The US Banking System Is...

The US banking system is built on the expectation that equity and bond holders accept the bank economic risk and depositors, particularly the small folks, do not. While that is not legally the structure, its important to keep in mind that's functionally how it works. Thread. (View Tweet)

Note: SVB

The system is set up that way because it is expected that financial investors in the enterprise (stock and bond holders) do the necessary diligence to quantify the bank risk and because those asset holders receive the economic benefit from the success of the bank. (View Tweet)

Depositors are not expected to do that since they are neither in a reasonable position to do that given their expertise combined with the fact that the depositors don't receive a meaningful part of the economic benefit of the bank's financial success. (View Tweet)

Think about an alternative where the expectations were for companies and individuals to do their own diligence on the creditworthiness of their bank and monitor it over time to ensure there wasn't a deterioration in the financial conditions. (View Tweet)

That would create an undue burden on every company and individual in the economic system. And one that would not create any benefit. Just as if we assumed that every individual driving on the roads needed to do their own inspection of every bridge they cross. (View Tweet)

Regulations and capital requirements are in place to limit the risk that the banks put these depositors at risk. Since the GFC the steps taken have been to further reduce the likelihood that depositors get knocked-in even in stressed scenarios. (View Tweet)

Banks have become pretty boring businesses as a function of those regulations. It's a lot harder to generate high returns on equity when capital ratios run at 15pct and there are extremely high liquid-asset ratios required. But that's all centered on protecting the depositor. (View Tweet)

Further accounting rules have significantly incentivized banks to hold a lot more treasury and agency MBS securities on their books in order to raise the share of liquid assets in the event they run into a problem. The regulatory regime makes this easier by limiting mkt-to-mkt. (View Tweet)

Any given individual case should be seen in this overall framework of how the banking system functions. Lets now consider a deposit funded, well-capitalized bank which has losses in its HTM treasury/agency portfolio. (View Tweet)

Lets start with the equity and bond holders. They should have done the diligence to know that the bank had too much rate risk, falling deposits, etc. to see that it wasn't a good economic bet. As a result they should lose money on their trade, no problem there. (View Tweet)

Equity holders could even suggest that the accounting framework pushed the bank to take more interest rate risk than desired by following the rules and that they should get relief in one way or another for it (liquidity, accounting relief, etc). But lets say they take the loss. (View Tweet)

Then look at the depositors. They invested in a top-20 bank which was meeting all the various regulatory requirements and overseen by the top bank regulatory authorities in the US. This was no corner case crypto community bank or offshore bank evading authorities. (View Tweet)

What is the costs and benefits of imposing losses on those holders of the assets? The benefit of freezing their deposits? There is no moral hazard here for those folks. Does it make sense to punish a small biz for not doing rigorous bank analysis for their deposit account? (View Tweet)

Lets just say the bank regulators were to choose to hit the depositors? Imagine what would happen if every non-FDIC insured deposit account now felt like it had to do rigorous analysis on their bank in order to feel good about it? (View Tweet)

The most likely result of that would be a big run on small banks to big banks. And for what good reason? To punish depositors at SVB? Create a systemic risk simply because the literal rules say that they could possibly impose those losses. That's a very foolish take. (View Tweet)

But that is the take perpetuated by the FUD purveyors of fintwit and the ill-informed VCs themselves that are exacerbating this crisis. (View Tweet)

It is also worth recognizing that the regulators have a stake in this as well. The failure of a top-20 bank because of something as simple as deposit decay and interest rate risk puts egg all over their face. They need to resolve it because they didnt catch it. (View Tweet)

The only reasonable solution is that the equity holders will lose their money and depositors will be made whole. If SVB is actually dead (which it may not be!) the way that will work is the FDIC/Fed will try to broker a private purchase and if not, capitalize it itself. (View Tweet)

Those regulators know full well how sensitive it is for the depositors to have access to their capital for cashflow reasons and will likely either keep it as a standalone while its being resolved (most likely) by capitalizing it or put it to a big bank (like JPM, BAC, etc). (View Tweet)

In the short term that will likely mean significant credit lines / liquidity lines to the bank. I'm sure they are already working on right now. Authorities may also be negotiating equity in the business to recapitalize it, just the way they did in the GFC. (View Tweet)

If it needs to be shuttered there is a swift, clear resolution process that the Fed/FDIC have done many times. On Friday they will announce the closing of the bank and on Monday the vast majority of deposits will be at another institution ready to be used. (View Tweet)

In the end equity holders be damned. But the depositors will be made whole because the cost of the alternative is far too high. (View Tweet)

This is a notable statement along these lines: https://t.co/RPsnMBbutL (View Tweet)