Paid subscribers can read on for my comments on banks’ first quarter earnings. It’s been a year since the collapse of Silicon Valley Bank. Has anything changed?

First, though, over to Dan:

Decisions Nobody Made

“The purpose of a system is what it does” — Stafford Beer

About five years ago, I started to get very interested in an obscure subject called “management cybernetics”.  It was a product of the technological dreamscape of the 1960s and 70s; after the invention of the computer, but before it became ubiquitous, in a period when there was room for speculation about how the new world of artificial intelligence would change our world.

I had just finished my previous book (Lying for Money: How Legendary Frauds Reveal the Workings of the World), and was keen to say a bit more about how organisations go wrong.  It seemed to me that it might be possible to expand the concept of a “criminogenic organisation” (one where the incentives structurally produce illegal behaviour) to a more general “bad-decision-o-genic organisation”.1  And furthermore, that the weird mixture of pure mathematics, philosophy, accountancy, physics and economics that came together in the work of now-forgotten management gurus like Stafford Beer and Barry Clemson might be the way to think about it.

What do bad decision-making organizations have in common?  Quite a few things, but one of the clearest signs is something you might call an “accountability sink”.  This is something that might be familiar to anyone who has been bumped from an overbooked flight.  There is no point getting angry at the gate attendant; they are just implementing a corporate policy which they have no power to change.  But nor can you complain to the person who made the decision – that is also forbidden by the policy.  The airline has created an arrangement whereby the gate attendant speaks to you with the voice of an amorphous algorithm, but you have to speak back as if to a human being like yourself.  The communication between the decision-maker and the decided-upon has been broken – they have created a handy sink into which negative feedback can be poured without any danger of it affecting anything.

This breaking of the feedback links is, I think, one of the most important things that has happened to large organisations – banks, but also large corporations and government departments – over the last fifty years.  In most cases, it’s not been carried out purely as a responsibility-dodging exercise, or as part of a conscious effort to make things worse.  That has happened, on occasion, but for the most part, after spending a lot of time looking into examples, I concluded that feedback links were being broken simply because they had to be.  The world keeps growing and getting more complicated, which means that individual managers gradually become overwhelmed; the problem of trying to get a sensible drink from the firehose of information that pours into any large organisation every day has become unbearable.

And this is why institutions have started delegating decisions to systems – credit scoring algorithms, regulatory risk weighting formulas and the like.  As well as allowing decision-making to be automated and industrialised, they provide a psychological defence system, preventing individual human beings from the consequences of having to make a decision and own it.

Most of the time, these systems work well.  But when they break down, the consequences can be spectacular.  Because every such algorithm or rulebook is, implicitly, based on a model of the thing they’re meant to govern.  And every such model is capable of failure.  And when something comes along that’s outside the model – like, for example, a sustained nationwide fall in US house prices – you end up in a situation where literally nobody knows what to do.

It’s really striking to compare the two big crises of the last two decades.  The Global Financial Crisis beginning in 2007 was purely a matter of book entries in computers.  No actual physical capital was destroyed, nobody died.  By contrast, the COVID-19 pandemic beginning in 2020 was a massive blow to productive capacity – millions of people died, buildings were rendered unusable.  But it was the first of these two crises that led to massive scarring and a prolonged global recession, not the second.  Why?

It might be said that the reason why is that if you consider the world economy as an organism, the pandemic attacked its muscles and sinews while the financial crisis attacked its brain.  The global financial services industry is a crucial part of the distributed decision-making system of the world, and its core component is a very old, but still surprisingly poorly understood technology called debt.

In the strictest, purest sense, debt is an “information technology” – it’s one of the mechanisms human beings have invented to handle information.  By structuring an investment in someone else’s project as a debt, you immediately reduce the space of possible outcomes to two – you get paid back, or you don’t.  There are a lot of other information-processing techniques that banks and investors use, from statistical credit scoring to modern portfolio theory, but this is the big one.  It allows a modern bank to keep track of vastly more financial investments than would ever have been possible for a medieval merchant in the first days of double-entry book-keeping.  Rather than having to preserve face-to-face relationships with every single borrower, you can rely on the fact that 99% of mortgage loans get paid back in full and on time, and concentrate your attention on managing the 1% of cases where something goes wrong.

The trouble is that if you build a business on this basis, what happens when it turns out that there’s a small variance?  Unfortunately, a small variance in the proportion of good loans from 99% to 97% means a tripling in the number of bad loans, and consequently a huge excess load on the systems that are meant to deal with them.  Faced with this massive cognitive overload, the system froze.  And even more unfortunately, in a world in which trillions of dollars need to be rolled over and refinanced every day, the one thing that the financial sector cannot do is stop for a moment to regain its bearings.  If information processing was free and the bankruptcy process frictionless, the Global Financial Crisis would have been over in a month.  As it was, all the information which had been attenuated by the use of multiple layers of secured debt came back, suddenly unattenuated and needing to be dealt with.

That’s the “cybernetic history” of the debt crisis which I outline in my book, and I think it’s a useful alternative perspective to the economic one, and one which makes it more comprehensible that a relatively small market for synthetic CDOs turned into a continental crisis.  But this might not even have been the most pernicious use of debt seen in our lifetimes.

Another aspect of debt, considered as an information technology, is that if affects the information environment of the borrower.  If you are managing a company which has borrowed money, making your payments becomes one of the survival conditions for that company.  At low levels of debt, generating short term cash flow is one priority among others, but for a highly indebted company it becomes a signal which swamps all others.  You might want to change the world, but if you don’t meet the coupon payments, you’ll never get the chance to see if your other strategic priorities would have worked.

Consequently, a company with lots of debt cannot help but have a bias toward the short term.  Which might be considered problematic, as the last few decades in the Western capitalist world have seen the rise of an industry (leveraged buyouts, or “private equity”) which has made it part of its fundamental operating strategy to load companies up with debt.  Considered in this light, debt is a technology of control as well as of information – it’s a means of exerting discipline on management teams who might otherwise be tempted to follow priorities other than short-term financial returns.

This is, as far as I can tell, the real meaning behind the populist critiques of “financialisation” in the economy.  There’s really nothing particularly bad about the growth of the financial sector, even to the extent that it’s outstripped the growth of the “real” economy.  Quite simple mathematics ought to be enough to convince us that as the economy grows, the number of links and relationships between producers, consumers and investors will grow at a faster rate, and so you’d expect the parts of the economy in which decision making and information processing take place to grow faster than the “real” economy.  It’s the same logic by which the brains of primates take up proportionally more energy than those of rodents; finance is part of the real economy, just like the cerebellum is a real organ.

What’s bad about “financialisation” is neither more nor less than the over-use of debt.  Modern corporations do often behave badly, and they make systematically worse decisions than they used to, this isn’t a delusion of age.  They do this partly because they have outsourced key functions (cutting themselves off from important sources of information), and partly because their priorities are warped by the need to generate short term cash flow.  Both of these problems can in large part be traced back to the private equity industry, working either as a direct driver of excess leverage, or as a constant threat which makes managers behave as if they were already subject to its discipline.

Management science and cybernetic history is all about things which began as solutions, then turned into problems because the world changed.  Once upon a time, back in the 1970s, private equity and LBOs were the solution to a problem of lazy, sclerotic incumbent management teams, self-dealing and failing to make tough decisions.  But it’s now the 2020s, and private equity may itself be the biggest problem in our global information processing system.  The way that corporate history progresses is that we try to keep up with the ever-increasing complexity of the world, and then when this is no longer possible, we have a crisis and reorganise.  We’ve had the crisis – or perhaps we are still going through it – and now it’s time to think about how to reorganise.

The Unaccountability Machine by Dan Davies, Profile Books £22, 304 pages

Paid subscribers read on for my update on US bank earnings and how they are doing against the backdrop of interest rates that are priced to stay higher for longer.

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Fresh on the case, the Regional Banking Organization upped the number of supervisors keeping watch over Silicon Valley Bank from eight to 20. But so as not to jam the bank with more stringent standards overnight, a transition period was granted. The new team started vetting Silicon Valley Bank’s supervisory ratings six months after the transfer and, armed with a waiver to delay their findings by another six months, they didn’t release revised ratings until August 2022. 

“The delay until August 2022 in issuing the 2021 supervisory ratings illustrates how the normal supervisory practices did not keep up with SVBFG’s rapid expansion,” regulators later admitted. “While supervisors did issue supervisory findings, the delay in a rating downgrade meant that SVBFG effectively continued to operate below supervisory expectations for more than a year despite its growing size and complexity.”

Having been burned once, supervisors were keen for it not to happen again. So when New York Community Bancorp (NYCB) shot through the $100 billion asset threshold, regulators were quick to respond. This week, the bank cut its dividend to preserve capital, and bolstered both its loan loss reserves and its liquidity buffers. “We have pivoted quickly and accelerated some necessary enhancements that come with being a $100 billion-plus Category IV bank,” said its CEO. “With this in mind, during the fourth quarter, we took decisive actions to build capital, reinforce our balance sheet, strengthen our risk management processes, and better align ourselves with the relevant bank peers.”

The market was caught by surprise. NYCB’s stock fell 45% over two days, taking out the long-term low it hit during the regional banking crisis last year. Having written a lot about the crisis as it happened, I retired the series in May. But performance this week prompts questions over whether it should be revived. To see if that’s the case, read on…

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Vernon’s Legacy

Republic First Bank of Philadelphia and Metro Bank of the UK have more in common than their shareholders may realise. Despite the ocean that divides them, their strategies were heavily influenced by one man: Vernon W. Hill II. After founding, chairing and then departing Metro Bank under a cloud, he invested in Republic First Bank, taking on the role of chairman and then chief executive officer before departing under a cloud. While unconnected operationally, the two banks share similar branding, an open-door policy for dogs, and similarly styled branches fashioned by a firm of designers owned by Hill’s wife.1

They are also both facing severe financial difficulty. Their stocks trade at a distressed 8% of tangible book, and management at each is casting around for fresh capital. 

The reasons for the banks’ problems aren’t identical, but they do share a common thread. Vernon Hill’s big idea was deposits. “Banking is, essentially, a government license to borrow money cheaply,” he wrote in his memoir. “Anyone can make loans, but only licensed, government-sanctioned banks can accept deposits. That’s why the legal and economic value of a bank is in gathering deposits from loyal customers.”

Both Republic First and Metro prioritised the growth of deposits. They used the model Hill honed at his first banking venture, Commerce Bank, to think about selling deposits like selling consumer goods. “From our inception, Commerce has refined a business model patterned after the great retailers of America, i.e., Home Depot, WalMart, McDonald’s, Starbucks, rather than the typical bank or financial institution,” he told shareholders in his 2000 annual report. 

In an environment of rising rates, this strategy should have paid off with higher net interest margins. Unfortunately, trained to think more like retailers than bankers, management didn’t focus sufficiently on where they were putting the deposits and are now suffering the consequences.

Republic First invested heavily in securities. At the end of 2022, its balance sheet ran with a loan/deposit ratio of 62%, giving its treasury team a surfeit of deposits to invest. By the end of that year, they had built up a portfolio comprising $898 million available-for-sale (AFS) securities and $1,629 million held-to-maturity (HTM) securities. But higher rates mean lower securities values and mark-to-market losses of $172 million opened up in the AFS portfolio and $264 million in the HTM portfolio. While AFS losses may be reflected in the balance sheet, HTM losses are not. With tangible common equity of $193 million, the bank was mark-to-market insolvent, just like Silicon Valley Bank and its close namesake, First Republic.2

By June this year, the hole was even bigger, with losses in the HTM portfolio having widened to $304 million. Not that any of this is recorded in SEC filings: Republic First still hasn’t filed audited financial statements for 2022, because of its “former executive team’s failure to maintain adequate internal controls.” All numbers come from the bank’s regulatory filings. 

Metro Bank invested in real estate lending, including a portfolio of commercial loans secured on immovable property (so-called CLIP Loans). All loans require careful risk bucketing to assess the amount of capital that needs to be allocated against them. Metro management thought its CLIP Loans were eligible for a 50% risk-weighting but it turned out the regulatory requirement was 100%. After the error came to light in 2019, the bank was fined for failing to maintain adequate internal controls. “There are multiple gaps in the controls framework at every stage of the process, from data sourcing through to report generation,” reported an external consultant. Metro Bank was later fined again when it emerged that management had sat on the error for longer than was appropriate. 

Metro never really recovered. It harboured hopes that regulators would allow it to use internal models to calibrate capital rather than rely on the standardised models it was subject to as a new entrant. This would have released significant capital. But last month the regulator announced that more work was required and approval would not be forthcoming in the current financial year. That leaves Metro skating on minimum capital requirements (its fully-loaded common equity tier 1 ratio is around 9.7% versus a minimum of 9.2%). The stock has fallen by 60% since.

So far, customers are taking these banks’ problems in their stride. Deposits were down less than 4% in the second quarter at Republic First, in the aftermath of Silicon Valley Bank’s collapse, even as 60% of them remain uninsured. But, as my friend points out, its customers are less very online than those of the California banks that failed. “Many of these customers work in office parks and commute home to 3 bedroom houses. They are not looking at crypto quotes, nor funded by VCs. They often don’t have a CFO.”

In Metro’s case, up to three-quarters of deposits are insured.3 The bank survived a mini-run back in 2019 when the risk-weighting error surfaced. A false rumour spread on WhatsApp that “the bank may be shut down or going bankrupt” and soon the Harrow branch was filled with anxious customers. This week, management released a statement saying that they saw continued momentum in personal and business account growth and customer acquisition during the third quarter.

Loyal customers give the banks breathing room to fix their capital problems. Vernon Hill at least had that foresight: “the legal and economic value of a bank is in gathering deposits from loyal customers,” he wrote. Last week, a shareholder group led by George E. Norcross III offered to inject $35 million into Republic First on the basis it can raise $40 million from other investors. George E. Norcross III had worked alongside Vernon W. Hill II at Hill’s first banking venture many years previously.4

Yet even if it’s able to raise the full amount of capital, the bank still has challenges. It has to resolve its filing issues; until then its stock is barred from Nasdaq and trades only over-the-counter. And it has to arrest deteriorating profitability. In the second quarter, Republic First earned only 2.33% on its securities against non-interest bearing deposit costs of 2.23% leading to a very narrow net interest margin of 1.42%, off which it couldn’t make money (assuming the regulatory filings are reliable).

Metro Bank is rumoured to be looking to raise up to £600 million in equity and debt from investors. The bank confirmed that it is evaluating a range of options, including a combination of equity issuance, debt issuance and asset sales. However, Metro’s weak profitability makes a capital raise hard as its high cost, branch-centric business model weighs on earnings. Even with a tailwind of higher rates, the bank reported losses over the eighteen months since the beginning of 2022, its cost/income ratio last year hitting 104%. 

Vernon Hill may have been right about loyalty, but he was sneering of cost control. “There are two ways to make money,” he wrote. “Grow your top line – that’s the best way. Cost cutting is your way to extinction.”

In the meantime, although Metro’s depositors may show forbearance, its bondholders may not. A £350 million senior bond issue drops out of a key regulatory capital calculation (MREL) in October 2024 one year ahead of its maturity, and unless it can be refinanced, it presents a dangerous cliff edge. An alternative to a public capital raise may be for an existing shareholder to step up, as in Republic First’s case, for bondholders to take control, or for a rescue bidder to emerge.5

Vernon Hill is not involved in either of these banks any more; he has retired to his home, the biggest in New Jersey. But as a great bank analyst once said, “Bank profitability is 50% macro and 40% decisions taken five years ago.” As the architect of those decisions, Vernon Hill’s shadow still looms.6

More on Vernon’s legacy here.

Equity Research

Regular readers will know that I harbour a deep fascination for the equity research industry. It’s a topic I’ve written about several times before, starting three years ago in The Cautionary Tale of Equity Research. Part of it is nostalgia: I used to work in the industry and subsequently, as a professional investor, became a consumer of its product. Part of it is that equity research presents a useful, ongoing case study in how to craft an economic model in the tricky segment of the Venn diagram where businesses that produce public goods meet businesses that operate at zero marginal costs. 

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Over the next twenty years, First Community Bancorp went on an acquisition spree. Months after listing on the Nasdaq stock exchange, it used its currency to buy a bank in West Los Angeles. The following year, it bought six more banks including Pacific Western National Bank with branches in Los Angeles and Orange County. In 2006, it deployed the Pacific Western brand across its franchise and two years later abandoned First Community as its holding company name in favor of PacWest Bancorp. By then, it had bought 17 banks across California.

The global financial crisis presented PacWest with an opportunity, allowing it to pick up failed banks that fell into the hands of the Federal Deposit Insurance Corporation. It bought three of them and by the end of its first decade in the banking business, had grown to manage 77 branches and $4.6 billion of deposits. 

But it was in its second decade that growth really took off. “Our management team has extensive expertise and a successful track record in evaluating, executing and integrating attractive, franchise-enhancing acquisitions,” the bank proclaimed. It progressed to larger deals, including a $2.3 billion purchase of commercial lending firm CapitalSource and an $850 million purchase of Square 1 Financial, “a commercial bank focusing on technology with entrepreneurs nationwide”. By the end of 2022, PacWest had done 31 acquisitions and sat on $33.9 billion of deposits. 

Smashing together so many banks wasn’t without its problems. Alongside “the long history of acquisitions that brought us great customers and talented employees,” new CEO Paul Taylor admitted in January that so many deals also brought “varied processes and different cultures.” Earnings declined in 2022 and in the five years through to the end of the year, the stock was down 55%, underperforming the regional banking index which was flat.

Taylor put the brakes on growth. “We will simplify and improve our processes to deliver an even higher level of service to our customers,” he told investors in January. He announced an exit from two business lines – asset-based premium finance and multifamily lending – as well as the restructuring of a specialist home lending subsidiary.

Underlying the shift, he needed to shore up the balance sheet of PacWest. By the end of 2022, the group was sitting on a pretty low common equity tier 1 ratio of 8.70%. For every $100 of risk-weighted assets (and the group had $33 billion of risk-weighted assets), it maintained just $8.70 of capital. Although in excess of the 7.0% required by regulators to maintain a minimum capital conservation buffer, it didn’t leave much room for maneuver. Taylor’s goal was to get that ratio up to 10% (still lower than other banks). 

“We are operating with a sense of urgency,” he told investors on his January call. He knew it wouldn’t be easy: “There are real challenges ahead with rising interest rates.”

And then Silicon Valley Bank happened.

(This one’s for paying subscribers only. To join the gang, sign up here.)

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In October 1968, Night of the Living Dead opened on screens across America. Zombies had been depicted in movies before, as versions of mythological creatures described in Haitian folklore. But Night of the Living Dead redefined the genre. Director George Romero breathed life into his reanimated corpses, infusing them with the shambling, flesh-eating mores that characterise zombies today. 

Made on a budget of just $114,000, Romero’s film was low key. Cast and crew were recruited from among the production team’s family and friends, and expenses were spared on props: Chocolate syrup was used for blood and consumed flesh consisted of roasted ham – donated by one of the actors who also owned a chain of butcher shops. 

In spite of the critical response that railed against its graphic violence, the film was a major hit. In the ten years following its release, it returned over 250 times its budget at the box office. It also paved the way for a new line in horror movies. According to critics, slasher films of the 1970s and 80s such as Halloween and A Nightmare of Elm Street, owe much to the Night of the Living Dead. And while the zombie genre waned for some years after Michael Jackson’s Thriller music video, it re-emerged in film, books and video games to cement its place in popular culture. 

As a metaphor, the zombie also proved deeply alluring.

At the time Romero was working on his second sequel, Day of the Dead, America’s savings-and-loan (S&L) companies were in a full-blown crisis. Higher inflation and interest rates through the late 1970s and early 1980s squeezed their profitability. Limited by what rates they were allowed to pay on deposits, savings-and-loan associations saw deposit balances shrink at the same time as fixed rate mortgages lost value against the tide of rising rates.

Federal regulators didn’t spot the problem emerging and by the time they did, they lacked sufficient resources to deal with the losses. In 1983, it was estimated that it would cost roughly $25 billion to pay off the insured depositors of failed institutions yet the savings-and-loan insurance fund, known as the FSLIC, only had reserves of $6 billion. Rather than address the issue head-on, policymakers first took steps to deregulate the industry in the hope it could grow out of its problems, and then adopted a policy of forbearance to give it time to recover.

The result was what Edward Kane, Professor of Banking and Monetary Economics at Ohio State University, identified as a plague of “zombie” S&Ls:

Zombie S&Ls are institutional corpses capable of financial locomotion and various forms of malefic behavior. Much as in George Romero movies, these undead entities wreak havoc in financial markets by feeding on the markets of the living.

Kane defined zombie S&Ls as those with negative economic capital. According to the US Government Accountability Office, there were 459 S&Ls holding more than $100 billion in assets with negative net worth in September 1985. Kane estimated that including losses not shown under generally accepted accounting principles, the number of zombies could be higher than 600, equivalent to around a fifth of FSLIC-insured institutions at the time. Although insolvent, these financial institutions were able to continue operating thanks to explicit or implicit support from the government. 

Edward Kane died on March 2 this year, a week before the collapse of Silicon Valley Bank, so he didn’t get to see the rise of a new crop of zombies.

But a look at First Republic Bank shows what one looks like. The bank had $174 billion of deposits the day before Silicon Valley Bank failed and went on to lose over $100 billion of them in the weeks that followed. Not able to liquidate assets as quickly, it turned to other funding sources for help:

• It borrowed $30 billion from a consortium of 11 banks as a term deposit with an initial term of 120 days at market rates. 

• It borrowed $63.5 billion from the Federal Reserve discount window, at a rate of 4.85%.

• It borrowed $13.8 billion from a new Federal Reserve Bank Term Funding Program launched in the aftermath of Silicon Valley Bank’s collapse, allowing it to borrow against the face value of its securities holdings (regardless of their market value).

• It upped its borrowings from “lender of second-to-last resort”, the Federal Home Loan Bank of San Francisco, from $14 billion to $28.1 billion. Bit of adverse selection here: As well as First Republic Bank, the Federal Home Loan Bank’s largest borrowers as at end 2022 included Silicon Valley Bank and Silvergate. But the Home Loan Bank makes funding freely available, as long as a bank has assets to secure against it, albeit at a high cost.

By the end of the quarter, 45% of First Republic’s balance sheet was funded via government-sponsored schemes, up from 7% at the end of 2022. 

The problem is that these funding sources are more expensive than First Republic’s core deposit funding. On average over the course of the first quarter, the bank paid 1.4% on deposits; its government-sponsored funding sources cost between 4.8% and 5.0%. Given that First Republic Bank only earns 3.7% on its assets, the shift in funding mix turns its business model upside down. Paying more for funding that you are yielding on assets is not exactly a recipe for business success.

The low yield on First Republic’s assets is also reflected in their market value. Like Silicon Valley Bank, First Republic acquired a lot of held-to-maturity securities, which now constitute around an eighth of its balance sheet. As interest rates rose, these securities fell into an unrealised loss, amounting to $4.8 billion at the end of 2022.

In addition, the bank made a lot of fixed rate mortgage loans, which react the same way to higher rates. At the end of 2022, two-thirds of its loan portfolio wasn’t due to reprice for at least another five years – a very high share compared with other banks. At the end of last year, First Republic estimated the mark-to-market loss on its loan portfolio to be $22.2 billion. Those losses may now be smaller as interest rates have come back in since the end of the year, but their sum is still likely more than the tangible common equity that the bank has available ($14.2 billion at at end March) rendering First Republic technically insolvent even if that is not reflected in accounting numbers. Under normal circumstances, the value of the deposit base would have risen to compensate, as higher rates make low-cost deposits more valuable, but…they’re not there anymore.

Edward Kane identified the problem with zombie banks as two-fold. First, as long as they roam the earth, zombies risk accumulating more losses. Second, by bidding up funding costs, they infect other institutions. The impact they have on funding costs can either be direct, as they force up the price all banks have to pay for deposits, or indirect, through higher deposit insurance assessments on the entire industry. 

Many savings and loans companies took excessive risks as they “gambled for resurrection” but this is not the only response available to zombies. An alternative is to hoard cash, do little new business and wait for profits slowly to pay down the losses. That was the approach taken by Japanese banks in the years after the S&L crisis. In a paper in 1993, Kane warned the Japanese of the risks incurred in creating zombies. Unfortunately, they didn’t pay heed. 

Before its crisis in the 1990s, Japan had a tried-and-tested formula for resolving bank failures: Authorities would orchestrate their acquisition by a healthy bank. When the Japanese bubble burst in the early 1990s, the scale of banking problems overwhelmed the formula but nor could the deposit insurance scheme step in: It was legally constrained in how much support it could provide in a single case of financial assistance. Instead, a hougachou approach was developed – a reference to a traditional festival for raising money from the community – that combined private and public sector support. Private sector institutions were invited to make capital contributions alongside liquidity and capital assistance from the Bank of Japan.

But the hougachou approach didn’t address underlying non-performing loan problems at the banks, and relying on other often weakened private banks led to consistently under-powered responses. In 1998, Long Term Credit Bank of Japan failed after having participated in the bailout of Nippon Credit Bank the previous year. By then, much of the sector comprised zombie banks, muddling along with weak balance sheets and insufficient capital to restructure and undertake new business.

Over the next five years, the authorities moved to resolve the crisis, initially by providing capital to the zombie banks, then by nationalising and shutting down banks. They also formed a resolution trust to take over banks’ bad assets. When it was done, banks had written off around $1 trillion in bad assets at a cost to the government of over $200 billion. The cost to the country was greater: A “lost decade” of subpar economic growth.

That lost decade cast a long shadow elsewhere in the world. In 2017, Andreas Dombret, a board member of Germany’s central bank, highlighted the lesson:

“Because zombie banks were propped up for years and were offered continued protection, they were actually able to support insolvent enterprises. As a result, the economy fared considerably worse than if authorities had intervened more courageously.”

Dombret warned about the risk of creating zombie banks in Europe, even though many had shuffled through its lands in recent years. The oldest bank in the world, Italy’s Banca Monte dei Paschi di Siena (BMPS), spent many years in a zombie-like state, under the burden of high non-performing loans and insufficient capital. BMPS suffered losses in nine out of the past twelve years. After delaying a capital raise for two years, it finally got one away at the end of last year. “Let me allow to say that Monte dei Paschi is not anymore a systemic problem, but it should be considered for what is a truly country’s asset,” its CEO announced in February this year.

Since the S&L crisis, American authorities have been acutely aware of the risk of creating zombies. They were quickest to recapitalise their banking system after the global financial crisis, and they are the most supportive of their banks making money. 

Which brings us back to First Republic Bank.

The bank could shamble along in a zombie-like state. At 9.3%, its regulatory capital ratio is above the threshold of a “well-capitalised bank” (unrealised losses are not included). Meanwhile, government-sponsored schemes can continue to feed it liquidity. But its mounting losses will eventually deplete capital and as that becomes more obvious, authorities have a duty to shut off the liquidity taps. 

So that leaves three solutions: a private-sector solution, a public-sector solution and … a hougachou solution.

A pure private-sector solution is difficult because accounting principles require any buyer to mark First Republic’s balance sheet to market which means even for the price of a dollar, the deal wouldn’t be economic. 

A pure public-sector solution is also difficult. When authorities took Silicon Valley Bank and Signature Bank into receivership in March, they invoked a “systemic risk exception” which allowed them to cover uninsured deposits as well as insured out of the deposit insurance scheme (at an incremental cost of $19.2 billion). It’s not clear that a failure of First Republic could be deemed “systemic” now that everyone knows it’s happening, which could mean uninsured depositors are relegated to unsecured creditors. Uninsured deposit balances have fallen, from $119 billion before the crisis to around $18 billion at the end of last week, but forcing losses on the last few standing without forcing losses on similar depositors at the other failed banks or even those depositors quicker to withdraw could attract controversy. And that doesn’t include the $30 billion of deposits placed by the 11 large banks. Reprising the “systemic risk exception” to cover them would definitely be seen as controversial.

Which leaves a mixed public/private solution. Various proposals seem to be on the table, although it’s interesting that after years of crafting detailed frameworks to deal with bank failure, a new, unique model may be exercised. As in the case of the S&Ls and Japanese banks, the key question is how to allocate losses between the various parties. Putting off the day of reckoning only serves to feed the zombie – and nobody wants that.

Paying subscribers read on for comments on Deutsche Bank’s acquisition of Numis Securities, European bank earnings…

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“There is an element in the readjustment of our financial system… and that is the confidence of the people.” — President Franklin D. Roosevelt

Of all the innovations that underpin the modern financial system, one of the most central is deposit insurance. Like many ideas in finance, it heralds from the United States, which was the first major country to introduce a national deposit insurance scheme ninety years ago. Since then, similar programs have been rolled out across the world. There is even an International Association of Deposit Insurers which convenes from time to time to promote guidance and share best practice. 

When it works, deposit insurance goes by largely unnoticed. Customers brush past the FDIC mark stuck inside their bank branch window without giving it a second glance, confident that any money they leave behind will be available for withdrawal at a later date. But occasionally, as in the weekend of 11/12 March, deposit insurance launches itself into the public consciousness. When that happens, it’s usually not good news.

Over the years, the parameters around deposit insurance have been revised to accommodate the latest events, and here we are again. 

This week, the Federal Deposit Insurance Corporation (FDIC) held an open board meeting to discuss what to do about the hole that has opened up in its accounts following the failure of two banks. Its staff estimate that losses from the collapse of Silicon Valley Bank and Signature Bank amount to $22.5 billion, of which $19.2 billion stems from the eleventh hour decision to protect uninsured depositors as well as insured.

The deposit insurance fund was already tracking below its target. Funds available to backstop depositors sat at 1.27% of aggregate insured deposits as at end 2022, against a statutory minimum of 1.35%. The long term target is at least 2% which implies a $73 billion shortfall even before these latest losses are factored in. 

Now there is a debate about whether deposit coverage should be widened. Currently in the US, insurance is available on $250,000 per depositor per financial institution. That covers $10.0 trillion of deposits. But there is a further $7.7 trillion that remains uninsured. Capturing it will come at a cost; the question is, who pays?

When Franklin Delano Roosevelt signed deposit insurance into law in 1933 he wasn’t exactly thrilled. On the campaign trail one year earlier he had pushed back on the idea of a blanket scheme, arguing that it would be “dangerous” because it would lead to “laxity in bank management” and be “an impossible drain on the federal treasury”. At his first press conference as president, he told journalists that guaranteeing deposits would “guarantee bad banks as well as good banks. The minute the Government starts to do that, the Government runs into a probable loss.”

Within a few months, Roosevelt had been cornered into a compromise. Banks were collapsing at a rapid rate – between 1 January and 30 June, 1933, four thousand of them failed – and deposits were fleeing the system. Deposit insurance was seen as a clearcut way to stop the bleed. One of its proponents, former Senator Robert Owen, argued that by convincing people that their deposits were safe and the banking system sound, deposit insurance was “essential to the stability of the income of the Nation… a far greater matter than the very important end of protecting the individual depositor or the bank from loss.” His views were shared by Representative Henry B. Steagall who worked to bring a deposit insurance bill through Congress. 

Deposit insurance was nothing new. It had been practised over a hundred years earlier in the state of New York. The program there was devised by Joshua Forman, a local businessman, who had been inspired by the mechanics of international trade in China. Regulations in Guangzhou required merchants trading with foreigners to be liable for one another’s debts in return for a licence to operate. Writing in 1829, when bank-supplied circulating medium was largely in the form of bank notes rather than deposits, Forman noted:

The case of our banks is very similar; they enjoy in common the exclusive right of making a paper currency for the people of the state, and by the same rule should in common be answerable for that paper.

Forman’s scheme required member banks to pay an annual assessment of 0.5% of capital until their total payments equaled 3% of capital. The accumulated funds would be used to cover the notes and deposits of member banks that failed in the event their assets proved insufficient. By the end of 1837, almost all of New York’s banks were members. 

In the years that followed, five additional states adopted insurance programs. However, various flaws in their design hampered their success. In New York, losses depleted the resources of the fund so that by 1842 it ceased to be able to repay losses of failed banks. The limit on annual assessments prevented adequate insurance during panics, and a poor supervisory regime allowed large risk-takers to free ride on other banks. Nor was the system compulsory; once solvent banks realised the extent of the losses, they checked out. 

Where schemes were successful, they paired effective supervision with the principle of shared risk. The mutual guarantee incentivised members to maintain discipline over each other and the best schemes afforded them that control. Such systems incorporated supervisory bodies staffed by bankers to keep a watchful eye over excessive risk-taking and free riding. 

By the time the Banking Act was being thrashed out in 1933, design features had been tested in numerous states all over the country. As well as the six schemes established before the Civil War, eight were established in the aftermath of the Banking Crisis of 1907. The only questions remaining were which banks would be eligible, how the scheme would be funded, and which deposits would be protected. The latter question was critical.

In earlier proposals, full insurance had been advocated. At the end of the nineteenth century, presidential nominee William Jennings Bryan pushed for all deposits to be guaranteed, regardless of size. He gave the example of a huge $150,000 deposit the Nebraska state treasurer had made in a bank that ended up failing. “He cannot tell how that bank is being managed. He simply puts his money there for security, and it is the business of the Government to make that bank as secure as possible,” Bryan told a Congressional hearing. 

It was a sentiment many corporate treasurers would reprise in March of this year, including digital media company Roku’s, who had $487 million on deposit at Silicon Valley Bank. 

But Roosevelt would only budge with something lower. He believed that a more limited liability would incentivize depositors to continue to exercise some discretion in their choice of bank and incentivize bankers to make good management decisions.

In the end, a compromise was settled on: a $2,500 insurance threshold. The cap mirrored a guarantee available in Postal Savings System accounts, creating an incentive to bring those deposits back into the mainstream system. And it covered 97% of depositors, so most fell under its protection. 

The industry didn’t like it – banks were mandated to fund the scheme via an assessment equal to 0.5% of insured deposits. But the cost of insurance would largely be offset by limits the Banking Act put on the amount of interest banks could pay on deposits. It was signed into law and, although greeted with little fanfare in the press, the new deposit insurance program had an immediate impact on financial stability. After over 9,000 bank failures in the prior four years, only nine banks didn’t make it through 1934. 

On 3 July 1934, Mrs. Lydia Lobsiger, a customer of the Fondulac State Bank in East Peoria, Illinois, became the first depositor to receive a federal deposit insurance payout in an amount of $1,250. 

The rise of deposit insurance in the US owes something to the fragmented nature of its banking system. Many banks (so-called “unit banks”) operated a single branch, reducing their capacity to diversify and increasing their risk profile. Geographic expansion and consolidation represented alternative system stabilisers – and states that allowed branch banking saw lower failure rates – but unit banking retained political patronage.

Deposit insurance was one way to protect the smaller banks. All of the six states that enacted deposit insurance before the Civil War were unit banking states, as were the eight that introduced it post 1907. Representative Henry B. Steagall, the architect of deposit insurance in the 1933 Banking Act, opposed branch expansion, warning that it could lead to a banking monopoly. “Something must be done to preserve our historic banking system, with its services and credit facilities for all sections and all communities in our country,” he said. 

For many years, deposit insurance did its job. Coverage was quickly lifted to $5,000 and then, to keep pace with rising prices, it was lifted again, to $10,000 in 1950; to $20,000 in 1969; and to $40,000 in 1974.

But then the parameters began to shift. In 1980, despite reservations of the Federal Deposit Insurance Corporation, new legislation jacked the threshold up to $100,000. Financial institutions were subject to limits on what they could pay on deposits and many had begun to suffer outflows as depositors switched to money market funds offering higher rates. By 1980, 85% of savings-and-loan associations were losing money and warnings were being sounded that without deregulation, they could collapse.

In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act. It began the process of eliminating interest rate controls on deposits placed with banks and savings-and-loans. But, under heavy lobbying from the savings-and-loan industry, lawmakers also slipped in an increase to the deposit insurance threshold. “It was almost an afterthought,” a House staffer later told a reporter. 

The increase would later be cited as a contributory factor in the savings-and-loan crisis that followed. In the few years after 1980, the industry reversed its losses to experience strong growth. But it was bad growth. Through brokers, savings-and-loans were able to attract pools of deposits from all over the country in $100,000 increments. Back in 1963, regulators had limited the amount of brokered deposits a savings-and-loan could hold to 5% of its total deposits but alongside the deregulation of 1980, the limit was repealed. Now, savings-and-loans had ready access to a stream of cheap funding. Their use of brokered deposits increased from $3 billion at the end of 1981, to an estimated $29 billion at the end of 1983.

It wasn’t until 1989 that limits were re-imposed on brokered deposits, by which time many savings-and-loans had collapsed under the weight of fraud, bad loans and balance sheet mismatches. But the $100,000 deposit insurance threshold remained intact.

At the height of the global financial crisis in October 2008, the limit was raised again, to $250,000, in a measure that was meant to be temporary but became permanent in 2010. (One reason it was made permanent was to address the issue of lapsed coverage on time deposits due to mature after the cap reverted. What’s easy to add is often less easy to subtract.)

At the time, the new limit covered most depositors as well as 71% of deposits. Since then, however, uninsured deposits have risen to 57% of the total. It’s slightly odd, because there are ways to retain coverage by splitting up a larger deposit into smaller chunks. With 4,706 FDIC insured institutions in the US, there is certainly enough capacity – depositing $250,000 with each of them provides $1.2 billion of cover – and the technology exists to do it.

Indeed, the bill that eased regulation around banks in 2018, relaxing the scrutiny of Silicon Valley Bank, also facilitated growth in a new kind of deposit. Since the savings-and-loan crisis, brokered deposits have been stigmatised. But the bill reclassified so-called “reciprocal deposits” from brokered to non-brokered if they total less than $5 billion or 20% of total liabilities. 

Reciprocal deposits allow banks to dice up larger deposits and place them with other banks, via technology networks such as IntraFi (which works with 3,000 financial institutions). Around $1 trillion in deposits flow through these networks, of which about a fifth are reciprocal. Perhaps unsurprisingly, Silicon Valley Bank didn’t participate. It had just $469,000 of reciprocal deposits at the end of 2022 out of a total deposit base of $175 billion.

It could be that depositors were simply inured to the risk. After all, we were coming off the second longest stretch without a bank failure in recent memory. Now, platforms like IntraFi are booming, although that may be short-lived if authorities raise the threshold again. The problem with insurance is that it isn’t free; banks need to top-up the fund and bolster it further if coverage is to be expanded. Already, the top-up plus any surcharge to cover losses on Silicon Valley Bank and Signature Bank mean the six largest banks have to cough up an additional $15 billion, equivalent to around 15% of their earnings. No doubt that will be passed on to consumers. 

Deposit insurance was never meant to preserve wealth, which is why insurance companies, pension companies and the like are not eligible. It was meant to preserve the functioning of the banking system. What the correct number is to accomplish that is a guess, but it’s going up. 

Sarah Jane Gates’ 2017 PhD dissertation, More Lives than a Cat: A State and Federal History of Bank Deposit Insurance in the United States was a valuable resource. As was Charles Calomiris’ Deposit Insurance: Lessons from the Record (1989) and Is Deposit Insurance Necessary? A Historical Perspective (1990). 

Paying subscribers read on for analysis of this week’s bank earnings…

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1. Customer or Creditor?

The first thing to understand about banks is that they operate a unique financial structure. Other companies borrow from one group of stakeholders and provide services to another. For banks, these stakeholders are one and the same: their creditors are their customers.

Most customers don’t realise this and as long as their loan to the bank (traditionally called a deposit) falls within the scope of their national deposit insurance scheme, they don’t have to. As US depositors have been reminded these past few weeks, the first $250,000 they lend to their bank is fully insured. The bank could close down on Friday and their loan would be available for immediate redemption on Monday thanks to a backstop provided by the Federal Deposit Insurance Corporation (FDIC). Anything over $250,000, though, and they become an unsecured creditor (at least in theory).

Banks in some countries take this further, exploiting a captive pool of naive lenders to borrow on even looser terms. Up until around 2015, Italian banks would regularly sell subordinated bonds to their customers, offering them a more attractive rate than they could get on deposit. By October 2015, over half of the circulating bonds issued by banks were held by retail customers. This practice has now been reined in, but uninsured deposit issuance is still rife. 

For an analyst, this structure complicates things. No use looking at the ‘enterprise value’ of the business – the traditional barometer for measuring a business’ worth – because the debt is the business. No use looking at cash flow statements which disentangle cash generated in operating activities from cash generated in investing and financing activities because the operating activities are the financing activities.1

Because it’s where the customers sit, if you want to understand a bank, you have to look at its balance sheet. As a bank analyst, I would often peer over in envy as colleagues covering other sectors would go on factory tours or visit flagship retail outlets. I’d stay at home and study bank balance sheets. 

To some extent the balance sheet is the business. The rest is there simply to feed it – the store a device to attract new funding. Bank executives may not want to admit it because it seems overly reductive, but those that forget do so at their peril.

Metro Bank is a case in point, discussed here a few months ago. Back in his home state of New Jersey, its founder, Vernon W. Hill II, “refined a business model patterned after the great retailers of America, i.e., Home Depot, WalMart, McDonald’s, Starbucks, rather than the typical bank or financial institution.”

On arriving in the UK, Hill designed Metro Bank “as a retail operation more akin to Apple than to the Bank of England.” After peaking at a market capitalisation of £3.5 billion in 2018, the company now flounders at a valuation of around £180 million. The stores turned out fine, the balance sheet not so much.2

In death, the balance sheet is all that’s left of a bank. When First Citizens Bank took over the remains of Silicon Valley Bank this week, it opened the casket to investors. Lying there was $72.1 billion of loans and $35.3 billion of cash, funded by $56.5 billion of deposits. Gone was all the talk about Silicon Valley Bank as “a networking tool” for its customers, all the talk about Silicon Valley Bank as a business. 

[More on the economics of this transaction for paid subscribers below]

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2. Public or Private?

Banks have a licence to create money which confers on them a special status somewhere between private enterprise and public entity. Economists argue that commercial banks create money by making new loans. When a bank makes a loan, it credits the borrower’s bank account with a deposit the size of the loan. At that moment, new money is created. 

Bank analysts don’t quite see the world like this. In their view, banks need deposits in order to make loans. ‘Deposits before loans’ is a more useful model for an individual bank. Either way, banks operate a two-sided platform and maintaining an equilibrium is important. Banks struggle when one side of the ledger grows more quickly than the other. Silicon Valley Bank grew deposits more quickly than loans; Northern Rock grew loans more quickly than deposits. 

The privilege of creating money comes with responsibility. To ensure banks behave responsibly, they are heavily regulated. Getting a licence at all can be a challenge. Neobank Revolut has been trying to obtain one in the UK for several years to no avail; likewise The Narrow Bank in the US. Depending on the particular jurisdiction, a licence can grant its owner the right to raise insured deposits as well as give it access to central bank facilities.3

Once the licence is granted, banks are subject to very heavy oversight. They must retain a certain amount of capital linked to the size of their balance sheet and the riskiness of their assets. And they must run their balance sheets within clear liquidity parameters.

As important, regulators are constantly checking up on banks (or at least they should be). The Federal Reserve’s budget for banking supervision and regulation was $1.7 billion in 2022. In addition, the FDIC budgeted $1.1 billion for supervision and consumer protection, and the Office of the Comptroller of Currency (OCC) spent $1.1 billion. Between them, these three organisations employ over 30,000 staff. A team of 20 took over day-to-day supervision of Silicon Valley Bank in the second half of 2021.

All of this lies in the normal course of business for a bank. What is sometimes overlooked, because it is utilised so infrequently, is the executive power that authorities retain over banks. In some countries, where state owned banks dominate the market, intervention is explicit. During the global financial crisis, state-owned banks in India and Brazil carried on extending credit even when their private sector peers pulled back. 

But even when a bank is notionally private, the state can exercise direct influence over its operations.

This became clear during the pandemic, when regulatory authorities in the US and Europe unilaterally shut down banks’ dividend and share buyback programs.

It became clear when sanctions were declared on Russia at the outset of the invasion in Ukraine that states exercise foreign policy through their banking sector. “In Treasury, we realised that private-sector actors – most importantly, the banks – could drive the isolation of rogue entities more effectively than governments,” writes former US Treasury official, Juan Zarate, in his book, Treasury’s War. 

And it became clear again in Switzerland recently, when authorities decided Credit Suisse was no longer viable as a private entity. 

Wherever you sit in a bank’s capital stack, make no mistake: a higher authority sits above you.

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3. Growth is … not good

Most companies thrive on growth. “If you’re not growing, you’re dying,” they say. For investors, growth is a key input in the valuation process. 

But if your job is to create money, growth is not all that hard. And if the cost of generating growth is deferred, because the blowback from mispricing credit isn’t apparent until further down the line, it makes growth even easier to manufacture.

Think about the mortgage market. The average life of a mortgage in the UK is seven years. An imprudent banker could originate as much volume as he likes right now; the cost may only become apparent later. The principle stretches into other areas of a bank’s business as well. When Deutsche Bank set up a special unit to ring-fence unloved assets a few years ago, the average life of a portfolio of interest rate derivatives it included was eight years  – they’d been put on three CEOs earlier.

Warren Buffett talks about a similar dynamic in insurance. In his 1985 shareholder letter he told how an advertisement placed in an insurance weekly garnered US$50 million of premiums. “Hold the applause,” he cautioned. “It’s all long-tail business and it will be at least five years before we know whether this marketing success was also an underwriting success.”

For these reasons, a focus on revenue growth for balance sheet businesses makes little sense, notwithstanding what some fintech companies would have you believe. 

Unusual asset growth has long been recognised as a red flag among bank analysts and regulators. Since the global financial crisis, regulators track how growth rates diverge from long-term trends. The Silicon Valley Bank collapse highlights how deposit growth can be just as unstable. If a balance sheet is a two-sided platform, it doesn’t matter where the growth comes from to make it vulnerable. 

The corollary to this is that, unlike in other industries, competition is not necessarily that good either – or at least it comes with a trade-off against financial stability. 

This is something I wrote about in my Bloomberg column this week:

There are many case studies of how competition can lead bankers astray. The classic is Chuck Prince’s acknowledgement that “as long as the music is playing, you’ve got to get up and dance.” Fifteen months later, his bank, Citigroup Inc. needed a government bailout. More recently, Silicon Valley Bank executives may have been incentivised to take more risk because their compensation was directly linked to the return on equity they generated “relative to peers.”

In a tradeoff between financial stability and competition, authorities will mostly choose stability. Last week, the chair of the Swiss financial regulator Finma brushed off antitrust concerns when she prodded UBS Group AG to take over a Credit Suisse Group AG that was dangerously close to collapse. “We can override monopolies and mergers as an institution and this is something we made use of,” she declared at a press conference.

It’s a playbook UK regulators used during the global financial crisis in 2008. When HBOS was shepherded into a merger with Lloyds-TSB, putting a third of UK personal current accounts into the hands of one institution, competition authorities baulked. They were overruled by a higher authority: “The public interest of ensuring the stability of the UK financial system outweighed competition concerns,” said Secretary of State Peter Mandelson.

US authorities are unusually squeamish about the trade-off. Partly, it reflects a respect for private markets but mostly it’s because their smaller banks harness significant lobbying power. More members of Congress have a small bank among their top 25 donors than a large bank, according to data compiled by Byrne Hobart.

The US is not necessarily making the wrong choice – its economy is more complex than others and its companies have more diverse financing needs. But it is a choice. As Thomas Sowell said, “There are no solutions. There are only trade-offs.”

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4. Confidence is king

The absolute foundation of banking is confidence. Depositors entrust their money to banks in the confidence that they will get it back according to the terms of their deposit. 

As Matt Levine of Bloomberg’s Money Stuff writes (emphasis mine):

“The bank doesn’t just put your dollars in a box and wait for you to take them out; the bank uses its depositors’ money to make loans or buy bonds, and just keeps a little bit around for people who need cash. If everyone asked for their money back tomorrow, the bank wouldn’t have it. But everyone is confident that, if they ask for their money back tomorrow, the bank will have it. So they mostly don’t ask for it, so when they do, the bank does have it. The widespread belief that banks have the money is what makes it true.”

The history of banking is replete with innovations designed to cement that belief. Before the advent of deposit insurance, banks would market the reputation of their directors and their years in business to cultivate confidence. In the financial crisis of 1907, banks took out newspaper ads, detailing their financial condition.

Since then, banks have grown more complex, making any disclosure of their financial condition less intelligible to most consumers. Instead, they rely on credit ratings, capital ratios, liquidity ratios and supervisory assessment.

The problem is that these are all proxies for confidence rather than confidence itself. 

Credit Suisse ticked off all the proxies. When it collapsed, it did so with a regulatory capital ratio of 14.1%, ahead of its 13% target, and a liquidity coverage ratio of 144%. Once central bank support was factored in, that liquidity coverage ratio jumped to 190%, signalling that the bank had sufficient liquidity to meet almost 60 days of stressed deposit outflows. Without confidence, though, the bank was toast. 

It’s very difficult to restore confidence once it’s gone. One thing not to do is put out a press release saying your liquidity is strong. You’d think people would have learned after Bear Stearns, but no. When the proxies cease to work, saying it ain’t so won’t help either. 

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5. Nobody knows anything

The dirty secret among bank analysts is that it’s quite hard for an outsider to discern what’s going on inside a bank. Former bank analyst Terry Smith knows it. “I think it is precisely because I understand banks that I never invest in their shares,” he wrote in the Financial Times last week.4

It’s only after the fact it becomes apparent what questions to ask.

For example, it turns out that Silicon Valley Bank’s top ten customers had $13.3 billion in deposits between them out of a total deposit base of $165 billion at the end of February 2023. That’s quite some concentration and it wasn’t disclosed. Since the bank has collapsed, we’ve also found out that regulators regarded the bank “not well-managed” as long ago as last summer. More unsavoury details will undoubtedly emerge when the regulators publish the findings of their inquiry in April. 

But historic inquiries reveal similar unknowns at other banks.

At Wells Fargo, management used to speak about “needs-based” cross selling. “Our cross-sell focus starts with customer needs,” said the group’s head of community banking in 2010. In contrast to these public statements, she implemented a volume-based sales model in which employees were directed to sell large volumes of products to existing customers. The cross-selling scandal was a huge reputational blow to Wells Fargo, leading to fines, regulatory censure and management turnover.5

At Credit Suisse, the inner workings of the prime brokerage business were laid bare only after the losses incurred on Archegos exposures came to light. The special report it commissioned into the episode is littered with examples of poor management practice. My favourite is that “neither of the co-heads of Prime Services believed he was specifically responsible for supervising CS’s relationship with Prime Financing clients in the United States—including Archegos.” 

Near-miss and indeed crash investigations are as informative in banking as they are for airlines and investors are wise to read them. The only problem is that the number of things that can go wrong is vast and so banks will find new ways to fail. One helpful heuristic is that banks are unlikely to be upended by the same factors that drove the last crisis. 

Paid subscribers please read on for my comments on the First Citizens acquisition of Silicon Valley Bank, the disintermediation of banks by money market funds, and the future of bank liquidity requirements. Also, a programming note. If you are not already a paid subscriber, please consider signing up.

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Paid subscribers can read on to see what it all means for UBS: Is theirs the deal of the decade? I will also be hosting a webinar for paid subscribers to discuss the latest developments in the current banking crisis. If you’re not already signed up, you can do so here.

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Fifteen years ago, shortly after I’d left the place, Credit Suisse was flying high. It had just generated record earnings of $9 billion and sat atop various league tables. In investment banking, it was the number one ranked firm for IPOs, number one in algorithmic trading and a leader in emerging market bond issuance. In private banking, it managed close to three quarters of a trillion dollars of high net-worth wealth, growing at a rate of around 6% a year. 

The firm had been embroiled in its fair share of controversy over the years, but it never seemed to cause lasting damage. A few months before I joined, a team of five traders known as the “Flaming Ferraris” made headlines over rogue share deals they’d executed on the Stockholm Stock Exchange. Elsewhere around the world, the firm ran afoul of authorities as far apart as the United States, the UK, India, Japan, New Zealand and Ukraine.

When John Mack was brought in as CEO of the investment banking unit in July 2001, he pitched a potential hire: “Brian, I’ve got the biggest, most fucked-up company in the world right here. Come back…and help me fix it.”

It took some time but, on the surface at least, it looked like things got fixed. The firm suffered a loss in 2002 – its largest (to date) – as it booked litigation charges on a raft of cases linked to research analyst independence, certain IPO practices and Enron. Fortunately, none of these issues infected its private banking franchise which had experienced its own trauma long before my time. They still spoke in hushed tones of the Chiasso Affair in the wood-panelled corridors of Paradeplatz; management seemed committed to preventing anything like that from happening again. 

After its bumper year in 2006, Credit Suisse entered the global financial crisis on a relatively strong footing. It suffered write-downs in 2008 on leveraged finance and structured products exposures, swinging the group into a loss. But its private banking business was seen by clients as a place of shelter and net new assets drove 5% asset growth over a period when rival UBS – much more severely hit by the crisis – suffered outflows. Unlike UBS, Credit Suisse avoided having to seek assistance from the Swiss government and shored up its capital base via a 10 billion Swiss Franc raise from private investors (notably the Qatar Investment Authority and long-standing Saudi investor Olayan).

The following year, 2009, Credit Suisse bounced right back and it didn’t do too badly in 2010 either. Over those two years, it made back the losses it incurred in 2008 nearly 1.5 times over. 

It was then that the rot began to set in. A near-death experience can have a profound impact on a person’s behaviour, and an institution is no different. Banks that had been closer to the abyss than Credit Suisse completely reformulated their strategy in response to the global financial crisis. NatWest Group is one we’ve discussed here before and, closer to home in Switzerland, UBS similarly overhauled its business practices.

But Credit Suisse didn’t suffer that near-death experience; it chalked the crisis up as another temporary setback on its long list. As far as Credit Suisse was concerned, you take risk in the course of business and if it doesn’t work, you clean up and move on. In the past, the market had always been forgiving. The global financial crisis fit into that pattern. 

The company stuck with existing management and ploughed on. As late as 2015, group CEO Brady Dougan reiterated his commitment to the old model of investment banking. “Some argue for a change of tactics,” he told shareholders at that year’s annual general meeting. “But instead, we have persevered and worked to reshape this business into a streamlined division that is focused on core clients.” 

Yet the world had changed. Credit Suisse adapted to higher capital and liquidity requirements imposed on the industry by regulators as adroitly as its peers. But it didn’t adapt to other shifts.

First, it failed to recognise that authorities had grown less tolerant of breaches of conduct. To settle its “Flaming Ferraris” case years earlier, the group had paid a penalty of around $250,000. Anticipating some inflation in conduct charges coming out of the crisis, Credit Suisse set aside 870 million Swiss Francs of litigation reserves to cover future legal liabilities by the end of 2011. Cases around research analyst independence, IPO practices and Enron were still pending and, in addition, a host of new cases had been brought, covering mortgage securitisation, breach of US sanctions, LIBOR rigging and more. To be extra cautious, the bank warned that “reasonably possible” losses could amount to a further 2.3 billion Swiss Francs. 

It wasn’t enough. In the ten years since, Credit Suisse has disbursed 15 billion Swiss Francs in legal settlements and, as at the end of 2022, it still anticipates another 1.2 billion Swiss Francs of charges. For every $100 of revenue it produced over that time, it disgorged $7 in penalties and fines. Certainly, the bank’s auditors may not have been able to predict the frequency of cases that would arise (at least publicly) but that’s a five times bigger cost than what was provisioned for at the beginning of the period. The market can be forgiving only up to a point.

Second, when management finally did grasp that the investment banking business was too unwieldy, it managed its wind down poorly. In 2015, new CEO Tidjane Thiam found that a fifth of the assets in the investment banking division didn’t earn their cost of capital. His solution was to shrink the business around its more profitable parts, promising that what’s left would deliver a return on capital well into the double digits. 

It was the first of many attempts to bolster returns. Over the next several years, “restructuring” would become a mainstay of life at Credit Suisse. In spite of – or perhaps because of – the continual tinkering, profitability never reached its promised heights, with return on equity averaging around 3% a year. Good assets got thrown out with the bad – an outcome that became apparent in 2021 when Credit Suisse lost around $5.5 billion from its involvement with Archegos Capital Management. An independent inquiry commissioned by the board concluded that the loss partly stemmed from “injudicious cost-cutting”: Headcount reductions led to a less experienced workforce, notably in risk management.

Third, as management was dealing with these issues, the competitive advantage of the group’s core private banking business eroded with the elimination of banking secrecy. In 2017, Switzerland adopted the International Convention on the Automatic Exchange of Banking Information (AEOI), agreeing to automatically release financial information to certain countries for the purpose of tax auditing. As part of this agreement, Swiss banks are obliged to send foreign tax authorities their client’s name, address, domicile, tax number, date of birth, account number, annual account balance and gross investment income. For a certain category of customer, that’s not good!

In 2012, Brady Dougan estimated that 35 to 45 billion Swiss Francs of assets could potentially be at risk from European clients leaving, out of a pool of a trillion. But the bigger impact was on margins. As well as opening themselves up to tax authorities and regulators, Swiss banks opened themselves up to clients. Opacity is a tried-and-tested way to extract fees in financial services, and its elimination hits profit. Gross margins in Credit Suisse’s wealth management business declined from around 1.10% of revenues to around 0.85%.

“I often say in Switzerland that we sell safety not secrecy,” CEO Tidjane Thiam said in the run-up to AEOI implementation. “And that’s a very important point for me about the business model we run.” As became apparent this month, Credit Suisse was able to sell neither.

All of these factors squeezed the group’s profitability. In the past ten years, Credit Suisse earned around $230 billion in revenue. Around $110 billion was paid out to employees as compensation and benefits, and around $100 billion was consumed by other expenses. After credit losses of $7 billion, that left $13 billion to be shared between investors and the tax person. The tax person took it all. Net of tax, Credit Suisse lost money in five of the last ten years and in aggregate it lost $3.4 billion over the period. 

Now, it’s not unusual for banks to lose money. European banks do it all the time (well, not quite, but they’re not very profitable) and it doesn’t lead to them being declared unviable by regulators. So why the urgency to shut Credit Suisse down over the weekend? “Credit Suisse meets the capital and liquidity requirements imposed on systemically important banks,” declared its regulator just four days earlier. (“We welcome this statement of support,” tweeted back Credit Suisse, rather sweetly.)

In its dying throes, the group had a regulatory capital ratio of 14.1%, ahead of its 13% target, and a liquidity coverage ratio of 144%. Once central bank support was factored in, that liquidity coverage ratio jumped to 190%, signalling that the bank had sufficient liquidity to meet almost 60 days of stressed deposit outflows.

The stock price and credit default swap spread highlighted a greater degree of stress but liquidity support was meant to break the reflexive feedback loop between the market’s perception of a bank and its ability to operate. Credit Suisse had already lost 37% of its deposits in the fourth quarter last year, in a preview of what would happen at Silicon Valley Bank, but had been able to hang on. When deposit outflows accelerated this month (10 billion Swiss Francs was leaving per day, according to one report) and it became clear that under the current group structure they were unlikely to flow back, authorities decided to act. 

Because in banking, authorities have absolute power. And even though the post-2008 rulebook was of no use in this case given the bank’s ratios, one thing policymakers learned from the last crisis is that it is better to resolve a situation than to lurch from weekend to weekend. 

When asked, “Who is responsible for this disaster?” Credit Suisse’s chairman cited Twitter. “Last autumn we had a social media storm and this had huge repercussions – more in the retail sector than in the wholesale sector. And too much becomes too much,” he said. It’s actually a risk the company has laid out in its annual filings since 2021:

Adverse publicity or negative information in the media, posted on social media, or otherwise, whether or not factually correct, can also have a material adverse impact on our business prospects and financial results, which risk can be magnified by the speed and pervasiveness with which information is disseminated through those channels.

In the end, Credit Suisse’s reputation became so damaged by years of neglect that depositors began to take notice. For anyone with memories of the place, it’s a shame but, through UBS, the institution lives on.

Paid subscribers can read on for further analysis on UBS’s acquisition of Credit Suisse. Details of the webinar I am hosting for paid subscribers is also below.

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Banks aren’t like other companies. A retailer or a builder goes bust and it leaves a hole in the market for others to step into, an opportunity for them to pick up market share. But when a bank goes bust, it sends ripples across the industry, impacting them all. Few executives of US regional banks this week welcomed the opportunity to win over Silicon Valley’s orphaned customers; they were too busy convincing their own customers they were different. 

There are several typical channels for financial contagion. 

One is that banks own similar assets to each other. When a bank is forced to liquidate its assets, their prices may take a hit. Other banks holding the same assets will have to mark their holdings down accordingly. To the extent banks use these assets as collateral against borrowings, their access to such borrowing may be curtailed. In a worst case scenario, banks may have to sell assets to raise liquidity instead, and a vicious spiral ensues. This was part of the story of the last financial crisis. 

Another is that banks originate similar assets to each other. Just like other companies, banks are a competitive breed. Many will sacrifice underwriting discipline in order to retain their market position. “As long as the music is playing, you’ve got to get up and dance,” the CEO of one bank famously remarked sixteen months before seeking a government bailout. This behaviour is one of the reasons policymakers are not as keen on competition in the banking industry as they are in other industries. In a stand-off between financial stability and competition, authorities will always choose financial stability. Again, this was part of the story of the last crisis.1

This week’s fears of contagion have little to do with these factors. Silicon Valley Bank’s assets were largely money-good. It sold a $21.4 billion portfolio of securities to Goldman Sachs days before its collapse but in the markets where they trade, that wasn’t enough to move the price. Indeed, Goldman may even have made a $100 million profit on the trade. 

Its loans were also pretty good. Non-performing loans made up just a fraction of its loan book and they were covered more than four times over by provisions. Most of its loans reprice over the short term so weren’t underwater from higher interest rates in the same way the securities book was. Ironically, if Silicon Valley Bank had written bad loans, it would have been given more time to work them out. In the last crisis, bank failures peaked in 2010, a full year after bank stock prices bottomed. 

Rather, contagion is spreading through an altogether different channel: customer confidence. The speed with which Silicon Valley Bank collapsed has customers questioning the fragility of the very model banks operate under. One day, Silicon Valley was open for business; the next it wasn’t. On Tuesday the CEO was at a conference calmly talking about his hobbies, on Wednesday the bank’s stock was still trading at a premium to book value, on Thursday it lost a quarter of its customer deposits, and on Friday it was gone.

So quick was the collapse, the authorities didn’t even wait until 5pm to close down the bank. When Washington Mutual was shut in 2008, it had lost $17 billion of deposits over two weeks; Silicon Valley Bank lost $42 billion in a single day. Washington Mutual’s stock had been under pressure for some time (I was short at the end of 2006); Silicon Valley Bank was trading above its Covid low until its very last day. 

Signature Bank suffered the same fate. Two days after Silicon Valley Bank was shut, authorities in New York closed down Signature Bank. Former US Congressman Barney Frank, one of the architects of the post financial crisis regulatory regime, was a board member. He didn’t see it coming. “Apparently, the Department of Financial Services in New York, which did the closing, hasn’t said we were insolvent,” he said. “I wonder, are we the first bank to be closed, totally, without being insolvent?” 

Nor did any of the signals designed to project confidence work. Moody’s conferred an A1 credit rating on Silicon Valley Bank right up until the moment it collapsed. The bank’s tier 1 risk-based capital ratio – a measure of its capital adequacy – was a sturdy 15.4%, close to twice its required regulatory minimum. And supervisory oversight was assured. As a “Category 4” banking organisation, Silicon Valley did not have to disclose its liquidity coverage and net stable funding ratios like larger banks, but these were metrics regulators should have been monitoring.2

In the event, none of the pre-emptive protections worked. “If those banks can be closed down so suddenly, why can’t mine?” customers might rightly ask.

We discussed the specific reasons why Silicon Valley Bank failed last week. We highlighted the asset side of its balance sheet, which was chock-full of long duration securities, most of which had been pushed underwater by rising rates yet did not have to be marked as such. And we highlighted its deposit base, which was heavily concentrated around a relatively small number of uninsured depositors, whose average deposit balance was $4.2 million (versus the $250,000 insurance threshold).

In the past week, people have debated which of the two factors is the more important. Some argue it was the losses in the securities book and draw concern from a recognition that US banks are sitting on $620 billion in aggregate mark-to-market losses as at the end of 2022. Others focus more on the deposit side, arguing the flighty nature of Silicon Valley’s deposits would have caused the bank problems whatever assets it held. The reality is that it was the combination of both factors that led to Silicon Valley’s demise. Its deposit base might have been fine if matched with short-dated securities, and it might have been able to withstand the mark-to-market losses with a more resilient deposit base.3

Nevertheless, depending on which factor you put more weight on, you can find your channel of contagion. The chart shows the banks on the frontline.

One thing we learned from the last crisis is that the market leads regulators. Before the Federal Reserve started conducting stress tests on US banks, analysts and investors performed their own. We would calculate the “burndown” tangible book value of banks by estimating cumulative losses across their various loan categories and writing down the overall book accordingly. Any gap between “burndown” tangible book value and some level of sustainable capital would have to be filled via a common equity raise.

Some bank executives argued that preferred capital would do the job, as per regulatory guidelines, but the market pushed back. No surprise the market view prevailed. “As you know…based on our Tier 1 of 11.9% [which includes preferred capital], we have been very well-capitalised,”  Citigroup’s CEO announced to the market in February 2009. “However, the markets became increasingly focused on tangible common equity, and the stock price and preferred prices reflected this focus.” Citigroup went on to launch a dilutive exchange of preferred to common stock. 

The parallel today is that the market will not wait for regulators. For sure, regulation will change. It is in the nature of regulation that it addresses the last crisis, and it is the nature of risk that it emerges where no-one is looking (policymakers had long anticipated that the next crisis would emerge from the non-banking financial sector, rather than the banking sector). Smaller banks will likely come under the same scrutiny as larger banks. Like the large banks, they may be obligated to sweep mark-to-market gains and losses in their available-for-sale securities portfolios into regulatory capital, and may have to disclose liquidity ratios. 

But the market won’t wait, and in the meantime deposits are on the move. Just as new indicators of stress became useful during the global financial crisis, several will come to dominate now. Those I will be looking at include the Federal Reserve H.8 report, released every Friday at 4.15pm. It collates deposit volumes across all US banks and will highlight any migration from small banks to large banks.

Bank deposit rates are also worth watching. No doubt they will go up across the board as deposit rates catch up with the interest rate hikes we’ve seen over the past year, but banks towards the top of the leaderboard may be signalling a particularly hard time retaining deposits.

Finally, activity at the Federal Home Loan Banks is worth watching as banks’ “lender of next-to-last-resort”. We talked about Federal Home Loan Banks two weeks ago in the context of Silvergate, which received a lifeline from them for a couple of months until its end. They issue bonds every day which they turn around to fund advances to banks; Monday’s issuance was a record high.

We won’t know for a couple of weeks yet whether current events turn into a crisis or not. But at the very least, depositors are now much more aware of the risk/return involved in making bank deposits and will assess relationships accordingly. Along the way, they are realising that a bank is not a business, it’s a balance sheet.

Paid subscribers can read on for further analysis on several institutions at the “frontline of contagion” — Credit Suisse, Charles Schwab and First Republic Bank.

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That was the last question Greg Becker, CEO of Silicon Valley Bank, fielded at an investor conference on Tuesday this week. 

“Cycling is my advice,” he replied. “Living in Northern California and being on the peninsula. That’s just—I think it’s the best bike-riding cycling in the world, period.”

Three days later, Becker’s bank is in receivership. 

We’ve talked before about the interest rate risk that lurks on banks’ balance sheets and how the industry manages it. During the pandemic, banks took in record volumes of new deposits. Between the end of 2019 and the first quarter of 2022, deposits at US banks rose by $5.40 trillion. With loan demand weak, only around 15% of that volume was channelled towards loans; the rest was invested in securities portfolios or kept as cash. Securities portfolios ballooned to $6.26 trillion, up from $3.98 trillion at the end of 2019, and cash balances went up to $3.38 trillion from $1.67 trillion.

When banks purchase securities, they are forced to decide up-front whether they intend to hold them to maturity. The decision dictates whether the securities are designated as “held-to-maturity” (HTM) assets or as “available-for-sale” (AFS) assets. HTM assets are not marked to market: Banks can look on nonchalantly as bonds lose value; they remain glued to balance sheets at amortised cost regardless. By contrast, AFS assets are marked-to-market—a purer designation but one that injects an element of volatility into a bank’s capital base. For smaller banks, regulators look through this volatility but for banks with over $700 billion in assets, that volatility directly impacts regulatory capital.

Initially, banks favoured the flexibility that AFS gave them. If conditions changed and they wanted to sell, they could do so without much fuss. Sell even a single bond out of an HTM portfolio, however, and the entire portfolio would need to be re-marked accordingly. Through 2020, around three quarters of banks’ securities portfolios were held as AFS.

But then interest rate expectations started to shift and bond prices began to slide. Having been sitting on mark-to-market gains on their securities portfolios, banks started to see losses emerge. Unrealised gains of $39 billion across banks’ AFS portfolios at the end of 2020 swung to unrealised losses of $31 billion by the end of 2021.

To staunch the bleed, many banks reclassified AFS securities as HTM. This meant recognising losses upfront, but the switch would protect balance sheets from further losses as bond prices continued to fall. The largest bank, JPMorgan transferred $342 billion of securities from AFS to HTM, taking its weighting of AFS down to 30%. Others followed suit: Across the industry, the weighting of banks’ securities held as AFS shrank from three-quarters to just over half by the end of 2022. 

But rising rates didn’t just present cosmetic challenges around how banks classify their bond holdings; they also gave rise to more fundamental challenges around how to manage the portfolio. Although bank treasury executives witnessed a brief tightening cycle in 2017/18, they had never had to contend with as sharp a rates move as occurred in 2022.

Different banks adopted different strategies. JPMorgan retained a lot of cash and chose to manage its AFS book aggressively. “We sell rich securities and buy cheap,” said CEO Jamie Dimon on his third quarter earnings call. Fifth Third decided to wait before deploying its excess deposits in securities. “We can afford to be patient,” its CFO said on an earnings call in January 2021. Fifth Third arguably made its move too early in 2022 but nevertheless was able to lock in slightly better yields than banks that had bought into the market sooner.

Some banks got it completely wrong. First Republic is one we discussed in October. Another, now apparent, is Silicon Valley Bank.

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A Peek Into Silicon Valley’s Balance Sheet

Silicon Valley Bank was set up in 1983 to service the burgeoning tech ecosystem taking root in the Valley. Revised regulations eased the process for acquiring a bank licence, and Silicon Valley Bank became one of 72 new banks launched in California that year. It grew slowly, surviving a real estate wobble that led to a big write off in 1992, before confronting the tech boom and bust several years later.

Silicon Valley Bank offers tech companies a range of products: deposit services, loans, investment products, cash management, commercial finance and more. Because younger companies tend to have more cash on hand than debt, most of the bank’s money is traditionally made on the deposit side of the business. 

Driven by the boom in venture capital funding, many of Silicon Valley’s customers became flush with cash over 2020 and 2021. Between the end of 2019 and the first quarter of 2022, the bank’s deposit balances more than tripled to $198 billion (including a small acquisition of Boston Private Financial Holdings). This compares with industry deposit growth of “only” 37% over the period. Around two-thirds of the deposits were non-interest-bearing demand deposits and the rest offered a small rate of interest. All-in, at the end of 2022, the cost of Silicon Valley’s deposits was 1.17% (up from 0.04% at the end of 2021).

The bank invested the bulk of these deposits in securities. It adopted a two-pronged strategy: to shelter some of its liquidity in shorter duration available-for-sale securities, while reaching for yield with a longer duration held-to-maturity book. On a cost basis, the shorter duration AFS book grew from $13.9 billion at the end of 2019 to $27.3 billion at its peak in the first quarter of 2022; the longer duration HTM book grew by much more: from $13.8 billion to $98.7 billion. Part of the increase reflects a transfer of $8.8 billion of securities from AFS to HTM, but most reflected market purchases. 

“Based on the current environment, we’d probably be putting money to work in the 1.65%, 1.75% range,” said the bank’s CFO at the beginning of 2022, referring to the yields he wanted to achieve. “The vast majority of that…being agency mortgage backed, mortgage collateral, things along those lines.”

The trouble is that when rates started to go up, mortgage assets got hit hard. The duration of Silicon Valley’s HTM portfolio extended to 6.2 years, as at the end of 2022, and unrealised losses snowballed, from nothing in June 2021, to $16 billion by September 2022. That’s a 17% mark-to-market hit. The smaller AFS book was also impacted, but not as badly. Mark-to-market losses there amounted to 9% by the end of September.

So big was this drawdown that on a marked-to-market basis, Silicon Valley Bank was technically insolvent at the end of September. Its $15.9 billion of HTM mark-to-market losses completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet.

Remember, though, that these losses don’t have to be recorded on the bank’s books and so Silicon Valley’s CEO could take his bike for a spin without a care. Although not great for its margin – much higher yields were now available in the market than the 1.65%, 1.75% the bank had chased – the situation wasn’t fatal. “The good news is that the securities portfolio is constantly paying down. And so we’re roughly seeing about $3 billion a quarter,” said the group’s CFO on his third quarter earnings call. It would take a long time, but the losses were expected to unwind as the bonds redeemed.

What neither the CEO nor the CFO anticipated, however, was that deposits might run off faster. Which is odd, because they’d seen deposits run off before. In the aftermath of the dotcom crash 20 years ago, deposits at the bank fell from $4.5 billion to $3.4 billion by the end of 2001 as customers drew down on their cash reserves.

The Chief Risk Officer may have spotted some clouds, but she didn’t hang around to find out. She left her role in April 2022 (after selling some stock in December) and wasn’t replaced until January 2023. 

This time around, deposits fell from $198 billion at the end of March 2022 to $173 billion at the end of December (and $165 billion by the end of February 2023). Part of the decline reflects a system-wide contraction. Prior to 2022, there had only been 10 quarters of deposit outflows in the US in the past fifty years; we’ve now seen four quarters of outflows. But the factors that led to Silicon Valley Bank gaining deposit share on the way up are instrumental in it losing share on the way down.

In order to reposition its balance sheet to accommodate the outflows and increase flexibility, Silicon Valley this week sold $21 billion of available-for-sale securities to raise cash. Because the loss ($1.8 billion after tax) would be sucked into its regulatory capital position, the bank needed to raise capital alongside the restructuring. 

Unfortunately, the capital raise never got done. The bank chose to announce its balance sheet restructuring the same day that Silvergate Capital announced it is going into voluntary liquidation. We spoke about Silvergate here last week. The business models are quite different, but the treasury challenges are not. Both banks struggled to contain bond losses at a time they were losing deposits. Customer fear turned Silicon Valley Bank’s trickle of deposit outflows into a flood. 

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Heart Attack in the Treasury

We’ve never really had a bank run in the digital age. Northern Rock in the UK in 2007 predated mobile banking; it is remembered via images of depositors lining up (patiently) outside its suburban branches. In 2019, a false rumour on WhatsApp started a small run on Metro Bank, also in the UK, but it was localised and quickly resolved. Credit Suisse lost 37% of its deposits in a single quarter at the end of last year as concerns mounted about its financial position although, at least internationally, high net worth withdrawals would have had to have been phoned in rather than executed via an app. 

The issue, of course, is that it is quicker and more efficient to process a withdrawal online than via a branch. And although the image of a run may be different, it is no less visible. Yesterday, Twitter was alight with stories of venture capital firms instructing portfolio companies to move their funds out of Silicon Valley Bank. People posted screenshots of Silicon Valley Bank’s website struggling to keep up with user demand. Greg Becker, the bank’s CEO, was forced to hold a call with top venture capitalists. “I would ask everyone to stay calm and to support us just like we supported you during the challenging times,” he said.

[Edit: According to an order filed by California’s bank regulator, the Department of Financial Protection and Innovation, customers initiated withdrawals of $42 billion in deposits from the bank on March 9, 2023, equivalent to a quarter of its overall deposit base.]

The problem at Silicon Valley Bank is compounded by its relatively concentrated customer base. In its niche, its customers all know each other. And Silicon Valley Bank doesn’t have that many of them. As at the end of 2022, it had 37,466 deposit customers, each holding in excess of $250,000 per account. Great for referrals when business is booming, such concentration can magnify a feedback loop when conditions reverse.

The $250,000 threshold is in fact highly relevant. It represents the limit for deposit insurance. In aggregate those customers with balances greater than this account for $157 billion of Silicon Valley Bank’s deposit base, holding an average of $4.2 million on account each. The bank does have another 106,420 customers whose accounts are fully insured but they only control $4.8 billion of deposits. Compared with more consumer-oriented banks, Silicon Valley’s deposit base skews very heavily towards uninsured deposits. Out of its total $173 billion deposits at end 2022, $152 billion are uninsured. 

So how could the bank have satisfied customers’ deposit demands?

One thing it couldn’t do is tap into its held-to-maturity securities portfolio. The sale of a single bond would trigger the whole portfolio being marked to market which the bank didn’t have the capital to absorb. 

It could have enticed depositors back with higher rates (as Credit Suisse has tried to do). In particular, Silicon Valley Bank oversees $161 billion of off-balance sheet client funds (as at end February) which it could have seduced back onto its balance sheet. But the bank already offers 1.17% on deposits which is almost twice the 0.65% median of large US peers. And… well… over $250,000 and you’re not insured.

It could have borrowed the funds. Last year, Silicon Valley Bank tapped the Federal Home Loan Bank of San Francisco for $15 billion and it had capacity to borrow more. We discussed the Federal Home Loan Bank of San Francisco here last week in the context of Silvergate. They’re the ones who pulled their funding lines to Silvergate, tipping it into liquidation. At year end, Silicon Valley Bank was already their biggest borrower, accounting for 17% of advances. To lock in that borrowing, Silicon Valley Bank had to pledge $19 billion of assets. The problem is that it doesn’t come cheap. The bank paid 4.17% on its total short-term borrowings at the end of 2022, of which Federal Home Loan Bank funding is the largest slice. Against a yield of 1.79% on the HTM securities portfolio, it’s not a particularly attractive enterprise. 

All of this is now moot. Its crisis meant that the capital raise to cover AFS portfolio losses was pulled, leaving Silicon Valley Bank undercapitalised. Earlier today, the bank was closed by the California Department of Financial Protection and Innovation (who have had a busy week, what with Silvergate as well) which cited inadequate liquidity and insolvency. [Edit: the California DFPI disclosed that as of the close of business on March 9, Silicon Valley Bank had a negative cash balance of approximately $958 million and that despite attempts to transfer collateral from various sources, it didn’t meet its “cash letter” with the Federal Reserve.]

The Federal Deposit Insurance Corporation (FDIC) was appointed as receiver. All insured deposits have been transferred to a newly created bank, the Deposit Insurance National Bank of Santa Clara (DINB). Uninsured depositors meanwhile are left hanging. They will receive an “advance dividend” next week, with future dividend payments contingent on FDIC selling Silicon Valley Bank assets. 

Fortunately, Silicon Valley Bank’s resolution plan is still fresh. The bank became large enough in 2021 that regulators required it to draw up a “living will” on a three-yearly cycle. Silicon Valley Bank submitted its first one in December. 

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Afterword

For the industry overall, the episode is likely to cast a long shadow. It’s been 868 days since a bank last failed in the US, close to the longest stretch on record. In the meantime, consumers have become inured to the risk, evidenced by the growth of uninsured deposits, including in digital wallets. 

One of the features of banking crises is that they rarely repeat consecutively. This matters because policymakers have a tendency to craft regulation around the last war. US stress tests include all manner of scenarios for bad credit, but few for interest rate shocks. The severely adverse scenario for 10 years Treasury yields is 0.8-1.5%; the baseline scenario, reflecting a shallower recession, incorporates yields of 3.2-3.9%. 

In Europe, interest rate risk is overseen by regulators through the Liquidity Coverage Ratio (LCR). It requires banks to hold enough high-quality liquid assets (HQLA) – such as short-term government debt – that can be sold to fund banks during a 30-day stress scenario designed by regulators. Banks are required to hold HQLA equivalent to at least 100% of projected cash outflows during the stress scenario.

Credit Suisse withstood its surge in deposit outflows with an average LCR of 144% (albeit down from 192% at the end of the third quarter). Silicon Valley Bank was never subjected to the Federal Reserve’s LCR requirement – even as the 16th largest bank in America, it was deemed too small. It’s a shame. Regulation is not a panacea since banks are paid to take risk. But a regulatory framework to suit the risks of the day seems appropriate and it’s one US policymakers may now be scrambling for.

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With their defined redemption terms and regular coupon payments, bonds just don’t move around as much as equities. Their value is anchored. As a result, bond funds tend to generate steadier returns than equity funds and managing them may not be as…hard? 1

This year, though, they haven’t behaved according to script. The flagship benchmark of US bond market performance, the Bloomberg US Aggregate Bond Index, is down 17% since the beginning of January and the largest actively managed bond fund, Pimco’s Total Return Fund, is down 22%. Granted, these numbers are less than an equity fund can lose in a month, but they reflect an unprecedented drawdown. The index last went negative on a rolling 12 month basis in 2018 and before that in 2013, but to have sustained losses greater than 2.5% you’ve got to go all the way back to 1981 and to 1994. 

For many of today’s investors, though, those episodes are ancient history, memories of them crowded out by a long period of low rates and low volatility. Two weeks ago, we looked at the increased frequency of margin calls as a feature of the current market environment. Today, we look back at these prior episodes of bond market stress to see what lessons can be drawn from how managers navigated them. Spoiler: it’s all about leverage. 

1981

Back in 1981, the bond market was a lot smaller. Today, the value of US bonds outstanding is $53 trillion, equivalent to around 220% of gross domestic product but back then it was only $2 trillion, or around 67% of GDP. In those days, investors would typically hold on to bonds until maturity, so the amount of trading activity was also very low.

One firm was at the forefront of a new strategy. Pimco had been founded ten years earlier around a strategy to trade bonds more actively. Its founder, Bill Gross, was a financial analyst in the fixed income department at Pacific Mutual Life Insurance Company. One of his jobs was manually to clip the coupons off bond certificates stored in the company’s vault and mail them in for interest payments. Suspecting returns could be enhanced by selling as well as buying bonds, he persuaded his employers to carve out a fund for him to manage. They handed him $5 million from their $1 billion bond portfolio and, together with a small team, Gross set to work.

His first year wasn’t particularly good – the fund lost money. But performance soon picked up. In the years following the recession in 1974, the fund did particularly well and Pimco began to attract interest from external clients, including AT&T and RJ Reynolds Tobacco. 

As the firm entered its second decade, interest rate volatility picked up, making the fund more difficult to manage. In response to high rates of inflation, the Federal Reserve began hiking rates sharply in October 1979, sparking a short recession. In the first three months of 1980, bond markets fell by 9%. After that, rates began to fall but, with inflation still rampant, the Fed had to move again. This time, its tightening prompted a more severe recession and bond markets slid during the first six months of 1981. 

Bill Gross characterises the job of bond manager as “one-third mathematician, one-third economist and one-third horse trader”. In 1981, the economist part of his role came to the fore as Gross anticipated the end of the recession. “Yields turned down in September almost exactly as we called for,” he recounted years later. At the time, he wasn’t managing much money – less than $15 billion of pension money. But his call earned him acclaim. 

While Gross may have navigated the turmoil of 1981 successfully, other investors fared less well. George Soros launched his Quantum hedge fund a couple of years before Pimco was founded, initially to invest in stocks. As macroeconomic conditions became more unstable, he increasingly ventured into bonds and currencies. Over his first 11 years in business, through to the end of 1980, Soros’ fund compounded at an annual rate of 38% and fund assets grew to $381 million. 

But 1981 was a “debacle” (his words). Coincident with a profile in Institutional Investor magazine heralding him as “the world’s greatest money manager”, his fund suffered its first ever down year, losing 23%. Soros was hit by a wave of redemptions and assets in the fund shrank to $193 million. The episode so impacted him that in September he stepped away from markets, entrusting his money to others to manage. Recognising that “macroeconomic speculation has become paramount,” he came back in 1984 with a new strategy, laid out in his book, The Alchemy of Finance. 

1994

By 1994, bond markets were much bigger, almost five times the size they were in 1981. At the beginning of the year, the Federal Reserve rate-setting committee met to discuss the economy, concluding that a buildup in inflationary pressures were a cause for concern. Led by Alan Greenspan, policy makers that February raised the benchmark rate for the first time in five years, moving by 25 basis points. Over the following 12 months, they raised rates a further six times, hiking the Federal Funds rate from 3% to 6%. 

For bond investors, it was a shock. On some estimates, capital losses in world bond markets may have been in the region of $1.5 trillion, equivalent to almost 10% of OECD countries’ gross domestic product. 

Pimco suffered. Its Total Return Fund had been launched in 1987, and this was its first test. Between October 1993 and the end of 1994, it was down 14%, against an index that was down 3% over that period. Part of the reason was leverage. 

Since the 1980s, Pimco had embraced derivatives as a tool to enhance returns. Because derivatives don’t involve buying the underlying asset they reference immediately, they require much less cash up front. Pimco could use derivatives to establish the bond exposure it targeted, and invest the cash it saved in other yielding instruments to boost its total return. At a meeting in the early 1990s, Pimco’s investment committee discussed how to account for the structure. Mary Childs picks up the story in her book, The Bond King:

Sitting on the trade floor in the early 1990s, Brynjo [trader John Brynjolfsson] explained this accounting system to the members of the Investment Committee. “… So, we’ll just call that leverage,” he concluded.

Every face went white(r). “That’s not going to work,” one of them said.

“You want me to change the formula?” Brynjo asked.

“No. No, the formula is fine. It’s the name.”

“Well, what else are we going to name it?”

Leverage, borrowing money, can amplify returns because you can invest more, which is great in good times. But leverage only ups the stakes; it can also help you blow up spectacularly. The cocaine of investing, leverage adds juice, but the price for using it might be higher than you can pay. That’s why its use is restricted in funds meant for pensioners, who cannot afford to lose all their money. Even using the word leverage can make conservative managers of mutual and pension funds nervous.

Brynjo cast around in his mind. Leverage … Finance loves the Greek alphabet, and Brynjo was vaguely familiar with it. “What about ‘Lambda Cash’?” Because Lambda also started with an L. 

The Investment Committee approved.

One of the reasons investor losses were so high compared with those in 1981, when the moves in underlying bond prices were actually more violent, is leverage. Fuelled by years of low rates, investors had attached more leverage to their portfolios than in the prior cycle. In Pimco’s case, leverage was quite low – according to Childs, “Lambda Cash” added between 0.25% and 0.40% a year to returns. Other investors were a lot more aggressive.

Like George Soros, hedge fund manager Michael Steinhardt had moved away from trading stocks into trading bonds and commodities as well. At the beginning of 1994, he put on a large position in Canadian bonds, adding to trades he already had on in Japan and Europe. In total, his bond positions amounted to $30 billion. When the Fed hiked rates in February, Steinhardt initially remained unphased. While he did have some positions in US bonds, they were small relative to his international exposures.

But contagion soon took hold across global bond markets as investors began to deleverage and sell assets wherever they could find liquidity. Yields in Europe and Japan spiked upwards. So large and leveraged was his portfolio that for every single basis point rise in European bond yields, Steinhardt was on the hook to lose $10 million. By the end of the month, he had sustained $900 million in losses, down almost 20%. Complicating matters, liquidity was now beginning to seize up as buyers evaporated and prices cratered further. 

“We were losing money and I couldn’t quite catch my breath,” Steinhardt later told author Sebastian Mallaby who writes about the episode in his book, More Money Than God. “Things were happening and we had positions and it was as if I just didn’t quite have the ability to understand where we were and why we were where we were. It was as if we were playing yesterday’s or last year’s game.”

Seeing no way out, Steinhardt directed his traders to dump his bonds at any price. Over a four-day spree in early March, they sold $1 billion worth of European bonds. By the end of the month, the fund had lost $1.3 billion, down 30%. “The trade in European bonds was crowded, a fact that totally passed me by,” confessed Steinhardt afterwards. 

At least he lived to fight another day. The following year, Steinhardt recouped around half of his losses, returning 27% in his fund. He quit not long after, on his own terms. Another hedge fund didn’t quite have that good fortune. 

Askin Capital Management was founded in 1993 by David Askin, a former head of mortgage research at a Wall Street firm. Askin invested in mortgage securities, building up a $2.5 billion portfolio. But the structure of his portfolio made it highly interest rate sensitive in ways Askin did not envisage. He pitched his portfolio as “market neutral” yet for any given rise in long-term interest rates, his portfolio would fall five times more than an ordinary bond. When the Fed began hiking, the fund rapidly lost money. In February alone, it fell by 20% and as conditions deteriorated in March, Askin was faced with an increasing barrage of margin calls. The fund ultimately imploded, leaving its three main brokers with $500 million of losses between them. 

At a Congressional hearing to discuss the fund’s implosion and the broader role hedge funds play in the market, George Soros was called to testify. He conceded that leverage can be destabilising for markets, but if restrictions are to be imposed, they should be applied not just to hedge funds but to a range of financial institutions including brokerage firms. Policy makers didn’t take heed and leverage continued to accumulate. 

Today

Bill Gross is no longer managing Pimco’s bond funds, having walked out of the firm he founded in 2014. But in a blog post this week he bemoans the direction his Total Return fund has taken, arguing that Pimco replaced the fund’s “total return” mandate with an index-hugging one. Yet among his criticisms he does concede that for most of the fund’s life, “a secular bond bull market was a huge tailwind”. And it’s easier to use a “host of other non-index strategies” to bolster returns when you have that tailwind behind you.

Mary Childs says that an insider at Pimco told her Gross only ever really employed four strategies: “There are only four things you need to know. Going long duration, rolling down the [Treasury] curve [i.e., capitalizing on a bond’s price rising as it ticks closer to maturity], going long credit, and going short vol.”

Going short vol is the flipside of going long leverage, and that may not be as profitable a strategy in the current environment. However, after the shakeout, bond returns may begin to look attractive again. As the biggest bond manager in the world, BlackRock clearly has a vested interest. The firm manages $2.35 trillion of bond money. But its President, Rob Kapito may have a point:

If we go back in 1995, to get a 7.5% yield, which is what many institutions were looking for, a portfolio could be in 100% bonds. If you fast forward 10 years, in 2005, it had to be 50% bonds, 40% equities, and 10% alternatives. Then move another 10 years, and in 2016, you needed only 15% bonds, 60% equities and 25% alternatives… Now today, to get that same 7.5% yield, a portfolio could be in 85% bonds and then 15% equities and alternatives.

So far this cycle, outflows from bond funds have been tracking close to the 1994 experience. Back then, flows eventually returned, as they will again. You just have to stay in the game to see it.

Paid subscribers can read on to see how banks are managing their bond portfolios. With securities holdings of $5.7 trillion, they are some of the biggest bond investors in the market. Their portfolios swelled over the past few years; now they have to navigate a difficult market. Will they cope?

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