Financial Institution Innovation Needed in Silicon Valley

The failure of Silicon Valley Bank to find a buyer opens up the possibility (and the need) for a new kind of bank that is focused on financial stability as well as the traditional banking functions of lending and running payment systems.  The distinctive elements would be (1) deposit commitments with a penalty for early withdrawal and (2) mutual stock ownership by depositors that zeros out upon early deposit withdrawal.  Better than money market funds, this kind of bank would address the problem of enormous sums looking for safe storage within the financial system.

The general problem is that there are institutional and commercial parties with very large cash holdings that they wish to store safely but within an infrastructure that facilitates use of these funds for investment or distribution. Putting these sums in any but the largest bank raises the SVB problem: Social media boosts the probability of correlated withdrawals, and electronic-account access enables rapid withdrawal of funds.  In combination, these factors greatly increase the run risk at any bank, even one that is solvent.  Capital regulation alone is insufficient to deal with this important liquidity problem. 

This year’s Nobel prize-winning economists proposed two solutions to a ‘panic’ run: deposit insurance and a lender-of-last-resort.  Deposit insurance in the multi-millions of dollars raises obvious moral hazard problems, meaning it would create irresistible temptation for a bank to take outsize risks.  The Fed’s recent moves show the limits of the lender-of-last resort: It works for SVB and other banks now only because the Fed is willing to mark collateral at hold-to-maturity values rather than lower market values in light of higher interest rates. This reads as a ‘bail-out’. 

What are the alternatives? First is putting deposits with a Global-Systemically Important Bank. The run risk is small; the insolvency risk is small.  Either through the Dodd-Frank special resolution machinery or the determination that such banks are ‘too big too fail’, the large depositor will surely be protected.  But this leads to further banking asset concentration and sacrifices the value of custom-tailored loan origination in specific industry or regional clusters.

Second is putting deposits into money market funds.  Indeed, these funds have received massive influxes in recent days, topping $5 trillion in total assets.  These are deeply flawed financial intermediaries, however, as evidenced by the need for bailouts in 2008 and 2020.  In order to make them relatively stable, their assets are short term, which encourages short-term finance throughout the economy, including the financial sector. Moreover, money funds that redeem at par depend upon the availability of short-term government securities.  The supply of T-bills is finite; eventually these money fund assets will consist of reverse repo accounts at the Federal Reserve.  If we want to give depositors accounts at the Fed, let’s just do it.  This form of ‘super-narrow’ banking sacrifices much in the way of credit intermediation.

So here is an alternative for a reorganized Silicon Valley Bank.  The distinctive problem to solve is run risk, given the nature of the likely depositors.  The bank should offer three kinds of deposit accounts.  First is a retail account, held by individuals, providing daily liquidity but subject to a threshold.  Second is a commercial transaction account used by an operating company to meet its regular transaction needs, such as payroll or vendor payments.  This should also provide daily liquidity, without limit.  The third is a ‘storage’ account for individuals above a threshold, for operating companies for their non-operating cash holdings, and for institutions holding funds for eventual investment or distributions. 

Storage account funds are held in ‘storage CDs’ bearing interest as deemed appropriate, with specific term (at least T+7); storage CD depositors have immediate redemption rights but with a discount for early redemption.  Storage CD depositors are also required to own bank common stock in an appropriate amount.  The goal is that a substantial amount of the bank stock will be owned by the storage depositors, a kind of mutual ownership.  Critically, a party exercising storage CD early redemption rights forfeits its bank stock.

The value in this structure is that it reduces what is the actual risk of Silicon Valley Bank, which is not poor loan origination but the risk of a depositor run, given the concentrated and connected nature of the depositor base.  The depositors say, ‘We have seen the enemy and we are it’. This new structure credibly lets depositors ‘hands tie’ to minimize  deadly run risk.  How?  The redemption penalty and stock forfeiture reverse the usual first-mover run incentives.  Here, a depositor facing the risk of a panic run thinks, ‘The first person to run faces a financial penalty and loses its bank stock. Because the bank is redeeming a credit obligation at less than par, my share of the bank has grown in percentage terms and has become more valuable. I’ll wait’.  This ‘later mover’ advantage means that a run becomes much less likely.

A bank so structured is better than a money market fund.  Not only does it enable socially valuable credit intermediation, including maturity transformation, but it also offers more security than a prime fund because a bank, unlike such a fund, has loss absorbing capacity, its equity.  Such a bank is better than a government money fund because it doesn’t impose distortionary demands on government finance and frees up funds for socially valuable lending. 

At the center of tech innovation, it’s time for some financial institution innovation.

Jeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School, co-director of the Millstein Center for Global Markets and Corporate Ownership, and co-director of the Richman Center for Business, Law and Public Policy, and Visiting Professor, University of Oxford.