From Balance Sheets to Bank Failures: The Reality of Banking Stability

>> Amit Seru: Welcome, everyone, to the Summer Policy Boot Camp. I'm guessing you're all gung ho. Keep it going for the next four days. That's what I asked. So, as Josh mentioned, I'm a senior fellow here at the Hoover institution, and I'm talking to you about Silicon Valley bank and the banking turmoil that just happened.

In case you missed it, that's my plan to remind you that this actually happened. And while I talk about it, what I thought would be useful is to connect it with some of the banking regulations that have happened in the United States over the last two decades, pretty much.

And are there any new lessons that emerge from this, or is this the same story that we have seen before? So what you see here is bank failures in the US banking system and generally periods of peace and tranquility. But there are periods when failures spike. You see, the previous spike happened around the financial crisis, The Great Recession, 2007, 2008, bunch of small failures.

The size of the bubble is how big the banks were that failed. And then some large ones, like Washington Mutual, you might have heard of that. And then fast forward, not much happening, and then you see Silicon Valley bank right there in the corner. So what I want to do is, as I sort of speak, I'm go try to do this in 25, 30 minutes and then open it up for Q&A.

Because I'm guessing that some of you at least will get intrigued and have questions, and others probably already have questions. So I'm gonna talk about four things, and I'll tell you what my answers are by the time we are done. So what happened to Silicon Valley Bank and other banks?

Was Silicon Valley Bank an outlier? Because that's the kind of rhetoric you see still coming from the Administration and the Federal Reserve Board and the other regulators. So we'll talk a little bit about that. What about Regulators and Regulation? Like I said, US has had a lot of regulation in the banking space for various reasons.

We can get into that. And we have had thousands and thousand pages of regulation, thousands of people, personnel, regulators, actually implementing this. So what about all of that? And finally, what do we do in the short run and in the long run? And I'll have some views on that, okay?

So that's the plan. So let's get going. So what happened in Silicon Valley bank? That's gonna be the first topic. So some of you, I was looking at your backgrounds and are pretty familiar with finance and banking, and others not so much. So what I think would be useful is just to quickly give you a story of what happened in Silicon Valley bank.

And then I'll try to put some more color as I talk about the entire banking system, because something pretty similar was happening across 4,800 banks in the US banking system. That's how many banks we have. So this story will talk about what's a bank. So if you don't know, don't worry, we'll talk about that.

What's going to be very critical around Silicon Valley bank's failure is the whole notion of time management. So what is it about time? And we'll talk about that, and then we'll talk about what blew up such that this thing blew as we saw a few months ago. All right, so what's a bank?

Very simple. It takes in money. Hopefully, all of you understand that, there is deposits, which is we put in some money, there are retail deposits like we do. And then there are larger deposits, like some commercial deposits from corporates, from venture capitalists, from companies and so on. And this is very close to what Silicon Valley Bank's balance sheet look like.

On the liability side, you should think about this in billions of dollars. So a huge chunk of money in the bank comes in form of deposits. This is like debt. You've got to pay it back. And then there is some equity, which is shareholders equity, that does the rest.

This money goes in and the bank puts it to work. What's on the asset side? Well, a typical bank may have a composition which looks like this. So what's going on? There is some cash. You invest a little bit of the money in bonds and securities, like government bonds, treasuries, mortgage backed securities, and then you make some loans.

So that's what a bank is. And as a reminder, this is called capital sometimes if you're in banking, you already know it. But this is gonna be pretty important as we go ahead because I'll refer to this again and again. So this is equity capital and something that folks talk about quite a bit, you'll see why.

So, okay, so that's the bank. So how does it sort of, kind of make money here? Well, the idea is that on the asset side, when we put the money to work, we get some return. It's not gonna be very risky, hopefully not like a venture capitalist. So you don't expect huge amount of returns, but reasonable returns.

So let's say you earn 2% on the asset side on average. And what about, where is this money coming from? Well, the money is coming from deposits and there are shareholders equity as well. But when you borrow it from depositors well, a bunch of retail depositors probably get nothing.

That's what we were getting. And then as the deposits become larger, commercial deposits and so on, you probably pay a little bit more. So let's say you pay 1%. Why am I telling you this? Because that's the spread. And this is the business model that if you look at, you make 2% on 200 billion and you have to pay 1% on 185 billion, and that's the return that you get.

Return on equity is you divide it by how much equity capital you have. So you get, like 14% return on equity. This is what everybody talks about as the key lever that the bank is trying to optimize. Now, where can this go wrong? Well, one is think about The Great Recession, the financial crisis of 2007, and 2008.

What happened there was, well, we didn't really earn 2%, why? Because we made loans and we invested, and these investments and loans were way riskier than we thought they were. So we ended up not making 2%. So that's one way in which this whole model can go kaput.

That's not what happened in the recent time. So let's see what happened. The other way in which this model breaks down is what we are gonna be spending some time about. So what is that? So then it gets into the notion of time management, because bank is supposed to do time management.

What do I have in mind here? Well, if you think about liabilities, there is this notion of duration. How much time is this money gonna be tied in inside the bank versus how much time is this money gonna be locked in in our investments and loans that we make?

So we capture this through the notion of duration. Those who have taken finance back in the day might remember this idea. So deposits are considered short term because they are available on demand, as you all know. So the duration is pretty small. So let's say 0.2 years. What about the asset side?

Well, the asset side, the story is a bit different, and you can look at duration of different types of assets. So cash has no duration, but if you think about loans and some mortgage backed securities, they might be tied in, locked in for three, four, five years, right?

So that's the time management, why? Because there is basically a duration mismatch here. The money is tied in long run for long term, and the money that is owed is short term. So how do you manage this? That's the trick. You can earn that spread, you can earn that return on equity, but you've gotta do this time management.

Now, what's the key to this time management is when is the deposit coming in and where do I employ the deposit, and how do I manage this?