A Little About the Failed Banks – Lessons for TradFi and Crypto

The banking crises of 2023 unfolded with lightning speed, revealing how risks can quickly emerge from unexpected corners of the financial system. Silicon Valley Bank (SVBVB), Signature Bank and Credit Suisse folded in a couple of weeks, while First Republic Bank teeters on the brink. The hasty failures shook confidence and brought a sense of déjà vu – flashbacks to the financial collapse of 2008-2209. During financial turmoil, governments have repeatedly stepped forward as the savior of last resort, as recently as 2008-2009 and now in 2023. For decades, traditional finance (TradFi) infrastructure and the surrounding regulatory oversight environment have sought to remove kinks, prevent banking, reduce system risk and achieve reliability.

“Crypto has already demonstrated its value as a potent addition to the modern financial system. Its innovations can help reduce risks associated with centralized single points of failure,” said Matvey Diadkov, Founder, CIO Bitmedia.io. Innovations in crypto and crypto finance were developed in response to the TradFi banking crises of 2008-2009. Like many new technology cycles, crypto got caught up in excessive hype and speculative frenzy. Numerous failures in 2022, mainly in Custodial Centralized Finance (CeFi), led to the current “crypto winter.” Ironically, the catastrophic implosions occurred due to TradFi (centralized opaque custody) practices infiltrating crypto platforms and the unsavory behavior of fake rogue actors at the helm. Crypto is not the cause of recent TradFi bank runs. On the contrary, crypto’s ingenious features, such as self-storage, on-chain transparency, tokenization, instant settlement, and more, offer new ways to avert catastrophic single-point failures; limit frivolous behavior by decision makers, and prevent loss of funds. “The more crypto businesses and institutions try to replicate the structures of traditional finance to claim credibility, the more prone they are to becoming major black box failures. At the heart of this is the demand for self-custody of digital assets,” said Jaydeep Korde, CEO of Launchnodes.

What went wrong with the banks in 2023 – Excessive risk, too little diversification and myopic profit-motivated managers who play fast and loose by the rules while avoiding red flags. They failed in their primary responsibility of risk management, capital preservation and adequate liquidity. Salaries and bonuses tied to the return on equity (RoE) in these listed banks encouraged executives to prioritize short-term profit metrics over risk management, setting the catastrophic events in motion.

After a decade of near-zero interest rates, the recent sharp rate hike by the Federal Reserve (Fed) tightened liquidity, putting stress on the balance sheet. Managers in these banks failed to balance long-term assets with short-term liabilities and manage interest rate risk. Risky bets on interest rate-sensitive bonds to shore up short-term finances without implementing adequate hedges began to accrue unrealized losses as interest rates rose. Thereby, the burden on the balance sheet worsens significantly, creates liquidity crises and becomes the Achilles heel of single-point failure. Large deposits from concentrated business segments, exceeding the $250,000 Federal Deposit Insurance Corporation (FDIC) limit, were uninsured and turned out to be super-flyers. At the whiff of bad news, the large pool of uninsured depositors escaped, creating withdrawal difficulties and bank runs. A networked community of sophisticated depositors, fear fueled by social media, and near-instant transaction-enabling technologies transferred vast sums electronically, catalyzing banking operations at astonishing speed. As reported, over 90% of deposits at SVB, Signature Bank and 68% at First Republic Bank were uninsured.

When the aforementioned banks began to spiral down under the tsunami of bad news, many public bodies quickly intervened to contain the contagion. Within a few days of SVB and Signature Bank going into receivership, the Fed and Treasury fully guaranteed all deposits, overriding the default limit of $250,000 per account. The values ​​of the share and bond holdings go to zero.

However, the government’s last-resort bailouts and backstops set a bad precedent by tacitly tolerating excessive risk-taking by profit-motivated senior executives at these failed banks. Reviving the “Moral Hazard” Dilemma and a Reprise of Risk Socialization. My Upside, Your Risk – Corporate insiders and stakeholders make money when risk-taking works, while others bear the losses when risky plays fail. Ironically, without government intervention, the existing settlement process would have exposed SVB depositors to only modest cuts (the losses in the bond portfolio). SVB’s sophisticated, risk-aware, high-net-worth clients could have resisted the potential exposure. “The 10 largest Silicon Valley Bank deposit accounts held a combined $13.3 billion,” the head of the FDIC stated. The government’s sweeping promises to depositors have apparently protected billionaires and the ultra-rich. “The uninsured depositors of the SVB are not a needy group… The biggest problem is the Fed’s quick unwinding of 14 years of loose monetary policy,” said Sheila Bair, former FDIC chairman and senior fellow at the Center for Financial Stability (link link FT) . Jamie Dimon, CEO of JP Morgan Chase, stated: “Regulations created banking turmoil.” He criticized regulators in the wake of the banking crisis for encouraging banks to stockpile government securities and introducing flawed stress tests.

Silicon Valley Bank: The latest sharp interest rate increases froze technology investments and stock market listings, and stopped SVB’s deposit supply at the same time as withdrawals and liquidity strain were accelerated. SVB management had accumulated a massive bond portfolio of $124 billion (more than 50% of assets) and decided not to adequately hedge against interest rate exposure, even as the Fed embarked on its steepest rate hike cycle in 2022. They increased further. short-term P&L by discontinuing or allowing expiration interest rate hedges on all its securities, entering 2023 almost completely unhedged against interest rate risk. This results in significant unrealized losses in the bond holdings. SVB was unable to raise money to meet cash flows, forcing them to sell their bond portfolio and realize large losses. News headlines about significant losses with reduced liquidity created a crisis of confidence. Investors from interconnected startups backed by sophisticated and herd mentality Venture Capitalists (VCs) quickly moved money out and orchestrated the bank run. SVB also operated without a risk manager from April 2022 to December 2022.

Signature Bank: As the crisis engulfed SVB, more than 90% of uninsured Signature Bank deposits from concentrated private equity and legal business segments began to flee, prompting a run and forcing the bank into administration. Signature’s assets were 66% loans and the rest in debt securities.

First Republic Bank had 67% of uninsured deposit accounts, somewhat in line with other regional banks and much less than the over 90% at SVB and Signaturbank. The bank also has a pristine loan book and conservative underwriting. Its geographic location, mostly high-net-worth Silicon Valley clientele, and business model similar to SVB made First Republic Bank the poster child for current banking crises that were caught up in the contagion and thrown to the sharks by the short sellers. First Republic recently lost approximately $70 billion in deposits, creating an urgent need to raise money. To bolster its balance sheet, 11 banks, including JPMorgan Chase JPM & Co., have placed $30 billion in deposits with First Republic. The company has also suspended the dividend.

Credit Suisse, the second largest bank in Switzerland, collapsed in March 2023 and was bought by rival UBS for CHF 3 billion (about US$3.3 billion). Scandals, management changes and significant losses had recently plagued Credit Suisse. Credit Suisse was a victim of bank failures in the US. Swiss regulators brokered the purchase of Credit Suisse by UBS.

Failed banks are not the norm in the banking industry. These failures do not banish TradFi institutions as inefficient and unreliable. On the contrary, TradFi banks efficiently leverage assets and manage risk. In the aftermath of the 2008-2009 financial crises, the Volcker rule was introduced within the Dodd-Frank Wall Act of 2010 to reduce risky transactions by banks and systemic risk to deposits. Basel III outlines liquidity conditions and mandated capital requirements, i.e. liquid assets banks must have available to maintain operations while still respecting withdrawals. Banks are required to ring-fence deposits, not conduct proprietary trading in deposits, and remain stress-tested for liquidity.

Crypto and blockchain provide inherently ingenious alternatives to centralized TradFi middle platforms. To gain widespread adoption with reliability, DeFi and CeFi crypto-financing products should incorporate TradFi’s risk mitigation framework, which has been evolving and improving for over a hundred years. “Crypto’s intricate technical concepts, and not seamlessly aligned with the mandates of existing regulatory bodies, create an urgent need for international coordination and development of consistent standards and regulations for crypto,” said Albert Davies, president of the Rotary eClub of Wall Street. Non-custodial crypto DeFi staking platforms and decentralized exchanges (DEXs) do not hold keys to users’ wallets and therefore cannot rehypothecate customer deposits. These already provide transparent and efficient trading mechanisms and immediate settlement. Their clearly visible on-chain, transparent liquidity pools and total locked-in value (TVL) provide complete accountability for all trades that add or remove assets. Such extensive transparency prevents malicious actors from hiding or manipulating assets and liabilities in the chain. In contrast, crypto CeFi platforms, such as TradFi, have custody of customer deposits and have been subject to fraud and mismanagement (add links). Therefore, CeFi platforms must delineate client funds and incorporate the existing TradFi rules regarding proprietary trading, liquidity conditions and imposed capital requirements.

The banking crisis in 2023 points to serious risk management failures by some bank managers and shortcomings in the existing regulatory structure. However, it is not a broad systemic problem within the banking sector. TradFi’s infrastructure, risk assessment mechanisms and regulatory compliance have evolved and improved for over a century. Crypto innovations that include TradFi’s risk management structure can create robust and reliable solutions for billions of banks and unbanked.