Understanding the stability of your banks and financial counterparties
A lot of founders and finance teams have questioned if it is safe for them to bank with ABC, or how they can best evaluate the stability of their financial counterparties.
Banks are generally extremely safe and there are stringent regulations in place to protect depositors. We all know that what happened some weeks ago is an outlier event. With that being said, banks are not devoid of risk mismanagement (e.g. Asset-Liability Management) or of irrational behavior (e.g. bad communication) as we saw with SVB.
The Federal Reserve and other regulatory agents take active action to protect deposit accounts with the standard $250k FDIC insurance limit.
In general, some of the underlying factors that can affect the stability of a bank are:
- Their tangible net assets
- The nature of their assets – is their valuation volatile?
- The nature of their liabilities – how much of its uninsured vs. insured?
- The amount of credit risk or interest rate risk the bank has
- And… The leverage ratio of the bank
I understand most of us do not have luxury to get into banks’ valuation, credit scoring and solvency assessment; we just expect our financial partners to work fine (and hopefully avoid bank runs in the future). However, questioning your financial counterparty risk and making a conscious decision as to where to allocate your company’s funds is relevant for running your business.
Why to diversify your deposit exposures
It is likely that as a reaction to the events of the past weeks, you diversified your bank deposits across multiple institutions. Perhaps you considered the impact of reducing the concentration of cash deposits in your corporate treasury and investing in various financial instruments.
If you haven’t already, I encourage you to consider spreading your cash deposits between three to four different banking institutions. This will help you avoid any idiosyncratic risks and ensure you have the correct guardrails in place.
Looking at data from the Federal Reserve we can see this is becoming the course of action for many, with money flowing out of smaller banks and into larger ones, which are considered safer and abide by tighter regulations.
Over the last three weeks, deposits to the 25 largest banks in the US (JP Morgan, Bank of America, Citigroup, Morgan Stanley, Goldman Sachs, and others) grew by $120 billion, while small banks lost $108 billion in deposits in the week following SVB’s collapse.
It is also worth pointing out that as of 2023, the following eights banks fall under the jurisdiction of the Large Institution Supervision Coordinating Committee, and are therefore deemed too big to fail. Those banks are: JPMorgan Chase, Citigroup, Bank of America, Wells Fargo, BNY Mellon, Goldman Sachs, Morgan Stanley, and State Street.
What this essentially means is that these eight institutions need to comply with more stringent capital and liquidity requirements, and more frequent reporting to regulators about their asset and liabilities positions. In other words, their regulatory hurdles are higher and thus they are likely safer.
However, as you might expect, the downside of working with larger financial institutions that are not specialized in serving tech companies is that you will most likely lose agility. Getting things done in larger banks usually takes longer and internal processes such as credit approvals are not startup-friendly. Unless you have a great contact or internal champion, get ready to push.
Besides storing your corporate treasury in cash deposits, I encourage you to think about the merits of allocating a part of it to safe financial instruments.
Financial instruments: not all are created equal
I often get asked by many founders “what should I do with the money that is sitting idle in our bank account? I feel we could put it to work.”
Being a former Investment Banker, I can write extensively on the different capital allocation strategies used by world-class corporates to optimize their treasury balances.
However, as a startup founder, I like to keep things simple. I think as founders our main concern should be running and scaling our core business. In other words, 100% of our focus needs to be directed to that objective.
In addition, if you are VC-backed, our investors (General Partners - GPs) and our investors’ investors (Limited Partners - LPs) trusted us with their funds and expect we build or business and deliver on our thesis, and we also have fiduciary responsibilities to abide by. GPs and LPs are financial professionals that can diversify their cash positions into complex financial instruments if they want to; when VCs buy your equity, they expect you to concentrate on building your business.
Having said that, we can take a few smart and simple actions with the goal of protecting our capital and still obtaining some return to mitigate inflation.
Let’s start with two simple questions to help anchor your decisions:
- How much forecasted runway do you have?
- How much liquidity does your business need? Frame liquidity in short-term (days or weeks), medium-term (months), and long-term (years)
As a rule of thumb, if you have 12 - 24 months of operating runway or more, you may need to think about creating a simple but effective cash management policy. For instance, the following time-horizons can guide your capital allocation:
- Short-term → Capital that you need to access on a daily, or week-by-week basis to meet operating needs. This can be allocated to cash deposits (spread between 3-4 institutions).
- Medium-term → Capital that you plan to not use for a few months, can be allocated to T-Bills, overnight loans (aka reverse repos) or money market funds with principal protection.
- Long-term → If you have enough operating runway and have investments that you will not need to access for 12+ months, you can allocate these to T-Bills with a longer duration.
Understanding how much capital you need for each of these three-time horizons will help you decide how to invest and allocate your corporate treasury.
A lot has been writing lately about leveraging other financial instruments such as corporate bonds to manage your treasury. Some founders have asked me on whether it is fine to invest in equities, ETFs, derivatives, or even crypto. Frankly, I don’t think it is. I know this may be a simplification, but if you are a startup of any size (as opposed to a large corporate), stay away from assets that put your principal at risk. The risks are not worth it. Keep it simple, focus on your business.
Writing a simple treasury policy to make things clear
Prior to the collapse of SVB, most founders or finance teams had no real urgency in thinking about their treasury policy, and it is not surprising. The majority of finance teams were concerned with extending runway, not managing unallocated cash.
It is important to acknowledge things have changed. However, I want to stress an important point: if your company is pre-Series-A, drafting a treasury policy may not be the most impactful project.
Nevertheless, if you believe this is important today, then following the guidelines shared below will definitely improve your operational best practices.
Writing your treasury policy is an iterative process, keeping it simple is key. As your business hopefully continues to grow and mature you will find opportunities for iterating and refining it.
I encourage you to focus on the following goals:
- Focus on preserving liquidity by matching assets with liabilities: this means answering how much cash your business will need in 3 months, 6 months, or 12 months. You can refer back to the time-horizons I shared earlier
- Focus on always ensuring principal protection: this means reducing your mark-to-market risk and being confident you won’t lose any money
To be clear, the first draft of your treasury policy can be three short paragraphs in which you set up your capital allocation goals and how you will execute them. Then, simply present this at your next Board of Directors.
An example of how you can present this is:
- Primary Objectives → preservation of principal, maintenance of liquidity to meet cash flow requirements, generation of modest yield on excess cash balances
- Roles and responsibilities → who has the ability to manage investments, who has to review the investments, how often this review will happen, and who is responsible for updating key stakeholders (e.g. Board of Directors)
- Investment guidelines → what are the approved and prohibited financial instruments, and if applicable, what is their required duration, liquidity, and credit quality
What investment guidelines should you consider?
When approaching tactical asset allocation, the focus needs to be on maintaining the necessary liquidity levels to satisfy the operational needs of your business. In my opinion, we should not ever compromise your principal (e.g. having to sell at a loss because you have an unforeseen liquidity need).
While I will not provide any investment advice, in practice it can look as:
- Pre-Series A: diversify your capital allocation between three to four operating accounts and have some funds in saving accounts, which typically provide some interest
- Post-Series A: at this stage, you probably have more capital reserves and are generating meaningful revenues. You should consider money market funds or T-bills with different durations (aka T-Bill ladders)
Allow me to repeat a point. Startups should not consider corporate bonds or equity investments. They have a significant mark-to-market risk, no maturity date, and compromise the security of your principal. It is simply not worth it to risk the capital that you have work hard to either raise or generate by chasing a higher yield return.
Conclusion
Wrapping up, if you want to take only two things away from this, please:
- Preserve your capital: this is your most important priority and it means never putting your principal at risk. You can safely obtain yields to mitigate inflation with T-Bills
- Maintain liquidity and manage counterparty risks: use 3 bank partners at least, potentially with a combination “small/agile/less cash deposited” and “bigger/safer/more cash deposited”
Remember, finance teams or founders do not get fired for not generating an additional percentage yield on excess cash. Our purpose is to deliver on our companies’ mission and ensuring that we can navigate a liquidity crisis, not chasing yield. Make sure you follow best practices, and remember that the best thing we can do is running and scaling the business.
