Can Community Banks Survive the Next SVB? | ModernFi CEO Paolo Bertolotti and Former Comptroller Gene Ludwig

0:00I remember reading The Cold Star Problem when we were getting this going together and thinking, you know, trying to solve the Cold Star problem in a network effects business with financial institutions. has to be the worst idea all the time. But now that we're on the other side, it's worth it. Once you get the flywheel going, it's hard to get it going. Zero to the first 20, that's the thing for it. Two and a half years ago, Silicon Valley Bank collapsed in 48 hours. Not because of bad loans or fraud, because customers could move money faster than regulators could react. The internet had turned a manageable problem into a systemic crisis.

0:34Here's what almost no one noticed. SVB was already a member of the deposit networks that could have prevented the run. They just weren't using them. 94 % of their deposits sat uninsured while the solution gathered dust. That failure revealed something bigger. America has nearly 10 ,000 banks and credit unions, an order of magnitude more than any other country. This fragmented system is either our greatest economic advantage or a ticking time bomb, depending on who you ask. Community banks fund the small businesses and startups that make America different. But without the right infrastructure, they can't compete.

1:08In today's discussion, A16Z general partner David Haber sits down with Gene Ludwig, former U.S. Comptroller of the Currency, and Paolo Bertolotti, founder and CEO of ModernFi, a company that could become one of the most systematically important financial institution utilities in the United States. Not by replacing banks, but by getting hundreds of them to work together. We're talking about the cold start problem in financial services, why the biggest opportunity in fintech might be the least sexy, and what happens when you turn former competitors into co-owners. Gene Paolo, thank you so much for joining me.

1:42It's great to be with you. Thank you for having us. Gene, it's two and a half years since the SVB crisis. You were a former bank regulator as the former head of the OCC. And I thought you'd have sort of a unique vantage point on that crisis, but maybe banking regulation, obviously, and its impact on the economy. Maybe just walk us through kind of what happened two and a half years ago with SVB, because I think it kind of can serve as an interesting backdrop up for some of the other conversations that we'll have. Well, the SVB crisis, in one sense, was inevitable. On the other hand, it's peculiar, and it's a real example of what we call tail risk.

2:18It was inevitable because people make mistakes, and the dynamism of the economy means that somebody's going to be out of match. They had an asset liability mismatch that was considerable, and if anybody had really thought about that, they'd say, look, I don't want to be riding along with the bank that is that out of balance. And if the Fed was actually doing its job, it would have noticed immediately and said, look, I don't care what you do, we're getting this back and back. But they didn't. On the other hand, it is a tail risk and unique event because it's the first time that I know of in American banking where the technology itself, that is the internet, and the ability to transfer funds more rapidly conspired together to put that kind of instantaneous pressure on a bank.

3:07And the regulators weren't ready for it. The whole problem would have been solved, irrespective of the asset liability mismatch, if the Fed had simply opened the discount window wide enough, early enough to stop the run. They actually did do that on Sunday. But unfortunately, the bank was gone early. Yeah, early. And I guess, yeah, two and a half years later, what's changed from your perspective? Well, really, it was Biden who stopped the run. Against all advice, he got on television, looked into the camera and said, oh, your deposits are safe. Your deposits are completely safe. They're insured.

3:47You don't have to worry about anything. Now, he knew at the time that wasn't exactly true. There was truth in it because he, as president, with getting the group together, could have done what they ultimately did, which is basically put everybody under a sort of either a stop order or a fund order or cause the Fed to open the window wide enough wouldn't have happened. But it was a bold move. People listened to him and they said, well, the president said our deposit insured it had cooled it right down. However, the system remains vulnerable over the long term because deposit sizes get bigger, the economy becomes more dynamic, the internet problem hasn't been solved.

4:28And as it turns out, there is one real solution to this problem that exists today. It's modern thought. Clearly. And worth the man. And we're going to get into that. I think America, and you guys are deeper experts on this than I am, has such an interesting banking ecosystem, right? It seems to me much more federated. There's a much longer tale of institutions in our country than in many other markets. You go to Brazil and it's an oligopoly of, I don't know, four or five large banks. You go to the UK or Canada, similar story. I guess either of you, like what is sort of the history of that? And then maybe more importantly, like what role from your vantage points do, you know, community, regional banks, even credit unions play in kind of the vibrancy in America's economy?

5:10So I think the history comes from, I mean, the history is pre-internet, it's pre-tech, right? I think before we had the connectivity, specific communities, specific industries needed access to credit. They needed access to banking products, which allowed for this wide diversity of institutions. And some of that has remained. Even as we have these digital products, these digital services, you still have these institutions that very much specialize in their pockets of the country. And we at Modernify are big believers that those institutions are actually a huge part of American differentiation, a big part of American excellence, a big part of the American engine, because these are where folks get credit to start small businesses, get their mortgages, car loans, whatever it may be.

5:58And that sort of differentiation compared to other countries, I mean, you mentioned it, but we have an order of magnitude more institutions than the next country. It is a very special thing, and I think SVB that you mentioned is a perfect example of that as well, where SVB was very good at and very focused on supporting a very vibrant and thriving tech ecosystem. And two and a half years later, I think, unfortunately, one of the things that hasn't changed is there hasn't been another institution to fill that gap. And I do think that's something that the ecosystem, the tech ecosystem specifically, has suffered from.

6:31That's an excellent answer, and I totally agree with it. Let me take you down memory lane. So, our founding fathers were not just patriots, not just warriors. They were actually businessmen, right? They were the businessmen of the day. They owned land. They owned this. Benjamin Franklin had a printing press, et cetera. And the problem was, in the United States, there were no banks. So, the banks they had to really bank with were the British banks. And they were the big oligopolistic British banks that constantly took advantage of them. So, the British banks and the central bank were absolutely anathema to our founding fathers.

7:15And they, beyond setting up a federal system to govern us, they wanted very much no central bank and a fractured banking system that could deal honestly and fairly with business people like themselves. who weren't, again, the biggest business people the banks in England were dealing with, but were important business folks. So we ended up with this multibank system. And as Paolo said, and I agree with him entirely, it's served us very, very well because we have an enormous economy that's incredibly diverse, and we are very innovative. I think it is not an accident that Andreessen Horowitz and Canopy and all kinds of venture companies exist in the United States.

7:59Now, as a practical matter, I'll give you this example why we don't want to let the country sink into a one-size-fits-all, three banks, four banks, five banks system. So I'm a businessman, say, in Indianapolis or Baton Rouge. And I have a problem with my business and I want to basically talk to the bank CEO to get advice and get a loan. I pick up the phone. I'm going to call Jamie Dimon. Now, do you think that Jamie Dimon, who is one of the most talented people that ever lived, has the time to call every little small business all over the United States? Of course he doesn't. And so he has very talented people around that help and do this, but you're not going to get the CEO.

8:43Totally. But if you're dealing with your local community and regional bank, and that fellow picks up the telephone and says, I want, that's who he gets on the phone. And that matters, both in terms of flexibility of the institution, the advice, et cetera. So, America's great. It has great institutions like JPM that are huge and fulfill an important role. And it has small and medium-sized institutions that fit our own, and it makes our economy unusually dynamic. And we want to do everything possible to keep that. Gene also sort of tied it back to VC. And I also love that analogy because something that Andreessen does, you have this sort of little tech manifesto, right?

9:22One of the things that is so special about Andreessen, but VC in general, is it allows little tech to get started and to dream and to execute and become big tech, right? And that's a key part, obviously, of so much of American economic success. But banks play that role on the credit side. It allows small businesses to get started and grow and thrive, and whether they stay small businesses or eventually become big businesses. So it's that access to credit. I mean, credit in a lot of ways is the lifeblood of any economy. And it's very easy when these institutions go away. The Fed, you have what the Fed calls banking deserts.

10:01It's just whole, not just communities, not just geographic areas, but actually verticals as well, industries, Whether it's agriculture or merchants or wine or VC or whatever you have, that becomes a little bit underbanked and that has larger downstream effects. So as we see consolidation in this space, we don't know what the end number may be. It's not going to be four. I think having access to a wider range of institutions that provide a wider range of services is going to be a critical piece of the picture. And that's why I wanted to start with like the SVB crisis because, you know, I mean, I remember we were actually as a GP group all in Las Vegas at an offsite when that whole thing was going down.

10:38I remember, you know, the CEO of SVB being on a big screen saying, you know, don't panic. You know, like it was just a wild weekend and many of our portfolio companies, you know, freaking out, you know, that they couldn't make payroll, you know, that Monday. But I think, you know, at the end of the day, I wasn't that concerned that their deposits would be gone. And I think the bigger kind of ripple effect concern was that, you know, people would lose faith in community regional banks, right? That the market would sort of consolidate into the GSIBs, you know, and that was the reaction that many companies like our portfolio companies were having, which was, you know, taking their deposits out of SUV and then putting them into, you know, one of the largest banks in the country.

11:19And so, yeah, the fear was that it would sort of hurt some of that dynamism and the kind of local context that I think a lot of these institutions, you know, play such an important role, you know, providing. Yeah, and to that point, I mean, you know, we're here talking about the importance of community and regional banks and something that I remember well from that weekend was, you know, one of the arguments, I'm sure there are arguments for and against the regulators stepping in that weekend. But one of the arguments for was, look, this is this institution or this concept of an institution so important that if we don't support this institution, you know, what does American startup ecosystem look like?

11:59What does the American tech ecosystem look like? So I think it is a reflection and a good example of how important these institutions actually are to the economy as a whole, but specific areas of the economy. Maybe we just take a step back. What is a deposit network? Well, a deposit network is, let me just give the concept, is each institution has a certain amount of deposit authority. Yep. and often a certain amount of that is not used. And a deposit network, in essence, allows one institution that has capacity that's unused to allow its fellow institution of the same size to use that capacity.

12:48And so it's basically a pooling of the capacity. Now, the way it has to be done is different than just simply trading insurance chips. But the concept is really taking a certain amount of unused capacity and sharing it. And I mean, maybe, Pal, just, you know, for those that aren't familiar, you know, with ModernFi, can you kind of describe what the business does and, you know, how you got into this? You know, why did you choose to start this company in particular? So, ModernFi helps financial institutions grow. That's the mission. and we're talking about the importance of these institutions regardless of size, regardless of location, and our mandate is to provide software, infrastructure, services to help them grow, compete, and thrive.

13:32And you can do that through a lot of different angles. Our core product is a deposit network. And a deposit network, to Gene's point, is you can almost think of it as a market for deposits. Institutions are really sweeping, sourcing, or reciprocating deposits or buying, selling, exchanging deposits. And folks use that for different reasons. Gene sort of touched on the insurance piece. One of the key pieces is, we'll get into it through the conversation, is what's called a reciprocal deposit. Gene invented the market, invented the idea in 2003, so a few years ago now. But the whole idea is through a reciprocal deposit, a community bank, a regional institution, can provide access to more deposit insurance to their customers.

14:15So you're a community bank. You want to bank a business. They have$10 million of deposits. normally that's insured up to 250 ,000. With a deposit network through these exchange mechanisms by placing deposits at other institutions, you can actually provide 10 million or access to 10 million, 20 million, 30 million returns. And that is so critical because for that institution is the difference between being able to serve that customer and not being able to serve that customer. So, you know, we talk a lot in VC about is this a nice-to-have or a must-have? It's a must-have for those institutions. Without it, they just don't serve those segments.

14:51And to Gene's point about that exchange mechanism, you can also use these in interesting ways in the sense that, you know, some folks are exchanging deposits one for one. Some folks, you know, a lot of sponsor banks want to remain a certain size due to regulatory requirements, things like the Durbin Amendment, which we can get into. So they have an incentive to just sweep deposits. You have folks on the other side willing to accept deposits for liquidity and lending purposes. And that's one of the beautiful things about deposit networks and just markets in general is that you have that efficiency, right?

15:26You're making connections. You're clearing the market. So that's, you know, the core of what we do. We have some analytics, some data services around that as well as we expand and grow. But no, this has been a field and a topic that the team and I and me personally have been involved with and fascinated by for a long time now. I was in finance previously. I was at a hedge fund. Really enjoyed it. Fixed income, doing funding markets. So thinking a little bit about these problems. And the firm was well known for robust portfolio optimization tools. So really enjoyed those market clearing problems and went off to grad school.

16:01I was fortunate to do my doctorate in ML and did a few different things, but was fascinated by a few things, but was fascinated by bank balance sheet optimization, talking about SVB. These institutions, the banking business model, as Gene and you know so well, is a fascinating business model because you are using short-duration deposits to make long-term loans. You're using money in a checking or savings account to make a 30-year mortgage. So how you do that matching, how you do that asset liability matching, the modeling, the optimization, how you source that funding is a fascinating problem.

16:39And unfortunately, we see from the SVB situation, the First Republic situation, you can get it wrong and you can get it wrong in a big way. And when you do get it wrong, it's critical or it's vital. and so I think you know this being both of you know this being founders you kind of start to see these ideas and they become like onions where it's like you peel back a layer and it's interesting and you peel back another layer and it's even more interesting and that was definitely the story of Modern Fire where okay it's a huge market there's you know 20 trillion in deposits in the US there's nearly 10 ,000 institutions roughly 4.5 trillion of that is wholesale funding where banks are just buying and selling these deposits turns out there's no real great deposit optimization.

17:20Turns out there's no real great deposit infrastructure. There are firms like, you know, the ones that Gina founded that have really been paved the way and have been vanguards in the space. But, you know, we're 25 years past the founding of a lot of those firms. So the opportunity set to build something so meaningful, so critical, and so impactful to these institutions was just too good of an opportunity to pass up. And that's how we ended up starting the firm and partnering. altogether. I remember when we first met, I think you were the only person I ever met that did a PhD machine learning at MIT on bank balance sheet optimization.

17:56I'm like, you're an N of 1, Paolo. It's a little niche. It's an important expertise. This is critical for America. It is a wonderful time for modern phi to start this because the mechanism that is being used, the reciprocal deposit mechanism, is now widely understood and accepted by the regulators, and indeed accepted broadly as a real contribution to American finance. And so now that it's understood both by the banking system that uses it and more broadly, it means that the ability for ModernFi to grow and prosper is dramatically different than it was when I started. creating it. Oh, nobody was against it.

18:48There was no regulatory negatives. But it seemed to people peculiar. One that smaller institutions had on occasion had larger institutions, neighboring institutions, say, well, you can't really take your business, Mr. Businessman, down to that bank because I'm sure they're fine people. But you have a fiduciary obligation and I'm the big one that's safe. Maybe for our audience who aren't as familiar with your career. You've had such a fascinating, you know, career in different capacities, both as an entrepreneur, as a regulator. I want to come back to the Modern FI, you know, business in particular and the unique approach you've taken.

19:26But maybe for folks, can you kind of share a bit more of, you know, your trajectory and, you know, even take us back also to like 2002, 2003, and, you know, first starting in Tripoli? I was headed, I thought, to the Justice Department to be a Justice Department official when President Clinton got elected. But as it turns out, there was a huge problem, and that was that the banks in the United States had been coming off difficulties of the late 80s and early 90s, had almost stopped lending. And in some parts of the United States, in California and New England, they had actually stopped lending.

20:06And Clinton, who was devoted to getting the economy rolling again, I remember James Carville, who I just saw the other day, said, you know, it's the economy, stupid, if you're going to be elected. So Benson and Clinton cooked up the idea that they had to do that, and the person to do it was, of all people, me. Now, I do not know to this day why I decided to do that. And they also, Benson was a very shrewd fellow. He decided the way to do that was to put me at the comptroller's office. Because one, we control the majority of the banking assets in the United States at the OCC. And two, that if they didn't confirm anybody else to any other position, which they didn't, that I, in essence, would have the authority to control the financial system and turn this around, which we were able to do.

20:58And that got me deeply into banking and regulation. and banking regulation of all sizes. And, you know, it was five wonderful years, that's the term of the office, to really try to make a difference and turn things around. But I was on the FDIC board, in essence, the only confirmed, well, not in essence, the only confirmed member of that board for a period of three and a half years who were really running the FDIC. And in terms of these kinds of issues, of deposit insurance, they were day-to-day, you know, sort of real to me. Now, oddly enough, as I know I've bored you guys with before, the idea of creating a reciprocal network came to me because of two factors.

21:49One was the little bank, and it was actually a little bank in a disadvantaged community in Kansas City that couldn't get a decent deposit flow because the big banks kept saying, you know, they're wonderful people, but, you know, you have a fiduciary responsibility. And if they didn't get 100 % deposit insurance, they weren't going to get decent deposits, even though they were a wonderfully run bank. But the second reason was how it affects the individual. So I had an aunt, Aunt Betty, Betty Chadwick in Philadelphia, who both my aunt and my father were both immigrants, sons and daughters, and themselves almost immigrants.

22:32And so they were very conservative, and they saved every penny, and they put it in the bank. But the problem was, as she got older, she realized, oh, my God, the bank only has 35 ,000 in those days, 35 ,000 of deposit insurance. And she had a couple hundred thousand dollars, that's all. She was able to save as a secretary to a brokerage house. But she still wanted every penny insured. So she used to get on the bus and go from bank to bank to get a CD that was insured, including interest up to the limits. When she got older, to this day, I believe she forgot where she put it. And I don't think the family's ever figured out where the money is.

23:17But it was an essential safety net for her. And it dawned on me that this is crazy. You can solve both problems one way. If a bank was in essence collecting for Aunt Betty all the deposits and basically parceling it out, her deposits to the other banks in terms of CDs. but it was actually creating the mechanism, it was solving Aunt Betty's problem. And if it did that, but there were other Aunt Bettys around the country with similar problems, that reciprocating mechanism would allow for deposit insurance, as I said earlier, using the unused capacity to be broadly shared and satisfied the need of the consumer for safety, Not just Aunt Betty's, but small businesses.

24:16And on the other hand, creating a larger funding, safety funding source or deposit gathering source for smaller banking organizations. And we created early models and algorithms to make it happen. I'll tell you, things were so early then that when we started to do our match, computer technology had not advanced to the degree that it could actually accommodate the complexity of a serious amount of money flowing. And we had to invent the use of resident memory as opposed to normal memory to basically be able to do the match instantaneously. So it grew from there, and it was a lot of fun getting the network together and running around the country to banks hither and yon taught me a lot too.

25:09This whole thing taught me a lot because you learned about the banks and their communities and their needs. And so I got myself the first 450 banks, bank by bank, and then I got a team together to sales, and I was pretty well exhausted. He's stronger. Younger is stronger. He's already exceeded 450. By your powers combined, you know. That's awesome. And, you know, obviously it was an incredibly successful business. You know, my understanding is, you know, I don't know, 75 % EBITDA margin, you know, style company and ultimately sold the business to perfect equity very successfully. Yeah, maybe we come back, you know, to modern-fi.

25:54I think, you know, describe kind of your business at a high level. You kind of have two businesses, you know, today, you know, both powering credit unions, which is kind of a new market. And then, you know, also serving, you know, the bank ecosystem. Yeah, maybe describe the company today. And also, I think people would be very interested in like some of the technical challenges of actually building this. Yeah, absolutely. Yeah, and I think Gene's far too humble as well with the story because Reciprocal on the bank side has grown now to roughly$450 billion in Reciprocal. And so that's a half trillion dollar market using these networks.

26:31But I think there's some interesting takeaways from that as well in the sense that it's a huge market, yet for the average person, for the average business, no one really has heard of these products. No one really utilizes these products. And why is that? And yeah, it's a few reasons, all of which we set out to solve, but it's technology, it's economics, it's alignment. And so I think SVB is actually a great example in the sense that SVB was a client, it was a member of these existing alternatives, of these existing networks. Yet, SVB had 94 % on insured deposits, meaning no one at the institution was using these products, which again raises the question of why.

27:13Because if they were, the institution would have had no trouble. Right. Because people were afraid that, you know, their deposits were uninsured and therefore that sort of costs the blood capital. That's the sort of classical bank run where everyone wants their money at the same time. And the bank on paper is solvent. You know, it has enough assets. But if everyone wants their funds at the same time, there's not enough liquidity. And that liquidity crunch causes a huge amount of money. And to show how very important this is and what Paolo's doing is essential is SVB didn't have like a lot of junk assets on the other side.