By Keith Meyer and John Olert
March 31, 2023
Board members with risk management experience are important — but a company also needs a chief risk officer.
With the collapse of Silicon Valley Bank (SVB) dominating the headlines and the impacts reverberating through the banking industry, the incident has brought to the forefront several key ways in which the company’s board fell short of managing risk, ultimately precipitating the crisis at hand. Moving forward, there are important governance lessons that boards — both in the banking industry and more broadly — should take away from recent events and steps they should take to proactively manage their exposure to risk.
First and foremost, board members cannot serve as a substitute for key executives. Case in point: The chief risk officer (CRO) position at SVB was left unoccupied for the better part of the past year, a period when board risk committee meetings more than doubled to 18, according to company records. CROs play a crucial role in the well-being of a financial institution and are the key operational resource for the risk committee. By failing to fill such a critical role in the management of enterprise risks, SVB left itself vulnerable to a situation exactly like the one that ultimately unfolded.
The chain of command for risk approval, management, mitigation and oversight needs to be prioritized. The management at each step must have more experience in these core risks than those seeking approval — a very simple best practice. Once the issue reaches the board’s risk committee, these risks should be prioritized based on the most significant threats to the organization. For SVB, this fundamental process broke down at the CRO level and was exacerbated by the lack of risk experience on the risk committee.
Additionally, boards should bear in mind that risk committees should be led by at least one individual who is a seasoned risk management professional. This professional must have prior experience identifying, assessing and managing risks inherent in a company’s business across the full economic cycle. Supplementally, this demonstrates a need for a breadth and depth of risk management experience in the boardroom.
Large banks with $50 billion or more in consolidated assets are required by law to maintain a risk committee that reports directly to the bank holding company’s board. After the financial crisis, an amended version of the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, stating that risk committees must include at least one member with experience in “identifying, assessing and managing” risk exposures of large financial firms. However, experienced risk professionals are hard to find on the boards of the top 15 commercial and investment banks. Among the 15 banks with risk committees, members have an average of only 2.4 years of experience in a risk-related function as a chief credit officer, CRO or similar role. By contrast, members of their audit committees have an average of 9.5 years of experience as a CFO, a corporate accountant or in a capital management role. Unfortunately, the recent bank failures highlight the weakness of the banks’ board-level risk committees, which often lack risk management expertise.
Market participants also need to recognize that regulators are not the front line of defense when it comes to risk management oversight. Rather, this responsibility should fall to experienced members of the company’s risk management organization and on the risk committee of the board. Unlike the audit committee, enterprise risk management does not have the benefit of consistent oversight from a third party. Regulators should not be expected to replace management and the board’s responsibility to effectively manage and oversee the company’s risk appetite, exposure and mitigation activities.
SVB’s collapse was primarily a result of the bank failing to properly assess and manage risk and the board’s failure to recognize the magnitude of risk exposure created by investment decisions during a period of rapidly rising interest rates. It’s important that boards learn from this experience and proactively take steps to ensure their risk committee and risk management team are not set up to fail. By assessing the missteps in this incident, boards can emerge stronger and more informed. Documents show that the Federal Reserve raised concerns about risk management at SVB starting at least four years before its failure. In January 2019, the Federal Reserve issued a warning to SVB over its risk management systems, according to a presentation circulated last year to employees of SVB’s venture capital arm. The Federal Reserve also issued a “matter requiring attention,” a type of citation that is less severe than an enforcement action. Regulators are supposed to make sure the problem is addressed, but it is unclear if the Federal Reserve held SVB to that standard in 2019. Over time, the central bank issued numerous warnings to SVB, suggesting the bank’s problems were on the radar of the Federal Reserve, the bank’s primary federal regulator. A central bank review of its oversight of SVB is due by May 2023.
This should be a learning moment in many ways. As the various parties pursue their claims, transparency in what took place is essential to educating all functions in this chain about where and when the warnings signs were evident and how the right structure, tools and people can be put in place to avoid unnecessary disasters.
Simply having authority and improved tools and resources is not likely to be effective if those on the front lines don’t see the need for the tools’ existence or the culture isn’t one of compliance. There can be disagreements in type of risk, magnitude of impact and the urgency of how a new or developing risk should be addressed, but there has to be identification and resolution. This is best accomplished with tools to foster those discussions on a regular and recurring basis. Learning from the failures of others can be a powerful way to get all parties on a similar (if not the same) page. Seeing others fined billions for known failures — and thinking about how that would impact your organization — can be very motivating.
Keith Meyer is global practice leader of the CEO & board practice at Allegis Partners.
John Olert is former chief risk officer at Fitch Group and managing partner at Continental Insights.
SVB and what it means more broadly from a risk and governance perspective
Financial Institutions are complex entities with a multitude of risks. Many of which can seem quite benign depending on which lens they are viewed from. SVB is a classic example. When looking through public filings its massive deposit growth was invested in long dated Mortgage Backed or Mortgage Backed related securities backed by the US Government. If you assume they were in the top of the capital structure and highly rated, that could be very comforting from a credit risk perspective.
However, when these are bought with deposits the bank had received, liquidity and interest rate risk should be deeply appreciated risks that Board is aware of and focused on. Deposits can be fleeting so what they are invested in needs to appreciate any gaps in their “expected” maturities compared to the instruments they are invested in. What is the history of these deposits or class of these deposits. 1yr, 2yr, 5yr, etc. How long do they “typically” stay on the books. These deposits are often invested in short term securities to earn something and minimize interest rate risk, while the institution waits for opportunities to deploy these funds into its loan opportunities in their core area of experience to maximize the returns for their shareholders. SVB decided to put “excess” deposits to work in long dated MBS securities. But looking at call reports from 12/31/21 and 12/31/22 there is a massive swing in fair value of the held to maturity portfolio compared to amortized cost. These was a $975 million MTM loss at 12/31/21 compared to $15,159 million on December 12/31/22. Massive.
The position was there. Were the questions being asked by the appropriate parties?
Based on the composition of SVBs board, there doesn’t seem to be the outside expertise needed to appropriately challenge management on this type of issue. Maybe they did and that will likely come to light as this is thoroughly investigated.
However, the 2022 10-K had this statement regarding interest rate risk.
The Federal Reserve raised benchmark interest rates throughout 2022 and may continue to raise interest rates in response to economic conditions, particularly inflationary pressures. Continued increases in interest rates to combat inflation or otherwise may have unpredictable effects or minimize gains on our interest rate spread.
So the board is responsible for this document. Minimize gains? With the mark to market loss being reported, an informed board member would have at least challenged this wording. The statement should have been focused on the potential to have severe losses based on what was an abundantly clear path from the Federal Reserve on interest rates.
Important to appreciate the distinction between policy expert and practitioner.
How do markets work? How do fundamental assumptions change when varied stresses present themselves? It is exceptionally helpful to have lived through early challenges, seen how things break down, mistakes made in response to unexpected developments, and how true, authentic leadership helps navigate and survive these situations. Risk professionals that have had operating, analytical, research, and internal control roles are key to ensuring all board members are appropriately informed and getting the reporting necessary to protect stakeholders. That is their duty. Growth is exceptionally important and highly desired. Having board members or an advisory firm that has been on both sides of this equation and appreciate all the plumbing (macro and micro) is essential to having a diverse and effective board in this space.
From John Olert, Continental Insights
SVB and what it means more broadly from a risk and governance perspective
Financial Institutions are complex entities with a multitude of risks. Many of which can seem quite benign depending on which lens they are viewed from. SVB is a classic example. When looking through public filings its massive deposit growth was invested in long dated Mortgage Backed or Mortgage Backed related securities backed by the US Government. If you assume they were in the top of the capital structure and highly rated, that could be very comforting from a credit risk perspective.
However, when these are bought with deposits the bank had received, liquidity and interest rate risk should be deeply appreciated risks that Board is aware of and focused on. Deposits can be fleeting so what they are invested in needs to appreciate any gaps in their “expected” maturities compared to the instruments they are invested in. What is the history of these deposits or class of these deposits. 1yr, 2yr, 5yr, etc. How long do they “typically” stay on the books. These deposits are often invested in short term securities to earn something and minimize interest rate risk, while the institution waits for opportunities to deploy these funds into its loan opportunities in their core area of experience to maximize the returns for their shareholders. SVB decided to put “excess” deposits to work in long dated MBS securities. But looking at call reports from 12/31/21 and 12/31/22 there is a massive swing in fair value of the held to maturity portfolio compared to amortized cost. These was a $975 million MTM loss at 12/31/21 compared to $15,159 million on December 12/31/22. Massive.
The position was there. Were the questions being asked by the appropriate parties?
Based on the composition of SVBs board, there doesn’t seem to be the outside expertise needed to appropriately challenge management on this type of issue. Maybe they did and that will likely come to light as this is thoroughly investigated.
However, the 2022 10-K had this statement regarding interest rate risk.
The Federal Reserve raised benchmark interest rates throughout 2022 and may continue to raise interest rates in response to economic conditions, particularly inflationary pressures. Continued increases in interest rates to combat inflation or otherwise may have unpredictable effects or minimize gains on our interest rate spread.
So the board is responsible for this document. Minimize gains? With the mark to market loss being reported, an informed board member would have at least challenged this wording. The statement should have been focused on the potential to have severe losses based on what was an abundantly clear path from the Federal Reserve on interest rates.
Important to appreciate the distinction between policy expert and practitioner.
How do markets work? How do fundamental assumptions change when varied stresses present themselves? It is exceptionally helpful to have lived through early challenges, seen how things break down, mistakes made in response to unexpected developments, and how true, authentic leadership helps navigate and survive these situations. Risk professionals that have had operating, analytical, research, and internal control roles are key to ensuring all board members are appropriately informed and getting the reporting necessary to protect stakeholders. That is their duty. Growth is exceptionally important and highly desired. Having board members or an advisory firm that has been on both sides of this equation and appreciate all the plumbing (macro and micro) is essential to having a diverse and effective board in this space.
New York, NY, March 20, 2023 – Continental Insights announced today that Polly Pao has joined Continental Insights as a Partner.
Polly brings to Continental Insights more than 15 years of extensive financial experience working on innovative structured products. She has outstanding operational and risk management experience. Across her risk roles at GE Capital, Ambac and Axon, she developed and implemented internal risk methodologies to proactively monitor and mitigate against risk. "Polly adds great experience to the CI team and her perspective will be highly valuable to our clients seeking to enhance their risk management practices" said Continental Insight’s Founder and Managing Partner John Olert.
On joining, Ms. Pao said, “The collapse of SVB highlights the importance of having robust risk management operations. The bank's failure was caused by a combination of factors, including excessive risk-taking with little focus on impacts, lack of regulatory oversight and poor risk governance. Effective risk oversight will strengthen the stability of financial institutions and protect the interests of investors and other stakeholders. I am excited to be joining John’s team and look forward to helping his clients fortify their risk management framework.”
Continental Insights, is a platform that provides unique subject matter expertise to select clients that are in need of an independent perspective on enterprise risk management and corporate governance. We have served as expert witness to government agencies, provided guidance on highly complex risk management challenges to management and board of directors. We also work closely with early-stage companies seeking senior advisors, as well as start-ups looking for assistance in planning, modeling, and fund raising.
The Continental Insights team has deep experience across corporates, financial institutions, structured finance, rating agencies, media, and real estate. We also have extensive board, governance, and regulatory experience.
New York, NY, March 20, 2023 – Continental Insights announced today that Gregory Raab has joined as a Partner.
Greg has over 30 years in financial services, brings a wealth of experience as a Chief Risk Officer at GE Capital and Ambac. He is skilled in esoteric, consumer and mortgage-backed securities; as well as insurance, corporate and public finance debt. During the sub-prime crisis, Greg was recruited to Ambac to lead all restructuring, loss mitigation and risk management initiatives on $430 Billion of net par insured and to Assured Guaranty, where he led the RMBS recovery, loss mitigation and litigation efforts; recovering $3B+ of R&W claims. “I am very pleased to have the opportunity to work with Greg again and add his rich experience to our team and solutions” said Continental Insight’s Founder and Managing Partner John Olert.
On joining, Raab said, “The importance of informed Corporate Governance and Risk Management expertise has come to the forefront once again with the most recent wave of bank failures, the resultant contagion risk in Financial Services and their impact on technology companies. Boards that are representing shareholders in companies that have these complex risks or are now under severe financial distress need independent advisors to support their Enterprise Risk Committee. In addition, there may be conflicts of interest relying on the advice of management and/or other financial advisors that are representing the firm. John and I worked closely together when I served as EVP at Fitch Ratings. I’m really excited to be joining his team.”
Continental Insights, is a platform that provides unique subject matter expertise to select clients that are in need of an independent perspective on enterprise risk management and corporate governance. We have served as expert witness to government agencies, provided guidance on highly complex risk management challenges to management and board of directors. We also work closely with early-stage companies seeking senior advisors, as well as start-ups looking for assistance in planning, modeling, and fund raising.
The Continental Insights team has deep experience across corporates, financial institutions, structured finance, rating agencies, media, and real estate. We also have extensive board, governance, and regulatory experience.
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