In the spring of 2023, the United States witnessed the country’s three largest bank failures since the 2008 financial crisis. Market-wide developments such as high interest rates and regulation rollbacks, along with company-specific factors including overly concentrated clientele and reliance on uninsured deposits, affected leadership’s ability to effectively manage interest rate and liquidity risks, leading to mass deposit flight and ultimately the collapse of Silicon Valley Bank (SVB), followed by Signature Bank (Signature) and First Republic Bank (First Republic).

The impact of macro-economic and strategic issues has been widely discussed. However, the banks’ inability to appropriately align strategy with the macro environment indicates that insufficient risk oversight was also a significant factor. This, in turn, suggests that stronger corporate governance structures could potentially have assuaged or prevented the outcomes of these events.

In this post we examine risk oversight and board composition gaps at SVB, and compensation practices at all three banks, in discussing how the prominent failures of these three mid-sized financial institutions emphasize the importance and impact of corporate governance practices and disclosures.

Risk Oversight

In its review of SVB following the bank’s collapse, the Federal Deposit Insurance Corporation (FDIC) found that “[the group’s] growth far outpaced the abilities of its board of directors and senior management. They failed to establish a risk-management and control infrastructure suitable for the size and complexity of [SVB] when it was a $50 billion firm, let alone when it grew to be a $200 billion firm.”

The lack of direction – and accountability – appears to have started at the top. After Laura Izurieta resigned as chief risk officer of SVB in April 2022, the position remained vacant for a critical eight-month period. The formal lack of executive-level risk oversight left the bank exposed during a crucial time in which its target venture capital- and tech industry-based clientele experienced capital decline.

The board of directors of public companies owe a fiduciary duty to their shareholders to appoint management and oversee decisions that best represent the interests of the shareholders and longevity of the institution. In this case, the lack of urgency in appointing a CRO during this period raises concerns about the board’s capability to recognize and mitigate the bank’s risk exposure.  Further, a governance and risk management target exam (PDF) conducted by the Federal Reserve and California Department of Financial Protection & Innovation in 2022 indicated “weaknesses in [SVB’s] ability to self-identify internal control weaknesses and manage risks proactively,” raising the question of whether the directors’ skills and experience was sufficient to best meet and perceive the needs of the institution.

Board Skills

A well-rounded and experienced board helps to effectively guide and hold management accountable. Among other core skills, it is of particular importance for boards within the banking industry to include directors with in-depth audit, risk, legal/public policy and senior executive experience.

In SVB’s case, assessments of whether the board was appropriately structured were complicated by its approach to reporting. SVB disclosed director skills in the aggregate, providing the number of directors with a specific skill or experience without identifying which directors the company views as possessing those skills. This approach makes it difficult for investors to evaluate individual directors’ skillsets or the board’s overall composition in comparison with peer companies. For example:

  • In its 2023 preliminary proxy statement, SVB’s aggregate skills disclosure claimed that six directors had experience in “global commercial banking”. However, in reviewing the directors’ disclosed biographies, it is unclear which directors had this experience.
  • SVB disclosed that eleven of its twelve directors had “relevant business experience relating to risk management and controls”. However, none of the directors had prior experience as a chief risk officer or in risk management related roles.
  • SVB disclosed that eleven of its twelve directors had “relevant business experience relating to audit/financial reporting”. Yet it appears that only three of the twelve directors had experience as a chief financial officer or certified public accountant, a current or former partner of an audit firm, a current or former role in auditing or accounting, and/or an executive role at a bank or in the finance industry.

The skills disclosure provided by SVB didn’t just make it harder for investors to assess the board. It may also have indicated deficiencies in SVB’s internal processes for highlighting potential skills gaps and ensuring the board as a whole could effectively perform its oversight duty and advise management.

Rather than traditional banking, SVB directors’ backgrounds and experience leaned heavily toward technology and venture capital, which likely helped the bank attract clients and achieve massive growth. However, this left the bank vulnerable when it came to managing those clients’ assets.

Based on SVB’s biographical disclosure, just three directors had direct experience in executive-level positions overseeing bank operations, interest rate risk, lending or treasury management; moreover, this core banking industry expertise was not even captured under SVB’s skills disclosure. Instead, the most closely related attribute captured by SVB was “leader of [a] large complex organization”. The company stated that ten of the twelve directors had such experience; however, once again the broad category and aggregate approach to disclosure leaves plenty of room for interpretation and speculation as to which directors satisfy this classification – let alone whether such experience sufficiently qualified directors to actively identify and manage risk within banking operations.

By contrast, individual skills disclosure, often in the form of a board skills matrix, allows shareholders to discern the board’s criterion when evaluating director skills and to cross compare against the directors’ disclosed backgrounds. Over two-thirds of Russell 1000 companies disclosed a skills matrix or some other form of individual skills disclosure in 2023. Stricter criteria and a more in-depth analysis of individual directors’ skills may have assisted in SVB’s assessment of skills gaps and its ability to discern the potential talent needed to empower the board’s navigation of the challenges and prospects presented.

Narrow Incentives

The banks’ CEO pay programs, developed and administered by their compensation committees, may have further incentivized inappropriate risk-taking by failing to align executives’ interests with those of long-term investors.

SVB and First Republic’s 2022 executive compensation plans were largely tied to short-term awards and covered a narrow range of performance, with significant overlap between the metrics used under the short- and long-term incentive plans. Within that narrow scope, these plans mostly failed to account for risk and shareholder experience: they did not include risk-related metrics, and relegated total shareholder returns (TSR) to a minor role as a 20-25% modifier. Instead, payouts were primarily determined by various return and efficiency measures. Bespoke metrics such as “after-tax return on average tangible common equity” accounted for three of the four short-term incentive metrics at First Republic, whereas Signature and SVB opted for more generic variants. While SVB’s long-term incentive program placed TSR on par with ROE, the same ROE measure also served as the sole metric in a substantial short-term incentive opportunity.

A heavy reliance on return metrics (e.g., ROA, ROE, ROATE, ROATCE, ROAE, ROAA, and ROTCE) is quite common for regional banks, as is using the same return metric under multiple plans. In a group of 215 regional and diversified banks, return measures were the third most popular short- or long-term incentive metric (used 61 times in 2023), behind only earnings (80) and efficiency ratios (67). But given that executive pay programs are expected to incentivize management while keeping the company’s long-term health in mind, it’s nonetheless noteworthy that SVB and First Republic’s 2022 short-term incentive plans paid out above target and at maximum, respectively, just months before these banks collapsed. Reconciling these payouts with performance is all the more difficult for investors due to the banks’ incomplete disclosure of short-term incentive performance goals; in some cases, the use of non-public or adjusted return metrics further reduces transparency.

Toothless Safeguards

Beyond the incentives themselves, safeguards like clawback provisions and minimum ownership requirements are intended to mitigate risk and provide alignment with shareholders. In the case of the regional banks, perhaps more remarkable than the failure of these safeguards is how unremarkable they were in the context of common market practice.

Like most U.S. public companies, First Republic, SVB and Signature each had clawback in place, yet they were not able to recover any of the incentive payouts already delivered to their NEOs when things went sideways. Executives were required to hold shares equivalent to 5-6x salary (and in practice held far more), yet were still able to sell huge portions of the shares received via the incentive program in the months ahead of the collapse.

Those share disposals were understandable for founders and long-standing veterans who’d accumulated 8-9 figure shareholdings over multiple decades of employment – but the sellers also included executives like the newly appointed CEO of First Republic, Michael Roffler, who offloaded millions of dollars’ worth of shares just months after being promoted from the CFO role.

The pre-collapse sales have also raised questions regarding the boards’ oversight of 10b5-1 plans, which are intended to promote transparency and eliminate notions of insider trading activity by creating a more systematic approach for executives to buy or sell stock. For the most part, the patterns of equity disposals were in line with standard U.S. market practice. Despite this, Becker’s sale of approximately $3.6 million of SVB shares on February 27, 2023, just days before the bank’s collapse, has sparked outrage. Standard 10b5-1 plans allowed the sales to go through and, under the terms of clawback and share ownership provisions that are not uncommon for the U.S. market, the banks were subsequently unable to recover any paid executive incentives, including share awards that the executives were largely free to offload as soon as they vested.

Legislative relief appears to be forthcoming on the clawback front, at least for banks, though it may be of limited benefit to shareholders: Congress has since introduced two different bills, the Failed Bank Executives Clawback Act and the Recovering Executive Compensation from Unaccountable Practices (RECOUP) Act. Effectively, the bills would allow the FDIC to recoup compensation paid to responsible executives when an insured financial institution is placed into FDIC receivership.

Regulatory Guardrails

It’s worth noting that many of SVB’s strategic missteps would have been impossible just a few years before, under a different regulatory regime. Following the 2008 financial crisis, bank failures became increasingly rare due to stricter rules that required stress testing, cash reserves for times of crisis or to absorb losses, and diversification. Then, in 2018, the federal government rolled back many of these conditions, exempting small and mid-sized banks from these stipulations.

The regulatory landscape is of course an external factor, outside of the board and management’s direct control. However, it’s also worth noting that SVB CEO Greg Becker actively lobbied for the rollbacks, describing the prior regime as an “unnecessary burden on mid-sized banks” in a written statement (PDF, page 119) to the U.S. Senate Committee on Banking, Housing and Urban Affairs.

Moving Forward

Regardless of the regulatory or macro environment, the implementation of strong governance practices promotes transparency, mitigates investor concerns, and builds trust within the institution. While the collapses of Silicon Valley Bank, Signature Bank and First Republic did not spark a wider run on the banking industry, shareholders of publicly traded financial institutions should remain conscious of these companies’ corporate governance practices and the need for enhanced risk oversight disclosures. The lessons learned highlight the importance of seemingly simple best practices, as well as the potential weakness of certain widespread U.S. market practices relating to executive compensation.

Developing and disclosing thorough, individualized analysis of directors’ skills allows both issuers and investors the opportunity to efficiently assess the board’s balance of expertise and ensures it is well-equipped to enact sufficient oversight. In addition, boards and investors should review executive compensation programs to ensure that performance metrics used in the incentive structure support the company’s long-term strategy, and that safeguards such as clawback provisions and minimum ownership requirements are sufficiently robust to align interests and discourage inappropriate risk-taking.