How the Psychology of Silicon Valley Contributed to a Bank Collapse

We wanted to ask behavioral economists about the kinds of erroneous thinking that could lead to bank failures in Silicon Valley.

I have a theory as to what is happening. It is related to something called “distortion”. A positive skewness is an upward likelihood. That means the odds of something really great happening, like buying a winning lottery ticket or a company becoming his billion-dollar “tech unicorn” in the startup world, are slim. Negative skewness is the opposite. It means that something terrible, like a bank run, is less likely to happen.

So venture capitalist [VCs] The startup world is very good in two very interesting ways. One is that VCs don’t mind losing all their money. They don’t want to, but if they’re investing in these potential unicorn portfolios, the positive skewness, or high upside, means a 9 in 10 bet, or a similarly large percentage, will end. I also understand what you mean. down to zero. And you have a 10% chance of getting a huge profit.

The idea is that we are trying to manage a portfolio that has as many unicorn winners as possible. And, as I mentioned, [VCs are] I’m pretty used to the idea of ​​losing money. Therefore, they are mostly immune. He invests $20 million in a company, and after three years it’s worth nothing. They just don’t budge because they understand that’s the price you pay.

So what about the second point, negative distortion?

What I think VCs are not very good at is worrying about possible downsides. What I’m trying to say is that when you read interviews with people at startups, there’s a huge amount of bloating. They’ll say, ‘This is a great product and we’ll be the next Facebook,’ or ‘We’ll be the next Google.’ “We will be Uber for school children” or something like that. And in this crowd there is usually an unbridled sense of optimism.

But banking and finance are polar opposites. It is related to something called risk management. That is why companies that handle large sums of money, especially financial companies, have risk managers. They usually report directly to executive management and are very important. Their job is to worry. Their job is to ask, “What are the scenarios where you could lose a lot of money?” And they try to protect themselves from downside risks. And I think most tech companies that have money in places like SVB just don’t think about risk management. [Editor’s Note: SVB itself reportedly had no risk officer for most of last year.]

Many of SVB’s customers, founders of the company, had personal money, mortgages, etc. in the bank. SVB was known for supporting founders. It is usually not the wisest thing to do if he keeps all his assets and company funds in one bank. The first rule of household management is diversification. He keeps all the eggs out of one basket.

From a risk management perspective, bank customers were not thinking about the strengths of their bank, SVB. It’s not really their job to do so. They rely on the regulator and her SVB manager to worry about the bank’s financial situation.

So I think the culture of risk management that is usually practiced is in contrast to that of Silicon Valley. Silicon Valley doesn’t have the most risk-averse people in the world, but they like the positive skewness and take risks. Bank startup customers don’t think about bank run risks.

It is not known to what extent this blindness to negative skewness extended primarily to SVB executives with a normal banking background. They made a number of unusual loans, including accepting collateral for shares in startup companies. If the loan was not repaid, they had to sell these shares somehow. They were known to “understand” VC and startup financing in a way that the big banks didn’t. The big mistake was putting many of his SVB assets into “safe” long-term mortgage-backed securities, which could see their value fall significantly when interest rates rise.

From a group psychology perspective, does this culture create a particular group consciousness that creates a false sense of trust? Economist and columnist Paul Krugman wrote in a tweet“In a deep sense, though not in a legal sense, what SVB really did was a kind of affinity fraud. [Bernard] Madoff. It was able to convince the VC/startup/cryptocurrency/etc world that it was one of them, part of the community and therefore trustworthy.”

Affinity fraud refers to existing group connections between people where fraud can occur. Affinity is usually within a religious group or based on some common background. There is also a certain affinity in the tech industry. Who did business with whom, did they go to Stanford University, and so on. There’s a kind of attitude in the tech industry that you’re part of a tribe, a naturally trustworthy group of people. In many cases, what that really means is: “He went to the same college as me” or “I met this guy and he put some money into our startup.” couldn’t have busted the bank.”

But things don’t always work that way. Humans are complicated. SVB seemed to be considered “our bank” in the tech industry, charismatic like Bernie Madoff or Theranos’ Elizabeth Holmes, but without all that bad intentions.

Any other thoughts on the psychology that actually fuels bank crackdowns?

There is a phenomenon called contagion that banking experts say. For example, if you think other people will withdraw all their money, you don’t have enough money in the bank, so you try to withdraw your own money first. Douglas Diamond and Philip Dybvig won the Nobel Prize in Economics last year for their mathematical model of how this happens and how to prevent it.

But the recipe for what causes contagion and how to prevent it is far from well-defined.far from getting a formula to predict When there is a risk of infection.

There are various fields that have studied behavioral contagion. For example, model a bank run, and if her three large customers in the network being modeled withdraw funds, whether other customers will continue the bank run. Or is there a tipping point like “three is good but five is too many”? The answer to this kind of question is usually “it depends”. Even with similar economic conditions and similar media publicity, you may win the lottery for one bank and not another.

I believe that future research to learn more about contagion should be a mixture of ideas from other fields such as group psychology and the study of herd behavior in groups of animals. is part of it. Apparently, many of the tech startups and his VC firm got in touch with each other and became concerned about the banks, which triggered the first few big clients to withdraw their money.

Have brain studies explored any ideas about these behaviors?

There are quite a few studies on the neural signatures of adaptability. In a typical study, people listen to a few seconds of a song. And then, for example, they say they liked her other three, but didn’t like one. There is brain activity associated with rewards when people agree with the majority and say “I liked it too.” Following the ideas of others seems to be a common reward, much like money and food. I thought there might be rewards for non-conformance instead, but a common finding is neural rewards for conformity.

As for SVB, the brain rewards generated by following what others are doing (“They are paying so I should too”) is perhaps one of the narratives that explain SVB. It’s just a department. But it can still provide a small amount of fuel to fuel bank runs.

Some of the solutions to problems such as epidemics seem to necessarily require political and regulatory action.

of [2010] dodd frank [Wall Street Reform and Consumer Protection Act] It introduced more controls and regulations, such as increased bank reserves and “stress tests”. This test looks at all the numbers and tries to guess what a bank’s balance sheet will look like after changes in interest rates and economic conditions. You want to financially harden your bank. But as you may know, a supplement to the 2018 Dodd-Frank Act was passed that raised the size of the largest banks most in need of this kind of scrutiny from $50 billion to $250 billion. increase. The SVB was $209 billion, so without the 2018 legislation, a better stress test could have picked up potential pain points. Then the bank’s regulator and his SVB itself could give an early warning signal and take steps to better protect depositors by requiring more reserves or raising capital. may have been

What steps can be taken to remind people to stay vigilant?

Ironically, I think one of the things that actually works best is making something bad happen on a large scale. And it raises everyone’s awareness. It is difficult to transform a culture into a culture of prevention. And political economy does not help, as the 2018 law shows. These are people who pride themselves on being risk takers. Keeping all your money in a bank that they might crack down on is also kind of a risk. But in my opinion the tech industry is blind to this kind of rare risk and not used to worrying about it. You will even be able to hear the story. Despite all this awareness, there will still be a perception that risk managers are cautious and concerned. They’re like forest rangers who go to campsites and say, This campfire is 2.5 feet wide. you have to put it out Campers don’t want to hear it.

I’m sure it could be rectified a little bit, but mostly it’s in the form of “let’s not be the next SVB or the next signature”. [another bank that failed in recent days]Now that this has happened, there probably won’t be another big bank run. And that could be because banks are voluntarily doing more stress testing, even if not mandated by regulation, or because venture capitalists have portfolios of 20 companies.

The Justice Department and the Securities and Exchange Commission have launched an investigation into the collapse of SVB and are in the early stages of investigating the conduct of senior executives at the bank, the Associated Press reported.But don’t encourage them all to use the same bank. Silicon Valley Bank did not respond to a request for comment by the time the article was published..