Banking Crisis – Love Thinking about Finance, Market Microstructure and Money View

By Elham Saeidinezhad

This piece is published initially in Phenomenal World Publications.

Executive Summary

In this piece, I examine SVB’s business model as a model of modern commercial banking. SVB has failed, but its business model will be reincarnated as modern banking. So, what would be modern commercial banking?

Liability Management

– The nature of depositors in large commercial banks shifts from uninformed to informed, such as fund managers.

– Bank’s behavior makes deposit-taking activity into a Ponzi scheme than traditional banking.

Asset Management

– Traditional bank loans to businesses will die. Instead, the banks lend to alternative investment managers themselves through financial engineering methods such as “subscription lines.” This makes banks an investor in the PE world rather than a creditor.

– This business is not that lucrative unless the fund managers default and bankers become the de-facto investors.

– Nonetheless, the loan directly to fund managers and the resulting relationship with them brings a stream of large deposits to such banks, hence the Ponzi.

– Banks invest heavily in fixed-income securities. Nonetheless, the investment strategy is not based on holding safe assets but on following hedge funds’ trading strategies, such as “fixed-income arbitrage.”

-In other words, banks’ investment in fixed-income and hedging strategies will be a bet on the arbitrage opportunities implied in the interest rate term structure. In doing so, they become excessively exposed to interest rate risk.

Vulnerabilities/Structural Shifts

– Lots of unknown ones.

– It will be the death of “Held-to-Maturity” accounting and the birth of “marked-to-market” ones.

-Informed investors keep mark to market banks’ assets and become ultrasensitive to interest rate risks and unrealized losses.

-In other words, banks will become a mixture of investment funds, such as hedge funds and PE funds, but with public support.

Introduction

Silicon Valley Bank’s (SVB) short lifespan—from October 17, 1983 to March 10, 2023—has been witness to crucial transformations in the world of modern banking. The bank’s collapse has sparked wide ranging reflections on the roots of the crisis, the utility of government bailouts, and appropriate responses. I identify two crucial shifts in the banking system exemplified by the Bank’s fall. On the liability side of SVB’s balance sheets, the shift from uninformed to informed depositors renders hedging against interest rate risk more critical. On the asset side, a strategy of “fixed income arbitrage” means that regional banks fell into similar difficulties as hedge funds—one in which low profits rendered betting on the shape of the yield curve too expensive to maintain.

From uninformed to informed investor

Among a number of channels, the crisis has been interpreted according to the classic Diamond-Dybvig Model. This model assumes that depositors in a particular bank are uninformed: as long as they do not reach the $250,000 threshold, they do not distinguish between depositing money in a bank and buying treasuries, given that both investments are backed by the government. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. Driven by “animal spirit” rather than the details of financial statements, they are capable of generating a run on the bank based on “any” worries, imaginary or real. The surest way to stop a bank run, the model thus argues, is through deposit insurance, which stabilizes investor confidence.

However, recent events deviated significantly from these expectations. Rather than being motivated by a herd driven shift in “animal spirits,” the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks were informed. Even prior to the run, they were known to extensively tweet about each detail and footnote in the financial statements of their bankers. In the case of SVB, for instance, they examined the bank’s balance sheet and “marked to market” its assets, revealing its exposure to interest rate risk. When the bank reported virtually no interest rate hedges on its massive bond portfolio, investors depositors instigated a bank run.

This distinction between traditional, uninformed depositors and modern, informed ones reflects a revolution in the structure of contemporary banking. In the first phase of this structural change, which took place during the 1950s, “retail” depositors were replaced by “institutional” ones such as pension funds. Though institutional investors injected far greater amounts of cash, they ultimately remained uninformed. They cared little about the financial condition and balance sheets of the banks that received their deposits, and instead prioritized the rate available on an FDIC-insured deposit. So long as they did not breach the $250,000 limit, putting money in a bank appeared as safe as buying Treasuries—particularly given that both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, were flooded with money so long as they posted attractive rates.

With the strengthening of liquidity ratios in the aftermath of 2008, systemically important financial institutions like JPMorgan Chase, Credit Suisse, and Bank of America increasingly transformed into market makers in wholesale money markets, buying and selling securities for their own accounts and thereby minimizing their deposit-taking activity. Liquidity requirements like liquidity coverage ratio (LCR) required banks to have enough high-quality liquid assets to survive thirty days of deposit outflows in a stress scenario. In doing so, they rendered short-term deposits, and the illiquid assets they fund, less appealing.

Big banks coped with these liquidity requirements by reducing deposit-taking activities, leaving medium-sized and large regional banks to pick up the slack. These banks sought to compensate for greater deposit-taking through other financial pursuits. In particular, they were betting on higher returns and attracting new deposits from a piece of financial engineering known as “fund subscription lines.” These credit facilities were different from a traditional business loan on three main fronts. First, a subscription line is a loan to venture capitalists (VC) and private equity fund managers themselves rather than the actual businesses. Second, unlike traditional corporate loans that use the firms’ assets as collaterals, subscription lines are secured against unfounded capital commitments by private equity investors. Finally, banks anticipate returns not through interest accrual but capital gains once the investment is finalized. In other words, subscription lines transformed regional banks into private equity investors rather than creditors.

Subscription lines appealed to venture capital and private equity because they enabled them to manage their cash flows and increase the internal rate of returns on their investments without issuing a capital call to their investors. As such, they increasingly constituted the primary clientele for subscription lines. While big banks fundamentally altered the market-making business, large regional banks’ changed the banking and deposit-taking world. On the liability side, the current banking era started with the “death of the retail deposits.” On the asset side, the trend continued with the death of traditional loans. Instead, VCs and startup depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. In this environment, regional banks, such as SVB, used Ponzi-like schemes, such as the fund subscription lines, to maintain the steady stream of deposits and become a stakeholder in the alternative investment world.

Marcy Stigum called this the “death of loans” in the late 1970s. This shift transformed banks’ asset management beyond their embrace of subscription lines. SVB and other specialized banks that served informed depositors practically eliminated their loan-giving activity. Lacking fixed assets or recurring cash flows, startups, and crypto investors were less reliable corporate borrowers. But more importantly, these customers did not need loans—equity investors provided them with a constant supply of cash. Consequently, banks shift their operations from issuing loans to purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

The shifts in the nature of depositors, from uninformed to informed, and the assets-liabilities management of banks contributed to the current banking mania. As a result of the large-scale addition of long-term bonds backed by the US government to banks’ portfolios, these specialized banks are unusually exposed to “interest-rate risk.” While most banks earn a higher interest on their loans during interest rate hikes, banks like SVB and Signature are stuck with long-duration bonds whose value goes down as rates go up. Every bank borrows short to lend long, but many banks ultimately strike a balance. Moreover, informed depositors continuously pay attention to the financial statements and footnotes of the banks in which they deposit. As a result, they constantly “mark to market” the banks’ financial assets and penalize them whenever the fair value of their assets is at a loss.

A brief example demonstrates the systemic importance of this point. 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 announces a rate hike from 0 percent to 2 percent. 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. This is especially true if the bank has announced that these assets are intended to be “held to maturity.” An informed depositor, by 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. When interest rates go up, this value falls: if a bond is issued with a 5 percent coupon and the market rate rises to 8 percent, demand for the 5 percent bond declines. Consequently, its price must fall until its expected return matches the competitive return of 8 percent. Informed depositors know this—if the bank has a bond with a face value of $100, they 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. Informed depositors notice—they write long tweet threads, initiating a bank run. In doing so, they heighten the bank’s exposure to interest rate risks, particularly if the bank is invested in fixed-income securities, such as government bonds.

Fortunately, this shift also opens up new directions for bank run management: interest rate hedges. Often in the form of swaps, this financial instrument effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. Once available for sale, the value of outstanding bonds can be protected if combined with interest rate hedges like swaps. Swaps transform the nature of an asset by converting a fixed-income investment into a floating-rate one and vice versa.

Consider SVB in our earlier 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 percent for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup, and enters into a swap where it pays the fixed rate (3.2 percent) and receives floating plus 0.1 percent. Its position would then have three sets of cash flows: it receives 3.2 percent from the bonds, and the floating rate under the terms of the swap, and pays 3.2 percent under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1 percent percent (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2 percent into assets earning the floating rate plus 10 basis points.

The real question underpinning the current crisis then, is why SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. On the contrary, its year-end financial report notes that it terminated or let expire rate hedges on more than $14 billion of securities throughout the year. The US government’s offer of unlimited deposit insurance has failed to calm markets, in part because it assumes the uninformed depositor behavior characteristic of the Diamond-Dybvig Model. But in reality, the banking world has changed: well-informed depositors treat their deposits as an investment vehicle. In this new financial reality, bank runs may be better dealt with using a proper hedging strategy. Strangely, the crisis teaches us that the current regional banking market structure may be better served by a private risk-management solution, available through the derivative markets.

Regional banks as the new hedge funds

The hedge fund crisis of 1998 offers a blueprint for understanding regional banks’ asset-liability management today. At the time, funds like Long Term Capital Management (LTCM) relied on a very popular, and very painful, strategy known as “fixed-income arbitrage.” 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 gain in value, justifying the purchase of government-backed securities like Treasuries and mortgage-backed securities. Nonetheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund enters an interest rate swap (IRS) and becomes 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. Most importantly, the fixed-income securities’ capital gain would compensate for the 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.

As LTCM’s failure showed, the strategy contains critical vulnerabilities. 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. With small profit margins and greater exposure to interest rate movement, fixed-income arbitrage has been described as “picking up nickels in front of a steamroller.”

There are many reasons to think SVB’s business model has come to resemble that of hedge funds. Unlike the traditional model of deposit taking, SVB invested most deposits in fixed-income securities. Of its $190 billion in deposits, it had invested $120 billion into Treasury and agency mortgage-backed securities. Conscious of the limitations of fixed-income arbitrage, SVB’s managers suddenly dropped the interest rate hedges without providing reasonable economic justifications in mid-2022. But attributing this decision to poor risk management can be misleading. SVB’s decision to liquidate the swap positions coincided with a shift in the market consensus on the Fed—towards the perspective that the Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. The shift made it too expensive to bet on the fall in interest rates.

But this strategy becomes even more dangerous in the hands of a bank. Whereas a hedge fund can lock up liquidity and ensure investors do not run, banks can only pressure government insurance schemes or threaten the stability of the financial system. While hedge funds can impose momentary lock-up periods, bank restrictions on deposits access generate a broader banking crisis. Finally, hedge funds can employ redemption notices which require investors to give weeks or months of notice before redeeming funds, thereby enabling investment in illiquid, high-return assets.

The transformation of banks into hedge funds thus bears enormous implications for financial stability. Their investment strategies are yet to be identified by regulators—so long as deposits flow into the regional bank, it can maintain its hedges. But unlike hedge funds, which are expected to periodically disappear, banks are meant to serve a public function, have a government backstop, and occupy a vital role in the financial system. For the sake of financial stability, they should not be engaging in a short-term, high risk, and high profit business model.

Through the shift to informed investors, and the utilization of hedge fund investment practices, the SVB crisis holds significant consequences for the structure of contemporary banking, and the tools available to prevent future collapse.

“Not all private equity people are evil. Only some.”— Paul Krugman

One of SVB’s financial indicators that were considered a missing red flag was its superior return before its collapse. SVB’s return exceeded that of large banks such as JPMorgan Chase. The returns were more in the caliber of those alternative investment funds such as Private Equities (PEs) than banks. The similarity, however, does not end here. In fact, a close examination of SVB’s business model reveals a practice at the heart of the firm that has yet to be known even after its collapse. SVB extensively used a piece of financial engineering known as “fund subscription lines (SL).” Technically speaking, SL is a form of bank credit. However, they are distinct from traditional commercial loans. Banks become a fund’s creditor by issuing bank loans. On the other hand, SL, in practice, transforms banking from being a fund’s creditor to one of the PE shareholders. In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game.

The subscription lines were one of the SVB’s primary businesses. However, it turned out that they were not a lucrative business. Unlike traditional commercial loans, SL does not fund companies and “operating businesses.” Instead, it subsidizes the venture capitalists and PE managers themselves. As a result, the loans generated very low returns, even compared to commercial loans, which yielded little due to the low-interest-rate environment. Nonetheless, the subscription lines brought new clients and deposits to the bank. In return, these deposits became the bank’s primary source of funding. In other words, the SVB’s deposit-taking business was more like a Ponzi scheme than a banking service to highly specialized businesses.

To understand SL, and the changing world of corporate loans, we should start the business model of the clients that SVB served and replicated. Over the last 40 years, the PE industry has grown from a relatively small niche for skilled bankers to an across-the-board area of modern finance. Importantly, buyout (BO) funds became the largest subsegment of PE. The primary business model of BO funds is to purchase a business through borrowed money using the business’s assets as collateral. Eventually, the PE would sell levered stakes of companies to generate profits. To finance their acquisitions, almost all BO funds are structured as closed-end vehicles in which a PE firm serves as the general partner (GP) and various (institutional) investors provide capital as limited partners (LPs).

PE fund managers receive lucrative compensations for their services. These financiers typically receive a fixed management fee of 2% of the committed or invested capital. However, they are mainly compensated by variable carried interest equal to 20% of the fund’s profit. However, before the fund managers are paid any carried interest, the PE investors should be compensated based on their contribution with a preferred interest of 8%. From a PE’s economic perspective, the relevance of SL mainly is the ability of this facility to artificially boost the internal rate of return (IRR) of the investment.

Fund managers’ compensation primarily depends on the IRR they achieve. The IRR, in return, has an inverse relationship with the amount of capital that the PE general investors would inject into the investment. Traditionally, such funds would call the investors to inject more capital, known as a “capital call,” as soon as the fund needs additional funding. However, in modern days, funds employ credit facilities. This is because IRR, the key assessment metric for PE fund managers’ performance, depends on when an LP’s capital is put to work. SL reduces the ultimate cash flow to investors because they pay the fees and interest on the bank loans. However, it helps the managers to delay the date when client money enters the fund and goose the fund’s internal rate of return.

SL transforms banking into alternative investment through at least two fronts. First, it makes deposit-taking into a Ponzi scheme. Second, SL makes banks, such as SVB, a private equity managers in disguise. Let us start to understand the latter effect. From a banker’s perspective, in SL, the bank funds limited partners themselves. However, in doing so, instead of becoming entitled to the businesses’ assets in case of default, the bank receives a “power of attorney” (POA) and “steps into the shoes” of the general partner or the investment manager. POA is a written agreement wherein the PE manager provides advance authority to the bank to make certain decisions or to act on the principal’s behalf, generally or in certain circumstances.

In the case of PE managers’ default to make payments in a timely manner, the bank could take any necessary actions without the requirement to provide prior written notice or obtain written or other consent from the PE managers and investors. Most importantly, banks can utilize POA to issue capital call notices or become a PE general partner. In the latter case, the bank becomes a private equity investor and will be compensated based on the fund’s return. In other words, if managers clear the loans promptly, banks receive the principal and interest payments on the loan. This is not a very lucrative business. However, if managers default, the bank becomes a private equity investor itself and receives a share of the return on investment.

In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. At the heart of SVB’s growth were the deals with thousands of venture capitalists and private equity firms that invested in everything from experimental medicines to artificial intelligence, with checks ranging from $5 million to more than $30 million. These financiers deposited their money with the SVB. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game. In this scheme, the SVB relied on SL as a backchannel to bring more institutional deposits and used the same deposits to fund this hidden activity.

The systemic risks of subscription lines are under-appreciated by both investors and regulators. Nonetheless, this technique has already become part of banking DNA. Many PE managers are using subscription lines more aggressively than a decade ago. The SVB crisis revealed that such dirty practices put a ticking bomb at the heart of the commercial banks’ balance sheets. It also destabilizes the alternative investment world by creating a more oversized interconnectedness between the banking system and such funds. After the SVB’s failure, banks recalled the subscription lines, forcing private equity managers to ask investors to deliver vast sums of cash immediately. This could create a downward spiral if investors are forced to sell assets into a falling market to meet their existing promises to private equity managers. SVB was not just a banker to alternative investment funds. It also transformed traditional banking to become a form of alternative investment. This creates a new threat to the stability of global financial markets.