In 2023, Silicon Valley Bank, one of the biggest banks in the US, was forced to close its doors due to a core risky financial decision: hedging bets on low interest US Treasury bonds. The bank’s failure indicates a particular understanding of how financial services organizations do not properly model risk and ensure that their short-term bets on Treasury bonds are not served well in the face of interest rates rising due to inflation risks. With Covid’s boon in interest rate decreases, Treasury bonds purchased in 2020 and 2021 are now virtually useless causing a shortfall of nearly $828 billion in most bank reserves. Let’s take a look at how we can prevent such catastrophic bank failures using proper model risk techniques as outlined in Basel III.
What is Basel III?
Basel III is an international set of banking regulations created to protect banks from insolvency during times of economic crisis. It sets guidelines for capital requirements and liquidity ratios that must be met by banks in order to remain solvent. The idea behind Basel III is to ensure that banks have enough capital on hand to absorb potential losses while also maintaining adequate liquidity so they can meet customer demand for withdrawals or lending purposes.
Model Risk Management Techniques Under Basel III
When it comes to model risk management, Basel III requires banks to design and implement models that accurately measure market risk exposure and provide early warning signs for any potential losses. Banks must also establish effective governance structures for their models which includes defining roles and responsibilities, setting up a model validation process, and developing strategies for monitoring ongoing changes made to the models over time. Additionally, banks must perform stress tests regularly to gauge how well their models would respond under extreme market conditions such as high inflation or deflation rates.
Loopholes in Basel III That Make Liquidity Crises Possible
Banks are constantly at risk of liquidity crises, which is why it’s essential that they have effective policies in place to protect against them. One such policy is Basel III, a set of international regulations designed to ensure banking stability. But even with Basel III in place, banks still need to be aware of potential loopholes that could lead to a liquidity crisis. Let’s take a look at what these loopholes are and how banks can close them.
The Asset Side Gap Risk: This loophole occurs when bank assets fail to cover their liabilities. This can happen for a variety of reasons, including if the bank has taken on more debt than it can service or if its assets have lost value due to changes in market conditions. To close this loophole, banks should review their asset side gap risk regularly and be prepared to adjust their strategies as needed.
The Market Risk Gap Risk: This loophole is similar to the asset side gap risk but it applies specifically to market risks. It occurs when banks don’t properly account for or manage the risks associated with volatile markets and sudden changes in interest rates. To close this loophole, banks should make sure they have adequate capital reserves and hedging strategies in place so they can weather any sudden shifts in the market.
The Credit Risk Gap Risk: This loophole occurs when banks don’t adequately assess the creditworthiness of borrowers or properly manage loan portfolios. To close this loophole, banks should ensure that they have strong credit policies and procedures in place that allow them to accurately evaluate borrowers and manage their loan portfolios accordingly.
Moving Forward with Model Risk Management After Silicon Valley Bank’s Failure
The failure of Silicon Valley Bank demonstrates just how important it is for financial institutions to adhere strictly to model risk management practices as outlined by Basel III regulations. In addition to following these regulations closely, there are other steps that banks can take beyond what is required by law. For example, they should review their existing operational processes and assess if they are able to adequately handle sudden shifts in market conditions such as those experienced during Covid-19 pandemic or Brexit negotiations. Banks should also consider implementing independent reviews which include third-party assessments of their existing models and systems before making any large-scale changes or investments into new ones. Finally, it is essential for all senior managers within the organization to receive ongoing training on model risk management so that they understand its importance and implications on the organization as a whole.
Model risk management is essential for preventing catastrophic bank failure such as what happened with Silicon Valley Bank earlier this year. Following proper guidelines such as those outlined by Basel III regulations can help ensure that financial institutions maintain adequate capital levels while still being able to meet customer demands when necessary. Beyond just following these regulations though, it’s important for organizations to continually evaluate their existing operational processes and consider implementing independent reviews before making major decisions about new investments or system changes moving forward. By doing so, banks can better protect themselves against future market volatility while still providing quality services without putting customers at risk.
Managing your model risk doesn’t have to be difficult. Using tools like Connected Risk’s Model Risk Management solution can assist your financial institution with the tools necessary to manage your risk and ensure your organization continues to prosper into the future. Learn more by clicking here.