Runs on the bank is an example of market failure

Just like many others experiencing the SVB bank shutdown and impending banking system crisis, I was waiting in eager anticipation of the next All In Podcast, to get the take of those 'esteemed,' well, maybe esteemed is too strong a word, 'interesting,' silicon valley insiders.

They did a fairly good job conveying the facts of the situation until David Sacks, a VC and right wing apologist, defended his actions advising his portfolio companies to withdraw all of their money from SVB, certainly tipped off by his bestie and fellow Pay Pal bro, Peter Thiel, and thereby helping to initiate a run on the bank. He defended this action, saying it was perfectly rational, and that it was based in Game Theory.

Most of us learned about John Nash, the winner of a Nobel prise in Economics for his pivotal theories on Game Theory, through the movie "A Beautiful Mind." In his work Nash described his eponymous equilibrium, in which each player's best action converges.

What Sacks failed to understand when he said that it was rational for startups to withdraw their cash, is that in each person’s choosing their best, most rational option, the Nash Equilibrium is that everyone tries to do that at the same time, leading to a situation where no-one gets their cash. Pursuing one’s rational self interest, in some situations, can lead to a worse collective outcome.

The failure to understand how game theory affects everyday life, and the prisoner's dilemmas that underly all forms of collective action, is pernicious in capitalism.

As in most situations of market failure, which is caused by things like information asymmetry, monopoly, public goods, externalities and tragedy of the commons, market participants will only abstain from the pursuit of their narrow self interest through the coercive force of a higher authority. In religion, this authority is God, punishing breaches of ten commandments or other taboos. In market economies, the external authority is the central government.

To prevent runs on the bank in cases of crisis, and in other cases of market failure, market participants will not be able to come up with a collective solution, only the government can.

This is informative for people interested in investing in Africa. As I have written before, much of the apparent disfunction may be attributable to unresolved market failure, where governments fail to step in and to play their essential regulatory role, or to provide for public goods. While in some cases, like information gaps, technology can play a role, in others, when market failure meets government failure, there is not much anyone can do. Importantly, this may not be an indicator of “poverty,” which to me is a damning word, it's just an indicator of weak government, unable to mobilize resources.

The Banking Business model may be in trouble

The fundamental structure of banking business models is duration mismatching, where banks take short term depositor cash, which is redeemable at any moment and make longer duration loans.

Silicon Valley Bank lent depositor money to the US Federal government, buying long term Treasury Notes and Fanny May and Freddy Mac issued, "risk free," mortgage backed securities.

Most banks seek to profit from the yield curve, which originates when lenders demand higher interest rates for longer securities which have greater degrees of uncertainty.

Taking advantage of the typically upward slopping curve, banks earn a spread of the difference between what they have to pay to depositors, which in recent times has been essentially zero, and the interest they earn from coupons on the longer term bonds. Since Treasuries and agency issued MBS are backed by the full faith and credit of the US government, this type of trade would appear to be low risk. In fact, by holding the securities to maturity, owners are essentially guaranteed to recover their money. Selling before maturity, however, means that banks sold at a discount to current market prices for other Notes with higher coupon rates.

Again, this has been played out in African economies, where banks may be equally exposed to inflation and interest rate movements in government securities. By lending below the rate of inflation, investing in government securities, African banks are enabling a transfer of value from depositors, who are often unremunerated even in high inflation environments, to governments, as a form of hidden taxation. When depositors figure this out, runs on the bank can make African banks equally vulnerable. Is anyone watching the store?

The convinience of Digital Banking makes things worse

I remember, just before the first dot com crisis, when digital banking was a new thing. New banks advertised how it would be possible to conduct all of your banking operations online, a big feature at the time. Ultimately, every bank was forced to provide online banking, in their begrudging if clunky way.

Twenty years later, the ubiquity of online banking makes runs on the bank as easy as clicking a few buttons; no pitch forks or bricks outside the bank branch are needed, and this created by silicon valley may prove to be modern banking's undoing.

This is true of every financial asset; if everyone dumps (or in the case of meme stocks and crypto, buys) at the same time, the price of the asset will be greatly affected. Other financial regulators, like the SEC in the US, institute shock absorbers, restricting trading for dramatic price declines.

Whereas for financial assets, selling may be in the long run contrary to an investors best interest, due to the underlying value of the asset, in the case of runs on the bank, banks forced to sell their assets under duress in order to provide liquidity to depositors can lead to a real destruction of value. While regulators may want to put in shock absorbers and restrict withdrawals from a bank, to constrain a natural tendency towards bank runs, this means many depositors would not have access to actual cash needed, and the notion of bank ceases to be.

The structure of modern banking, therefore may be a relic of the past. As bank runs, fueled by the speed of social media, and the simplicity of making an online transactions, become more of an existential threat to the banking system, governments may rely less upon them, and more on a monopolistic, centralized digital currency.

It will be interesting to see how many banks around the world will survive this newly apparent existential crisis.