What to Expect When You’re Expecting (Your Bank to Fail)

As with any business, a bank can become insolvent. But unlike most businesses, your bank holds your money or your customers’ money, making insolvency particularly fraught. In recent days, the parent corporation of Silvergate Bank (“Silvergate”) has delayed filing its 10-K report and publicly stated that it is “reviewing its ability to continue as a going concern.” The potential failure of Silvergate is alarming to financial institutions and investors active in the digital asset and cryptocurrency industry considering Silvergate’s importance as a depository for corporate and customer funds and as a facilitator of fund transfers between industry actors.

In this client memorandum, we summarize the bank resolution process and discuss some practical considerations for customers of failed banks.

1. Bank Failure

A bank “fails” and is subject to resolution in any one of the following situations:

• The bank has insufficient assets or liquid funds to meet its obligations or depositor demands in the normal course of business;
• The bank is in an “unsafe or unsound condition” as determined by the Federal Deposit Insurance Corporation (“FDIC”) or the bank’s chartering authority¹;
• The FDIC has revoked the bank’s deposit insurance;
• The bank’s conduct poses a risk to the FDIC’s Deposit Insurance Fund;
• The bank is “critically undercapitalized” as defined in the FDIC’s regulations.²

If any of these conditions is satisfied, the bank’s chartering authority will revoke the bank’s charter and close the institution.³ The chartering authority may then appoint the FDIC as receiver or the FDIC may appoint itself.

2. Pre-Failure FDIC Actions

The FDIC usually acts even before a bank “fails,” and may require the bank to adopt a capitalization improvement plan. If failure appears imminent to the FDIC, it will begin its preparations and begin a search for a healthy bank willing to acquire some or all of the failing bank’s assets and liabilities– a process known as “franchise marketing.” In the case of Silvergate, we would expect that the FDIC already has “boots on the ground” analyzing the bank’s assets and liabilities and engaging in franchise marketing.⁴

3. FDIC Resolution Process

a. Establish a Receivership

There are essentially two ways that the FDIC can resolve a failed bank: (1) sell the bank in whole or in part, or (2) “pay out” the bank. In either case, the FDIC establishes a receivership – a legal entity to resolve the bank – the moment a failed bank is closed.

Banks are usually closed after the close of business on a Friday to avoid unnecessary customer disruptions. Upon closing, customers may no longer deposit or withdraw funds, though the FDIC aims to enable customer withdrawals from transaction accounts (i.e., checking accounts) on the Monday following closing. If the FDIC has already found an acquirer, the assets and liabilities are transferred from the receivership to the healthy bank over the weekend.

Once a receivership is established, the FDIC will, among other things, sell any assets an acquirer does not purchase; perform bookkeeping, accounting, and reporting tasks; identify, verify, and pay claims as funds become available; determine whether to file suit or refer for criminal prosecution anyone whose actions contributed to the failure; and monitor any ongoing agreements with acquirers or the purchasers of assets; and so forth. A receivership is terminated only when all the bank’s assets and liabilities have been sold, liquidated, or transferred.

b. Sell the Failed Bank to a Healthy Bank

The FDIC’s preferred resolution mechanism is to sell the failed bank through one of the following purchase and assumption (“P&A”) structures:

• Basic P&A. A healthy bank purchases the totality of the failed bank’s assets, insured deposits, cash and cash equivalents. Sometimes, the healthy bank will contractually retain the option to sell certain specified assets back to the FDIC. The FDIC may also agree to share in future losses the healthy bank incurs in connection with certain assets.
• Loan purchase P&A. A healthy bank purchases a portion of the failed bank’s loan portfolio, insured deposits, cash and cash equivalents.
• Bridge bank. The FDIC temporarily acquires the failed bank’s assets until a purchaser can be found and the assets sold.

c. Payout

If the FDIC cannot sell the bank through one or more P&A arrangements, it will “pay out” the failed bank. To do so, it will first determine, based on the insurable capacities and limits set forth in the FDIC’s regulations, the appropriate payout amount owing to each depositor based upon either the records of the bank or the records submitted by agents on behalf of depositors claiming through the agent. The FDIC will then pay out the insured deposits as soon as possible after the bank closes (with the goal of paying off all depositors within two business days). In its almost century of existence, the FDIC has never failed to make a full payoff of insured deposits.

If a depositor holds funds at the failed bank exceeding the insurable limit, the depositor will have a claim against the failed bank’s estate for the uninsured amount. Under the principle of “depositor preference,” the claim of an uninsured depositor is prioritized and will be paid prior to the claims of any general creditors. Based on a preliminary assessment of the estimated value of a failed bank’s assets, the FDIC may pay uninsured depositors a portion (an “advance dividend”) of their claim. Advance dividends often range from one-third to one-half of a depositor’s claim and are typically paid within 30 days of the failed bank’s closing.

If the failed bank is acting as custodian for a customer’s assets (either cash or securities), those assets will not become part of the failed bank’s estate and will be returned to the customer or transferred to another custodian at the customer’s direction.

After returning custodied assets and paying out insured deposits, the FDIC will then liquidate the bank’s assets, pay out the remaining claims of uninsured depositors first, and then creditors and shareholders generally according to common bankruptcy procedures.

4. Practical Considerations for Customers

In general, if your banking partner is in danger of failing you should consider taking one or more of the following steps:

• Anticipate the closure of a failed bank on a Friday, the transfer of deposits to another bank over the weekend, and thus having a relationship with a new bank the following Monday.
• Evaluate whether your banking relationships are sufficiently diversified.
• If your bank is acting as your custodian, establish a custodial relationship with another bank or financial institution and determine whether to transfer your custodied assets to the new custodian.
• Determine whether any deposits you hold at the bank, either in your own capacity or in an agency capacity, are fully insured by the FDIC.
• If you have uninsured deposits at the bank, determine potential loss amounts.
• Determine whether it is appropriate to continue depositing funds into the bank.
• Establish contingency plans for the inaccessibility of any funds on deposit at the bank (up to one week for insured deposits and up to six weeks for uninsured deposits).
• If you hold deposits for your customers as their agent, consult the FDIC’s Deposit Broker’s Processing Guide (https://www.fdic.gov/deposit/deposits/brokers/index.html) to ensure that you can timely provide customer information to the FDIC for deposit insurance payouts.

If you are a participant in the digital assets or cryptocurrency market with particular expose to Silvergate, you should also:

• Establish contingency plans for the potential unavailability of the Silvergate Exchange Network which may disrupt and delay funds transfers.
• Analyze potential future ramifications, potentially including:
  • For asset managers, losses caused by any uninsured deposits at Silvergate;
  • Increased regulatory scrutiny of other banks serving the industry causing loss of access to banking services from U.S. banks; or
  • The future unavailability of credit from U.S. banks or less economic terms.

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If you have any questions or concerns based on the foregoing, please reach out to your Seward & Kissel relationship attorney at any time, or directly to Casey Jennings (jennings@sewkis.com).

¹ In the case of Silvergate, the California Department of Financial Protection and Innovation (“DFPI”).

² Generally, a bank must be closed within 90 days of becoming critically undercapitalized. See 12 U.S.C. § 1831o. It is unclear if or when Silvergate crossed this threshold.

³ If the chartering authority is unable or unwilling to close a failing bank, the FDIC or a regional Federal Reserve Bank can close the bank and appoint the FDIC as receiver. See 12 USC § 1821(c).

⁴ This process may be a bit more difficult than usual because a large portion of Silvergate’s deposits appear to be tied to entities active in the crypto industry. Many banks are shying away from offering services to anyone active in the crypto industry, which could limit the pool of potential acquirors.