Everyone Involved in the SVB Collapse Did Badly on Tape – 03/24/2023 – Ezra Klein

An observation made by journalist Matt Klein has been circulating widely. Speaking of the collapse of Silicon Valley Bank, he wrote that “it was more a case of ‘an idiot run on the bank’ than ‘a bank run by idiots'”.

But why choose? Everyone involved came out badly on tape.

The regulators did nothing, although the SVB’s problems were noticed by many. Bank managers failed at the basic task of hedging against the risk of rising interest rates.

Midsize banks, including Silicon Valley Bank itself, lobbied Congress and the Trump administration to be exempted from regulations imposed on banks deemed too big to fail.

Investors unleashed an unnecessary panic that annihilated an institution fundamental to its own industry. The Federal Reserve has turned a blind eye to inflation, and its hasty reaction has itself become a risk factor.

I don’t believe that all these people are or have become idiots overnight. A more generous interpretation is this: none of us is ready for change, and we are living in an age of change. Three of them, in particular, deserve our attention at this point.

1) Low interest rates are over

In his 2020 letter to investors, Seth Klarman, CEO and portfolio manager of the Baupost Group, wrote: “The low interest idea has seeped into everything: investor thinking, market forecasts, inflation expectations, valuation models, indexes. leverage, debt ratings, affordability metrics, property prices and corporate behavior”.

He went on to say that “by truncating negative volatility, preventing company failures and postponing the day of accountability, these policies have persuaded investors that risk has gone into hibernation or simply disappeared.”

Point to Seth Klarman. The collapse of Silicon Valley Bank cannot be seen in isolation from the long era of low interest rates.

The bank specialized in serving startups that had little or no revenue but still had plenty of cash — much of it coming indirectly from the huge increase in the money supply created by the Fed. Deposits at Silicon Valley Bank rose from $62 billion at the end of 2019 to $189 billion at the end of 2021. And the bank has tried to play conservatively. He stashed the money in what, in the low-interest era, was seen as the safest and safest investment of all: US Treasuries and other long-term bonds.

But, as historian Adam Tooze wrote, what this really meant was that they were “placing a huge, over $100 billion, one-way bet on interest rates.”

When interest rates fall, the value of bonds falls as well. It wouldn’t have mattered, perhaps, if Silicon Valley had hedged or diversified properly. But he didn’t. It might not have mattered if your customers hadn’t needed their money back, and fast. But they did. With the rise in interest rates, those startups were unable to raise money so easily and had to withdraw part of what they had in the bank.

As a result, SVB was heavily exposed to rising interest rates on its deposits and investments.

The reason SVB’s difficulties led to the more general panic – which is now gripping banks with very different characteristics – is that its circumstances may have been specific, but its problem is general: the financial economy we are in was built on a low interest basis.

If you ask “who owns a lot of long-term bonds and mostly banks tech startups in the Bay Area?” then there are few institutions that fit that description.

If you ask instead, “Who planned for rates to stay low and might be vulnerable now that they’re going up?” there are many, many possible candidates.

2) The dangers of viral financial movement are evident

John Maynard Keynes had little patience with the myth of the rational market. He wrote that choosing stocks to buy was like playing a game “in which the contestants must choose the six prettiest faces out of a hundred pictures, with the prize awarded to the contestant whose choice most closely matches the average of the contestants’ preferences as a whole. So each contestant needs to choose not the faces he finds most beautiful himself, but the ones he thinks are most likely to please others.”

What he wanted to demonstrate is that, in the short term, a lot of what you do in finance is predicting what other people think. But one difference between our era and Keynes’s is that we have real and immense access to what other people think. We don’t have to try to figure out which faces our competitors consider to be the most beautiful.

It has been debated whether Silicon Valley Bank would have survived if a small group of investors had not created a panic with their exchanges of ideas in various group chats. I don’t know if this is a useful question.

It is not possible to ban group chats (and, let’s be clear, this is not something you should do). But digital information and digital banking mean that bank runs can happen with astonishing speed and spread to other institutions.

As Gillian Tett pointed out in the Financial Times, “a notable detail is that around $42 billion, a quarter of the money deposited at the SVB, left the institution in a few hours mainly digitally”.

And it’s not just bank runs. Everything from the accelerated rise and fall of cryptocurrencies to the odd timing of meme stocks reflects the digital acceleration of the financial world.

There’s been a question floating around financial regulation for a few years: should we slow down the system again, to a speed at which humans can work?

There is no single idea here that could be applied to all cases – a financial transaction tax would curb high-speed algorithmic trading but not prevent a bank run – but it is worth reflecting on whether speed should be seen. and seen as a financial risk factor in itself.

3) Financial regulators were waging the last war

In 2015, SVB CEO Greg Becker argued with the Senate Banking Committee that the Dodd-Frank financial regulatory rules should be relaxed for banks like his.

If they weren’t, he warned that Silicon Valley Bank “will likely have to divert significant resources that would be used to fund companies that create jobs in the innovation economy towards compliance with heightened prudential standards and other requirements.” Too bad this wasn’t done!

But it is interesting to read his testimony, for reasons that go beyond simple irony. It’s an argument about what makes a bank “systemically important,” a term used to describe a financial institution that cannot be allowed to fail.

It’s an argument that has persuaded the Trump administration, as well as nearly all Republican congressmen and a good number of Democrats.

In his book “The Money Problem,” Morgan Ricks, an expert on financial regulation at the Vanderbilt School of Law, writes that the problem has deep roots. According to him, systemic risk “has not yet been defined in a way that is even close to being satisfactory”. In the Dodd-Frank Act, lawmakers tried to define it in terms of assets: with $50 billion or more, you represent systemic risk.

Becker and senior executives at many other mid-sized banks have argued that this threshold is too low and too simplistic. To them, you wouldn’t be a systemic risk if you weren’t a big bank trying to do exotic financial engineering.

“Like our midsize peer banks, SVB does not pose systemic risks,” Becker said. “We do not market making, underwrite securities or engage in other global investment banking activities. Nor do we trade complex derivatives, offer complex structured products or engage in other activities of the type that contributed to the financial crisis.”

In other words, the idea was that we know what a systemic risk bank looks like: it’s like the banks and other financial institutions that caused the crash of 2008. This is a classic case of fighting the last war. But it is something that is very present.

When Silicon Valley Bank failed, it had approximately $200 billion in assets. It was a significant amount, but not huge. As Becker put it, the bank wasn’t trading complex products or doing anything like what sent the global economy into crisis in 2008. Yet, when it failed, regulators declared it systemically important and pumped in cash to insure all its deposits. . The government’s definition of systemic importance has proven to be false.

But that brings us to a broader issue: banking is a crucial type of public infrastructure that we pretend to be a private sector of risk management. The concept of systemic risk was intended to protect quasi-public banks, differentiating them from truly private banks which, in most cases, can be left to manage their liabilities on their own.

But the lesson that the last 15 years have taught us is that there are no truly private banks, or at least we don’t know in advance what they are.