Digest #101

Necessity to Relearn Risk Management

John Oommen

Three months into 2023, everyone is on edge. I hope the shifting ground has not affected you. But the entire world is looking at each other and wondering if it’s really going to rain. I propose a positive spin. Rain can’t bother us too much if we bring an umbrella and wear all-weather shoes. Let’s choose preventative care.

March 2023 has been a month of banking turbulence in the United States and Europe. It was triggered by the Federal Deposit Insurance Corporation's (FDIC) takeover of Silicon Valley Bank (SVB). I have been thinking about these events and the history of affected companies and the sector. I want to share some key takeaways.

What can we learn from SVB’s collapse?

SVB was a profitable and well-regarded bank by its clients until it wasn’t. The company operated a simple business model. It took deposits and provided loans to a niche client base with a lot of cash. According to SVB’s website, “nearly half [of] U.S. venture-backed technology and life science companies” banked with SVB.

I am a firm believer that a time-bound or purpose-bound existence is optimal for companies. If SVB existed with the explicit purpose of serving the fast growth company ecosystem through the easy money era, that is a great purpose-bound existence, and we should celebrate its dissolution as a completion of that purpose.

But just as we do as individuals, companies strive for more time and a greater purpose with scale. Recalibrating how a company’s strategy and operations align with a renewed and often expanded purpose is critical. This is where SVB went off track.

We all practice the fallacy of expecting the past and present to continue if we keep doing the same thing. Our current prospects are based on a few basic assumptions. We assume gifts like good health, continued care of loved ones, or that stable job providing for our lifestyle will continue in perpetuity.

SVB didn’t do a good job of pressure testing the predictable shifts in two obvious assumptions underpinning their entire business—customer sentiments and an increase in interest rates. This oversight caused the bank’s collapse.

First, SVB rose to prominence due to very conducive tailwinds of the easy money era. SVB’s assets under management doubled between 2020 and 2022 through the venture capital funding boom. This is celebratory news. But it also presented a problem. The FDIC only guarantees $250,000 per entity or person per bank. By 2022, 96% of SVB’s deposits were uninsured, compared to an industry average of 52%. This metric highlights the risk that an average SVB client should be significantly more worried that they have too much uninsured money parked at SVB.

Wouldn't we spread our money to other banks if we had too much uninsured money at one bank? This predictable customer reaction happened during the run on SVB.

Second, the business model of any bank is to ensure that interest income, which is the interest that it gets by loaning money out, is higher than interest expense, which is the interest that it gives depositors. SVB’s investment of customer deposits to make money was rudimentary. It invested in mortgage bonds and US treasuries and their value decreased by a large margin when the federal reserve predictably raised interest rates.

This spooked all those uninsured clients who also know and influence each other. This started full-blown panic and resulted in the fastest bank run in history.

In the aftermath, the FDIC and US treasury covered all SVB depositors, including uninsured customers. We could argue that’s the right thing. A counter argument is that FDIC is simply an insurance program paid for by all banks. As SVB's remains are being sold, FDIC said the loss of making all depositors whole will be $20B. FDIC will take a special assessment from all banks to cover this $20B. But think about it—would we rather have our bank pay us a bit more interest for our personal cash or pay more insurance fees for preventable mistakes?

What can we learn from the SVB story? We could all use a refresher on the basic principles of risk management.

Key Insight

In the post easy money era, our organizations must relearn how to assess and mitigate risk. Risk management is not a department or a complex Excel model. It is a practice that requires an objective, what-could-go-wrong mindset and meticulous contingency planning. It is not just important to institutions that manage people’s money or workplaces where health and safety considerations are high. Any institution can pose significant risk to one or more stakeholder groups and those risks require proactive consideration.

Call To Action...

Choose the organization that you care about the most, whether it’s a workplace, a not-for-profit, or a religious institution. Take 5 minutes and answer the following questions.

  • What are the 3 to 5 adverse outcomes that have crossed your mind recently, and why?
  • On a scale of 1 to 10, 10 being the worst impact, how badly will each adverse outcome hurt one or more stakeholder groups of the organization?
  • On a scale of 1 to 10, 10 being most likely, how likely will this adverse outcome happen within a reasonable period?
  • On a scale of 1 to 10, 10 being least effective, how effective are the protection mechanisms in place to prevent each adverse outcome?

Multiply these three numbers for each adverse outcome. For the two adverse outcomes with the highest score, summarize your answers to the four questions above. Meet with the most senior executive that you can access in the organization and share your write-up. Institutions pay us to care about all stakeholder groups.

Let's wrap this story...

As obvious as this call to action is, when is the last time any of us objectively assessed our surroundings, wrote a memo, and took it to someone important and said, “We have a problem, and I would like us to address it!” Yes, it is a hard thing to do and implies personal risk. But it is the right thing.

There are more lessons we can learn from this March’s financial sector turmoil. Stay tuned. Until then…

…Listen to the audible versions of my recent articles on Spotify. I suggest going back 18 months to review my strategic planning series, which I shared to prepare companies for the changes we are experiencing. Given the slow-burn nature of this economic correction, those themes continue to apply today.

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