We cover the three main ways failures happen. First, we discuss fraud, both external and internal. Then we discuss underwriting, which affects both lending institutions and insurance companies. Finally, we discuss asset-liability mismatches, known as a “run on the bank”. We go back to the 1800s to today, when these happen (mostly) digitally.
- 💡 Name: Marc Rubinstein
- 💡 What he does: He’s the writer of the newsletter Net Interest and a former financial analyst and portfolio manager.
- 💡 Company: Net Interest
- 💡 Noteworthy: He’s an investment professional with 25+ years of experience in researching and investing in financial services companies. He’s also a retired partner from one of Europe’s largest hedge fund firms.
⚡ Financial companies have a unique relationship with fraud. Financial institutions can be both victims and perpetrators of fraud. So, why do failures like this happen? Marc explains, “There was a famous bank robber in the US, Willie Sutton. He was asked why he robbed banks, and he said because that’s where the money is. Very famous line. And cognizant of that, those that work within financial companies clearly have the opportunity, if not the motive, to conduct fraud. Financials, very much, therefore, have a unique relationship with fraud.”
⚡ Lack of transparency in underwriting costs poses problems. While the revenues are transparent in underwriting, the costs are not. This creates potential problems. Marc explains, “Underwriting is fundamentally the core business of a lending institution or an insurance company. What’s unique about that business line — compared with selling a tangible product the way other companies might — is that the costs aren’t known at the point the sale is made. The insurance premium is taken in; the loan is underwritten. The revenues are fairly transparent from that point on, but the costs are not. And this is what creates problems, particularly as the two cycles don’t necessarily coincide. So the revenue cycle might be a function of the broader business cycle.”
⚡ Growth is not necessarily good. Sometimes growth can be bad for financial institutions. Marc explains, “[It’s] very important not to be consumed by the competitive environment and to pursue growth. One of the heuristics that I and other investors in financial services apply is that growth is not necessarily good because today’s growth is often the precursor for tomorrow’s losses. And there are often reasons in an efficient, competitive market as to why other financial institutions aren’t taking on those risks, thus affording you that high growth.”
The “bezzle” and underwriting
“There’s a time lag where money is being made, and in this context, banks are generating revenue, but the losses haven’t yet been incurred. And he classifies that as the ‘bezzle.’ […] There’s a period of time between when the fraud has been initiated, the fraudsters are benefiting from the value they’re extracting from that fraud, but the victims don’t yet feel that they’re being defrauded. But it’s the same in underwriting too. There’s a period where accounting profits are being booked, but economic profits aren’t really present. And that’s the difficult thing when it comes to underwriting. It’s true in insurance. It’s true in banking.”
Failure can take a long time
“There’s a great line that bankers talk about. They say that banks can either die of cancer in the loan book or a heart attack in treasury. The point being that we spoke, in the context of underwriting-driven failures, that failure can ultimately take a long time when it comes to a run on the bank or the asset and liability mismatch that occurs in the treasury business that you mentioned that will happen very, very quickly.”
Non-banks are not subject to the same regulations as banks
“It’s been a lot of regulatory arbitrage that has happened because the regulations are more stringent on banks. A lot of institutions that do banking-type activities — they take in funds, they invest those funds — there’s an asset-liability mismatch, but they’re not banks, so they aren’t subject to those same regulations, and they certainly don’t have insurance.”
[14:15] “They say banks can either die of cancer in the loan book or a heart attack in treasury.”
[20:09] “There was no premium on liquidity in the past ten years.”
[20:55] “This risk now, this kind of run risk, I think it is much more of a risk outside the banking sector than in the banking sector — given regulations that have been put in place since the financial crisis.”
[00:00:00] Marc Rubinstein: Financials very much, therefore, have a unique relationship with fraud. What’s interesting is, examples we’ve mentioned are where the fraud has been conducted by members of that organization, by executives within that organization themselves. The flip side is, the benign perspective is that financial companies are also victims of fraud from outside.
[00:00:25] Intro: Hello and welcome to Signals by AlphaSense, where we hear thoughtful insights from business leaders, investors and experts.
[00:00:36] Nick Mazing: Hello and welcome. You’re listening to Signals by AlphaSense, and I’m your host, Nick Mazing. They were going to talk about how financial institutions fail with Marc Rubinstein, who is a former financials analyst. Currently, he’s writing Net Interest, and we’ll have all the relevant links in the show notes.
[00:00:54] I’m personally subscriber, and I can tell I have learned more about financial institutions from Marc than from anywhere else. I’ve been reading for, I think, two years now, and I did learn quite a bit by experience, as well. I worked at Lima Brothers. And so, financial institution failure is a topic that is near and dear to my heart.
[00:01:11] Maybe not dear, but certainly near. And Marc is also a client we’ve spoken before several times. I think he makes the perfect guest for a high-signal podcast. Mark, can you tell us a little bit more about yourself?
[00:01:26] Marc Rubinstein: Sure, Nick, and thanks for having me. As you said, I’m a former financials analyst, I worked as a partner in a hedge fund, based in London for 10 years. We specialized exclusively in the financial services sector. So, I would go touring the world, looking for opportunities on the long side and the short side in, amongst financials.
[00:01:51] Prior to that, I’d been a sell-side financials analyst. I was at Credit Suisse, which is a firm very much in the news at the moment, for many years Managing Director there. And since leaving the hedge fund a few years ago, retained my interest in financials. It was a, a bigger component of the market than it is now.
[00:02:11] It’s not as big a sector now as it was then, but it’s still foundational, very important. And I find a lot of investors don’t have, a lot of generalist investors don’t have the knowledge of, of financials. And hopefully, my expertise can help them.
[00:02:31] I’m going to recommend the, the Substack, again, I personally love it. Every Friday, there is a great write up on several topics actually. So, now financial institutions play a special role in the economy, right? They, you have the, they connect savers with people who need credit. They facilitate payments.
[00:02:47] Nick Mazing: And you think about GDP, to release actually payments, right? And it goes through the, through the system. So, financial institution failures, as a result, are always very newsworthy and very risky because of the potential effects down the line. And I think what we’re seeing now in the crypto space is a little bit of a crash course on why regulations exist.
[00:03:08] So, , I thought it would be very useful if our listeners have a good framework about how failures happen with financial institutions. So, let’s talk about fraud first. And, you know, recent prominent example was Wirecard, which was a German payments company. For our US listeners, uh, that was a company that was in the DAX 30, which is called the Dow Jones of Germany.
[00:03:30] Obviously, extremely, extremely high profile situation. So, what can you tell us about fraud?
[00:03:36] Marc Rubinstein: Well, financial companies have, in my view, a unique relationship with, with fraud. You mentioned crypto, FTX, obviously a high profile current fraud case, Wirecard, which you mentioned. I don’t think it’s a coincidence that many of the highest-profile fraud cases are financials. Financial companies are,
[00:03:58] there was a famous bank robber in the US, Willie Sutton. He, he was asked why he robbed banks, and he said, “Because that’s where the money is.” Very famous line. And cognizant of that, those that work within financial companies clearly have the opportunity, if not the motive to conduct fraud.
[00:04:19] Financials very much, therefore, have a unique relationship with fraud. What’s interesting is, examples we’ve mentioned are where the fraud has been conducted by members of that organization, by executives within that organization themselves. The flip side is, the benign perspective is that financial companies are also victims of fraud from outside.
[00:04:45] There’s data in the UK, I don’t suspect it’s that different in the US, that for every 100 pounds spent, for every a hundred dollars spent on a credit card, seven and a half cents, seven and a half p, it is skimmed off through, through fraud. It’s a, a cost that we’re all bearing. UK regulators have said that a couple of years ago, uh, over a billion pounds was pilfered through the banking system via by fraud.
[00:05:16] And actually, twice that was caught at the door, twice. So, there was an attempt to defraud banks of 3 billion that was identified, a billion got away, and 2 billion was caught at the door. So, financial, it’s where the money is. Financials are highly exposed to it, both as victims and as perpetrators.
[00:05:35] Nick Mazing: Mm-hmm. And dovetailing with that, the second way that we’re discussing that framework is an honest way to fail, which is underwriting. And we’ll talk about underwriting in, in the wider sense of the word. So, there is obviously bank underwriting, let’s say, you know, a bank gives credit to a consumer to buy a house, or whether it’s credit card based on, let’s say, credit score or other profiles, there is also insurance underwriting.
[00:06:01] If we widen the definition of, of financial failures. When you look at, let’s say, specifically, I’m more familiar with the United States. When you look at Florida Homeowners Insurance, very famous graveyard for bad underwriting, or another one, which is Long-term Care Insurance, which is an insurance product that
[00:06:18] Nick Mazing: offer protection for long-term care expenses as people get older. It was dramatically, dramatically underpriced and a number of companies ended up being under reserve in some other kind of trouble because of the bad underwriting. Now, obviously, the great financial crisis in the United States was also bad underwriting.
[00:06:35] It was based, you know, kind of in a classic Soros way, you know, there was a trend where the premise was wrong. Right? And the, the premise that was wrong in this specific case was that in the US, national housing prices never go down, right? And it led to a lot of bad underwriting. So, underwriting is supposed to be a core skill, but is it also core risk?
[00:06:54] How do you think about underwriting failures?
[00:06:57] Marc Rubinstein: So, you are right. Underwriting is fundamentally the core business of a lending institution or an insurance company. What’s unique about that business line compared with selling a tangible product, the way other companies might do, is that the costs aren’t known at the point the sale is made. The insurance premium is taken in, the loan is underwritten, the revenues are fairly transparent from that point on, but the costs are not. And this is what creates problems, particularly as the two cycles don’t necessarily coincide. So, the revenue cycle might be a function of the broader business cycle.
[00:07:40] You know, there’s a famous line from the time of the financial crisis, it was Chuck Prince, who was the CEO of Citigroup, spoke about, “When the music’s playing, you’ve gotta keep dancing.” And what he was referring to was the business cycle. The competitive environment made it very important for him in order to stay competitive to focus on price. Costs didn’t matter because cost of risk didn’t matter because it was gonna have a long-term impact. It’s an interesting point, actually. One of the reasons regulators, banking regulators, which have a big say in the way banking is conducted globally, bigger post-crisis than they did immediately pre-crisis.
[00:08:25] It’s a really interesting point. They’re not that keen on competition. You know, you would kind of think as market regulators, they should be extremely pro-competition. In fact, most financial regulators, competition is secondary to financial stability. And sometimes, there can be a conflict between financial stability and competition.
[00:08:48] So, again, going back to the financial crisis in the UK, it was suggested to one of the more successful banks that they take over one of the more failing banks. The competition authorities actually said, “No.” That this would create too much of an oligopoly in UK retail banking.
[00:09:08] Marc Rubinstein: The government overrode that and said, “Doesn’t matter, this is a financial stability issue, and competition has to play second fiddle.” Coming back to the point. So, there’s a market cycle which drives Price Inc, but there’s also a credit cycle, and the two aren’t necessarily, as I say, aligned. You know, there’s a famous point about the Bezzle,
[00:09:28] which was popularized by Galbraith, uh, and also Charlie Munger spoke about it. And he, both of them make the point, there was a period of time, there’s a time lag where money is being made, and in this context, banks are generating revenue, but the losses haven’t yet been incurred.
[00:09:47] Marc Rubinstein: And he talks about that, as he defines that, he classifies that as the bezzle implications in terms of fraud, the first thing we discussed as well. There’s a period of time between when the fraud has been initiated and where the victims, the fraud had been initiated, the fraud does, are benefiting from the value they’re extracting from that fraud, but the victims
[00:10:11] don’t yet feel that they’re being defrauded. But it’s the same in underwriting, too. There’s a period where accounting profits are being booked, but economic profits aren’t really present.
[00:10:22] And that’s the difficult thing when it comes to underwriting. It’s true in insurance, it’s true in banking.
[00:10:27] Buffet has given some great examples of how he has suffered from it, as well. Because the way round it is through pricing. If that risk is priced for appropriately, irrespective of whether the music is still playing, then it can be absorbed through that excess profits when the losses ultimately accrue.
[00:10:48] Nick Mazing: Yeah, there is that famous Taleb chart, right, of the Thanksgiving Turkey, right? It keeps gaining weight, and things, things are great. And then, right before Thanksgiving Day, it gets, goes to zero.
[00:10:59] And these, these things have gone for years. A, actually bank failures, you know, you opened up this conversation talking about bank failures. We know of the headline cases, we know of Northern Rock in the United Kingdom, Washington Mutual, and Lehman Brothers, where you worked, in the US. They’re actually more common than you would think.
[00:11:19] Marc Rubinstein: The FDIC publishes a list of failed banks, it updates it once a week. Typically, the FDIC, Federal Deposit Insurance authority will go in on a Friday night to resolve a failed bank over the course of the weekend. And they will announce it, uh, on the Friday night after the bank is closed. There actually hasn’t been a failure of a US bank for a while.
[00:11:46] We’re actually at the second longest streak historically where there hasn’t been a failure. The last failure to occur was in October, 2020. It was a, a, a small bank in Kansas. But what’s interesting about it, if you drill down into it, is it was in a pretty crappy state because of poor underwriting for a long period of time.
[00:12:09] Marc Rubinstein: And actually, the bank before that to fail, like a week before, also October 2020, a Florida-based bank had been unprofitable for 12 years. It was posting credit losses linked to poor underwriting on commercial real estate for 12 years before it ultimately failed. So, underwriting very, very important. Very important not to be consumed by the competitive environment and to pursue growth. You know, one of the heuristics that I, and other investors in financial services, apply is that growth is not necessarily good. Because today’s growth, uh, is often the precursor for tomorrow’s losses. Uh, and there are often reasons in an efficient, competitive market why other financial institutions aren’t taking on those risks, thus affording you that high growth.
[00:13:05] So, we talk about fraud, we talk about underwriting, and the third way an institution can fail, again, we’re trying to have the framework in place here, is a run on the bank, or, you know, if you wanna sound more sophisticated, you can call it an added liability mismatch. But, you know, you can really look at like, go to Wikipedia, enter,
[00:13:28] Nick Mazing: “Financial panic of.” And see how many Wikipedia hunters there are, there are on that. So, it’s a fundamental business risk, obviously, where, you know, a bank may be funded by short-term deposits, and then, then they loan, let’s say, a 30-year mortgage or a 15-year mortgage, or a 10-year and so on. And,
[00:13:48] in that case, the bank, if all the depositors want their money back, right, they can cover it if, if they want my money back at the same time. Although that risk has been in the United States and in other developed countries, has been reduced quite a bit by, in the United States is the FDIC, Federal Deposit, Deposit Insurance Company or Corporation,
[00:14:08] I’m forgetting what it means. But, you know, they cover depositors up to, I think, $250,000. And in other countries, there were similar fees, but you’re still a counterparty, right? There is still the risk that something can happen with that. And we saw some of that as well, kind of the counterparty risk during the meme stock mania when
[00:14:26] a number of the three brokerages actually stopped doing business with people who want to buy certain stocks. Right? Because they had to put collateral just on the backend of, of how it works. So, can you discuss, run on the banks and how they work?
[00:14:41] Marc Rubinstein: Yeah. There’s a great line that bankers talk about. They say, “Banks can either die of cancer in the loan book, or a heart attack in treasury.” The point being that we spoke in the context of underwriting-driven failures, that failure can ultimately take a long time. When it comes to a run on the bank, or the asset and liability mismatch that occurs in the treasury business, that you mentioned,
[00:15:07] that will happen very, very quickly. And there’s something of the psychology about it. There was, uh, a case, you know, you talked about financial panics of the past. There was a case in the UK, I mean, there’d been multiple cases. There was one that I can recollect now in the UK, just in 2019, where a rumor spread on a WhatsApp group around one bank, Metro Bank, public company, which had reported some losses, but a rumor went round that they were, uh, in trouble. Notwithstanding that there’s deposit insurance in place. And line started forming outside some particular branches around London. These days, and this is reminiscent to the panics, you know, you mentioned, my favorite is the,
[00:15:48] uh, financial panic of 1857 where half of the deposits of New York banks went, in the form of run. And the, the photos of that era, of people lining up down Wall Street to withdraw their money are stock images of what a bank run is. These days they tend to be more silent.
[00:16:12] We got a silent bank run. Clearly, it’s possible to withdraw deposits, uh, online and through electronic means, and therefore the need to line up outside a bank is obviously diminished. Recently we saw Credit Suisse, there was speculation about their financial position that became prominent in, on Twitter. Actually, in October,
[00:16:37] last year, beginning of October, there was an Australian-based journalist, talked about authentically, about a problem he’d heard amongst a major bank. And the company started suffering withdrawals, both of deposits and also wealth management products. And by mid-November
[00:16:58] 6% of the group’s assets under management have been withdrawn. Some of that’s now come back, but that’s kind of a, a recent, a recent case.
[00:17:07] Nick Mazing: Mm-hmm. Can you comment on a similar dynamic? I think sometimes it happens with real estate funds. I think it was a, a case in the UK where, essentially, a run on the bank, but it wasn’t a bank. It was simply people who had invested in e-liquid assets through a fund.
[00:17:23] It’s a really interesting point because, you know, I’m not a bank regulator, but I read a lot of what they publish, and I’m quite close to various regulatory bodies. They are increasingly worried less about banks because there are frameworks in place through the requirement for them to hold certain levels of liquidity.
[00:17:45] Marc Rubinstein: So, I’ll come back to your question. But another example, right now, of a bank suffering a run is Silvergate, in the US, La Jolla, California-based bank. Very, very heavily immersed in crypto. About 90% of its deposits were from crypto firms. At the end of September, they had just shy of $12 billion of deposits.
[00:18:09] But because of the collapse in crypto, they suffered a run. And they announced recently that they’re down to less than 4 billion of deposits. They lost, they lost 8 billion out of 12 billion of deposits. It’s huge. Now, in bygone days that would’ve been a problem ’cause the issue a bank faces is that it hasn’t got that kind of cash on hand.
[00:18:31] Doesn’t have that liquidity available. Hence the mismatch you spoke about to satisfy that degree of withdrawals. Regulatory requirements now require banks to have high-quality liquid assets on, on hand. And what was interesting about Silvergate is, you know, they kind of announced, I mean, you know, “The stock’s down 90%, the company’s in trouble.
[00:18:55] The deposits have all gone, but it’s, it’s still standing.” And they had a conference call, they had an earnings call last week. And I think it was a Goldman Sachs analyst, he, you know, normally, “Great quarter, guys.” An analyst would throw that remark when the results were good. Here, he said, I’ve got the quote here,
[00:19:13] Marc Rubinstein: he said, “I just wanna say congratulations. I don’t think that there are that many banks that could say with a 70% decline in deposits and come out of it with no operational liquidity issues.” And it’s kind of congratulations to the regulatory authorities for imposing that framework post-financial crisis, which requires banks to have liquidity.
[00:19:35] Now, back to your question, that’s not the case for non-banks. It’s been a kind, a lot of regulatory arbitrage that has happened because the regulations are more stringent on banks. A lot of institutions that kind of do banking-type activities, they take in funds, they invest those funds, there’s an asset-liability mismatch, but they’re not banks, so they’re subject to those same regulations and they certainly don’t have insurance. And they might be, because there was no premium on liquidity in the past 10 years, rates were zero.
[00:20:11] Everything was liquid. And there were various new business models being generated to make illiquid things liquid. And, consequently, a lot of these institutions, you know, you write about the one in the UK, to be fair, some of them, famous one is Blackstone. Blackstone, real estate income trust, put its gates up.
[00:20:31] But, to be fair, they already specified that they had gates in place and that they would prevent withdrawals if they were to exceed certain limits. So, that was all very clear. People may not have listened to it because there was no premium on liquidity previously, so they may not have listened to it, but that was always what was specified.
[00:20:52] So, this risk now, this kind of run risk, I think it is much more of a risk outside the banking sector than in the banking sector, given regulations that have been put in place since the financial crisis.
[00:21:09] Nick Mazing: Marc, thank you for joining us today.
[00:21:12] Marc Rubinstein: Thank you, Nick.
[00:21:14] Nick Mazing: This is Mark Rubinstein of Net Interest. We discussed how financial institutions fail, and we specifically focused on fraud, bad underwriting, and runs on the banks. My name is Nick Mazing. This is Signals by AlphaSense, and you can subscribe to us on the major platforms.
[00:21:30] Thank you for listening.
[00:21:32] Outro: Thank you for joining us. This was another episode of Signals by AlphaSense. Keep in mind that all views presented here are the views of the guests and hosts and do not represent the views of their employers or of AlphaSense. Nothing in this podcast constitutes investing, tax, legal, or medical advice.
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