We’ve seen this movie before, so how could history be repeating itself so soon? A pair of thought leaders shares what went wrong.
The last time Shaun Davies saw a movie about bank failures, he was living it as a research analyst on a fixed-income trading desk at Smith Breeden.
“Watching what’s happening at Silicon Valley Bank right now is bringing back all those warm fuzzy feelings of 2007 and 2008,” said Davies, an associate professor of finance and research director of the Burridge Center for Finance at the Leeds School of Business. “It’s eerily reminiscent.”
Silicon Valley Bank’s failure last week, and the subsequent failure of Signature Bank, reminded Davies of his industry career, when questions were being raised about the health of Bear Stearns and its hedge funds.
“We had a lot of political figures saying the problem was contained. We had a lot of CEOs coming on the news saying everything would be OK,” he said. “Being removed from the financial crisis for nearly 15 years, we can look back and understand how everything unfolded. But in that moment, no one knew what would happen, or how bad it might get. That’s a little how I feel now.”
Sanjai Bhagat, a professor of finance at Leeds, wasn’t working at trading desk when the subprime crisis unfolded, but he did write the book on the factors that contributed to it. “Financial Crisis, Corporate Governance and Bank Capital” was featured in Harvard Business Review, among others, and the subject of discussion in the U.S. Department of Treasury and the FDIC as experts and regulators worked to head off the next crisis.
Two of Bhagat’s key recommendations were ignored by Silicon Valley Bank—tighter controls on executive compensation and requiring lenders to finance more of their banks with equity capital.
“VCs and entrepreneurs cannot be allowed to say they want the upside of greater equity without having to face the downside of debt financing.”
Professor Sanjai Bhagat
In the 2008 crisis, he said, “CEOs sold hundreds of millions of dollars of stock just prior to the crisis. We recommended restricting compensation, so that executives cannot sell stock or exercise options for six or 12 months after they leave the office.
“But we saw exactly the same behavior here, with senior executives selling significant amounts of their holdings leading up to last Thursday’s announcement. The SVB board needs to explain why there were no restrictions on the sale of those stocks.”
He also argued that 20 percent of banks’ total assets should be financed with equity capital. At 2022 year end, 5.8 percent of SVB’s assets were financed by equity capital.
‘A parade of non sequiturs’
“Banks’ arguments against having more equity capital amounts to a parade of non sequiturs—arguments that are just economic nonsense,” he said.
A major difference from the 2008 subprime mortgage crisis is that this time around, the Federal Reserve is actively fighting inflation. Davies pointed out that Fed Chairman Jerome Powell said last year that the agency would aggressively raise interest rates to curb inflation, a process that would be painful.
“It was completely coincidental,” he said.
However, he’s not surprised when finance students come up to him, as they have in the last day or so, to ask what this might mean for their futures. “I was just teaching and a student in the quantitative finance program pulled me aside and asked about whether she’d be able to get a job,” he said. “In six months, there will be so many opportunities for a quant who can model risk. Your job prospects are probably better today than last week.”
He also pointed out that new regulations for smaller and regional banks will create new employment opportunities for compliance and other experts.
“Yesterday’s actions”—guaranteeing deposits at the banks—“were probably the right ones, but the U.S. government undermined the Fed’s credibility in the inflation fight. Because at the first sign of real pain, they flinched.”
Furthermore, Davies said, if this becomes a long-term approach by the Fed, it will encourage excessive risk from banks, since they’ll have a federal safety net for their depositors, creating potential havoc in the markets going forward.
He’s also concerned about investor psychology, especially for those with accounts at regional banks, whose stock prices have taken a beating since SVB’s news came out.
“Panic can cause good banks to fail,” he said. “We don’t have much recent experience with bank runs in this country, but people are getting concerned. If you have deposits above the $250,000 FDIC threshold, you might say, ‘Well, the government will insure that, but it might be safer to pull my money out.’ That’s a real threat to those regional banks, especially the ones with a high concentration of their deposits with just a few people and companies.”
Another unknown in this particular crisis is the impact on venture investment. In a world of rising interest rates, it was always going to be that much tougher for startups to raise capital. Now, with an institutional advocate like SVB sidelined, “you may see innovation stifled as it becomes harder to get capital to entrepreneurs,” Davies said.
“Silicon Valley Bank had a very unique skillset. Maybe they can maintain that knowledge if they’re sold, but you may see that knowledge lost and dispersed among competitors,” he said. “There will be players who move into this space, but you’re not going to replicate the kind of expertise this bank had overnight.”
But, as Bhagat pointed out, the run on SVB might be part of a larger question about how high-tech, high-growth ventures should be financed.
“Financing your high-tech, high-growth company with debt is the original sin,” he said. “I understand why founders and VCs would do it—it means they don’t have to dilute their own equity ownership in the startup. But that comes with additional risks.
“VCs and entrepreneurs cannot be allowed to say they want the upside of greater equity without having to face the downside of debt financing, because now, the U.S. taxpayer is stuck holding the bill.”