18 Mar Silicon Valley Bank
“SVB’s excessive duration risk punched a government bailout ticket.” – The Lonely Realist
The recent failure of Silicon Valley Bank (SVB) spotlights fatal flaws in America’s banking system. America’s bankers (as well as its uninsured savers) are being rewarded rather than punished for mismanaging their risks, a fundamentally un-capitalist approach. Risk and reward should be reasonably matched. Yet, the banking system incentivizes banking executives to take outsized risks since the consequences of failure fall on the public (in the case of SVB, through a tax on prudently-managed banks that establishes a dangerous (and unfair) Statist backstop for the industry). We’ve been in this movie before (and not only in 2008). It would be wise for America to avoid yet another sequel without increasing already weighty and to-date unsuccessful regulatory and fiscal measures (after all, what meaning does FDIC insurance have when the government bails everyone out?).
SVB took outsize “duration risk.” “What,” you ask, “does it mean for a bank to take duration risk? And why is doing so bad?” First, taking duration risk isn’t bad. It’s what banks do. That’s the business they’re in. The problem is with excessive duration risk-taking. The trick is determining how much and what type of duration risk is prudent.
Banks accept deposits and pay savings and checking account owners a minimal rate of interest to reflect depositors’ right to withdraw cash on-demand. Depositors are making short-term loans to their banks. Banks profit by making longer-term investments to earn a higher rate of interest. That interest-rate spread is responsible for banks’ profits – the larger the spread, the more profit … and the more duration risk. If interest rates are rising and banks are forced to sell those longer-term investments before they mature, they will suffer losses that reduce their liquidity and, at an extreme, render them insolvent. That’s precisely what happened to SVB. It borrowed short with an overly-long loan portfolio and a concentrated depositor base. When that depositor-base demanded the return of its money (in a classic “run on the bank” (as portrayed more than 75 years ago in It’s a Wonderful Life)), it had to sell its portfolio at a substantial loss.
The most conservative banking strategy would be to invest depositors’ cash in secure, short-term debt, for example 30-day, 60-day, 90-day U.S. Treasury bills. However, that would mean that the bank would receive a too-low rate of interest, which would eliminate its ability to earn a profit on the spread between its depositor-rate and its loan portfolio-rate. What banks generally do, therefore, is invest deposits in a diversified portfolio of “laddered” instruments, some of which are longer-term and some shorter-term, some of which are backed by sovereign governments and others more speculative, some of which earn a higher rate of interest and others a lower rate. The longer the duration of a bank’s loan portfolio, the more profit a bank can earn, but that means that its business becomes riskier. Also, the longer the duration of a bank’s portfolio, the more compensation flows to the bank’s executives …, until there’s a bad time.
The problem, therefore, is the disconnect between bank executives’ rewards when a bank’s investment strategy succeeds and the risk to the bank when the bank’s strategy fails. The most efficient solution would be for senior bank executives to be held economically liable for the bank’s failure. Unfortunately, vested interests will not allow that to happen. Were executives’ personal wealth to be on-the-line, they would be motivated to select an investment strategy for their banks that most effectively aligns risk and reward. In the absence of such a balance, it is inevitable that America’s taxpayers will continue to bear the burdens of those who engage in excessively-risky banking and borrowing practices.
Next week: “The canaries have stopped singing” – Cassandra.
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Finally (from a good friend)
tronzi
Posted at 14:03h, 19 MarchWasn’t all of the equity in the bank wiped out, so the investors lost their entire investment? Isn’t the potential loss or gain of equity the central driver of management behavior? And, if that’s the case, why not guaranty all deposits?
The depositors (who can’t manage the bank and shouldn’t be asked to perform regular analysis of bank management) are made while, not the bank’s investors. If all deposits were guaranteed – with government fees charged for that guaranty – bank runs would end. As we have it now, we have bank runs which cause massive fear and concomitant economic contraction. Meanwhile the “too big to fail” banks have a de facto guaranty of all deposits and can be dangerously powerful.
The Lonely Realist
Posted at 14:46h, 19 MarchFederal law and policy since the Great Depression have provided for limited government guarantees, and for good reasons. The government cannot (and cannot afford to) stand behind all indebtedness for all Americans and American businesses. Individuals and businesses necessarily must themselves evaluate risk and reward. That the essence of successful capitalism.
FDIC insurance limits the Federal guarantee to $250,000 per person. Those depositors who maintained balances in excess of that guarantee understood that they were taking a risk …, and decided that the risk was commensurate with the effort/reward. The 1980s savings and loan fiasco demonstrated that open-ended government guarantees create incentives for inappropriate risk-taking at public — that is, taxpayer — expense.
Bank runs are undesirable, but they have causes. How to minimize bank runs should not mean that the government insures all comers against loss. The exercise should be about maximizing efficiency and prudent/transparent risk-taking …, at least in TLR’s view.
The Lonely Realist
Posted at 16:34h, 19 MarchAnother reader commented: It’s one thing to bail out small depositors (still wrong). But to bail out a bunch of vc’s who were probably on both sides of the trade (controlled vc investment cash and owned stock in or wanted favored treatment from the bank) and took insane risks for new company cash. If it wasn’t for the politics, they would have been left on their own. So? No lesson learned!