Aswath Damodaran thinks perception is everything, and for banks even more so

Aswath Damodaran says he is a teacher first, who also loves to untangle the puzzles of corporate finance and valuation. The Professor of Finance at New York University’s Stern School of Business says that the current banking crisis is a problem of trust deficit and there will be pain till the lenders regain the trust. In an interview with Business Today’s Global Business Editor Udayan Mukherjee, Damodaran talks about the banking crisis, recession, why regulators put together do not have the resources to stop a complete bank run and why it is healthier for start-up ecosystems not to have too much money. Edited excerpts:

Q: The banking crisis started off with Silicon Valley Bank, followed by Signature and then Credit Suisse. And just when we thought it couldn’t get any bigger, there are concerns about Deutsche Bank. What is the endgame?

A: The central problem with a banking crisis is that banks are built on trust. When I talk about banks, I think of them as the exact opposite of when we talk about bitcoin. Bitcoin, I would describe as a currency for the paranoid by the paranoid and essentially built on no trust at all. Banks, at the other extreme, are built entirely on trust. As an example, if we all decided to withdraw money from JPMorgan Chase, the largest bank in the world today, tomorrow, there would be no bank left. So with banks, it’s very difficult to figure out when the trust comes back. You can almost see the game play out: you get a weak bank, it gets knocked over, and the next target gets lined up almost immediately. I think it will end… no, let’s hope it ends because otherwise, the end result is a catastrophe. It will end, though it’s almost unpredictable when it ends, but it is going to play itself out and eventually, trust will come back. But there’s gonna be a lot of pain along the way.

Q: Will there be a serious accident by the time this ends? Or because the regulators know what the collapse of a single institution can do to the system, they will do whatever it takes—throw whatever money it takes—to prevent that from happening?

A: See, they can do that with a single institution, but they can’t do it for all institutions collectively. The reality is that [all] the regulators put together do not have the resources to stop a complete bank run. And that’s what I meant about this being unpredictable. If, in fact, the regulators were in control of the process, you could rest easier, but they’re not. They only have partial control; they will do what they can to try to change the game. But the game here is to bring trust back. And no minor money brings that back instantaneously. Unfortunately, we have a trust deficit; we’ve had a trust deficit for a decade or more, and I trace it back to 2008. When I described 2008 as the year we lost trust, we lost trust in governments, we lost trust in regulators, we lost trust in banks, and that trust never quite came back. So, I think we’re starting with a trust deficit, to begin with. And with social media playing out the way it is, it becomes a lot more difficult to stop rumours from spreading and trust to come back.

Q: That’s exactly the point, Aswath. Because the trust deficit that you allude to, we can see how it raises doubts even about a behemoth like Deutsche Bank. Do you fear that this could actually lead to far greater damage than is warranted today in the banking space?

A: Yes, you can get into a death spiral very quickly. I remember November of 2008 when there was a very real chance that nothing would be left standing when a rumour started that Morgan Stanley would not be around in a couple of weeks. And the rumour itself created enough trouble that Morgan Stanley actually got into trouble. The perception that you’re in trouble can actually create trouble. How can you know at what point trust comes back enough that people leave their money? That’s what the regulators and the governments are looking for, some kind of a signal that this is not going to be an end run where everybody’s got to take their money out.

Q: Prudential norms in banking in the US are actually not making things easier because apparently the bond losses of all the banks put together is very, very close to the entire contingency reserves of the US banking system put together...

A: What you’re talking about is the fact that many of these banks hold long-term government bonds, which they bought in 2019, 2020 and 2021. That’s not just banks, governments too have significant holdings of US Treasuries, and there’s a markdown of about 18-20 per cent, because rates have risen. But that’s neither here nor there. None of these banks need to sell those bonds to cash out right now to cover deposits. That’s why I said it’s about trust. It’s a trust deficit. If nobody had withdrawn money from Silicon Valley Bank, we wouldn’t be talking about SVB right now, as a bank that shut down. The fact that there’s $620 billion in potential losses weighing on the banking system is neither here nor there. What made SVB so unusual was that 60 per cent of its assets were in [US] Treasury bonds and mortgage-backed securities; it was more like a hedge fund than a bank. In contrast, we look at a typical bank in the US, it’s more like 20-25 per cent, or a typical bank in Europe, which also faces the same issue. So, the magnitude of the bond holdings is much smaller at other banks. The worry you have though is that this banking crisis triggers a bad recession and the loans that these banks have start to fail, then you have a real problem on banks’ hands... The next step in this process is to make sure this banking crisis doesn’t become an economic crisis.

Q: This is an interesting point, because economic history suggests that these bank failures typically happen just before the US economy goes into recession. Do you see this as a prelude or a harbinger of recession to come?

A: There’s been talk of recession even before the bank failures, right? I’ve heard more talk of recession in the last year than I’ve had in my entire 40-plus years in markets. The amazing thing is, in spite of all this talk of a recession, the economy has been remarkably resilient. Let’s see though if it’s resilient enough to bounce back from this. My guess is it adds one more chip against the economy continuing to stay strong. Weakness by itself is not the issue. It’s how deep the recession is, and how much it might lead to losses on those loans that banks have on their portfolios. I’m not quite ready to write the obituary of the US economy yet. It is not a good sign if you think about what the economy would do over the next year, but it’s not a fatalistic sign either.

Q: Now a lot of people have rushed to say that, don’t panic, this is not 2008. But people who have watched markets for a long time know that every crisis is different. Should we take comfort from the fact that regulators are aware of the problems that led to the previous crisis and therefore, we will not land up there again? Or could this crisis actually play a little differently, but be no less damaging in a sense?

A: I think both statements can be true. You can take some comfort in the fact that regulators have lived through something like this before and have the ammunition to deal with it. At the same time, in every crisis, regulators say, ‘Don’t worry, this is not a crisis. Everything’s going to be okay.’ I think we need to be on high caution. And my suggestion is, don’t go about closely tracking markets every day, because there’s nothing you can do to stop a banking crisis. Just take care of your own finances the best you can. And that might mean putting safety first, at least in the near term, if you’re an investor who cares about protecting the principal, in your portfolio.

Q: How do you see the US Fed moving right now, because they had inflation as their central target, but given the noise in the banking space, has their job become much more complicated in a sense? Could they now begin to think that their primary problem is to restore trust in the banking system rather than fight the fires of inflation?

A: It really has made their job much more complicated, because in the near term, you’ve got to stop the banking crisis. If there is a major banking crisis, victories against inflation are going to be hollow; because what are you fighting for if the entire economy is being taken down by the banks in trouble? I think for the near term, I’m sure there’s as much focus on the banking crisis as there is on inflation. But the Fed can’t let inflation not be taken care of, because part of the reason banks are in trouble is because of inflation. People have said, well, banks are in trouble because the Fed raised interest rates; well, the Fed did not raise interest rates, inflation raised interest rates! The Fed chased interest rates up in the market, [but] inflation is the real source of the banking crisis. These are not two separate problems. Inflation gave rise to the banking problem. And I think the Fed knows that it needs to fix the banking problem. But it also knows that there’s a bigger source problem, which is inflation, and they need to take care of that as well. The two are interconnected.

Q: Now, is this an American problem, because there have been ripples and tremors across Europe as well. In India, the regulators have said so far that our system is different, our safeguards are different, and India is not in the same boat. Do you therefore see it as a localised American problem? Or does it have global ramifications?

A: It is less to do with geography than with parts of the world where interest rates have risen a lot. That’s true in Europe and the US; if you look at interest rates, the T-bond rate at the start of 2022 was 1.5 per cent. At the end of 2022, it was 4 per cent. In Europe, at the start of 2022, the Euro 10-year bond rate was close to 0 per cent. By the end of 2022, it was 2.5 per cent. Any market where rates have gone up significantly is a market with a banking problem. And it’s not just a banking problem. It’s a problem with a lot of companies that have essentially mismatched durations, which companies do all the time. But these are the times when that mismatching comes back to haunt you. What saved us is not that the Indian regulators are more forward-looking and banks are more secure. It’s simply because rates in India have not risen the way they have in the rest of the world. And that’s true for a lot of Asia. So I think what separates the parts of the world that are not seeing a banking problem from the parts of the world that are seeing a banking problem is looking at what rates in that part of the world have done. And that’s going to give you the answer.

Q: Speaking of the Indian banking system, you said recently that the Adani Group had exposed the weakest links of the Indian financial system. Were you alluding to specific banks or insurance companies?

A: I think this is no secret that if you go back in time, [the] Indian banking and Indian family group companies have been linked at the hip, which is you loan to a family group, and you don’t always do the due diligence that you would have done with an individual company. Not because you’re necessarily corrupt, but because you assume the family will come through. I think that’s a very dangerous mechanism for lending. I was talking about the close relationships between lenders and the businesses they lend to, which can lead to being sloppy in your lending. I think that that is a weak link in the Indian system, we know it’s a weak link, it’s led to some Indian banks having loans on their books to family groups, that should be written down that haven’t been written down yet. And this is a fight that goes back to the days of Raghuram Rajan when he brought this problem up to the surface; it’s not a problem that’s gone away. And it’s a problem that India has to deal with, frankly, if it wants to become the economic power that it aspires to be.

Q: Do you see this as more of a public sector problem, or all across the financial spectrum?

A: See, if State Bank of India goes down, guess what, it’s not just State Bank of India going down, it’s going to bring down the whole banking system. Look at Silicon Valley Bank, the 16th largest bank in the US. In the larger scheme of things, you’re saying, who cares… The 16th largest technology company goes down, you wouldn’t even have noticed! But the 16th largest bank going down threatens to bring down the entire system. Unfortunately, in banking, there’s no such thing as separability. So if the big public sector banks have troubles, guess what? It’s everybody’s problem.

Q: That is true. But the other thing that is going on is in the ecosystem of digital companies, where they don’t have recourse to bank debt and take the money from private equity companies. And now there is a squeeze out there as well. How do you see that crisis playing out?

A: Well, two things. First is that young companies should never borrow money. So not having access to bank debt is a good thing. Banks shouldn’t be lending to young companies, because what are they going to pay it back with? So it’s true, you’re at the mercy of venture capitalists, which is the version of private equity that plays out here. But come easy, go easy. These are companies that came out of nowhere to be worth billions of dollars. And these are companies that will lose value as easily. So why do we shed tears about this? This is the nature of the process. In the good times, you raise too much capital and in the bad times, you won’t raise very much. It’s healthy for the weakest of these companies to essentially be shaken out of the system. I know it’s painful in the near term, but I think it’s healthier for an ecosystem not to have too much money sloshing around. And in my view, for a decade, we had too much risk capital funding these companies. What happened in 2022 was a reversal to normalcy. It wasn’t some retreat to some bad spot. It was just a reversal to what a normal risk capital market looks like. So I think in a sense, you might be shedding tears for the wrong companies—these young companies that raised too much capital and went after traditional companies and regular businesses and ruined them. I mean, nobody shed tears for those disrupted companies. So why are we shedding tears for the disruptors now?

Q: On hindsight, would you therefore say that easy capital is the root of too many problems? We’ve seen before how companies go through a cycle of five or six years when there is abundant risk capital, whether it’s in form of debt or equity, and inevitably end up in a major crisis.

A: Absolutely. Everybody becomes lazy and sloppy. It’s not just companies, it’s investors, it’s regulators, it’s governments. Everybody thinks that the good times will last forever. And guess what, through history, we’ve had these booms and busts. So in a sense, when we have a bust, people wring their hands and say never again. But guess what, 10 years from now there’ll be a different boom and a different bust. It’s almost like human beings are doomed to repeat this process over and over again. We never learn, and we never will.

Q: The last few weeks have raised fears of a 2008 kind of a situation again. Do you think we will get away lighter this time, or could we be staring at a crisis of that magnitude?

A: ‘Could’ is a weak word. Of course, we could be. I don’t think it’s a high-probability event, but there’s definitely a chance it could happen. I mean, anybody who claims it cannot happen is lying. There is nothing in this system that can prevent a panic, like we saw in 2008. But here’s the good news. We did survive 2008. And we came out intact. It created an incredible amount of pain, but we got through that. So even if that is the outcome, you’ve got to figure out a way of surviving the outcome and coming out on the other side. Because sometimes there are opportunities in the worst of threats. And that’s something that I think we need to keep in mind.