How Banks Turned Into Giant Synthetic Hedge Funds

Summary

Odd Lots Podcast Summary

Episode Title: How Banks Turned Into Giant Synthetic Hedge Funds
Host: Joe Weisenthal & Tracy Alloway
Release Date: February 21, 2025
Guest: Elham Syedinijad, Term Assistant Professor of Economics at Barnard College, Adjunct Professor at NYU, Author of "Banks as Synthetic Hedge Funds"

Introduction

In this compelling episode of Odd Lots, hosts Joe Weisenthal and Tracy Alloway delve into the intricate transformation of traditional banks into entities resembling synthetic hedge funds. Featuring insights from Elham Syedinijad, an esteemed economist, the discussion unpacks the underlying mechanisms that led to significant financial upheavals, notably the collapse of Silicon Valley Bank (SVB).

The SVB Crisis: A Catalyst for Change

02:52 - 05:18

Joe and Tracy kick off the conversation by reminiscing about the sudden anxiety surrounding regional banks following the SVB collapse. They reflect on previous discussions about banking reforms and semi-public banking structures, noting the lack of substantial changes post-crisis.

Tracy highlights past regulatory shifts, such as the 2018 Trump administration changes that permitted regional banks to engage in riskier activities, potentially contributing to SVB's downfall.

Synthetic Hedge Funds Explained

05:18 - 06:00

Elham Syedinijad introduces the concept of synthetic hedge funds, defining them as non-hedge fund entities, like banks, that replicate hedge fund activities to achieve similar returns and risks without being traditional hedge funds.

“Synthetic hedge fund is a type of activity [...] replicates the activities of a hedge fund and therefore get the same type of return.”
— Elham Syedinijad [05:33]

SVB's Dual Strategy: On and Off Balance Sheet Operations

06:00 - 10:48

Elham elaborates on how SVB operated both on and off the balance sheet in ways that mirrored hedge fund strategies:

• Off Balance Sheet Operations: SVB engaged in interest rate swaps not merely to hedge against interest rate risks, as traditional banks would, but to conduct fixed income arbitrage akin to hedge funds seeking to exploit bond market mispricings.

  “The timing of entering and exiting the interest rates [...] replicates what a hedge fund would do.”
  — Elham Syedinijad [06:31]

• On Balance Sheet Operations: SVB utilized subscription lines or capital call lines of credit, primarily in dealings with private equity fund managers. These lines had unusually low-interest rates, incentivizing fund managers to defer capital calls, thereby artificially boosting fund returns.

  “The interest rate on these lines of credit [...] is actually very low.”
  — Elham Syedinijad [17:36]

Distinguishing Between Hedges and Trades

10:48 - 13:15

Tracy probes the fine line between hedging and trading activities within banks. Elham suggests that the distinction lies in the narrative and strategic intent behind the transactions:

“It’s about connecting activity with the mispricing in the bond market and what the shape of the yield curve should be.”
— Elham Syedinijad [11:17]

She emphasizes that while traditional hedging focuses on mitigating risks, synthetic hedge fund activities aim to exploit market inefficiencies for higher returns.

Management Decisions and Strategic Missteps

13:15 - 15:24

Joe raises the possibility of SVB's actions stemming from incompetence or poor management. Elham counters by attributing SVB's failure not to traditional banking incompetence but to inadequate hedge fund-like risk management.

“They were a very bad hedge fund manager [...] their goal was to exploit a mispricing in the yield curve.”
— Elham Syedinijad [13:15]

The Role of Subscription Lines in Banking

17:23 - 22:40

Elham delves deeper into subscription lines, explaining how they function as instruments for banks to become synthetic limited partners in private equity funds. This strategy allows banks to participate in higher-return investments typically reserved for hedge funds or private equity firms.

“They want to become a synthetic private equity Limited partner.”
— Elham Syedinijad [18:58]

She notes that major banks like Wells Fargo are expanding departments to exploit these lines, indicating a broader industry shift toward hedge fund-like operations within traditional banking frameworks.

Regulatory Challenges and Future Implications

23:01 - 26:38

The discussion shifts to the regulatory landscape. Tracy questions the extent of banks' involvement in synthetic hedge fund activities and the availability of data to monitor such practices. Elham acknowledges the current lack of comprehensive data but anticipates future insights through her ongoing research.

Elham argues that regulators need to evolve their frameworks to better oversee banks engaging in alternative investment strategies, emphasizing that traditional regulatory models may no longer suffice.

“Regulators need to change their identity [...] understand that banks do not want to be banks anymore.”
— Elham Syedinijad [26:38]

Broader Industry Interconnections

32:29 - 41:25

Tracy and Joe explore the intertwining roles of banks, private equity, and insurance companies in the evolving financial ecosystem. Elham suggests that this convergence indicates a fundamental transformation in banking, where institutions are increasingly adopting strategies typical of alternative investment funds.

“Banks are extremely uncomfortable with their identity and they want to shift their identity.”
— Elham Syedinijad [35:07]

Final Thoughts and Conclusions

42:04 - 43:59

As the episode wraps up, Joe and Tracy reflect on the unique nature of SVB's situation and its implications for the banking industry. Elham posits that SVB's collapse is a signal of ongoing changes within the banking sector, highlighting tensions between traditional banking roles and emerging investment strategies.

“The business model of the banking system is changing [...] they are looking for alternatives.”
— Elham Syedinijad [35:07]

Tracy and Joe agree that understanding these shifts is crucial for anticipating future financial dynamics and regulatory needs.

Notable Quotes

• Elham Syedinijad [05:33]: “Synthetic hedge fund is a type of activity [...] replicates the activities of a hedge fund and therefore get the same type of return.”
• Elham Syedinijad [11:17]: “It’s about connecting activity with the mispricing in the bond market and what the shape of the yield curve should be.”
• Elham Syedinijad [17:36]: “The interest rate on these lines of credit [...] is actually very low.”
• Elham Syedinijad [18:58]: “They want to become a synthetic private equity Limited partner.”
• Elham Syedinijad [26:38]: “Regulators need to change their identity [...] understand that banks do not want to be banks anymore.”
• Elham Syedinijad [35:07]: “The business model of the banking system is changing [...] they are looking for alternatives.”

Conclusion

This episode of Odd Lots provides a nuanced exploration of how banks like SVB have increasingly adopted strategies typical of hedge funds, transforming their operational models and challenging traditional regulatory frameworks. Elham Syedinijad's insights shed light on the complexities and future implications of this shift, urging a reevaluation of how banks are supervised and understood within the broader financial landscape.

For those interested in the evolving dynamics of banking, hedge funds, and financial regulation, this episode offers invaluable perspectives and thought-provoking discussions.

Transcript

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[Tracy Alloway]

It's Tracy Alloway and Joe Eisenthal. We are very excited to announce that Odd Lots is going to Washington.

[Joe 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 D.C. at the Miracle Theater and guests will be announced in the coming days. But in the meantime you can find a Ticket [e-mail] Odd Lots Bloomberg Audio Studios Podcasts Radio News. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.

[Tracy Alloway]

And I'm Tracy Alloway.

[Joe Weisenthal]

Tracy, do you remember svb?

[Tracy Alloway]

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

[Joe 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 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?

[Tracy Alloway]

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

[Joe Weisenthal]

Yeah. What? Actually I haven't been following that. What's happening with that?

[Tracy Alloway]

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

[Joe 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 1st 5th. And there's a widespread expectation and I think pretty well founded that the Trump administration is gonna 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 take our eye off the ball of financial regulatory issues. Cuz also if history is any guide, like the next thing that happened, like we'll get no warning of it. It'll just happen one day.

[Tracy Alloway]

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

[Joe 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 are going to be speaking with Elham Syedinijad. 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 fund. So Elham, thank you so much for coming on.

[Elham Syedinijad]

Odd lot, thank you so much for having me. I'm very happy to be here.

[Joe 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?

[Elham Syedinijad]

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 the 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.

[Joe Weisenthal]

Tracy, I already like this conversation because normally we talk about shadow banks, right? And so the idea 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 hedge funds being replicated inside regulated institutions.

[Tracy 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.

[Elham Syedinijad]

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 unbalance 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 kind of like continue the conversation to discuss what SVP has done in the balance sheet as well. When it comes to the off balance sheet operation, it is like the way SVP 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? Like when you try to kind of like match the activities of the SVB risk managers with the narratives of the CFO of the svb. We see that the timing of entering and exiting the interest rates to a BSVP 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 day exit, it just doesn't make sense. 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. And in order to minimize the losses, it tried to kind of like exceed 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 exceeded the interest rate top 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 if it wanted to actually protect itself against interest rate risk because it was holding very 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 operations 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 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 unbalance sheet operations. When we look at the asset side of the suv, 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.

[Tracy 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?

[Elham Syedinijad]

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 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 parallel and saying in parallel about their prediction of what the shape of the yield curve should be. Because when it comes to like most hedge funded 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. And if there's a difference between the two, a hedge fund is going to conduct a sort of 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 and then they want to actually kind of like very immediately and short term exploit those particular directional benefits.

[Joe Weisenthal]

So I take your point about, okay, the CFO is saying one thing, we're doing a hedge, but some of this stuff, stuff doesn't line up. Could it be incompetent? 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?

[Elham Syedinijad]

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 rates, 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 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 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 patients. 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 are 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 case swap versus you are entering interest rate swap because it is part of your broader portfolio. And I do think that in the case of svb, they were entering interest rate swap because it was part of a broader portfolio. And that portfolio, the goal of that portfolio was not to hedge a particular risk, in this case the interest rate risk of the those US Treasuries, but rather the goal was us to exploit a mispricing in the yield curve.

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[Tracy 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?

[Elham Syedinijad]

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 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 is actually the opposite. When it comes to the interest rate on these lines of credit, the interest rate is actually very low. They are structured to be low, they are structured 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 pull, postpone the capital call and instead bridge those funding gaps. Through this particular line of credit.

[Joe Weisenthal]

Explain that. Sorry, I don't understand that.

[Elham Syedinijad]

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. 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 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. 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 are a banker and if you have extended these type of line of credit, you're just like praying and like you're hoping that the fund manager doesn't show up 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, 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, it is because the bank want to become a synthetic private equity investor.

[Tracy 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?

[Elham Syedinijad]

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 us to the data set that gives me this kind of like concrete picture of like how many banks are actually using these 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 hopefully going to 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 the one professor who is just trying to listen to the market. But hopefully this is soon going to be formally shown to the rest of us through the data that I will have access to.

[Joe 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.

[Elham Syedinijad]

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

[Joe 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, pretty interesting charts, lines going.

[Tracy Alloway]

Up and to the right, 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. 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.

[Elham Syedinijad]

Really good question. I still do believe that SVB was a good bank, a very bad alternative investment fund, and also weren't very good like in accounting. So like Speaking of the U.S. treasury, the holding of the U.S. 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 reason 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 back, but they just didn't like to be that. They wanted to be something beyond that and that's where they 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 suppressed and they wanted to take advantage of that and they failed dramatically and mostly because they couldn't wait long enough because they 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 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, same flexibility to execute those type of strategies and you do not have the same time and you are considerably more constrained 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.

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[Joe 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.

[Tracy Alloway]

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

[Joe 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, I'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're in Silicon Valley. You probably don't just want to be a bank. Right. Everyone else is getting super rich and you're just getting rich.

[Tracy Alloway]

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

[Joe 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 get something that resembles equity upside. All this being said, and this is sort of my final question, the fact that we're having this conversation, SVB is a weird situation. There aren't many banks like svb, I don't think in that one specific industry, in 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 basically, they're 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 the prevalence of this type of risk elsewhere? Because it feels to me that SVB intuitively feels like a unique situation.

[Elham Syedinijad]

I should disagree with you and I don't think it's about the question of, okay, what happened Immediate aftermath of 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 what the biggest lesson we have to learn from this will be 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 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 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 banking model. 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.

[Joe Weisenthal]

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

[Tracy 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.

[Joe Weisenthal]

I'm just a normal, moderate guy.

[Tracy 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 funds, what type of regulation or limitations would you envision coming into play?

[Elham Syedinijad]

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 Swaby's failure, was that one of the reason 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. 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 risk, maybe you want to remove some of the protections. What type of protections can be removed so that you are can still maintain the stability of the deposit taking world and the stability of the financial system? 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.

[Joe Weisenthal]

Alham Sayyid Dinushad, thank you so much for coming on Avlat. We had a little three way debate there at the end that was a lot of fun. Thank you so much. Glad to finally have you on.

[Elham Syedinijad]

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

[Joe 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.

[Tracy Alloway]

No opinion wise and thought, yeah, that's me, that's me. 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 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.

[Joe Weisenthal]

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

[Tracy 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. 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.

[Joe 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 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 Elham said something kind of fascinating at the end in response to your question about regulation, which is that that if banks don't want to be banks, there's kind of nothing we can do to stop them. And I think that's like an interesting principle of financial regulation, period. That it is always this cat and mouse game. Right. And in the end there's sort of like entities will evolve into the new thing and at some point there's going to be a blow up and hopefully regulators get ahead of the curve. But in the end it feels like all financial entities of any sort, well, like they'll evolve into what they want to evolve into.

[Tracy Alloway]

Yeah, you gotta change your opinion when the facts change, right?

[Joe Weisenthal]

Yeah.

[Tracy Alloway]

Right, Joe? Joe, no opinion wants to do.

[Joe Weisenthal]

Yeah, that's right.

[Tracy Alloway]

Yeah. Okay, shall we leave it there?

[Joe Weisenthal]

Let's leave it there.

[Tracy Alloway]

This has been another episode of the Oddh Lots podcast. I'm Tracee Alloway. You can follow me at Tracy Alloway.

[Joe Weisenthal]

And I'm Joe Weisenthal. You can follow me at the Stalwart. Follow our guest Elham Syedinijad. She's elhamsaiedi and check out her recent paper Banks as Synthetic Hedge Funds. Follow our producers Carmen Rodriguez at CarmenArman, Dashiell Bennett at Dashbot and Kel Brooks at Kel Brooks. For more Odd Lots content go to bloomberg.com oddlots where transcripts, a blog and a newsletter and you can chat about all of these topics 24. 7 in our Discord Discord GG oddlots.

[Tracy 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 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.

[Akshat Ratty]

There are two kinds of people in the world. People who think about climate change and people who are doing something about it. On the Zero Point podcast we talk to both kinds of people. People you've heard of, like Bill Gates.

[Elham Syedinijad]

I'm looking at what the world has to do to get to zero, not.

[Akshat Ratty]

Using climate as a moral crusade and Justin Trudeau.

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Climate change and the creative minds you haven't heard of yet really don't need.

[Elham Syedinijad]

To have a tomato in December. It's gonna taste like nothing anyway.

[Joe Weisenthal]

Just don't do what we've made here.

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[J]

Drilling industry has come up with some of the most creative job titles. Yeah, tell me more you can imagine. Tool pusher?

[Elham Syedinijad]

No.

[J]

Driller? Motorman? Mud logger.

[Akshat Ratty]

It is serious stuff, but never doom and gloom. I am Akshat Ratty. Listen to Xero every Thursday from Bloomberg Podcasts on Apple, Spotify or anywhere else you get your podcasts.