Tag: Bank Run

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Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #3: Have Regional Banks Become New Hedge Funds with A “Fixed-Income Arbitrage” Strategy?

“Prophesy as much as you like, but always hedge. – Oliver Wendell Holmes, 1861” 

Hedge fund trading strategies provide a blueprint for understanding regional banks’ Asset-Liability Management (ALM), such as SVB’s. During the hedge-fund crisis of 1998, market participants were given a glimpse into the trading strategies used by large hedge funds, such as Long Term Capital Management (LTCM). Few of these strategies were as popular or painful as “fixed-income arbitrage.” As a highly leveraged strategy, fixed-income arbitrage effectively bets on the shape of the yield curve. Despite its big role in the LTCM’s fall, the regulators have not internalized this strategy, and its dangers, well enough. In fact, the so-called puzzling facts about the SVB’s business model would make sense once examined as a hedge fund with a “fixed-income arbitrage” strategy. For instance, unlike the traditional model of deposit taking, SVB invested most of the deposits in fixed-income securities. In addition, SVB was unusually exposed to interest rate risks when failed. These characteristics could be explained through the mechanics of fixed-income arbitrage trading. Indeed, the small margins and the massive exposure to interest rate movement are why this strategy is known as “picking up nickels in front of a steamroller.” The problem with becoming a hedge fund for a bank is that a hedge fund can lock up liquidity and ensure investors do not run. Banks do not have such an option, and when they face the run, they either put pressure on the government’s insurance schemes or the stability of the financial system, or both.

An anomaly in the business model of the SVB is that, for a bank, it had a lot of safe fixed-income securities. SVB had about $190 billion of deposits and invested nearly $120 billion of that money in Treasury and agency mortgage-backed securities (MBS). However, this mystery would be resolved once we consider SVB a hedge fund. Hedge funds, including the doomed LTCM, function based on different strategies, including “fixed-income arbitrage” trading. This strategy uses the model of the term structure of interest rate (yield curve) to identify and exploit mispricing among fixed-income securities. For instance, let us assume that the firm’s reading of the Fed is that the central bank pivots toward cutting rates sooner than the market expects. In this case, the firm’s models show a yield curve below the market yield curve. The difference between these two is the so-called “mispricing.”

In this environment, when rates are expected to fall, the fixed-income securities would gain in value, which justifies purchasing government-backed securities such as Treasuries and MBS. Nontheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund would enter an IRS and become a fixed-payer and floating-receiver. If the hedge fund’s prediction is correct, the IRS will generate slight cash outflows for the fund. In this case, the floating rate (determining the value of the fund’s cash inflow) would fall while the fixed rate (setting the cash outflow value) would remain unchanged. Nonetheless, and most importantly, the fixed-income securities’ capital gain would compensate for such a slight fall in the value of the IRS. Alternatively, if the hedge fund’s bet was wrong and rates increased instead, the IRS value would rise and neutralize the loss in the fixed-income securities’ fair value. Fixed-income arbitrage has its roots in the fixed-income trading desks of most brokerage houses and investment banks.

However, as LTCM’s failure showed, two critical vulnerabilities are implied in such an apparent risk-less strategy. First, profits generated through fixed-income arbitrage transactions are often so small that managers have to use substantial leverage to generate significant levels of return for the fund. As a result, even a slight movement in the interest rate in the wrong direction could make hedging too expensive to be maintained. This aspect, known to the hedge fund watchers, could explain the behavior of the SVB’s managers to drop the interest rate hedges. In mid-2022, the managers suddenly dropped the interest rate hedges without providing reasonable economic justifications. However, labeling this decision as mere poor risk management can be misleading. The mechanics of the fixed-income strategy explain this behavior more accurately. SVB’s decision to liquidate the swap positions coincided with when the market consensus on the Fed shifted. Fed watchers started to believe a more hawkish tone of the central bank. Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. In this environment, it becomes too expensive for the fund that has bet on the fall in interest rate to maintain the hedging aspect of the portfolio.

To understand this point, let us go through an example together. Let us assume that a hedge fund manager takes a long position in 1000 2-year Treasuries for $200. His unhedged position is worth 1,000 × $200 = $200,000. The bond’s annual payout is 6% or 3% semiannually. The bond Duration is 2 years, so the fund would expect to receive the principal after 2 years. After the first year, the amount earned, assuming reinvestment of the interest in a different asset, will be: $200,000 × .06 = $12,000. After two years, the fund’s earnings are $12,000 × 2= $24,000. However, the risks in the above transaction include: (a) not being paid back the face value of the municipal bond and (b) not receiving the promised interest. To hedge this Duration risk, the manager must short a 2-year IRS with a notional value of $200,000. The fund negotiates so that the fixed rate in the IRS is less than the 6% in annual interest, let us say %5.9.


The final hedged position results in the following short cash position for the first year: $200,000 × .059 = $11,800, and for the two years, the fund will pay a total of $11,800 × 2 = $23,600. In this example, if the manager has to pay out a total of $23,600 to hedge his duration risk, we must subtract this amount from the anticipated interest made on the bond: $24,000 −$23,600 = $400. Thus $400 is the net profit made on this transaction. Profits generated through fixed-income arbitrage transactions are often so small that managers drop the hedge when the interest rates move in the wrong direction for a relatively consistent period. This explains the use and the drop of the IRS by the SVB.

An essential problem with fixed-income arbitrage is that maintaining the hedges can be unsustainable for firms adopting this strategy. In addition, empirical evidence shows that the so-called arbitrage opportunity might not be riskless. In fact, the deep losses, and extra returns, might be less due to the high leverage and more a reflection of more profound risks, such as market risks, inherent in the nature of such strategies. Fixed income arbitrage is assumed to be a riskless, market-neutral investment strategy. This strategy is considered market-neutral as it consists of a short position in a swap and an offsetting long position in a Treasury bond with the same maturity (or vice versa). In actuality, however, this strategy is subject to the risk of a significant widening in the fixed (swap rate)-floating (SOFR rate) spread. Suppose this spread is correlated with market factors, which in most cases, it is. In that case, the excess returns may represent compensation for this strategy’s underlying market risk. In other words, this fixed-income arbitrage strategy has little or no riskless arbitrage component.

In addition, this strategy has exposure to a wide array of price risks. In particular, the strategy has exposure to the stock market, the banking industry, the Treasury bond market, and the corporate bond market. In particular, the researchers have shown that the excess returns for these fixed-income arbitrage strategies are related to excess returns for the stock market, excess returns for bank stocks, and excess returns for Treasury and corporate bonds. This suggests that the risk of a significant financial event or crisis is a risk that is priced throughout many financial markets. Thus, the financial-event risk may be a critical source of the widely-documented commonalities in risk premia across different asset classes. These results are consistent with the view that the financial players, including the market-makers and their balance sheet positions, play a central role in asset pricing.

One practice that connects the regional banks’ business model with hedge funds is the Ponzi aspect of their businesses. Both types of firms rely on the continuity of short funding to finance their assets. For hedge funds, the cash inflow is in the form of capital from the investors, while in the case of the banks, it is depositors’ money. Nonetheless, there is one more similarity between these two that is even more fundamental yet is more obscured. At first glance, it might look like regional banks’ holding of fixed-income securities was an attempt to invest in safe assets. However, after examining the SVB’s business models and their managers’ narratives, these investments start to look more and more like the “fixed-income arbitrage” strategy of hedge funds and less like their investing in safe assets. This strategy tries to exploit mispricing amongst fixed-income securities. It is based on the firms’ understanding and modeling of the term structure of interest rate. In doing so, it creates excessively high exposure to interest rate risk. This is because if the fund is betting on the shape of the yield curve, it becomes at the mercy of its financial model’s predictions. If these models are incorrect, interest rate movements will crush their profits. Unfortunately, this is what happened with SVB.

When the dust settles, SVB might be more like a hedge fund than a bank. However, banks becoming hedge funds have implications for financial stability. For example, their business model could be concealed from the untrained eyes of the regulators as long as deposits flow into the regional bank. However, once the profit margin collapsed, the bank had to drop the strategy of acting like a hedge fund as it was no longer hedged. Nonetheless, the difference between a hedge fund and a bank is that hedge funds are designed to earn lots of money and disappear. Therefore, no one misses them once they disappear. However, banks serve a public function, have a government backstop, and occupy a vital role in the financial system. As a result, adopting such a short-term, high-risk-high-profit business model for such an important institution is dangerous for financial stability.

Most importantly, banks, if they decide to restrict people’s access to their deposits, they generate a banking crisis. On the other hand, hedge funds often impose lock-up periods, such as several years in which investments cannot be withdrawn. Many also employ redemption notices requiring investors to provide notice weeks or months before their desire to redeem funds. These restrictions limit investors’ liquidity but, in turn, enable the funds to invest in illiquid assets where returns may be higher without worrying about meeting unanticipated demands for redemptions. The events leading to the banking disruption of March 2023 suggest that market participants or regulators needed to adequately internalize essential lessons from the 1998 hedge fund crisis case. If they did, they could recognize the fixed-income strategy at the heart of the SVB’s business model.

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Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #1: Have SVB’s Informed Depositors Created a Derivative-Based Solution to Bank Runs?

“[Interest Rate Swap] is a perfect example of the gains that can be realized from specialization along the lines of comparative advantage. Triple-A and single-B can together reduce their joint costs of borrowing by each borrowing in the market in which they get the best terms; then, using a swap, they can divvy up the savings they have realized, and each ends up with the type of liability they wanted in the first place.” Says Marcia Stigum (1978)

Silicon Valley Bank (SVB) was born on October 17, 1983. It was announced dead by the FDIC and other government agencies on March 1o, 2023. Nonetheless, SVB’s failure began an intriguing postmortem debate on bank runs. Many discussions have been conducted on essential issues such as the roots of the crisis, the nature of government bailouts, and recrafting bank regulation (such as making liquidity measures such as liquidity coverage ratio (LCR) time-sensitive). However, one of the standard narratives indicates that the SVB’s doomed fate is determined by the classic type of depositors who follow herd behavior and are primarily driven by human psychology and panic. 

However, the March 2023 banking crisis revealed that modern depositors’ behavior, including their decision to run on a bank, is less driven by the animal spirit and more by the actual information in banks’ financial statements. In other words, modern depositors’ behavior has shifted from being uninformed and displaying herd behavior to becoming individually informed and information-derived. This distinction between traditional, uninformed depositors and modern, informed ones has essential implications for the measures to stop the bank run. Given the nature of the modern depositors, banks’ usage, and reporting of hedges, including interest rate futures and swaps, would be a better option to stop a run on a bank and a banking crisis in general than other classic solutions such as deposit insurance. In addition, accounting for the structural change in the type of depositors, from uninformed to informed, could open new avenues, such as using derivatives, to improve financial stability in the future.

Most standard narratives of the March 2023 bank run are based mainly on classic models such as the Diamond-Dybvig Model of bank runs. In this model, the assumption is that the depositors are uninformed. To such depositors, as long as they did not reach the $250,000 threshold, putting money in a bank appeared as safe as buying Treasuries. Both investments had full government backing. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. As their behavior is driven by “animal spirit” rather than a particular detail in banks’ financial statements, “any” worries, imaginary or real, about the viability of such insurance, if believed by enough people, could lead to a run on a bank. In this environment, the model suggests that even though some banks tend to stop the convertibility of checkable deposits to currency, the best option to stop a bank run would be “deposit insurance.” 

In contrast to the assumption of such models, the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks are characterized as informed, finance-savvy, well-informed, and informed. They are known to use all the available information and extensively tweet about every detail and footnote in the financial statements of their bankers. For instance, in the case of SVB, they examined the bank’s balance sheet, “marked to market” its assets, and noticed its exposure to interest rate risk. Moreover, they initiated the run on the bank once the bank reported virtually no interest rate hedges on its massive bond portfolio. In other words, the run on the SVB revealed that modern depositors’ behavior is less driven by the animal spirit and psychology and is indeed informed. 

This distinction between traditional, uninformed depositors and modern, rational ones has essential implications for the measures to stop the bank run. It opens the door for derivatives to be considered as a private-risk management tool that enhances financial stability. One of the most significant risks to SVB’s business model was catering to a rational group of investors who treated bank deposits as a form of investment vehicle and continuously checked the bank’s balance sheet. This change from uninformed to rational (well-informed) depositors is a continuation of the existing evolution in banking. In the first phase of this structural change, “retail” depositors were replaced by “institutional” ones such as pension funds. The main difference between these two was the amount of cash they would inject into the banking system.

Nonetheless, both were uninformed. They cared not about the banks’ financial condition and balance sheets to which they gave their money. Instead, they just wanted the top rate available on an FDIC-insured deposit. To this depositor, as long as she did not breach the $250,000 mark, putting money in a bank appeared as safe as buying Treasuries. Moreover, both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, found they were flooded with money if they posted attractive rates. This is a pretty good picture of things in the fifties.

After the Great Financial Crisis (GFC), and the strengthening of the liquidity and capital ratios, systemically important banks, such as JPMorgan Chase, Credit Suisse, and Bank of America, restructured their business models to become market makers in wholesale money markets. They minimized their deposit-taking activity. As a result, medium-sized and large regional banks changed their business model to pick up the slack. For these banks, retail deposits were a dead end. Nontheless, attracting large deposits per se was not the only goal when it came to institutional deposits. Instead, they sought “well-informed” clients such as tech, crypto, venture capitalists (VCs), and startups. Therefore, banks such as SVB, Signature, and Silvergate preferred serving highly specialized, local, and finance-savvy depositors. These regional banks structured their business models to become the Bank of Crypto, VCs, or Startups.

If the change in systemically important banks’ business model transformed the market-making business, large, regional banks’ restructuring changed the banking and deposit-taking world. On the liability side, the modern banking era started with the “death of the retail deposits.” This evolution was revealed in the balance sheet of the SVB. On the liability side, much of the recent SVB’s deposit growth was driven by VCs and startup businesses. These depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. 

On the asset side, SVB and other specialized banks that served rational depositors were outside the business of making loans. Indeed, startups and crypto customers do not have good collaterals like fixed assets or recurring cash flows. As a result, they are less-reliable corporate borrowers. Nonetheless, the most important reason was that these customers did not need loans. Instead, equity investors provided them with a constant supply of cash. Marcy Stigum, in the late 1970s, called this a “death of loans.” The idea is that top corporate customers have access to public and private market credit, where they can borrow more cheaply than banks. Banks have adjusted to the loss of this business by instead purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

This change from uninformed to rational depositors and the corresponding assets-liabilities strategies contributed to the ongoing banking mania in at least two hybrid ways. On the one hand, serving rational depositors who do not need loans implies the large-scale addition of long-term bonds backed by the US government to the banks’ portfolios. The result is that these specialized banks are unusually exposed to “interest-rate risk.” When interest rates go up, most banks have to pay more interest on deposits but get paid more interest on their loans and end up profiting from rising interest rates. On the other hand, banks such as SVB and Signature own a lot of long-duration bonds. These bonds’ market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that is what banking is — but many banks end up more balanced. At the same time, rational depositors, unlike traditional ones, continuously pay attention to the financial statements of the banks and the footnotes. As a result, they constantly “mark to market” the banks’ financial assets and extremely penalize the banks whenever the fair value of their assets is at a loss. 

Let us use an example to understand this point and its systemic importance. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announced a rate hike from 0% to 2%. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. A rational depositor, in contrast, continuously marks to market the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. If the bank has a bond with a face value of $100, this type of depositor will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Rational people notice, tweet, and write long threads. Then, they start a bank run. This characterization explains the behavior of SVB’s depositors, mainly from the tech and VC industries. As rates went up fast, SVB’s depositors, who were all on Twitter a lot, read the footnotes on the notices on the financial statements of the SVB and started to write long threads on the topic that SVB was insolvent. As a result, they all pulled their money out at once. 

Rational depositors, not unlike traders and capital market investors, use all the available information and continuously mark to market the balance sheet of financial institutions. Unfortunately, in doing so, they heightened the bank’s exposure to interest rate risks, especially for the banks that invest in fixed-income securities, such as government bonds. However, this opens up an opportunity for using interest rate hedges to stop the run on the banks. Interest rate hedges are often in the form of swaps, a financial instrument that effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. These can be important for banks like SVB because many of their investments are tied to fixed-income bonds like mortgages or Treasuries. 

When rates go up, fixed-income bonds fall in value, as with SVB. Why do bond prices respond to interest rate fluctuations? Remember that in a competitive market, all securities offer investors fair expected rates of return. If a bond is issued with a 5% coupon when competitive yields are 5%, then it sells at par value. If the market rate raises to 8%, however, who would be willing to pay a par value for a bond that only offers a 5% coupon bond? The bond price must fall until its expected return increases to the competitive return of 8%. In this environment, the fair value of the bonds will fall. Even if the investors are intended to hold these assets until maturity, which indicates they would still earn the par value, a mark-to-market method reduces the fair value of these investors’ assets. 

However, once these available-for-sale, outstanding bonds are combined with interest rate hedges, such as swaps, their value can be protected against interest rate movements. One of the swaps’ functions is to transform the nature of an asset. Consider SVB in our example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2% for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup. We assume it agrees to enter into a swap where it pays the fixed rate (3.2%) and receives floating plus 0.1%. Its position would then have three sets of cash flows. First, it earns 3.2% from the bonds. Second, it receives floating under the terms of the swap. And third, it pays 3.2% under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1% (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2% into assets earning the floating rate plus 10 basis points. In the real world, however, SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. Instead, it terminated or let expire rate hedges on more than $14 billion of securities throughout the year, the company said in its year-end financial report. Being unhedged was SVB’s fatal sin that its depositors did not forgive.

In this piece, I shed light on a corner of the crisis that has made this run on the bank different from the classic ones. In the current banking crisis, the collective behavior of the depositors to withdraw their cash from these banks, more than being driven by pure speculation and panic, is driven by depositors’ careful examination of the banks’ financial statements. In other words, in this crisis, we are dealing with rational depositors rather than uninformed ones. Although small, this detail would change the best approach towards stopping the run on the banks, away from deposit insurance towards using derivatives. The influential Diamond-Dybvig Model posits that deposit insurance is the best way to deal with bank runs. Accordingly, in March 2023, after the SVB’s failure, the government introduced extraordinary measures to extend the deposit insurance “to all the deposits” and disregard the $250,000 threshold. Nonetheless, despite the government’s all-in approach to providing deposit insurance, such a state-backed promise did not stop the run on the other banks. 

The US government’s failure to calm the market, despite offering full-blown deposit insurance, calls for a new framework beyond the classic Diamond-Dybvig Model, where the depositors choose to remain uninformed about the financial health of their bankers. The SVB’s tragedy revealed a modern financial system made by modern, well-informed depositors. These depositors treat their deposits as a form of investment vehicle. In this new financial reality, what stops the run on a bank is a proper hedging strategy that is reported in the bank’s financial statement instead of government-backed insurance. In a strange twist, the March 2023 banking crisis teaches us that the regional banking market structure has moved in the direction that a private risk-management solution, available through the derivative markets, would be a superior resolution than the government-backed insurance for financial stability. Every cloud, even if it includes a cascade of bank runs, seems to have a silver lining. 

Footnote: While writing this piece, I am visiting my family in Iran. My access to the internet is nonexistent. However, a student of mine sent me all the articles through text messages. Like always, my students are my main drivers and backers in my intellectual journey.