CONVENTIONAL FINANCE

Lesson 3: Reading the Warning Signs - How Supervisors Detect Problems

Today, we'll discover how supervisors actually spot problems before they become disasters.

Welcome to Your Detective Training!

In Lessons 1 and 2, we learned what supervisors do and what tools they have. Today, we'll discover how supervisors actually spot problems before they become disasters. Think of this as learning to be a "financial detective" - finding clues that others might miss.

Part A: The Two Ways Supervisors Watch Banks

1. Off-Site Monitoring (Watching from a Distance)

Imagine trying to check if your friend is healthy without meeting them. You might:

Ask them to send regular health reports
Check their fitness app data
Look at their social media for signs of illness

Supervisors do something similar with banks:

Regular Reports Banks Must Submit:

Daily: Liquidity position (How much cash do they have?)
Monthly: Loan quality, deposit levels, profit/loss
Quarterly: Detailed financial statements, risk assessments
Annually: Comprehensive reviews, stress test results

A supervisor said:

"Off-site supervision primarily consists of the analysis of regulatory returns... to monitor the financial condition of firms"

Real Example from SVB: The Fed received reports showing:

December 2022: Unrealized losses of $15 billion on securities
January 2023: Deposit outflows beginning
February 2023: Liquidity coverage ratio declining

The warning signs were in the reports! But supervisors didn't act quickly enough.

2. On-Site Inspections (The Deep Dive)

This is when supervisors actually visit the bank and dig deep:

Another report said:

"Supervisors need to be a felt presence in the institutions they supervise... developing a thorough knowledge of each institution"

What happens during an inspection:

Supervisors arrive at the bank (sometimes with little warning)
They examine internal documents not in regular reports
Interview management and staff
Test whether systems actually work
Review specific loan files and transactions
Can last from a few days to several months

Part B: The CAMELS Framework - Your Diagnostic Tool

Remember CAMELS from Lesson 1? Let's now learn how supervisors actually use it to "diagnose" a bank's health:

C - Capital Adequacy

The Question: Does the bank have enough of its own money as a cushion against losses?

What Supervisors Check:

Capital Ratio = Bank's Own Money ÷ Risk-Weighted Assets
Minimum is usually 8%, but troubled banks need more
Quality of capital (real money vs. accounting tricks)

Warning Sign Example:

Bank A: Capital ratio = 12% (Looks healthy!)
BUT: Most capital is "deferred tax assets" (future tax breaks)
Real money buffer = only 4%
Supervisor's Verdict: PROBLEM! Not enough real capital

A - Asset Quality

The Question: Will borrowers pay back their loans?

What Supervisors Check:

Non-Performing Loans (NPLs): Loans where borrowers stopped paying
Concentration risk: Too many loans to one sector?
Underwriting standards: Is the bank checking if borrowers can pay?

SVB's Fatal Flaw:

56% of loans to venture capital/private equity (very risky!)
When tech sector struggled, many loans went bad simultaneously
Classic concentration risk that supervisors identified but didn't force change

M - Management Quality

The Question: Are the people running the bank competent and honest?

From a report:

"Often the root cause of bank failures and crises can be traced to poor governance"

What Supervisors Assess:

Does the board challenge management?
Is there a proper risk management function?
Are internal controls working?
Track record of management

Red Flags from SVB:

No Chief Risk Officer for 8 months during critical period
Board didn't understand interest rate risk
31 open supervisory findings not addressed
Management consistently over-promised and under-delivered

E - Earnings

The Question: Is the bank making sustainable profits?

What Supervisors Examine:

Profitability trends (improving or declining?)
Sources of profit (sustainable or one-time gains?)
Compared to similar banks

Warning Pattern:

Year 1: High profits from risky lending
Year 2: Even higher profits, everyone happy
Year 3: Losses start appearing
Year 4: Bank fails

L - Liquidity

The Question: Can the bank meet withdrawal demands?

The Critical Metrics:

Liquidity Coverage Ratio (LCR): Can the bank survive 30 days of stress?
Deposit concentration: Are a few large depositors controlling the bank's fate?
Asset liquidity: Can assets be sold quickly for cash?

SVB's Liquidity Crisis:

94% of deposits were uninsured (above $250,000)
When panic started, $42 billion withdrawn in ONE DAY
Securities portfolio had $15 billion in losses if sold
Perfect storm: Couldn't sell assets without massive losses

S - Sensitivity to Risk

The Question: What could go wrong and would the bank survive?

Types of Risk Assessed:

Interest Rate Risk: What if rates rise/fall?
Credit Risk: What if many loans default?
Operational Risk: What if systems are hacked?
Market Risk: What if asset prices crash?

Part C: Modern Risk Detection - Beyond CAMELS

The Business Model Analysis

"A thorough business model analysis aims to assess the viability and sustainability of a bank's current business model"

Supervisors now ask bigger questions:

Is this bank's entire strategy flawed?
Can this bank make money without taking excessive risks?
Is the bank prepared for technological change?

Example Analysis:

Traditional Bank: Makes money from loan/deposit spread
Challenge: Interest rates near zero
Response: Moving into risky trading
Supervisor's Concern: Bank lacks trading expertise - recipe for disaster

Forward-Looking Risk Assessment

Modern supervision isn't just about current numbers - it's about what's coming:

Stress Testing: Banks must prove they can survive scenarios like:

GDP falling 5%
Unemployment hitting 12%
Property prices dropping 30%
Major cyber attack

SVB Failed Its Own Stress Tests:

July 2022: Failed internal liquidity stress test
Management's response: Changed the assumptions to pass!
Supervisors saw this but didn't force immediate action

Peer Comparison

"Peer analysis is used to identify outliers across the industry"

How It Works:

Average Bank: 15% of loans to commercial real estate
Bank X: 45% of loans to commercial real estate
Supervisor's Question: Why are you so different? What do you know that others don't?

Often, being very different from peers signals hidden risks.

Part D: The Art of Pattern Recognition

Early Warning Indicators

Experienced supervisors learn to spot patterns. Common early warnings include:

Growth Patterns

Red Flag: Assets growing much faster than peers
Why: Rapid growth often means lower standards
SVB Example: Tripled in size in 2 years → Classic warning sign

Behavioral Patterns

Red Flag: Constantly arguing with supervisors about findings
Why: Suggests cultural problems and unwillingness to address risks
Real Example: "Banks that fail often have a history of disputing supervisory findings"

Financial Patterns

Red Flag: Profits heavily dependent on one activity
Why: No diversification, vulnerable to shocks
Example: Bank making 80% of profits from crypto trading

The "Too Good to Be True" Test

"Supervisors should be skeptical of institutions that report returns substantially above peers"

Case Study Pattern:

Bank claims: "We've found a new way to make risk-free profits!"
Supervisor thinks: "There's no such thing as risk-free profits"
Investigation reveals: Hidden risks or fraud
Outcome: Bank fails or major losses

Part E: Why Problems Still Get Missed

The Challenge of "Low Probability, High Impact" Events

Supervisors struggle with risks that:

Seem unlikely to happen
But would be catastrophic if they did

Example: "What if all tech companies withdraw deposits on the same day?"

Probability: Seemed very low
Impact: Destroyed SVB in 48 hours
Lesson: Must prepare for "tail risks"

The Timing Dilemma

From the IMF paper:

"The supervisor who intervenes in what appears to be a well-run, profitable bank will seldom be appreciated"

The Supervisor's Paradox:

Act early when problems are small → Criticized for overreacting
Wait for clear evidence → Criticized for acting too late
No winning!

Today's Key Takeaways

Supervisors detect problems through continuous monitoring (off-site) and deep dives (on-site)
CAMELS provides a systematic framework for assessing bank health across six dimensions
Modern supervision is forward-looking - using stress tests and scenario analysis
Pattern recognition is crucial - rapid growth, outlier positions, and behavioral red flags
Early detection requires skepticism - questioning good results, not just bad ones
The best supervisors see what others miss - connecting dots across different risk indicators

A Critical Lesson from SVB

All the warning signs were there:

Failed internal stress tests ✓
Massive concentration risk ✓
No Chief Risk Officer ✓
Rapid, unsustainable growth ✓
31 unaddressed supervisory findings ✓

The detection wasn't the problem - the response was.

Check Your Understanding

What's the difference between off-site monitoring and on-site inspection?
What does each letter in CAMELS stand for and what question does it answer?
Why might rapid growth be a warning sign rather than good news?
What is a stress test and why is it important?
How did SVB manipulate its stress test results and why should this have triggered action?

Preview of Lesson 4

Next time: "The Rules of the Game - Understanding Banking Regulations"

We'll learn about the key regulations banks must follow, why these rules exist, and how they create the framework for safe banking. We'll decode capital requirements, liquidity rules, and the international Basel standards.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Fuel more mind-shifting insights: Buy me a coffee and watch the wisdom percolate! ☕💡

Buy Me a Coffee

If you found this blog post insightful, don’t forget to subscribe to our website for more updates. Your subscription will help us continue to bring you the latest insights. And if you think this post could benefit others, please feel free to share it. Let’s spread the knowledge together!