How Banks Turned Into Giant Synthetic Hedge Funds

Hedge funds are notorious for making big and sometimes risky trades. Banks, meanwhile, are supposed to be a lot more boring by comparison — for obvious reasons. But in recent years, we've seen banks like Silicon Valley Bank make some pretty bad bets themselves. Elham Saeidinezhad, an assistant economics professor at Barnard College, Columbia University, argues that banks have been turning into giant "synthetic hedge funds" by blending traditional lending activities with advanced financial strategies. The big question, of course, is whether they should be doing this at all, given that banks typically operate with a lot more regulatory constraint and might not be as nimble when it comes to entering or exiting positions. Read more:SVB’s 44-Hour Collapse Was Rooted in Treasury Bets During PandemicSVB Failure Sparks Blame Game Over Trump-Era Regulatory RuleThe Thorny Question of Why We Treat Banks Differently At All? Only Bloomberg subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

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• 0:00Speaker 00

  Finance is increasingly being built on digital rails. But as the adoption of virtual assets, tokenization and stable coins grows, can regulation not only keep pace, but help accelerate it? Find out more later in the podcast.

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• 0:51Tracy Alloway?

  Hey there, Odd Lots listeners. It's Tracy Alockway.

• 0:53Joe Weisenthal?

  And Joe Weisenthal.

• 0:55Tracy Alloway?

  We are very excited to announce that Odd Lots is going to Washington.

• 0:59Joe Weisenthal?

  That's right. For the first time, we are going to do a live public Odd Lots recording in our nation's capital. That's going to be March 12th in Washington DC at the Miracle Theater. And guests will be announced in the coming days. But in the meantime, you can find a ticket link at Bloomberg.com/oddlots.

• 1:22Speaker 04

  Bloomberg Audio Studios. Podcasts, radio, news.

• 1:37Joe Weisenthal?

  Hello and welcome to another episode of the Odd Lots Podcast. I'm Joe Weisenthal.

• 1:43Tracy Alloway?

  And I'm Tracy Alockway.

• 1:44Joe Weisenthal?

  Tracy, remember SVB?

• 1:46Tracy Alloway?

  I vaguely remember something happening with a bank called Silicon Valley Bank.

• 1:51Joe Weisenthal?

  Here's actually sort of something I've been wondering about is like, okay, there was this moment where suddenly people got anxious about regional banks and stuff like that. You know, we like did episodes like, how should we reform banking and should banking be semi-public and all this stuff. But like, nothing happened in the wake of it, right?

• 2:08Tracy Alloway?

  No. And in fact, I mean, the Basel end game stuff seems to be pretty much off the table at this point.

• 2:16Joe Weisenthal?

  Oh, yeah. What actually, I haven't been following that. What's happening with that?

• 2:19Tracy Alloway?

  I don't think it's happening. Michael Barr has like, he's left, hasn't he?

• 2:23Joe Weisenthal?

  Yeah.

• 2:23Tracy Alloway?

  I mean, it seems like there's not going to be a big change on that front. I will also say, like, one of the interesting things when it comes to bank regulation is there was a 2018 change where I think the Trump administration made it easier for regional banks to do some potentially riskier stuff. And the argument there was that regional banks should be treated differently to large banks. They should be able to do certain things, blah, blah, blah, blah, blah. And I guess you could argue that that might have fed into some of the SVB drama as well.

• 2:58Joe Weisenthal?

  Actually, it's good that we're talking about this because when we talk about financial markets these days, like so much of it is about tech in particular. But if you go back and look at a chart of KRE, the regional bank ETF, that is another one that was just a straight line up on November 5. And there's a widespread expectation, and I think pretty well founded, that the Trump administration is going to have a much more sort of liberal attitude towards financial market regulation than the last administration. And so we shouldn't go too long with, you know, take our eye off the ball of financial regulatory issues because also if history is any guide, like the next thing that happens, like we'll get no warning of it. It'll just happen one day.

• 3:38Tracy Alloway?

  Yeah. Also, I love talking about banks. Like, let's just do it for bank purposes.

• 3:44Joe Weisenthal?

  Okay. Well, I'm very excited about this episode. It's a guest I've actually wanted to have on for a very long time. We're going to be speaking with Elham Sayadinejad. She's a term assistant professor of economics at Barnard College at Columbia, as well as an adjunct professor at NYU, and also the author Of a recent paper sort of revisiting the collapse of SVB and applying a new lens to it. The paper is called Banks as Synthetic Hedge Funds. So Elham, thank you so much for coming on Odd Lots.

• 4:12Speaker 05

  Thank you so much for having me. I'm very happy to be here.

• 4:15Joe Weisenthal?

  Absolutely. I'm not used to this phrase or this term synthetic hedge funds. I can sort of take a stab in my mind of what it means. But what does this term synthetic hedge funds mean?

• 4:25Speaker 05

  A synthetic hedge fund is a type of activity and rather than being a specific type of like firm. And this is when a non hedge fund wants to replicate the activities of a hedge fund and therefore get the same type of return. And it is about a replication, but it's about the replication of the return and risk of a hedge fund without being an actual hedge fund. So this is when we call an institution doing what we call a synthetic hedge fund type of activity.

• 4:53Joe Weisenthal?

  Tracy, I already like this conversation because normally we talk about shadow banks, right? And so the idea of that there's banks inside regulated institutions and then other non-banks sort of replicate their activity. And it feels like we're looking through the other end of the telescope here talking about, you know, hedge funds being replicated inside regulated institutions.

• 5:12Tracy Alloway?

  Yeah, it's replication all the way down. But, okay, talk to us about how SVB fits into the category of synthetic hedge funds. Because I think that'll help us understand exactly what's going on.

• 5:24Speaker 05

  So basically SVB kind of like fits in this category from two different perspectives. And like one type of activity is actually being generated through the on-balance sheet kind of like operation and the other one is being generated through off-balance sheet operation. So I want to start with the off-balance sheet operation and then I will kind of like continue the conversation to discuss what SVB has done in the balance sheet as well. When it comes to the off-balance sheet operation, it is like the way SVB have used interest rate swap replicates what a hedge fund does in order to conduct a fixed income arbitrage strategy rather than what a bank does in order to protect itself against interest rate risk. So to be more specific, what do I mean by that?

• 6:06Speaker 05

  Like when you try to kind of like match the activities of the SVB. SVB risk managers with the narratives of the CFO of the SVB. We see that the timing of entering and exiting the interest rates swap by SVP really replicates what a hedge fund would do in order to kind of like exploit the so-called mispricing in the bond market. And that mispricing in the bond market would generate this so-called like arbitrage opportunity that a hedge fund wants to naturally exploit. So I want to start with what happened to the SVB in order to decide to exit the interest rate swap positions. So when you look at like the timing of the exit, it just doesn't make sense.

• 6:49Speaker 05

  If you think of SVB as a bank that wants to actually hedge itself against interest rate movements. But if you think of it as a hedge fund who has entered this particular position of having a long position in the US Treasuries and a short position in interest rate swap. Because it was actually thinking that the swap rate, which is the difference between the swap spread, which is the difference between the swap rate and the US Treasury rate is too narrow. And like the hedge fund was predicting that this spread is going to widen in the future. But at some point, it realizes that that prediction was wrong. And the swap spread is not actually going to widen.

• 7:32Speaker 05

  And in order to minimize the losses, it tried to kind of like exit that particular position sooner rather than later. This is the narrative that the SVB CFO was kind of like offering to the rest of us. That they tried to minimize losses and that's why they exited the interest rate swap position. Which again matches with what the very same CFO and very same type of like people from the SVP group were telling us about their prediction about the shape of the yield curve, which informs such a strategy. But it does not align with what a typical bank risk manager would do

• 8:14Speaker 05

  if it wanted to actually protect itself against interest rate risk. Because it was holding very long. Long term US Treasury securities. So in short, when it comes to the off balance sheet operation, the timing of entering and exiting the swap positions. And the reason the SVB has actually conducted both operation matched with their understanding of what the yield curve should be and what the yield curve is, rather than what the interest rate risks are. And they wanted to protect themselves against those type of risks. So if you want to understand it from the traditional bank risk management, this doesn't make sense. If you want to understand it through a hedge fund strategy

• 8:59Speaker 05

  that want to actually exploit mispricing in the bond market and then realizes that that mispricing was mistake, that estimation of a mispricing was mistake, then it does make sense to do what SVB did. At the same time, when it comes to the unbalanced operations, when we look at the asset side of the SVB, there is this item in the asset side, which I think we should explore more and we haven't done so yet. And that's what we call the subscription line or a capital call line of credit, which is something that I think is growing in the commercial banking world. And in terms of the economics of this credit line is a very unusual type of bank credit.

• 9:41Tracy Alloway?

  I just want to ask a question on the swap spreads. So I remember this came up a lot when the Volcker rule was coming into being. But a reality of the way banks operate is that the line between a hedge and a trade can be pretty thin. And hedges can end up being very profitable or they can end up losing a lot of money. How do you actually distinguish between the two? Because again, one man's hedge is another man's trade, right?

• 10:10Speaker 05

  That's a very, very good question. Like, one way to distinguish between the two is that, again, listening to what they are saying and the reasoning behind their entrance and they entering a particular position and they exit from that particular position. So it's really about collecting narrative. That's one thing. The second thing is to match what they are doing with what They also doing in peril and saying in peril about their prediction of what the shape of the yield curve should be. Because when it comes to like most hedge fund strategies, especially the fixed income hedge fund strategies, is all about what a particular hedge fund manager thinks the yield curve should be and what the yield curve in the market actually is today.

• 10:55Speaker 05

  And if there's a difference between the two, a hedge fund is going to conduct a sort of an inter and compose a portfolio that enables the hedge fund to actually exploit that so-called mispricing. So what I would say is that the defining point here is whether that particular entity, it can be a synthetic hedge fund such as a bank or an actual hedge fund, is connecting its activity with the mispricing in the bond market and what the shape of the yield curve should be versus what the shape of the yield curve is or what they do think about like a particular direction in the prices

• 11:39Speaker 05

  and then they want to actually kind of like very immediately and short term exploit those particular directional benefits.

• 11:47Joe Weisenthal?

  So I take your point about, okay, the CFO was saying one thing, we're doing a hedge, but some of this stuff doesn't line up. Could it be incompetence, right? Like, so there's one say, okay, this does not look like a hedge. They're making a trade. They're taking some sort of risk that's different from the economics of the bank. Could it just be bad management?

• 12:07Speaker 05

  It can be, but in terms of SVB, I don't think it was. I do think it was incompetence, but not because they were incompetent in terms of being a bad risk manager as a bank or as a banker, but I think they were a very bad hedge fund manager. And again, I want to go back to what they were saying about like what they think the market is doing, which they thought is this wrong and they thought that the swap rates are too low and they thought the swap rate, they're based on the fundamental value, they should be higher. And then when you look at their action, they were actually acting based on. That particular belief and I would not call that incompetence. I would call that someone, in this case, a banker, who is actually trying to think like a hedge fund

• 12:52Speaker 05

  and is trying to align his action based on that particular belief about the shape of the yield curve. And the other important difference between a hedge fund's strategy and a trade, just going back to the previous point, is that a trade is usually shorter term. But when it comes to the hedge fund strategies, these guys are patient, at least some of these guys are very, very patient. And especially in the world of fixed income arbitrage, you need to be patient. But when you're acting, you need to be very quick. And that's also one of the distinctions between just like you are entering the interest rate swap because you just want to trade a particular derivative, in this case, a swap, versus you are entering interest rate swap because it is part of your broader portfolio.

• 13:36Speaker 05

  And I do think that in the case of SWB, they were entering interest rate swap because it was part of a broader portfolio. And that portfolio, the goal of that core portfolio was not to hedge a particular risk. In this case, the interest rate risk of those US Treasuries, but rather the goal was to exploit a mispricing in the yield curve.

• 14:17Speaker 00

  What's next for virtual assets? I'm Jacob Rees, host of Economy Scale, a series exploring growth in key global sectors. And in this episode, we're diving into the digital forces shaping finance. Sean McHugh from Dubai-based Virtual Assets Regulatory Authority has this to say.

• 14:33Speaker 06

  We're seeing a lot of institutional players come in, digital asset dedicated hedge funds, high-frequency traders and that sort of thing, and folks who service institutional clients.

• 14:42Speaker 00

  As more capital enters the market, adaptive regulation is likely to become increasingly key. Rees-Merrick of Ripple says.

• 14:50Speaker 07

  A lot of regulators. Globally, would like to keep the industry at arm's length. That's the opposite here. I think also what you'll find is that regulation and frameworks can come out, but some of them are maybe a slight iteration on some 80-year-old policy and not actually in line with what the technology can do and offer. And again, that's very different in Dubai.

• 15:09Speaker 00

  Listen to the full episode wherever you get your podcasts. This series is brought to you by Bloomberg Media Studios and the Dubai Department of Economy and Tourism.

• 15:19Speaker 08

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw, innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices.

• 16:03Speaker 08

  But according to recruiters, advisors and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates, quote, "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute brought to you by ChatGPT. Get started at chatgpt.com.

• 16:42Tracy Alloway?

  Talk to us about the on-balance-sheet activities. You mentioned them earlier. So, alternative credit lines, subscription lines, how did those actually factor into this idea of SVB being a synthetic hedge fund?

• 16:55Speaker 05

  That's a very good question. And when it comes to the capital line of credit, there are so many interesting differences between this particular credit line and a typical bank credit line. I want to start by saying something which is very different from what banks do. So, as a bank, when you extend a line of credit, when you extend a loan which earns interest, your biggest incentive is to actually earn return based on the interest you are actually kind of like earning. And your biggest fear is for the guy, for your counterparty, not to show up. You don't want to actually be engaged in this type of credit activity. But when it comes to the capital line of credit or subscription line, it's actually the opposite.

• 17:40Speaker 05

  When it comes to the interest rate on these lines of credit, the interest rate is actually very low. They are a structure to be low. They are a structure to be too low so that, in this case, this is actually a line of credit between the bank and usually a private equity fund manager. So, the interest rates are very low because you want to attract those private equity fund managers to come to you and actually postpone the capital call and instead bridge those funding gaps through this particular line of credit.

• 18:14Joe Weisenthal?

  Wait, I explained that, sorry. I don't understand that.

• 18:16Speaker 05

  Basically, like, the first thing is that these subscription lines are not a credit line between a bank and a private equity. It is a credit line between a bank and a private equity fund manager. So, the reason the private equity fund manager goes to the bank in order to kind of like establish this line of credit is that they want to postpone capital call from their limited partner. Because that's how the private equity fund manager can actually kind of like synthetically or artificially increase the internal rate of return and therefore increase its own compensation.

• 18:57Speaker 05

  So we know why private equity fund manager is doing so, but why the bank is involved in this type of activity? Given that the interest rate on this particular loan is not very attractive. The answer to this question is the type of collateral. Unlike the other type of credit lines, where the collateral is usually, let's say, the physical assets or, you know, another type of like financial assets. In this case, the collateral is the implied liability of private equity limited partners. Even though these limited partners may have no idea, as a matter of fact, they do not have any idea

• 19:41Speaker 05

  that this line of credit has been established at all. In this case, the incentive is structured in a very interesting way. The incentive for the banker is structured so that if for any reason the private equity fund manager doesn't show up and does not clear the loan or the line of credit, and it defaults, that's where the money and the profit and the attraction is going to be for the banker. So what is going to happen in this case? In this case, the banker can use what we call the power of attorney, and then it becomes a synthetic limited partner in that particular private equity.

• 20:25Speaker 05

  And the amount of loan, the amount of credit that was extended to the private equity fund manager now is going to be like as if the banker was actually one of the limited partners in that particular private equity investment. And the rate of return for the banker in this case is going to be the internal rate of return of the private equity fund. Which is considerably higher than the interest rate. In a sense, if you're a banker and if you have extended this type of line of credit, you're just like praying and like you're hoping that the fund manager doesn't show up

• 21:08Speaker 05

  so that you become the synthetic private equity fund manager. So in this paper, basically, I am actually highlighting this activity, which was actually a significant part of SVB's activity as well, to say that in this case, what the banker wants to be is to become a synthetic private equity limited partner. And this particular line of credit is enabling the bank to do so. And I also want to say something about the prospect of like other banks using this. This is actually a growing business. Wells Fargo now does have a whole department trying to exploit this type of line of credit. And I do think if a bank is interested in this,

• 21:53Speaker 05

  it is because the bank want to become a synthetic private equity investor.

• 21:59Tracy Alloway?

  Wait, talk to us more about how endemic this actually is. And I'm curious as well, like how you know that other banks are doing this? And I can think of one deposit-taking institution that does this and loads has been written about them over the years. But where are you getting the data from and how are you making that judgment?

• 22:20Speaker 05

  So basically, like I am conducting this research on market microstructure. And this project is called Market Microstructure Project. And because of this project, I am actually kind of like reading everything that the bankers, the fund managers are saying like in the news, in the newspaper, in the news articles. So to answer your question, I would say that unfortunately, as of now, I do not have access to the data set that gives me this kind of like concrete picture of like how many banks are actually using this subscription lines or extending these subscription lines. But the good news here is that I'm in touch with a few people in the Fed. They might extend such data to me. So this is.

• 23:03Speaker 05

  Hopefully gonna be the next project for me to formalize that and showing that in the data. But I'm collecting narratives, I'm listening to the people and also because of this market microstructure project, I'm talking to all the bankers, like I go to this like, let's say, happy hours of the bankers, like the hedge fund association, like parties, and I talk to these guys. And I'm hearing over and over again that like the bankers are either using this in their business model, as part of their business model, or they are trying to actually adopt it. So as of now, this is me as one professor who is just trying to listen to the market.

• 23:42Speaker 05

  But hopefully this is soon gonna be formally shown to the rest of us through the data that I will have access to.

• 23:49Joe Weisenthal?

  So there are like multiple things going on. There's the question of is the bank hedging or is the bank trading? There is the question of are they trying to establish collateral that's in a sort of like hedge fund or private equity structure so that they can get higher returns and so forth? If the data is available, is this the type of thing that like that you believe is detectable in advance? This bank is starting to look more like a synthetic hedge fund than what we think of as the economics of a bank.

• 24:18Speaker 05

  I do think it is, and I do think like the data is amazing source. And I'm very glad that the central bankers, at least, they do have access to so many data. At the same time, I think right now there is not that much the question of like data, but rather our framework, the lens through which we are looking at. And also the lens through which we are looking at this data. If you are looking at the same data and the only framework that you have adopted is the industrial organization of a bank, you're gonna see what you want to see. That this was a bank who did a very bad and even a stupid type of like risk management. And because they just exited their interest rate swap position just before the Fed started to increase rates.

• 25:02Speaker 05

  So it is about the industrial organization that you adopt in order to assess the data that is being provided to you by banks. And I really think that in order for the regulators not to fail, it's not that much the question of supervision. I think banks are being supervised, but you have to supervise and assist the bank through new perspectives and understand that the banks do not want to be banks anymore. And they want to actually have some share of those higher returns that are actually being accumulated and generated in the private market and also like in the alternative investment fund market. So once you look at what banks are doing

• 25:46Speaker 05

  through the business model and industrial organization of alternative investment fund, I think then you can become even a more effective bank supervisor.

• 25:57Joe Weisenthal?

  By the way, Tracy, I'm looking at a blog post right now from MSCI. And it doesn't look at it from the bank level, but through the fund level, you can just see the rise in charts, whether it's looking at venture capital, buyout, various forms of private equity. The number of them using subscription lines of credit is pretty interesting. Charts, lines going up and to the right.

• 26:17Tracy Alloway?

  Lots of lines going up. So, I mean, I agree with the point that supervisors should be looking at this activity. And we probably don't want banks to be synthetic hedge funds. We don't want them to do risky things because we would all like to one day get our deposits back. But in the case of SVB, I don't think I agree with the point that they were a bad synthetic hedge fund versus just a bad bank. And I guess my question is like, is this the right thing to focus on for SVB? Because even without the swap spreads, SVB's bond portfolio would have had massive losses, right? And they also misjudged their deposit base. That's a pretty big failure for a bank.

• 27:02Tracy Alloway?

  And by the way, I saw a presentation that was made to their asset liability committee in late 2020, and the recommendation there from the Treasury was to buy shorter term bonds as deposits were flowing in. And the ALM committee basically decided not to do it. They said, like, if we do it, it'll cost $18 million in earnings. So they didn't want to do it because they wanted to protect their profits. But it seems to me like there are some bigger issues here.

• 27:34Speaker 05

  Really good question. I still do believe that SVB was a good bank, a very bad alternative investment fund. And also they weren't very good like in accounting. So like speaking of the US Treasury, the holding of the US Treasury is one of the other mistakes they made was that instead of like accounting for them as held to maturity, they did do that as available for sale. And that was also one of the reasons that their balance sheet was negatively affected. So if anything, they weren't really good accountant. But in terms of like being a banker, I do think they were decent enough bank, but they just didn't like to be that. They wanted to be something beyond that. And that's where they

• 28:16Speaker 05

  weren't really good at. And again, I'm going back to like the narratives that I collected, and these are all public narratives. And when you look at why they did what they did, they really had a very, very specific view of what the yield curve should be and what the yield curve is. They thought the swap rates are going to increase. And in order to actually match their fundamental value, and they thought the swap rates are kind of like artificially like suppressed, and they wanted to take advantage of that. And they failed dramatically, and mostly because they couldn't wait long enough, because they

• 28:57Speaker 05

  were actually constrained by regulation as well. So for me, rather than thinking that SVB was not a good bank, this is actually showing an inherent tension for any type of banks who wants to actually do something that non-banks Banks are doing, especially like alternative investment funds are doing, that even if you manipulate your models in order to synthetically replicate the trading strategies, investing strategies, or the risk and return portfolio of a hedge fund, you do not have the same flexibility to execute those type of strategies. And you do not have the same time and you are considerably more constrained

• 29:39Speaker 05

  in terms of being supervised, in terms of like you have to put considerably more capital. This is something that hedge funds do not need to do. And you have to respond to people who are very impatient and those are depositors, people that as a hedge fund, you don't need to deal with. So for me, this is an inherent tension between being a bank with all the realities of being a bank and just think that's not good enough. You want to be something better.

• 30:26Speaker 08

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices.

• 31:09Speaker 08

  But according to recruiters, advisors and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company. And Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates quote, "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute, brought to you by ChatGPT. Get started at ChatGPT.com.

• 31:48Joe Weisenthal?

  You know, I, for a long time, and I still do, like, I consider myself like, Tracy probably heard me at various times, I'm like an SVB apologist. And I've said on the podcast, I'm like, oh, they're like a good bank. They like took themselves really seriously.

• 32:03Tracy Alloway?

  Everyone here has a different view of whether they were a good bank.

• 32:06Joe Weisenthal?

  That's right. I think like I'm like in the middle here because I was for a long time, it's like, no, this is like what a bank should be. And they really get to know their clients and they really get to like know their industry. On the other hand, I agree with like Tracy that they just seem to have like made a lot of bad mistakes and miscalculated the flightiness of its depositor base. And they probably didn't have traditional lending opportunities like most banks. So they're like, oh, we'll just put it in something safe. Like Treasury is not thinking about that. Treasury sometimes go down. I also take your view that, you know, like you're in Silicon Valley. You probably don't just like want to be a bank, right? You know, everyone else is like getting super rich and you're just getting rich.

• 32:47Tracy Alloway?

  And management is dealing with tech people, right? So I imagine some of that optimism kind of rubs off on them.

• 32:53Joe Weisenthal?

  Yeah. So it's like everyone else is getting mega rich and they're just getting kind of rich. So it's like, you probably want to look for ways to like get something that resembles equity upside. All this being said, and this is sort of like my final question, the fact that like we're having this conversation. SVB is like a weird situation. There aren't many banks like SVB, I don't think, in that one specific industry and an industry that's specific to a location, et cetera. And then there wasn't much contagion. There were a few other sort of similar banks that went down. There were some crypto-related banks, but it was not contagious in the end. It was not a big crisis of regional banks. There was not a big flight of deposits away. Regional bank stocks have been doing very well lately and they're like basically, they're

• 33:38Joe Weisenthal?

  a little bit above where they are when SVB collapsed. How do you think, this is all a long-winded way to set up, but like the prevalence of this type of risk elsewhere? Because it feels to me that SVB intuitively feels like a unique situation.

• 33:52Speaker 05

  I should disagree with you, and I don't think it's about the question of like, okay, what happened immediately after the collapse of SVB. To me, this is a signal that where the banking is going. And this is about like the commercial banking, those are like, they're not too as big as JP Morgan, the Citibank, or Bank of America. I do think that the biggest lesson we have to learn from this SVB is that the business model of banking system is changing. And SVB was just showing a window, or opening a window towards that new world, that the banks are doing different things. They are manipulating their model in order to take advantage of some flexibility, or any flexibility they

• 34:37Speaker 05

  might have, in order to conduct hedge fund-like strategies. So to me, the collapse of SVB was very important, not because what happened immediately afterwards, or the bank run on other banks, but because it is showing us that there is this tension in the banking system, that banks do not want to be banks anymore, and they are looking for alternatives. And these alternatives are usually being found in the alternative investment world. And the banks are going to move towards the direction of adopting more of that type of strategies into their traditional banks.

• 35:19Speaker 05

  And it is in that regard, it is from this perspective that I think what happened to SVB is very important. Because it is showing us that banks are extremely uncomfortable with their identity. And they want to shift their identity. Is it a bad thing or a good thing? I actually don't know. I think it's a very exciting thing.

• 35:43Joe Weisenthal?

  This is Tracy Elham has my approach to news, no bad or good, just exciting.

• 35:48Tracy Alloway?

  Yeah, although I was gonna say it was actually pretty amazing to hear you take a middle ground position on something. I don't think I've ever heard that before.

• 35:55Joe Weisenthal?

  I'm just a normal moderate guy.

• 35:57Tracy Alloway?

  Yeah, okay. So just on this point, one thing I remember from our discussions around SVB, I think we were talking to Lev Menand. And he made the point that the US has basically made a conscious decision to outsource a lot of bank supervisory processes to shareholders and shareholders, you know, they like making money. And so the incentive is typically skewed towards more risky behavior. If we decide that we don't want banks to be synthetic hedge funds, what type of regulation or limitations would you envision coming into play?

• 36:35Speaker 05

  I want to answer your question in a different way, like if that's the future of banking, if banks are actually moving towards this world of being a synthetic hedge fund. I do not think the next regulatory question is how to limit the banks, but how to create a safer environment for them. Because the other lesson that we learned, at least I learned from the SVB's failure was that one of the reasons they failed was that at some point they realized that they do not have enough time to fully execute their strategy. Their strategy wasn't necessarily wrong, but they actually prematurely exited that as soon as they thought they might be wrong and they might actually face so many losses.

• 37:19Speaker 05

  I know this may sound like a revolutionary point, but I do think if the reality of the banking system is that the banks are moving towards that direction, the first regulatory ...task is for regulators to change their identity as well. Because you cannot force banks to be banks if they do not want to be banks. At the same time, if banks are actually conducting riskier strategies, and if as a regulator you're allowing them to take on some of those risks, maybe you want to remove some of the protections. What type of protections can be removed so that you can still maintain the stability of the deposit-taking world and the stability of the financial system?

• 38:04Speaker 05

  This is a question that I'm proactively thinking about it. I do not have the answer for. But I don't think the first regulatory step is to limit what banks are doing, but rather for regulators to change their DNA and identity as well and know that they cannot be a simple, plain vanilla bank regulators anymore if banks are not banks anymore. And banks want to be something else.

• 38:33Joe Weisenthal?

  Alhamdulillah, Dinajat, thank you so much for coming on Avlat. We had a little three-way debate there at the end. It was a lot of fun. Thank you so much. Glad to finally have you on.

• 38:41Speaker 05

  Thank you so much. It was a pleasure being here and discussing my ideas with you.

• 38:58Joe Weisenthal?

  Tracy, I can't believe you've said I've never taken a middle ground before. I don't take any positions. I just, you know, I just like to learn.

• 39:05Tracy Alloway?

  Joe, no opinion, wise and tall.

• 39:07Joe Weisenthal?

  Yeah, that's me. That's me.

• 39:09Tracy Alloway?

  I thought that was a really interesting discussion. I mean, broadly, what we're talking about here is reach-for-yield behavior. And whether that comes about through synthetic leverage or something old-school, like just buying a bunch of long-duration bonds and then not hedging the interest rate risk. It kind of amounts to the same thing, right? They're still doing this to boost returns.

• 39:34Joe Weisenthal?

  We should do more on the rise of sublines. There's always one more thing, isn't there?

• 39:39Tracy Alloway?

  Yeah. Well, and the other thing I was thinking is this feeds into that idea of banks and private credit, private equity being frenemies.

• 39:48Joe Weisenthal?

  Yeah.

• 39:48Tracy Alloway?

  Right? Like, they are objectively becoming more intertwined. Insurance companies, by the way, are also big players in private credit now. So it does feel like the trifecta of the three biggest financial industries, banks, private equity slash private credit, and insurers are becoming more intertwined.

• 40:10Joe Weisenthal?

  Totally. I mean, it's interesting, and it makes total sense, right? If other entities are going to try to become banks or credit, you know, expanding entities, as we've been talking about forever, it makes sense that banks are going to want to look for upside elsewhere and maybe take on positions that resemble more sort of like equity upside. I thought Alham said something kind of fascinating at the end in response to your question about regulation, which is that like, if banks don't want to be banks, like, there's kind of nothing we can do to stop them. And I think that's like an interesting principle of like financial regulation, period, that like, you know, it is always this cat and mouse game, right? And in the end, like, there's sort of like entities will evolve into the new thing.

• 40:54Joe Weisenthal?

  And at some point, there's going to be a blow up. And, you know, hopefully regulators get ahead of the curve. But in the end, like, it feels like all financial entities of any sort will like, they'll evolve into what they want to evolve into.

• 41:06Tracy Alloway?

  Yeah, you got to change your opinion when the facts change, right? Right, Joe? Joe, no opinion.

• 41:12Joe Weisenthal?

  Yeah, that's right.

• 41:13Tracy Alloway?

  Yeah, okay. Shall we leave it there?

• 41:14Joe Weisenthal?

  Let's leave it there.

• 41:15Tracy Alloway?

  This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 41:21Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at theStalwart. Follow our guest, Alham Sayed-Dinajad. She's at Alham Sayed. And check out her recent paper, Banks as Synthetic Hedge Funds. Follow our producers, Carmen Rodriguez at Carmen Arment, Dashell Bennett at Dashbot, and Kel Brooks at Kel Brooks. For more Odd Lots content, go to Bloomberg.com/oddlots, where it's transcripts, a blog, and a newsletter. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

• 41:50Tracy Alloway?

  And if you enjoy Odd Lots, if you like it when we talk about banks that don't want to be banks, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

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