‘There’s more than one Silicon Valley Bank out there,’ professor says

Stanford University Professor of Finance Amit Seru joins Yahoo Finance Live to discuss SVB’s downfall, the cause of the banking crisis, bank solvency, regulation, and the outlook for banks.

Video transcript

- Looking back at the banks, the high profile failure failures of not only Silicon Valley Bank and Signature during the March bank crisis were in part caused by rising interest rates, but recent research suggests it wasn't SVB's unrecognized losses or capitalization that caused it to fail. Let's look at one key indicator of bank failure with Amit Seru the Steven and Roberta Denning Professor of Finance at Stanford University. Ahmed, thank you for joining us here today.

Lay this out for us, because we've been hearing a lot about all these unrealized losses-- that is, losses that banks haven't put necessarily on their balance sheet just yet-- but that wasn't necessarily the biggest cause of the downfall for SVB, because other banks had bigger, unrealized losses. So what was the culprit here?

AMIT SERU: Thanks for having me. So in a study with several of my colleagues, what we find is that there was turbulence on the asset side-- like you said-- for many banks, because they had a lot of unrealized losses. But what really matters as well is if you have the flight risk-- which is, how many depositors do you have who can get spooked and start running?

And it turns out that the Silicon Valley Bank-- while it was on the extreme-- is not the only one in the study that terms has flight risk. And if you marry the turbulence on the asset side with the flight risk, what you will find is that there is more than one Silicon Valley Bank out there. And so we got to worry a little bit about the fragility in the banking sector.

And you saw the Fed come up with pretty unprecedented steps. And part of the reason is, I think, they realize that there is some fragility in the system.

- And so I've heard some rumblings that the Fed may take a different tack in their macroprudential approach to some of these banks that operate in very specialized capacities. So if you say SVB is an outlier, maybe the Fed starts looking at other outlier banks. Do you see this as a way to potentially contain the problem? Just wondering if that, or any other ideas have been thrown out that you've heard of.

AMIT SERU: So there are too many banks in this situation to resolve with one-off solutions is my view. So if you look at these conditions, -- this insolvency situation is across the banking system. And government backstops have stemmed the problem for now. But it's laying the seed for potential problems-- pretty much like the savings and loan crisis.

So you got to think a little bit ahead further down the game tree. And think about what is a reasonable solution which fixes this problem in the system? And one way in which you could address this is by at some point in the near future, requiring banks to go out and raise equity capital, because what that will do is it will give you a market test to figure out which are really the insolvent banks out there.

And it will also get some skin in the game for banks. Those who are solvent will survive-- will get some government backstop. But those who are not solvent need to be weeded out of the system. Otherwise, we are looking at a prolonged savings and loan crisis once again if we don't do anything.

- Well, that's really interesting. I quote-- or paraphrase-- Warren Buffett here. "It's only when the tide goes out that you can see who's swimming naked." And having to raise capital seems like a pretty good way. Just wondering, then-- would this be a blanket policy? Everybody has to go to the capital markets and see how you fare? How is this implemented on a regulatory level?

AMIT SERU: I think before the market tells you which bank they think is solvent or not, you don't want to discriminate. So you want everybody to go out and raise capital. We have information on how much shortfall or unrealized losses there might be in the system. And essentially, you need to ask banks to fill the void and not just rely on government backstop.

A temporary fix right now is fine, but we can't expect this to be a permanent solution. There have been lots of proposals right now being extended in the House and the Senate where you want to insure the entire banking sector. We are talking about trillions of dollars here-- like an additional $9 trillion of insurance provided through taxpayer money.

And that doesn't seem a reasonable and a viable solution, especially if you have a lot of banks which are zombie banks right now. So you don't want the zombie banks to prop up through these subsidies and insurance that we are providing. In the short run it's fine, but in the medium to long run, we got to think about forcing banks to come out and face the market test.

- Well, and that's kind of the way the market is supposed to work. Weed out those mal-investments that have been made prior. You mentioned the savings and loan crisis a minute ago. A lot of people comparing this to the global financial crisis, because that's the most recent one-- or banking crisis in memory. Where do you see this falling? You could even go back further to continental Illinois in 1984. Where do you see this landing in the spectrum of previous bank failures?

AMIT SERU: I think one thing which is similar to 2007 and 2008 crisis is that a lot of banks took similar bets. The difference is those bets were different-- that those bets were on the housing market through the credit, through the loans that they had made. And as a result-- also, the banks had lent to each other. So when there was a spark in the subprime sector, in the housing market, it led to a propagation through the banking sector which was pretty leveraged.

Here, it's a little bit different. You'd still see banks facing correlated shocks, because they have all invested in these long term securities which have fallen in value because of the increase in the fed rate. What's different is that it's not yet hit the credit side of the balance sheet.

It's just these securities which have fallen in value. And if the uninsured depositors get spooked, they start running, and that then forces the bank to liquidate these securities, which can then have a ripple effect on the credit side. It's not gone there yet, but if it did, then there would be similarity to the financial crisis. So you might have seen some folks talking about the commercial real estate sector, where maybe some of these ripple effects might show up.

But they haven't yet. And that's what distinguishes it from the 2007 and 2008 crisis. There is similarity with continental. There is similarity with the savings and loans crisis. I think savings and loans crisis is the most similar in spirit, because that was, again, a scenario where banks took bets which were unhedged and faced interest rate risk. And because of the interest rate risk, the assets depreciated, and the depositors wanted higher rates. And that led to a spiral-- pretty much similar to what we are seeing. But we have seen how you resolve these banks before it becomes a systemic problem.

- We've got to leave it there. I really appreciate your insights here. Amit Seru, the Stephen and Roberta Denning Professor of Finance at Stanford University.