Spreading Silicon Valley’s Economic Ecosystem

by Christopher Meyer on 11/29/2010

siliconvalleyI have yet to meet anyone that to one degree or another isn’t angry at the large banks’ “head’s I win, tails you lose” behavior.  With that acknowledged, this piece reaches beyond the personal anger to explore the damage done to our global competitiveness.  Part of the  remedy is to actively spread the economic ecosystem that drives Silicon Valley’s success across our nation.

Our Economic Engine

Banks are the fuel system for our economic engine.  They aggregate excess money from individuals and corporations and then lend it to those who are building or expanding businesses, financing college, buying homes, cars, etc.  Banks add leverage by lending more than they have in capital reserves.   They can do this because excess capital is just that; it is not needed for daily life or commercial operating expenses.

This fuels growth that in turn generates new excess capital which goes back into the banks to be lent to others.  Economists note phenomena such as the multiplier effect and the increasing velocity of money that accelerate these flows to society’s advantage.

The last two words are key, society’s advantage.  The problem is that large banks now earn most of their profits from trading rather than lending.  By doing so, they are effectively siphoning fuel from the economy for their own gain.  What happened and why?

Unlike Teams, There are Three I’s in Financial Services: Individual Interests & Income

The books and articles documenting the financial industry’s greed and outright mismanagement continue unabated.  Most recently, there are two excellent pieces, both by John Cassidy, in the New Yorker and the New York Review of Books.  Cassidy points out two important facts:

  • Since the end of WWII to 1980, people of equal skill and education working in finance earned the same as those in other industries.  Around 2006, finance pay skyrocketed 60% higher than other industries.
  • Last year, when many couldn’t find jobs, the average pay at Goldman Sachs, JP Morgan Chase and Morgan Stanley rose 27% to $340,000

This spring, approximately 1/3 of Harvard graduating MBA’s are heading into finance.  Understandable considering the salaries, but is this how we will fuel our global competitiveness in the future?  Do we want our best young minds applying themselves to extracting more value for their firms and themselves from the existing pie rather than creating compelling new products and services that enlarge the pie for all?  How can will we fare Competing Against the New Autocratic Economies such as China as they invest billions to our millions?

Stockholders, Credit Scoring and Securitization

Michael Lewis argues in The Big Short that the shift from lending to trading was caused when investment banking partnerships became publicly traded companies.  His point is that senior partners who had their own capital at stake were far more circumspect about taking risks.  When they became public companies, they could pass on the risk to shareholders (and taxpayers).  This led to the thoughtless risk taking of the subprime crisis.

Others cite the disproportionate growth of large banks combined with the rise of credit scoring.  As illustrated below, during the subprime crisis the largest banks grew enormously.

Pre Crisis Share of Deposits (%) Post Crisis Share of Deposits (%) Change %
Wells Fargo 4.4 11 150
JPMorgan Chase 7.0 10 43
Bank of America 9.6 12.9 34

Large banks control 57% of the assets but only 18% of their total commercial business goes to small businesses whereas small banks control 22% of assets and devote 54% to borrowing.  Additionally, due to their distance and lack of community knowledge, large banks rely more on credit scores.  Contrast this with how John Kimball of Park Midway Bank in Saint Paul, describes their lending philosophy.  “We don’t use credit scoring…We still rely on a thorough understanding of the financial information the borrower brings us and understand what the numbers mean in the context of that business.”

A third explanation is that securitization has further distanced banks from risk.  Securitization removed most of the incentive for banks large and small to manage home loan risk since they could sell any qualifying loan to Fannie Mae.  Fannie Mae then distanced themselves from risk by bundling the mortgages into mortgage backed securities which it sold to the public.

The common theme between all three is that they reduce the relationship requirements between banks and their customers.  Increasing shareholder value became more important than fueling our economic engine.  Credit scoring relieved bankers of the need to understand an entrepreneurs’ experience or the potential of the next new idea.  Securitization distributed risk and increased liquidity but to what end?  Plus as we saw in the sub-prime crisis, liquidity can also disappear.

What strikes me is the irony.  In a business world where every other industry is striving to get closer to customers, banks have stepped further away.

Silicon Valley: A Financial Ecosystem Built on Relationships

Many have studied and described Silicon Valley as an economic miracle.  After living and working here for thirty years, three critical success factors stand out:

1.  The financial ecosystem of angel investors, venture capitalists, banks and entrepreneurs is aligned to creating new wealth through new ideas inspired by technology and driven by entrepreneurship.

2.  The network of relationships between all parties is the glue that makes it all work.

3.  Failure, an essential part of the process, controls waste as it informs future choices.

One of the most interesting roles I have the privilege to enjoy is sitting on the Band of Angels deal screening committee.  The Band is the Valley’s oldest community of individual angel investors.  With approximately 120 members, the Band has seeded over 200 companies in our history with 40+ profitable M&A exits and 9 Nasdaq IPOs.

We review six potential deals from over thirty submitted every month.  The questions we ask follow a pattern not unlike a bank or venture capitalist.  A top item is always “who’s the team?”

The magic of the Band is that between the 120 of us, we can usually find a member who either knows the entrepreneur or can lead us to someone who does.  With an email and a few calls, we can learn more about them and their team as well as get an informed assessment of their proposed venture.

Startups come to the Band because this same relationship network brings valuable resources to them.  There’s a high likelihood that one of our members has hands-on experience or knows someone that served as an executive, consultant, board member or investor in their specific industry.

This pattern repeats itself within the venture capital community as well as local banks such as Silicon Valley Bank.  The network of relationships swells as successful entrepreneurs move on to become serial entrepreneurs, new investors or venture capitalists.  Those who fail, normally pop up again with another startup, seasoned by their prior experience.

What makes the network of relationships critical is that the knowledge of what it takes to create new wealth and jobs cannot be reduced to a score or formula.  The tacit knowledge or wine making required is usually far greater than the explicit facts available or algorithms to process them.  Therefore, when banks step back from customers, they are also stepping away from wealth creation.

Expand the Valley’s Financial Ecosystem

Let’s face it:  trading is a relationship void.  At best it takes a person sitting in front of a dumb terminal.  The fact of the matter is that today, over 75% of stock trades are driven by automated programs.  Many have been written by physicists who left science to make more money on Wall Street.  While this occurs, faster growing economies are throwing all they can at building new industries and technologies.

If we continue on this path, it’s likely that we will only figure out how to cut the same pie into even more pieces; with most of us getting a little less.

I’m not an expert in tax policy or incentives.  Still it doesn’t take a rocket scientist to figure out that if we raised taxes on short term trading profits it wouldn’t be hard to significantly reduce the advantage trading has over commercial lending.  Similarly, tax incentives to foster local investment by large banks would unleash significant new sources of capital.  The hardest part will be building the local networks but with fuel flowing, opportunity will attract attention.

What the banks have done is outrageous.  If we keep letting them do it, we’re complicit.

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