In this episode of Lehigh University‚Äôs College of Business ilLUminate podcast, we are speaking with Kathleen Weiss Hanley about the recent Silicon Valley and Signature Bank failures that touched off so much turmoil in the markets both in the United States and globally. Hanley holds the Bolton-Perella Endowed Chair in Finance and the College of Business's Perella Department of Finance. She's also the director of the Center for Financial Services and the co-director of the FinTech Minor.

From 2011 to 2013, Hanley was the deputy chief economist at the Securities and Exchange Commission and the deputy director in the Division of Economic and Risk Analysis. Prior to that time, she was a senior economist at the board of governors of the Federal Reserve System in the risk analysis section and a senior financial economist at the SEC.

Hanley spoke with Jack Croft, host of the ilLUminate podcast. Listen to the podcast here and subscribe and download Lehigh Business on Apple Podcasts or wherever you get your podcasts.

Below is an edited excerpt from that conversation. Read the complete podcast transcript

Jack Croft: Your background at both the SEC and the Federal Reserve System included specifically risk analysis, which seems to be a key part of the story behind the recent bank failures at Silicon Valley Bank and Signature Bank. So let's start there. How large a role did risk management play in what happened at those banks?

Kathleen Hanley: I think that much of this is still developing even as we speak, but the circumstances surrounding Silicon Valley Bank, in particular, was that deposits began to be withdrawn. Some have said it was for liquidity reasons because of recent hikes in interest rates, and that necessitates the bank to sell assets to meet that demand. Generally speaking, a bank will get rid of assets in order of their liquidity and the ability to get par for those assets. So for example, obviously, cash would come first, and then treasury securities would be next.

Now, generally speaking, we think of treasury securities as being risk-free, which they are free from default. But what they are not free from is the risk of interest rate movements. And as we know, interest rates have been climbing in the past four to six months. And some of the treasury securities the bank held were then worth less than the amount that they paid for them because as your listeners probably know, when interest rates rise, bond prices fall. So when they had to meet demand, they began to sell assets, in which they realized a loss. And that meant that they were unable to meet the demand with assets in the bank that were highly liquid and at their full value.

So from my understanding of this, it then meant that they had to try to raise some capital to try to do that. It was unsuccessful, and the regulators began to step in in order to shore up the deposits of that bank in order to eliminate a bank run.

So the risk management failure, one of them, as I understand it, is that the bank did not hedge their interest rate risk fully. In other words, they were betting on interest rates. From the numbers that I can find, they had a portfolio of $125 billion of investments, of which only half a billion were hedged. When the run began and deposits were being withdrawn, they sought to sell $21 billion of assets for a loss of almost $2 billion. So one risk management failure is the willingness of the management of the bank to not pay for those hedges in order to potentially be more profitable.

Croft: Clearly, it seems interest rates also were a big part of this story, and we had had very low interest rates for what seemed a very long time. And did people just kind of get used to this idea that it was going to go on this way indefinitely?

Hanley: I think, certainly, consumers thought it would go on indefinitely. I don't know that everybody thought it would go on indefinitely. But because the assets of the bank, the treasury securities that had the interest rate exposure were held on the books of the bank at par value or at purchase value rather than at mark-to-market value, it was unclear what the losses, (A), were in this bank, and (B), the bank did not have to realize any of those losses on their balance sheet.

And so interest rates here, in this case, may have caught them off guard. But again, there are sophisticated hedging activities that a bank can take, or any other entity for that matter, to reduce the exposure to interest rate risk. Now, of course, that reduces their profits as well because you have to pay for those hedges.

Croft: So what are some of the key differences between the causes of the 2008 global financial crisis and the recent failures at those two regional banks?

Hanley: Well, I think the causes are quite different. The Silicon Valley Bank is a classic bank run in which the assets of the bank are insufficient to cover deposits. During the [2008 financial] crisis, many banks held assets, mainly mortgage-backed securities, that were highly correlated with other banks. Therefore, when one bank got in trouble and tried to sell those assets, all the other banks were affected because now the assets that they held would then be worth less.

In this case, this is a more isolated incidence. It doesn't seem to me that, neither of these banks were having problems because of a correlated risk with other banks. In other words, there may be other banks that hold treasuries, so that may not be fully the idea. But this Silicon Valley Bank had a lot of depositors that were not insured. They had very large deposits on this bank, and so withdrawing them is very problematic for that bank. 

I don't see this as being a systemic event per se. It has systemic implications, but in itself, it's a mismanagement of the bank's assets that partially generated this problem. In the financial crisis, even good banks were affected by this because of the collapse of the mortgage market. We're not seeing a collapse of the mortgage market. We're not seeing huge losses in the banking sector in their investment portfolios on other assets. So it is quite different than the financial crisis.

Croft: While you were at the SEC during the early years of the past decade, one of your responsibilities was overseeing implementation of the Dodd-Frank Reform Act, which was enacted after the financial crisis of 2008 that sparked the Great Recession. So looking at it, are there regulatory changes you think make sense in response to what's happening now?

Hanley: I think one possible contributor to this entire episode is the fact that Congress increased the threshold for a bank to be considered a systemically important financial institution. So under Dodd-Frank, that value was $50 billion, and Congress raised it to $250 billion. So SVB was clearly above the $50 billion range and would have been required to comply with enhanced regulatory standards, including more liquidity.

But the repeal of part of Dodd-Frank and the implementation of a higher threshold may have contributed to this by not having these banks be more overseen and being designated as being more important. And I think this episode demonstrates that a bank of $50 billion or more has the ability to send systemic shockwaves through the financial system. So I anticipate that this threshold will then be changed once again to encompass banks of First Republic or Silicon Valley Bank size.

Kathleen Weiss Hanley

Kathleen Weiss Hanley

Kathleen Weiss Hanley, Ph.D., is a professor in the Perella Department of Finance; and is Director of the Center for Financial Services at Lehigh Business.