Bay Area Behavioral Economist Says Psychology Has a Lot to Do With Silicon Valley Bank Collapse

With the Biden administration taking emergency steps to address the failure of Silicon Valley Bank (SVB) — the second largest bank collapse in U.S. history — Rep. Ro Khanna, who represents parts of Silicon Valley, said he’s glad the situation got resolved.

“The venture capital money that was in the bank would have been protected regardless, but the small-businesses’ accounts were at risk and it would have affected hundreds of thousands of Americans, not just in our area but around the country, from getting paid,” he told KQED Monday morning.

Khanna said that, after the news of the collapse Friday, he was in touch with hundreds of constituents affected by the bank’s downfall, which was driven by an apparent panic-induced bank run.

Hersh Shefrin, behavioral economist at Santa Clara University, says the psychology underpinning this financial turning point can’t be ignored.

“The most important part of the story is panic,” he said.

Despite the federal government’s measures on Monday that were meant to alleviate customers’ fears, many bank stocks, including those of First Republic, a regional bank based in San Francisco, tanked. The question is whether these ripple effects will last — especially when it comes to the trust between tech start-ups, which drive the Bay Area economy, and their financial institutions.

KQED’s Brian Watt discussed with Shefrin the role psychology played in the Silicon Valley Bank collapse.

This interview has been edited for length and clarity.

On how Shefrin understands the latest bank collapse

We know that bank runs are simply part and parcel of the banking industry. We had thought that we had it pretty much under control: the establishment of the FDIC, Federal Deposit Insurance Corporation, that basically insures deposits up to $250,000.

What makes Silicon Valley Bank different from some of the other regional banks that are in trouble is that most of their deposits are too large to fall under the $250,000 limit. They’re just outsized. And that’s because the depositors are corporations rather than individuals who need large corporate checking balances. So if you’re a financial institution in that situation, you need to be more prudent than the other large commercial banks that cater to individuals. I think what you saw at Silicon Valley Bank was weakness in terms of risk management for psychological reasons that had to do with overconfidence on the part of the management leaders’ leadership and Silicon Valley Bank.

It was a breakdown in confidence and trust that led to a mass reaction on the part of depositors as they pulled out. And it’s that psychological aspect. Primitive fight or flight is really what you had take over last week on the part of depositors. And so it was that combination psychology on both sides.

On how a financial institution can get overconfident, even after what the tech industry has experienced

It’s related to personality and it’s also related to the culture of the environment. So I would say Silicon Valley Bank executives were not atypical of an overconfident culture within Silicon Valley itself. And I want to be clear to say that this is a double-edged sword. You need to have a little overconfidence and a little excessive optimism to do great things. And so having that combination of mild excess has fueled innovation and creativity within the Valley. It’s when you get too much of a good thing that you wind up in trouble.

I make a point of telling my students, don’t confuse overconfidence with stupidity. So executives who are successful are oftentimes very smart. But that doesn’t stop them from being overconfident. Overconfidence doesn’t mean they’re not smart. It just means they’re not as smart as they think they are. It’s like a Greek tragedy, where you have heroes who do great things but have fatal flaws. And that’s what I think we had happen at Silicon Valley Bank.

On the role of state regulators in oversight

Silicon Valley Bank is a state-chartered bank, and so state regulators have first-line responsibility in regulating these institutions. What we know historically is that the strength of regulation ebbs and flows depending on the political environment. So sometimes, especially after crises, there’s a demand for stronger regulation. That’s what we’re hearing now, and over time, when the threats and the risks aren’t as salient, then you will have efforts made to sort of dial back on regulation, because it is true regulation is costly. It’s a balancing act. The question is where is the right balance point.

On how people should think about SVB’s failure and financial unrest with a potential recession this year

I think that the [Federal Reserve] is going to feel pressure to pull back on their inflation fight because they might make things a whole lot worse. JPMorgan and other financial institutions have been telling us they think that a recession is going to be in the cards. We get recessions as a natural part of economic activity. It shouldn’t be a surprise if it happens. The question is whether we’ll be able to have a fairly mild recession. I think that’s what we are sort of looking for and hoping for rather than no recession. And so can policymakers take very careful steps, do the best job they can, in order to not throw gasoline on the fire?