The demise of Silicon Valley Bank

Tech was not the problem with SVB. The old-fashioned role of the bank as a facilitator of commerce was. But tech might indirectly benefit

Silicon Valley Bank (SVB) is often referred to as at the heart of Silicon Valley’s tech ecosystem. SVB has financed numerous ventures, both high-tech and not so high-tech (such as wineries). But SVB’s demise did not come about due to its lending. It was an old-fashioned bank run right out the plot of the movie It’s a Wonderful Life. That movie dramatically pictured what happens when lots of people want to withdraw their money at the same time. As the character George Bailey, head of Bailey, explains “You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.” In other words, I can’t give you your money because it isn’t here. It is invested out in the economy.

To understand what did and did not happen as SVB, let us look at the role of the banking system in the economy. [Note that there are many types of entities in what I am calling the banking system, including, fintech companies, etc.] The banking system provides three interrelated services. First, it facilitates savings by providing a place (an account) where funds could be stored and a small incentive to keep (and increase) those fund through interest payments (the savings function). Second, it provides transactional services to their customers. People make payments out of those accounts. This facilitates transactions between buyers and sellers by provided instruments for the transfer of funds (the commerce function). Third, it aggregates and then allocates capital (the lending function). Banks pool the money from deposits and lend is out to business and individuals. These three are interrelated and can be combined in various ways in what is referred to banking services.

Given SVB’s position in the tech sector, one would think that the problem was with the lending function – that SVB made too many risking loans. But it wasn’t shaky loans that did in SVB. The problems were more in the savings and commerce functions. SVB put a large amount of its deposits into long term government bonds. It essentially transferred its savings function over to the bonds market. That was fine as long as interest rates were low and. But once interest rates started to go up, the value of those bonds went down. This forced SVB to sell bonds at a loss, which lead to concerns over SVB’s ability to pay off depositors wishing to withdraw funds, which lead to everyone wanting to withdraw funds at the same time, aka a bank run. As a result, SVB ceased operations and depositors were faced with the possibility of losing all their funds (except for the $250,000 covered by deposit insurance).

The problem of SVB’s collapse was made worse by its role in the commerce area. SVB was the Valley’s major provider of banking services. It was a holding spot for their customers’ funds, especially start-up companies. Start-ups would raise a large amount of fund that would be deposited in an account and then slowly withdrawn to meet payment needs (e.g., salaries, equipment purchase or rental, office rent, etc.). It was this function that potentially could have caused the greatest economic harm. If tech companies’ funds held by SVB were wiped out, these companies be unable to pay current expenses. And they would lose the funds that they had stashed away for future expenses. In other words, all the funds raised to finance these start-ups would be wiped out.

The SVB experience should be a wake-up call for banking executives, investors, and regulators. The current regulatorily system is focused on dealing with systemic risk especially the risk of contagion where there is the possibility that the failure of one financial institution will cause other financial institutions to fail. The collapse of Lehman Brothers and the financial crisis of 2007-2008 is a classic example of contagion. The SVB case illustrates the danger to the “real” economy even when there may not be a large impact on other financial institutions.

The difference is important. It is not clear to me that the current system recognizes the danger from SVB-like situations.  Under current law, a finding of a systemic risk is needed used to allow the Federal Deposit Insurance Corporation (FDIC) to provide additional deposit insurance, the so-called systemic risk exception. The SVB situation was questionable as to whether it was a systemic risk in the traditional definition. But it is clear that a write-off of the deposits over $250,000 would have a negative impact on the economy. Government officials understood that. The statement from the Federal Reserve on its actions cited the need to “minimize any impact on businesses, households, taxpayers, and the broader economy.” But the authority was based on systemic risk.

The question facing policymakers is what do we do to prevent this from happening in the future. And what is the criteria for government intervention. The systemic risk exception is meant to protect the banking system and thereby indirectly mitigate any negative impacts on the economy. The deposit insurance system is designed to protect individuals and, to some extent, small companies. But it could be argued that the $250,000 limit is too low to truly protect all but the smallest of small businesses. And it clearly does not protect start-ups or other cases where large reserves of cash are common.

I don’t have any answers to that question. At a minimum however, we should take a new look at the purpose of deposit insurance and of the meaning and relevance of systemic risk as the intervention trigger.

Now for the possible silver lining. It has been said that you should never let a crisis go to waste in terms of opening up a new opportunity. In the SVB case, the opportunity exists to learn something from their loan portfolio. As I mention above, SVB’s loan portfolio was not a factor in their demise. But the autopsy of their demise gives us an opportunity to look more closely at the process of Intellectual Property (IP)-backed debt financing.

According to one estimate, SVB’s loans given them a security interest in “tens of thousands of US patents.” I assume that most of these security interests were created as part of a routine “all-asset” or “blanket” lien included in the loan. As such, they were not specifically included in the calculation of the loan’s collateral; they were simply swept up along with everything else. On the other hand, it would be important to know the extent to which patents (and any other forms of IP) were valued as collateral.

It is unclear exactly how SVB’s loan will be dealt with. The FDIC has been looking for someone to buy SVB outright but may end up selling off the loans individually (or in packets). If the loans are put up for sale, a wise buyer would be smart to look at the value of those patents. Some may be worthless and some might be very valuable. As Joff Wild points out, “there are people who do understand IP value and have robust methodologies for working out what it might be when applied to a particular patent portfolio or family. Using this knowledge, they are able to develop profitable monetisation programmes. It is hard to believe that, in the US, they are not already taking a deep dive into what is on SVB’s books to work out whether any of the bank’s loans are worth acquiring.”

Such an exercise would be very useful to those who study patents – and for banking regulators. Assuming that the data could be made available without compromising proprietary information, it would give researchers insights into the role of IP in financing. For banking regulators, the ability to analyze a bank’s IP portfolio would add another dimension of oversight.

Banking regulations and regulators will be under intense scrutiny. Since the problems were mainly illiquidity, we can expect this to be the focus of attention. But the debate over what to do provides an opening for a wider look. Both SVB and banking regulators seem to have been caught off guard by the degree of interest rate risk. Regulators should take this opportunity to look at where there are other blind spots. And as I have argued before, the amount of IP in the loan portfolio, and its implications, is one such blind spot.

To improve oversight of banks’ loan portfolios, regulators need access to the “robust methodologies” mentioned earlier by Wild. One way of doing this is for the regulators to develop their own mechanisms for valuing IP. I’m sure that would be opposed by those with proprietary methodologies who would see the regulators as unwarranted government competition. An alternative might be similar to the system of credit ratings. The government does not have its own methodology. Instead, it relies on credit rating agencies for bonds and other securities. Officially known as nationally recognized statistical rating organizations (NRSRO), the big three, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, control approximately 95% of the market.

As I’ve stated several times before, having an agreed upon methodology for determining IP value as loan collateral would boost the use of IP-backed financing. Having a means for regulators to assess the strength of a bank’s loan portfolio would result in banks adopting that standard for loan underwriting purposes. Having a standardized methodology would give lenders a level of comfort about including IP as part of the collateralization calculation. This, in turn, would opening up additional financing for intangible heavy companies, especially start-ups. And increase economic growth and prosperity in this age of intangible assets.

When is a trade- agreement not about trade? When it is about economic integration

During my Senate staff career, I had the good fortune to be involved in the beginning and the end of the Uruguay Round (i.e., the authorizing legislation in 1988 and the implementing legislation in 1994). That experience convinced me that trade agreements were no longer about trade; they are about economic harmonization. Earlier fast track legislation and trade agreements were narrow. For example, the Trade Expansion Act of 1962 which authorized Kennedy Round of trade negotiations under the General Agreement on Tariffs and Trade, and the Trade Act of 1974, which authorized the Tokyo Round, were mostly about tariffs. As I have noted before, trade entered a new era in 1994 with the inclusion of TRIMS (Trade Related Investment Measures), TRIPS (Agreement on Trade-Related Aspects of Intellectual Property Rights) and GATS (General Agreement on Trade in Services) in the Uruguay Round. These moved trade negotiations past tariffs and at-the-border issue to internal economic and regulatory policies.

But these non-trade issues are still usually discussed as part of larger trade negotiations, such as the various free trade agreements (FTAs) with individual countries.

Now we see an example of a trade negotiation that is purely about economic harmonization. As the New York Times article “U.S. and Europe Angle for New Deal to Resolve Climate Spat” points out, “Unlike a traditional free-trade agreement, which entails reducing barriers to trade between partners, this agreement would not involve lowering tariffs on either side.” Not only are tariffs not involved, the agreement does not seek to address any non-tariff barriers (NTB). Nor, it appears, does it require the European Union to change any of its trade laws and regulations. It is strictly about the participation of European companies in a U.S. technology program.

Of course, this isn’t the only example of a negotiation/agreement on economic harmonization. For example, a major international agreement on the taxation of multinational companies was negotiated under the auspices of the OECD (an agreement has recently come under fire from the newly GOP-controlled House Ways and Means Committee).

There is an interesting twist to the story. Under the provisions of the Inflation Reduction Act (IRA), tax credits for electric vehicles are only available to those vehicles using batteries using critical mineral from the U.S. or nations that have a free trade agreement with the U.S. And since there is no US-EU free trade agreement, EU companies are not eligible for the tax break. To deal with this issue, the US and EU are negotiating a “free trade agreement” covering just this one point. Which has raised the question as to whether such an agreement is really a “free trade agreement” as meant in the Inflation Reduction Act.

Assuming that an agreement is reached (and it looks like it will), there could be consequences for future negotiation. Will negotiators latch on to this free trade agreement-like model for other issues rather than attempt to craft a full-blown agreement? Does the help move agreements forward or simply create an ad-hoc and potentially chaotic situation? There is a long-standing debate over whether bilateral free trade agreements lay the groundwork for larger multilateral agreements or remove the incentives for multilateral negotiations. That debate has just gotten more complicated with the injection of this micro-level FTA-lite option.

Personally, I think the more focused version of the process is the way the system will evolve. As I’ve discussed before, I think the large multilateral negotiation is a thing of the past. The shift from trade to economic harmonization changes the dynamics of the negotiation process. The old dynamics don’t work. It was based on the concept of reaching an agreement by linking everything in a big package. But linkage doesn’t work the way it used to. In previous negotiations with a focus on tariff reduction, the dynamic was simple. I’ll reduce my tariffs on steel if you reduce your tariffs on autos. This allowed for a win-win situation that pushed for lower and lower tariffs. Everyone agreed that the end point was lower tariffs. The question was how to get there.

In the new situation, it is unclear how the trade-offs work and in what direction the dynamics points. I’ll lower my tariffs on steel if you increase your copyright protection to 100 years? I’ll allow you to subsidize your aircraft industry if you don’t ban my genetically-modified beef? I’ll decrease my agricultural subsidies if you reduce regulations on investment banking?

It is not clear to me that trying to deal with such a complex set of trade-offs is useful. Instead, we may have to approach each of these economic integration/harmonization issues separately – possibly in separate forums, such as the OECD and the G20. Yes, this being a negotiation, there will be linkage. But the complex web of links will not become so great as to bring the entire structure down. And it will allow all parties to clearly focus on a specific issue not the trade-offs — leading, one would hope, to a better outcome.

Economy Continues Chugging Along

The U.S. labor market continued to grow in February. The Bureau of Labor Statistics reports that nonfarm payrolls grew by 311,000 jobs while the unemployment rate rose slightly to 3.6%. Employment in intangible-producing industries and tangible-producing industries continue to track one another. The growth in the tangible-producing industries was the biggest in Accommodation and Food Service (up 84,300 jobs). In intangible-producing industries, Professional & Business Services (excluding tangible services) was up 31,500, Educational & Health Services (excluding tangible services) grew by 56,100 and Government (excluding Postal Service) was up 42,600.

This continuing parallel employment growth is a structural change from the pre-2010 period when employment in intangible producing industries grew as a percentage of total employment while employment in tangible producing industries declined.  

For more on the categories, see my explanation of the methodology in an earlier posting.

“Services” Trade Surplus Down but Intangible Trade Surplus Up in January 2023

The story line from this morning news from the Bureau of Economic Analysis (BEA) is that the trade deficit is up in part because the trade surplus in services is down. That is bad news. But it is a little misleading. The good news is that the U.S.’s trade surplus in intangibles continues to grow.

The biggest gain in intangibles was made in Business Services where exports grew by more than the increases in imports in January. Revenue from Intellectual Property was also a major contribution to the overall rise where exports (payments in) declining by less than the drop in imports (payments out). The surplus in Telecommunications, Computer & Information Services grew as exports grew by more than the increases in imports. Maintenance & Repair Services are slowly recovering from their dramatic decline at the beginning of the pandemic, with exports growing slightly faster than imports. The deficit in Personal, Cultural & Recreational Services improved slightly as exports rose and imports declined. Unfortunately, the trade deficit in Insurance continued to grow as export declined and imports rose slightly. And the trade surplus in Financial Services declined as imports grew more than exports.

The real problem is with the sectors that I call “Tangible Services” which are made up of the BEA trade sectors of Transport, Travel, Construction, and Government Goods & Services. These are sectors primarily involved in physical activities. [See below.] The trade balance in tangible services turned negative in 2022 following a steady decline in the trade surplus through the past decade. Exports grew in fits and starts including drops during the financial collapse of the mid-2000’s and around the COVID-19 pandemic. However, imports have grown at a relentless pace, overtaking exports early last year. The cause of the overall balance decline is the large and increasing deficit in transport services and a smaller, but still significant, deficit in travel.

Note: Tangible activities are primarily physical activities (involving atoms); intangibles are primarily information/analytical activities (involving bits). Production of goods is almost exclusively a tangible activity. Services can be divided into tangible and intangible activities. Tangible services involve physical activities such as cutting hair, ringing up a sale at a cash register, cooking and serving a meal, and transporting someone or something. Designing a poster, negotiating a deal, writing an article, and approving a loan are examples of intangible services. For more, see my earlier postings.