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Amanda Kramer: Every episode, we have an LBIdea or a key takeaway. And the key takeaway here is that we're looking at a risk return situation, and it's really important to keep your eye on the long term.

Welcome to the Leeds Business Insights Podcast, featuring expert analysis to help you stand out from the herd. I'm your host, Amanda Kramer. We are thrilled to be discussing the fallout from the Silicon Valley Bank collapse, and take a look-ahead with Shaun Davies, Associate Professor and 91ÃÛÌÒ¸ó Director of the Burridge Center for Finance at the Leeds School of Business.

Welcome to Leeds Business Insights, Shaun. And thank you so much for being here today.

Shaun Davies: Pleasure being here.

Kramer: Well, we're really interested in hearing from you, especially because you've got an interesting perspective. You were working on a trading desk when the last collapse happened. What do you see as parallels between the two situations, the last collapse and then the SVB collapse?

Davies: Well, you're taking me back several years back to 2007, 2008. I had just graduated from, coincidentally, the 91ÃÛÌÒ¸ó 91ÃÛÌÒ¸ó, and had started working at a hedge fund out in North Carolina. We were what's called a fixed-income hedge fund, which means that we are trading primarily in the bond market. So, we are trading both U.S. treasuries, as well as mortgage-backed securities, corporate debt, and then also asset-backed securities that were backed by things like subprime mortgages. And so, it was, sort of, ground zero for the events that unfolded in 2007, 2008.

A lot of people think the financial crisis really started in 2008, but in fact, in the fixed-income markets, we started seeing signals of cracking in the summer of 2007. As we stepped into 2008, those cracks turned out to be major fault lines. And in March of 2008, sure enough, we saw Bear Stearns needing to be rescued. And then, the question was, is it over or is it going to get even worse? We saw the stock market rally into the summer. Everyone thought everything was good. And then, of course, we know what ended up happening at the end of the summer of 2008, which was ultimately the bailout of AIG and the collapse of Lehman Brothers, which was, sort of, the crescendo of the entire great financial crisis.

So, when I think about that time and think about now, there's a lot of strong parallels on the dimension of uncertainty. We have no idea how deep this goes. Is it isolated to just Silicon Valley Bank and Signature Bank in New York? And, you know, maybe Credit Suisse over in Europe this past week was just merely coincidental. Or, is this the canary in the coal mine for something much bigger?

Kramer: Absolutely. And then, Shaun, are you comfortable sharing a couple of the similarities to, kind of, create a thread for people who are listening in terms of the prior collapse and this collapse? Anything that would be common factors, essentially?

Davies: So, I think a few of the common factors are the speed at which things can happen. One weekend, you think everything's fine and it's just going to be like the previous weekend. By Friday of that next week, the world has changed. And it's amazing how quickly that can happen. I think back just to a few weeks ago, going into the week that Silicon Valley Bank collapsed. I don't think you could probably have found a headline about Silicon Valley Bank in the Wall Street Journal or on CNBC on Monday of that week. Or, if you did, it would have nothing related to their financial health. Then, by Thursday and Friday, it was everywhere.

And, you know, it was one of the largest bank failures in American history. In fact, Signature Bank, which failed just two days later on Sunday, both Silicon Valley and Signature Bank are two of the top three largest bank failures in American history, both in terms of dollars, but also on an inflation-adjusted basis. Even when we take bank failures 25, 30 years ago, these ones are still larger, even on an inflation-adjusted basis. And it's just hard to believe that we saw that out of nowhere and in the span of a few days.

Kramer: Absolutely. And one thing you've talked about, Shaun, related to this situation is the notion of contagion risk. And you have said panic can cause good banks to fail. What might we watch for in terms of investor activity in banks? And will we see more runs?

Davies: So, if we think back to 2008, the contagion risk was in these assets that a lot of financial institutions and funds were holding, which was subprime mortgage-backed securities, and there was concerns that there was financial risk in the assets themselves and that the valuations of them were overly high relative to how much they really were worth, given the high amounts of delinquency and failures of folks to pay their mortgages back.

If we fast-forward to 2023, the contagion risk is on two sides. We still have the financial asset concerns, which is that, with the way that the Fed has recently been increasing interest rates to fight inflation, as interest rates go up, the prices of securities go down. And it's just due to the time value of money. So, if I have a higher interest rate, that means the time value of money is higher. And so, I'm willing to pay less for a financial security today, all else equal.

And so, as the Fed has increased interest rates, we have a lot of unrealized losses on particularly bond portfolios. And that's a contagion risk in terms of the financial assets, is a lot of folks are holding what we'd call mark-to-market losses, that if these portfolios were marked to market, these firms would have incurred a substantial financial loss. But we haven't marked these portfolios to market, meaning that we haven't listed what the current market price is. So, we just don't know how bad that is, or, you know, to that extent, what the Fed's going to be doing with interest rate policy in the wake of these bank failures.

Just to reiterate, the first risk is still there that we saw in 2008, which is the financial asset risk. The second risk is one that relates to what I'd call depositor psychology. And that's the idea of bank runs that you were alluding to. Typically, when we think about bank runs, we think back to black-and-white movies, like It's a Wonderful Life, and we think that, you know, bank failures, they're a thing of America's past. Well, the Silicon Valley Bank failure, that showed us that bank frauds still exists. They can still happen. And so, now, suddenly that's salient in depositor's minds. "I've got my money in a bank, and that bank might shut its doors and lock them tomorrow."

And so, the second source of contagion risk is that depositors suddenly all in, sort of, a herd, take their money out of a bank all at the same time. Now, Silicon Valley Bank was not a healthy bank. We know that now. They had some large losses on their bond portfolios. And, you know, it's understandable that people were afraid because they were not a healthy bank at the time of their failure. That said, if suddenly depositors decide to take their money out of a healthy bank, that can still cause it to fail, even if it's a healthy bank.

And the reason why is that banks borrow using deposits, what we'd call short-duration liabilities, meaning that when you go to the bank and withdraw your money, they have to give it to you. So, they have these very short-run liabilities. And they use those short-run liabilities to fund long-duration assets, things like giving a household a mortgage so that they can buy a house, or giving a small business a loan so that they can build a new factory. And so, you've got this duration mismatch between the liabilities in the deposits. And so, if people run on the bank, it's not like they can call those loans back and pay the deposits. So, if enough people show up to take their deposits, there's just not enough cash to give everyone their money back.

Kramer: A scary situation to think about. And speaking of which, some of our listeners here may be thinking, shouldn't we have learned our lesson in 2008, 2009? Didn't we create regulations to prevent what we're seeing today? Can you speak to that?

Davies: Well, regulation is oftentimes backwards-looking. And certainly, the results of this past few weeks will lead to new regulations. So, if you go back to 2008, sort of, the hallmark regulation that came out of it was the Dodd-Frank Act. And so, certainly, there was new capital requirements for large financial institutions. But again, regulation is always backwards-looking and not always necessarily forward-looking in terms of the future risks. So, I don't think, when that regulation came in, that people were thinking that the Fed would hike as aggressively as they have over the last 18 months in terms of bringing up interest rates and thinking about what that could imply then for banks and other financial institutions holding large bond portfolios. I mean, after all, these bond portfolios were not junk debt, meaning, like, junk bonds or high-yield bonds. These were portfolios of U.S. treasuries and very safe bonds. It was purely the losses associated with higher interest rates. So, it's not like this was, like, bad collateral, by any means. And so, I just... I don't think that the regulators even considered this possibility at the time.

That said, banks should have risk-managed it. And it's unfortunate that Silicon Valley Bank did not interest rate hedge. Hedging is a way that you can, sort of, offload that risk so you're not internalizing it. And they did not. But I don't think that the regulations were set up for this particular incident.

That said, we certainly will have new regulations, especially for regional banks and small banks going forward, because the first thing that everyone wants to do after a big crisis like this is add new regulation.

Kramer: Thank you for providing that context for us, Shaun. And in terms of context, can you help us understand how historic the Fed action has been here and what the potential long-term implications of that action are?

Davies: Yeah, of course. If we think about the Fed... And when I say Fed in this context, I'm talking about the entire government, not just the Federal Reserve. Just recently, the government, it was, you know, a combination of FDIC, the U.S. Treasury, and the Federal Reserve, came in and said that they would make depositors whole, both at Silicon Valley Bank as well as Signature Bank. That was unprecedented because FDIC insurance is only up to $250,000, meaning that when you deposit money in a bank you're guaranteed that $250,000 of it is insured if the bank were to fail. But if you have $250,001, that $1 is not insured and you could lose it.

That said, if we look at the number of insured deposits at Silicon Valley Bank and Signature Bank, most accounts far exceeded that $250,000 threshold. And so, there were a lot of deposits that weren't insured. So, Sunday night, just after Silicon Valley Bank failed, the Treasury, the Federal Reserve, and the FDIC came in and used emergency powers to make those depositors whole. That said, that ability, it's unclear if they'd be able to do that going forward because FDIC insurance needs the blessing of Congress. And we live in a very bipartisan world where it's hard to get Congress to agree on anything. So, it's unclear whether or not that precedent that they set on that Sunday night will be able to be carried forward.

Now, it's interesting from the standpoint that it was the right thing to do in the... at the time. We could have had massive amounts of bank failures going into Monday morning, had they not done that. Because as soon as the government stepped in with this very unprecedented action, basically, had dulled the incentive for people to run on the bank. The reason people run on the bank is they're afraid that their money won't be there. But now, if they know that their money is safe, regardless if they're over that $250,000 FDIC insurance, now they don't have an incentive to run.

The question now is how credible is that, going forward, since Congress has not blessed it? And then, it also opens a whole new can of worms in terms of, are we basically providing a safety net for banks to take on risky behavior, because they know that their depositor's money is safe? And that introduces something called moral hazard, which is a much bigger issue. And we may not see the effects of today or even next month, but could play out over, say, the next year up to 10 years.

Kramer: Wow. Thank you so much for that look-ahead, Shaun, in that context. I want to move in a slightly different direction and just take a look at this from an entrepreneur's perspective and see what your perspective might be on this. Generally, in a climate where interest rates were already going up, an entrepreneur needs to have that much better of an idea, that much better of a pitch. What is this combined environment of fear in the marketplace, volatility in the stock market, absence of places like SVB to fund them, what does this mean for innovation and for business at large?

Davies: So, large companies that are sitting on war chests of cash, like a Google or an Apple, they're going to be able to continue to fund innovation, either internally or through joint ventures, where they, sort of, are effectively the bank for these. That said, if you're an entrepreneur that's looking to access the capital markets through, say, getting debt from a place like Silicon Valley Bank or raising equity through venture capitalists, you have to imagine that this has made that job considerably harder. We know that the wells go dry when people are scared and uncertain about the economy.

And so, we've got that headwind, in addition to the fact that the largest player in the startup space is non-existent. There's not banks out there that make debt investments in startups like Silicon Valley Bank did. And so, we'll need new banks to step in and do that. And we're not sure if they're willing, right? Silicon Valley Bank was willing, but maybe it wasn't a profitable thing to be doing in hindsight. And so, we don't know that anyone's going to step in and do it. Moreover, we had all this expertise at Silicon Valley Bank that is now going to be dispersed, and it's going to just take a while for a player to build the same level of acumen that Silicon Valley Bank had, as well as the brand of Silicon Valley Bank. So, I think that this is very bad news for startups and early venture companies, going forward.

Kramer: And that brings me to my next question. And you've, kind of, already answered it. But does somebody go and buy SVB and keep that expertise related to funding ventures in-house, or do you think that will be dispersed amongst other banks?

Davies: I think that the problem right now for Silicon Valley Bank is the brand issue. Now, we've seen other large corporations run into situations where their brand value is tremendously hurt by some cataclysmic event. And they changed the name. We saw that with audit firms around the time of the Enron scandal, where there was all this in-house expertise and then they got acquired by someone else and changed their name or just got pulled in.

So, I do think that's a possibility. I guess we'll just have to see on that. It's going to be a very interesting situation because it's not like this was necessarily in the best environment. We're currently in the setting where we have no idea what financial markets are going to look like, because at the same time of all of this, the Fed is aggressively fighting the highest levels of inflation that we've seen in 40 years. And so, there's so many X factors right now that we just... it's difficult for me to prophesize what's going to happen. But I think that the fact that we've got the Fed fighting inflation simultaneous with this just makes it so much more difficult.

Kramer: And as we think about other current events, I want to note that we are recording this episode with you, Shaun, on Tuesday, March 21st. And so, from that perspective, are there any other current events that we should be keeping our eye on right now?

Davies: I mean, the biggest one is what the Federal Reserve is going to do tomorrow, Wednesday, March 22nd, in terms of whether or not they hike rates; and if they do, whether they do 25 basis points or 50 basis points. If we go back to last summer, Jerome Powell, chairman of the Fed, gave a speech in which he said that fighting inflation is paramount. And our policies are going to be very aggressive, as we tighten. And there will be pain. Fast-forward, and we're now in March, there's pain. And suddenly, the credibility of the Fed is on the line because, did they flinch? How serious are they about fighting inflation?

And so, I think a lot is going to be learned tomorrow after the Fed comes out with their announcement on what they're going to do with rates, as well as the press conference that Jerome Powell will have after the announcement comes out in terms of how he talks about how their forward-thinking, and as well as something called the dot plots, which give us an idea of what the different people at the Fed think about terminal rates going forward.

Kramer: On March 22nd, the Federal Reserve raised rates by 25 basis points or a quarter of a percent. In the Federal Reserve chairman's press conference following the announcement, Jerome Powell reiterated that the Federal Reserve will be vigilant in fighting inflation. We connected with Shaun after the announcement, and he noted that not pausing, that is there was some talk that the Federal Reserve would not raise rates, was an important move by the Federal Reserve. Raising rates added credibility that the Fed will not back down from its fight. That said, the next few months will probably be pretty volatile. It would not be surprising to see more bank stress. This is only the first act of the play.

Shaun, what else do you think is important for people to know right now?

Davies: I think the thing that no one wants to talk about, because it's the least important thing in the moment, is what is this going to do in terms of risk-taking behavior for banks, going forward? If the government... and I'm not talking about the Federal Reserve here. I'm talking about treasury. I'm talking about White House. I'm talking about just the general U.S. government. If they're not willing to let depositors experience pain, that's going to feed back into bank's behavior, right? To attract depositors, I could take on really risky bets, offer higher rates of return on, say, your savings account and track more money. And I know I can do that because, if my risky bets turn out to go poorly, you're going to be okay.

And so, I think that what this is doing in terms of setting the stage for moral hazard, where you have people taking on unnecessary risk or bad risks, I think this is, perhaps, really bad for financial institutions in the long run. That said, I do think the government did the right thing the other Sunday night when they, basically, fully insured the depositors at Silicon Valley Bank and Signature, because I think we would've seen massive bank runs the next morning, had they not. But I wonder if the remedy to that problem has just created bigger problems that we have no idea what they're going to be yet. And we don't know how deep this can go in the future. So, that's my concern, is the long-term effects. It may not materialize for many years and may never materialize. We don't know. But it does send a very bad message to banks that, "Hey, you can be risky. You can do things without hedging risks, and we got you."

Kramer: Thank you, Shaun. What are the implications of this for institutions where we are not sure the money would be backed by the FDIC?

Davies: I think that's a really interesting question because we live in an era of financial innovation. We have so many financial tools on our smartphone, and a lot of it are from startups. For example, you know, it's not necessarily a startup, per se, but Robinhood has opened the door to investing in stocks and crypto and options just at your fingertips. And it's very simple to open account and deposit into it. You also have cryptocurrency exchanges, like Coinbase. And so, you've got all these different entities that are holding investor dollars. And you have to wonder, you know, which accounts are you putting money into that are FDIC-insured? And which accounts are you the custodian of the assets there? Or, have you given that custodianship to someone else? So, if that firm were to fail, it would take a while to get your assets back. And so, there's a lot of complication there, because these firms also don't have all your cash on hand, necessarily. They're not necessarily piggy banks. And so, I think that we run into some potential risks with these new startups that aren't prepared in the same way that a lot of larger financial institutions are just because of history. And if I can tell you a personal anecdote —

Kramer: Absolutely.

Davies: ... of why I am concerned about this. So, on the Friday that Silicon Valley Bank failed, having been on the trading desk back in 2008 and having lived through it, I knew that weekends can be incredibly scary because you have headline risk. There can be things that happen over the weekend, and you have no ability to hedge yourself in your portfolios or do anything about it because the markets are closed. So, out of an abundance of caution, to hedge my portfolio, I bought what are called put options on Signature Bank, which at that time still existed. And so, put options pay out when the stock price falls. And so, I bought put options to hedge myself. And going to Sunday, I'm sitting around, again, notification on my phone from the Wall Street Journal that Signature Bank had been seized by the FDIC and that the bank had failed, which presumably means that the value of that stock had gone to zero and my insurance, the put contracts, were as valuable as they possibly could be. Now, I obviously was glad I had hedged. I was sad because it meant that we'd see a lot of volatility and more losses in the market, as a whole, going into Monday.

Went into Monday. And sadly, admittedly, I bought these put options on Robinhood, which I should not have done. But Robinhood is super convenient. But in hindsight, I should not have done it on Robinhood. Going to Monday, open my account. And it's marked them at the same price I paid for them on Friday, which isn't what they were worth. Let's just put it that way, because these words deepen the money as you could possibly be on these put options. And so, after several hours with customer service, both on Monday, Tuesday, and Wednesday, I was told by Robinhood that they did not have institutional ability for me to exercise those put options and receive my payout.

Kramer: Wow.

Davies: So, as you can imagine, that was quite stressful. I am not the only one that experienced this. And so, there was a massive amount of outrage, particularly, in the Twitter sphere. I also was able to speak with reporters about it and share my experience. And Robinhood caved to it on Thursday of last week, where they opened the ability to exercise your put options. That said, they used a very, sort of, archaic way of doing it. Basically, they let me what's called naked short shares. So, they basically gave me credit for having shares that I did not own and I still don't own, and then let me exercise to put options and capture my payoff.

Now, this should have then closed the trade. But unfortunately, still to this day, Tuesday, March 21st, I still hold a naked short on Signature Bank stock. And it's currently marked at $70 a share, which shows that I have a huge deficit that I owe to Robinhood. And I'm carrying that deficit until they can figure out how to close the division. So, you have situations like that where you have fintech platforms that are just not prepared for these events that we haven't seen in 15 years.

And so, I am concerned about the liquidity of Robinhood, because I know there's lots of investors right now carrying negative account balances because of how they were able to exercise the options. But we don't know. But I worry, though, they're funding that with their cash, the Robinhood's cash, and they don't have dollar for dollar with their investor deposits. And so, right now, they've encumbered a large part of their cash by the way that they facilitated the exercising of these puts.

So, I think that there's, probably, lots of other headaches. I just know about that one because I personally am involved in it. But I'm sure that these fintech platforms, whether it's FDIC insurance or whatever it might be, there's lots of headaches out there. And I think that uncertainty is very scary in the fintech startup space.

Kramer: Absolutely. Thank you for walking us through that example, Shaun.

So, every episode, we have an LBIdea or a key takeaway. And the key takeaway here is that we're looking at a risk-return situation, and it's really important to keep your eye on the long term.

Davies: There will never be a time in which all risks are hedged and everything is safe. Moments of crisis, moments of massive stock market volatility, moments of your portfolio going down in value, those should be expected. They're not fun, but they should be expected. And when we think about why stock portfolios earn money over time, more than say if you invest in bonds, it's because you earn a risk premium. And that risk premium is compensating you exactly for times like now. And so, we don't get that risk premium if we don't go through times like this. So, you can't have the sweet without the sour. And so, while it's really unfortunate to go through this, sort of, episode of this market volatility and, perhaps, market sell-offs, know that you are compensated for that in normal times by earning higher returns on your stock portfolio.

Kramer: Thank you, Shaun, so much for joining us today.

Davies: It was a pleasure being here.

Kramer: Thank you again for listening to Leeds Business Insights. Don't miss a single episode, subscribe to Leeds Business Insights wherever you get your podcasts. You can also find more information about our podcast series at leeds.ly/LBIpodcast.

If you've enjoyed this episode, you may also enjoy Creative Distillation, an entrepreneurship research podcast from the Leeds School of Business. Check it out at pod.link/creativedistillation.

Leeds Business Insights Podcast is a production of the Leeds School of Business, and it's produced by University FM. We'll see you next time.