What We Learned: Something Is Seriously Wrong With Silicon Valley

I am seeing a lot of attempts to argue in favour of major changes to banking because of what happened with Silicon Valley Bank. Although I see a chance that Congress might reconsider the lax regulations of regional banks in the same category as Silicon Valley Bank, it is going to be hard to get too much momentum for broad reforms. The actions of everyone involved was breathtakingly stupid, and it is going to be hard to replicate that level of stupid at any other bank of a similar size.

The American banking system is designed to be competitive and allow easy entry of new banks. This is in distinction to a country like Canada, where the large banks have a stranglehold on market share. Small banks do not have the resources to build sophisticated risk management teams, since those teams are an expensive cost centre. As such, a certain amount of incompetence at the fringes is the expected result of the American system design. The FDIC has a lot of practice in shutting down such banks.

Regulation of the banking system is based on two premises. Firstly, large depositors probably got those large deposits as a result of some knowledge of how industrial capitalism works, and they presumably have at least some sense of wanting to preserve that wealth. Secondly, the assumption is that bank management wants their bank to survive and will at least take some minimal steps in that direction. Over the centuries of the existence of banks, we generally see such behaviour. Silicon Valley has managed to create a group of wealthy people that violated those assumptions.

On the bank side, we have a bank management that catered to cash-flow negative firms and individuals, and relied on exceedingly large deposits from a concentrated group. The brain trust managing the bank then stuffed a bunch of long-dated bonds into held-to-maturity accounts to match those deposit liabilities. They managed to accumulate unrealised losses that were larger than equity would be enough to largely wipe out book equity, and then did the amazing step of doing absolutely nothing about the situation (until it was too late).

On the depositor side, we had VC’s loudly organising a bank run against a bank that had been showering VC’s with sweetheart financing for decades, destroying the bank far faster than anyone could be expected to react.

We are faced with the situation of a bank in the centre of a deal-making community with members of that community sitting on bushels of cash, yet still being unable to arrange a liquidity injection. I find it very hard to believe that anyone else could replicate that feat any time soon.

There is going to be enquiry into the situation, but I see no reason to blame the regulators based on available information. Even if they knew the interest rate risk management was insane, regulators have to enforce the law, not what they think the law should be.

I have also seen lame attempts to blame the Fed and their “promise” not to raise rates. Unless the Fed is offering a legally enforceable guarantee about future bond prices, their statements — and a few bucks — gets you a cup of coffee. It is possible to agree with Fed governors’ statements, but you still have a duty to do your own risk management analysis.

American banks are like hedge funds in that there are always weak links that blow up during “market” turbulence. We have had an impressive interest rate shock, so we may see a few more victims. That said, we need to keep the size of these blow ups in mind. If a bank blows up because of interest rate risk, that pretty much guarantees that it was not plugged into derivatives markets, so there is not going to be contagion to capital markets. Sure, there will be capital losses to equity and corporate bond funds — but those funds have very high risk budgets.

If one wants to be cautious and/or a doom monger, you could argue that this blow up is just the first sign of things unravelling. That is a somewhat plausible argument. That said, you still need to find a way to eat into the equity of the big banks at the centre of the system. The way to achieve that outcome is for large credit losses in the real economy.