As my readers (all three of them) know, on May 5, 2017, I joined the Board of Home Capital Group (TSX “HCG”). At that time, the company had been through a very grueling period where there was a “run” on demand and HISA deposits resulting in a severe crisis of liquidity. Before I had arrived, the board of directors had arranged a rescue facility of short duration and high cost with one of Ontario’s large pension funds, granting the company some breathing room in order to try to deliver a longer-term plan for stability of financing.
I am pleased to say that the company recovered (very quickly) from the issues of 2016 and 2017 and is now in a stable and profitable position with a wide range of funding alternatives. During the recent issues with mid-sized deposit-taking institutions in the US, there was effectively no concern expressed by markets for Home Capital or any of its mid-sized competitors.
There were a number of reasons for Home Capital to have had liquidity issues in the 2016 and 2017 period, most due to issues within the operations and governance of the company itself. Those issues were exacerbated by reactions of the company’s banking and investment partners, by the actions or lack thereof of government and regulators and by both formal and informal activities of the Ontario Securities Commission.
With the recent demise of Silicon Valley Bank and First Republic Bank in the US, I thought it useful to reflect on where there were similarities to the situation of Home Capital Group in 2016 and 2017. The reason why those banks had liquidity issues was dramatically different than the situation of Home Capital in 2016 and 2017. However, both SVB and First Republic suffered from some of the same issues in the stock market – which effectively threw substantial accelerant on the issues of institutional and retail trust that already affected both institutions.
It is axiomatic that banks and other deposit-taking institutions run on trust. While banks now perform a number of roles in the economy, their traditional role of savings/maturity transformation is still fundamental, especially to the regional banks. As such, the asset/liability term structure of banks that provide both operating deposit accounts and corporate and commercial loans is inherently unbalanced. Even if asset/liability interest rate exposure is effectively matched and banks utilize as much term funding as may be available, there will nonetheless tend to be an excess of deposits/liabilities in the very short end of the market. Banks will hold liquid assets that can be used as a cushion for unexpected loan or deposit flows, but there is a limit to such holdings while maintaining a viable business. A bank that held 100% liquidity reserves against demand deposit liabilities would not attract a lot of capital, at least to that part of its business.
As has been recently demonstrated, the trust that allows for the mismatch of maturities can move from strong to “gone” in a short period of time. Despite the substantial number of both regulatory rules and corporate policy around the adequacy of capital, when there is a dilution of trust, no amount of capital can overcome that dilution. Experience has also shown that despite effort by FDIC, CDIC and other deposit guarantors, depositors’ reflex is to withdraw even amounts that are fully subject to the guarantee. For non-guaranteed accounts, obviously the motivation is even stronger.
The entire regulatory and legislative apparatus, including the broad requirements of financial institution governance and the multitude of detailed rules around capital, liquidity reserves, underwriting guidelines, deposit insurance, etc.,etc. are intended to improve perceptions of trust and allow for competitive institutions for the betterment of the efficient functioning of banking, transaction and capital markets. In the case of SVB and First Republic these rules and guidelines were clearly insufficient to maintain trust.
In these cases, despite the substantial differences in the causes of the lack of trust there was another factor at play and interestingly a factor that only applies to financial institutions that are publicly listed on stock exchanges: a toxic combination of short-selling and social media.
In the case of privately held financial institutions no one benefits from a demise of a financial institution, there is only pain. However, through short selling of the common shares of a publicly listed financial institution, one class of actor has a very strong vested interest in the dilution of trust and the consequential reduction in share prices. This may have not been as significant 30 to 40 years ago when the amount of hedge fund capital was not large, electronic trading was in its infancy and social media was not a concept. In addition, 30 to 40 years ago, the stock lending desks of major institutions were small backwaters of limited profitability that were required to provide service to large clients with index exposures.
Today however, there is a significant amount of capital applied to short selling from activist funds and others. Electronic trading allows for techniques other than short selling to be used to accomplish the same end. For example, “spoofing” through electronic trading allows funds to place a large quantity of fake sell orders to create downward pressure on a stock, cancel the orders and then profit on the buyside.
It is, however, the combination of short-selling and social media that provides the most toxic mix. A group of co-ordinated short sellers, can create significant and sometimes unsubstantiated rumours about a company’s operations or risks, seeking to profit from the decline. This can be done with fake identities and bots that can make it appear as if there is a huge groundswell of unease about a company, and in the extreme cases there can be pure fraudulent intent. Obviously, there is no regulatory control over what these individuals and funds might say or do on social media, but there is very significant control over what the board of an attacked company can say under securities regulation.
In the case of non-deposit taking institutions, these attacks can be worrisome and in a number of cases can result in contagion to other financial sources such as banks and capital markets for such companies. However, for companies who raise deposits on trust, once these attacks take hold, it is very difficult for the boards of these companies to rescue the situation. In the case of Home Capital Group, we were very lucky to have support from significant financiers and eventually a globally respected shareholder. However, many other companies, including SVB and First Republic were not as lucky.
Two other factors have made recent short-selling campaigns more toxic. In 2012 in Canada the previous “tick-test” was repealed. This trading test required that all short-sales be executed on an “up-tick,” thus putting some brakes on concerted short-selling activity, especially those trades under algorithmic trading platforms. While there were mixed views of the effectiveness and efficiency of this test, it was one element in the short-selling mix. The other factor that has grown over the last decade has been the use of the “extended fail.” In all short sales, there most be an intention to borrow the underlying shares in order for the short sale not to be “naked.’ Market participants and access persons are required to file an Extended Failed Trade Report if a trade has not settled in 10 days and in that event participants are not supposed to trade further until the original trade has settled. There is substantial market uncertainty as to whether this reporting and trading regime is being administered uniformly by all participants and access persons, leading to the potential for abusive trading and naked selling.
In a recent interview after the SVB and First Republic issues, Jamie Dimon, Chair of JP Morgan has speculated on the potential for short sales of financial institutions to be prohibited. We remember that in September of 2008 to October 2008 the SEC did ban the short selling of 799 financial institutions in the US market. The ban was not viewed to have been effective in any way to provide support to the shares of such institutions and in fact had deleterious effects on price discovery and liquidity.
So, it is likely that a ban on short selling would not be appropriate and effective and clearly would not even be feasible in a world where short selling is part of the financial plumbing, from the humble pair trade to the construction and execution of ETFs, indexes and total return swaps. While it is tempting for a mid-size bank to privatize under a strong shareholder, this is unrealistic in most cases. Regulating social media chatter around a short position is also fraught with issues, including those of free speech.
There is no clear solution to these issues. In my opinion the regulators should continue their examination of abusive tactics and the plumbing of failed trades. The large stock lending desks should examine themselves to ensure that they are not part of the problem. Everyone knows who the bad actors are and a more aggressive policy of naming and shaming might have some effect on their institutional LPs.
There may be a real temptation to attempt to curb the combination of short selling and social media by requiring regulators to police “misinformation”. However, the ingenuity of short-sellers and their supporters and bots and the sheer volume of information to police makes this unrealistic and as noted above, fraught with issues of free speech.
The other reaction to these trends is to consider a substantial increase in deposit insurance levels. That would, in effect, socialize the costs of failure, but with the burden taken up principally by the larger and likely more stable institutions. I would not support this increase as it is unlikely to ever be truly sufficient unless governments want to be guarantors of the financial intermediation process.
It has also been noted that on occasion there is insider selling prior to dilution of trust, which selling also likely adds to the issues. However, there are very strong rules and penalties already in the system to prevent selling (or buying) with inside information. Active prosecution of these trades might be helpful to provide an example.
The only technical solution that I can come up with is a set of speed bumps. For example, trading halts based on daily movement (for example a 10% down day), could give companies the time to correct social media mis-information campaigns so that trading could resume with more complete information. Coupled with more aggressive information campaigns from regulators and deposit insurers and a proactive media monitoring process on the part of the institutions themselves, this might slow down, but obviously would not completely stop an attack.
I believe that there is a role for the trading and stock lending desks and their regulators to be much more active in policing and reporting of suspected bad actors in these situations. While very few short sales are likely to be suspicious, it is clear that a number of these actors are repeat sellers and thus I suspect well known to the traders. Companies themselves will have an idea of who the shorts are (or at lest they’re social media tags) and should be trying as quickly as possible to get regulators to pay attention.
For Boards of Directors, it is important that they have daily insight into trading (much as we do when there is an acquisition or divestiture transaction) and that management be very proactive, within the boundaries that they are able to control.
However, there is no silver bullet to the problem of short-selling businesses that are based on trust. It would be unfortunate, however, if the net result of this activity is that regional and specialist competitors end up in the hands of the very few globally stable organizations.