Stewart Hotston

Hope, Anger and Writing



2/2 The slow motion banking crisis of 2023

Silicon Valley Bank, a regional American bank with a focus on funding venture capitalists and tech start ups.

It took the cash it had to keep as its buffer and invested it in US Government Treasury securities. USTs as they’re known are considered the single goldest of the gold standard of global investments. Absolutely guaranteed to return your money to you when they mature because they’re backed by the US Government.

You would be forgiven for thinking ‘what happened then?’

To understand what went wrong and what’s still going wrong, I need to explain how these instruments work, at least in part.

USTs are tradeable, there’s always someone who wants to buy/sell them. That means they’re what we call liquid instruments. In other words they are considered very much like cash but just in a formalised format that can be shifted between different people (imagine a glorified £10 note being passed around a pub).

Now, different USTs pay the holder a different amount because, they are after all, debt issued by the US Government and you, as the holder, as the lender. As such they US Government pays you an interest rate. That interest rate can vary. Now, assume I have two USTs, one paying 1% and the other paying 5%. The latter is clearly more valuable to me as I earn more from owning it. So I will also pay more to obtain it. This means that the 1% UST is worth less.

On the day the UST was issued it was worth exactly what it said on the front. In other words I could by a £10 note for £10. Think of it like a rare comic or action figure. On the day it’s made I can buy it from the store for the list price but by the time I get it home the resale value has changed. The comic, if kept in good condition might be worth more than the list price. Or, if they print loads more, it might suddenly become worth less (same if I tear the front cover).

All financial investors know the instruments they invest in have values which can change. Most hedge against these changes so they are not exposed to violent changes in value. Why? Well, imagine if I invested in 100bn of these instruments, paying 100bn for them on day 1 only to discover a few weeks later than their value had changed and they were worth just 50bn…that’s a loss of 50bn and, worse still, it’s other people’s money I’ve lost, money which they want back.

All of a sudden I might not have enough money to pay what is owed and, as we all know, when that happens, we go bust.

Now there’s loads of ways of managing this and it’s absolutely a normal part of running an investment book, not least a bank.

Except SVB did none of these things. It behaved like it could never lose money. Except it did and now it doesn’t exist.

The last bit happened because people got wind of what was happening and, worried about SVB not being able to pay its bills, they asked for their money. And when they did that, other people saw them doing that and did the same because if they didn’t they might end up being the ones left owed money by the bank after all the money it did have had been given to others. In other words, there was a run on the bank as all the people with savings there asked for their cash back at the same time.

So much, so It’s A Wonderful Life.

Except I’ve mentioned the cause here and moved on. Let’s circle back.

Why did those USTs change in value so much?

Because the US Federal Reserve raised interest rates. As soon as they did, all new USTs issued by the US Government would be paying that new rate (roughly) meaning that any which were issued before which paid less, were suddenly worth MUCH less. Holders of that older debt were (and are) facing significant losses in the moment. Sure, if they keep them to maturity they get paid every penny and there isn’t a loss. But SVB couldn’t hold on until maturity because people wanted their money back now.

In other words you could say that through a combination of SVBs incompetence and the Red’s raising of interest rates, the US Government bankrupted its own bank. (Regulations are in place to stop this but they weren’t enforced with this bank (and many hundreds of others and guess what, when not policed properly the banks played to the rules they did have to follow not to what prudential risk management required).

There are currently 4200 regional banks in the US. A very large proportion of them are facing something similar.

But it gets worse for us all.

Central Banks around the world have been responding to inflation by raising rates. They have done this despite knowing it’s the wrong economic thing to do because politically they have not choice. They’ve been given one hammer and hence their problems all look like nails.

Those rates rising mean that government securities across the globe are now paying more interest.

2 years ago they were paying nothing. If i invested in an office block in central london it was probably paying me 4%, an amazon warehouse might be paying me 3%, a prime hotel in the west end of London or elite Paris…2%. All these assets are illiquid – that is they can’t just be exchanged between people and their value is contingent not on rock solid governments but on tenants and performance and even the age and location of the building.

Which would you rather own? That’s right – government debt. And that’s now paying 5% in the US and more than 4% in the UK. So why on earth would you own any other asset that relative to government debt is riskier, less liquid and much lumpier. Again, that’s right – you wouldn’t.

In order for those assets to attract your attention they’d need to pay, say 10%. Now if I have an asset paying me 2m a year and that yield is 2% of its value, that implies it’s worth 100m (sorry for the arithmetic here). Now, suddenly I have to pay people 10%. I haven’t got more money coming from my shop or office’s tenants. I still only have 2m a year. So if 2m is suddenly 10% of the asset’s value, not 2%….that implies the value is now worth just 20m. In other words it’s lost 80m of value.

You could dismiss this as paper value. You would be dead wrong. Because the bank who gave me a 60m loan to buy that office is suddenly looking at the value of my asset and panicking that they could face losses of 40m if I sell it – because if I only get 20m back and I owe them 60m – hopefully you see the problem here.

I’ve used real property as an example but this is true for ALL financial instruments.

I’ve been calling 2023 the year of valuation resets. I mean that this is the year that rising interest rates reset the value of all the assets in the economy. And those values are ALL going down. In some cases by a little but there is evidence that commercial property values have fallen by 30% both here and in the US. This is a HUGE problem for investors and their banks.

And for us. Because when a bank faces losses it stops lending. When it stops lending everything grinds to a halt. When companies can’t borrow they can’t expand, they can’t grow and, more often than not, they struggle to continue making a profit.

Inflation is making us all poorer but it’s worse than that. By raising interest rates, Central Banks have created the risk of a slow spiral into a crisis where banks cannot/will not lend.

This isn’t obstinacy by the banks but a desire to protect themselves from further losses. And the secondary issue here is that this drives fear through the markets as people start to look very carefully at banks who maybe haven’t performed well historically and who might be exposed more broadly than others to these assets changing in value so rapidly and by such large amounts. First SVB, then Credit Suisse, today Deutsche Bank. None of these banks are really connected in a financial plumbing sense – they are distinct entities. Yet they are connected in that they are poor performers in a market where Central Banks are deliberately engineering a banking crunch.

I’ve written at length about why raising rates is the worst tool to use when inflation is supply side. I won’t cover those arguments again here.

However, the question remains, where do we go from here.

I refer you back to the point that there are 4200 regional banks in the US. The market probably can’t sustain that. What if they reduce to just 1000? That’s a loss of 3200 banks. Imagining the impact of that on the economy is beyond anyone no matter how smart.

The UK banking system and Europe’s too to a large extent, does not face these laxities in regulation nor the fractured market landscape. We consolidated our banking system after 2008 where the number of building societies dropped from more than 100 to less than 20. Europe did largely the same (although France and Germany in particular are likely to experience more pressure for consolidation).

That means that we may well not see the same issues here in the UK (or in Europe) that are likely to unfold in the US. Except. What happens in the US market is absolutely going to infect us.

I’m going to finish with some questions and answers.

  1. Do you need to move your money? No. The UK government’s deposit scheme and our overall banking regulation is pretty solid. I’m happy that there aren’t any UK banks at risk
  2. Is it possible this is all a storm in a teacup? Yes. Of course. Yet Bear Stearns collapsed in March 2008 and it was 6 months before Lehman Brothers fell apart. So just because a few days goes by without a disaster don’t assume it’s all over…I currently believe we have much more road to run before we emerge from this.
  3. What can I do? Nothing. Well, don’t take your investment advice from reddit.
  4. What should I do? All this may well mean nothing to you because, fucking hell, energy prices and food prices and a lack of a wage increase mean the very idea of savings is nonsense. I get it. However. if you have cash? Find high quality places to put it. And perhaps think about looking at how you might support banks who have super strong ESG credentials. I say strongly that this is NOT investment advice! It’s just my personal moral opinion.
  5. Will interest rates keep going up. Very unlikely.
  6. Will interest rates come down. I’m afraid that’s equally unlikely. The era of ultra low interest rates is over (for now – who knows if this turns from a slow grind of a crisis into something worse).
  7. Is all this the result of people gambling in the financial markets? No. it is perhaps the absolute opposite – financial institutions have done what was required to be prudent and, in a shock move, Central Banks using the only tool they have to tackle something that isn’t a nail, have created a situation in which everyone is facing incoming pain.

What is clear to me is that, smart as they are, the complexity of the financial system and its response to rapidly rising interest rates has been missed almost entirely by those responsible for raising those rates. Why? Because they were focused on what classical economics says the economy would do if interest rates rose and never, for a moment, thought about how bank balance sheets would respond. Was this incompetence? I would err on the side of it being an area that no one saw coming but for pity’s sake we need to update economics degrees as a matter of urgency from their ideological capture by people whose theories were discredited by reality 20 years ago (I’m looking at you Friedman and Hayek and all your inglorious acolytes).

In other words I finish as I started – regulators legislate based on the last crisis and 2008 was about badly performing banks and an economy glutted on easy credit. 2023 is about a cash rich economy discovering all the things they’ve invested in are suddenly worth much less than yesterday. We didn’t legislate for this because it seemed inconceivable to us that fighting inflation would precipitate a banking crisis after we spend 15 years shoring up those same banks.

1/2 How a bank works

There’s no real start to any story except to look back as far as you can go but no one has time for that. I could start talking about the post WWII economic settlement, the war in Vietnam and how that precipitated the collapse of the gold standard to pay for itself and then I might talk about everything which came after that – not that there’s cause and effect so much as these things made other stuff possible that wouldn’t have been otherwise. For instance, without Nixon there’s no oil shock in the 70s. Without that there’s probably no Thatcher and Reagan in the way they were. You could also talk about the rise of microprocessors and their impact on the financial markets and how, without them, modern finance doesn’t exist.

Truth is we have to start somewhere and this (long) post is, hopefully, going to explain a little of what’s going on, why I’m pretty pessimistic about the next few months (in a strictly personal capacity!) and what we can and can’t know about what’s to come.

There’s a truism in financial circles that regulators legislate for the last crisis and its from this cliché that we find the seeds of what is going to be a slow motion swirling car crash of a crisis.

I promised to keep this lay-person friendly so I won’t put references and I’ll try not to use high-fallutin language that is common in the circles in which I move.

So to start. What is a bank? There are lots of answers to this question but at its simplest, a bank is a place where we socialise money. Ok, so I’ve utterly failed already. What I mean by this is a bank is a place where lots of people come together, in trust, to put their money. They don’t just put their money there for shits and giggles (see Matt, swear words). We also want these collections of money to be used for our benefit.

What that means in practice is that a bank acts as a social hub where I can borrow against my future wealth today. I need to pay that money back but the risk I take is that I can take money today and turn it into more tomorrow so that when I repay the amount I have borrowed, I still have some left. When lots of us do this, the money going into a bank also flows out, from you to me and vice versa. This is what I mean by the socialisation of money. A bank is what we call an intermediary – it matches up those who have money to store with those who need sources of money to spend/invest.

So far, so simple.

However, when I put actual money into a bank I don’t want to leave it there forever. The actual amount of time people leave savings is, actually, far shorter than the length of time they want to borrow it. i.e. on the whole we want to wait as long as possible before repaying our debts but we want free access to the actual money we do have. This is entirely reasonable and rationale.

But it presents a bank with a problem. If the money your using as loans for other people might need to be returned to depositors before borrowers have repaid it you have something we call a maturity mismatch. Think of it like this. My sister gives me a tenner for a week. I give that tenner to my mate, Adrian, who says that he’ll use it to by a rare pokemon but it won’t be delivered to him for a month. But when it arrives he’ll sell it for £12, give me my £10 back and keep the £2 profit for himself.

On a one to one basis you can see this doesn’t work as my sister’s going to take back her money before I get repaid by my mate, Adrian. I end up out of pocket.

I also run the risk that Adrian doesn’t give me my money back…I have a risk of not being repaid.

I’m not going to get into how we price for the risk of not getting paid back nor into how I might persuade my sister to leave her money with me for longer by offering to give her a few pence each day if she does. Suffice to say there are lots of mechanisms in place to help make sure I get my money back from Adrian and to help encourage my sister to leave her money with me

These are all designed to close the maturity mismatch.

Now. Banks work because there are LOTS of people wanting to put their money somewhere. Some of them are you and me, others are companies. But none of us want our money back at the same time. We all have different periods over which we’ll leave our money, which means that, on average, the bank can lend it out without worrying that all the money it’s been given will be asked for on the same day.

I’m hoping all that makes sense so far. Please feel free to comment where it gets bewildering.

So. The next bit is that based on the fact that it’s really very rare for any group of people to all want their money back at the same time, a bank is permitted under nearly every law there is, to lend more money than it has been given. In fact, it’s weirder than this. Banks are permitted to lend money as long as they keen an amount available that would meet two possible risks.

The first is that they should have enough cash on hand to be able to absorb losses arising from people not repaying their loans. The second is they have to have enough to be able to pay depositors their cash back if they do want it. The amount they hold is sized to absorb both the above under stressed situations – when things have gone wrong and lots of losses are happening and more people than average want their money back.

You’ve got to remember that if I kept all the money you gave me witout lending it out anywhere, that’s not a bank, it’s a safe. You’ve also got to remember that if that sounds good, then you will also have to live without your credit card, mortgage, student loans, pension, insurance, healthcare, roads, computers, movies etc. etc. etc. This act of being a financial intermediary is critical for a modern way of life (whatever other criticisms you might have).

For the conspiracy fiends out there. No one designed it this way. What happened was there have been lots of attempts to make money socialised across the centuries and most of them have failed (for honest as well as nefarious reason). What people have done is learn from those failures and try to make the next attempt more robust. This is what we call emergent behaviour and although it can feel spooky it’s really just the fact that when lots of people come together communities and organisations emerge naturally from them being in close proximity to one another over time.

The current global regulations, put into place in the wake of the GFC are extremely complex but when boiled down to their simplest, suggest that banks must keep c.12% of their money in a form that can be readily returned to depositors should the need arise. (The banker in me is crying at just how actually wrong that is but it’s close enough for this post).

If I have a bank with 1 trillion dollars of cash, that means I have 120bn of cash in my buffer. I cannot just leave that cash there because what with inflation, a pound tomorrow is literally worth less than a pound today. So I need to put it work.

Silicon Valley Bank did just that and we’ll get to why it was a disaster in the next post.

Back to front

There’s a lot of discussion about algorithms at the moment. Algorithms are nothing more than recipes. If people say ‘algorithm’ they normally mean the recipe for whatever they’re talking about. A mathematical algorithm for finding a solution? Think the recipe for finding the solution.

Why do I care about algorithms and whether we should really call them recipes (the analogy isn’t perfect, don’t @me, I’m quite aware)? Mainly because the discussion about algorithms in the public sphere relates almost exclusively to social media and how these processing recipes lead users to ever more extreme and unpleasant content.

I’ve been quite concerned with this book over the last few days. Reminded as I was by a lecture by the author in which they said something I had entirely missed in my general thinking about the kind of content we’re shown online. I am almost embarrassed to admit it as well – because I like to think I ruminate on economics quite a lot.

As a reminder, the book is called: The Age of Surveillance Capitalism: The Fight for a Human Future at the New Frontier of Power and is written by Shoshana Zuboff. Zuboff has written a lot about this subject but this book is (despite the cover being uninspiring) a very good piece of work.

I don’t want to talk too much about the book except I want to draw out one key idea because it should turn your world upside down a bit.

First though. We have been told all over the place by tech-bros, concerned citizens (I’m in this category), opinion piece writers and others that the algorithms which we look at blaming for the slow radicalisation of people as bland and formerly innocent as our grandmothers, our friends and our children are i) in need of fixing and ii) often beyond understandding.

We’re told that these algorithms are often the product of unconscious bias (such as when facial recognition software didn’t recognise PoC as human or when Google associated PoC with gorillas in image search software). We’re told it’s a side effect but one which makes them money and so they’re loathe to change their ways. We’re told it’s the tail wagging the dog – unfortunate but fixable.

Zuboff dismisses this idea and reminds us these companies have made their fortunes by learning about us. So far so not surprising. Yet Zuboff then reminds the economically literate among us what that learning is good for. It’s not good for knowing what we did in the past because we can’t make money from that. Nor is it good for knowing what we’re doing now – again, I can make money on what you’re interested in NOW but it’s not the prize. The real prize from this learning is to know what you’re trending towards tomorrow – because then I can make real money from knowing your future tastes and preferences.

Zuboff then reminds us about the point of advertising – not simply to let us know a product is available, but to create a felt need we didn’t know we had and then sell us the solution for that sudden new found desire.

In short, these algorithms are designed to do two things.

  1. They’re designed to predict what we’ll want to buy tomorrow
  2. They’re designed to push us into buying products we don’t know we needed today.

Algorithmic drift into showing you more extremist material such as racist content, anti-vax nonsense, anti-elite conspiracies serve the two goals above. Why? Because these drifts don’t exist in a vacuum – social media companies (and let’s be honest, we’re only really talking Google and FB in liberal societies) are selling these predictions to companies – telling them they can guarantee purchases and eyeballs on adverts. Deliberate drift to extreme material is proven to guarantee both of those things.

Furthermore, there is an argument which goes like this: SM companies could see extremist material was both attractive to many people and a direction society was moving in, in part because of their exposure via SM companies’ activities, and they had a choice:

i) do they change their business model to avoid these excesses, or

ii) do they lean into extremism knowing their activity will appreciably shift society that way and thereby increase their revenue

Zuboff, among others, suggest only the second of those two options can be true without regulation.

So in the discussion around free speech this week (and possibly next?) you’ll see lots of back and forth over whether private companies have the right yadda yadda yadda. What you won’t see (yet) is much on whether these companies deliberately created these environments exactly with the intent of fostering extreme content to increase revenues.

My proposition is this: the tail never wagged the dog. The algorithms we’ve seen were designed explicitly to monetise user data by predicting their behaviour and nudging them towards it in order to create opportunities for companies they were pitching their services to. This has always been the dog wagging its tail.

Over the next few months as regulation becomes a more central concern of liberal governments (with the possible exception of the current far right UK conservative government) one key plank of companies’ defence will be it wasn’t their fault – they were, at worst, as surprised as us by the outcomes. Do not believe them. This isn’t about free speech – that is a distraction – and a different argument. This is about whether companies with our personal lives stored on their servers should be required to treat that data not as if it’s their never ending gold mine but as if it’s something to which privacy and political standards around propaganda and manipulation should be applied.

The financial impact of Covid 19

I’ve just read and watched the unprecedented statement from the British Chancellor of the Exchequer. Shortly after him, within a matter of hours or days the US Congress will come to a similar place – with their own twist on it of course.

Someone asked me just what this money is. Where does it come from and what is it really – a loan, a repo or something else, maybe money printing.
The answer is, qualitatively the same for all people putting in place fiscal stimulus right now.

It’s based on several things but probably the best analogue are the warbonds which had no maturity but would be called at the appropriate time (the last of which weren’t called until last decade). It is unprecedented. It’s also impossible to foresee the long term consequences of this. I’m sure people are thinking about them. Ironically perhaps – this is how you get inflation because supply side is going to become more and more strained the longer borders are closed and people can’t work. Prices can and will go up because of that – not because we’ve got more money. However, this will clearly be offset by people not actually having money. It’s a hugely risky strategy – but clearly the risks of doing nothing will be worse. Rishi Sunak has just promised to cover 80% of salary up to 2500 per month indefinitely. This is astonishing and tremendously welcome but tells you just how scared everyone is by the economic impact of this. If you’re not taking this seriously right now then you are, simply, a fool. A government composed of right wing nationalists and fiscal conservatives for whom Hayek and the Chicago school remain idols have just announced Universal Basic Income and an effective socialisation of salary and all of society’s risks. This is the tiger making dinner for the rabbit, it’s the coyote apologising to Roadrunner. (and for those in the know…don’t be Peck.) The term unprecedented here is both correct and far too small to underscore what’s going on.

Back to the question of ‘how do we pay for this?’

Well I mentioned warbonds earlier. Specifically those from WWI and II. They didn’t think about how they would repay – the nation was supposed to be facing an existential crisis. So they borrowed from a future they hoped was there to be borrowed from. The sense of desperation here is the same. We fail and it’s a generational depression to make the financial crisis look like losing your lunch money vs. losing your house and being forced to live on the street.

If we successfully meet this challenge? Well then we’ll worry about the implications then. What’s clear is no western country, especially the UK, will be the same after this. The US still has a journey to go on but they too will be no less different after this is over and, perhaps a silver lining, but this will be a real insulation against partisan politics and especially popularists because the virus respects nobody. It’s not an innoculation but like a large volcanic eruption can stall climate change, this can stall the growth of populism if only for a time.

I’m not sure there’s anything further to say – beyond this point everything is speculation. There are precious few voices I’m interested in listening to on this right now – I’m kind of absorbing lots and filtering 95% of it as the noise people make when they’re scared – it’s all shouting and fear and fastening onto any details which people see that appear new.

Yet the above is relevant. The government is doing something beyond the wildest fantasies of any serious economist I know – including me. You may criticise them all you like but I’ll have less respect for you if you do (see my reference to Peck). I guarantee you, you don’t know better and you wouldn’t do better. The choices made today by Sunak and by other European countries ahead of him this week and by the US over the weekend are literally undreamt of – not simply because the world economy was never structured to allow it (and there’ll be a lot of previously important influencers in the system who will now either fall into line or disappear into irrelevance) but because fundamentally literally no one could imagine this situation and moreover, no one can foresee the consequences of this in a month, a year or a decade.

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