Inadequate capital and unrestricted executive compensation took down SVB
The current banking crisis sparked by the recent implosion of Silicon Valley Bank (SVB) has several interrelated causes. To wit, inadequate bank equity capital, misguided capital structure of SVB’s client companies (high-tech high-growth ventures) and misaligned bank executive compensation. Additionally, the risk from duration mismatch between SVB’s assets and liabilities was a major cause of its implosion.
In the aftermath of the 2008 banking and financial crisis, I studied its causes and concluded that if banks were financed with a significantly greater proportion of equity capital, a banking crisis would be much less likely. The proposal has two components. First, bank capital should be calibrated to the ratio of tangible common equity to total assets (i.e., to total assets independent of risk) not the risk-weighted capital approach that is at the core of Europe’s Basel Committee for Banking Supervision’s regulatory standards. Second, bank capital should be at least 20 percent of its total assets. Finally, total assets should include both on-balance sheet and off-balance sheet items; this would mitigate concerns regarding business lending spilling over to the shadow banking sector.
Ironically, another group of financial economists at Stanford University, in SVB’s own backyard, also studied the 2008 banking crisis and concluded that bank equity capital should be at least 20 percent of total assets.
As of Dec. 31, 2020, SVB’s ratio of equity capital to total assets was 6.8 percent, and 6 percent as of Dec. 31, 2021. Had SVB tried to increase its ratio of equity capital to total assets in 2021 or 2022 (by selling equity capital worth, say, $5 billion), it would not have been facing financial calamity today.
Moving forward in time to Dec. 31, 2022, SVB’s ratio of equity capital to total assets was 5.8 percent. Significantly less than the recommendation of 20 percent. As a point of comparison, M&T Bank Corporation, another regional bank of similar size to SVB, is not under any financial distress, and their ratio of equity capital to total assets is 11.6 percent.
Proponents of low to minimal bank equity capital have offered a parade of horribles that would befall the economy if banks were required to hold significantly more equity capital. For example, bankers and their allies argue that if they were required to hold more equity, they would be forced to curtail their lending. If this lending would have been to individuals for mortgages, and startups for human capital development, R&D and working capital, a reduction would dampen economic growth and employment.
This argument is a classic confusion between a bank’s investment and financing decisions. Lending activities are part of a bank’s business operation decision. Financing this lending with debt or equity is a financing decision. In general, if a bank is engaged in value-enhancing business activities, its business activities should not impact how the funds are obtained (through debt or equity). As an illustrative example consider a successful software startup that produces custom enterprise and social media software in quantities that the company managers believe maximize their profits, which is financed with 20 percent debt. If this software company were to decrease its financial leverage to 5 percent debt, would it start producing more software for social media companies and less enterprise software? Probably not. In other words, if a bank were to lower its financial leverage (debt ratio), its business operations would not be impacted.
Another fallacy that is promoted by bank managers and their allies is that a bank’s cost of capital will increase, leading to higher lending costs if the banks are financed with less debt and more equity. Since the cost of debt is less than the cost of equity, bank managers and their allies incorrectly argue that greater financing with equity will increase the bank’s cost of capital.
The reason this argument is incorrect is based on the Noble prize-winning work of Merton Miller and Franco Modigliani — essentially as the bank is financed with more equity, the equity becomes less risky, hence, the cost of equity decreases. In general, the increase in equity financing by itself does not have a substantial impact on the bank’s cost of capital. This argument is not just a fine theoretical construct. A substantial amount of academic finance research validates the above with U.S. and international bank data.
A question arises: Why did high-tech high-growth tech entrepreneurs and venture capitalists in Silicon Valley choose to finance a significant part of their companies with debt? Finance theory recommends all, or almost all, equity financing for high-risk high-growth companies. A possible reason: Entrepreneurs and venture capitalists would retain larger equity ownership in their company if they choose some debt financing. However, debt financing makes the company more susceptible to financial distress. These entrepreneurs and VCs are suggesting that they get to keep the upside (by not diluting their equity ownership), but the U.S. taxpayer should take ownership of the downside losses.
Regarding SVB’s misaligned executive incentive compensation, its CEO and other senior executives reportedly sold millions of dollars worth of SVB stock just weeks before the bank’s demise. (The Biden administration has recently suggested proceeds from these stock sales should be subject to clawback.) The stock trading behavior of SVB executives is very similar to the trading of the CEOs of the big banks circa 2008.
The following compensation structure for bank executives can address these misaligned incentives:
- Incentive compensation should consist only of restricted stock and restricted stock options — restricted in the sense that the executive cannot sell the shares or exercise the options for six to 12 months after their last day in office.
- Incentive compensation for bank directors should include the same restrictions for six to 12 months after the director’s last board meeting. This will focus bank managers’ and directors’ attention on the long run and discourage them from investing in high-risk financing arrangements that look attractive in the short run but are disastrous for the bank’s shareholders, customers and employees in the long run.
There are solutions to many of the caveats that arise from the above incentive compensation plans, specifically regarding under-diversification and loss of liquidity for these executives and directors.
If SVB’s directors had adopted an incentive compensation arrangement as noted above, perhaps they and their executives would have been more cognizant of long-term risks (including the risk from inadequate equity capital and duration mismatch) and SVB’s customers, employees and shareholders would not be in the current situation.
Sanjai Bhagat is the author of “Financial Crisis, Corporate Governance, and Bank Capital,” Cambridge University Press. He is a professor of finance at the University of Colorado.
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