Opinion Credit

Duncan Sankey

What do the failures of institutions as diverse as Silicon Valley Bank (SVP) and Credit Suisse have in common? Answer: governance.

The immediate cause of SVB’s failure is well rehearsed. It (over-)extended duration on its ballooning securities book in a falling rate environment. In an attempt to staunch a bleeding net-interest margin as deposit rates rose, it planned to sell down some of its $26 billion available-for-sale portfolio (which was largely unhedged) in order to reposition it, with an attendant $1.8 billion loss, which it sought to plug with a $2.25 billion capital raise. As the capital raise wobbled, SVB’s depositors yanked out $42 billion in one day, leading SVB to topple over.

So why had SVB aggressively extended duration? And why did years of deterioration in the risk environment go unchecked?

Weak executive pay guidelines

However, missing from SVB’s C-suite compensation policy is anything to qualify and contextualise equity return-based performance. Fifth Third, an institution to which SVB benchmarked itself in its proxy statement, also largely uses ROE-based criteria in determining executive remuneration. However, it may reduce its compensation pool — with no downside cap — based on a common-equity tier-one-ratio floor and modifiers, including metrics for non-performing assets, customer satisfaction and ESG priorities. Tellingly, as of this year, Fifth Third will revisit the use of a loan-to-deposit ratio as a qualifying factor in determining variable compensation.

Absent such checks and balances, SVB’s management reached for the stars in terms of ROE and got there: between 2017 and 2018 the bank’s ROE rose from 12.4% to more than 20% and, indeed, part of the goal of restructuring the securities book was to keep equity returns (and compensation) at such elevated levels.

But the focus of the compensation package was disproportionately geared to reward over risk. While executive variable compensation at SVB was subject to clawback, such recoupment only applied to malfeasance or misstatement rather than excessive risk-taking. This stands in contrast to Regions, another institution to which SVB benchmarked itself, which provides for clawback if an executive engages in “excessively risky or detrimental conduct”.

Attention must move to the board. To provide a constructive challenge to the C-suite on such issues as risk management, it must have adequate independence from management and the appropriate expertise. So it is surprising to find that SVB’s risk committee had only one individual with banking experience, which, given they departed the banking industry 27 years ago, was possibly a little stale. Again, some of SVB’s chosen peers fare better. For example, over half of the members of Capital One’s risk committee are current or former bankers.

Unfortunately, assessing the appropriate expertise and independence of a board is a qualitative action. Similarly, evaluating executive compensation regimes and the perverse incentives they may create requires a judgment call. It is up to investors to make the call based on their own — unashamedly subjective — judge of character. It all seems a bit touchy-feely, doesn’t it?

But, as we often realise too late, true corporate sustainability derives from sound governance. A bit ‘woke’? Possibly. But better than being caught asleep at the switch.