Change Makes Fools of Us All

 

OPINION

Change Makes Fools of Us All

Credit...Photo illustration by Justin Metz

 

Ezra Klein

By Ezra Klein

Opinion Columnist

March 18, 2023

https://www.nytimes.com/2023/03/18/opinion/svb-banks-change.html

 

Over the past week, an observation by Matt Klein, a financial journalist, has gotten passed around quite a bit. “This was more a case of a ‘bank-run by idiots’ rather than a ‘bank run by idiots,’” he wrote, referring to the collapse of Silicon Valley Bank.

 

But why choose? Everyone involved in this looks terrible. Regulators did nothing, even though Silicon Valley Bank’s woes had been widely noticed. Bank managers failed at the basic work of hedging against the risk of interest rates rising. Midsize banks, including Silicon Valley Bank itself, successfully lobbied Congress and the Trump administration to be exempted from the regulations attached to too-big-to-fail banks. Venture capitalists sparked a needless panic that annihilated an institution central to their own industry. The Federal Reserve ignored inflation for too long, and the whiplash of its response has become a risk factor all its own.

 

I don’t think all these people — many of whom performed quite well before in crises and amid uncertainty — are, or suddenly became, idiots. Here’s a more generous interpretation: Change makes fools of us all, and we are living through an era of change. Three changes, in particular, are worth thinking about right now.

 

Low Interest Rates Came to an End

In his 2020 letter to investors, Seth Klarman, the chief executive and portfolio manager of the Baupost Group, a hedge fund, wrote, “The idea of persistent low rates has wormed its way into everything: investor thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics, housing prices and corporate behavior.” He went on to say that “by truncating downside volatility, forestalling business failures and postponing the day of reckoning, such policies have persuaded investors that risk has gone into hibernation or simply vanished.”

 

Point for Klarman. Silicon Valley Bank’s collapse is inseparable from the long era of low interest rates. Silicon Valley specialized in providing banking to start-ups that had little or no revenue but were nevertheless flush with cash, much of it coming, indirectly, from the Fed’s huge increase in the money supply. Deposits at Silicon Valley Bank grew from $62 billion at the end of 2019 to $189 billion at the end of 2021. And the bank attempted to act conservatively. It squirreled that cash away in what was, in an era of low interest rates, understood as the safest, surest of investments: U.S. Treasuries and other long-term bonds.

 

But as Adam Tooze, the financial historian, wrote, what that really meant was they were “taking a huge $100-billion-plus, one-way bet on interest rates.” When interest rates rise, bond values fall. Maybe it wouldn’t have mattered if Silicon Valley had hedged or diversified properly. But it didn’t. Maybe it wouldn’t have mattered if its customer base hadn’t needed its money back — and quick. But it did. As interest rates rose, those same start-ups couldn’t raise money as easily, and they needed to tap their cash. So Silicon Valley Bank was acutely exposed to interest rate hikes in both its deposits and its investments.

 

To be fair, rate hikes were widely thought unlikely. Interest rates had, with a few exceptions, been on a downward trend for 40 years. Since 2009, they had often been near zero, and negative when adjusted for inflation. In April 2021, Richard Clarida, who was then the vice chairman of the Federal Reserve, said the conditions keeping rates low were “a global phenomenon that is widely expected by forecasters and financial markets to persist for years to come.”

 

Less than a year later, the Fed would embark on one of its fastest rate-hiking campaigns in history. As it did, all manner of assets that had levitated toward eye-popping valuations in recent years — stocks, cryptocurrencies, NFTs, Swiss watches — began to tumble. As Edward Chancellor writes in “The Price of Time,” “A disconnect between finance and the real world lies at the heart of all great bubbles.”

 

The reason Silicon Valley Bank’s travails have led to a wider panic — one now engulfing banks with very different characteristics, like First Republic and Credit Suisse — is that Silicon Valley Bank’s circumstances might’ve been specific, but its problem generalizes: The financial economy we’re in was built atop low interest rates.

 

If you ask the question: “Who holds a lot of long-term bonds and provides banking largely to tech start-ups in the Bay Area?” Well, not many institutions fit the description. If you ask, instead: “Who planned for low interest rates to continue and may be vulnerable now that they’re rising?” There are many, many possible candidates.

 

The Dangers of Viral Finance Made an Appearance

John Maynard Keynes didn’t have much patience for the myth of the rational market. Picking stocks, he wrote, was akin to a game “in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces that he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.”

 

His point was that in the short run, much of finance is about predicting what other people think. But one difference between our era and Keynes’s is that we have real-time, overwhelming access to what other people think. We do not have to imagine which faces our competitors consider the prettiest. They’re talking about it, constantly, loudly, with their opinions ranked by likes and retweets all the time.

 

There’s been some debate about whether Silicon Valley Bank would have survived if a klatch of venture capitalists hadn’t worked one another into a frenzy in various group chats. I’m not sure that’s a useful question. You can’t ban group chats (nor should you, to be clear). But digital information and digital banking mean bank runs can happen — and spread to other institutions — at astonishing speed. As Gillian Tett noted at The Financial Times, “One remarkable detail about the S.V.B. debacle is that, in a few hours last Thursday, about $42 billion (one-quarter of S.V.B.’s deposits) left the institution, mostly through digital means.”

 

And it’s not just bank runs. Everything from the fast rise and fall of crypto to the weird moment of meme stocks to the 2010 flash crash reflects the digital acceleration of finance. There is a question that has lurked on the edge of financial regulation for years now is: Should we slow the system back down to a speed humans can work at? No one idea here would address all cases — a financial transaction tax would curb high-speed, algorithmic trading, but it wouldn’t stop a bank run — but it’s worth wondering whether speed should be seen and addressed as a financial risk factor unto itself.

 

Financial Regulators Turned Out to Be Fighting the Last War

In 2015, Greg Becker, the chief executive of Silicon Valley Bank, submitted testimony to the Senate Banking Committee arguing that the Dodd-Frank financial regulation rules should be loosened for banks like his. If they weren’t, Becker warned, Silicon Valley Bank “likely will need to divert significant resources from providing financing to job-creating companies in the innovation economy to complying with enhanced prudential standards and other requirements.” If only!

 

But Becker’s testimony is an interesting read for reasons other than grim irony. It is an argument about what makes a bank “systemically important” — the term of art for a financial institution that cannot be allowed to fail. It is an argument that persuaded the Trump administration, alongside nearly every congressional Republican and no small number of congressional Democrats.

 

In his book “The Money Problem,” Morgan Ricks, a financial regulation expert at Vanderbilt Law School, writes that the problem here runs deep. Systemic risk, he says, “has yet to be defined, let alone operationalized, in anything approaching a satisfactory way.” Lawmakers had tried, in Dodd-Frank, to define it in terms of assets: $50 billion or above, and you posed a systemic risk.

 

Becker, and top executives at many other midsize banks, argued that this cutoff was too low and too simplistic. You could not be a systemic risk, in their telling, unless you were a large bank attempting exotic financial engineering. “S.V.B., like our midsize bank peers, does not present systemic risks,” Becker said. “We do not engage in market making, securities underwriting or other global investment banking activities. We also do not engage in complex derivatives transactions or dealing, offer complicated structured products or participate in other activities of the sort that contributed to the financial crisis.”

 

Put more simply, the idea here was that we know what a systemically risky bank looks like: It looks like the banks, and assorted other financial institutions, that caused the 2008 crash. This is a classic case of fighting the last war. But it is pervasive.

 

As galling as it is that Silicon Valley Bank got itself exempted from being regulated as systemically important, it’s not clear that regulators would have caught the bank’s problems even if Dodd-Frank had remained untouched. As Joseph R. Mason and Kris James Mitchener noted, the Fed’s 2022 stress tests didn’t include interest rate risks. It, too, was fighting the last war.

 

At the time of its detonation, Silicon Valley Bank had roughly $200 billion in assets. It was significant but not huge. As Becker said, it wasn’t trading complex products or doing anything that looked like what sent the global economy into crisis in 2008. And yet regulators still declared it systemically important when it failed and backed up all its deposits. The government’s definition of systemic importance — the one that is, even now, written into law — has been proved false.

 

But this gets to a broader point: Banking is a critical form of public infrastructure that we pretend is a private act of risk management. The concept of systemic risk was meant to cordon off the quasi-public banks — the ones we would save — from the truly private banks that can be mostly left alone to manage their liabilities. But the lesson of the past 15 years is that there are no truly private banks, or at least we do not know, in advance, which those are.