To The Moon

When the second-largest bank collapse in U.S. history occurs, the guy whose profile starts with “ex-banker” should probably write something about it.

A lot of my employees and colleagues who know my employment history have been picking my brain on this subject for a while now, as have more than a few of the folks that I report to. I find the subject interesting, and it really provides both a great case study in mismanagement and a good example of how banks operate in the modern economy.

I’ve been kicking this story around for a bit, all while watching others take their stab at it. As one could expect in today’s climate, most people immediately seized on Silicon Valley Bank $SVB Financial Group(SIVBQ)$ as an opportunity to talk politics. One side of the aisle was quick to point out the bank’s prominent role in diversity, inclusion, green projects, and others to show the bank’s priorities were not finance-related.

Never mind the fact that most of those programs were probably spearheaded by one mid-level VP who was tasked with all that to appease the public. Others immediately seized on the regulatory component and wealth of SVB’s clients to point at massive holes in how we monitor banks. That argument is nothing new and has been a topic since the Great Recession and even earlier. Technically, it started with Glass-Steagall in 1933.

We’ll get to both of those items in a minute, but the overarching themes behind SVB are both uniquely idiotic and, at the same time, perfectly normal. You can also discuss them mostly without political posturing. While SVB’s mismanagement ranks among the most interesting and blatant examples of poor executive leadership, the circumstances that allowed that unique problem to exist and cripple an entire institution are actually fairly common. So we’ll look at both.

Ready for a long one? Let’s try.

Mismanagement

There’s no doubt that SVB — and the less-discussed First Republic & Signature Banks, by the way — were terribly mismanaged. All failed to recognize broader market softness and weaknesses, all allowed their investment and depository situations to get out of control, and they all made plenty of other mistakes as well. We’ll get to the Monday-morning quarterbacking in a minute, though. First I’d like to address the “Diversity, Equity & Inclusion” argument.

SVB’s fairly vocal support of DEI initiatives was going to make them a target of conservative media no matter what the end result was, and we haven’t been surprised on that front. Admittedly, it does look pretty bad to have a Chief DEI Officer but no Risk Officer following a collapse, but that’s a long way away from DEI causing a collapse.

DEI programs have become commonplace in the last couple of years, largely as a corporate effort to appease the pieces of their customer base that care about such things, and very rarely as an actual concentrated effort to improve such areas. A lot of talk, no action. But having some sort of program in place allows you to talk about that program as if it’s doing something, and it looks nice in a press release, and so we have DEI.

The idea that any of these programs were taking up a lot of executives’ time is ridiculous, let alone the notion that they were somehow responsible for SVB’s downfall. In the organizations I’ve worked for and consulted with, here’s how DEI actually works:

Generic Corporation $GENERIC GOLD CORP.(GGCPF)$ needs to get with the times and have similar PR standing as its peers, so it needs to appear to take this stuff seriously. So GC creates a position out of thin air and likely calls it something along the lines of “Diversity Officer” or, maybe, depending on how much money they’re going to throw around, “Chief Diversity Officer.” Art Vandelay is appointed to the position.

Vandelay’s job is half PR and half operational, but both halves are poorly defined and executed in a mediocre fashion. Art does decide that GC needs a group of people to talk about this, though, so he grabs 12 volunteers to meet once a month and talk about the subjects, so the company can gain “awareness” and “insight” into their issues. The group may or may not make recommendations, but they’re probably never implemented. But, in a press release, it looks like this:

“We at GC take diversity, equity, and inclusion seriously. After discussions with our staff, we’ve realized we have a long ways to go before reaching our goals in this area. As a result, GC has brough on Art Vandelay as the Chief DEI Officer in an effort to address these shortcomings.Art comes to us from…where he had 16 years as … We’ve also created a Diversity Council of employees from various backgrounds and cultures that will help us create the structural change we want to see. This council will be instrumental in steering our organization’s goals and hiring policies for the foreseeable future.”

At some (but hardly all) organizations, these groups may actually have real input, real value, and real work to do. But even so, the notion that the CEO, CIO, or CFO is more than tangentially involved in this process is not one I put much stock in. Not in my experience, anyway.

No, instead, SVB’s mismanagement was pretty garden-variety. Failure to predict market trends, over-leverage, too much asset concentration among a few large depositors, ignorance of what was being told to them, etc. And that, to me, is the interesting part.

Tea leaves

Many people are rightly focused on regulation as a concern related to SVB’s collapse and other, previous egregious failures. We’ll get to that in a bit, but there are parts of banking that actually have regulations — nearly one for each letter of the alphabet, actually. In home mortgage lending, most banks have entire departments of people whose job is merely to package and send the required disclosures out to new buyers after they apply. Whether there’s any monitoring? Another matter.

Why this matters in this particular paragraph is this: given that the box in which you must operate is given to you by various regulations, the actual role of executive leadership in banking is a little different than it is in other fields. There’s a heavier regulatory and compliance piece, sure, but you also have teams that are somewhat self-managing once they’re up to speed on current regs and what they need to do.

Certain areas — like residential lending — have very little critical thinking or leadership components at all. Since most lenders re-sell their loans to Fannie or Freddie, they have to be written to comply with those institutions’ policies. That means that you’re not setting guidance on credit scores, asset requirements, employment history, or anything else. You’re not the architect of the building— you’re the guy who drags the wood to the construction site.

Retail and deposit banking function in much the same way. As a result, the actual operations piece of a bank is largely self-sufficient. Executives are paid handsome salaries, then, to monitor the investment and financial components of the company. Staffing and strategic decisions fall to them as well. And, most importantly, they are the leaders tasked with monitoring risk and predicting future economic trends, as well as making sure the institution is prepared for them.

So, in other words, the only areas that failed were the ones that executives were supposed to be focusing on. Naturally, predicting the future can be a fool’s errand, but not always. And there’s nothing out there that suggests to me that SVB executives were totally in the dark on how screwed they were — I presume they knew pretty well.

Blindsided by the bank run? Maybe. Even that, though, was somewhat predictable. Maybe SVB executives just looked at the climate, shrugged, and decided to go down with the ship. At least, I hope they knew. Because, if not? That’s even worse.

Totally Normal

It seems, through various sources, that the consensus on what caused the crash of SVB was a combination of the following:

1. Rising interest rates — this had an impact on the bank’s investments and its depositors alike, which we’ll get into shortly.

2. A disproportionate share of deposits held by large, market-savvy individuals or corporations — This made a bank run not only more likely but easier as well

3. Overexposure to the tech community — This overlaps with items 1 & 2

4. Too little oversight, or too much leverage — One and the same

As a bonus for you loyal readers, I’ll throw in a #5 which applies to Signature Bank $Signature Bank(SBNY)$ :

5. Extreme trading and asset losses booked through crypto exposure

Now here’s where, for the finance guy in me, this gets interesting. Except for Signature Bank’s crypto exposure, none of this is abnormal at all. Hell, none of it was even that surprising.

Reading tea leaves is hard, but it gets significantly easier when the tea leaves grow a face that begins talking to you, as the Fed did for banks when it began plainly and loudly telegraphing its interest-rate intentions over a year ago. While the rate hikes have been steep and rapid, the banks and their investors had ample notice. It’s hard to argue you’ve been blindsided when the only thing investors have been talking about is interest rates for two years.

Instead, SVB held on to long-term investments like bonds that once appeared to promise a steady, safe return. But in a market where interest rates are rising, bonds lose value as newer ones are issued with higher rates and better returns. Instead of booking some small losses when investors were less skittish, SVB waited until liquidity needs forced a large sale of (now) significantly less valuable assets, booked a massive loss, and scared the living s*** out of anyone who had their money with the bank.

This is sort of the banking equivalent of the gambler who adamantly refuses to walk out a “loser.” So, rather than just walk away having lost $200, he sits at the roulette table for hours waiting for his number to come up, only to wind up in hock to the casino for $20,000.

When it came to the deposit side of the equation at SVB, it wasn’t much better. Naturally, you should be somewhat aware of your deposit sources if you’re a bank executive. I mean, it is still a bank, after all. Knowing that you have a smaller, wealthier, savvier base of depositors, you have to realize your situation is different from that of, say, TD Bank.

You should also know the makeup of those depositors — if they’re all in, just for example, the technology field, they’re going to get hit just as hard or harder than you when interest rates rise. Efforts should be made to secure other, smaller depository accounts and get a healthier base for your business.

To my knowledge, though, SVB made no such efforts. I may have missed it, but after reading up extensively on the bank, I saw no refocused effort on bringing in new deposit accounts — no “Switch to us and get $250” like Chase is known for, no renewed focus on small business banking or other outlets to stop the cash flow blood loss.

To be honest, that particular effort should have started long ago. SVB’s exposure to the tech industry — in lending, deposits, you name it — essentially put the bank into a total risk-on posture when it came to interest rates. While banks can already be extra sensitive to rate changes, the tech industry can be overwhelmed by them even more so.

Since technology companies are largely based on future or theoretical values, and many are start-ups, they run on credit in the here and now. Financing. LOCs. Whatever. As a result, the debt-to-assets ratio of technology companies tends to be much higher than those in other fields. When the cost of all that borrowing starts to rise as the Fed hikes rates, tech companies can feel the pressure quickly.

As their payments increase, they can find themselves in need of cash pretty quickly. Meaning those deposits in SVB’s accounts aren’t nearly as secure as they might be if their clients were Campbell’s Soup and a bunch of individual depositors. They also tend to watch for signs of instability closely, as do most investors whose funds are over the FDIC insurance limit of $250,000. Big losses, like those recorded by SVB immediately prior to the depositors fleeing, can spook these account owners easily. In other words, the chance for an “accidental” run on the bank is higher.

You’ll also lose that steady stream of start-up funding as your lending arm dries up amidst more expensive loans, significantly lowering your ability to counteract your bad investments with a good interest rate spread on lending activity. In other words, a perfect — and perfectly predictable, particularly in hindsight — storm.

Reality

The regional and mid-sized banks aren’t subject to the same regulations that the big boys are. This allows a greater risk for bad management to cause a calamity, as it did here.

Without getting into too much boring banker detail, there’s a little bit of balance-sheet maneuvering and loss-booking that you could do heading into an environment where rates skew higher. There’s a decision about whether to pursue AFS (available-for-sale) or HTM (hold-to-maturity) assets. Some of the historically smarter banks, like JPMorgan $JPMorgan Chase(JPM)$ as one example I kind of somewhat trust, have navigated these moves correctly, retained a lot of cash, and kept a healthy leverage ratio. It hasn’t been smooth sailing, but it isn’t catastrophic. SVB didn’t follow suit.

What we’ve covered here is just the surface of how SVB failed and the missteps it made compared to similar institutions. All of this information, and I’ve barely even touched on all the stuff I’d like to talk about here, such as loan loss reserves, the above-referenced AFS versus HTM assets, the impact of lending freezes on liquidity and profitability, and all other sorts of items. As long as this piece was, it would barely qualify as an overview of SVB’s problems, let alone banking.

I may carve out a deeper analysis here or on Substack at a later date. In the meantime, I just wanted to establish how surprisingly routine events can cause a collapse of this size. Whether that points to an issue with our regulatory environment, economic system, both, or neither is up for debate.

Blanket regulation is often not smart enough to catch where problems lurk, or the ensuing monitoring is not detailed enough to view warning signs. We can try, but I’m not sure laws as they’re typically written would have stopped SVB’s problems.

For example, we can — and do — require a certain liquidity level from our banks. SVB exceeded that ratio handily in their 2022 report to the FDIC. Even if we were to nearly double the liquidity requirements for banks of their size, they would’ve largely met the standards.

Controlling what when and how banks invest is another option being discussed, but I don’t see how that could prevent it either. You can’t exactly say “don’t buy bonds ever” when that could, in fact, be a perfectly wise choice in a year or two.

Instead, maybe the stress-test requirements should be imposed on banks of anything above a small, local stature. In these exercises, the Fed creates a hypothetical recession, global crisis, or both, and tests the banks' liquidity, investment performance, and other items in such a scenario. If the bank fails, they’re immediately subject to liquidity-raising measures to reduce the potential fallout if the economy turns sour.

In other words, it’s what a risk officer is hired to do in the first place. But, obviously, risk officers are either not always right, or not always listened to. In SVB’s case, there wasn’t a chief risk officer at all. Seems fitting.

The only way to avoid mismanagement collapsing a financial institution as was the case with SVB is to do their job for them. Monitor risk. Imagine future scenarios. Apply the bank’s current holdings and policies to different market situations and see if they, you know, explode. I know very well that plenty of people at each of these institutions are tasked with doing just that. But they’re obviously not doing it well. Maybe we need to step in and do it for them.

https://medium.com/@pshanosky/silicon-valley-bank-both-uniquely-stupid-and-terrifyingly-normal-834faae9c03e