Financial Crisis in the Classroom

SVB was a disaster for many, but not for my students

As you may (or may not) have noticed, I have been off B&B for a few months now, due to my heavy spring teaching load. During this time, I haven’t been writing for public consumption but I have been engaged in a very active current events dialogue with my students, which after all is the reason I started this blog in the first place. But classes have now ended and all my exams are graded, so you can expect to hear more from me in the coming weeks and months. I promise that future posts won’t be as long as this one, but it seems the banking world has been quite eventful while I was gone and I have some catching up to do.

Ten years ago I started teaching at William & Mary, launching a new introductory finance course called The Financial Services Industry. W&M and I had three goals for the course: One, to give younger finance students a high level overview of financial institutions and markets before they began their deep dive into the study of bond math, corporate finance and investment management. Two, to help our students land hard to get jobs in banking and other competitive sectors of the financial services industry. And three, to enhance the financial literacy of our students and in the process help them become more capable participants in our increasingly financialized economy and better informed citizens to boot.

This was at a time when many of our top finance students were heading to Wall Street, a trend which seems to have abated somewhat in recent years. Having spent most of my professional life working for large banks, however, I understood that Wall Street is not for everyone and that the financial services industry is much broader than just banking. And so in designing my course I decided to cover three segments of the financial services industry: banking, insurance and asset (investment) management. But given my background, and student interests, I tend to overweight the banking module, a decision which this year proved fortuitous.

When I started this course back in 2013, we were just five years out from the Lehman bankruptcy and the tremors of the Global Financial Crisis (GFC) were still reverberating strongly, particularly outside the US. And so I decided to add a fourth module to the course, in which we would study the GFC. I did this not only because the GFC was a truly historic event, but also because studying the GFC would provide a good capstone learning experience for my students. Drawing on the content covered earlier in the course, our study of the GFC would reinforce our understanding of how financial institutions work by exploring how and why they fail. It would also provide us with an opportunity to discuss the causes and consequences of financial crises, how central banks and other policymakers respond, and why it is that we seem to have so much difficulty maintaining the stability of our financial system.

Current events play a large part in both of the courses I teach, Financial Services and Corporate Financial Strategy. Rarely a day goes by that the Wall Street Journal doesn’t feature some story of direct relevance to one or both of my courses, and these past few months have offered many such ‘teachable moments’, from the failure of SVB to the various corporate shenanigans of Elon Musk. There is really no better way for young students to appreciate the practical importance of what they learn in the classroom than to see it play out in real time on the front page of the (digital) newspaper, often in quite chaotic fashion. And my students take great comfort in observing that they aren’t the only ones in this world who don’t seem to know what they are doing, including far too many people in positions of great responsibility, some of whom get paid a lot of money for screwing things up.

Take the failure of SVB as an example. This was of course a complete disaster for the Company and many of its constituencies, and a big hit to the credibility of our banking regulators and supervisors, but for my students it was a real blessing. As a result of SVB’s failure (and the extensive press coverage), my students had the opportunity to advance their understanding of banking well beyond what one would normally expect from young college undergraduates, something I will discuss in more detail below. The highlight of our SVB discussion, for me at least, was the day on which several students came to class wearing their custom-made tee shirts with the logo: “SVB Risk Management Intern—Spring 2023”. The tee shirts were great, and I am now a proud owner of one, but they should really have had this message on the back: “Even I know this is not how to run a bank”. Pun intended.

For my students, however, the highlight was no doubt the last day of class when they got to discuss the finer points of SVB with the former Chief Risk Officer of Goldman Sachs, Craig Broderick. Craig is just one of many W&M alums (and others) who have over the years served as guest speakers in my classes, bringing years of professional experience into the classroom for the benefit of our students. We really couldn’t do what we do in the Business School without these generous volunteers and we owe them all a large debt of gratitude.

Even with this help, however, it is not easy to get a group of neophyte college students, mostly sophomores and freshmen, to the point where they can discuss the failure of a complex financial institutions on an informed basis with the former CRO of a large investment bank. To do this we had to begin at the very beginning, which is exactly what we did.

And here is how we did it:

The basic banking business model. On the first day of class, we begin with a discussion of the famous bank-run scene from the holiday film classic, It’s a Wonderful Life. During this discussion, students discover that the basic banking business model consists of three principal components: “Take deposits, make loans and capture NIM (Net Interest Margin).” That is how they did business at the good old Bailey Building & Loan and it is still what most of America’s 4,000+ banks do today. Earlier generations of students may recall this as the Banker’s Rule of 3-6-3: “Take deposits at 3%, lend them out at 6% and be on the golf course by 3pm.” Of course this isn’t quite how most contemporary banks work—not all bank funding comes from deposits, not all income comes from loans, and not many bankers get out on the golf course by 3pm. Nevertheless, this simple business model remains at the core of most of the contemporary financial institutions we call ‘banks’.

Risk and risk mitigation. By the end of this first class session, students can not only describe the basic depository-lending business model, they can also expound upon its inherent risks: credit risk, interest rate risk, solvency risk and of course liquidity risk. They can also describe at a high level how banks might go about mitigating or managing each of these risks, and the costs and consequences of doing so. And when I ask my students how the Bailey Building & Loan might have done a better job managing its own liquidity risk, they wisely suggest that a good starting place would have been to fire Uncle Billy and find someone more responsible to manage the cash.

Why banks are important. Over the course term, students learn about the important role played by banks in our economy, most notably with respect to the safeguarding of customer assets (deposits) and the creation and allocation of credit (loans). In the process, banks (like insurance companies) facilitate much of the economic activity that we all take for granted but which doesn’t just happen automatically. Banks provide critical financial services essential to our collective economic and social well-being, and we all benefit when they do their job responsibly and without drama. We forget this at our peril.

Bank accounting. I require that all students take at least one semester of college-level accounting before enrolling in my class, as we spend a lot of timing poring through the financial statements of banks and other financial institutions. I don’t know what is taught these days in Accounting 101, but it doesn’t seem to be much beyond basic debits and credits. Nevertheless, the students in my course are forced quickly to learn some more advanced accounting, which many find difficult and a bit scary, akin to learning to swim by being thrown unprepared into the deep end of a cold-water pool. In my experience, this approach has proven to be unpleasant but generally effective, and I haven’t yet had anyone drown, although some students have accused me of the academic equivalent of waterboarding.

Starting more or less from ground zero, students learn how to read bank income statements and balance sheets. They learn about the various components of net income and how banks account for their major classes of assets and liabilities. They learn to distinguish between ‘liquidity’ and ‘capital’ and to explain the related but distinct functions of loan loss reserves and shareholders equity. They learn about mark-to-market accounting and that strange financial statement account known as ‘other comprehensive income’. And they learn to read financial statement footnotes, which apparently puts them one step ahead of many bank depositors, shareholders and supervisors. Compliments of the SVB fiasco, students also now learn more than they ever wanted to know about the different ways of accounting for the value of investment securities on a bank balance sheet, where HTM apparently does not stand for Hide the Money.

Deposits. The subject of deposits comes up during our first class session when we discuss the bank run at the Bailey Building & Loan, where customer ‘deposits’ took the form of ‘shares’ in a mutually-owned bank. But the first real (non-Hollywood) bank that we study in class is Towne Bank, a local $16 billion community bank which relies heavily on non-interest bearing retail deposits to fund its banking operations. In its SEC filings and investor presentations, Towne highlights its deposit base as a critically important source of competitive advantage, which has no doubt been the case since Towne was founded 25 years ago.

In class, however, students are encouraged to consider what might happen to the future stability and cost of retail deposits at banks like Towne during a prolonged period of higher interest rates and elevated financial stress, which of course is exactly what is now playing out in the real world. The SVB collapse focused our attention on yet another related issue, that of insured vs uninsured deposits, the legal and regulatory treatment of which we all thought we understood. Until we didn’t. And neither it seems did the board of SVB. Or the FDIC for that matter.

Loans. Like most community and small commercial banks, the Towne Bank balance sheet is pretty simple. Liabilities consist mostly of deposits, equity is common equity, and assets consist primarily of loans plus some cash and short-term investments held mostly for liquidity purposes. Towne Bank does not own a lot of long-term bonds, but it does have a large loan book with a substantial amount of credit and interest rate risk exposure (and more limited marketability). Like its peers, Towne’s loan book has a big allocation to real estate, with half or more of the portfolio consisting of various sorts of owner and non-owner occupied commercial real estate (CRE). And while the performance metrics on Towne’s loan book have been excellent in recent years, this may be about to change if the economic cracks in the CRE sector continue to widen and deepen.

Interest rates and NIM. When I first began teaching this course ten years ago, banks were still wrestling with the challenges of managing in a ZIRP world and our early class discussions centered around the impact of historically low interest rates on bank profitability. For years we listened to bank executives complain about Fed-induced NIM compression, with no apparent sense of concern about what might happen if and when the Fed finally raised rates. Well the interest rate environment has now changed, quite dramatically, and it seems that many banks have been caught flatfooted. One thing that has not changed, however, is the proclivity of senior bank executives to blame the Fed. And this time they are blaming the Fed for taking away the low-cost funding punchbowl, before the banks had time to sober up after one heck of a good party.

From ‘lend and hold’ to ‘originate and distribute’. Over the course term, students learn how ‘fractional reserve banking’ works and what we mean by ‘maturity transformation’ and ‘credit intermediation’. And in the process they come to understand some of the tensions inherent in the basic depository-lending business model, as noted above. Students also learn about the historical disintermediation of depository-lending banks by investment banks and other ‘shadow banks’, and they come to understand why it is that most traditional ‘lend and hold’ commercial and consumer banks have now incorporated the ‘originate and distribute’ underwriting model into core parts of their own business.

We get more deeply into this topic later in the term when we study investment banking, securitization and the GFC, but our first exposure to the originate and distribute business model comes early in the course term when we study the mortgage lending business at Towne Bank. Like most community and commercial banks, Towne now securitizes and sells off most of its qualifying residential mortgage loan portfolio, transferring the credit risk to Fannie and Freddie and the interest rate and pre-payment risk to capital market investors, reducing the bank’s balance sheet risk quite substantially. Which is something the 1930s Bailey Building & Loan was not in a position to do, with or without Uncle Billy on the job.

Capital adequacy. At the end of our commercial banking module we devote an entire class session to the topic of capital adequacy, a critically important subject which we come back to regularly throughout the course. We begin by distinguishing between ‘capital’ and ‘liquidity’, concepts that many students initially find a bit confusing. We don’t get too deep into the weeds on the various regulatory definitions of capital (CET1 and all that), but we do discuss the concept of ‘risk weighted assets’ and explore why RWA metrics may or may not be a more informative measure of solvency risk than some broader-based leverage metrics. And this past term we broadened our classroom discussion of capital adequacy to consider why it is that regulatory risk weightings reflect credit risk but not interest rate risk, a question that many SVB depositors and shareholders are no doubt asking as well.

Investment banking. We begin our discussion of investment banking by studying the Goldman Sachs IPO prospectus from 1999, a time when GS was a smaller and more pure play investment bank than it is today and when Hank Paulson was the bank’s co-CEO, not Secretary of the Treasury. We focus on Goldman’s corporate finance and market making activities and we explore the related sources of revenue and expense, funding and risk. We go through Goldman’s financial statements line-by-line and we try to make sense of some rather esoteric items like securities lending, repo and derivative exposures. We take note of the amount of financial leverage employed in the business and the large share of net revenue paid out to employees. (This last item often piques students’ interest in pursuing IBK careers.) We look at selected financial performance metrics and we deconstruct the components of ROE to highlight the impact of financial leverage on a low ROA business. We talk about the various risks Goldman must manage, most notably market and counterparty risk, and how risk management is different in the investment and commercial banking contexts. We discuss the reasons Goldman decided to go public and the impact this decision may have had on the firm’s culture, business activities and subsequent performance. We also talk about Goldman’s cherished Business Principles, a topic we come back to later in the course when we examine banking culture and values in the context of the Global Financial Crisis.

The Big Short. One of the most popular things we do in my Financial Services class is discuss the film The Big Short. If you have ever seen the film, you will know that it is not only great fun but also quite educational. When my students hear the phrase “sub-prime” they immediately think “shit”, as instructed by Margot Robbie drinking champagne in a bubble bath. When they hear “CDO” they think of three-day old fish in the fish stew, as explained by celebrity chef Anthony Bourdain. When they hear “Credit Default Swaps”, they think of Selena Gomez making a secondary market in wagers at the roulette table. And in my experience nothing explains securitization structures quite as well as Jared Vannett (Ryan Gosling) with his Jenga Tower, even if we do cringe at some of his socially insensitive and distinctly non-PC commentary.

The Fed. Perhaps the most important topic we study in class, at least from a civic financial literacy perspective, is the role of the Fed (and central banks more broadly) in promoting financial stability. Here we are aided by a wonderful short book written in 2011 by Ben Bernanke, The Federal Reserve and the Financial Crisis. In this book, Chairman (formerly Professor) Bernanke provides some historical context on the Fed and explains the relationship between its two primary missions: promoting a healthy real economy and maintaining financial stability. Bernanke also describes the principal policy tools used to accomplish these missions: monetary policy, liquidity provisioning, and financial regulation and supervision. Much of what the Fed does remains shrouded in mystery, often intentionally so it seems, but with the help of Professor Bernanke our students are able to understand better what the Fed really does and why and how it does it. This understanding greatly facilitates our discussion of the GFC and similar events and it prepares our students to participate more actively in the ongoing public debate over central bank independence and the proper parameters of the Fed’s mandate. Compliments of Dr. Bernanke, students also learn about that key tenet of central banking crisis management policy known as ‘Bagehot’s dictum’, a phrase they now feel comfortable casually dropping into dinner party conversations, as one so often does.

Banking culture and values. One of the last things we do in class is to watch the four-part PBS Frontline documentary Money, Power and Wall Street (2012), which examines in a rather harsh light the culture and values of the banking industry at the time of the GFC. I won’t attempt to summarize all that is in this film, but let us just say that it presents a view of banking industry ethos that does not bear much resemblance to the story of George Bailey using his own honeymoon money to bail out the BB&L and save its customers from ruin. And while I don’t share many of the viewpoints highlighted in the documentary, I do think it is important to expose students to these critical perspectives before they leave DoG Street for Wall Street.

Heads we win; tails you lose. In the film version of Too Big to Fail, the Jamie Dimon character (Bill Pullman) famously says to a group of Wall Street CEOs gathered at the New York Fed to hammer out a private sector resolution of Lehman Brothers: “Main Street wants us to pay; they think we’re a bunch of overpaid assholes”. And he’s right, of course—that is exactly what Main Street thinks. But you don’t have to be an Occupy Wall Street veteran or a diehard supporter of Elizabeth Warren to acknowledge that the financial services industry has more than just an image problem. No, the financial services industry has some serious issues which need to be addressed, including the persistent tendency of banks and other financial institutions to pay their executives outrageous levels of compensation for taking big risks with other people’s money, strategies which occasionally fail spectacularly, leaving the rest of us to pick up the tab for their gambling debts. These are serious institutional and systemic problems which did not end with the GFC and Dodd Frank, despite what we may have been led to believe at the time. But why is this exactly?

In that same film, the Hank Paulson character (William Hurt), now working as Treasury Secretary and no longer as the CEO of Goldman Sachs, proclaims with admirable candor but no apparent sense of irony that “Wall Street has a gambling problem” and “Moral hazard is something I take very seriously”. And yet here we are fifteen years later, and it still seems to be the case that “heads we win, tails you lose” remains a cornerstone principle of our approach to managing and governing banks in this country. And if you think I’m overstating things, which I am admittedly wont to do, please explain to me how SVB could possibly have made the risk management decisions it did and why it is that when SVB failed its ‘uninsured’ depositors walked away with 100 cents on the dollar, leaving others to pick up the tab.

I don’t have a good answer to these questions, but then I am not Secretary of the Treasury, Chairman of the Fed or CEO of a big bank. What really troubles me, however, is that it is not clear to me that any of these folks have particularly good answers either. But I know what George Bailey would likely have had to say about all of this. And now so do my students.

Even if they forget all about it when their annual bonus checks arrive.