As I was catching up this weekend with Ellevest’s Chief Investment Officer, Dr. Sylvia Kwan, she and I were sharing “war stories” and our perspectives from past bank runs. And we've been there for a number of them; we’ve both been in the investing industry or on Wall Street for 30+ years — she as a portfolio manager and Chief Investment Officer; and I as a banking industry research analyst, Chief Financial Officer of Citi, and head of Merrill Lynch.
So we’ve seen our fair share of ups and downs and bank runs, from different angles. Here are some of our answers to the key questions you’ve been asking us over the past few weeks:
WTH is going on with the banks?
Back to first principles: The core business of banks is to take in deposits and, with those deposits, make loans or invest in securities. So the difference between what banks earn and what they pay out = their earnings. Many banks are in other businesses, like trading or asset management or wealth management. But the biggies are deposit-taking and lending.
This means that, at their core, banks are risk-taking enterprises. Their earnings are the result of taking on and managing risk: interest rate risk, property price risk, liquidity risk, basis risk, stock market risk, fraud risk, consumer credit risk, counterparty risk, currency risk, information security risk, operational risk … I could go on and on with additional risks. (And often do.)
These risks are then further amplified by the financial leverage that banks employ. For those who aren’t familiar with the concept, one useful way to think of this may be to draw an analogy to your own “household balance sheet.” To buy a home, you’ll probably take on a mortgage. Say you make a 20% down payment — now you “own” 20% of the value of the home, and the mortgage provider “owns” 80%.
If the value of the home goes up, you benefit from the increase in the home’s value, since you’re only on the hook for the amount of the mortgage (plus interest). But conversely, if the value of the home goes down, you’re taking that hit, too, since the amount you owe the mortgage lender doesn't change. So if the value of the home goes down 20%, your 20% stake in the home is then worth nothing.
Same idea with the banks. They have assets (loans and securities, which can go up or down in value) that they fund with deposits and debt (which do not). The values of the securities and loans can increase or decrease; but as a customer, you’ll always want 100 cents of every $1 you deposit with the bank back, at the time you want it. Also, instead of having a cushion (ie “owning”) of 20% of its assets, like with a mortgage, Silicon Valley Bank “owned” just $7.50 for every $100 of assets. Credit Suisse had $8.50.
Tell me more. How should we think about this?
In our analogy, if your home loses 20% of its value, you're wiped out. But the banks only have to take a single-digit-percent loss on their assets to get wiped out. This is why banking can be such a confidence game: It works when people feel like their deposits are safe, and all hell breaks loose if they don’t. And it’s why the FDIC insures $250K of deposits, to add to the security — and sense of security — of the banking system.
What is the big lesson that will come out of this bank run?
In our opinion, it’s going to be diversification, diversification, diversification. And also diversification’s cousin: diversity. Both as means for reducing risk.
As I wrote last week, SVB’s business was concentrated in the venture capital world — an industry that is, itself, concentrated in a certain part of the country; an industry that isn't exactly known for the diversity of its key players; and an industry where some participants actually state that their investment criteria is “pattern recognition” (translation: rinse and repeat … the opposite of diversity).
When one of their own, a prominent venture capitalist, called for a run on SVB, the banks’ clients “pattern recognized” — I mean, stampeded — their deposits right out of the bank. (Secondary lesson: Nothing good happens on Twitter. Nothing.) My guess is that this bank run probably wouldn’t have happened if it was some guy they’d never heard of before who panicked; that it was a prominent “one of their own” likely mattered, a lot.
Another area where banks should strive for diversification / diversity: their teams. The research is crystal clear that bringing in diverse perspectives reduces risk and increases returns. And also increases innovation.
Pattern recognition can be insidious internally, too. Just as fish don’t see water, the public often doesn’t even blink when a leadership team is mostly middle-aged white males. And, as I saw when I was at the big banks, when leadership teams don’t see their homogeneity, they proceed believing they’re fully vetting of all facets of a problem, and can draw false comfort when they reach consensus. But the lack of diversity on the team may mean that they haven’t considered all of the angles. I think of this as the “false comfort of agreement.”
Sadly, if history is any guide, we’re probably going to see leadership team diversity actually go backward in the wake of this crisis. The “false comfort of familiarity” is another pitfall that rears its head during periods of stress.
Are there any lessons for individual investors?
Diversification. (Yes, again.)
For example, you shouldn’t “just” have one bank, with all of your money in deposits there, if your deposits total more than $250K.* Or in one asset class in your investments: People who were solely invested in regional banks have had a tough few weeks. Or even too much of the stock your company granted to you: Ask folks who received stock in SVB and held onto it, because things were looking pretty good there, and I should know since I work(ed) there, and the stock has gone up and I don’t want to pay taxes on the gains.
There are no free lunches — in investing or in life — but historically, diversification has come as close as possible, by reducing risk during a cycle and thereby mitigating losses. And in the long run, when you lose less, you tend to earn more.
What’s the Fed going to do? And should I care?
For more than a year, the Federal Reserve has been increasing interest rates, to fight inflation and slow the economy. By some measures, this has been the most dramatic increase in rates in history; it set the stage for the banking panic, as banks failed to anticipate this environment and position their balance sheets appropriately.
Given the events of the recent weeks, banks are now likely to lend less than they otherwise would have; this, on top of the Fed’s interest rate hikes, will be an additional means to slow the economy. To avoid the risk of this tightening doing any further harm, the Fed is probably approaching the end of its rate hike campaign. We don’t like to play the game of “Will the Fed increase by 25 bps? Or nothing? Or 50 bps?” But a bell has certainly been rung.
As for whether you should care — yes, it affects you. The end of the tightening cycle is good news if you’re paying interest (like on credit card balances, where rates are at the highest levels they’ve ever been), but less good if you’re earning interest (in your savings accounts, for example).
What does this all mean for equities?
The answer to that is less clear. Myriad factors are creating a lot of crosswinds, from the economy (which is doing well, from what we’ve seen in the jobs reports) to interest rates (“declining and lower” is better than “increasing and higher”). Which is why we don’t “call the market” but prefer … you know the answer … diversification in our investments.
How do I think about my Ellevest accounts?
If you’re an Ellevest digital client, your investment assets are held by Goldman Sachs Custody Solutions. It holds your investment assets separately from their own assets — they do not, and legally cannot, comingle them.
Should I do anything different with my investments?
So should you pause autodeposits and / or pull your money out of your Ellevest account(s) (and thus the markets) until this volatility passes?
Short answer: no.
Longer answer: You’re investing for the long run — not a quick turnaround. Right? And with a long horizon, it has historically paid to stay invested — and to keep investing — through rough patches, because the stock market tends to start recovering before we’re able to confirm that the worst is behind us.
At Ellevest, we don’t try to time the market (which is one way to describe pulling your money out until things start improving). Instead, we recommend staying invested — and diversified. (Don’t worry, we take care of the second part.) In the past, the markets have tended to right themselves over the long term — even taking into account crises like the housing bubble or the crash of 1929. If you’re investing consistently, thanks to dollar cost averaging, you’ll be purchasing some stocks while they’re “on sale” (when the markets are down), too.
The TL;DR answer: Keep calm and invest on.