Silicon Voodoo Bank and the managed funds industry

So what is the big deal with the failure of SVB?  The story goes that SVB’s depositor base was a bunch of tech startups.  The asset’s went down in price, chewing up the Bank’s capital and then some.  This triggered a classic ‘bank run’ where depositors tried to withdraw their deposits at a price that was higher than the true value that remained in the bank.   Put simply, due to bad investment decisions, the price of a deposit had fallen from $1 to, say, $0.87, yet the bank was paying out deposits at $1 until assets were seized and SVB put into administration.

Shocking as this may be, there were/are some simple ways to avert such a collapse.  The financial press has worked over the SVB crisis quite thoroughly so there is no reason for me to list them here.  But one aspect that has attracted little attention, which strikes me as the most important issue, is mark-to-market. The managed funds industry lives by this principle.  That is, the withdrawable amount of any investment is the daily NAV of a fund.  NAV is calculated by taking assets, subtracting liabilities, and dividing by the number of shares on issue.   Were this principle applied to SVB, the NAV would have been $0.87 and there would have been no incentive to withdraw in a panic.

Now banks and managed funds work on a different premise.  The bank deposit is supposed to be a safe, no brainer for investors with no brains.  $1 in, $1 out.   From a social standpoint there are classes of investors that go to banks for transaction services alone and do not need to think about investment risk they are bearing. The bank’s capital is supposed to cushion the investment risk for depositors. Money market funds provide a similar service.  However, the mark-to-market principle enables a demonstrably larger industry with much less capital to operate effectively.  The mark-to-market principle shifts the investment risk from a bank intermediary to the investors directly.[1]  Socially this is seen as involving requiring too much knowledge from investors.  But does it?

The idea that investors are better off bearing investment risk directly and earning the spread themselves rather than suffering the rarer but debilating catastrophe of a bank run, is considered ‘radical’ in policy circles.  The concept echoes the relation between Defined Benefit and Defined Contribution pension plans where the former uses the company balance sheet to pay pensions in the future while the latter places the investment ownership and risk on the individual beneficiary.   In economies where DB has been replaced by DC plans, there is ample evidence of non-panicked and intelligent investor behaviour under DC plans which are marked-to-market and for which there is substantial investment risk variation.  Even relatively unsophisticated investors can cope with investment risk.

The above makes the case for direct ownership of assets and mark-to-market to avert the problem of SVB.  Ironically, however, the regulatory authorities in the US have done exactly the opposite.  The Federal Reserve has suspended the mark-to-market principle lending on 100% of initial cost of bank investments despite those securities trading in the 80’s.  The managed fund industry tends to avoid the widespread problems of traditional banking and this should be embraced.  The traditional bank model is a dinosaur in need of a comet.  Isn’t it better for society if, during a financial crisis, many investors wake up to find their bank balances decline by a few pennies rather than a smaller number of investors discovering their balances have been completely erased?


[1] In the US there is a strange rule that requires MMF’s to only publish a lower NAV is the daily mark-to-market is less than half a percent.  This provides the feeling that the MMF is a bank deposit so long as it doesn’t ‘break the buck’.


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