## A Tale Of Two Banks

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What does it mean to say something is risky? How would we know? Would a failure confirm the view that a particular activity was risky?

Consider two people gambling at roulette. Joe puts \$100 on each number from 1 to 35. Jane puts \$3500 on number 36. Both have bet \$3500, and both bets have negative expected values (assuming a 36-1 payoff on the winning number, and 38 total numbers.)

To me, Joe’s bet looks less risky. There’s more than a 90% chance he’ll win \$100, although the expected value of the bet is still negative due to the fact that he loses \$3500 if number 36, 0 or 00 comes up. Jane has more than a 90% chance of losing all \$3500 but will win very big if number 36 comes up. That seems riskier.

Now let’s assume that both people make their bets, and the little ball lands on number 36. Does that improbable outcome mean that Jane’s bet was actually less risky than Joe’s. I’d say no; she just got lucky.

When I speak with people, I often get the impression that they conflate “risky” with “failure”.That’s not how I interpret the term. Consider two banks:

1. Silicon Valley Bank (SIVB) takes deposits and invests them in Treasury bonds. It is a fast-growing bank.

2. Bank OZK (formerly Ozark) rapidly grows from a small Arkansas bank to a major lender for real estate projects in America’s largest cities.

Which bank’s assets seem risker? Based on this evidence, I would say that Bank OZK was far riskier.

Now assume that SVB goes bankrupt, while Bank OZK is doing great. Does that impact your view as to which bank engaged in a riskier strategy? Should that fact influence your view as to which bank engaged in a riskier strategy?

If failure is evidence of riskiness, what does that imply about the roulette example discussed above?

In 2018, I did a post on Bank OZK, citing it as an example of the sort of risk-taking bank encouraged by the moral hazard in our banking regime. In retrospect, it looks like SVB would have been a better example. But is that true? Was SVB actually a riskier bank? Or did number 36 come up on the roulette wheel?

My failure to spot the bank that actually failed illustrates a problem faced by regulators. In 2018, I was presumably looking back at the banking crises of the 1980s and 2007-10, and noticing that real estate lending often led to banking distress. At that time, Treasuries had been in a bull market from almost 4 decades. We tend to estimate risk based on past performance, especially the recent past. Regulators are unlikely to spot risk that comes from an area that was not previously a major problem. (Recall that in 2006, MBS investors were lulled by the fact that the US had never experienced a large nationwide decline in house prices.)

In recent years, real estate has done surprisingly well, as inflation tends to boost the value of hard assets like land and buildings. On the other hand, inflation reduces the value of T-bonds. It’s quite possible that, ex ante, SVB’s approach was less risky (perhaps even profit-maximizing!), but these unpredictable macro trends hurt SVB and helped Bank OZK. (To be clear, I suspect that there were other differences as well, perhaps Bank OZK has superior management.)

I don’t believe we’ll ever be able to fix the banking system through regulation. Regulators will always be like generals fighting the previous war. Instead, we need to remove the underlying problems—moral hazard and a lack of diversification. Trump likes to talk about “Making America Great Again”.How about “Make America’s banking system more Canada’s”?

PS.  David Beckworth has an excellent piece in Barron’s discussing how the rise in interest rates has helped long-term borrowers (including the Treasury) while hurting bondholders.

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