I see so much confusion out there about the banking troubles. This perception that any bank who didn’t receive a bailout 15 years ago is in trouble is so misguided. Or that social media makes bank runs more likely. Or that duration is suddenly a bigger risk than credit.
So in an attempt to set things straight, I thought I’d take an attempt at remedying some of the misunderstandings.
The fundamental issues with banks – both today and during the financial crisis – was non-bank financials (NBF). These other financial institutions created problems for the banks and, later, began the runs on them to protect their own interests.
Yes, it’s ironic that the financial institutions which largely avoid regulation were able to bring down the ones who had to follow the rules. It’s also absurd.
2008: Hedge Funds Kill The Banks
So what do I mean when I say NBF caused the 2008 panic? The “bank” runs of Bear & Lehman were created by institutional investor clients worried about trading losses at the investment banks leaving them without enough capital to trade forward.
Note, Bear and Lehman weren’t traditional banks holding deposits. In fact, their lack of deposits was considered a weakness. Their funding came from their trading clients, primarily hedge funds, in what were called “prime brokerage” accounts.
In normal times, this acted a little like insurance float. They would finance their client’s holdings and, in return, the client would let them lend out the assets for other trades to make a little spread. What’s not to like?
The problem was nothing stopped a hedge fund from leaving for another prime broker if they got nervous about your solvency. And because hedge funds all talk to each other, if one got nervous, they would all get nervous.
This meant the solvency of an investment bank depended on perpetuating a confidence game to keep their clients believing they were good risk managers.
When the financial system started experiencing large mark to market losses on risky securities, the confidence was blown. Nobody cared whether the paper losses at Lehman or Bear were legit or would recover in time.
That was irrelevant. They were playing a game of chicken. Prime brokerage clients had to gamble their bank could weather the storm and wait for the paper losses to recover or leave for safer shores.
Meanwhile, hedge funds who didn’t have exposure were more than happy to short Bear’s stock (and others) and feed the rumor mill for a short term score (even if it made the larger financial system more precarious and likely cost them $ long term).
What’s the lesson here? Bear and Lehman’s biggest risk wasn’t their trading assets. Many of these eventually recovered in value to some degree.
No, the problem was they put their fortunes in the hands of a small number of lucrative clients who talked to each other and thus took on a hive mentality which effectively meant they had one uber-client who could take down the bank.
It was the concentration of similar clients that destroyed Bear and Lehman (and Merrill and others).
2023: VCs Act In Concert
You can probably see where I’m headed next. The problems that began at Silicon Valley Bank were caused by venture capital funds.
Just like the hedge funds in 08, the VC firms concentrated their deposits, in this case with SVB. While the Treasury duration bet was misguided, it could have been managed over time if SVB had a stable deposit franchise.
But because SVB had NBFs as its funding source, they were also playing a confidence game with depositors. The VC world is even more incestuous than the hedge fund world.
When news emerged that something was wrong, the hive mind was instantaneous. The idea that “social media” caused a bank run is misleading. VCs on social media, all amplifying the panic of their peers, caused a bank run.
If social media didn’t exist, they would used that antique called a phone and started calling each other to assess the state of fear. The outcome would have been the same.
Similar to hedge fund money in prime brokerages, VCs could move $ out of SVB nearly instantaneously. Make a couple of phone calls and you’re done.
The hedge funds at least had to get in house counsel involved to draft agreements with their new primes. VCs could set up a new account online, spend 1/2 hour visiting the branch to turn in the paperwork, and be done.
But again, the speed of the move was enabled by having sophisticated clients who all talk to each other.
Note, Signature and First Republic were fairly similar. Just substitute wealthy New Yorkers for Silicon Valley founders. But there was a common theme of sophistication, big $, and interconnected clients.
Now, it’s easy with hindsight to blame these banks for not realizing the overlap of their clients really meant they only had one client who was a high flight risk.
That said, there is also a Tragedy of the Commons issue here. The banking system is a public trust. Loss of trust in it harms all Americans, as we saw in 08.
Is it right that unregulated financials like hedge funds and VCs can game the system and demand banks hold capital to fund their flight risk?
Should the broader economy have been put at risk to protect the interest of unregulated NBFs? Nobody protects the interest of their “depositors”!
If you are a LP of a hedge fund or VC, you don’t get deposit insurance if the firm makes bad investments. So why does the GP get protected when they make deposits at a bad bank? Isn’t the person who runs the hedge fund far more sophisticated than a wealthy individual writing a LP check?
It doesn’t seem right that sophisticated financial firms get to free ride off the capital restrictions at banks while having few rules of their own.
Pro Cyclical Accounting
Let me squeeze in one last topic as best I can (it arguably deserves its own full post) – pro-cyclical accounting.
Mark to market accounting for financials leads to panics. Therefore, accounting causes banks to fail that wouldn’t have otherwise. This is terrible public policy.
Did SVB own too many Treasuries? Yes. Should they have hedged the rate risk? Yes.
But if a bond price is temporarily marked down, that doesn’t mean it has to liquidate at that price. If the depositors kept their cool, SVB would have been able to meet all normal deposit withdrawals over time.
They did not suffer permanent investment losses, such as if there were a bad credit that defaulted. All those Treasuries were guaranteed by the US Government and would have been paid at par.
The risk to SVB was that their earnings would have been lower because they accepted too low a yield vs. what they would have had to pay in interest to keep the deposits. But a depositor doesn’t care what the bank’s earnings are.
The only reason there was a run was because supposedly sophisticated financial investors believed that the mark to market losses were permanent.
Is this only a result of bad accounting? No, but the bad accounting makes it easier for people to come to that conclusion.
For example, nobody has started a run on banks with big commercial real estate exposure. Why? Because it’s not marked to market.
What’s riskier as a depositor? A bank with too much duration in risk-free Treasuries or one with too many CRE loans that will eventually default but haven’t gone delinquent yet?
By the way, if you want to know why P&C doesn’t have this bad accounting, it’s because about 10 years ago a motley group led by myself and several readers of this blog stood up to FASB to fight back against plans to mark to market everything and, amazingly, we won.
If you want an idea of what things would have looked like, check out this miserable new IFRS 17 that has destroyed the meaning of a combined ratio overseas.
But to the broader point, mark to market information is useful, but can also be very deceiving. Remember, marks change daily.
Nobody forced you to default on your mortgage when gas prices or egg prices got high because the market price means they’ll stay there forever!
Market prices are only a reflection of the price of the most recent trade. The entire banking system shouldn’t be evaluated based on a single day’s trading that may look foolish months from now.
What Have We Learned?
If you’re a bank, make sure your clients don’t all look the same.
Also, make sure they aren’t NBFs who will shoot you to protect themselves.
NBFs (not just HF & VC but all the non-bank lenders) pose more risk to the financial system than banks and need greater regulation.