Odd Lots - Dan Davies On What Brought Down Silicon Valley Bank

Episode Date: March 14, 2023

Silicon Valley bank collapsed at record speed. And the world is still trying to figure out what went wrong? How did a bank with a strong history, a strong brand, and a fairly conservative investment portfolio go belly up so fast? On this episode of the podcast, we speak with Dan Davies, a Managing Director of Frontline Associates, who previously worked as a bank analyst. He explains why the bank's customer base turned out to be so much more flighty than expected, and why the bank reached for yield buying long-dated Treasuries at a time of ultra-low interest rates. We discuss what to watch next, and why he's concerned that the initial salvo to stanch the bank run may not be enough.See omnystudio.com/listener for privacy information.

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Joe, a lot has happened in the past few days. I don't even know where to start, really. Yeah, I mean, I don't either. But I would say, look, the developments, I think, related to Silicon Valley Bank, the speed of the run and the speed of the response are extraordinary.

And it feels to me like this episode could change like how banks work in this country. I mean, it's incredible. It's like all deposits seem like they're de facto guaranteed changing the collateral schedules so that banks don't have to take a mark-to-market hit on some of their assets. This is extraordinary stuff here. Absolutely. And I am going to start this particular odd lots with a caveat, which is that Obviously, things are very fast moving and we're trying to get some emergency episodes out as quickly as possible.

So this is our first entry into what I'm sure will be very, you know, a lot more on this topic. But we are going to be speaking with Dan Davies. He is a managing director at frontline analysts. He's also a former regulatory economist at the Bank of England. He was a banking analyst for a very long time and the author of Lying for Money, which is a book. all about financial fraud, a very good book, I might add. Dan, thank you so much for coming on all thoughts. Thanks very much for having me. It's always bad news when people want to talk to a guy like me. It's too good to be here. I was going to say at short notice as well, but we appreciate you coming on. So why don't we just start with a very big picture question, but how would you characterize the events of the past week or so? I think what's happened is that we're seeing why certain kinds of

deposits are considered to be hot money. At the end of the day, you've got corporate deposits, which people like to think are sticky, and wealth management deposits in Signetia, New York, which is the other bank that's been shut down and taken over by the FDIC this weekend, which people like to think are sticky, but they're big amounts of money. It's not like a few thousand in the bank that people have for their transactions. It's a sum of money that people get worried about if they think they're going to lose it. And that means it can be sticky for a while, but when it moves, it really moves. And that's why most regulators don't let you fund long-dated assets out of that kind of deposit. Right. Or put limits on your ability to do it.

So I didn't, so what was this case with Silicon Valley Bank specifically in, you know, which it would, I mean, not only did it accumulate an extraordinary amount of a corporate deposits, but also highly, all more or less than sort of one industry. Yeah, I mean, well, Silicon Valley Bank, according to everyone I've spoken to about it, we're just very good at customer service with tech companies in Silicon Valley. There's no particular magic to the business model. It's just they built themselves around that. They did a lot of business on the golf course. I'm told. And when you had a venture capital funded startup, which might easily have $10 million in the bank, they would be the guys who would onboard you easily, give you a bunch of corporate

credit cards for your kind of teenage coders who've never had a credit card before, and just generally look after you in a way that other banks weren't as sharp on the consumer customer service. My wife used to be involved in a tech startup in New York City, and she said, like, at every accelerator event where startups would, like, get money or like raised from VCs, they're always just reps from Silicon Valley Bank there, ready to, like, show people how to open up an account like instantly. And that was just like part of the process of raising VC money was basically part and parcel with getting your Silicon Valley Bank account. And being good at gathering those deposits means that you gather a huge amounts of those deposits. And then through the last couple of years, when you had a massive boom in terms of VCs, putting money into their portfolio companies, they just got these huge inflows of deposits. So, I mean, one of the most difficult things to manage your banking is rapid growth.

And in particular, you had rapid growth in deposits at a time when interest rates were very low. So, you know, the actual equilibrium covering their cost of business spread on these deposits, you know, they might have had to pay negative 50 basis points of interest rates. And the company doesn't want to do that because it's going to damage the franchise in the one turn. The company certainly doesn't want to turn business away. So what they end up doing is putting the money in higher yield and securities. And to do that, you've got to move out on the maturity curve. And this is the sort of thing that has switched on bank supervisor ought to be stopping you from doing it. Right. So I do want to get into the regulation aspect of it. But before we do, just on SVB specifically, I mean, it seems to me like you had these

inflows of hot money. You had a concentration of depositors in the tech industry where money tends to be very volatile and momentum driven. And certainly over the past year, you can imagine a lot of people were pulling stuff out. And so you had this sort of classic asset liability duration mismatch. But why didn't they hedge more? Because it would seem like this was an obvious vulnerability just based on the dynamic that I just described. Yeah, I think that's a, you know, that's a real, really good question that presumably they're going to be asking themselves right now. And I think to some extent, they haven't realized the extent to which their customers were not separate entities in terms of their financial decision making. So you might have thought you had some diversification there, but in fact, if all these people are funded by the same few VCs and all those VCs are on the same WhatsApp group, then actually behaviorally, this isn't a thousand guys with 10 million each.

It's one big conglomerant of guys with 10 billion. And the real trouble was, though, that their commercial incentives were completely the other way. you've got these deposits, you're providing this excellent customer service, which was the backbone of their franchise, that costs a lot of money. So you've actually got to do something that earns you a bit on the asset side or give up the business. And if you start hedging out the risk, then you're hedging out the return as well. And so, you know, they could have managed it more smarter. I think you pointed to a story showing that they had discussed internally whether they should be reducing that risk position.

But all of the incentives were to push them in the direction of taking that interest rate risk. And then obviously interest rates themselves moved quite a bit faster than anyone was expecting. So they were just caught on the wrong side of the trade. Yeah, this was a story that I wrote with some of our Bloomberg colleagues, but it cites internal documents from SVB where they discussed this exact issue and they were actually talking about the need to reduce duration exposure, so exposure to interest rates. And they had an estimated cost for how much it would affect their net interest margin or their earnings. And I think they said it was in the millions of dollars, you know, 18 million the first year and then going up to 36 million over the next few years.

And so it seems there was a conscious decision not to actually do it. Absolutely, yeah. You have the desire to help to make a real difference? The College of the City you offer the program Dependance and Scenti Mental. Acquare the competences essential

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Bloomberg Television, radio, and wherever you get your podcasts. Dan, you know, one of the, you mentioned that perhaps one of the sort of analytical errors that either the bank made or regulators made was not appreciating that they did not actually have really thousands and thousands of depositors, but actually just a handful of depositors who may have all taken their cues from a small group of VCs and a few WhatsApp rooms. The scale of the withdrawals that have been reported on, particularly that happened on Thursday or Friday, is there any amount of sort of like liquidity requirements that could have satisfied them because there's talking like, oh, they should have had more on hand, they should have been treated, you know, some of the Dodd-Frank requirements should have been extended to a bank of that size. but like is there a level of run that can happen in which no amount of like preparation can really prepare for it? Well, it's kind of difficult to know what the counterfactual was.

Sure. Just in sheer amounts of numbers of the amount of money that left, there was nothing that could have stood in the way of that. Yeah, I think that's correct. On the other hand, there's no quantum of funds they could have had hanging around that would have stood up to that kind of a deposit run. but you have to ask whether the room would have been so big or whether it would have happened at all if they'd managed financing more conservatively. Because the other part of this

is that it's not just the kind of hot money on the deposit side. There were big unrealised losses on the securities portfolio because they'd kept that interest rate risk there. And if you're hanging around with an unrealized loss on securities that's bigger than your shareholder's funds, the, you know, the former bank regulator in me says, if you're doing that, then something bad is going to happen sooner or later. You know, it's not a good idea to ever let yourself get into that position. Right. So something I wanted to ask is just on the bond portfolio losses, which have obviously garnered a lot of attention. A lot of these were

unrealized losses. They were on bonds that were classified as held to maturity, which, means we're going to hold them until maturity. And so we don't have to take mark to market losses on them unless, you know, they're impaired in some way because we fully expect to get the money back versus securities that are usually held as available for sale where because you might sell them at any point in time, you would mark them to market and those losses would show up on your balance sheet. So because of the proportion of bonds held by SVB in HTM and because of the extent of the losses, there is now this concern about broader debt and interest rate exposure in the banking system, and especially at some of the smaller banks where they

might have been more pressured to generate net income margin by taking additional duration exposure. Can you talk to us about those concerns? How worried should we be about other banks versus how much of this is maybe an SVB specific story where it's a mix of fly-D depositors plus a lot of duration exposure? Yeah, well, it's clear that the Federal Reserve is concerned that it's not necessarily confined to those two banks, because this new facility they've put up there, the bank term finance program just looks to me like a term finance program that's there for the Fed to say, if you've got any of these kind of things, if you've got any of these problems

hanging around on your balance sheets. The Fed is put together this term funding facility in order to allow banks that have got some kind of problem or something on their balance sheet that they need to get rid of and trade out of those positions in a reasonable, graceful and orderly fashion.

And you can tell that this is the concern because they've said that they will provide funding against the face value of power value of any of these bonds rather than the market value, which could be 30% lower. How extraordinary is this? Because this to me seems like a huge, a pretty extraordinary, like intervention to say, okay, these, you can pledge these assets as collateral potentially, as you said, 30% higher than they're currently trading. And isn't this like a de facto capital injection, basically? It's not quite that. But obviously, if you're,

Some got a bond that's valued at 70 and you're lending 100 against it, then slightly more than a half of your loan, a third of your loan is unsecured. It's not unknown for central banks to lend unsecured in emergency situations. It would be a complete debaucher if they started doing that in the normal course of their business. But this does look like it's a specific time-limited facility that's going to go on for a year and where I would expect that most of all the borrowing that's ever going to be done is going to be taken out in the next couple of weeks. You know, you touched on this earlier, but can you talk a little bit more about where regulators

were specifically for SVB, but I guess on the wider bond exposure question? Because it does seem like one of the themes that's emerging now is maybe the smaller banks, the regional lenders escaped some of the extra regulatory scrutiny that was heaped on the larger systemically significant banks in recent years. And so now they are more vulnerable to the threat of both deposit flight and higher interest rates. Well, yeah, they did. I mean, what basically happened is that in the USA, there were a couple of Basel international standards that were meant to address pretty much this exact risk, which were only. implemented for a very small number of the largest internationally active banks.

And a lot of that appears to be because medium-sized and community banks in the USA have got a strong political lobby. Not running this risk was, you know, as we discussed, a threat to the earnings. And so people decided that they were going to lobby hard to get these things restricted to the very biggest banks. as a result, Silicon Valley Bank wasn't required to calculate or report some of what I'd regard as the key regulatory ratios with regard to its use of hot money to financial liquid assets and its kind of high-quality liquid assets on hand. Those policies were just really meant to be

managed by the company itself and by the company in discussion with its supervisor, but because there's no hard and fast regulatory number being calculated there, it's easy to lose track, and it seems that that's what's happened. Dan, just, you know, sort of zooming out for a second, and as someone who analyzes banks around the world, how unusual is the sheer number of banks, regional community banks that exist in the United States relative to other rich countries? It's not unknown. It's not as extreme as in Germany, where you have lots of, one.

and lots of really, really small savings banks. But it is quite unusual to have that much of the banking system in smaller kind of local savings banks. And then you have these things like Silicon Valley Bank, which grew so quickly that although it was a local Silicon Valley and a local tech industry entity as recently as four or five years ago, by the time of last week it was the 16th biggest bank. in the United States of America by asset size.

So one of the things that seems kind of inevitable now is the idea that you are probably going to see some consolidation of smaller banks and you are going to see more money flowing into some of the big guys if there is, you know, concern about the health of the banking system. And I was just talking to one tech person just this morning. He just got his, oh, I should say, we are recording this on Monday, March 13th. He just got some of his first wire transfer from SVB out, and he's moving it into JPMorgan. So that seems kind of inevitable. Money going into the bigger G-Sibs and also maybe the smaller banks have to start raising their deposit rates as they try to hold on or compete for more customers. Yeah, I think so. When you have something like this, you're always going to see what they call a flight to safety or a flight to quality. And in the case of deposit runs like this, because people look at the too big to fail banks

and presume that they've got a de facto guarantee, despite the fact that actually what we've seen in the case of the signature in Silicon Valley is that the FDIC seemed to be quite happy to extend coverage to uninsured deposits, even in this kind of second tier and signature is actually quite a small bank, as long as they are reasonably happy about the quality of the assets, and as long as there is a decent cushion of unsecured bondholders, because obviously the bondholders in these banks are going to be taking losses. They're not covered in the way that the large deposits are. Well, this is a question I was going to ask you, which is that, like, are all deposits de facto now insured at any size? Like, can you envision a scenario of future,

bank failure in which depositors aren't made whole? Or is this, is this over? If you're a depositor, you'll be insured? It's actually quite unusual for depositors of any sorts to lose money in a bank resolution. Usually, you have a cushion of bondholders there and de facto deposits are considered to be senior to bondholders. I can only think it's happened a couple of times in the USA, and there are actually regulations on the way to just generally say that you've got to have a layer of bondholders in there, which are, you know, they're not going concerned capital, but they're an extra cushion for the deposits. So I don't think anyone's ever really thought of deposits of any sort as being money

at risk. You know, I mean, the depositors of Silicon Valley Bank didn't think of their deposits as being money at risk before Wednesday, Thursday of last week. And it's turned out that they were correct. It's turned out that they're getting all of their money back. So one thing that I'm still trying to get a handle on is this notion that it's not as if banks do not have access to emergency lending facilities before the events of the weekend and the announcement of the new Fed facility. And this is something that Joe and I talked about, I think just last month, the episode on banks tapping the discount window. and you also have the possibility of banks borrowing from the FHLBs, the federal home loan banks.

And yet it seems like there was an issue at least when it comes to SVB. But what could have happened there? Why couldn't it tap more short-term cash from either the FHLBs or the discount window? Or was it the case that, you know, at some point, no amount of short-term liquidity is actually going to cover the amount of deposit outflow? that the bank was seeing? I think it's the second of those, really. There did seem to be something going along with the FHLB, where just simply Silicon Valley Bank was very large when you compared it to the San Francisco Federal Home Loan Bank. For the Federal Reserve and the other discount window operations, you have access, but it's access against collateral. Previously to this

week, it was against collateral at market value. So if you've got a mark to market loss on that portfolio, you can only raise money against the haircut on the market value. And it's got to be the right collateral brought together in the right place at the right time. So you can, you know,

in ordinary situations, you can always deal with the ordinary problems of banking. What you can't deal with is something absolutely kind of off the charts crazy like we saw on Thursday and Friday last week. You have the desire to help, to make a real difference?

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What does it tell you, if anything, that no private buyer stepped up? Because, as you see, you know, they had great customer service, this great product fit that seemed to really fit with the Valley. It seems like, you know, some banks probably kind of offer commodity banking services. And Silicon Valley Bank didn't. And they seem to have some sort of unique franchise value. A lot of people like the bank. What should we read into the fact that there was no buyer? And also, What is your take on whether it should have been sold to a G-Sib like a Chase, an entity that could have easily absorbed it? I'm genuinely surprised that didn't happen. The London operations, the UK subsidiary, was bought by HSBC over the weekend. And it looks like HSBC have brought themselves a small, because it's obviously small compared to the overall bank, but nice little local tech banking business. The thing about banks is that when banks go into resolution, all sorts of strange things start kind of bubbling up and things that you never knew were going on tend to be uncovered.

So people tend to be a little bit risk-averse. But yes, I'm surprised that none of the big players felt that they could buy this one. Although, you know, that's still a possibility over the coming weeks. The FDIC is still, as I understand it, looking to sell this thing as a going concern as an operating business. So it might be that they'll just keep on doing their due diligence, bide their time and bid for it in the auction. So what are you looking out for going forward and in terms of wider contagion? Because, you know, as I mentioned, it's Monday, March 13th. There's a lot happening.

There will no doubt be a lot of developments that have happened by the time we release this episode. But for now, there are quite a few bank stocks that are down, which maybe that makes sense because the Federal Reserve facility, the new one is going to help in terms of some of those bond losses. But it's not necessarily going to do anything for equity holders. And so there's an expectation that banks will have to raise additional capital. But what are you on the lookout for? I think I'm on the lookout for a real sign that the authorities are taking this seriously. because the one thing we learned over the kind of great financial crisis, and then again, those of us who are active in Europe learned it in the Euro crisis,

is that if you're dealing with the crisis of market confidence, you need to bring the absolute entire power of the state and the central bank to bear. One thing I was quite disappointed seeing with the announcement of these facilities was all of these announcements saying this is not a bailout, and no taxpayers' money is at risk. and I think that the market sees those things and it doesn't go, you know, how fiscally responsible, it sees those things and thinks nobody's taking this seriously. What you need is someone to do what Mario Draghi did and come out, bang the table and say,

this is a bailout, taxpayers' money is at risk, we have unlimited firepower, we will stop this thing, you know, in its tracks, we will underpin the liquidity of the US financial system. And, you know, it's always my view that with these things, you're always going to end up doing that. So you might as well save yourself a couple of days, heartache and do it right out of the gate. Right. Europe spent about, you know, Angela Merkel spent about three years trying to avoid that. And then it ended up being massively costly in the end. Is your view that what has happened is it a bailout?

And be like, how do you even define that? Is it useful to define that? Or if someone asked you, Dan, what's a bailout? What is that? Well, I think people have stopped asking me what to bailout. I'm asking you. I'm giving them, you know, I keep giving them the wrong answer. Yeah, it's a bailouts, and bailouts are good. Baylouts are almost always the right thing to do. There's a bailout just means that the state steps in and provides insurance so that something economically destructive doesn't happen. And lots of people who did economics degrees start talking about moral hazard.

But I noticed that there's very few people who work in the insurance business, whose first concern right now is about moral hazard. I also very much doubt that anyone involved with Silicon Valley Bank, even those that are getting paid back at 100 cents in the dollar, will look back at this last week and regard it as a case of moral hazard where they got looked after really well. In a crisis, you just need someone to stand in and show that they are managing it. And there's a lot of, to my mind, really quite silly rhetoric about bailouts.

Because when it happens, it's kind of easy to do a political speech about how you're against bailouts and how you're in favor of saving money for the taxpayer. But it doesn't actually solve anything. And the next time the crisis comes around, it's still a crisis and it still needs something to be done about it. and all that happens is that that necessary corrective action takes longer to execute because there's still people who think that they can gain short-term political advantage by shouting about bailouts. And that's the story of the Euro crisis. And I very much hope that it doesn't happen in the USA right now.

Yeah, it just feels like at the height of a crisis isn't necessarily the time to start addressing systemic injustices and weaknesses. Dan, we're going to have to leave it there. We very much appreciate you coming on odd lots, our emergency oddlots episode for an emergency banking crisis. So thank you so much. Thanks very much. Have a great rest of the day.

So, Joe, I thought that was a really good summary of what's been going on. There are a lot of moving parts. And as I mentioned a couple of times, I'm sure we are going to be talking about this for a long time to come. But I thought Dan's point about how this is and is it. a bailout was a really good one because, yes, you know, in some sense, depositors are being protected. You know, the Fed is flinging a lot of money at this problem. But on the other hand, you are seeing the bank stock reaction this morning. There is clearly still a concern that even with the additional

facility, banks are going to have to go out and raise capital and that's either going to be dilutive to shareholders or wipe them out completely. And, you know, Dan made the point. point about when you're in crisis mode, you kind of have to leave some of the issues of moral hazard at the door. Come back and solve them later, but now might not be the best time. No, I thought that was a great point that you like, you, you want to like, oh, we're protecting the taxpayer. It's not a bailout. It's not unlimited. There's finite. It's like exactly, like, if you want to nip it in the bud, those are the opposite of what you want to say. So I think that's really interesting and maybe really telling about some of the other bank stock weakness.

And then just like some of these interesting dimensions, you know, like about the idiosync. I thought Dan described really well what made Silicon Valley Bank unique, particularly having just a handful of de facto depositors. On paper, it looks like you have thousands and thousands of depositors all around the world. In practice, if they all have a few sort of top VCs that they listen to. They're all on the same WhatsApp chat. Then they only have a few depositors.

And if it's known that corporate deposits are much less sticky, then, man, you really, like, do create some, like, a flight risk. No, absolutely. To me, this is as much a sort of cultural or social story as it is a financial one, where you have this group of really tight-knit depositors, all of whom are talking to each other are very plugged in online and also have a sort of tendency to want to be first. I mean, you know, you're talking about Silicon Valley and move fast and break things and all of that. Like, they want to get out there with the bragging rights about warning people of an impending banking collapse. And so, you know, to some extent, they were successful with that, but obviously they caused a larger problem. And then I wouldn't want, I don't want to underplay the very subpar risk management. And I'm choosing my adjectives very carefully here.

and I'm being very conservative in how I describe this, but the hedging of the interest rate exposure left a lot to be desired on the side of SVB. Yeah, but, you know, I do, I mean, it was clearly, look, mistakes were made to say the least. But like, I get it, right? It's like they have a costly franchise to run because it's obviously so high touch. You get this huge flight of capital inflows at a time of very low interest rate when there isn't yield. you have to pay for that high touch service. So I do sort of in my mind, like at least get why they felt this impulse, which many banks don't do to like just go so far out on the yield curve.

Obviously it turned out to be sort of like catastrophic, but at least the story sort of like fits together of why they ended up in that position. Well, it's also interest rate exposure squared, right? Because all your depositors and everyone you're lending money to is in the tech industry and they're massively effective. by higher interest rates, and at the same time, all your assets are in long duration stuff that's also impacted by higher interest rates seems to be a bad situation. Very bad. And hopefully, for the broader economy, et cetera, hopefully the unique badness of that situation means it doesn't spread. But I think it's way too early to know whether,

you know, people will just say, look, I don't want to have money in a regional bank. What's the point? I can be in Chase. So we'll see. Yep. More to come. For now, shall we leave it there? Let's leave it there. Okay. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway.

You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. Follow our guest, Dan Davies, phenomenal Twitter user at D Squared Digest. Follow our producers, Carmen Rodriguez, at Kerman Armin and Dash Bennett at Dashbot. follow all of the Bloomberg Podcasts

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