The issue explained: Why do banks fail and could it happen in Cayman?

“Banking is very good business if you don’t do anything dumb”– a quote from the esteemed Warren Buffett.

Perhaps no truer words have been said about banking given the recent chaos that has engulfed banks.  

First, let’s try to understand what happened. Silicon Valley Bank dealt with ultra-sophisticated clients, predominantly in California. 

In a nutshell, some of SVB’s clients woke up one morning and decided to read the bank’s financial accounts and what they saw was not pleasing. 

They saw a bank that had taken lots of depositor money and had invested it in safe government bonds. Safe, though, only if those same bonds are held until they mature. 

What the clients realised was that since interest rates had risen a lot over the last 12 months, if everyone withdrew their cash from SVB, then the bank would have losses on those safe bonds. The so-called safe bonds would need to be sold at a loss (before maturity), meaning that if everyone withdrew their money before the bonds matured there wouldn’t be enough cash to pay everyone. If everyone only took their cash out in five years when the bonds mature, all would be fine.  

The why: Part one

These extremely sophisticated investors all realised that if they were concerned about this situation then so were others. 

Rather than wait to see how things panned out they took their cash out, meaning others took their cash out, meaning that there wasn’t enough cash to pay everyone. Imagine being on the Titanic – best to be off the boat first since there weren’t enough lifeboats for everyone; so it was with SVB. This is the very definition of a “bank run”.

The why: Part two

The second part is a function of dumbness. One of SVB’s senior directors (in charge of risk management) was on the board of the Federal Reserve Bank of San Francisco. The Federal Reserve Bank of San Francisco is part of the Federal Reserve that sets US interest rates. 

In other words, it appears as though SVB’s risk management person, who was part of the group that sets US interest rates, either (i) didn’t realise that raising interest rates would harm his bank or (ii) wasn’t aware interest rates were rising. Either way, pretty dumb! It shouldn’t be unreasonable for the general public to expect better of the regulators, and the regulators to be held to account for their poor behaviour.

What about Credit Suisse?

Ah yes, Credit Suisse – (formerly) one of the most well-respected institutions in the global banking world. Did they have the same problem? Basically, no. 

Let’s go back to Buffett’s quote –  “…if you don’t do anything dumb”. Credit Suisse didn’t follow that rule very well. If you type ‘Credit Suisse fines and penalties’ into Google, one of the first articles that pops up is ‘Credit Suisse has paid over US$11 billion in fines and penalties since 2000.’ 

That’s a huge number and, eventually, if all your staff are so busy paying fines, it’s quite difficult for them to focus on doing good things and making money. So imploded Credit Suisse; unable to make enough money to reassure investors and therefore forced into the hands of its rival.

Protecting depositors

In historic banking crises, depositors used to get hosed when a bank failed. In 1933 in the United States, over 9,000 banks failed and many people lost their life savings. 

As a result, the federal government decided that it needed to protect depositors from the dumbness of bankers. Thus was born the Federal Deposit Insurance Corporation which guaranteed that the first US$2,500 of every depositor’s cash was safe. This now stands at US$250,000 per depositor. 

Similar schemes exist in most other countries (though not the Cayman Islands) and they are designed to reassure depositors that banks, while not necessarily ‘safe’, are ‘safe enough’, since banks are a necessary ingredient in sustaining a vibrant economy (without banks no one could easily borrow money to fund investment, or get a mortgage or car loan, for instance).

Banks are useful but they always do dumb things…

A very smart argument can be made that providing this protection to depositors causes them to neglect the risks of their bank. In other words, if there were no safety net might depositors care far more about the quality of their bank, its employees and management?  Economists call this ‘moral hazard’ – the risk that people don’t properly analyse risks because they don’t have to. 

Should we all pay more attention to what our banks are doing? Unarguably, yes is the answer but who has the patience, time or stamina to sift through hundreds of desperately dull and uninformative pages of accounting – pages that are seemingly almost deliberately designed by accounting standards to hide the bad news from investors?  

Talking of auditors, it may be worth asking why KPMG, the auditors of SVB, didn’t spot the problem and notify anyone beforehand. We may find out – there’s a lawsuit against KPMG in California.

What’s the conclusion?

Well, in essence it would seem that (i) we can’t exactly trust banks not to do dumb things; (ii) that regulators don’t really know what’s going on at the banks they regulate, and are potentially ridden with conflicts of interest; (iii) the auditors don’t seem to care or know what’s happening; and (iv) trying to do one’s own research is a herculean task. 

Thus it was that governments set up deposit insurance. They reasoned that solving this banking ‘conundrum’ is just too difficult. Therefore, rather than try to solve it, they decided it would be easier to make the problem go away by guaranteeing deposits, so we didn’t all have to worry!

What about Cayman?

Inevitably, the subject needs to move on to Cayman. Banks in Cayman are subject to the same regulatory and capital adequacy standards as banks in other parts of the world. 

But a crucial difference in Cayman is that there is no deposit insurance. If a bank fails, your money isn’t guaranteed, by anybody. The officials may say, “Ahh, but there’s a Cayman depositor protection rule” – which there is, but this only gives depositors preference on cash up to CI$20,000 held in a bank. No protection, just preference. 

What this means is that if a bank fails, the first people to be paid out of the bank’s estate will be those with CI$20,000 or less. After that, it’s a free-for-all. And if the bank has done something truly dumb, there may not even be enough for that payment.

What should Cayman do then?  

Should Cayman rely on the general public to properly and carefully evaluate the health of banks or contemplate legislative changes? The problem with the latter is what would Cayman do? 

Imagine if there were a bank collapse. Where would Cayman get the money to guarantee depositors? Cayman is strictly bound by UK rules on borrowing. One possibility is that Cayman could change the bankruptcy rules so that more cash is subject to preference – raising that $20K threshold. 

Another, perhaps more radical, suggestion would be to think about the implicit subsidy that banks and the government get from the Cayman dollar/US dollar exchange rate. There’s a minimum 2% spread in there for every transaction that happens. In essence, that’s free revenue to banks. Perhaps some of that could reasonably go into a deposit insurance fund which would then be used to protect depositors? Almost certainly there would be many problems but is doing nothing the better alternative?

To end on a happy note, most banks act properly, most banks operate prudently. Indeed, one good thing about Cayman’s banking system is that the banks are relatively cautious – they haven’t (mostly) tended to do the exotic things that have got banks in other jurisdictions into trouble. They haven’t done the dumb stuff… yet.

But that’s no reason to be complacent, both as consumers and as legislators; there’s always scope for improvement.

Simon Cawdery, CFA is an investment manager and governance professional who lives and works in the Cayman Islands. He will be writing regularly for the Compass on business and finance matters.