepare for the absolute worst: the seemingly low-probability event that could break the bank, like massive outflows in deposits such as those that caused SVB and Signature Bank to fail. This reverse stress testing process provides clues to help leaders avert a disaster. At what point does the bank lose so much liquidity that it can no longer operate? How quickly could that occur?

Stress testing should help foster a larger conversation around risk, and strengthen risk management governance and policies, says Koeser. Scenarios and models should consider the bank’s size, geography and other factors relevant to the business, like concentrations on either side of the balance sheet.

Examiner scrutiny on risk management promises to get more onerous in the year ahead. “We should all expect the pendulum to swing toward heavy, heavy oversight and strict regulation of very discrete issues,” says Hanchey. “Banks should be prepared and have their answers ready when the regulators come in and ask them about things like deposit concentration, interest rate risk, stress tests, rising rate environments. The more proactive banks can be on the front end, the more pleasant their examination experiences will be.”