Posted by on December 13, 2015

The Wall Street Journal had an article this past week entitled “Tech’s Hometown Bank.”  This has convinced me that Silicon Valley has replaced Wall Street as the new epicentre of financial malfeasance and conflict of interest.

The article is about the Silicon Valley Bank (“SVB”).  The business model of SVB is to make loans to tech start-up companies which very often have negative cash flow, limited (if any) tangible assets and are financially dependent on successive rounds of fickle venture capital funding.  In other words, these are entities that have absolutely no debt capacity and which should be entirely equity financed.

SVB funds these loans overwhelmingly with borrowed money, almost all deposits benefiting from FDIC insurance[1].  The bank reported a ratio of tangible equity to assets of 6.4% at the end of 2014 (see page 51 of these financial statements).

What could explain this seeming madness?  The answer is simple: in addition to charging interest on the loans, SVB takes warrants[2] in its high-tech borrowers.  At last count, the holding company of the bank had warrants in 1,625 of these companies.

This means that SVB has perfected the business model of “heads we win, tails the taxpayer loses.”  If things go well, the shareholders of SVB cash in on the warrants; if things go badly, the FDIC picks up almost all of the loss.  By playing this game with high volatility tech start-ups, SVB has gone way beyond anything that Wall Street was able to manufacture with the relatively prosaic sub-prime mortgage loans of the financial crisis.

By keeping the warrants in the holding company of the bank, they have even created the theoretical possibility of the bank going under, leaving large losses for the FDIC and the taxpayer, while the shareholders continue to benefit from the warrants.  Bravo!

But it doesn’t end there.  It turns out that SVB has an active business with the venture capital funds, and very often the personnel of these funds, that provide equity financing to these companies.  The article points out that SVB is often willing to work with its borrowers when they go “off plan” and are unable to comply with their loan agreements – one venture capitalist even praised SVB as “the kindest bank in the business.”

This leniency is hardly surprising, however, when you consider that SVB would be foreclosing on itself, as a warrant holder, and some of its most important clients.  And if their tender-hearted banking leads to a greater ultimate loss, well once again, this would be primarily the problem of the FDIC.  That is, of you and me.

These flagrant conflicts of interest are bad enough, but what makes them particularly galling is that they come from a technology sector that overwhelmingly practices liberal politics.  At least Gordon Gecko had the honesty to declare “greed is good” and spare us the sanctimonious hypocrisy of Silicon Valley.

This story is also a cautionary tale about the latest fad among central bankers: “macroprudential regulation.”

The theory of macroprudential regulation is simple.  Occasionally, central bankers are honest enough to admit that their policies of zero interest rates (“ZIRP”) and quantitative easing (“QE”) can produce asset bubbles.  However, the bankers think that they cannot take their foot off the monetary gas because this would have extremely negative consequences for the economy and inflation.  Instead of a monetary shot gun, they propose to control these bubbly byproducts through rifle shot regulation.

The problem with this theory should be obvious.   As I have pointed out before, we should all have very little confidence in the ability of regulators to anticipate and forestall problems.

SVB is a perfect example of this.  In addition to the abuse of the FDIC guarantee described above, this bank has been growing its loan book by leaps and bounds over the last few years (about 30% annually), a period widely believed to be tech bubble 2.0.  If the regulators have not stepped on something as flagrant as SVB, then there is little hope that they will protect taxpayers from more subtle schemes.

And there is another problem.  The WSJ has run another article recently about how the Federal Reserve is cracking down on leveraged loans[3] in the banking system.   Now, I happen to believe that this is long overdue since the excesses in this sector have been obvious for a long time.   But the problem is that we are supposed to have a “capitalist” economy.  As the name implies, this means that the private sector should, at a minimum, be responsible for the allocation of capital.  We have chosen this system because it has been shown to be a far more efficient than bureaucrats making these choices through something like macroprudential regulation.

As I have argued before, there are two ways to try to control the behaviour of a third party.  The first is to write an enormous rule book that attempts to anticipate and prescribe every possible action, and then to spend a fortune trying to monitor compliance.  Among other things, this assumes some very clever rule-makers and some pretty inert rule-takers, who won’t find ways to subvert them.  It also assumes that the rules, which must be broad and generic, can still be flexible enough to accommodate the logical exceptions.  Good luck on finding these people and crafting these rules.

The second way is to build a legal and economic environment where the third party is incentivized to produce the type of behavior that is sought.  This requires far fewer rules and much less oversight, and readily accommodates logical exemptions.

The problem is that we have far too much of the former, which is the natural instinct of lawmakers and regulators, and far too little of the latter.  Instead of root and branch changes, such as requiring far more equity in the banking system and eliminating the tax incentives to borrowing[4] and avoiding risk-inducing monetary policies, we continue to take false comfort from band aids like macroprudential regulation.

Roger Barris

Weybridge, United Kingdom

I Wish That I Had Said That (and Sometimes Not)…

“It should not be conditional.  It should not be earmarked because we know what we’re dealing with in our countries.  We know better,” by Nizipho Mxakato-Diseko, a South African diplomat in the Paris climate control talks, arguing that the $100 billion annual amount pledged by wealthy countries to developing countries to help them deal with climate change should not be subject to any donor control…and reminding me of the old saying that “foreign aid is taking money from poor people in rich countries and giving it to rich people in poor countries”

“It is useless to attempt to reason a man out of a thing he was never reasoned into,” by Jonathan Swift

“When a candidate for public office faces the voters he does not face men of sense….So confronted, the candidate must either bark with the pack or be lost…All the odds are on the man who is, intrinsically, the most devious and mediocre – the man who can most adeptly disperse the notion that his mind is a virtual vacuum.  The Presidency tends, year by year, to go to such men.  As democracy is perfected, the office represents, more and more closely, the inner soul of the people. We move toward a lofty ideal. On some great and glorious day the plain folks of the land will reach their heart’s desire at last, and the White House will be adorned by a downright moron, ”  by H.L. Mencken


[1] A “warrant” is a contract that gives the holder the right, but not the obligation, (an “option”) to buy a newly issued share of a company for a fixed period of time.  The value of a warrant increases with a leveraged effect if the value of the shares of the company increases.  However, since the warrant does not oblige its holder to buy the shares, the downside of ownership is limited.  A warrant is, therefore, a very effective way to benefit strongly from the improved financial performance of a company, while limiting downside risk.

[2] I would be curious to know if SVB has been actively raising money through brokered deposits.  If so, this would be the biggest red flag of all.

[3] For those who don’t know, “leveraged loans” is horrible Wall Street jargon for relatively risky loans granted to companies, frequently in the context of a takeover or a take-private transaction.  The loans are often syndicated to various bank and non-bank investors.

[4] And maybe even more radical change, such as forbidding fractional reserve banking completely.

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