SVB failure: the limitations of moral hazard, and the difficulty of assessing risk

I saw this viral article by Arnold Kling, Moral Hazard is widely misunderstood. He argues that bailouts allow bankers to be reckless with impunity (heads they win, tails you lose, so to speak):

At this point, if I obtain some more funds from depositors , I can go to Las Vegas and hope I get lucky. If I lose, I have not lost anything, because my bank was not profitable. If I win, I can get rich. In fact, I will be desperate enough to try this that I will pay an above-market rate to get deposits. And depositors will be content, knowing that the government is providing a guarantee.

Except things are hardly working out fine for the executives of SVB, given that the bank is worthless (along with all their stock), they are out of a job, and under investigation that may lead to civil penalties or even jail time. I agree though that if a bank is already insolvent, and the management knows this, it does create an incentive to try to ‘earn it back’ by taking added risks and failing to disclose such risks, but this is not unique to banks. However, it’s not risk free either as it incurs a risk of the scheme being detected and punished, or hastening the collapse of the bank. It may be more profitable to collect a salary and wind the bank down slowly, than run it to the ground quickly with risky behavior.

Additionally, Scott Sumner argues that fraud can be prevented if people pay more attention, writing:

The second misconception above also illustrates a basic lack of understanding of moral hazard. Yes, people don’t tend to pay attention to bank balance sheets when making decisions on where to put their money. But that’s exactly what you’d expect to happen if moral hazard were a major problem. People would stop caring about bank risk, and highly risky banks would understand that they could attract deposits every bit as easily as conservative, well-run banks. Clueless depositors are not evidence of a lack of moral hazard; they are evidence that moral hazard exists.

Hedge funds have every possible incentive to look at balance sheets, yet how many warned of SVB or 2008? One or two firms or individuals? Here you’re talking an industry in which participants have a huge, direct incentive to scrutinize this stuff and make their findings public in order to profit from a panic, yet even the experts find it hard. What hope do average people have? Of course, there are people who can do this, but it’s hard enough that when they succeed, movies and books are produced about them.

Getting rid of FDIC is not the answer, given that many of these depositors were knowingly well above the $250k limit. If not having insurance is supposed to mitigate risk, by his argument, then SVB, which only had a small percentage of its deposits within the limit, should have been among the safest in the world, which obviously it was not. By his logic, these companies would have performed the necessary due diligence to see that SVB’s long-term bonds were losing enough money that a run would subsequently be triggered, and then either take their money out (but not too fast or else others would get wind of it) or not use SVB at all? They would have to perform due diligence frequently enough to know how SVB’s bond portfolio changes over time. And not only that, trust that SVB is not lying. This sounds impractical.

Also, having more information or transparency is not always helpful, because one must also interpret the data, which is also hard. Here is the headline from March 8th that sank SVB. 48 hours later SVB would be worthless. Imagine as an SVB customer being privy to this information, not on the 8th, but maybe on the 6th or something. So now you have to make a decision: get out or stay? On the surface, a $1.8 billion loss for a $22 billion bond investment for a bank with a market capitalization of $22 billion (at the time) and with over $175 billion in deposits ($150 billion unsecured), does seem survivable. It’s not unprecedented for companies to lose money on bad investments (like Facebook’s Metaverse losses) or raise additional capital. Likely, the $1.8 billion loss would have been survivable had it not triggered a run, which was not.

Interestingly, if you look at the minute-by-minute afterhours data of SVB after the story broke, for the first hour or so the stock is only down 3%, at around $250 or so:

In other words, the collective wisdom of Wall Street cannot make heads or tails of this press release, which shows the inherent difficulty of assessing risk even when everything is public. It’s not good news, obviously, but a $1.8 billion loss is not that much for such a large bank, and raising additional capital should not be that hard either, so the initial reaction was muted. [Of course, until it went into freefall and was worthless a day later.] So one would have to not only make a judgment call based on disclosed, known financial information, but also try to predict how other market participants will react, too, which again is really hard.

There are no good answers. Moral hazard is bad, but so is the economy freezing up, like as we saw during Covid. I think the bailout was justified and worthwhile from a consequentialist perspective, although I can understand the public being upset about it. Bank stocks were plunging Monday morning despite the bailout, such as First Republic Bank, which was down 60% Monday morning, and Charles Schwab, down 20%. Without the bailout, it’s conceivable the S&P 500 could have fallen 5-10% and led to a situation worse than even 2008.

The major difference between this and 2008 is that this crisis affected regular customer deposits, not hedge funds, mortgages, or derivatives. This had much more severe repercussions for the daily functioning of the economy and business. In 2008, the crisis was more sequestered to investment banking, not retail or commerce.

The problem with the ‘should have known better’ argument is that the number of things that can conceivably go wrong is endless. Anyone in hindsight can argue how “regulation X” or “policy Y” would have prevented the collapse of SVB, yet banks have been failing forever; they always find new ways to fail (that is a reason why on my blog I have never recommended banking stocks). SVB depositors were not aware of the risks, not that they should have reasonably been expected to. It’s not really a ‘buyer beware’ sort of thing. It’s assumed that a bank as large as SVB is well managed, or at least reasonably safe.

The left blames Trump in 2018 rolling back some of the Dodd-Frank regulations, in which the threshold for annual fed stress testing was raised from $50 billion to $250 billion (which SVB fell below), but would this have been good enough? It’s worth noting that SVB in 2020, after crossing $100 billion in assets, had well-exceeded the capital ratio requirement stipulated by Dodd-Frank:

So, SVB Financial Group (and the commercial bank itself) had capital ratios approaching twice the minimum required, even after if crossed the $100 billion threshold. Given that the 2018 amendments to Dodd‐​Frank were at the holding company level, and that what regulators have done to implement enhanced requirements after Dodd‐​Frank effectively amounts to higher capital and liquidity ratios, it is quite a reach to connect Silicon Valley Bank’s failure to the Economic Growth Act.

From the perspective of the start-ups, the biggest risk is losing money from business operations, not the bank itself failing. The only way to hedge this would have been to spread one’s assets across many banks (which becomes less useful for risk mitigation if there is contagion), or buying put options on the bank itself (again, making sure that there is no counterparty risk due to contagion…see, this is harder than the armchair pundits would have you believe).

Again, as discussed above, professional auditors and hedge funds apparently find it really hard to identify fraud, as the scandals of Enron, WorldCom, and others have shown (and these are the pros, who have huge budgets and tons of manhours). Start-ups are in the business of creating things, not being auditors.

Overall, it’s easier or more practical to have systems in place to occasionally rescue the financial system, than to have to create a new financial system that is immune from failing, or hope that customers can adequately assess risks of large, complex financial institutions (and also predict how other market participants will respond to material developments that can also affect risk). Same for airlines: it would be nice to have air travel that is profitable, safe, and convenient. Given that safety is non-negotiable, we’re stuck with unprofitable travel or inconvenient travel.

As discussed earlier, regarding the ‘libertarian hypocrisy’ argument or the ‘bailing out the rich’ argument, the rich also pay the most in taxes, so having paid into the system already, the bailout is like collecting on an insurance policy.

Ironically, part of the blame goes to technology, too. The very technophiles that the bank catered to were also its demise. This was just so sudden…12 hours and all the money was drained from SVB. That is what happens when everything is electronic, and you got Slack meetings in which founders and VCs are coordinating to pull out as much as possible as fast as possible. It was a feeding frenzy in reverse. As a possible solution, instead of rebuilding the system, which is too impractical or hard, is to find ways to somehow have a orderly exit instead of a frenzied one? Having to sell assets at fire sale prices means less money that can be raised.

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