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Control is just an illusion (Michael M. Santiago/Getty Images)
Vladimir Lenin was wrong about many things, but his maxim about the Soviet Union’s bureaucratic state apparatus — “better fewer, but better” — was undoubtedly right. Perhaps more than anything, the USSR demonstrated the flaws of rigid central planning. And yet, at the very heart of Western free markets, it not only survives — it flourishes.
Today’s financial rules often seem designed to maximise inconvenience for individuals carrying out small transactions. Despite the stupendous number of business regulations, however, the big events often seem to be missed. The collapse of Silicon Valley Bank (SVB), the bank of choice for large numbers of tech companies, is just the latest to surprise us.
On Saturday, more than 200 UK tech companies, worth £3.5 billion in venture funding, riled themselves up into a state of panic. They wrote an open letter to the Chancellor warning that they now face an “existential threat”, and suggested that the Bank of England’s attempts to downplay its impact showed “a dangerous lack of understanding of the sector and the role it plays in the broader economy”.
The truth, however, is that shocks like this are inherently difficult to predict. Indeed, it is more or less impossible, unless the central regulator is omniscient. The losses which have caused SVB’s collapse, for instance, seem to have arisen from the bank making complicated bets on interest rates and getting them wrong. It’s easy enough to explain after the event — but it’s very hard to anticipate.
And so Lenin’s maxim springs to mind: it’s better to have a few bright minds capable of thinking outside the box about the resilience of a system than legions of box tickers designing myriad rules which purportedly eliminate risk.
A similar issue confronts Rishi Sunak ahead of his first Budget tomorrow. Apart from the SVB crisis, two financial developments haunt his financial programme. They are both bad — and they both stem from a misguided attempt by regulators to control risk.
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SubscribeSVB’s collapse presents a dilemma for the US Federal Reserve.
The Fed has 2 jobs: stabilize the banking system via regulation; and stabilize prices by using interest rates to control inflation.
However, banks have been parking huge amounts of depositors’ money in US Treasuries. They’re useful: immediately liquid and generate a small return. The Fed encourages this practice, effectively treating Treasuries as cash-on-hand.
Here’s the dilemma though. Every time the Fed raises interest rates, it raises current treasury yields, which tanks the resale value of prior T-bills. Why? If I can loan my money to Uncle Sam today for 1 month and get 2%, if you have a older T-bill that is yielding only 1%, I’m not going to buy it for full price from you. This is what brought down SVB. Their on-demand deposits were parked in multi-month T-bills which had declined in value, rendering them technically insolvent. The bank run was just the straw that broke the camel’s back.
SVP isn’t the only bank in the position though. So now, the Fed has a problem. The goal of price stability requires further raising interest rates to squash inflation, but each increase lowers the price of existing 0-3mo T-bills (that are held by lots of banks), thus raising the risk bank insolvencies. If they instead prioritize bank stability, they will have to at least take their foot off the interest rate gas pedal, thus risking higher inflation. It’s a serious dilemma that has no easy solution.
Personally, I believe the Fed will opt for the latter course. SVP should have scared them. My money is on minimal interest rate increases (1/2bp by the end of the year, maybe). They will do this for two reasons: 1) it’s easier to recover from an inflation surge than from a major bank collapse; and 2) these are bankers, who do you think they will protect first?
Great analysis. And since a Silicon Bank type of event was predictable for the reasons you describe, I assume the Fed has been waiting to see how far it can push interest rate hikes and will now ease off. My concern is with the mortgage market. So far, US housing prices have held up reasonably well, but a lot of people, at least in major urban areas, took out big, variable rate mortgages. When their rate increases we might see significant defaults and there’s no easy solution for that.
“The Fed has 2 jobs: stabilize the banking system via regulation; and stabilize prices by using interest rates to control inflation.” And there’s yer problem. A much better ‘job’ would be simply to provide sound money. And I doubt that the Fed knows what ‘inflation’ actually is.
Historically, they have failed at both.
Historically, they have failed at both.
Seems to me raising rates was inflationary and has had dire consequences such as SVB. We had low rates so long with minimal inflation, then Covid hit as well as Ukraine, and supply iissues drove up prices, and the labor shortage drove up wages. Inflationary but entirely due to supply issues, not demand. And raising rates only increases business costs, which get passed down. So, I think the real reason for the rate hikes is exactly what is happening, an opportunity to consolidate banks, pick up assets cheap, and create another crisis, which they won’t let go to waste.
Great analysis. And since a Silicon Bank type of event was predictable for the reasons you describe, I assume the Fed has been waiting to see how far it can push interest rate hikes and will now ease off. My concern is with the mortgage market. So far, US housing prices have held up reasonably well, but a lot of people, at least in major urban areas, took out big, variable rate mortgages. When their rate increases we might see significant defaults and there’s no easy solution for that.
“The Fed has 2 jobs: stabilize the banking system via regulation; and stabilize prices by using interest rates to control inflation.” And there’s yer problem. A much better ‘job’ would be simply to provide sound money. And I doubt that the Fed knows what ‘inflation’ actually is.
Seems to me raising rates was inflationary and has had dire consequences such as SVB. We had low rates so long with minimal inflation, then Covid hit as well as Ukraine, and supply iissues drove up prices, and the labor shortage drove up wages. Inflationary but entirely due to supply issues, not demand. And raising rates only increases business costs, which get passed down. So, I think the real reason for the rate hikes is exactly what is happening, an opportunity to consolidate banks, pick up assets cheap, and create another crisis, which they won’t let go to waste.
SVB’s collapse presents a dilemma for the US Federal Reserve.
The Fed has 2 jobs: stabilize the banking system via regulation; and stabilize prices by using interest rates to control inflation.
However, banks have been parking huge amounts of depositors’ money in US Treasuries. They’re useful: immediately liquid and generate a small return. The Fed encourages this practice, effectively treating Treasuries as cash-on-hand.
Here’s the dilemma though. Every time the Fed raises interest rates, it raises current treasury yields, which tanks the resale value of prior T-bills. Why? If I can loan my money to Uncle Sam today for 1 month and get 2%, if you have a older T-bill that is yielding only 1%, I’m not going to buy it for full price from you. This is what brought down SVB. Their on-demand deposits were parked in multi-month T-bills which had declined in value, rendering them technically insolvent. The bank run was just the straw that broke the camel’s back.
SVP isn’t the only bank in the position though. So now, the Fed has a problem. The goal of price stability requires further raising interest rates to squash inflation, but each increase lowers the price of existing 0-3mo T-bills (that are held by lots of banks), thus raising the risk bank insolvencies. If they instead prioritize bank stability, they will have to at least take their foot off the interest rate gas pedal, thus risking higher inflation. It’s a serious dilemma that has no easy solution.
Personally, I believe the Fed will opt for the latter course. SVP should have scared them. My money is on minimal interest rate increases (1/2bp by the end of the year, maybe). They will do this for two reasons: 1) it’s easier to recover from an inflation surge than from a major bank collapse; and 2) these are bankers, who do you think they will protect first?
Let me suggest some edits to help all the jigsaw pieces fit into place…
On Saturday, more than 200 UK tech executives wrote an open threat to the Chancellor warning the Bank of England’s attempts to downplay its impact showed a dangerous lack of understanding of where their wealth comes from and the role he needs to play to protect it for them if he wants a slice.
As individuals move into their 50s, their pensions are pushed by the regulator into a “lifestyle” investment approach. Their funds are unnecessarily sold and fat commissions generated and their wealth used to create buyers for government bonds so the government can continue spending like a drunken sailor and the BoE can avoid the public realisation its QE schemes were a giant money printing exercise.
Rishi Sunak and Jeremy Hunt’s overregulation and over taxation fulfils their backers desire of stopping Britain competing with the current Silicon Valley.
Sunak has kept to form and has backed up his spoken words with written words. Last week, along with the Technology Secretary Michelle Donelan, he launched another document from the newly created Department for Science, Innovation and Technology in lieu of actually governing.
The UK’s flexible and speedy response has been equally encouraging. A crisis broke — and rather than form a committee to try and work out the perfect response like they do for the prols, the Government acted because this time some very wealthy people were affected and they were threatening Rishi and Jeremy’s next careers.
Let me suggest some edits to help all the jigsaw pieces fit into place…
On Saturday, more than 200 UK tech executives wrote an open threat to the Chancellor warning the Bank of England’s attempts to downplay its impact showed a dangerous lack of understanding of where their wealth comes from and the role he needs to play to protect it for them if he wants a slice.
As individuals move into their 50s, their pensions are pushed by the regulator into a “lifestyle” investment approach. Their funds are unnecessarily sold and fat commissions generated and their wealth used to create buyers for government bonds so the government can continue spending like a drunken sailor and the BoE can avoid the public realisation its QE schemes were a giant money printing exercise.
Rishi Sunak and Jeremy Hunt’s overregulation and over taxation fulfils their backers desire of stopping Britain competing with the current Silicon Valley.
Sunak has kept to form and has backed up his spoken words with written words. Last week, along with the Technology Secretary Michelle Donelan, he launched another document from the newly created Department for Science, Innovation and Technology in lieu of actually governing.
The UK’s flexible and speedy response has been equally encouraging. A crisis broke — and rather than form a committee to try and work out the perfect response like they do for the prols, the Government acted because this time some very wealthy people were affected and they were threatening Rishi and Jeremy’s next careers.
“And so Lenin’s maxim springs to mind: it’s better to have a few bright minds capable of thinking outside the box about the resilience of a system than legions of box tickers designing myriad rules which purportedly eliminate risk.”
Those bright minds would have to be very bright indeed to cope with today’s financial sector. It is huge and horribly complicated. It is peopled by very intelligent market players, who are highly motivated by money. The prospect of making more money is a powerful incentive to come up with innovative ideas.
The result is a system which is evolves like Darwin on acid. The regulators are in a bind: do they slow things down, and risk losing competitiveness to other financial centres, or do they take a hands off attitude and cross their fingers?
Even more pertinently, the regulators are civil servants, and think like civil servants. They love committees, interim reports and knocking off at 5pm. The market players run rings round them.
Mr. Ormerod’s idea is attractive, but is it within the realms of the practical?
“And so Lenin’s maxim springs to mind: it’s better to have a few bright minds capable of thinking outside the box about the resilience of a system than legions of box tickers designing myriad rules which purportedly eliminate risk.”
Those bright minds would have to be very bright indeed to cope with today’s financial sector. It is huge and horribly complicated. It is peopled by very intelligent market players, who are highly motivated by money. The prospect of making more money is a powerful incentive to come up with innovative ideas.
The result is a system which is evolves like Darwin on acid. The regulators are in a bind: do they slow things down, and risk losing competitiveness to other financial centres, or do they take a hands off attitude and cross their fingers?
Even more pertinently, the regulators are civil servants, and think like civil servants. They love committees, interim reports and knocking off at 5pm. The market players run rings round them.
Mr. Ormerod’s idea is attractive, but is it within the realms of the practical?
Good article.The SVB collapse came from a level of stupidity one would not expect from Bank executives.Instead of investing their liquid funds with entrepreneurs they put them into long dated bonds never seeming to ask themselves what would happen if interest rates rose and the price of the long dated gilts fell .
As a layperson i have been punished for investing in index linked inflation gilts as i did not understand the product I was investing in and had assumed i was protecting myself against inflation but it has not worked out like yet for complicated reasons similiar to SVB’s collapse .The price of UK listed Inflation Linked Gilts funds fell in 2022 from 40% to 60% when inflation was rising due to interest rates rising as well
The moral of this is make sure you understand the investment vehicle you are investing in.I did not with gilt funds but i do not claim to be a professional unlike the SVB executives would have done.
Good point. I’m not sure why Mr Ormerod thinks it was hard to anticipate the failure of SVB. Holding low interest yielding treasuries through the fastest rate hiking cycle in history seems like a disaster waiting to happen. They even disclosed $15bn of unrealised losses in their last audited accounts. Hard to anticipate – really?
Indeed, a baffling level of basic mismangement of bonds by SVB that the average retail “investor”/layperson has been successfully managing without problems for the last few years.
Good point. I’m not sure why Mr Ormerod thinks it was hard to anticipate the failure of SVB. Holding low interest yielding treasuries through the fastest rate hiking cycle in history seems like a disaster waiting to happen. They even disclosed $15bn of unrealised losses in their last audited accounts. Hard to anticipate – really?
Indeed, a baffling level of basic mismangement of bonds by SVB that the average retail “investor”/layperson has been successfully managing without problems for the last few years.
Good article.The SVB collapse came from a level of stupidity one would not expect from Bank executives.Instead of investing their liquid funds with entrepreneurs they put them into long dated bonds never seeming to ask themselves what would happen if interest rates rose and the price of the long dated gilts fell .
As a layperson i have been punished for investing in index linked inflation gilts as i did not understand the product I was investing in and had assumed i was protecting myself against inflation but it has not worked out like yet for complicated reasons similiar to SVB’s collapse .The price of UK listed Inflation Linked Gilts funds fell in 2022 from 40% to 60% when inflation was rising due to interest rates rising as well
The moral of this is make sure you understand the investment vehicle you are investing in.I did not with gilt funds but i do not claim to be a professional unlike the SVB executives would have done.
The current inflation, which has driven interest rates higher is the single most predictable economic event of my lifetime caused by massive deficit spending by governments combined with supply suppression through lockdowns and misguided energy policy. Yet many banks apparently missed the signs and governments remain in denial continuing their massive deficits. If inflation is to be contained by interest rates alone they will have to go much higher but we’re seeing banks, the one industry that should have been best prepared, are heavily exposed to interest rate hikes. Far from a few bright people, the world is being run by box ticking mediocrities. If rates can’t go higher without crashing banks and the governments refuse to change their policies then we can expect ever higher inflation for the foreseeable future.
I would ask you all to watch John Titus latest video on best evidence. He walks you through the fact that most banks are underwater due to unrealised bond losses
I would ask you all to watch John Titus latest video on best evidence. He walks you through the fact that most banks are underwater due to unrealised bond losses
The current inflation, which has driven interest rates higher is the single most predictable economic event of my lifetime caused by massive deficit spending by governments combined with supply suppression through lockdowns and misguided energy policy. Yet many banks apparently missed the signs and governments remain in denial continuing their massive deficits. If inflation is to be contained by interest rates alone they will have to go much higher but we’re seeing banks, the one industry that should have been best prepared, are heavily exposed to interest rate hikes. Far from a few bright people, the world is being run by box ticking mediocrities. If rates can’t go higher without crashing banks and the governments refuse to change their policies then we can expect ever higher inflation for the foreseeable future.
The regulators are, of course, resisting change and neither Sunak nor Hunt show any signs of putting the necessary rocket under Bailey. I’m afraid Rishi is all talk.
The regulators are, of course, resisting change and neither Sunak nor Hunt show any signs of putting the necessary rocket under Bailey. I’m afraid Rishi is all talk.
It’s not just the MiFiD2’s 1.5 million paragraphs. There are also the One million plus paragraphs of the Financial Catastrophe Authorities rule book. And all the similar stuff from the Patently Ridiculous Authority and so on.
It’s not just the MiFiD2’s 1.5 million paragraphs. There are also the One million plus paragraphs of the Financial Catastrophe Authorities rule book. And all the similar stuff from the Patently Ridiculous Authority and so on.
Just wait for the CDS, credit default swaps… who will be landed on? Credit Suisse is looking a sound ante- post favourite?…. but watch the non- life reinsurance sector, propped up by Warren Buffett. this stone age industry, run and staffed by people who cannot get jobs elsewhere in the FIG sector is the next Lehman….
Alas, Mr. Samengo-Turner, non-life will not be the next Lehman, it was the last Lehman. It was because AIG was in big trouble (big as in potentially terminal), that Lehman’s was allowed to fail. Even the American government could not bail both out simultaneously.
(https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig)
Alas again, it probably won’t be the insurance industry that blows up next. In Britain, we had a small problem last autumn, when our pension funds got themselves into a negative-feedback loop from which they could not escape. The Bank of England had to intervene to steady things. This (https://capx.co/did-liz-truss-really-cause-the-bond-market-rout/) is the most coherent explanation of that event I have come across.
So the next blowup could be… cryptocurrencies? Trade finance? Loss of confidence in the Italian government? Panic in the Chinese shadow-banking world? Take your pick. As a rough guide, look for parts of the financial world which are under stress. That’s where you will find corners being cut and (eventually) birds coming home to roost.
I think it’s interesting that the SVB team consisted of former Lehman managers. It would seem they had not shed their yield chasing ways. Perhaps the US Federal Reserve should have told all US banks they were very serious about raising rates. Therefore any long duration investments that would be adversely effected by higher rates should be avoided, or at least kept to a minimum. It’s really not that complicated. It’s banking 101.
I don’t think cryptocurrencies will be the next to fall. In fact, they are on the rise during this chaos. Bitcoin in particular is an alternative form of custody for cash when people lose faith in their institutions. It’s like a bank with a branch on every street corner in every country in the world. It also has the potential to act as a sort of decentralized central bank since it possesses the same characteristics of a central bank. I suspect governments are beginning to realize this and why they seem intent on killing it. A good example is the recent government imposed death of Signature Bank in New York.
I think it’s interesting that the SVB team consisted of former Lehman managers. It would seem they had not shed their yield chasing ways. Perhaps the US Federal Reserve should have told all US banks they were very serious about raising rates. Therefore any long duration investments that would be adversely effected by higher rates should be avoided, or at least kept to a minimum. It’s really not that complicated. It’s banking 101.
I don’t think cryptocurrencies will be the next to fall. In fact, they are on the rise during this chaos. Bitcoin in particular is an alternative form of custody for cash when people lose faith in their institutions. It’s like a bank with a branch on every street corner in every country in the world. It also has the potential to act as a sort of decentralized central bank since it possesses the same characteristics of a central bank. I suspect governments are beginning to realize this and why they seem intent on killing it. A good example is the recent government imposed death of Signature Bank in New York.
Alas, Mr. Samengo-Turner, non-life will not be the next Lehman, it was the last Lehman. It was because AIG was in big trouble (big as in potentially terminal), that Lehman’s was allowed to fail. Even the American government could not bail both out simultaneously.
(https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig)
Alas again, it probably won’t be the insurance industry that blows up next. In Britain, we had a small problem last autumn, when our pension funds got themselves into a negative-feedback loop from which they could not escape. The Bank of England had to intervene to steady things. This (https://capx.co/did-liz-truss-really-cause-the-bond-market-rout/) is the most coherent explanation of that event I have come across.
So the next blowup could be… cryptocurrencies? Trade finance? Loss of confidence in the Italian government? Panic in the Chinese shadow-banking world? Take your pick. As a rough guide, look for parts of the financial world which are under stress. That’s where you will find corners being cut and (eventually) birds coming home to roost.
Just wait for the CDS, credit default swaps… who will be landed on? Credit Suisse is looking a sound ante- post favourite?…. but watch the non- life reinsurance sector, propped up by Warren Buffett. this stone age industry, run and staffed by people who cannot get jobs elsewhere in the FIG sector is the next Lehman….
With the State getting inexorably bigger, the client state (bureaucrats, public-sector workers and welfare recipients) getting more numerous and voting in their own interests for more government, more regulations, and higher taxes, the big beneficiaries in future will be the client state and lawyers, whilst the rest of us drown in red-tape and taxes. It’s what happens when universal suffrage meets the Pareto principle.
With the State getting inexorably bigger, the client state (bureaucrats, public-sector workers and welfare recipients) getting more numerous and voting in their own interests for more government, more regulations, and higher taxes, the big beneficiaries in future will be the client state and lawyers, whilst the rest of us drown in red-tape and taxes. It’s what happens when universal suffrage meets the Pareto principle.
Is this the soft landing?
Is this the soft landing?
I agree with a lot of the comments on Central Bank interest rates being the source of the problem. I also have to agree with Paul Ormerod on regulation. In my experience over complicated procedures are put in place by people that don’t understand things, or that are just trying to put a shield between themselves and blame. Whilst I am trying to find proof of my identity for some obscure purpose, I often wonder how any criminal organisations can possibly still exist. Could they possibly have found a way around these regulations?
I agree with a lot of the comments on Central Bank interest rates being the source of the problem. I also have to agree with Paul Ormerod on regulation. In my experience over complicated procedures are put in place by people that don’t understand things, or that are just trying to put a shield between themselves and blame. Whilst I am trying to find proof of my identity for some obscure purpose, I often wonder how any criminal organisations can possibly still exist. Could they possibly have found a way around these regulations?
During the 2007-09 there were many comments about the foolishness of strategies characterised as picking up pennies in front of steamrollers (with the inevitable result of getting squashed sooner or later). But that is exactly what SVB were doing – with the predictable outcome. Remember that it was no surprise that interest rates were going to rise. The point was that SVB was transparently undercapitalised and following the steamroller penny strategy to get away with this. Thus, the real question is whether central bankers should bail out all depositors at institutions run by fools. The current practical response – though not the theory of deposit insurance – is yes.
In that case the only way to deal with moral hazard is to treat all of the wealth and past income paid to managers – or all staff – at all financial institutions as unpaid equity that can be tapped in the event of a bailout being required – i.e. a combination of joint and several liability with no limits. That is the old 19th century way of dealing with bank failures. However, its effects can be modified by allowing staff to buy reinsurance against the potential liability, because then the market in reinsurance will clearly signal an external assessment of the risks being taken by company strategies such as the steamroller penny one.
None of this either new or unexplored by financial economists. The problem is that politicians, bureaucrats and regulators are unwilling to jeopardise their cosy future incomes from the financial sector. The effusions of people like Senator Elizabeth Warren are merely a distraction from the issue of getting real incentives right. Populist demands to send fools to jail are pointless because laws and regulation are procedural rather than substantive so being a well-advised fool is protection against conviction. On other hand, bankruptcy is considerably easier to enforce, especially under a regime of strict liability.
During the 2007-09 there were many comments about the foolishness of strategies characterised as picking up pennies in front of steamrollers (with the inevitable result of getting squashed sooner or later). But that is exactly what SVB were doing – with the predictable outcome. Remember that it was no surprise that interest rates were going to rise. The point was that SVB was transparently undercapitalised and following the steamroller penny strategy to get away with this. Thus, the real question is whether central bankers should bail out all depositors at institutions run by fools. The current practical response – though not the theory of deposit insurance – is yes.
In that case the only way to deal with moral hazard is to treat all of the wealth and past income paid to managers – or all staff – at all financial institutions as unpaid equity that can be tapped in the event of a bailout being required – i.e. a combination of joint and several liability with no limits. That is the old 19th century way of dealing with bank failures. However, its effects can be modified by allowing staff to buy reinsurance against the potential liability, because then the market in reinsurance will clearly signal an external assessment of the risks being taken by company strategies such as the steamroller penny one.
None of this either new or unexplored by financial economists. The problem is that politicians, bureaucrats and regulators are unwilling to jeopardise their cosy future incomes from the financial sector. The effusions of people like Senator Elizabeth Warren are merely a distraction from the issue of getting real incentives right. Populist demands to send fools to jail are pointless because laws and regulation are procedural rather than substantive so being a well-advised fool is protection against conviction. On other hand, bankruptcy is considerably easier to enforce, especially under a regime of strict liability.