(branch-sourced) and wholesale deposits. Retail deposits are cheapest since federal deposit insurance backs up each account to a significant level which helps hold funding costs down at banks and thrifts. However, as banks grow, their ability to grow deposits from retail branches may not be able to keep pace with asset generation and so bank treasurers may seek out wholesale deposits that can be procured in open markets. Brokered deposits are one such type of wholesale deposit, which allows banks to buy deposits from intermediaries at higher costs than would be the case for retail deposits. Bank regulators for many years have looked at brokered deposits as a source for fueling aggressive risk-taking at some banks that ultimately led to their failure. While such funding sources do need to be carefully evaluated, they can be an important way to augment funding when gaps exist. SifiBank also uses a wide variety of debt instruments of various terms (tenors). As previously mentioned, the bank must manage the composition of both its assets and liabilities in order to reduce exposure to interest rate risk. The weighted average life, or better yet the duration of its assets and liabilities, must be in relative balance for the bank to avoid major declines in the bank’s market value of equity (MVE). Since SifiBank has a large portion of its portfolio in mortgages and other longer-dated investments, it needs to extend the life of its liabilities in an effort to accomplish its asset-liability management (ALM) objectives.
Industry Structure and Competition
Since SifiBank operates in nearly every corner of the traditional banking sector, its competition comes from a variety of different entities. Banking in the United States has undergone significant consolidation for decades as economic forces have driven a large number of banks and thrifts into insolvency or merger precipitated either by economic downturns or weak performance at individual institutions. The nature of bank competition directly influences the risk exposure of SifiBank since its profitability and growth depend on how effectively it can compete in different businesses. To provide some perspective on the overall banking sector, at the end of 2013, there were nearly 7,000 commercial banks and thrift institutions operating in the United States. The industry at that time had a combined asset base of $14.6 trillion. However, 106 firms had assets greater than $10 billion and this group accounted for about 80 percent of the industry’s assets, illustrating a high level of concentration among the largest institutions. More astonishing, 36 banking institutions in the United States had assets at or above $50 billion and these firms accounted for 70 percent of all banking assets in the country.
The performance of the banking sector not surprisingly ebbs and flows with regional and general economic conditions as seen in Figure 1.3. The figure shows how in the period immediately following the financial crisis, net income for the sector was negative, driven to a great extent by mounting credit losses taking place around mortgages. With extraordinary measures taken by the Federal Reserve and Treasury Department to support banking, in time net incomes rose and the industry has stabilized since that time. Another way to look at the relative performance of the industry is to compare net interest margin (NIM) by bank asset size category (Figure 1.4). Net interest margin is defined as the difference between interest income and expense as a percent of average assets. NIM has steadily declined for banks since 2010, reflecting lower income from mortgages as interest rates began rising over time and banks started to see erosion in its fixed income sales as interest rates began coming off very low levels after the crisis.
Figure 1.3 Bank Net Income over Time
Source: FDIC Quarterly Banking Profile, 2013.
Figure 1.4 Bank Net Interest Margins Over Time
Source: FDIC Quarterly Banking Profile, 2013.
Figure 1.5 provides insight into the extent of damage done to the banking sector during the crisis as reflected in nonperforming loans (loans that are 90 days past due or worse). Banks write off (charge-off) bad loans as they become apparent and during the crisis, the noncurrent loan rate was five times that of 2006 levels and the charge-off rate was about six times 2006 levels. Since peaking at the end of 2009, credit performance has significantly improved.
Figure 1.5 Bank Trends in Credit Performance
Source: FDIC Quarterly Banking Profile, 2013.
SifiBank did not escape the financial crisis and in fact in the months following the failure of Lehman Brothers in September 2008 and both mortgage government sponsored enterprises Fannie Mae and Freddie Mac were placed into conservatorship under their regulator, SifiBank saw its stock price nearly evaporate from a price of $50 to just under $2 per share. Bank management realized that it was in trouble both in terms of liquidity and capital. It had not adequately developed its contingency liquidity plan; a framework for maintaining a level of liquidity that would allow the firm to operate under extreme conditions in which funding dried up and/or became prohibitively expensive, for the crisis that unfolded proved to be devastating to capital markets. The bank suffered several downgrades in the months leading up to receiving this special financing. It had been rated by all three credit rating agencies as AA but by October 2008, it was rated C making it more difficult and costly to raise capital. In October of 2008, the U.S. Treasury offered a financial lifeline to SifiBank in the amount of $250 billion to ensure the company would be able to weather further erosion in financial markets.
SifiBank got into this situation through a combination of errors in the way the company was managed that led it to take oversized risks as well as by way of systemic risk to the entire financial system that created a contagion effect throughout the industry. The degree of interconnectedness of capital markets and financial institutions during the year leading up to the crisis led to a sort of financial flu that spread across the sector like a viral pandemic.
In the years leading up to the crisis, senior management ignored repeated warnings from its enterprise CRO regarding an excessive buildup of mortgage loans and securities in its HFI and AFS portfolios. The bank during that period had compounded their problems by originating a set of brand-new mortgage products that had variable payment terms and other features that while flexible for borrowers often meant that they would likely run into payment shock if and when interest rates rose in the future. There had been no prior experience with such products from which to develop an estimate of credit losses and yet the bank accelerated its production of these loans at the request of senior management.
The bank, as stated earlier, had been under pressure to grow earnings and these new nontraditional mortgages enabled SifiBank to originate mortgages at spreads to Treasuries that were significantly above mortgages originated and sold to Fannie Mae and Freddie Mac. The business line CRO for the bank whose bonus was dependent in part on the success of this program acquiesced to a significant amount of risk layering taking place in credit underwriting on these new loans to the point that significant credit risk was embedded in the products for which the bank was not being appropriately compensated. Risk layering occurs when individual risk attributes such as credit score and loan-to-value (LTV) ratio are combined in ways that materially raise the credit risk profile of the loan. For instance, allowing a lower credit score for a low downpayment mortgage raises the likelihood of default for the loan beyond a loan that has both higher FICO and lower LTV (i.e., is less risky). The bank had little historical information on which to base its loan loss reserve or price these new loans and so its models reflected the low level of risk that had been present for the last decade. As a consequence it vastly underestimated the amount of credit risk it was putting on its books.
During this same period, the bank continued to reduce its corporate risk management staff believing that they would be
