Rabbit Hole #7

“W” starts with “D”

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March 21, 2023

Rabbit Hole #7

Two-Tier Fractional Reserve Banking is a Broken Metagame

Welcome to Rabbit Hole #7. The Rabbit Hole series offers deep dives into random trading and macro topics that fascinate me. Today’s note offers philosophical thoughts on moral hazard and the current US banking crisis.

12-minute read, 2500 words

Did you ever pull an all-nighter to finish a tough assignment at school and then you walk into class totally fried at 8 a.m. that morning and the professor says: “I see a lot of people had trouble finishing this assignment! How about a 1-week extension, then.”

Have you ever been 9 years old and bet your entire Pringles can full of marbles in exchange for a Crystal Beauty Bonk, won the game of marbles, then been left empty-handed as your opponent refused to pay off the bet because he was older, larger and stronger than you?

Remember when Dallas Fed President Kaplan traded S&P futures willy nilly with impunity… And Richard Clarida went in and out of short-term securities trades days before and after major Fed announcements, quit in disgrace, then landed a 7-figure job at a private financial behemoth months later? Yet a junior analyst would be fired and banned by the Fed for doing these things.

For structured games to work, they need rules. For a financial system to work, it needs rules. For society to work, it needs rules. Those rules need to be written beforehand and they must be enforced equally for all participants. If the rules change mid-game or retroactively after the game is over to benefit the most-connected players… The integrity of the game is lost.

In the case of deposits at tech-focused banks, one might argue that the depositors should be bailed out because the $250,000 insured limit is too low. But the insured limit is the rule. If we don’t respect or enforce the rules, we ruin the game.

IndyMac depositors (mostly individuals in much worse shape than Roku or other Silicon Valley “startup” employees) lost their money. Silvergate and SVB depositors were made whole. Why? The answer is that VCs and tech billionaires have more clout than random Americans who thoughtlessly plunked their inheritance or disability settlements into checking accounts at IndyMac.

The argument in favor of ad hoc rule changes centers on the idea that the US fractional reserve banking system is a shared illusion, and we cannot allow that shared illusion to crumble or the entire financial system will collapse. There are so many banks in the US that they can’t all possibly survive every cycle. So we need to fudge the rules to keep the game going.

But when we backstop or bail out depositors, we give preference to those with lobbying power and we prevent market forces from playing out. We change the metagame going forward and distort the risk/reward calculation of future players.

Maybe the US doesn’t need 4000+ different banks? Maybe the natural equilibrium for a fractional reserve banking system is a small group of large, diversified depositary institutions? I don’t know! Maybe decentralization makes the system more fragile, not stronger. Here’s an excerpt from: “Why Canada doesn’t have bank failures like SVB”:

Between 2001 and 2023 the U.S. endured 562 bank failures according to the FDIC, plus the most recent, SVB. In Canada, that number? Zero.

The last material bank failure sparking consequential political shockwaves across the country was a century ago when the Home Bank of Canada collapsed under the weight of bad loans, mismanagement, and new bank regulations proposed by Ottawa in 1923.

Maybe the US needs 4,157 banks. Maybe not. Let the market decide.

Or, create rules and a regulatory structure that protects bank depositors from poor (or non-existent) risk management at regional banks. But don’t say after the fact that the system will collapse if we follow the rules and thus we can’t pay attention to the existing rules. That’s insane.

The common knowledge seems to be that the US fractional reserve banking system is inherently fragile and cannot withstand cyclical stress. Therefore, the rules change whenever the foundation starts to crack. Banks, investors, and depositors take excess risk in the boom times and get rescued when the Fed tightens and the chickens inevitably come home to roost. That is not a stable equilibrium.

What is moral hazard?

The term moral hazard started in the insurance business in the 1600s and describes a situation where an economic actor has an incentive to increase exposure to risk because it does not bear the full cost of that risk. It ranks up there with other important externalities that create a rift between any theoretical description of capitalism and its practice in the real world.

When costs and benefits are aligned, individuals and companies that take huge risks or act irresponsibility pay the cost of their bad decisions when something goes wrong. In a world of moral hazard and externalities, oil companies pollute and the public bears the cost of the pollution. Social media AI destabilizes mental health and foments misinformation while megatech gets the money. Procyclical speculators take risks, and society bears the cost when those risks go pear-shaped. And so on.

But the costs of moral hazard in finance have expanded well beyond the simple dollar costs of backstopping or bailouts. In fact, proponents of the 2008 rescue plans are quick to point out that many of the packages enacted at the time made a profit. This is an example of the type of argument that tends to dominate moral hazard debates before and after bailouts and backstops are enacted.

But imagine if we didn’t bail them out!

It is possible or even probable that we learned exactly the wrong lessons from the fall of Lehman and the 100-cents-on-the-dollar rescue of just about every other entity that crumpled in ’08.

Counterfactual arguments like: “What if we didn’t bail out the banks in 2008! Imagine what would have happened!” or shouts of “Fire!” in a crowded theatre like this word salad monstrosity from Bill Ackman are the way the moral hazard gets jammed through. Never mind that the people yelling “Fire” may or may not be positioned to profit from the stampede they are encouraging. Hard to say.

It’s difficult to rebut that sort of panicky end-of-the-world language because a run on a bank is scary! Even a run on a wildly mismanaged, ridiculously concentrated regional bank is scary! Anything could happen after. That’s why you can believe that a bailout is justified while also believing it creates moral hazard. The only question is whether the cure is worse than the disease. My view is the cure feels nice today but creates exponentially more harm in the future.

Each time the government changes the rules of engagement in the financial markets ex-post, it’s another link in a long chain of actions that further bolster the idea that the financial system is designed for the benefit of wealthy stakeholders and not for average voters. To be fair, this is not just an American thing.

Some have asked: “How does a full backstop of deposits create moral hazard and create greater risks in the financial system going forward?”. Or: “You can’t expect individuals to do due diligence on banks, can you?” Well, no, but you can expect them to know the FDIC limit (it’s on a sticker on every bank doorway), cap their deposits at $250,000 per institution, and use treasury management and cash sweeping to stay below that limit. It didn’t require a PhD in forensic accounting to sniff out the weirdness. From Bloomberg:

Brad Hargreaves, who has founded three companies, including General Assembly, says he considered taking a loan from Silicon Valley Bank a few years ago but found the terms too onerous. In order to take out a loan, he says he would have also had to do his banking with them as well. Part of the bank’s pitch was how they could tend to all aspects of a founder’s finances, he says. “They would not only be the corporate lender and corporate bank for your startup, they would also provide a mortgage for your house as a founder. They would be your personal wealth manager,” says Mr. Hargreaves. “They’re very highly integrated in a lot of aspects of founders’ lives.”

Next time, the Brad Hargreaves of the world (and the Rokus) will just put their money wherever they can get the best terms. Concentration and credit risk are irrelevant. The US fractional reserve banking system and the $250,000 FDIC deposit guarantee are predicated on many depositors putting money into a bank. The system is not fit for giant deposits from one industry all concentrated in a single entity. It is also not designed to backstop stablecoin deposits.

Keep in mind that Silvergate was not a regional bank in any sense that one might normally envision a US regional or community bank. It was an undiversified, single-sector global bank with gigantic hot money deposits.

Chase has an average of $37,000 per customer on deposit. That number at SIVB was $4,243,000.

Basic treasury / cash management says you don’t leave millions of dollars on deposit in a bank account that has $250,000 of protection. You sweep the money into risk-free T-bills and such, or you buy extra insurance. You don’t just hope for the best. But those that hoped for the best got the worst possible outcome in 2023 and bore a cost of exactly zero.

Now, the Fed has again backstopped the largest banks via the BTFD BTFP program and cancelled mark-to-market on collateral to stabilize the shared illusion that fractional reserve banking works. Instead of admitting that a fragmented, 4000-bank system is prone to hot money flight spurred by social-media-induced panic, another gigantic Band-Aid has been slapped on the latest wound.

When the next speculative bubble inevitably arrives during the next round of aggressive monetary easing from the Fed, depositors will flock to the creakiest bank with the loosest lending standards. They won’t think twice about depositing their entire net worth and company cash balances at that bank because they know the government has their back if anything goes wrong. If that’s how the system is meant to work, fine. Legislate it. But don’t keep changing the rules (like now) or not changing the rules (like IndyMac) depending on the scariness of the moment and the lobbying power of the constituency involved.

I am not a perfect person who follows every rule and every law and sits on a high horse looking down. If I gamble and I lose, I expect to have less money than I started with. If I drink too much, I expect to wake up with a hangover. If I speed, I expect I might get a ticket and I pay the ticket. Actions have consequences and when they do not have consequences, that’s moral hazard.

There is plenty of blame to go around for the deaths of SI, SIVB, and SBNY. For example:

  • The bank runs are a huge stain on SF Fed bank regulators as argued by these emails that dropped into my inbox one/two on Thursday (and many others).
  • They are a direct byproduct of the 2020/2021 zero rates / inflation is transitory error / fiscal mania / disruptoooor / crypto influencer / web3 bubbles.
  • They are the product of possibly-semi-intentional or self-motivated social media induced panic induced by various VCs and finance peeps who yelled “Fire!” all at once.
  • They are possibly a product of lending and deposit functions being tied or loosely tied together. Such tying is illegal in many countries and can be illegal or gray in the USA.
  • They are the product of online banking that allows instant money transfer, sans line-up. Think about this: $42 billion was withdrawn from Silvergate on its final day. If that was a normal bank back in ye olden days, that would be more than 1,000,000 depositors of average size standing in a line up. Impossible. Online banking makes bank runs too easy.
  • And of course, the deaths of SI, SIVB, and SBNY are an indirect consequence of the 2008 bailouts.

Who you blame mostly depends on your priors.

Moral hazard has been around since well before the Greenspan Put, but by changing the rules and plugging their noses to ignore banking system rule of law in response to 2008, authorities gave rise to a parallel, speculative crypto financial system. Ironically, losses from players in that new game brought SI, SIVB, and SBNY to their knees. The unintended consequence of a game with fungible rules is that some players leave and start a new game. If you want people to participate in the existing system, you must enforce the rules.

Much worse, changing the rules or fudging arbitrary and capricious interpretations to benefit wealthy shareholders and management in 2008 and wealthy depositors in 2023 (while hanging less-wealthy depositors out to dry at IndyMac in 2008) contributes to the ongoing decay of trust in institutions.

That decay is a major contributor to the lotto-ticket, “the system is rigged!” mentality that spurs everything from all-in life savings bets on Dogecoin to incel activity on 4chan to chants of “BITFD”. I am not here to say moral hazard is the root of all the evils of this world. But it is one of the roots. Moral hazard stems the immediate panic but destroys the foundation of public trust. Much as we see in other parts of current society such as with the US opioid crisis: The avoidance of short-term suffering leads to much more serious and potentially terminal suffering down the road.

Unfortunately, or fortunately, it doesn’t matter what I think. I am Grampa Simpson, yelling at clouds. Incentives rule.

Last week, Yellen said out loud what everyone already knew: The US has a two-tier banking system comprised of large, diversified systemic banks where your deposits are safe, and small, non-systemic banks where deposits are not safe. And some banks in between where decisions will be made on the fly, depending on the lobbying power of the depositors.

Sheila Bair (ex-head of the FDIC) also called out the lunacy here. Community banks are paying into the rescue fund, but they do not receive government protection.

In a world where the professor doesn’t enforce deadlines, you will procrastinate. In a world where it’s cheaper to break the law and pay the fines, companies will break the law. In a world where moral hazard is a given every time a crisis happens in the US financial system, the optimal metagame is to deposit your money in whatever large, systemically important institution gives you the best terms. No need to worry about credit or concentration risk. Your deposits are safe.

Especially if you’re rich.

Final Thoughts

I am travelling, meeting hedge funds this week, so there is probably not going to be another am/FX until Monday. New subscribers don’t fret… It’s rare that I’m off for more than a week at a time and my business travel helps me gather intelligence that makes am/FX better. Have a hazard free day.

good luck ⇅ be nimble


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