A disastrous case of history repeating

Treasury Spring - Kevin Cook

Kevin Cook

Co-founder and CEO
Sunday, Mar, 12, 2023
5mins

I was 28 and barely 6 years into my career on September 15th 2008. I’ll never forget standing at the doors of Lehman Brothers’ London office that morning, trying to get in to speak to our RM, as people carrying boxes barged past me on their way out of the building for the last time. A little under 15 years later, it is saddening and frustrating to be watching a different version of the same movie unfold.

I don’t profess to have anything like the full picture here and I am sure that there is much that we do not yet know about exactly how the SVB situation played out, but based on everything that I have heard and seen to date there are several themes that were pervasive across both events. The two that seem the most stark are the dangers of concentration risk and the inherent issues with maturity transformation.

 

Diversification. Diversification. Diversification

I am sure that many of us recall being told throughout childhood not to “put all your eggs in one basket”. Allegedly, the origin of that phrase is attributed to Miguel Cervantes who wrote Don Quixote in 1605. It seems extraordinary that 400+ years of human evolution later, a lack of diversification was at the heart of the SVB situation on at least four different levels.

  1. A lack of diversification across SVB’s client-base meant that rumours of its troubles spread like wildfire. The global venture capital community is a narrowly distributed village, with lightning-fast connectivity across its elders. And when those elders talk, their followers listen. When certain leading VC firms started briefing their portfolio companies to “get out” of SVB on Thursday afternoon, even SVB’s most ardent supporters had no choice but to follow suit for fear of being left behind.

Could it all have been different if the market had coalesced around a stance to protect the bank? Possibly. But this was classic prisoner’s dilemma stuff and I’m neither surprised nor critical that many firms chose self/portfolio-preservation. It was the rational decision under the circumstances.

  1. It wasn’t just that SVB’s depositors all lived in the same village that was the problem. Unlike many other banks of its size ($200B+ balance sheet), SVB’s funding was comprised almost 90% of deposits – compare that with BAML whose deposits make up <70% of its funding.

Why is this important? Different types of funding means different types of actors, with different types of risk tolerance and operating in different echo-chambers. Wholesale funding markets can be brutal when they smell blood but they are at least orchestrated mostly by wizened market professionals who have seen a crisis or four in their time. They may also take a different view if they have collateral, funding only on a secured basis and hence having much greater protection if the worst happens.

SVB’s lack of diversification by funding type meant that there was no counterbalance to the run, no-one who knew that they had assets to protect them if the bank went down, few large institutional long-term sources of support that could be called on to calm the cries that the village was on fire.

  1. Then there was the correlation in SVB’s lending book. The bank ran a large and very profitable venture debt business, lending capital to its depositors to fund their future growth at relatively high rates. The logic ran that if you were a founder that backed yourself and had a high-growth business, why would you pay for expensive equity when you could have cheaper debt and just pay that back from future revenue, without diluting yourself?

As the VC market got frothy through 2021 however, equity became irrationally cheap and venture debt terms had to move in line in order to keep up. More and more businesses started to believe that they would always be able to raise new funding at ever higher prices and so sacrificed thoughts of profitability in favour of “growth at all costs”. As such, the potential take-out for the venture debt moved from an expectation of payment from free cash flow to payment from fresh capital. When the market turned last year, that take-out suddenly disappeared. Of course, I have no transparency on the performance of SVB’s venture debt book but I am told that it held up reasonably well. Whatever the reality, the fact that it was highly correlated will have been far from helpful.

  1. Perhaps the saddest instance of a lack of diversification is the many companies that had all or substantially all of their liquidity at SVB. Indeed those that had venture debt from SVB were generally required to keep it all there. As such, many VC firms had most of their hard-raised funds in SVB, via their portfolio companies and in lots of cases their own balance sheet was deposited at the bank as well. That may have put the entire industry in jeopardy. It didn’t have to be this way – if companies had used SVB for their core services but diversified their excess cash across multiple providers (and ideally multiple sectors), the current situation would have been much less cataclysmic.

There were considerable benefits to SVB becoming the bank of choice for the tech and life science community. But the other side of that coin was huge concentration risk.

 

Maturity transformation and liquidity

Maturity transformation is arguably the central tenet of fractional reserve banking. Very simply, the process runs as follows: 1. offer daily/short-term liquidity to depositors; 2. leverage those depositors’ funds, investing the proceeds in longer-term, higher yielding assets; and 3. rely on the fact that not all depositors will pull their money all at the same time.

Much has been done by regulators over time to limit the extent and shape of this maturity transformation, with most of those limitations being instituted following market-damaging bank runs. Post-Lehman, Basel III put in place key ratios like LCR (liquidity coverage ratio) and NSFR (net stable funding ratio) on top of previously drafted leverage ratios and others.

Whilst these changes absolutely made the banking system safer and will hopefully help to limit the contagion from the SVB event, they still allowed a LOT of maturity transformation. This was permitted on the provisos that a bank’s assets were of a high credit quality and its funding base was not made up of too much “hot money” in the form of wholesale financing. That being the case, maturity transformation shouldn’t present too much risk.

That all makes sense, but the SVB situation highlights two major deficiencies. One of them centres around MBS, or Mortgage-Backed Securities – yes similar to those assets at the centre of the Lehman debacle, however this time the reasons were different. Having been flooded with new deposits in 2021/2022 on the back of the venture capital boom; and without sufficient opportunities for safe, profitable lending, SVB made an ostensibly sensible move – it purchased large amounts of high credit quality securities that offered a return that was higher than its deposit rates. Profitable business. So far so good. The problem was that these were long-term fixed rate securities with a duration of 5 years+.

Long-term fixed rate securities carry a huge amount of interest rate risk. If yields on them are fixed at roughly 1.5% (as was apparently the case with SVB) but current interest rates rise to levels that are multiples of that fixed rate (US base rate is currently 3x that level at 4.5%), the value of those securities falls dramatically. Any buyer will demand a significant discount to compensate for the lower interest payments than those that are available even for current short-term investments of a similar credit quality.

As the Fed aggressively raised rates throughout 2022, that is exactly what happened. But that was OK, SVB didn’t need to sell the assets, right? So mark-to-market changes in price were irrelevant? All true; provided that SVB didn’t burn through its liquid assets and need to sell its long-dated MBS at a huge discount. Which is exactly what happened last week.

The other deficiency was that regulations and predictive models assumed that corporate deposits (funding from companies) were not “hot money” as they were largely uncorrelated and would not all move out of a bank at the same time, precipitating a run.

In most corporate sectors this is true – business cycles are somewhat idiosyncratic and it is unusual for there to be coordinated action across corporations to withdraw funds from a bank all at the same time. VC-backed companies are naturally classified as corporates for the purposes of these definitions. Whilst this makes sense in the abstract, the reality is that there is arguably much more of a herd mentality in the sector than even traditional “hot money” segments of the market. That herd mentality exposed SVB to much faster and larger outflows than any model of “corporate” behaviour would have predicted and ultimately meant that the regulations massively underestimated the amount of liquidity that SVB might need to hold to protect against a run.

There were many other common themes with the Lehman event that merit discussion including the role of credit rating agencies, the challenges with always regulating for the events of the last crisis, the problems with short-term incentives and the lack of institutional muscle-memory within the financial system. But I will leave those for another day.

 

What now? 

It goes without saying that the coming days will be pivotal to determining the fallout from this disaster. It is critical for our market that resolution is quick and definitive and that we do not allow 40 years of progress to be unwound at a stroke due to market frailties.

Hopefully the regulators and the market can come together to deliver a solution that gets the bank back on its feet (even if under a new umbrella), that gets funds back to depositors quickly and in full, and that protects the jobs of those that have worked so hard to make Silicon Valley Bank a vibrant force for good in the innovation economy.

The coming days will also tell us much about the potential for contagion from SVB’s downfall. Here, the concentration risks that were so problematic to the bank may in fact serve to limit the effects on the broader market. The lack of material wholesale funding should restrict the amount of spillover into other areas of the money markets; and the sector concentration of depositors should moderate the impacts on other areas of the economy.

There will almost certainly be unexpected consequences though. Based on the calls and messages that I have received over the weekend, there is naturally a lot of fear and panic in the market. That fear and panic may well translate into decisions that would have looked irrational just a few short days ago as people suddenly see risk in every situation. And those decisions may well impact other areas in ways that are difficult to predict. We will certainly be on heightened alert for any signs of possible contagion as the situation develops.

Whatever happens over the coming days and weeks, I really hope that if anything good can come out of this, it will be that market finally learns some important lessons, which might prevent us from finding ourselves in the same position next time.

 

How can we help?

Whilst we take absolutely no joy in the events of the last few days, these unfortunate circumstances are exactly why we built TreasurySpring. Lehman taught us that unexpected events happen more often than they ought to; and that the consequences can be disastrous. And since then, Brexit, COVID, war in Ukraine and Trussenomics also all caused near misses for the financial system.

By definition we can’t predict these events, so the best that we can do is be prepared for them. When managing cash that means having access to multiple high quality investment options, taking collateral where possible and limiting your exposure to maturity transformation. Doing that is hard and requires more time, money, resources and expertise than most firms can muster. TreasurySpring exists to give our clients all of those options under one roof, enabling them to minimise risk on their excess cash holdings through a single swift onboarding and a fully digital and transparent platform.

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