485 Canaries in the Banking Coal Mine 

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We’re recording this in real-time on Friday, March 10th, just after 9 a.m., right after the FDIC issued a press release announcing that Silicon Valley Bank had been closed by the state regulators in California and that they have appointed the FDIC as receiver to oversee the liquidation of the bank. Just two days ago, the big news was the shutdown of Silvergate Bank, also in California, a specialist in serving various corners of crypto-related businesses. Who knows what the big story will be by the time you’re hearing this, but I could hardly have two better guests to help us make sense of this perilous new phase of the industry.

Kia Haslett, managing editor at Bank Director, joins me along with John Maxfield, who’s the former editor-in-chief at Bank Director, currently a senior banking analyst for Motley Fool, in principle at Maxfield on Banks, where he’s written extensively on the history of banking and bank failures. Kia, maybe just start off, like, what actually happened over the last 24 hours here at Silicon Valley Bank? Yeah, where to start? Silicon Valley has faced some operating pressure based on who their customer base is and the problem their customers are having, but really what kind of set this off is that earlier this week they announced a balance sheet restructuring ahead of their quarterly earnings announcement. The balance sheet restructuring included selling 95% of their available-for-sale securities at a $1.8 billion loss, as well as a large $2 billion capital raise that they had some commitments for.

These two actions taken together did not signal confidence or strength in Silicon Valley, but they are very big decisions that banks have to make when they realize their balance sheet is breaking under the current operating conditions. Obviously, it seems that they were not able to buy themselves enough time to change, you know, to, you know, deposits left the bank faster than they could restructure the balance sheet. The shares sold off.

It does seem like some venture capitalists recommended to their clients that are companies that they withdraw, and we just had a good old-fashioned deposit run, and the FDIC and the DFI of California have decided to step in to kind of stop the run and to finally buy this bank the time now to unwind. Yeah, you know, when Silicon Valley Bank first announced capital changes, I noted you, among others, commented that, look, I don’t know all the details here, but this seems like responsible, prudent moves, and, you know, maybe they’re just the first and the bravest to, you know, go out and do it, but this probably has some implications on lots of other banks, and not because of anything to do with technology or crypto, but just years of zero interest rate policy and how people have been chasing yields with, you know, duration risk in their portfolios. Yeah, I mean, what I said on Tuesday almost doesn’t matter anymore, or Wednesday, but I don’t think, you know, Silicon Valley, they were trying to get rid of 20 billion, 21 billion dollars in AFS securities that was only going to pay them 180 basis points for the next 40 months.

That is not enough money, and that is way too long of a time, and so to do that, they were going to have to sell them, you know, as rates rise, bond yields fall, and so they were going to have to take this giant loss all at once. Now, in hindsight, it was too late, that this sale might have been a good move. It was just way too close to the end of their story, but many banks are carrying these very large unrealized gains, and they are in a position currently where they don’t have to tap that securities portfolio to raise money because they have adequate liquidity.

The reason why Silicon Valley had to do it is because they had pressure, you know, they had these deposit outflows, and they needed to raise funds, and so this interest rate risk management, coupled with liquidity management is a situation that a lot of banks are in because they have reached for duration for the last three years in this low interest rate environment, and you know, for a while, low loan growth environment. Many banks decided to lock up their excess deposits in loans that are not paying, or sorry, in bonds that are not paying very much today, and they have very little incentive to sell them even though, you know, they might have rising need for cash. John, you are a longtime follower and watcher of banks and interest rates and balance sheets.

I mean, what do you, in the big picture, what’s this look like in terms of a trend of how we got to where we are, and where do you think this goes from here? So, one of the things that you will notice if you study like the whole story of banking, in the history of banking, and you go through the data, you will notice that the principal thing that drives changes, that drives the direction of banking, that drives trends in banking, is an abundance of liquidity, and when I say an abundance of liquidity, like you can think about that on a system-wide level. And so, on a system-wide level, we’ve really gone through three or four different eras in banking, if you really do use a correct periodization of the industry, and all of those eras were dictated by huge insurges or outflows of liquidity, I call novel liquidity flows. So, there’s not money sloshing around within the system, there’s money coming into or out of the system from externally, and that’s the story of banking, that’s the way to understand the story of banking.

Well, you can look at it on an institutional level as well, and let me give you an example. When Andrew Jackson got rid of the, vetoed the recharter of the Second Bank of the United States, which would have been rechartered in 1836, what he did is he took the money that was in that bank, and he distributed it to the state banks, they called them pet banks, and they put all this money into them in the form of deposits. Well, almost all of those banks, either within a couple years, failed or came really, really close to failure, because they’re sitting on all that liquidity.

And so, you think about banking, you think like, well, isn’t that great to have all those deposits? Well, the reality is that there can be too much of a good thing, because when you have all these deposits sitting on your balance sheet, you got to do something with them. And typically, that forces you to reduce your credit metrics, and to widen up who you’re gonna loan money to, to ease up on the policies. Well, even a step more basic than that, if you’re not in or around the banking industry, you don’t realize that the deposits that you own, which are your asset, those are liabilities for a bank.

So, having a lot of deposits is a lot of liabilities. So, go ahead, John. And so, the overarching, like, we can learn, but we don’t know a lot right now, okay? Like, we all have to, things are gonna change in an hour, things are gonna change in two hours, but we can step back and make some general, you know, kind of observations.

And one of those general observations is that abundance in banking begets failure. It’s very unusual. Abundance, the main constraint in any other industry, any other business, is scarcity.

Scarcity of demand, scarcity of supply, scarcity of labor. In banking, it’s abundance. Abundance is a primary constraint in banking.

And so, we have this situation here, where yet, over the past, since the pandemics began, you had, I think, they had an increase in deposits of, like, something like $100 billion. It was a huge amount of increase in deposits. And they took all those and put them in long-dated, long-dated bonds.

Now, we can, you can, you know, money, money, quarterback that all day, every day, but these are sophisticated people. That was an incredibly good bank. But it was, it was caused by this notion of abundance.

Yeah, that’s not a bad decision that, that they made with, right, right, like, relative to the other options they had in 2020, 2021, right? Well, now, now we can say, but at the time, that was reasonable. It felt reasonable. That’s debatable.

Because you can look at other banks, you look at what Renee Jones did at M&T, he was really good and really prudent about how he managed, but he didn’t have the $100 billion inflow. But the bigger issue here is not all this other stuff. The bigger issue is that only 5% of that bank’s deposits are insured.

That’s it. 5%, your typical bank in that, in that size group, 60%, or 55, 56% of their deposits are insured. You have 5% insured here.

So that means that they’re sitting on 100, and I don’t know, $70 billion in uninsured deposits. And so they’re going to lock those things up. Now they’re going to release a little bit next week.

But like, all those VC companies, I mean, you’re talking like, all the VC companies in America, aren’t going to have access to the funds to pay payroll, potentially on Monday. So it’s an issue. I mean, there’s not a fundamental credit quality problem with the bank.

No. Could be. That we know of.

Well, think about this, though. Who are their customers? Who are their depositors? Oh, their depositors are their customers, yeah. Are their loan customers? So we have this, we don’t know, this is an unusual situation.

It could create credit problems for them. I feel like the FDIC can work out, hey, you have a loan, but you also have a lot of deposits. Well, you know, given how we’ve exercised forbearance in the banking industry in the last three years, and the fact that TDRs don’t exist anymore, hopefully the FDIC can work out both sides of the column.

You know what I think, Seth? No, your faith is misplaced. Why? Why is your faith misplaced, John? Your faith is misplaced. You go back to, there have been nine major banking crises in the United States.

1819, 1837, 1857, 1873, the Civil War, 1873, 1893, the Great Depression, the 1980s, which was a trio of crises, and then the financial crisis. Through eight of those crises, what you’ll see is you’ll see a double bump of the spikes in bank failures. Double bump, double bump, double bump, double bump, all the way through to the financial crisis.

Every single crisis, there’s a double bump of failures. It’s like, what is the double bump? What the double bump is, it’s the initial response by the industry, the failure because of the deleveraging, but the second bump is caused by the regulatory response. The only one that didn’t have this shape was the financial crisis.

To say, well, why did the financial crisis not have that shape? Well, because the Fed was run by a guy who was an expert on the Great Depression. He just said, let’s just throw everything at this problem that we have. We’ll even throw more at it.

These are tools, we’ll just make up some new tools and throw those tools at it too. I’m not anti-regulator, but the facts over the past 200 years of banking would give no one any reason to be optimistic about how they would handle this. Well, certainly the blame game is already starting.

The banks are blaming the regulators and the Fed and fiscal policy and monetary policy. There’s a blame game starting blaming the VCs and particularly around advising companies to pull out when there was concentration here. We do wonder, is there concentration risk that we haven’t thought about or talked about here before? Before we get into that, let me back up.

The reason I made the comment I did, John, is where I was heading is from where I’m sitting right now, this appears to be acute, but not necessarily chronic in the case of Silicon Valley Bank. I assume someone will swoop in once the dust settles. There are many viable banking operations under that label today that will be under somebody else’s logo soon.

That’s my assumption. Do you buy that? 100%. Yes, that is one of the preeminent banking franchises in the United States.

Again, this is all Monday morning quarterbacking. It’s so easy for us to look back on and say, this is a mistake made. We would have made maybe worse mistakes.

When they came out and they said, look, we’re not going to sell any of our securities. A couple weeks later, they said, no, not only are we going to sell some, we’re going to sell $21.8 billion worth of securities, take a $1.8 billion loss, our biggest loss on record, but then we’re going to do this at the same time that we’re raising $2 billion in capital. As soon as that capital raise failed, which was this morning, I talked to people who were dealing with Goldman Sachs on that capital raise last night.

Goldman Sachs was saying, well, what price are you going to give us? They were basically just begging people to be like, we’ll take anything. The prevalent feeling as recently as last night was, this doesn’t look so great, but they’re raising capital and they’re good for it. There’s going to be plenty of people that are going to jump in with capital.

What, 12 hours later, we now officially have a first bank failure of 2023. When you need capital, that’s when you can’t get it. You know that.

You were at US Bank. What years were you at US Bank, JP? 92 through 2012. Just so the listeners understand the significance of that, JP was at the bank that emerged from the financial crisis with the highest credit rating in the entire banking industry, even higher than JP Morgan Chase.

Remarkable bank, remarkable story how that was managed, that crisis by Richard Davis. Yes, near triple A rating. Yes, you had a good experience, yeah.

Well, I mean, that leads us to a whole other conversation around, there was a true flight to quality at that time. US Bank and a handful of others really benefited well for that. Like many other phrases around this, and I suppose other industries, they get misused.

I’ve heard people in the last 5, 10 years talk about flight to quality, meaning, hey, we’re a good bank, so people want to bank with us. And that’s not really what that means. And I think we’re going to find out, again, what it really means as people are looking to, you know, here’s another phrase we haven’t heard in a really long time.

Fortress balance sheet. But I think we’re going to hear it a lot coming really soon. But JP, if you were to look at Silicon Valley’s balance sheet, you’d be like, that’s a fortress balance sheet, you know what I mean? 47% loan to deposits.

I mean, I think a lot of people wanted to bank that type of client in that economy, in that geography, you know, they had a lot of things going for low cost deposits, really big balances. It will be, you know, it’ll be interesting to see how like what percentage of the uninsured depositors get their funds back through the asset sale. Because, you know, it is interesting to see these two, you know, two bank failures or closures tied to liquidity and not assets.

It is. It’s kind of interesting. I know it’s probably happened throughout the history of banking, but we didn’t see that very much during the great financial crisis.

So it is. And then we also didn’t see the just the role that interest rates are playing and wrecking havoc on these. You think that banks are higher interest rates are good for banks, but it at least in these two banks, it was devastating.

Well, especially if your balance sheet isn’t asset sensitive. Or you realize what had happened was the rate of increase has just been unreal. And they went underwater so fast.

If you’re looking at the FDIC is quarterly banking profile, you get the slight margin and then billions of unrealized losses. Well, I talk to bankers every day and we had been hearing pretty loud. And Jason just wrote about this in our blog when he was at Aoba, the bank director event that he was joking, you know, many years, a long time ago in a galaxy far, far away.

Oh, no, that was just a few weeks ago. There really wasn’t a lot of discussion around liquidity or needing deposits. In fact, it was the other way around.

Right. We have lots of cash and liquidity and we need to increase our loans to make up on that. Well, John, you started on this, but let’s take us back a little bit.

You’ve done a tremendous amount of research on what do bank failures look like? What are the causes of them? And, you know, what does this look like where we are today and what can we expect broad based? Again, we’re not projecting on any individual institution, but, you know, as the saying goes, history doesn’t always repeat itself, but it does often rhyme. Indeed, it does. So we only have one historical precedent for what’s going on right now.

And that is the early 1980s. And so you mean SNL crisis and related spillovers? Yeah. In 1973, in 1973, you have the Yom Kippur War.

In response to that, the OPEC puts an oil embargo on the United States. That causes oil prices to jack up. That causes inflation to jack up.

That causes Carter bring Volcker into the Federal Reserve. Carter or Volcker then jacks up interest rates. That turns the yield curves upside down, which is basically what we’re dealing with right now, because he jacks up the fed funds rate to 18 percent at its max in 1980.

I think and this is when savings and loans were, they were the only thing they could hold on their balance sheet was 30, basically 30 or fixed rate mortgages. So they were yielding 8 percent in their assets, paying 18 percent on their posits, get this huge, huge mismatch. Okay.

I’m not real good at math, but that’s probably not a good business model. Yeah. He can burn through a lot of capital.

Okay. Real quick in that situation. And so, but what’s interesting about that period is that there were very, very few failures as a consequence of mismatch.

And now we don’t know if that was because of mismatch, we can only last in nature will only last for a very short period of time. And we don’t know that because we’ve only seen it once before. So it could be totally different.

We just have no sense for that. But we didn’t see very many mismatch failures back then. But the ones we did see were, I’ll give you two of them.

First, First Pennsy is what they called it. First Pennsylvania Bank. Remember that one by run by a guy named John, oh man, what was that guy’s name? He was a real personality.

I can’t remember his name, but I don’t remember him, but I know what you’re talking about. So in the 1960s, as the interest rates were climbing at the late 1960s, First Pennsy, so this like makes the main bank in Pennsylvania at the time. And it was like a darling.

Everybody was like, oh my God, they’re so amazing. They’re growing so fast. They’re doing all these innovative things.

And so it bet that interest rates weren’t going to, they weren’t going to continue climbing. And they’ve made this bet like 68 and 69. Right? Well, I mean, in the 70s, interest rates just shot way up.

And so I think they only had a 22% or something like that of their asset portfolio in long-term government bonds, but that was enough to kill them. So that took them down in a kind of similar situation to this one, although like Silicon Valley Bank is like legions further along in terms of the quantity of securities on their portfolio. And then there was a similar one around the same time, the Bank of the Commonwealth that did the same thing that First Pennsy did, but it did it with munis.

And so it failed for the same reason. But so we know that. So if you just base it off that one experience, you’d say there’s probably not going to be a lot of mismatch failures, but we don’t know.

But based on the one precedent we have, probably not going to be a lot of mismatch. The bigger issue is that you have a situation where these banks lose a bunch of money. They’re sitting on these losses in their securities portfolios, and they want to make up for those losses doing other stuff.

So they chase for yield in other areas. So that’s what we had in the savings in the S&L crisis. So then what do they all do? The policymakers give them the ability to then go out and do stuff like make commercial real estate loans, buy junk bonds, all these crazy things.

So they want to make up for that loss profitability. So it’s the ricochet effect. They go out and buy all these crazy stuff, put on their balance sheet, but then you have a second wave of failures that was even much, much larger than the mismatch failure.

So the concern is that if you’re a bank and you’re listening to this, I assume your listeners are bankers, one of the things you learn from history of banking is that in times like this, it’s better to do less than it is to do more. Much better to do less than it is to do more. There was a hearing at the House Financial Services Committee, and I think it was 1984 or something like that, where they brought in six or seven of the CEOs of savings and loans that performed really well through the 80s.

So they went through this whole hearing. And at the end of it, it was basically like, well, what did you guys do that other people didn’t do? And they said, we just kept doing what we were doing. So that’s really kind of the lesson in this situation.

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To learn more about the program, submit your resume for a candidacy review at stern.nyu.edu.msft-breakingbanks. Well, what are some of the other causes? So let’s keep going. I think this kind of builds on itself, right? So then you get into the go-go late eighties, early nineties and merger mania, where what rules the day is operating leverage. And so we’re all running the same business model.

If I can run it a little bit more efficiently and cut the cost, then I can acquire the next one. So where’s it take us as we come out of that, right? That all dies down around, we had another little blip in the early nineties, right? Ninety one or so, right? Yeah. Okay.

So I’m sorry. I forgot that the rest of that question. So we can talk about the world.

So there’s about 10 reasons that banks fail. Yeah. Okay.

And this is really interesting actually, because there have been about 17,000 failures in the United States that I’ve been able to aggregate since kind of the beginning. Okay. There’s probably 24, 25, if you really had all the pure data.

So you think 10 reasons they failed, so I think 20,000 failures. That means that for every bank that fails today, there’s at least 22,000 that failed for the same reason before in the past. And yet we don’t learn from the past, which is an interesting, there’s a longer discussion, but there’s reasons for that.

But if you go through the whole universe of bank failures, what you’ll find is that the majority of them, or the plurality of them, at least, are commercial real estate related. Commercial real estate, it’s a very sharp up and down curve. So you get a lot of those.

I mean, this goes back, the very first failures in this country happened in 1809. They were related to a project in Boston. A guy named Andrew Dexter decides, hey, it’s the top of the cycle.

What am I going to do? I’m going to build a building, the tallest building in Boston. This is the story of all cycles. He goes, he gets control of five banks.

They all lend him this money. He builds a building up, the cycle turns down. He can’t lease it up.

They default on loans. Those five banks all go. It’s just from the beginning of time.

So commercial real estate is the main thing. After that, you’ll have trading errors that will cause, like Franklin National, you probably remember Franklin National when it failed in 74, I think it was. It had made a bunch of directional bets on foreign exchange rates.

So it failed. So you’ll have directional bets on interest rates, like Burst-Penzey did. You’ll have situations like, do you remember the Windstar cases at all? Vaguely.

So Windstar cases are fascinating because in that situation, you had this S&L crisis, you had all these savings and loans that were in trouble. And the big ones couldn’t, the FSLIC could not come in and take them over without just going completely broke. So they said, listen to what we’ll do for you.

You all can merge together. And any type of goodwill that came about as a result of that merger, you can count that as regulatory capital. So they’re doing that.

All these- Because that’s super easy to liquidate when you need to. Super, yeah, yeah, yeah. You can sell that on the street any day, right? But then in 1989, the Congress passed a new piece of legislation that said that doesn’t count.

So all of those they just dropped like that. So you have that situation where the government gets in. You have situations where, this is a really interesting one.

So in the lead up to the civil war, when you had found it, you and I want to found a bank, you, me, and Kia want to found a bank. So we have to raise $20 million to found that bank. Kia’s got a million, you’ve got a million, and I’ve got like $5.

So we got like $2 million between the three of us. We need to raise 18 million more. How are we going to raise that? We’re going to borrow it.

Who are we going to borrow it from? We’re going to borrow from the bank that we’re about to create. We’re going to bootstrap this baby up. I like that.

Isn’t that great? That’s a good one. Someone should bring that method back. I totally in on that.

The free banking era, that’s what they did. That’s how all the banks were founded. And so you go and say like, well, so what, and what you do is you arbitrage the dividend on that stock against the interest payment that you’re paying to the bank.

And so what does that lead you to do? It leads you to chase for yield, to jack up the yield, to jack up the dividend relative to your interest payment. So what do they do? Well, they go and they chase for yield. And what do you chase? What do you buy in the 1850s to chase for yield? What do you think you buy in the 1850s to chase for yield? Farmland? Well, I was going to guess either- Do I buy stock in gun manufacturers? What is for sale in a… Do I buy covered wagons? What? Gold or- Mercantilism? Yeah.

Yeah. Government bonds. Human bodies.

You can buy humans in the… Sorry. That’s sadly true. So sorry.

So JP, you’re right. So government bonds, but what kind of government bonds? State government bonds, but not just any state government bonds. Confederate state government bonds.

That was fine and dandy until Fort Sumter. Literally like 95% of the banks in Illinois failed in the immediate way before Sumter, because then all those southern bonds just tanked. So you have that situation.

We have bets on government bonds that fail for different reasons. I mean, you can go through, there’s a catalog up there, but that really covers the main ones. And then you have, I guess the other, the last main category is you’ll have a freeze, you’ll have the lend to securitize model, and then a freezing in the securities market.

That’s what brought down IndyMac. That’s what brought down Countrywide. That’s what brought down, really, that’s what brought down WAMU as well.

So those are kind of the main categories. Yeah. So what’s notably absent from that list is digital banking, or being innovative, or non-banking, non-credit fee income.

I just find it ironic that the banks who have been slow movers on innovating and adopting new things always do so under the guise of, because we’re conservative, and we don’t believe in taking risk. And yet, the risk that brings down huge companies, and sometimes huge swaths of the industry, are really the basics of being a bank. Managing the balance sheet, managing the relationship between assets and liabilities, and the pricing of each of those, and the yield and duration.

And at the end of the day, you’ve got some fraud cases, yeah, some boom and bust cycles like you noted in commercial real estate, but at the end of the day, it’s really about managing the balance sheet. And that’s part we’re supposed to be good at as bankers. So there’s a little bit of an undercurrent now of kind of blaming crypto.

And let’s take a step back. And earlier in the week, just two, three whole days ago, the big news was that Silvergate Bank was going to shut down, much smaller. Silicon Valley Bank, $209 billion bank.

Silvergate, about a $1.1 billion bank. But they went in hard as a specialist for being bankers to those involved in crypto in various ways, and providing liquidity to that. So what do you know about the Silvergate situation? And what, if anything, does that have to do with Silicon Valley and some of the broader issues we’ve been talking about? Well, like Silicon Valley, Silvergate picked a very specific and distinct customer line group to service.

And they really structured their entire bank around that. And I think a year ago, you’d look at that and say, that’s a pretty safe looking bank. You’ve got lots of deposits, and you’ve got very little long-term assets.

So you’ve hopefully figured out your duration mismatch or your duration matching. But I think what we learned truly about Silvergate was that they had a very volatile deposit base. The niche industry, crypto is very volatile.

And for reasons that had nothing to do with Silvergate’s own safety and soundness, crypto had big concerns. Silvergate had overexposure to one entity that ended up filing for bankruptcy. And then we discover that Silvergate also has a concentration in their securities portfolio that is five to 10 years, and 10 years or longer.

So you can talk about all of the risks they didn’t take to keep their balance sheet very liquid. But it turns out that they also have just too much duration risk. And so something that I see as very common between Silicon Valley and Silvergate is that they have this monoline business where they have overly concentrated.

And in banking, we normally see that on the asset side. But it was just so interesting to see what it looks like when you focus on one industry or one set of customers, and they all need their money at once. And so we ended up having another deposit run.

I will also say that Silvergate managed to buy themselves some time by taking out a federal home loan bank line of credit or funding line. That was paid back after the end of the fourth quarter. And it looks like that was maybe potentially the straw that broke the camel’s back.

It seems like that was the reason why they had to file their non-timely 10Q disclosure or K disclosure. And then that seems to be what set off their final deposit run was the fact that they had lost that wholesale funding that was probably propping the bank up or helping assuage a lot of their borrowers that they could cash them out. And I do want to say that I give all props to Silvergate that it seems like they made many of their depositors whole in this before they decided to liquidate from just public reports.

And that can’t be said of most crypto companies that when they have entered bankruptcy, it looks like Silvergate was able to facilitate the full payment of those accounts. And so I think that that’s just such an interesting thing about banks is that, you know, just trying to get people their money and, you know, have trust in the banking industry. And they’re shutting down voluntarily, right? Yeah, it’s a voluntary liquidation.

Voluntary. John’s doing air quotes. So quasi-voluntary.

Well, we know that the FDIC does not count it as a failure given what the language that appeared in the SVB press release. So for, you know, the sheet was clean for about two more days, and then we had our first failure. So there’s liquidity, and then there’s liquidity, right? There’s real liquidity right now, cash.

And you both have hit this a couple of different times from a couple of different angles. But let’s just be crystal clear about this. Deposits are the lifeblood of banking.

It’s really one of the core definitions of what is a bank, right? We’re able to gather low or no cost deposits. And in order to have a banking license, that means we make some explicit and implicit promises that those will be available to the depositors when they want those money back. Of course, we operate on a fractional reserve system.

And so it can be fragile in times like this. But part of this risk comes from then instead of holding that in short term, you want to make money on the difference. That’s the other big part of the definition of being a bank is we gather the deposits, but then we lend it back out or buy securities with it, something to generate a yield higher than what we’ve paid out.

And when we have to reach out into longer durations, that means that money actually isn’t so liquid, right? If I need to give it to you today, I don’t have it. Yeah, it was so interesting to think about Silvergate, again, Monday morning quarterbacking, but that if you have all of these deposits coming in and you actually have a pretty decent fee and income, the choice to, where do you put those deposits and for how long? And why 10 years? Because I was remarking the treasury will sell you a one month bond. And I think that that’s really what we tried, what Silicon Valley tried to do is really emphasize that they were going to get out of these longer term bonds and get really liquid really and get really short.

And so I don’t know, a lot of banks with these unrealized losses, they just have to wait for those bonds to mature so they can reinvest it because they don’t want to recognize the proceeds. But if you picked four years ago, a five-year bond instead of a one-month bond or a one-year bond, that’s a choice you’re living with today. Yeah.

So I guess the big question is how much of a canary in the coal mine is this, right? And without naming any names or looking, but just thinking about the industry and the way, right, these are not unusual choices that a couple of rogue banks made, right? These are kind of the very difficult challenges that treasurers are making at every bank across this industry, right? So what do we think the fallout looks like? And by the time you listen to this, you’ll find out if we’re anywhere close to accurate. Let me answer a different question before I answer that one. And you kind of alluded to this earlier, JP.

There’s a sense that banks are non-innovative and the banks that don’t innovate, they fall behind and they’re at more risk of failure. When you actually go through the data and you go through the history, what you find is the exact opposite. What you find is that not only is there not a first-mover advantage, there’s a first-mover disadvantage almost universally across the board.

I mean, I could go through stories of different banks at different time periods. The first bank that decided, oh, we’re going to be open 24 hours a day. It wasn’t around for very long.

There was this innovative idea, right? First Union, remember First Union’s future bank initiative, FBI, where they go in, they’re going to put all this technology in their branches and then you don’t have to deal with their tellers. People hated it. It took a huge hit.

CEO had to leave. There was a bank in Ohio that when ATMs first came out, it said, this is the future, we’re going in heavy on these. So they put all this money throughout their branches, but it was the first iteration of ATMs.

The first iteration of ATMs used punch cards. Well, it wasn’t like six months before the magnetic strip came out. And so what’s interesting is that in banking, the job of a bank is to keep people’s money safe.

That’s what the job, the job of the bank is not to innovate. The job of a bank is to keep people’s money safe and to serve as a lubricant for credit in the economy in the United States. I mean, it’s like, that’s their job.

Their job is not to be fancy. Their job is not to wear vests that say Patagonia and have some sort of logo on it. Like that’s not their job.

And so, you know, when you hear these, I talked to really good bankers. That’s kind of the people that I deal with. And I talked to some FinTech people and you go around to these FinTech people and they’re like, oh, these bankers, they don’t know what they’re doing.

They’re so non-innovative and stuff like that. And I’m like, well, that’s interesting because we’ll tell you, you know, the average bank in the United States is 102 years old. The oldest bank in the United States was founded by Alexander Hamilton.

Like they’ve seen quite a bit of change. And they say, well, tell me about you. Like tell me about your company.

You know, you guys must be like, have been around for a long time, right? Like, well, no, we’ve been around for 18 months. We’re like, well, did you make a profit? You know? Well, no, we don’t really make a profit. They’re like, well, what do you know about innovation? You don’t know anything about innovation.

They’re just like tinkering around with Legos. They have no clue. Banks have made it through the cycles.

You know what I mean? And so like, I think it’s in there. But one of the big challenges though, John, is how many of those do we need? How many does the system need, right? If you’re all the same and you’re just, you know, maintaining a bread and butter balance sheet, how many of those do we need as an economy? Okay. So this is getting good.

And so this question right here, you’re going to get some like, this is good. Okay. Well, we said this wasn’t a hot takes episode, but maybe we should have had some wings.

That’s Jason. This is an audio medium, John. Yeah.

He’s getting up for a prop. Oh, nevermind. That’s all right.

Go ahead. Well, I’ve got video on. Well, we may show this clip.

John’s showing a giant poster. He pulled up his white, he pulled up a cork board. There’s a lot of strings, red strings on it.

Yes, John, we can see it. You’re a little far from your mics now though, your audio. Yeah, but that’s okay.

I can see it and I’ll talk through it. So it’s a giant poster size canvas John has created. He’s also been dabbling in art.

Yeah. Graphic design and art. And it’s a chart, a line chart of all of the eras that he was kind of highlighting.

So yes. All right, John, we see it. What that chart shows, it’s the population of banks.

It’s the population of banks in the United States going all the way back to 1790. And what you see is that it looks like if you’ve been to Florence… Oh, sorry. Yeah.

I missed it. Oh, yeah. There’s a lot more banks.

That was the big takeaway. That’s number of banks. Sorry.

Go ahead. That’s the population of banks in the United States. And so if you go to like Florence, like just to paint the picture of what this chart looks like in people’s heads, there’s the Duomo in Florence, that big cathedral that overlooks Florence.

It’s got a big dome and then it’s got a flat back and then like a little thing at the end that goes up a little bit and comes down. So… You have that on your Twitter, don’t you? We’ll share it. Yeah.

I have that on Twitter. All right. We’ll share it.

Okay. So like what you see, there’s this huge, huge bump. Okay.

Huge bump. And you know what that bump is? It starts in the 1870s. This huge increase in number of banks.

And then they drop down in the Great Depression, 1920s, plateaus. And then there’s a consolidation cycle starting in the mid-1980s. But that whole bump is the consequence of the birth of disposable income.

Okay. In the 1880s, the average person had $4 on deposit in an account. Now, there’s been a lot of inflation, but it’s still only $27 today.

Okay. There was no disposable income. With the birth of disposable income, all this cash flooded into the United States in particular.

And so the banks were like, oh my God, we got to go arbitrage that. So all these banks founded them. So it got formed.

So it shoots way up. We have the Great Depression. They come down.

Then you have this long period of time called the Great Moderation. Then it comes back up again after the energy crisis a little bit. And it dies back down after the changes were made that allowed merger and acquisitions amongst banks, like interstate banking and branch banking.

Right. But where we are still coming from is that like, we are still coming down from the boost in disposable income, from the birth of disposable income. Now, how far do we go? How far would we go back to like, I think there are a couple, a thousand banks before it all started? Don’t know.

But what that would be a function of is, in my opinion, consolidation in agriculture. So you look at the map of the banks in the United States, where are they? They’re in Iowa. They’re in Illinois.

They’re in Missouri. They’re in Minnesota. Like they’re in the farm states.

And why are they in the farm states? Well, you go out to a farm and you want to make a loan to a farmer. What do you have to know? Does the farmer drink and drive? Does the farmer work hard? Does the farmer take care of his equipment? Does he have good water rights? How long do the water rights last? Are there indentations on his property where you can’t just take it on a per acre basis because the water will collect there and like lower the yield? Does he really have 500 heads? Or is he moving around the same 30? Does he have a kid that helps out and that’s going to be good and that’s going to take over for the farm? Like you have to know all of these really bespoke things. So as long as we have a lot of little farmers in this country, we’re going to have a lot of little banks.

Now, how many? We don’t know, but there will be thousands of them. But then if you go, but if agriculture consolidates down on those little farms and they spread the risk there, that’s when banking in the United States could go down to like 15 banks, 20 banks, 30 banks. But consolidation of both farming and banking has been undeniably happening over the last several decades.

I joined the industry in the late 1980s. We had over 13,000 banks. We have less than 5,000 today.

I’ve been kind of wondering what the catalyst is for the next big push for that. This might be it. Well, I mean, JP, we talked a couple of months ago about M&A and why there’s so little M&A right now.

And going back to, again, this albatross of the bond book on banks is really making it difficult to get deals worked out. Your question about what banks should actually be doing right now today, I think drawing on some of John’s previous remarks, do less, it sounds like doing less is probably a good idea right now, hunkering down, I think staying as liquid as possible. Jannie published a report today, and I’ve written about it a little bit.

Capital is useful. Certainly, if you think you might need it in three months, maybe raise it now. Don’t wait till you need it.

And then there’s a couple of capital ratios that are used currently. And regulators tend to use a ratio that doesn’t include unrealized losses in the ratio. But there is a ratio called tangible common equity that is calculable.

It’s a common ratio. It’s just not the one that regulators seem to use. And that one does actually- But it’s the one investors tend to use.

Yeah. So it exists. It’s one you need to know.

And that’s the one that includes unrealized gains and losses. And so there are, I believe now, more than 500 banks in the industry that have a tangible common equity ratio. That is below 5%, which for many banks could put them in the adequately capitalized or less than well capitalized category.

Those banks will probably need to have conversations. It’s not dire, but they are in a position where they will have to probably maybe game out some potential choices and maybe do some liquidity or interest rate stress testing. I think one thing that we know is that the Federal Reserve is not taking their foot off the gas.

For interest rate increases. And so any losses in your bond portfolio, they might increase. And that probably should be modeled.

It seems now wildly optimistic to think that there will be an interest rate decrease in 2023. Maybe it’ll just stop rising, but I don’t think it’s going down. And so those banks that are in that position where they have low tangible common equity, but right now their regulators aren’t concerned.

Now’s the time to probably shore up liquidity and then stop taking duration. Or maybe start buying some of those 12-month bonds that are paying 5% to make up for some of these, to hide some of these losses. So I think that that’s probably what banks should have conversations around.

And then kind of long-term, right? This is a long-term game, right? Maybe focus a little bit less on the idea of innovation at the moment and focus more on those fundamentals that fail banks. Well, in times of crisis are often times of great opportunity. And so I know that there are some banks already reaching out publicly and personally to some of the VCs and the tech funds and the entrepreneurs and saying, move your banking here from one of those other institutions that’s maybe not doing so well.

I think there is opportunity there. I also think the big opportunity and one we’ve been focused on for quite a while now is helping banks to understand what kinds of non-rate features and benefits and products can you add to really help make, first of all, make your customers’ lives better. But secondly, create sticky relationships.

How do you get out of the rat race of just the spreadsheet of yields and net interest margin? And it’s what other kinds of things can you offer to your customers that are relevant to them that allows you to play to the strengths of being a bank, which is about having a strong balance sheet and the liquidity. So I think there’s going to be lots of opportunities there, both for banks and for fintechs. I think there’s a bigger conversation that probably needs to be had around, how do we know how quote-unquote sticky these deposits are? Rate is probably not as useful of an indicator in this current event.

Maybe it is. But at these two banks, at least they had very, very low-cost deposits, and they were still apparently a little bit more volatile and risky. And there needed to probably be some more diversification in the deposit base earlier.

And so I think as technology is bringing in different types of deposits into banks, as banks try to service different types of customers in different ways, they probably need to game out the situations under which those deposits will leave, how they will leave, how fast they leave. I think that as more faster payments, so FedNow and the RTP and Zelle and all these different ways that money can leave banks, not just through checks, not just through loan payments, banks probably need to incorporate maybe a faster rate of their deposit flight than they have in the past. And then also figuring out how they will replace those funds.

I’ve been covering some of the changes that the Fed has made in their discount window to make it more competitive to the FHLB to reduce some of the stigma. around borrowing from that window. And maybe that’s something banks need to be exploring too, because I think there might be some changes coming to the FHLB, given that they are currently in some listening sessions around their 90th anniversary.

You bring up some good points about speed. It really does cut both ways. And it’s a wonderful life with people clamoring around the teller window, looking for cash.

The money does move in fast and moves out fast as we’re seeing. All right, John, I’ll give you the last word here. Any wrap up thoughts before we close out today? Yeah, two thoughts.

I’ve been texting back and forth with a bunch of my banker friends. Rude. Did they lose access to all their money? No, no, no, no.

These are people who run banks. I was going to say, it must be nice to have more than $250,000 in a bank account. Yeah, yeah.

These are people who run banks. And so in times like this, the issue in times like this is a loss of confidence. The whole banking industry is predicated on this confidence in our system and in our institutions.

And when things go crazy, people lose that confidence, and wacky things start happening. And right now, these guys are seeing things that they’ve never seen before. These guys have all ran banks through the financial crisis.

So it’s interesting, but it’s important to appreciate that we have a very, very stable banking industry structure in the United States. The FDIC, the federal government, backs it up. We have a distribution of all these banks across the country, little banks, big banks.

I mean, it creates a very, very stable system. So there’s going to be news probably, it looks like, coming out relatively soon and throughout the day that it’s pretty. I mean, I’m getting these texts from these guys.

These guys have been running banks for decades, and they’re like, this is crazy. But the thing about it is that if your money’s in a bank, just chill out, you’re probably going to be insured. You don’t want to add to the panic.

You want to kind of dissipate it if you can. So that’s what I would say. Yeah, it’s kind of the opposite of irrational exuberance, right? It’s irrational despair right now, which will even out over time.

Well, thank you both for being with us today, especially on somewhat short notice. I appreciate both of your insights and expertise. Yeah, and I’m eternally grateful to the FDIC who put out that press release before recording.

Yeah, it’s almost like they knew. But also, if you’ve ever worked in bank reporting, you know that every single newsroom tonight was gearing up for a 7 p.m. press release and a pizza party, probably, because it was about to be a late night and that shifted at 1045 this morning, central time. So, you know, everyone enjoy their Fridays, I guess.

Well, today I discovered that there is a Twitter account called, I think it’s Bank Failure Fridays or something like that. And it’s been pretty quiet, Bank Fail Friday. It’s been so quiet for 32 months, I think.

It’s been quite quiet. And guess what? They’ve got news again. Hey, JP, real quick.

Let me put a plug in for, I’m rolling out a newsletter next week. And it’s going to be, like, predicated upon 15 months worth of research, which I’ve written nothing about. This is brand new stuff, fresh stuff.

It’s excellent. It’ll be excellent. Check it out at Maxfield on Banks.

Check out my Twitter handle, Maxfield on Banks. I’ll talk about it there. All right, we’ll put a link in the show.

If we’re promoting stuff, Bank Directory’s second quarter issue is about to come up, where we also talk about, take the long game on deposits. So it sounds like we’ll have some signups to do. We’ll do that.

Then you have to talk about your podcast with Alex. What about your podcast with Alex? Oh, well, I think, I mean, you know, Alex and I record a podcast once a month about FinTech and bank news. We recorded the podcast episode that comes out last week, several weeks ago.

So there will be, so everything was fine and a little bit more boring in banks. But certainly check that out. That’s FinTech Takes.

Bank Directory produces a podcast, The Slant. We produce a newsletter. And then, of course, our quarterly magazine is coming out pretty soon, next month.

So in addition to Breaking Banks, definitely follow Kia Hazlitt, John Maxwell. Thanks to you both. Well, thank you so much, JP.

That’s it for another week of the world’s number one FinTech podcast and radio show, Breaking Banks. This episode was produced by a US-based production team, including producer Lisbeth Severins, audio engineer Kevin Hirsham, with social media support from Carlo Navarro and Sylvie Johnson. If you like this episode, don’t forget to tweet it out or post it on your favorite social media.

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