The Takeaways:
- Decentralized finance (DeFi) with smart self-regulations through technologies like blockchains, smart contracts & generative pre-trained transformer GPT inside each financial institute represents the future of efficient risk management.
- We can establish interest rates markets to allow different parties with different financial profiles and different needs to trade to their desires rates based on their needs, risk levels, time lengths, credit ratings, insurability, and expected returns from fund investment.
- FDIC should raise its coverage cap above $250,000 — partly paid by depositors with an excess amount — because uninsured deposits proved riskier this time than we assumed due to the self-fulfilling prophecy.
Not All Lessons Were Born Equal from SVB
Learning the right lesson is the key for the better future. There are so many potential lessons out there and everyone can and will have a different opinion on what to learn and how to prevent future crisis of financial institutions like banks.
Part of reason is that the case itself is very complicated, making it possible to have many things to say. If someone fell down from his bike, there is one or at most two lessons to learn: Either the road is too slippery or the rider was not focused. But when a bank with billions of dollars of asset fell, having only one or two lessons sounds like a failure in learning. It has to be more involved in it.
Not all lessons were born equal. For one thing, we must focus on risk management more than rescue scheme. The best that a rescue scheme can do is to arrive at a “no-loss + loss” result, while the best of risk management is to achieve a “win + win” for all parties.
Another relevant point is mindset more than demographics. For example, a lesson that I have heard many talking about is to attract a diverse pool of clients and avoiding over-exposure to any single sector, single industry or single type of clients. This is always true and always makes sense. However, I do believe we can do things without for an ideal client base. After all, having a special type of clients is not always a bad thing. For one thing, they allow us to develop the best resources for serving a unique group of people, rather than serving everybody. Imagine such a boring landscape picture, in which all banks have the same customers. I would rather see a more diversified picture in which banks are proud of their unique clients.
It’s an open secret that regional banks always face a bigger challenge in attracting diversified clients than national banks. The way the former compete with the latter is not in size and types of clients but in doing one or two things better than the latter.
Ultimately, the key is not about client type but always about risk management. A good risk management strategy starts with, and grow on, the existing clients, not betting on changing them.
With SVB clients, we can learn to (1) know the existing clients well, especially their demand liquidity; (2) do periodical stress tests and (3) possessing bond funds and/or bond ETF. All these can be done without waiting for a safer diverse client base to come by.
A Deeper & Bigger Lesson
If there is one forward looking lesson out of all lessons, if we must say something fundamentally important, it is this: Stop trusting central human regulators and switch tech enabled decentralized smart regulations, where the word “tech” refers not only to FinTech but all the new technologies in and out of financial world.
We can start from the recent report on Fed’s San Francisco branch that missed the red flag of SVB. More generally, the time of central bank intervention determines everything. Regulators need to allow a time cushion following a quick turn of monetary policy. For example, banks with maturity mismatch should have access to funds to keep liquidity and to avoid “fire sale” of their portfolio with huge losses.
But it is always easier said than done with the current system. We have witnessed the modern bank run this time but there is no guarantee that it will not happen again. Humans are not always smart learners and we do have a tendency of repeating the same mistakes over time. In my last post, I highlighted two lessons from SVB: interest risk and liquidity risk. We have been talking about them since day one in financial world, and yet we are still struggling with them decades later.
How do we truly make progress in financial risk management from now on for the future?
The first thing I want to say is this: Although one of the direct casualties this time was the Signature Bank with strong crypto link, the message that carried by the dead messenger is more relevant than ever: The future lies in decentralized and proactive “smart regulations” that assist each bank, including those led by “zombie leaders” like in the case of SVB whose only strength is to guard self-interest but little else (尸位素餐), to constantly monitor current and future risks.
“Smart” More Than “Decentralized” Regulations
The name “decentralized” may sound exclusive rather than inclusive. In my mind “smart regulations” will reserve a big seat for central banks instead of eliminating them. The SVB case tells us that sometimes only words and resources possessed by central authorities would work, and does so dramatically.
Here is another example from the insurance industry. According to this commentary of AM Best, the largest credit rating agency in the world for the insurance industry, that had the U.S. government not stepped in to make all depositors whole, underwriters of directors and officers insurance for startups and venture capitalists, as well as the financial institution insureds supporting such entities, could have faced financial distress given that they are operating on very thin capital.
This is because “’startups are by nature much more agile and less risk-averse than other companies, their directors and officers often make decisions quickly,’ said David Blades, associate director, industry research and analytics, AM Best. ‘Therefore, the potential for D&O claims for startups would have been high in the case government had decided not to help the depositors.’”
There will be lawsuits for sure no matter what. According to this report of AP, “A class action lawsuit is being filed against the parent company of Silicon Valley Bank, its CEO and its chief financial officer, saying that company didn’t disclose the risks that future interest rate increases would have on its business.”
“It is looking for unspecified damages to be awarded to those who invested in SVB between June 16, 2021 and March 10, 2023.
“In particular, the lawsuit said that annual reports for 2020 through 2022, “understated the risks posed to the company by not disclosing that likely interest rate hikes, as outlined by the Fed, had the potential to cause irrevocable damage to the company,” the lawsuit stated.”
“It also claims that the company “failed to disclose that, if its investments were negatively affected by rising interest rates, it was particularly susceptible to a bank run.”
With the above being said, let’s go back to remedies and we can do two big things toward smart regulation.
Decentralized, Flexible FDIC Caps
We have already seen solutions include raising FDIC insurance coverage cap above the current $250,000 line. Lawmakers all seem to be open on this idea, with the focus on how much the new cap should be.
This is a good idea because we have learned this time that non-FDIC insured deposits can post a big risk. It directly triggered the bank run of SVB, and explains why the share price for the First Republic Bank has been down by 70%. Uninsured deposits prove riskier this time than we assumed due to the self-fulfilling prophecy.
However, unlike the old cap of $250k, this time we probably do not want to have a fixed, nationwide new cap of FDIC coverage. Instead, we want FDIC’s new coverage cap determined through a negotiation process by individuals, and to be paid partly by depositors with an excess amount, sort of like copayments in the healthcare business. This way, depositors will share the responsibility and will be given personalized choices in determining how much risk they want to take.
The range of caps can go from 100% to 0% theoretically, and it’s up to the depositors to decide. Those who choose 0% extra coverage can always take advantage of the existing cap of $250k by having multiple accounts across financial institutions for excessive amount of money, not leaving all eggs in a single basket.
Depositors can either spread fund across banks or using Certificate of Deposit Account Registry Service CDARS, opening a cash management account, relying on MaxSafe by Wintrust or finally using Depositors Insurance Fund (DIF).
Either way, each depositor will sign a legally binding contract with FDIC and the bank where they deposit their money, stating that they fully understand the risk and in case of bankruptcy, only the amount they have purchased will be covered by the program.
Establishing National and Regional Interest Rates Markets
This is a bigger deal and of course will be subject to discussions and debates. But the basic idea is simple and interest rate swaps already exist and are an important component of the fixed-income market according to a Smartasset.com article. We just need to expand it to make market interest rate floating rather than fixed and to allow variation
The first thing about interest rate swap is that they are financial derivatives traded over the counter, where investors will typically exchange a fixed-interest payment for a floating-rate interest payment, which is known as vanilla swaps. Investors use these contracts to hedge or to manage their risk exposure.
But we do more than vanilla swaps, including allowing parties with different needs and profiles to trade directly among themselves.
The basic driver of an interest rate market or markets is different needs and different financial profiles of different parties. On the profile side, entities with low credit rating are willing to offer higher interest rates to attract buyers of their products, while the opposite holds true for the high credit rating entities.
The other profiling factor is time of economy. During a booming economy, parties don’t mind paying a higher interest rate because their returns from the fund are expected to be higher. On the other hand, when a future project does not have big expected return the owner of the project is only willing to pay lower rated fund. To the extent that a region is growing fast, many investment projects can expect high return, which push up a higher interest rate in that region.
At the end, we just need to calculate the average bidding interest rate in a region to come up with a region specific & time specific interest rate as the “going rate” for all.
On the need side, some entities are willing to pay a higher interest rate when getting funds quickly matters more than higher interest rates. Other entities do not have any urgent need for fund and will only pay low rated funds. The average of the ongoing highest price a fund buyer (the bid price) is willing to pay will be the “going bidding rate” of interest. The average of the ongoing lowest price fund sellers (the ask price) are willing to accept will be the “going asking rate” of interest. The average of the going bidding interest and going asking interest will be the market going interest rate.
The idea is to replace the single nationwide interest rate set by central banks to a diversified and decentralized, market determined interest rates, in which central banks can still set basic rates but anything beyond is subject to market forces.
