Bank Failures: Sails Set, Flags Flying, and All

Sails Set, Flags Flying, and All…

Even when everything seems perfect a gust or two can sink you if you don’t leave a margin of safety. Getting caught up in potential upside and forgetting downside risk is easy. Being too focused on the attack and not enough on the ability to weather storms is the death of many banks. Sometimes unpredictable circumstances cause the failure other times just a slight bit of turbulence can catalyze a much larger reaction.

“Only when the tide goes out do you learn who has been swimming naked.”

- Warren Buffett

During this summer I visited the Vasa Museum in Stockholm. After some time conceptualizing the 200-foot ship in remarkable condition (pictured below) that had been submerged for 300 years I couldn’t stop thinking about the symbolism of it. The Vasa is a prime representation of bank failures.

The Vasa was a Swedish military ship built from 1626-1628. The vessel famously sunk on its maiden voyage after just 1500 meters of sailing. It didn’t even make it out of Stockholm harbor. Much of the focus on the ship is the recovery process that occurred from 1958-1961 involving lifting the ship from the bottom of the harbor completely intact. That was an unbelievable feat, however, I want to focus on how it ended up on the bottom of the harbor in the first place.

Vasa was sailing on its maiden voyage in Stockholm harbor when a squall blew across the ship. It made the massive wooden vessel tip a bit until it passed moments later. Soon a second gust made the ship list even more than the first. Water began coming in through the gun ports (openings for cannons on the side of a ship). This new ballast (water) made the ship heel more and take on water faster. Not long after that, the ship was sinking quickly and became submerged.

This story seems odd. Ships of that size should be able to handle a lot more than a couple of gusts in a harbor. Why couldn’t the Vasa? The designers of the Vasa were required to have two rows of cannons. This caused two problems. First, there were lower-than-usual openings in the hull for the bottom row of artillery. Second, the cannons added significant weight to the ship, which meant a reduction in the weight in the keel (ballast at the boat of a ship). However, this wasn’t trading one type of weight for another. The cannons were near the top of the deck. Which meant the center of gravity of the ship was raised. This makes the ship far more vulnerable to capsizing.

What does this have to do with banking?

The Vasa designers optimized the ship for combat and the offensive. In the process, they sacrificed safety and the margins necessary to keep the boat operational. In banking, there are similar concerns. Bankers should never sacrifice safety and the ability to weather a storm for increased top-end performance or returns. It doesn’t matter how many cannons are on a ship if it is at the bottom of the ocean.

Nothing scares me more than an overly ambitious bank. In banking “abundance begets failure” (

John Maxfield

). We don’t need to go far to find an example of this, Silicon Valley Bank saw an influx of over $100b in deposits and failed soon after. This was mainly due to a lack of a strong strategy for investing the significant new deposit base. Then rates rose while the deposits were invested at a low rate, a squall hit the bank. Silicon Valley Bank was not prepared to cope with the environmental challenge.

At its core, banking is a constant balance between credit quality and returns. The lower credit loans a bank makes generally the higher rates they can charge on those loans, however, the difficult part of this equation is risk. When you move down the credit scale returns become more attractive, but potential risk is not as easy to measure. When returns need to be improved credit standards are typically the first thing to be sacrificed. Lower quality loans can easily increase volumes and on paper returns just like buying bonds with lower ratings. This is dangerous because the increased return potential is clearly measured, however, the increased risk is not nearly as visible. This is why I become uneasy whenever I hear about a high-returning bank. It is difficult to have high returns in a bank without decreasing the safety of the loan book. The Vasa had some of the most impressive offensive equipment of any ship of its time, but that was rendered useless at the bottom of Stockholm harbor. Similarly, in lending the yield is irrelevant if the loan defaults.

In most businesses, there is comparison in performance. In banking, there is comparison first in survival and then in performance. The average age of a bank is over a century, but that doesn’t change the fact that more banks in US history have failed than survived.

“To finish first, first you must finish”

- Michael Schumacher

Banks are not like other companies that should target the best performance or returns. In banking, the best offense is a good defense. Tangibly that means having cash reserves, limiting deposit risk, maintaining strong credit quality, being relentlessly efficient, and building confidence with your clients. This is all easier said than done. Many variables in banking can be difficult to predict. If not enough margin of safety is in place then banks and bankers can get into trouble quickly.

The Vasa is far from the first cautionary tale of over-ambition and huberous. Since the ancient Greeks with Icarus flying too close to the sun this has been a commonly talked about lesson. Banking is an industry where the value of limiting risk at the expense of some topline performance can be the difference between failure and survival. Banking and lending are much more binary than other industries and the stakes of the outcome are higher too.

Until Sunday,

Soren