Dan Davies On What Brought Down Silicon Valley Bank

It's like all deposits seeming like they're de facto guaranteed, changing the collateral schedule 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 Lots with the 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. Oh,

thanks very much for having me. It's always news whether people want to. 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 signature in 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 their 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 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 deposits or put limits on your

ability to do it. So I didn't. So what was this case with Silicon Valley Bank specifically, in which it would I mean, not only did it accumulate an extraordinary amount of a corporate deposit, but also highly all more or less in 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. And there was 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 ten million dollars 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. The 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 every elevator event where startups would like get money or like raised from vcs, there are always just reps from Silicon Value Bank.

They're 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 Value Bank account, you know, and being good at gathering those deposits. It means that you gather a huge amount 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 fifty basis points of interest rates and the company doesn't want to do that because it's

going to damage the franchise in the water. The company certainly doesn't want to turn business away. So what they end up doing is putting the money in how you yield of securities, and to do that, you've got to move out from the maturity curve. And this is the sort of thing that are switched on Bank Supervisor ought

to be stopping you from doing 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 the 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 you know, that's a really 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 know, 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, they're actually behaviorally this isn't a thousand guys with ten million each. It's one big conglomerate of guys with ten 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. And 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 sites 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 say it was in

the millions of dollars, you know, eighteen million the first year and then going up to thirty six million over the next few years. And so it seems there was

a conscious decision not to actually do it. Absolutely. Yeah, 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 um liquidity requirements that could have satisfied them, because there's talking to like, oh, they should have had more on hand, they should have been treated, you know, some of the DoD 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. Well, it's kind of difficult to know what

the counter factual was. Sure, just in share amounts of numbers of the amount of money that left, there was nothing that could have stood in the way of us. Yeah, okay, 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've managed financing more conservatively. Is the other part of this is that it's not just the kind of hot money on the deposit side. There were big unrealized 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 shareholders funds. You know, the former bank regulator in me says, if you're doing that, then something bad is going to happen

soon 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 into 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 that this is maybe an SVB specific story where it's a mix of FLDY 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 backs 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 balk sheet that they need to get rid of and trade out of those positions in a reasonably graceful and orderly fashion. And you can tell that there this is the concern because they've said that they will provide funding against the face value or the power value of any of these bonds, rather than the market value, which

could be thirty percent. Other 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 clatter or potentially, as you said, thirty percent higher than they're currently trading. And isn't this like a deft actel capital injection? Basically it's it's not quite that.

But obviously, if you're sort of got bonders valued at seventy and you're lending a hundred against it, then slightly more than 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 departure if they started doing that in the normal course

of business. But this does look like it's a specific, time limited hostility 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 moderate is going to be taken out in the next couple of weeks. You know, you touched on this earlier, but you 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 things 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 buzzle 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, as we discussed, a threat to the earnings, and so people decided that they were going to be hard to get these things restricted to the very biggest banks, and 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 it's kind of high

quality liquid assets on HAPD. 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 all known. It's not as extreme as in Germany, where you have lots of with whats and lots of really really small savings banks, but it is quite unusual to have that much of the banking system in small kind of local savings banks, you know.

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 both last week it was the sixteenth biggest bank in the

United States of America by asset sis. 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 thirteenth, but he just got some of his first wire transfer from SVB out and he's moving it into JP Morgan. So that seems kind of inevitable money going into the bigger gesibs. And also maybe the smaller banks have to start raising their deposit rates as they try to hold on or

compete for more customers. And 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 prosing that they've got a defacto guarantee despite the fact that actually what we've seen in the case of the Signature and Silt and Valley is that the fd I see seems to be quite happy to extend coverage to one insured deposits, even in this kind of second tier and Signatures actually quite 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 loss, it's they're covered in the way that the latch depositors are. Well, this is a question I was going to ask you, which is that, like, are all deposits de facto now ensured at any size? Like can you envision a scenario of future bank failure in which depositors aren't made all? Or is this over if

if you're a depositor, you'll be insured. It's actually quite unusual for depositors of any sort of fools money in a bank resolution. Usually you have a cushion of bondholders today and de facto deposits are considered to be senior

to bondholders. 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 it's not as if banks do not have access to emergency lending facilities, you know, 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 homelan banks, and yet it's teams 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 outflows 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 Homeland 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 market value. So if you've got a mark to market loss on that portfolio, you can only

raise money against a haircut on the market value. And it's going to be the right collateral broad together in the right place at the right time. So as 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 chance, crazy like

we saw on Thursday and Friday last week. What does it tell you if anything that no private buyer stepped up, because as you said, you know, they had great customer service, there's 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 brought 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 which the FDIC is still, as I understand, it's 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 by 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 thirteenth, 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 you know, maybe that makes sense because the Federal Reserve Facility, the new one, is going to help in terms of some of those bomb 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 want to look out for a real signs that the authorities are taking this 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, send go, 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 Marry or Druga did and come out to bang the table and say, this is a bailout. Taxpayers money is at risk. We have

unlimited firepower. We will stop this thing in its tracks. We will underpindle the good is of the US financial system. And you know, it's always my view that with these things always going to end up doing that. So you might as well save yourself a couple of days heart sake and do it right out of the gate. Right Europe spent about you know, Angelo 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 people have stopped asking me what's a bailout? Keep giving them, you know, I'll keep giving them the wrong answer, and yeah, it's a bailout, and bailance are good. Bailance are almost always the right thing to do. And 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. Also, very much doubt that anyone involved with Silicon Valley Bank, even those that are getting paid back at one hundred cents in the dollar, will look back at this last week and regard it as a case a 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 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 a 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 termple of skill advantage by shouting about bailants. And that's the story of the euro crisis, and I'm 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 add Lots our Emergency add Blots 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 point about how this is and isn't 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 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 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 he I thought Dan described really well what made Silicon Valley Bank unique, particularly having just a handful of defective 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, they're all on the same what then they only have a few deposit book face. And if it's known that corporate deposits are much less sticky, then

you really like do create some like a flight risk? No. Absolutely, to me, this is as much as 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 and 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 mistakes were made, to say the least, but like you, 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 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 affected 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, etc. 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 would 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. Yeah, more to come, but for now, we leave it there. Let's leave it there. Okay. This has been another episode of the Old Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe wi Isn'tal. You can follow me

on Twitter at the Stalwart. Follow our guest Dan Davies, phenomenal Twitter user at d squared Digest. Follow our producers Kermen Rodriguez at Kerman Arman and Dash Bennett at Dashbot. Follow all of the Bloomberg podcasts, some to the handle at podcasts, and for more Odd Lots content, go to Bloomberg dot com slash odd Lots, where we'll post the transcripts. Tracy and I blog, and we have a weekly newsletter. Go there sign up for it. Thanks for listening.