Future of Finance 2024: The Future of Banking After Silicon Valley Bank

Fortune

Tomasz Piskorski, Edward S. Gordon Professor of Real Estate, Finance Division, Columbia Business School

Transcript

00:00Welcome everybody, glad to be here. I'm a professor at Columbia Business School. I

00:05do a lot of work on financial intermediation, banking, fintech, and real

00:09estate, and recently, along with my colleagues, I've done quite a lot of work

00:12on financial stability and drawing lessons from the recent bank failures

00:17such as the Silicon Valley Bank I would like to tell you a little bit about. So

00:22let me tell you our view. What we think is one of the main sources of risk

00:26currently in the US financial system. From our perspective, it's really the

00:31fact that banks have very high leverage. If you look on a typical bank in the

00:37United States, and there is really very little variation, whether you're a small

00:41bank, whether you're a large bank, banks are essentially about 90% debt funded

00:47and only 10% of equity. So think about what it means. Consider, for example, a

00:52situation when there is a modest decline in the value of bank assets, let's say

00:5710%, that already potentially put these institutions at the brink of

01:01insolvency, because the value of the assets will be less than the face value

01:06of the liabilities. And if you look on the banking sector as a whole, you know,

01:12this is a 24 trillion dollars of assets. On the asset side, banks take a lot of

01:16duration risk and credit risk. They give a lot of assets like securities, long-term

01:22treasuries, long-term mortgage-backed securities. In addition, they have

01:26real estate loans, including commercial real estate loans, and other loans

01:31like corporate loans with a credit risk. And the way they finance it is

01:35essentially with short-term debt. Most of these debts are deposits, about 18

01:41trillion of them, and about half are insured by FDIC and half are uninsured.

01:46These are deposits above $250,000. And in addition to that, the banks have

01:51fairly thin equity cushion. So you can see, this is a pretty fragile system with

01:58very little equity financing and a lot of debt financing. And in that sense, the

02:03recent monetary tightening illustrates this point. The Fed raised interest rates

02:07very aggressively, and essentially in a matter of a year, they went from 0 to 5%.

02:12What it means to the value of long-duration assets, there has been a

02:17very big decline in the value, including U.S. treasuries and so on. If you look on

02:21long-duration assets, long-term bonds, they decline by, you know, in the order of

02:2530%. So when you take this decline, the market implied decline in the value of

02:31assets, and apply it to bank balance sheets, what you will find is that in the

02:36aggregate, the value of the bank assets right now is about $2 trillion less

02:41relative to where it was at the beginning of the Fed tightening cycle.

02:46And in fact, there's quite a few banks in the U.S. right now, and Silicon Valley

02:50Bank was one of them, that currently have the value of their assets, the market

02:55value, being less than the face value of their debt. So in principle, if the

03:00depositors would show up, this bank would fail, unless of course regulators step in.

03:05Now, I'm not trying to say that all these banks will fail. It depends on your

03:09funding, and in particular, it depends what portion of your funding is unstable,

03:13especially uninsured deposits, because uninsured depositors can lose money if

03:17the bank fails. And, you know, in that sense, you know, the Silicon Valley Bank was an

03:21outlier, that 80% of its assets were financed with uninsured deposit.

03:27Essentially, Silicon Valley Bank had just uninsured deposit funding, so it's very

03:30fragile in that sense. And the question is, you know, and the mechanism is as

03:35follows, you know, the interest rates go up, you can add to this credit risk, bank

03:39asset values decline like they did, uninsured depositors get spooked, they

03:44see these big declines in asset values, they worry about solvency of the bank,

03:47they start withdrawing money, and then you can end up with a run equilibrium.

03:51The key question, and I was talking a lot with regulators about that, is how

03:56special is the Silicon Valley Bank? Are there other banks like that? And the

04:00short answer is yes. There is quite a few banks in the United States right now

04:04that have very similar risk characteristics. Now, they're extreme as

04:08Silicon Valley Bank, but you can support a run on them. They are actually at the

04:12risk of run. And this is just the duration effect. If you add to this

04:18credit risk, remember that for a mid-size banks, about 25 to 30 percent of the

04:23assets are commercial real estate loans. With that analysis, loan by loan, 14

04:28percent of these loans are underwater, meaning the property value is less, worth

04:32less currently than the face value of debt. If you look on office loans, it's

04:3644 percent. So in addition to this duration risk, there is also a credit

04:40risk that would enlarge the set of banks that could potentially fail. So the

04:45obvious question is, and you know, talking all the time of this with regulators, you

04:49know what to do about it. And one natural answer is, well, let's raise the bank

04:53capital requirements. Maybe not right now. Once the things come down a bit, that

04:57would make the system more safe. But the obvious question is how much leverage

05:01financial institutions really need to provide efficient functions like

05:06originating loans and doing other things. And in fact, we have a window in it. We

05:11compare the leverage of banks to non-bank lenders. The black curve shows

05:16you the non-bank lenders. These are the institutions that make loans like banks.

05:20This is in the mortgage market, but don't have access to insured deposit funding

05:24and are lightly regulated. And guess what? In this private market benchmark, without

05:30access to insured deposit funding, these institutions have much less leverage and

05:34much more equity funding. And the lesson we draw from this, you can be a pretty

05:39good lender with much lower leverage. And what's interesting is the biggest

05:44discrepancy is actually for smaller and mid-sized banks. What it means is, let's

05:49say the JP Morgan, their leverage is pretty close to what they would have

05:53been levered even if they wouldn't have access to insured deposit funding. It's

05:57precisely the smaller and mid-sized banks, including banks like Silicon

06:01Valley Bank, that were levered much more and because of this implicit and

06:06explicit guarantees. You know, Silicon Valley Bank did not have much insured

06:10deposit funding, but there's a lot of other banks that do and take advantage

06:13of that. One, of course, thing is that, you know, if you talk to bank CEOs, they

06:19will tell you, hey, if you raise bank capital requirements, the lending will

06:22collapse and we're going to have contraction of economic activity. We just

06:26really cannot do it. Of course, the answer to this question depends on how

06:29important are banks in financing credit to households and firms. And let me just

06:36tell you, they are not as important as commonly thought. In the 1970s, bank

06:41balance sheet financed 60% of lending to households and firms. So in other words,

06:46in the 1970s, banks were very important. Nowadays, bank finance only about a third

06:52of credit to house concerned firms. The rest is financed with debt securities,

06:56private credit, and so on and so forth. So in the aggregate, the banks are much

07:01less important than they were a few decades ago. And what it means, it has

07:06interesting implication for capital regulation. What would happen, we actually

07:09did a simulation, if you would raise capital requirements on US banks, well,

07:14the amount of bank balance sheet lending will drop substantially and so is the

07:19bank profits. So, you know, it's kind of understandable why some bank CEOs might

07:22not like it, but the aggregate decline in lending would actually be quite

07:26modest. What would simply happen, bank would still make loans, but instead of

07:30keeping them on balance sheet, they would sell them and there will be expansion of

07:34non-bank and private credit. So let me just conclude with some thoughts where

07:38I'm thinking it will go going forward. First, I think the banks are continuing

07:43to become increasingly less relevant, and especially smaller and mid-sized banks.

07:47We have ongoing consolidation in the banking industry. I predict in a few years

07:52we'll have much fewer smaller and mid-sized banks. I also think that we'll

07:57see a growing rise of debt securities and private credit. Private credit is

08:01rapidly increasing right now, and of course who's going to finance a lot of

08:05that, you know, vehicles like money market funds, exchange-traded funds, and so on.

08:09On the asset side, the traditional banks already lost a lot of edge. Think about

08:16the mortgage finance, which is a very important debt market. Now banks account

08:21for less than half of the lending there, and the biggest lender is Quicken Loan.

08:24Quicken Loan is currently called Rocket Mortgage. You know, they just have,

08:29you know, the platform, they don't have deposits, it's a non-bank. And, you know,

08:34impact of AI is likely to make things potentially worse for banks, as we just

08:39heard a little bit in an earlier session. I expect these non-bank financial

08:43institutions to possibly be more able to innovate in this space, especially because

08:48they are more lightly regulated. And so essentially the main value that banks

08:53currently derive is on the liability side. Is this access to insured deposit

08:57funding allows them this cheap debt, they can recycle into loans, but also in

09:01securities and other vehicles. So in some ways survival of especially mid-sized

09:06and smaller banks critically depends on continual access to this implicit and

09:11explicit subsidies, and if the regulators decide to crack it down, we will see

09:16further contraction of smaller and mid-sized banks. Bigger banks, of course,

09:21will have to innovate harder and harder to stay relevant, but they have a scale

09:25so they probably will be able to continue operating. And the last thing,

09:30even on the liability side, there are many innovations that threaten banks.

09:34Think about central bank digital currency, or alternative payment systems.

09:38If this takes the deposit role from the banks, they will be really in a precarious

09:42state, because, you know, the asset side is already very difficult for them to

09:45make money. Once they lose this deposit advantages, it will be a difficult

09:49position for them. So thank you very much and thanks for your attention.

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