The real issue with bank regulation in the modern era
There are plenty of hot takes on SVB right now. Heck, there are hot takes on fighters hitting drones, and AI becoming sentient, and Credit Suisse collapsing, and GPT-4’s Red Team saying it’s exhibiting “increasingly agentic behaviour,” and, well, let’s just say that Everything Everywhere All At Once was an appropriate Oscar win. I’m having a really hard time concentrating on anything right now, because my brain is trying to find some underlying pattern that can make sense of all this information. I guess this is what a singularity feels like.
With that in mind, here’s a broader thought on the nature and function of banking, and how it has to change to deal with a new kind of risk. Welcome to a lukewarm take on SVB.
Heads up that I write about a lot of different things. The next post might be about the Suez Canal, or Digital Government, or Game Theory, or designing boardgames. I’ve been told this is a terrible way to build subscribers. You’ve been warned.
On Thursday morning, I woke up to some posts about Silicon Valley Bank. Their stock was tanking. I joked in Slack that they likely wouldn’t be sponsoring startup events this year.
By Friday afternoon, I was regretting that joke, and the government had taken over the bank. Both the collapse, and regulators’ efforts to stop the contagion from spreading, happened at an almost unthinkable speed: The Treasury Secretary, Federal Reserve and the FDIC issued a joint statement in just a weekend (and a 47 hour one at that, thanks to Daylight Savings Time.)
It was a busy weekend for founders and the people who help them. One CEO I support had a simple, four-word subject line to reassure her investors: We Bank With Chase. Another spent the weekend moving startups to other banks. “I’m on the phone back to back helping people move accounts over the weekend,” she messaged me. “I’ve moved 25 companies in 3 days.”
By Monday morning, the government had chosen to make depositors whole—even those whose deposits exceeded US$250K. This wiped out a significant chunk of the Federal Deposit Insurance Corporation’s US$128B safety net. If you want a quick recap of why this happened, and why every bank is vulnerable because no bank keeps all its deposits on hand, read this (hat tip to Annette Hester for the link.)
Who’s to blame?
If you’ve been on vacation for a week, or just want to keep track of all the reasons you’re angry at late-stage capitalism, here’s a recap of all the places you can point your finger:
Regulations were loosened. The Dodd-Frank regulations, created after the 2008 market crash, restricted banks from investing deposits in risky assets. These were rolled back in 2018 for banks worth less than US$250B. SVB had just under that amount. Elizabeth Warren explained how that happened pretty eloquently, but it’s paywalled.
Interest rates rose. Interest rate hikes designed to fight inflation made other investments less attractive, diminishing the value of SVB’s investments. Why invest elsewhere when you can get more money from a savings account?
SVB didn’t have to report a drop in the value of its investments. SVB had invested some of its depositors’ money in mortgage securities. This wasn’t the same as the sub-prime loans that caused the 2008 financial collapse; these were relatively stable long-term investments. But accounting rules say these kinds of investments are “held to maturity,” meaning that the holder doesn’t have to declare a gain or loss until they’re sold (if this weren’t the case, you’d owe taxes when your house value increased, rather than when you sell the house.) Accounting rules for another type of stock, “held for trading”, are also ambiguous. Whether those exceptions should exist for bank investments is an excellent question.
Accountants said it was fine just two weeks before. KPMG signed off on an audit report February 24. The question is whether they missed the weakness, or if their report led SVB to take action that in turn triggered the collapse. But when the patient dies two weeks after the doctor says they’re fine, you’re definitely going to be talking malpractice. (It’s notable that KPMG also pronounced Signature Bank fine, and the crypto-heavy bank was also taken over two weeks later.)
SVB sold some investments and those losses became real. On March 8, SVB announced that in order to meet the volume of withdrawals it was seeing, it had sold some of those investments at a loss (forcing it to now report their drop in value.) It also announced that it would also issue US$2.25B in new shares. The timing might not have been so smart.
VCs urged startups to get their money out. There are rumours that some investors noticed delays in capital calls and other transactions going through the bank. Whatever happened, VCs got spooked. In chatrooms and message boards, word of the bank’s frailty spread quickly. SVB had money—quite a lot, in fact. It was the speed with which depositors raced to withdraw their money that brought it down.
SVB’s vulnerability wasn’t a well-kept secret. Back in July 2022, Zerohedge noticed that the math around SVB didn’t really work, and actually flipped the stock to “sell” back nine months before the bank collapsed:
In December of last year, SVB itself included a footnote in its reports, saying that the bank had US$15B of “unrealized” losses (i.e. losses in investments that hadn’t yet turned into accounting changes.)
Once the run on the bank had begun, investors—many of whom are fair-weather Libertarians—suddenly became vocal proponents of government overreach. They urged the FDIC to cover their lost deposits. Farrah Bostic told me she had seen “a lot of posts essentially threatening the Fed—if you don’t bail us out there’ll be a run on all regional banks (aka ‘nice banking system you’ve got there, shame if something should happen to it.’)”
The regulators’ alacrity was no doubt helped by both “rich people want us to do this” and “we made this happen and our rules created the loophole.” But while all of the things I’ve listed above are serious issues, there’s a broader change underway for which our entire financial system, and indeed model of society, will now have to adjust:
When everyone’s a market maker
The financial system relies on “market makers,” large organizations that aggregate stock orders and make massive transactions. These transactions can be so big, they move the market itself. Bernie Madoff’s legitimate business, Madoff Securities, was one of the largest market makers in the U.S. (the Netflix documentary on his crimes is amazing. Fun fact: Madoff’s company built the high-speed trading tech behind the NASDAQ.)
Because market makers have such large transaction volumes, they can influence the market, so regulators scrutinize these organizations carefully. For decades, there were relatively few organizations whose behaviour could shape an entire market in this way.
Social media changed that. Now, large groups of investors, creditors, and depositors can coordinate their behaviour—intentionally or otherwise—and become market makers of a different sort.
Gamestop was a good example of this, allowing otherwise unconnected actors to agree to drive up the stock price of the company—ignoring normal self-interest and the pressures of supply, demand, and pricing—to the point that those who had bet against it would be forced to buy shares at ever-increasing prices. They use scale to hack the financial system in a way regulators hadn’t anticipated.
Just as Gamestop began in reddit chatrooms, so the SVB bank run began in WhatsApp and Signal channels. And just as GameSpot was an easy target (because its short sellers exceeded buyers, making them easier to squeeze when prices climbed), SVB was ripe for a run (because 90 percent of its deposits uninsured and its long-term debt was less than its potential short-term liabilities.)
Shingai Manjengwa pointed out that “the role of social media in the SVB collapse will be the subject of at least a few business school essays.” Paraphrasing Alexis O’Hanian in an interview over the weekend, she pointed out that “the Venn diagram of SVB clients, founders etc, and people active on Twitter is almost a perfect circle.”
When everyone’s a short seller
Short sellers, who bet against companies, have looked for ailing businesses for years. Hindenburg Research and Harry Markopolos both saw Bernie Madoff delivering impossible returns and sounded the alarm, but were ignored far too long. The way these companies work is simple: They find bad investments, bet against the stock (known as short selling), publish their research, and profit from the resulting decline in stock price.
Today, however, everyone can be a short seller. We no longer need seasoned analysts who pore over financial documents, interview former employees, and make trips to the trading floor to learn whether a company is secretly unwell. The whole world has:
Widespread access to AI and online documents means we can find vulnerable companies quickly.
Chatrooms that can crowdsource investigations, debate allegations, and learn from former employees.
Search engines that can find keywords in documents and filings.
“Look at proxy statements and do a word count on the word ‘risk,’ and then compare it to their governance and diversification strategies,” said Farrah. “If it’s a lot of risk but not a lot of mitigation, it’s reasonable to call that, uh… risky.”
Certainly, some people shorted SVB. The stock has been in a freefall since late 2021.
There were plenty of red flags beyond Zerohedge and SVB’s own disclosures. SVB hadn’t had a Chief Risk Officer for around nine months. Yet half the board was on a risk committee that met an unusually high 18 times in one year. In a chat this weekend, Farrah wondered, “was the board seeking a new risk officer, and if so, was the risk profile of SVB the cause of their inability to replace the risk officer?”
Why we have banks
For centuries, human societies were authoritarian, run by the warlord or king or religious leader who had the most power. After the reformation, we came up with a different approach.
Liberalism is the system of government that says you’re free to do what you want, as long as it doesn’t infringe on others’ freedoms. The constitution says what those rights and freedoms are, and we have a legal system to sort out what happens when they bump into one another, and democratic representation to update the rights and freedoms from time to time.*
(The word “liberal” has other definitions, which makes all this confusing. Up here in Canada, one of our political parties is the Liberals. Sometimes political groups are called “democrats” or “Tories” or “republicans” or “labor.” But all these parties are “liberals” in the sense that they believe in a constitution, and a peaceful transfer of power.)
Liberalism goes hand-in-hand with capitalism, because when you’re not allowed to take things from others by force, you need to do so with incentives, and that means money. There’s plenty not to like about this mix of liberalism and capitalism, but it’s the system in which we live for now.
Banks are a necessary function of that social model. Banks take money that’s idle (“savings”) and put it to work (“loans.”) A bank is an engine for turning long-term savings into short-term liquidity, and it extracts a profit for doing so. Some of that profit is paid into deposit insurance, preventing depositors from losing everything.
We don’t often think of banking as a societal function, but it is. Money is a consensual delusion, a thing we’ve all agreed to trust because it makes transactions easier. And banking is a delusion atop that delusion—banks hold only 10-30 percent of the money we’ve deposited, so any bank could fall the moment its customers agree to withdraw their savings.
Every facet of banking regulation is an attempt to balance risk, reward, liquidity, and stability so that society (or at least, the one we have right now) can function.
Social media and chatrooms now let retail consumers coordinate their actions, provoke mass behaviours, and become market makers; and ubiquitous, freely searchable digital information that can be summarized by AI turn anyone into a short seller. How long until someone asks GPT-4 to identify companies with weak financials, and then suggest disinformation campaigns that might make the stock drop? Who’s to say this isn’t already happening?
There are national security implications for this as well, because it also allows foreign agents to manipulate free market banking systems. If you can create the impression of a run on a bank, you can stop money from working.
Small wonder the Fed stepped in.
Liberalism, constitution, amendments, justice—look, that’s how things are supposed to work. They haven’t worked well for most people for a long time, and they haven’t worked at all for many people forever. We’ve stopped making amendments, and we still use ancient systems of government. That ain’t this post. Just want to acknowledge that this description of how society functions works in textbooks, but often, not in the real world.
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