Editor’s Note: Before we get into the big topic, some of you may be expecting my NCAA picks. Unfortunately, I have no time for that right now, but I will share with you my old guide on that for reference as well as the link to the public pick’s you want to bet against.

The one piece of advice I can give is don’t pick a Alabama-Houston final. Even if it happens, you won’t win your pool. If you want to pick one of them, at least pick a 2 or 3 seed against them.

Interestingly, this may be a year to pick a favorite as your winner given there is no clear consensus. In prior years, the popular pick would be at 30-40% to win. This year it’s half that. So Houston may be a “value” pick as they’re the favorite in the statistical models but only being picked by 14% of the public.

I had a different post planned that will have to wait for next week as I think there might be more near term interest in the events at Silicon Valley Bank (SVB) and what it means for the broader financial sector and economy.

By way of background, my first job out of undergrad was doing asset-liability management (ALM) for a large regional bank. My role was to help build a better model, principally one that could estimate the duration of demand deposits.

I don’t have the space to go into a full analysis of what went wrong with SVB but all of this was easily avoidable with better ALM practices, some interest rate hedging, and a regulator who wasn’t asleep at the wheel.

But that’s not today’s topic. Today’s topic is why the way the Fed handled the SVB failure is bad for everyone. In particular, the decision to protect depositors but wipe out shareholders creates some awful incentives that will make the next crisis worse.

The New Precedent

During the financial crisis, banks that were taken over rightly wiped out their shareholders given there was plenty of awareness of the risks involved given the time between cracks emerging and failure. The shareholders at the end were speculators.

At the same time, the Fed also extended protections to depositors. This was reasonable crisis management given the circumstances.

However, it was unclear if that would always be the law of the land. Now, it has been made clear that it is.

Once again, the Fed decided to protect depositors but do nothing for shareholders, and it is clear this will now be the expectation going forward.

Why is this so problematic? I’ll get to some examples momentarily. But first, consider that depositors at SVB were sophisticated.

Arguably, they were as sophisticated as the shareholders. This wasn’t a bank for widows and orphans. It was for investment firms and CFOs of startups.

Information Advantage

Normally, you would think investors would be more knowledgeable about a bank’s wellbeing than its depositors. But not for SVB. Investors would have had some understanding of SVB’s investment portfolio, but likely only had generalities about hedging activities and duration management.

I couldn’t even get insurers to talk at length about PMLs or variable annuity hedge sensitivities. Investors don’t know everything and often are making their best guesses off limited information.

Yes, there were reasons to be suspicious of SVB, but this wasn’t like owning Bear Stearns in early 08 or Lehman in the summer of 08.

On the other hand, depositors knew very well how poorly startups were doing and how quickly they were burning cash. They were advantaged relative to shareholders. Yet, they still got bailed out.

Why is this a problem? For a number of reasons.

The Wicked Short Seller

Back in the financial crisis, aggressive shorts forced the ultimate collapse of some of the large banks. They often used rumor and innuendo to make things sound worse than they actually were in reality.

But that was child’s play compared to what a nefarious short seller could do today. Imagine finding a bank with the appearance of a problem. You short the stock heavily.

Then, you spread rumors about its financial condition (or misrepresent data) to try to ignite a run. If you succeed even a little bit, the Fed will step in and take over the bank.

The depositors don’t care because they get made whole. The only losers are the stockholders. The short makes 100% and nobody is mad at him because it’s an “innocent crime”.

After all, who cares about the shareholders?

If you don’t think this will happen more often going forward, I’m afraid you’re naïve.

Higher Cost of Capital

Even if you doubt the above scenario, there is no doubt the cost of capital will rise for banks. If the best case for shareholders is mediocre returns, while the worst case is an increased probability of losing everything, who is going to want to own banks?

It’s a terrible risk/reward setup and suggests they should trade well below book (side note: this is probably good for insurance valuations as they become a more attractive alternative).

Why should you care about this?

Higher Cost of Credit

Because if banks’ cost of equity rises, and they are less confident in the stickiness of their deposits, they are going to make fewer loans. Or, at least, they will charge a lot more for loans.

So credit in the US just got more expensive. Think of it like a supply shortage of credit.

What else? If banks make credit harder to access, then markets will evolve and people will go elsewhere. Maybe it’s Blackrock or Rocket or Carlyle or Square. There are plenty of options outside the banking system that offer credit.

The problem is these companies have less regulation than banks so the Fed has less ability to step in if something goes wrong. It is true that most of these companies rely on wholesale funding rather than retail deposits, but there is still the potential for contagion.

Remember, Bear and Lehman and AIG didn’t have bank deposits. The problem with their failing was their interconnectedness to their competitors. It was like a row of dominoes.

So we are moving risk from the regulated banking system to the lighter regulated non-bank system where there is more potential for contagion. Sounds great!

Slower Economic Growth

Even if the shadow banks make more inroads, the cost of credit will still rise. That is bad for economic growth.

If banks have a higher cost of capital and understand the depositors will always be protected, what will their response be? They will take greater risks!

Think about how wildcatters will bet on the most binary outcome wells while large oil companies will require more proof of recoverable oil to start drilling. (If you prefer, think of the Florida home insurer behavior relative to State Farm.)

Banking will follow a similar path. Bank of America will make safe loans. A regional bank with a 20% cost of capital will take chances.

If they take greater risks, then there is a greater chance something goes wrong…which precipitates more bank runs and more depositor bailouts.

More shocks aren’t good for the economy either.

How To Draw the Line

So should we let all banks who behave badly fail? No. There are good reasons to prevent runs.

However, when there is excess risk taking, like we had over the just ended financial repression era, there needs to be consequences or the bad behavior will be worse next time.

SVB was a perfect candidate to send that message. It was a unique bank that was unlikely to presage trouble elsewhere (that doesn’t mean there wouldn’t have been fears, but the Fed could have extinguished them).

Furthermore, the simplicity of the balance sheet, the level of investment losses, and the ability for the Fed to manage the runoff, suggests depositors would have been paid 85-90c on the $. It’s not like people would have lost everything like some of the fearmongering.

While that isn’t a great outcome, it’s actually not unreasonable to think a facility could have been structured to get people to par over time and they could have easily borrowed to cover the gap.

In other words, this was not a desperation scenario where the consequences of letting the Fed manage a runoff would have been disastrous.

Yes, it would have taken weeks to play out rather than days, but is that not a fair price to achieve a better long term solution for the system? I’m guessing most here don’t remember the S&L crisis but one THOUSAND banks failed during that.

Sure, many of them were small but think about that. It was a rolling wave over ten years. Surely, we can withstand a small haircut to corporate clients of one bank for the greater good?

Buffett has the famous quote about you find out who was swimming naked when the tide goes out. It seems we have amended that to “when the tide goes out, give the shareholder’s bathing suit to the naked swimmer”.

3 thoughts on “Bankrupting Bank Shareholders Is Bad For America”

  1. I’m new to the blog, but enjoying the content very much. Great points above!

    Maybe it’s the $250k FDIC limit which makes me think of the NFIP and simultaneously wonder why a private “excess-of-FDIC” insurance market has not further been supported to underwrite deposits at various institution based on the inherent risk of default (I do believe it exists, but never talked about). I would love to see a market that’s sole purpose is to quantify and price that risk – what is the return period on an SVB run ? Maybe we would be less blindsided in the future if work was done to quantify this and someone ,other than the taxpayers, were on-risk to bail out depositors. This would however require that banks provide a similar return profile on deposits as debt capital – to your point about increased cost of capital. A private deposit insurance policy kind of acts like a mini CDS in this way. Of course, then maybe AIG would eat the whole market and 2008 repeats all over again when a systemic issue rolls around, I guess we would just circle back to our present moment if that happened….it was a nice idea when I first started typing. The originating thought was, as a depositor I should be able to lay off my risk of total loss in excess of $250k for a price and I should be reasonably compensated some close & offsetting price by a bank to effectively borrowing my capital…yes, immediate liquidity comes with a price as do running the business but maybe there is something there, we love a good free market solution in this country the last I checks and pricing this risk may be the best way to actually understand it.

    Looking forward to the next post

    1. It’s a good point and would also address the moral hazard around chasing high yield accounts. If I want more yield, I’d probably give a little back to buy cover.

      That said, it’s not hard to manage multiple banks and there are sweep products that will split your account daily. So this isn’t some insurmountable problem, other than laziness or ignorance.

      My guess is the main challenge would be how the sellers of protection would collateralize the risk. Do you just transfer the problem to instead of worrying about SVB, you worry about whether Citi can pay your excess claim?

      We can never truly fully collateralize bank risk, nor should we, unless we want a much lower standard of living. But there could be room for say a thin excess layer that comes between the primary and the Fed that might be able to be collateralized?

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