What founders and investors in startups need to know about the history of bankruns and how to protect themselves from them in the future.
Here's the text on which my talk was based:
Historical Perspective on SVB’s Failure for Investors & Founders
This is Sal Daher of the Angel Invest Boston podcast. Prior to becoming an investor in tech startups, I spent decades as a banker and trader involved with the distressed debt of countries. My experience came in handy recently in allowing me to reassure the startups in my portfolio with deposits at SVB that the FDIC would have no option but to make all depositors whole.
This piece aims to explain why the business model of banks and past government decisions precluded any other options. It also points to ways that founders can manage deposit risk. While it bothers me to see well-off people bailed out by the taxpayer, it is the necessary if imperfect course of action until we make structural changes to hold bank management more accountable.
Why was I so certain in my assurances? Because financial authorities in the US and other countries had learned a hard lesson back when Lehman Brothers (not a deposit-taking bank) was allowed to fail in September of 2008. Lehman’s bankruptcy set off an inevitable chain of events that led to the meltdown of the market for credit risk insurance. This revealed pervasive rot in financial instruments widely held by institutions starved for yields. Thus began the Sub-Prime Crisis that ruined millions and blighted the career of so many of my colleagues in finance for nearly a decade.
The hard lesson learned was that when a financial panic gets going it’s impossible to tell where it will stop. The term contagion is apt. Financial authorities understood the need to take prompt steps to reassure investors not to make irrational moves that could impoverish us all. Back in 2008 they ended up taking over banks which created lasting distortions, some of which are still with us today.
While the circumstances of SVB’s failure are different from Lehman’s, the fundamental lesson of maintaining the orderly functioning of financial markets still applies. If the FDIC had stuck strictly to its $250K deposit insurance limit (which BTW had been $100K until the Lehman event) chaos would have ensued. Depositors everywhere would have immediately started spreading any holding in excess of $250K to other banks to avoid the possibility of loss and could have melted down the entire banking system. An impaired banking system would have resulted in hundreds of thousands of companies going under and millions of people losing their jobs. So, preventing financial panic is a public service for the entire population. It’s comparable to the fire department. Fire brigades were set up to prevent individual house fires from spreading and burning down entire neighborhoods.
There is a fundamental flaw in the business model of banks. Banks lend long and borrow short. Borrowers want to repay banks months or years into the future. Depositors usually are not willing to tie up their money for more than a few months. This creates a mismatch between the maturity of loans made by banks (assets) and deposits taken by banks (liabilities). The delicate balance between assets and liabilities is hard to achieve. This is why banks keep cash reserves on hand, i.e., they don’t lend out all their deposits. They also have short-term borrowing lines with other banks or the Federal Reserve to make sure they have cash meet all their obligations.
But if enough depositors decide that a bank is impaired, even the soundest bank would not be able to meet the demand for immediate payment without outside help. This is the role the FDIC has come to play. A role with which I am not entirely comfortable, but as we have seen, is essential as things stand.
Many argue that unlimited deposit guarantee removes the incentive from depositors to vet a banks’ books. In the absence of this vetting there is a natural temptation for banks to take all the risk possible with depositor’s money because if things go well the bank’s shares will go up and the management will get bonuses. This moral hazard of deposit guarantees is supposedly mitigated by regulations that limit how much a bank can lend and impose minimum capital requirements.
Unfortunately, the regulations failed in the case of SVB. The bank appeared to meet its capital requirements but when depositors started to draw out money, it started to sell its reserves. This prompted changes as to how assets were valued and put it suddenly in default of capital requirements. This led to a failed attempt to raise more equity in the stock market.
One moment SVB seemed fine, the next moment it was on the rocks. Bank books are complicated beyond the ability of even the most sophisticated depositor to figure out. The idea of savvy depositors keeping banks honest is fanciful. The only parties who have any hope of knowing enough about what’s going on in the bank are its management and its board of directors. I support making bank directors and senior management personally liable if a federal rescue is needed.
So, what’s a founder to do when holding more than $250,000 in cash? One thing to consider is to have the funds in more than one bank, if only to avoid a sleepless weekend as so many founders experienced recently. But that only gets you up to protecting $500,000 or $750,000. Another option to consider is putting funds into money market funds held by Fidelity, Schwab or Vanguard. Funds held in custody for a beneficiary are legally protected from claims against the entity. This does not mean that there is no risk. Even safe money market instruments may lose value in times of stress, but the exposure to any one entity is much less concentrated. There’s always the risk of fraud or unauthorized trades but those are not usually system-wide and the entities usually make good on those.
Founders are in the business of sailing in uncharted waters. However, many of the risks that threaten a startup are known to accountants and board members. My advice is to bring up the matter of risk with your CFO and your board. If you don’t have one it’s time you found at least a fractional CFO and functioning board.
If found this brief piece useful I invite you to follow Angel Invest Boston on your podcast app. Thanks for listening. This is Sal Daher.
