It’s all bad/good (delete as appropriate)…

As human beings, we have the tendency to struggle with the nuances, and often unexpected randomness, of future outcomes.

And the predictions of “experts” are notoriously unreliable, with the only question often being: “Wrong by how much?”

Of course, as underwriters and managers of complex credit, economic and financial risks, it is natural for the Awbury Team to place more emphasis on the downside element of risk/reward calculations.

Nevertheless, the world has not (so far) come to an end; and, over time, positive outcomes tend to outweigh the negative- otherwise we human beings simply would not be here- what one might call Humanity’s Positive Skew!

Yet, we still have to deal mentally with the fact that we seem predisposed to pay more attention to negative or bad news/information than the opposite.

In one sense, this is a rational survival mechanism; but most of us now live in a world in which we do not have to wonder whether a rustle in the undergrowth means that we are prey for some more efficient and lethal carnivore.

Naturally, the recent pandemic demonstrated that complacency, or the view that extreme events cannot happen, is dangerous. However, that has to be tempered with the fact that, in the face of the challenges posed, many societies and most businesses coped remarkably well.

So, at a time when not much seems to be going right in geopolitical terms, and economic outlooks in many parts of the world are uncertain at best, we should bear in mind that the “fat tails” of risk distribution can exist at both ends of the curve, even if we are pre-disposed to worry (quite rationally) about the left-hand tail of that distribution..

These thoughts were prompted by a Bloomberg article we read, authored by John Mickelthwait and Adrian Wooldridge, entitled “The 10% World Offers a Sliver of Hope for 2024”. In this (as a counterpoint to a previous article from 2016 (The 20% World), in which they posited a number of downside risks assessed as a 20% probability) they posit that one may well be surprised that a number of seemingly lower probability outcomes may actually transpire, or negative outcomes be avoided. In other words, one should not be surprised if outcomes do not conform with “received wisdom”- something an underwriter always has to bear in mind.

The determined pessimist (or self-professed “realist”) is likely to dismiss the likelihood of any positive outcomes in the Ukraine/Russia conflict; in the Middle East in the wake of the October 7 terrorist attacks; or in the consequences of the Chinese Communist Party’s dogma requiring the “absorption” of Taiwan into One China. Taken individually, one could argue that such a view is entirely rational; yet across the spectrum, an unexpected outcome is far from impossible. If outcomes were only ever bad, and apparent trends irreversible, we would not still be here; and not enjoy the benefits we do today.

With all that unaccustomed optimism expressed, we shall now re-apply our “tin hats”; and resume our usual, deeply skeptical approach to the idea that there are any upsides in this world!

The Awbury Team

Always Remember that You Might be Wrong…

In a world in which everyone wishes to believe that they are “above average”, we have long argued that a little epistemic and intellectual humility is essential in trying to minimize error and avoid ruin.

While, in order to be effective decision-makers and risk managers, we have to have the courage of our own convictions, we should always consider that we might, actually, be wrong.

The aphorism about the benefit of having “strong convictions, loosely held” comes to mind.

If there is anything that experience has taught us, it is that being dogmatic and refusing to address contra-evidence, or a change in circumstances, is a sure way-point on the road to mediocrity at best, and self-destruction at worst.

Expertise and specific, relevant knowledge are, of course, hugely valuable in any professional undertaking such as underwriting complex credit, economic and financial risks. One really does have to have some idea of what one is doing; what is realistic; and how an environment can change with blinding speed if one is not to be seen and taken advantage of as the “dumb money”.

A related issue is that, in thinking about issues or factors following what one might term “well-worn, synaptic grooves”, one runs the risk of becoming mentally trapped in a form of linear, deterministic thinking, which can lead to ignoring signals that would cause a change of direction. Couple that with wishful thinking and one has the recipe for potentially very poor outcomes, or degraded and lazy thinking.

Sometimes “ ‘Twas ever thus” makes sense; but not always.

Consider the now seemingly endless economic “party game” of forecasting the next US recession…

Supposedly, it has been going to arrive within the next quarter for at least a year, if not longer. Yet, so far, it has not. Economists, “pundits” and other soothsayers fixate on such matters. If one of their forecasts proves prescient, are they smart, or just lucky?

After all, economies are complex systems. Yes, there can be feedback loops, and cause and effect; but to engage obsessively in a predictive game of false precision is self-defeating.

Far better, as an underwriter, to think about a range of possible timings and outcomes, and assess how they may have an impact upon the existing or potential exposures one may have or select. After all, in this business cycle, the key thing to consider is the consequence of a rapid doubling of the cash cost of interest payments on floating-rate debt, and the availability and replacement costs of all debt when re-financing. After all, funding costs have risen materially. Trying to predict the timing and extent of any central bank decision to start reducing rates is all very well for those who make a living from trading on such factors; but, for corporate treasurers, ensuring that their business has sufficient available cash and access to liquidity to meet all obligations as they fall due is rather more pressing.

When many in the market have never had to operate in world in which a 10% cost of debt is a reality, accepting that that world has changed can be paralyzing, unless one has experience of prior examples and their consequences.

However, perhaps paradoxically, the COVID pandemic has taught us that company managements can be remarkably adaptable in facing unexpected risks. All this means that one must try to avoid viewing the world in ways in which one assigns probabilities to the more extreme outcomes that are not warranted by realities- neither following the naïve path of Voltaire’s Candide, nor the existential gloom of his interlocutor, Martin- “What a pessimist you are!” exclaimed Candide.
“That is because I know what life is,” said Martin.”

The Awbury Team

What now…?

At the start of a new year, it is worth pausing and thinking about what may come next- for good or ill.

Obviously, as underwriters and managers of complex, multi-year risks, the Awbury Team has something of an obsession with trying to parse how the forces acting upon the present will impact the future, and so the risks which we have selected.

As should be obvious by now, in many sectors, supposed “experts” have no more ability to predict outcomes than the proverbial dart-throwing monkey. Our world is complex; and, even if trends or patterns appear to be discernible, they can change rapidly, or turn out to be a mirage, even a fata morgana.

So, is all this a counsel of despair?

Absolutely not!

One simply needs to recognize that the art of underwriting is exactly that, an art, with an overlay of achievable scientific rigour, or at least parametric constraints, in certain areas.

For example, the next US recession has been predicted for at least a year, and has yet to show up. Do recessions matter. Yes, they do, but their consequences depend upon scale, length and scope- i.e., many variables. Rather than try to be unduly specific, far better to look at the nature and outcomes of past recessions and see the extent of their actual impact. In so doing, one will get a more informed idea of potential outcomes, which one can then overlay upon one’s portfolio and risk selection. Of course, there are always outliers- examples being the Great Depression, the GFC and the Pandemic, yet even these add to the understanding of potential outcomes given different causes and responses.

Conversely, with real cash interest rates effectively doubling over the past 18 months or so, it is not hard to understand how this will impact future cashflows of leveraged balance sheets- reducing the margin for error in corporate performance; forcing managements to re-consider the availability of discretionary cashflows; increasing vulnerability to re-financing risks and “market seizures” and closings; and re-emphasizing that “lack of cash kills companies”.

Given that, in underwriting credit and related risks, one is always focused on the “downside”- how might 2024 and beyond turn out?

The honest response is that no-one can properly know the answer to that question; while those who have certainty are deluding themselves and others.

That said a few points are worth making:

• Geopolitics (or, as Adam Tooze terms it, Geo-economics) are ever more complicated. This generates a higher probability of sharp changes in the risks attaching to certain industries- such as hydrocarbons, shipping, semiconductors, and certain metals and minerals. We may live in an increasingly digitized world, but it is one that still depends on the availability and free movement of resources; the stability of supply chains; and the ability to produce and transport finished products
• Spending on defence by the US and its global allies is going to have to increase significantly if certain desired outcomes are to be achieved, or negative ones prevented- especially for materiel such as munitions, rockets/missiles and drone technologies
• A likely hyper-focus on the US election cycle may well provide distracting theatre, and potentially detract from attention being paid where it should
• Central bank monetary policy will continue to create market volatility when decisions do not conform to expectations
• There will be “pain” for banks in certain segments of their loan books; while, at the same time, they are trying to work out how to address the rise of Private Credit

All of these factors are likely to lead to period dislocations, which tend to increase the demand for the bespoke solutions which Awbury can and does provide.

As always, we shall continue to combine our extensive and demonstrable expertise with intellectual humility and institutional paranoia…

The Awbury Team

The uncanny valley… A future too perfect…?

There is a term used in robotics and now in Artificial Intelligence (AI): the uncanny valley.

The phrase was created in 1970 by a Japanese engineering professor, Masahiro Mori, to suggest that a person’s response to robots would shift from affinity and feeling comfortable to one of revulsion as robots became increasingly lifelike, passing through the “uncanny valley” whose far side leads to a “normal” human being.

Now, of course, increases in computing power and regular advances in AI, are creating a situation in which the digital equivalent is becoming real- whether written, verbal or visual. The Turing Test would certainly seemed to have been superseded and passed when it comes to written interactions online; while the ability to manipulate images, both static and moving, coupled with the synthesization of voice capabilities and “normal” speech, can make it very difficult to distinguish whether a “person” is real (“authentic”), or a realistic digital human avatar.

If you could present yourself as an image of your “perfect self”, with the semblance of reality far outstripping “Photoshop”, what would you decide?

Avatars that are clearly caricatures, or represent specific tropes, are not seen as threatening; but what of a perfectly-sculpted face that might or might not be “real”, such that one is not sure who or what one is interacting with?

As much business in now conducted remotely and digitally (including via the infamous Zoom/Teams/Webex meeting), especially in the worlds of finance and (re)insurance, how can one be sure whether that broker or underwriter one is dealing with is truly human, or just plausibly so? What or who is controlling and directing the process?

Ironically, of course, it is the real humans who are imperfect, in appearance, computation, communication, and speech.

Until fairly recently, all of this need for assessing “realty” would have been seen as implausible or unlikely- a science fiction fantasy.

However, over the past year or so, we have moved on from some (re)insurers touting their “algorithmic capabilities”, to one in which generative AI systems can execute very sophisticated processes- especially so-called “multi-modal” ones (that can process and communicate by, say, both text and images); and which increasingly have also been given the ability to use tools (such as a version of ChatGPT-4, with access to a Wolfram Alpha plug-in, which can perform complex mathematical calculations).

And given that all such models rely upon vast amounts of data, as well as access to significant processing capacity (all of which is expensive, even as efficiencies improve), one can see the potential for a “winnowing”, in which only the largest and/or the most specialized businesses will be able to survive and thrive, including in (re)insurance- yet another example of the hollowing out of the “great middle”. One can already see that the more and the more complex your data archives are, the more valuable they are.

While it is far too early to make any definitive predictions as to how the impact of generative AI will pan out within the industry, trying to pretend that it does not matter, or is irrelevant, would simply be foolish.

The whole point of the industry is to assess and understand new risks or other factors as they arise. Whether that will include self-analysis of whether existing business models remain viable remains to be seen.

In the meantime, you may care to ask yourself whether that underwriter with whom you have been communicating is actually human, or merely plausibly so…

The Awbury Team

The Times They Are A-Changin’…

In 1964,, when Bob Dylan released the song and eponymous album with the above title, there was little doubt that the US was seen as, and regarded itself as the “liberal hegemon”; the “world policeman” tasked with sustaining its interpretation of democracy where feasible, and preventing the spread of competing ideologies or forces, such a Communism.

At that time, China barely registered on a global scale (having turned inwards after the Korean War, and soon to face the turmoil of the Cultural Revolution); the USSR and the Warsaw Pact were the identifiable, obvious Enemy; and Iran an autocratic monarchy and quasi-protectorate.

How the world has changed.

The question is whether our mental models and assumptions also have, even if there have been a number of “tremors” over the past decade or so.

The benefit of hindsight will be a wonderful thing. However, one does wonder whether the consequences of the Russian invasion of the Ukraine, and the conflict arising from Hamas’s acts of terror and their propaganda impact on Israeli society and military self-belief, coupled with uncertainty over the PRC’s intentions and capabilities in the South China Sea and towards Taiwan, mark a shift in the tectonic plates underpinning the current geopolitical landscape.

Military doctrine states that fighting a major war on two fronts simultaneously is rarely a good idea. Adding a third would be regarded as folly. Of course, the US is not actively engaged in any major wars at present. Yet, having, in effect, experienced mission failures in Iraq and Afghanistan, it is, nevertheless, in supplying materiel to the Ukraine and Israel, depleting its own resources, while the PRC has continued scaling up the capacity of the PLA’s various components (although it should be borne in mind that the last time the PLA fought a war- against Viet Nam in 1979- it did not prevail; and it has no modern combat experience.)

And now, to say the least, there is increasing disunity within the Federal Government, and elsewhere within the US “political establishment”, in terms of the extent to which the US should continue to try to “make the world safe for democracy”. The trend may not yet be towards full isolationism, but the signs are there. The question then becomes whether there will be actually be a return to a world equivalent to that of the pre-World War II “America First”, of even “Fortress America”, with the US increasingly and explicitly disengaging from alliances such as NATO, and gradually running-down its overseas military presence, except perhaps in the Western Pacific to provide forward defences, or in the Middle East (for now).

Such a world would be very different from that which has existed for the past several generations.

All of this makes underwriting, selecting and managing credit, economic and financial risks, as Awbury does, even more “interesting” than usual. Is history going to repeat, rhyme, or wander off in an, as yet, uncharted direction? Human nature does not really change; and, for now at least, key political and military decisions are still taken by flawed, biased, sometimes delusional human beings. Is it, therefore, realistic to continue to rely upon past assumptions as to how individuals and societies behave?

The level of “noise” and (dis-/mis-) informational distortion continues to increase; which emphasizes the need to be able to discern the signal, however faint.

So, as always, we remain institutionally paranoid and skeptical; and extremely careful about the risks we do place in our portfolios. There is no upside in behaving otherwise as stewards of our own, and our Partners’ risk portfolios.

The Awbury Team

Of course we’re resilient…!

We recently came across an article written by Jonathan Evans (a former Director General of the UK’s MI5 domestic intelligence service), and Paul Martin, a Distinguished Fellow of the Royal United Services Institute (RUSI), and published some three years ago in depths of the onset of the COVID pandemic.

The article (facetiously, but alarmingly accurately) posits 14 Rules that large, complex organizations “should” adopt to ensure that they are adequately resilient in the faces of complex crises.

We highlight below a few of the key ones, with some of our own commentary, which may perhaps induce a little self-reflection:

• Have a Plan and Stick to it: This plan must long and detailed, with many diagrammes and annexes; and reassuringly authored by a “business continuity specialist” or consultant- neither of whom remain with the organization. If it is not precise, clearly it is not up to the task; and it must be oblivious to “sunk-cost” bias, so that all involved keep digging an ever larger hole when crisis strikes- perhaps for some collective “head-in-the-sand” communing. Of course, as Field Marshal von Moeltke famously said: “No plan of operations extends with certainty beyond the first encounter with the enemy’s main strength.” In other words, make sure that you have alternatives and options available, and not just The Plan
• Take Comfort from Your Risk Register: Beloved of regulators everywhere as evidence that management actually is aware of the risks which an organization supposedly faces. This will have been constructed years ago by the firm’s risk management specialists, with many ill-defined or nebulous terms; and brought out in fetishistic ritual at least twice a year for review by The Board, preferably at the end of an all-day board meeting. The Board’s role is to admire the artefact for its aesthetics. Perish the thought that its members should actually have a robust discussion, or suggest any changes!
• Have Faith in Quantitative Risk Models: Make sure that your planning is based upon highly-complicated quantitative models developed for the financial services industry. We all know how well those performed during the GFC
• Stay Focused on Immediate Returns: Current Return on Equity (RoE) is what you are rewarded for. “Resilience (whatever that means) costs money and does not feature in your accounts”. Efficiency and productivity are what really matter
• Do not Bother with Semantics: Trying to clarify what “resilience” or “business continuity” actually mean is pointless. Everyone knows that all you are trying to do is to limit the damage after bad things have happened
• Ignore the Human Dimension: Trying to assess and factor in how people are likely to behave in a crisis is an unnecessary extravagance. After all,  we now have Generative AI to tell us what to do
• Leave Everything to the Specialists: Clearly, it is their job to sort out all this mess. Involving executive management or the Board is simply a distraction from their “strategic” responsibilities
• Keep Moving People About: HR “best practice” requires ensuring that people are moved sufficiently frequently to meet their expectations, and avoid bogging them down in acquiring relevant knowledge and experience.

We could go on, Dear Reader; but you should by now get the drift…

As one can infer (and as the pandemic all too clearly demonstrated), one of the key attributes of a truly resilient organization is the ability to make swift assessments, and adapt to changing realities, rather than remain wedded to “The Plan”

We commend the article as one that should be read in its entirety.

The Awbury Team

Heresy in Financial Risk Management…

Following on from our previous post (“Fighting the Last War…”), we were prompted to write a further, related post after we came across the work of Jon Danielsson, an Icelandic economist, Reader in Finance at the LSE, and Director of its Systemic Risk Centre.

As we pointed out in “Fighting…”, the Fed (and other financial regulators) are still generally using the “GFC Playbook” to deal with financial crises, privatizing gains (for most), and socializing losses. Their aim, quite understandably and laudably, is to prevent systemic contagion and collapse, but the result is that moral hazard, hidden behind the protections of limited liability, always lurks in the undergrowth. The general absence of personal liability for the incompetent and avaricious tends to encourage risk- and rent-seeking behaviours, as the incentives of risk vs. reward are skewed.

Of course, it is easy to criticize those, such as financial regulators, who face a thankless task. However, as Danielsson has pointed out in his recent book “The Illusion of Control”, the characteristics of current financial regulation present some inherent problems in terms of effective risk management and mitigation.

As mentioned above, what the regulators truly care about is avoiding systemic contagion, which was obvious with the series of recent US bank failures, and with the forced acquisition of Credit Suisse by UBS. At the same, they do not wish to constrain the financial system to the extent that economic growth also becomes constrained because of a contraction in the availability of capital. To put it another way: effective risk management does not simply mean reducing risk; but rather it is supposed to be done in such a way that it avoids introducing further risk, or shifting its consequences elsewhere.

The paranoia which the GFC engendered created an ever more complicated framework which relies upon trying to quantify risk and then containing it through a prescriptive system of rules dependent upon those quantitative measurements, such as capital ratios, leverage, and liquidity. In themselves, these rules are a logical outcome. However, they are also backward looking. Danielsson makes that point that, in 2008, the ECB’s Composite Indicator of Systemic Stress (CISS) predicted a low probability of a crisis, only to predict a very high one after the GFC had waned.

One systemic irony is that, because banks are regulated individually, the focus is on ensuring that each component of the system is safe, in the expectation and hope that that will make the overall system safe. In essence, financial regulatory systems tend to encourage “herding” and conformity, which is all very well; but, in the absence of macroprudential regulation, the approach introduces an illusion of safety and resilience. If there are flaws or gaps in the prescriptive regulations, the whole system can be at risk. This is compounded by the fact that everyone is supposed to use the same methodologies in modelling risks (VaR, anyone?!). The GFC highlighted the dangers of that homogeneity.

A key point which Danielsson make is that financial regulation is endogenous: the mere fact of observing, measuring and then legislating for managing risk in a system actually affects those risks. If regulation is designed to encourage or discourage certain behaviours or risk selection, those regulated will act accordingly; and, at the same time, look for gaps that can be exploited.

The paradox is that, because system components are encouraged to act in similar ways, if there is a failure in the system, the consequences tend to be much more severe.

All this means that one should be very wary of accepting at face value the contention that, because everything appears to be stable and volatility is low, the system itself must be stable, and the risk of an adverse shock or failure is low. As the phrase from the iconic BBC TV series states: “It’s too quiet….”

A little heretical thinking can help prevent, or at least, minimize, the consequences of a flawed regulatory system, as it creates a healthy skepticism, which may enhance the possibility of avoiding becoming swept up in the general mayhem and uncertainties of a financial crisis.

The Awbury Team

Fighting the last war…

If it does, it was all your fault. Any credit underwriter can identify with that!

Yet the events do require a dispassionate look at whether bank regulators were, and are still fighting the proverbial last war, and need to adjust their perspective.

After all, the various reforms instituted after the Great Financial Crisis (GFC) – an episode which revealed how comprehensively banks had “gamed” the system- were intended to reduce the probability of a recurrence.

In 2023, that did not stop banks that were supposedly fully compliant at the point of failure, from having to be “put out of their misery” in a matter of days, if not hours, to prevent systemic contagion.

There are certainly differences between what lay behind what happened in the US, and in Switzerland. Nevertheless, each episode revealed that fractional reserve banking is inherently unstable, because the ability to continue to function depends upon retaining the confidence of both depositors and markets, as well as of regulators.

They also revealed that what one might call the “velocity of failure” and the possibility of a “gap to default” have increased substantially as the result of the speed of information flows and network effects. Bank depositors are supposed to be “information indifferent”. Clearly that is not the case.

So, if an architecture dependent upon regulators monitoring and adjusting minimum capital ratios, leverage caps and liquidity coverage ratios is insufficient in the “use cases” that actually matter, what then?

The underlying problem with all rules-based systems is that the entity intended to regulate them, while nominally having the power to act, is often resource-constrained; faced by managements which are not; and wary itself of sparking panic.

This creates the paradox that regulators (as the Federal Reserve has admitted in the case of the recent US bank collapses) could have acted, should have acted, but did not act until there was no realistic alternative but to seize the institutions involved.

In the case of Credit Suisse, FINMA (the actual regulator) seems to have felt constrained from acting until loss of confidence in the capacity and ability of the Bank’s management became self-fulfilling. The outcome (the hastily-enforced “merger” of Credit Suisse with UBS) has created a new paradox (and danger): what happens if the supposedly stable and Too Big To Fail (TBTF) merged entity becomes unstable, or loses the confidence of its depositors, customers and market counterparts?

It does not matter what the reality is of a bank’s solvency, asset quality and liquidity, but rather the external perception.

All of this argues not so much for more stringent regulatory capital and available liquidity requirements (although both might help), but rather for regulators having the courage (and ensuring that they have the unarguable authority) to act pre-emptively to stabilize or re-structure impaired banking entities.

Easy to say; hard to implement. Either way, it seems likely that there will be a period of regulatory introspection before it becomes clear what steps will be taken (yet again!) to mitigate the probability and scale of potentially catastrophic bank failures.

The Awbury Team

It’s not magic, but it’s not simple either…

By definition, anyone who underwrites credit risk is dealing with a combination of understanding and analyzing data; then assigning probabilities which (should!) lead to a rational decision, based upon what is known or foreseeable, and focused on risk versus reward within the terms of a business’ risk appetite and capacity.

Seems obvious, does it not?

Well, the concept may be, but the process is not.

Objectively, the future is unknowable; yet, as credit underwriters, we still have to make decisions, and try to avoid, or at least control for negative outcomes.

While the universe may, for practical purposes, be infinite, our world is finite, albeit complex.

We have access to ever-expanding quantities of data, and new tools in the form of generative AI. However, we are constrained by the quality of our decision-making, which is a topic and discipline that still seems to receive too little attention, even though (re)insurers constantly tout the quality and (supposed) accuracy of their underwriting and pricing models.

In Nicholas Nassim Taleb’s book “Anti-fragile”, he make the following point:”… risk management professionals look in the past for information on the so-called worst-case scenario and use it to estimate future risk- this method Is called “stress-testing””.

Quite so. Think of the concept and tool of Value at Risk- VaR- which is one cornerstone of risk assessment for managing derivative and similar transactions which are “marked-to-market”. Everyone likes to talk about “confidence intervals”, and whether they use 95%, 97.5%, 99%, 99.5% or 99.9%, which is just a mathematical expression of standard deviation from the observed or modelled measurement of risk. Of course, (re)insurance regulators have built whole capital models on similar concepts.

This does not mean that any of them are accurate!

In the same section of his book, Taleb refers to this approach to stress-testing as the Lucretius problem (and an example of a mental defectiveness) after the Roman poet and author of the influential poem “De Rerum Natura” (On the Nature of Things), who made the point that fools believe that the tallest mountain they have seen must be the largest that exists.

The Great Financial Crisis (GFC) forcefully demonstrated how misleading VaR models could be. We see the same muddle now with discussions of climate or cyber risks. It is not that the risks do not exist, but that we assume that they are easily measurable. As the Greek orator, Demosthenes said: “What a man wishes, he will also believe”.

All this leads to be point that, in underwriting credit risk, we are always grappling with the quandary not only of whether we are asking the right questions, but also whether we can actually arrive at truly useful answers, and avoid trying to “fit the facts to the desire”. Avoiding wishful thinking and self-delusion is essential.

In reality, the key is trying to distinguish between risks which are clearly “bounded”, and those which, even if we choose to believe otherwise, are potentially unbounded. One can price for the former; while, for the latter, one has to try to find some means of mitigating and containing the risk exposure in order to avoid the potential for ruin- failing which one should simply refuse to accept it. It should also be borne in mind that sponsors and corporate executives, or politicians and bureaucrats, will be at some pains to try somehow to deflect an underwriter from asking the questions that they cannot or do not wish to answer- the “shiny bauble” and “righteous indignation” approaches.

At Awbury, we try to harness our institutional paranoia when it comes to risk selection and acceptance, to minimize falling for the delusion that we can always fully understand a risk. If we cannot create and test a valid thesis, then the risk should not be accepted.

The Awbury Team

Bank deposits- too much of a good thing…?

Customer deposits are the “lifeblood” of fractional reserve banking, as the recent US banking crisis has amply reinforced.

It is, therefore, somewhat ironic that the flow of deposits can, in itself, sow the seeds of failure; while being an “outlier” is a signifier of potential future trouble.

Bear in mind that two of the three largest bank failures in US history happened within the past few months- Silicon Valley Bank and First Republic. Those with a sense of nostalgia may recall that another “FRB” failed in 1988 in Texas during the Savings and Loan (S&L) wave of failures. In the case of SVB and FRB II, the proximate cause was a catastrophic level and speed of deposit outflows.

However, what is really interesting is that over the past 25+ years, the rate of US bank deposit growth has steadily outpaced that of bank lending, opening up a significant gap in the process.

Given that a bank has, by definition, to balance its books in real-time, something has to be done with the “surplus deposits”.

Much of that surplus has been invested in liquid and supposedly safe securities, such USTs, AAA GSE Agency bonds, and high-quality corporate debt.

It is here that the quirks of US GAAP accounting are of interest, as an increasing percentage of those securities have been booked as Held-to-Maturity (HTM), rather than Available for Sale (AFS). The crucial distinction between the two categories is that in the former securities are booked on balance sheet at “amortized cost”, whereas in the latter they are periodically marked-to-market. In public and regulatory reporting, the change in realizable value of AFS securities is clearly visible, whereas for HTM securities the balance sheet shows little if any variation. Strangely enough, quite a few banks have moved an increased percentage of their securities holdings from AFS to HTM over the past year or so, thereby masking (unless one carefully reads the notes…) how much realizable value has actually changed (i.e., declined) over time versus original cost because of the rapid rise in US interest rates

All this may seem a little arcane, but is crucial.

SVB had, over the past several years, essentially “gorged” on deposits, as its core client base of early stage and growing VC-backed businesses was overwhelmed by investor inflows. The bank could not deploy those deposits fast enough in its loan book; and, in a low-rate environment, bought long-dated USTs in a classic “reach for (at least some) yield. When the Fed, finding itself “behind the curve” in controlling inflation post-COVID, increased interest rates more quickly than for a generation, SVB’s HTM portfolio also plummeted in realizable value. In theory, it had a compliant regulatory capital base. In reality it was insolvent. Couple that realization with a deposit base that was also extreme in the level of uninsured deposits (>90%) and in its rather “incestuous” nature, and one had the makings of the deposit flight which rapidly brought down the bank when management attempted to re-position its AFS portfolio and raise some capital at the same time to bridge the gap.

Of course, hindsight is a wonderful thing. However, what happened to SVB and FRB, both of which had somewhat idiosyncratic business models (and misaligned management incentives), simply reinforces the fact that one should always look closely at any business, bank or not, which has a business model or growth rate that diverges materially from the relevant norm. That may be a function of some unique and sustainable competitive advantage. More often, it conceals a flaw which make its more vulnerable when its operating environment changes rapidly.

The Awbury Team