Dark Forest: The Brutal Game of Modern Banking

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Longtime Epsilon Theory readers know that I am a huge fan of Cixin Liu's Three-Body Problem trilogy. In fact, the eponymously titled first volume - The Three-Body Problem - is the title of one of my more popular ET notes ever. But it's the second volume in the trilogy - The Dark Forest - that is my personal fave. I think that's because The Three-Body Problem refers to a famous physics puzzle while The Dark Forest refers to a famous game (in the game theory sense of the word), and I am a game-player at heart.

Here's the game. You are a hunter, well armed with your trusty rifle, and you are a good shot. You are very hungry, but there is very little game to be found in these woods where you hunt. And now the sun has gone down and you find yourself in a dark forest at night. It is pitch black. You know that you are not alone in the forest, and that in fact there are other hungry hunters out there, also well armed and also good shots, and given the lack of game to be found you suspect that another hunter might want to shoot and kill you to remove a competitor. You rummage around in your pack and you feel what you know is a powerful flashlight. You pull it out.

Do you turn on the flashlight?

It's the only way to track and find a deer or some other game to hunt, right? If you don't turn on that flashlight, you will stay hungry. And cold. You will be miserable sitting out there in the middle of that dark forest, hoping for a sunrise that - given how crazy the physics of your world has become - you're not sure will illuminate anything. But if you DO turn on your flashlight, then all the other hunters in the forest will know exactly where you are, and you do not trust their intentions. It is not lost on you that all of the hunters will have flashlights in their packs, and none of them have turned on their flashlights. But maybe they won't notice you. Maybe they're all nice hunters and won't mind you doing a little night hunting and taking down one of the few remaining game animals in the forest. Hmm, right. On second thought maybe you'll just sit out there, hungry and cold, waiting for a sunrise that may be a long time coming.

The equilibrium outcome of this game is that no one turns on their flashlight until they are so near death from hunger and exhaustion that they figure they've got nothing to lose, that in all likelihood they're going to die anyway, so why not go for it. Flashlights are used only by the dying and the desperate. Which of course makes them even easier pickings for the other hunters, who are only to happy to dispatch a competitor for the limited food supply. In a forest full of self-interested hunters, the dark forest stays dark.

Our financial world today is a dark forest, and every big investor, every hedge fund, every bank is a hunter. We all require cash money (liquidity!) to stay warm and happy, but liquidity - which used to be oh-so plentiful in a zero interest rate world - has been harder and harder to find now that Mother Nature the Fed has plunged the forest into the icy darkness of higher for longer interest rates after promising warm sunshine forever. Some of the hunters - the ones who need a LOT of liquidity to satisfy their insatiable balance sheet hunger, let's call them banks with more than $100 billion in liabilities (i.e., deposits) for argument's sake - are getting very, very hungry indeed. It's not the biggest of these banks who are very, very hungry. No, the biggest of the banks have all been blessed by Mother Nature with all the food/liquidity they could ever eat. The biggest hunters can gorge themselves all they want, no matter how dark and forbidding the forest becomes. It's the pretty-big banks, the ones who have gargantuan appetites to satisfy their liabilities but aren't quite big enough to be blessed by the Fed with an infinite food supply, who are in trouble.

Silicon Valley Bank turned on their flashlight. They went looking for liquidity by selling some assets at a loss. They went looking for equity capital to make up the difference on those losses. And as soon as they turned on their flashlight, as soon as the rest of the financial world saw that they were weak and exhausted ... wham! other hunters shot them dead. For some hunters, a shot is selling the stock short. For other hunters, a shot is publishing a credit downgrade. For other hunters, a shot is pulling out their deposits, encouraging others to do the same and creating a bank run. These hunters aren't bad for doing this. It's their nature. It's their self-interested nature. And SVB made a lot of stupid mistakes that put them in a position of liquidity hunger and exhaustion so that they felt they had no choice but to turn on the flashlight. That was their nature, too. I'm not going through this exercise to assign blame.

I'm going through this exercise to describe what IS.

The Dark Forest is a miserable place. It is an unfair place. The hungry regional banks who are out there now aren't evil or bad or stupid hunters, or at least not to the degree of SVB. They didn't make liar loans and poorly underwritten sub-prime mortgage loans and all the other terrible mistakes of the years leading up to the Great Recession. They were promised warmth and sunshine for all their days by Mother Nature, and they hunted for all the good, safe stuff that Mother Nature wanted them to hunt, like Treasuries and agency MBS and munis. But in the process, the pretty-big regional banks became fat and sloppy hunters. They developed larger and larger appetites, requiring them to hunt/purchase more and more game/assets to satisfy their hunger/liabilities. As the French would say, l'appetit vient en mangeant. The appetite grows in the eating.

But then Mother Nature took away the warmth and sunshine. Mother Nature gave them a Dark Forest instead, where the liquidity went away as interest rates went up, and all that was left is the hunger. And a lot of hunters waiting in the night with their guns.

Mother Nature can't solve the Dark Forest problem without making everything worse. We've come off a zero interest rate world for a reason - namely the world-destroyer of inflation - and if you go back to easy liquidity and lower for longer interest rates then you're just exchanging the Dark Forest for the Burning Forest. We all lose, including those big banks blessed by the Fed, including - ultimately - the Fed itself.

There's only one way to solve the Dark Forest problem. A group of the biggest hunters, large enough individually and as a collective so that no other group of hunters will challenge them, have to turn on their flashlights and ring the hungriest of the regional banks. They have to go hunting for the regional banks. They have to share their food, i.e. liquidity, with the regional banks. They have to protect the weak and exhausted regional banks from the other hunters who - not out of evil but out of their self-interested nature - would shoot them dead.

I think that's exactly what today's announcement by JP Morgan, Bank of America, Citi, Wells Fargo, Goldman Sachs, Morgan Stanley, BNY Mellon, PNC, State Street, Truist and USB did. I think that these banks' collective deposit of $30 billion in uninsured accounts with First Republic is the first step in solving the Dark Forest problem of the American banking system.

I call it a first step because there are an awful lot of other hunters out there, and there are an awful lot of hungry, hungry regional banks. The hungry regional banks are going to have to get thinner, meaning they're going to have to shrink their balance sheets, meaning that they're not going to have a stock price anywhere near what it used to be. Mother Nature is going to have to be tougher on the pretty-big regional banks who got so fat and sloppy. No more unfettered appetites even when it's all warmth and sunshine. We still have a two-tiered system of banks, where the big and pretty-big hunters get far more protection and the small hunters pay far too much for what little protection they get. The big banks who are shining their flashlights in defense of First Republic can't stop here. And they can't defect from each other.

It's a tall order.

But tonight for the first time in a long time I see a way out of the Dark Forest for all of us.