Banking Turbulence: The More Things Change,
The More They Stay the Same
NEW YORK,May 1, 2023: In a review published April 28, the Federal Reserve didn’t mince words about the failure of Silicon Valley Bank, citing it as a textbook case of mismanagement, with senior leaders fumbling their oversight of basic interest rate and liquidity risks. On the same day, the FDIC made similar pronouncements in a review of Signature Bank, saying managers pursued rapid, unrestrained growth through an overreliance on uninsured deposits, and failed to implement liquidity risk controls appropriate for an organization of its size and complexity.
The funding sources that failed at these banks were different from those of the bank failures of 2007, in which financial institutions were undone largely by poor management of wholesale deposits and trust-preferred securities, as well as hyper-growth in real estate lending. However, the failures accelerated from a “contagion effect” and a lack of appropriate risk management.
Contemporaneous credit conditions accelerated their decline in April, with the Kamakura Troubled Company Index closing the month at 9.21%, up 0.22% from the prior month. The index measures the percentage of 41,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.
At the end of April, the percentage of companies with a default probability between 1% and 5% was 6.66%. The percentage with a default probability between 5% and 10% was 1.30%. Those with a default probability between 10% and 20% amounted to 0.80 of the total; those with a default probability of over 20% amounted to 0.45%. Short-term default probabilities ranged from a low of 8.70% on April 19 to a high of 9.38% on April 26. Volatility in the index diminished, but both the lows and the highs were above the prior month’s levels.
Figure 1: Troubled Company Index — April 28, 2023
At the end of April, the riskiest 1% of rated public firms within the coverage universe included eleven companies in the U.S. and one in the UK. The riskiest rated firm remained Cyxtera Technologies, Inc. (NASDAQ:CYXT), with a one-month KDP of 52.53%, up 17.69% from the previous month. There were seven defaults in the KRIS coverage universe in April, with six in the U.S. and one in Switzerland.
Table 1: Riskiest Rated Companies Based on 1-month KDP – April 28, 2023
The three-year default probability provides a more forward-looking view than the one-month probability. As we look further out on the curve, the impact of higher interest rates, the reduction in market liquidity and the rollover risk of existing debt have a greater impact on credit quality. This can be seen in Figure 2.
Figure 2: 3-Year Term Default Probabilities – U.S. Market, April 28, 2023
The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.01% at 0.96% with the 10-year rate down 1.92% at 10.71%.
Figure 3: Expected Cumulative Default Rate — April 28, 2023
Commentary
Stas Melnikov and Martin Zorn
SAS Institute Inc.
The failures of Silicon Valley Bank and Signature Bank and the vulnerable position of First Republic Bank prove that regulations are not enough to shore up the banking system. Only good management can do that. Like a driver navigating a steep mountain road, an astute bank manager should already have the right plan, tools, and skills in place to avoid a disaster, instead of simply relying on speed limit signs.
One of the most interesting statements in the FDIC report is the fact that New York Regional Office assigned Signature Bank a composite CAMELS[1] rating of 2 through March 11, 2023, indicating that its overall condition was satisfactory. As we write this report, the FDIC is preparing to take over First Republic Bank unless an acquisition occurs very soon.
As early as October 2022, Silicon Valley Bank, Signature Bank and First Republic Bank were the riskiest banks in the U.S., In December, their one-year default probability—which we use as a comparative indicator of stress—exceeded 1% as can be seen in Table 2.
One wonders what happened to the lessons managers should have learned from both the S&L crisis and the 2007-2008 global financial crisis. Didn’t bank leaders learn the necessity of having basic asset management and robust liquidity tools in place, with or without rapid growth? Hopefully, we do not need a banking crisis every decade to provide a refresher course on risk management.
One of the key questions now is whether the current banking crisis will accelerate and become a contagion. Thus far the failures have been concentrated in institutions with unique business plans and poor risk controls. Because it was a globally important institution, the failure of Credit Suisse arguably posed much greater risks.
Table 2: Riskiest Large US Banks based on 1-year KDP – as of December 2022
More broadly, the current problems will negatively impact lending, as banks naturally rein in risk at a time when overall market liquidity is being reduced. Lingering concerns about inflation point to a slowing in interest rate increases, but not a reversal of the trend. Markets sought shelter in defensive stocks, with low volatility stocks leading and high beta stocks lagging for the month. Most fixed income markets showed gains, while the commodity markets were mixed.
From an investment standpoint, this is a market that requires a solid understanding of the factors driving company risk. This is true for both liquidity risks faced by non-insured deposits in regional banks and the interest rate and macroeconomic risk faced by the broader markets. The underlying factor correlations are undergoing changes that need to be understood. This environment calls for robust data and equally robust models and tools, which can not only help financial managers understand the risks, but profit from reacting to early warnings.
SAS is well-positioned to provide all the analytics necessary to answer the myriad of questions today’s challenges pose.
About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 41,500 public firms in 76 countries that have an annualized one-month default risk of over one percent. The average index value since January 1990 is 14.31%. Since July 2022, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 7.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.
The KRIS version 7.0 models were developed using a data base of more than 4 million observations and more than 4,000 corporate failures. A complete technical guide, including full model test results and key parameters, is provided to subscribers. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, Kamakura Risk Manager. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model. Related data includes market-implied credit spreads and prices on all traded corporate bonds traded in the U.S. market. Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities yields in Australia, Canada, France, Germany, Italy, Japan, Russia, Singapore, Spain, Sweden, Thailand, the United Kingdom, and the United States, plus a 13-country “World” model. All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow.
The version 7.0 model was estimated over the period from 1990, through the Great Recession and ending in February 2022. The 76 countries currently covered by the index are Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.
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Editorial contacts:
- Martin Zorn – Martin.Zorn@sas.com
- Stas Melnikov – Stas.Melnikov@sas.com
[1] Bank examiners review and evaluate an institution’s condition using the Uniform Financial Institutions Rating System, also known as CAMELS (Capital, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk). CAMELS ratings are scored on a scale of 1(best) to 5 (worst). Examiners assign a rating for each CAMELS component and an overall composite rating.