Speaker 1: Hello, and welcome to another episode of the Odd Lots podcast.
Speaker 1: I'm Joe Wisenthal and I'm Tracy Allow. So Tracy, we obviously,
Speaker 1: I think have a sense of why Silicon Valley Bank failed.
Speaker 1: We just published a really good episode with Dan Davis,
Speaker 1: like sort of like talking about where things went wrong
Speaker 1: on the sort of deposit side and failing to balance
Speaker 1: assets and liabilities and the issues of strengths and weaknesses
Speaker 1: of the business model. But then the other question, there
Speaker 1: are many, many more questions beyond just like why they failed. Yes,
Speaker 1: I mean some of the big ones that are emerging
Speaker 1: are where were the regulators right it? You know, people
Speaker 1: were already analyzing spb's balance sheet, you know, certainly the
Speaker 1: week before it collapsed and for some time before that,
Speaker 1: and you could see these vulnerabilities when it comes to
Speaker 1: duration exposure. And again that's something we talked about with
Speaker 1: Dan Davies. And then the other thing I guess just
Speaker 1: in general is it's not like bank failures are that
Speaker 1: unusual over the course of history. So this is the
Speaker 1: first big one, I guess since the two thousand and
Speaker 1: eight financial crisis. And so it's obviously garnering a lot
Speaker 1: of attention, But we do have bank failures throughout history
Speaker 1: from time to time, and it kind of begs the
Speaker 1: question of, well, if we're going to keep having them
Speaker 1: in different ways, and if the government or the Federal
Speaker 1: Reserve are going to keep coming in and rescuing them
Speaker 1: in various ways, should we maybe do something to the
Speaker 1: system to make it different. What were the failures and
Speaker 1: can we at least you know, we're always going to
Speaker 1: be fighting the last War cliche obviously, but what does
Speaker 1: it tell us about weaknesses in the system? And there
Speaker 1: may be things that we could do, And of course
Speaker 1: there's things that people are talking about on the sort
Speaker 1: of written law side, which is like, Okay, maybe we
Speaker 1: need more banks to have greater liquidity, ability to meet withdrawals, etc.
Speaker 1: I think some of the smaller, more regional banks don't
Speaker 1: have a stringent requirements on that front as the really
Speaker 1: large banks. And then people are talking about supervision, and
Speaker 1: I don't think supervision gets as much attention as the
Speaker 1: sort of written laws, but it's essentially, well, why did
Speaker 1: the supervisors the bank regulators allow the bank to create
Speaker 1: this confluence of risks, this big like sort of very
Speaker 1: specific mismatch between the nature of its assets, the nature
Speaker 1: of its deposit base that allowed it to unravel really quickly. Absolutely,
Speaker 1: and then of course, with the FED announcing this new facility,
Speaker 1: which is quite a dramatic one, you have a question of, Okay,
Speaker 1: if we're just going to guarantee all the US bank
Speaker 1: deposits out there, then should we maybe make a more
Speaker 1: fundamental change to the banking industry itself? Right? And actually,
Speaker 1: Matt Klein over at the Overshoot, I think he tweeted this,
Speaker 1: but he had that great first line in his most
Speaker 1: recent newsletter about how basically banks are these private investment
Speaker 1: funds that are grafted on top of critical infrastructure, and
Speaker 1: that structure is designed to extract subsidies from the rest
Speaker 1: of society by basically threatening people with banking crises whenever
Speaker 1: one of them is allowed to fail. And we saw
Speaker 1: that last week, right, We saw especially a bunch of
Speaker 1: vcs coming out and saying, if you don't rescue all
Speaker 1: the SVB depositors right now, this is going to happen
Speaker 1: to all the banks. And so you kick off that,
Speaker 1: you know, privatization of profits versus publicization of loss's argument
Speaker 1: over and over and over again. Well, that's been like
Speaker 1: really clear in this particular episode, like there's something about
Speaker 1: this story really raises some like uncomfortable days because it's
Speaker 1: not coming in like a wholesale financial collapse that's related
Speaker 1: to the collapse of the economy like in two thousand
Speaker 1: and eight or two thousand nine. It's like it's this
Speaker 1: very specific industry that sort of got it in trouble. Anyway,
Speaker 1: we could go on and on, but I'm excited. We
Speaker 1: do have the perfect guest for us to talk about
Speaker 1: the role of regulator, the role of regulatory failure, the
Speaker 1: role of the FED in all of this in the
Speaker 1: history of banking, and how we got here. We're gonna
Speaker 1: be speaking to a Levmanon Here's a professor at Columbia
Speaker 1: Law School written a lot about the FED and regulation.
Speaker 1: So Lev, thank you so much for joining us, Thank
Speaker 1: you so much for having me. So just you know,
Speaker 1: very top line view. You know, what would you say
Speaker 1: was the main regulatory failure with SIV with SVB, So yeah, yeah,
Speaker 1: we can distinguish between maybe regulation bright line rules yeah,
Speaker 1: put down in advance, and sort of supervision, yes, which
Speaker 1: is discretionary safety and soundness oversight by by examiners and
Speaker 1: federal federal regulators, federal officials, and both the sort of
Speaker 1: bright line rules and the sort of supervision failed here. Yeah,
Speaker 1: there was an overreliance on the bright line rules and
Speaker 1: a failure to do the discretionary oversight, the safety and
Speaker 1: soundness oversight effectively. So on the bright line rules side,
Speaker 1: SVB figured out a way to take additional risk without
Speaker 1: holding additional capital. Because of what's called the risk capital rules,
Speaker 1: treasury securities are risk weighted zero. That means that a
Speaker 1: bank has to hold zero equity against their treasury positions.
Speaker 1: And so SEP was able to go and buy a
Speaker 1: lot of long dated treasuries and actually build up quite
Speaker 1: a bit of interest rate risk without that being reflected
Speaker 1: in the capital that was required of them under the
Speaker 1: under the bright line rules, under the under the regulatory framework.
Speaker 1: Now we have a whole supervisory framework that's designed to
Speaker 1: deal with these sorts of holes in the rules. Everybody
Speaker 1: knows that the rules are insufficiently precise, and in fact,
Speaker 1: we didn't even have the rules until the nineteen eighties
Speaker 1: in meaningful sense. We used to just do discretionary safety
Speaker 1: and soundness oversight. And so the real question here in
Speaker 1: some sense is how come the supervisors didn't pick up
Speaker 1: on the fact that SVB had gamed the rules to
Speaker 1: take on a lot of interest rate risk without holding
Speaker 1: an adequate amount of capital against it. It's a pretty
Speaker 1: obvious maneuver. It's not nearly as complex as some of
Speaker 1: the maneuvers the gaming and it's not novel. It's not novel. Yeah,
Speaker 1: this is an old move. It's not like they camp
Speaker 1: with something new. You would think any seasoned supervisor looking
Speaker 1: at the balance sheet could pick up on this pretty quickly.
Speaker 1: So so what happened, I think is exactly the right
Speaker 1: question to be asking, and I think the answer requires
Speaker 1: maybe And this might just be my approach to these
Speaker 1: issues twenty thirty years worth of history to understand, because basically,
Speaker 1: I think contemporary supervision is broken in some sense and
Speaker 1: this is a manifestation of that. Okay, um, well, I'm
Speaker 1: I'm just gonna go ahead and buy and say, please,
Speaker 1: please give us the you know, thirty or forty years
Speaker 1: of banking history building up to those. Yeah, So let me.
Speaker 1: I'll say why I think it's broken, and then I'll
Speaker 1: tell you how we got sure, how it got so broken.
Speaker 1: So it's broken because outside of the stress testing framework,
Speaker 1: which I think we should definitely talk more about. Supervisors
Speaker 1: primarily now focus on process and procedures. Our insight into
Speaker 1: what actually goes on in supervision is very limited, and
Speaker 1: that's because supervisory materials are all confidential and can't be
Speaker 1: disclosed by the bank and aren't disclosed by by the regulators,
Speaker 1: and often never made public. So there's a lot of
Speaker 1: opacity into into what supervisors are actually doing. But it's
Speaker 1: it's fairly obvious, and I'll go through a few examples
Speaker 1: that what supervisors today tend to focus on is the process,
Speaker 1: and so they will look to see does the bank
Speaker 1: have a good risk management process, does it have the
Speaker 1: right board committees, does it have the right management committees
Speaker 1: looking at its risk decisions? Are there three lines of defense?
Speaker 1: And if the supervisors see the requisite process, they are
Speaker 1: very reluctant to make judgments about the actual decisions that
Speaker 1: are coming out of that process, and so they don't
Speaker 1: want to impose. They are reluctant to impose their own view. Oh,
Speaker 1: that is excessive risk, that is too much interest rate
Speaker 1: risk as opposed to we like the procedures that you're
Speaker 1: set up to manage interest rate risk. Just to be clear,
Speaker 1: though they certainly could under current law, they're allowed to
Speaker 1: say they're supposed to. Arguably, that's what current law is about,
Speaker 1: and the process approach being grafted onto this is an innovation.
Speaker 1: The purpose of safety and soundness law is really very
Speaker 1: much to address risk, and the process angle is born
Speaker 1: of the view that the best way to do that,
Speaker 1: the most efficient way to do that across a massive
Speaker 1: banking system, is just to make sure that the procedures
Speaker 1: are good. If the procedures are good, the problem will
Speaker 1: sort of take care of itself. So as long as
Speaker 1: you see the bank kind of debating its risk exposure internally,
Speaker 1: which you know seems to have been the case at SVB,
Speaker 1: and I know I brought this up in the previous episode,
Speaker 1: but you know, there were some internal documents which I've
Speaker 1: seen where they're talking about interest rate exposure and they're
Speaker 1: debating it, you know, with their asset liability committee and
Speaker 1: presumably with their risk specialists. But if they come to
Speaker 1: the conclusion that actually we're okay, the regulators are just
Speaker 1: going to look at that and take out on face
Speaker 1: value because the process is there, and they assume that,
Speaker 1: you know, the bank is kind of doing what it
Speaker 1: should be doing. Yeah, exactly, if you're not one of
Speaker 1: the big gesips, the global systemically important banks, and you're
Speaker 1: not in the stress testing route game, I think that
Speaker 1: is what tends to happen. It doesn't have to happen,
Speaker 1: As Joe said, they're certainly going to be examples where
Speaker 1: supervisors exercise them independent judgment. But there is a tendency
Speaker 1: still in the supervisory process to look at compliance with
Speaker 1: the rules, to check for processes, and if you see
Speaker 1: compliance with the rules and you see processes in place,
Speaker 1: to give the bank a clean bill of health, as
Speaker 1: it were. And so the question is how did we
Speaker 1: get to this place, because actually this was an innovation.
Speaker 1: At one point, we used to do safety and soundness
Speaker 1: substantive supervision without much bright line rules at all. Capital
Speaker 1: rules date only to the mid eighties, and this focus
Speaker 1: on process is really an innovation from the nineteen nineties.
Speaker 1: And so it's part of what I think is the
Speaker 1: toxic brew of regulatory supervisory policies that brought us the
Speaker 1: two thousand and eight crisis. And we still sort of
Speaker 1: have supervision guided by this nineties approach, and I think
Speaker 1: the SVB failure is one of several really significant examples
Speaker 1: of post two thousand and eight supervisory failure where the
Speaker 1: supervisors are still focused on process and too unwilling to
Speaker 1: make substantive judgments, reflecting the sort of approaches that were
Speaker 1: developed by primarily the greenspan fed but also the Ludwig
Speaker 1: occ in the nineties. Can you explain what it was
Speaker 1: or what happened in the nineties, was a directive that
Speaker 1: came down what caused this philosophical shift or just maybe
Speaker 1: mechanical shift in the approach to supervisory Let me start
Speaker 1: with the eighties, actually just with the birth of the
Speaker 1: capital rules. So what's the baseline. So supervision, safety and
Speaker 1: signed supervision dates all the way back to the nineteenth century,
Speaker 1: and so the way that the government's managed the incentive
Speaker 1: misalignment between bank shareholders and managers and bank depositors and
Speaker 1: the public has been through discretionary supervisory oversight safety and
Speaker 1: soundness oversight. That's been the bywords of federal law since
Speaker 1: the nineteen thirties. And the way that supervisors would do
Speaker 1: their job is they would make judgments about the riskiness
Speaker 1: of banks assets and the riskiness of banks leverage and
Speaker 1: the amount of capital and they would write letters, and
Speaker 1: they would job bone and they would take enforcement actions.
Speaker 1: They would issue cease and desist orders if they thought
Speaker 1: banks were under capitalized, or like in the case of
Speaker 1: Silicon Valley Bank, they would tell Silicon Valley Bank that
Speaker 1: it had to shorten its duration risk. That's what supervisors
Speaker 1: would do. In the eighties. You have a moment that's
Speaker 1: quite similar to today in that the banking system business
Speaker 1: model comes under a lot of pressure for macroeconomic reasons.
Speaker 1: Inflation goes up and then interest rates go way up
Speaker 1: because of the Vulker shock. This causes the yield curve
Speaker 1: to change in a way that's very ugly for a bank.
Speaker 1: Because a bank's business is a positive net interest margin.
Speaker 1: You earn more on your assets than you pay on
Speaker 1: your liabilities, and your liabilities are short duration, and so
Speaker 1: if interest rates go way up quickly, you can end
Speaker 1: up in a position where you are paying more on
Speaker 1: your liabilities than you are in your assets, which is
Speaker 1: which is going to run right through your capital. That's
Speaker 1: not a profitable business model. This happened in the eighties
Speaker 1: and a lot of banks became undercapitalized and supervisors were
Speaker 1: swamped with cease and desist orders and supervisory directives to
Speaker 1: banks all over the place to raise more capital. Some
Speaker 1: banks sued. One bank was able to prevail in the
Speaker 1: fifth Circuit, and Congress intervened and pass a new law
Speaker 1: authorizing forward looking, ex anti brightline capital rules for the
Speaker 1: first time and saying that capital judgments of supervisors can't
Speaker 1: be second guests by courts. And so, in a sort
Speaker 1: of accidental way, you have the birth of capital regulation.
Speaker 1: The supervisors are overwhelmed and there are laws, suits, and
Speaker 1: you have Congress saying, actually, just write a rule that
Speaker 1: the banks all have to comply with so that you
Speaker 1: don't have to get into litigation over whether this bank
Speaker 1: or that bank is undercapitalized. Fast forward a few years.
Speaker 1: You get these rules, and you get you get Basel one,
Speaker 1: you get an effort to align these rules internationally, and
Speaker 1: you get Alan Greenspan as fed share. Going into the nineties,
Speaker 1: the banking system starts to transform. You have the emergence
Speaker 1: of large, complex banking institutions, and you have a lot
Speaker 1: of soul searching in Washington and the Federal Reserve at
Speaker 1: the occ about whether supervisors are really up to the
Speaker 1: task of assessing the risk taking of these new large
Speaker 1: complex financial institutions, these large complex banking organizations that we
Speaker 1: never had in this country before through the traditional means,
Speaker 1: or whether we should actually embrace these new rules that
Speaker 1: have developed up and rely primarily on the rules and
Speaker 1: shift supervisors to a task that they are that they're
Speaker 1: more capable of performing. This is this is very self
Speaker 1: conscious for the policymakers at the time. You can go
Speaker 1: back and read some of Alan Greenspan's speeches about the
Speaker 1: changes that he's making, and he basically thinks that, especially
Speaker 1: for large banks, supervisors are just not going to be
Speaker 1: able to do it the way they used to. What
Speaker 1: we need are capital rules that require shareholders to have
Speaker 1: enough skin in the game, and then the shareholders will
Speaker 1: do it. The shareholders were supervised banks. And so Alan
Speaker 1: Greenspan says, it's not about needing net less regulation. It's
Speaker 1: about whether it should be public sector regulation or private
Speaker 1: sector regulation, and we need to reorient the banking system
Speaker 1: so that we have more private regulation. So that obviously
Speaker 1: goes terribly wrong in two thousand and eight. It's not funny,
Speaker 1: but this happens over and over and over it does,
Speaker 1: and so by two thousand and eight you have supervisors
Speaker 1: have more or less unilaterally disarmed. They have shifted to
Speaker 1: enforcing the capital rules. The banking agencies are relying almost
Speaker 1: entirely on the capital rules for making judgments about whether
Speaker 1: a bank has adequate capital for the risks that it's taking,
Speaker 1: and instead they are looking at processes. And there's a
Speaker 1: real theory behind this. The theory is, in order for
Speaker 1: market regulation to work, private regulation to work, there has
Speaker 1: to be disclosure, and so a bank has to be
Speaker 1: transparent about the risks that it's taken. A bank can't
Speaker 1: be transparent about the risks that it's taking if it
Speaker 1: doesn't have processes to monitor and disclose those risks. And
Speaker 1: so the job for supervisors is to make sure banks
Speaker 1: are monitoring their risks and disclosing them to the shareholders
Speaker 1: so that the shareholders can discipline the banks. And by
Speaker 1: two thousand and eight, supervisors have stopped bringing in cease
Speaker 1: into sists. There's no safety and soundness enforcement actions against
Speaker 1: any of the major banks, any of the major banks
Speaker 1: that take TART for years running up to two thousand
Speaker 1: and eight, because if they're in compliance with the rules
Speaker 1: and they're disclosing to the market, the judgment is that
Speaker 1: system is going to work. What goes wrong is that
Speaker 1: bank shareholders have an incentive to take much more risk
Speaker 1: than is in the interests of the government or depositors.
Speaker 1: It's sort of basic economic stuff. The shareholders have an
Speaker 1: incentive to extract wealth from the depositors and from the public.
Speaker 1: And so the shareholders is gonna be much more comfortable
Speaker 1: with a lot more risk than the public should be.
Speaker 1: And so if you're going to rely on them to
Speaker 1: monitor risk, cake and you're going to get a much
Speaker 1: riskier bank. And this is Silicon Valley Bank story. I mean,
Speaker 1: it's very much Silicon Valley Bank story. So you get
Speaker 1: two thousand and eight, and you get a modification after
Speaker 1: two thousand and eight, which is stress tests, but a
Speaker 1: lot of ordinary day to day supervision continues to be
Speaker 1: I think procedurally oriented. And you see this with the
Speaker 1: London whale, and you see this with the fake account
Speaker 1: scandal at Wells Fargo, both of which I think are
Speaker 1: really important data points for outside observers to think about
Speaker 1: how much did we fix supervision after two thousand and eight,
Speaker 1: how much do we move away from the green span
Speaker 1: nineties cocktail of bright line capital rules and procedural oversight
Speaker 1: oriented to shareholder discipline. And I think the answer is
Speaker 1: for the small banks that are not subject to stress tests,
Speaker 1: and even for the big banks that are subject to
Speaker 1: stress tests, outside of the stress testing regime, we still
Speaker 1: have a lot of procedural oversight. So this is actually
Speaker 1: a very quick mechanical question. But for a bank like
Speaker 1: Silicon Valley Bank, is it as supervisor? Is it a
Speaker 1: panel like hot Like what do you know? Do you
Speaker 1: have a sense of like how many people? I mean,
Speaker 1: because it's someone at the SFED presumably, Now assume there's
Speaker 1: thousands of banks in California probably or at least hundreds,
Speaker 1: Like what kind of just like human resources could even
Speaker 1: go currently to paying attention to Silicon Valley a bank
Speaker 1: like Silicon Valley Bank. So there are thousands of supervisors
Speaker 1: across the federal system. Okay, they're split across three agencies,
Speaker 1: the Federal Reserve, the Federal Deposit Insurance Corporation, and the
Speaker 1: Controller of the Currency. They split up responsibility for supervising bank.
Speaker 1: Silicon Valley Bank is a state chartered bank and it's
Speaker 1: a member of the Federal Reserve system. So as a result,
Speaker 1: as you say, it's the FED that would have responsibility
Speaker 1: at the federal level for primary responsibility for supervision if
Speaker 1: there's always overlap, So the FDIC has some ability to
Speaker 1: come in because it's insuring the deposits obviously, and then
Speaker 1: it's very involved now. But the day to day job
Speaker 1: here is FED personnel in San Francisco who are really
Speaker 1: actually exercising delegated authority of the Board of Governors, which
Speaker 1: is the federal agency with the power to supervise member banks.
Speaker 1: And the Reserve Bank of San Francisco is actually a
Speaker 1: federal bank of Federal corporation, and so it's it's facilitated,
Speaker 1: it's helping the board, and the board has supervisory staff
Speaker 1: that are supposed to sort of oversee what is going
Speaker 1: at the reserve banks. So is San Francisco doing a
Speaker 1: good job, And obviously at the top of that is
Speaker 1: Michael Barr, the Vice champer supervision. I'm going to have
Speaker 1: some more questions on the San Francisco FED and the
Speaker 1: fhlbs as well. But just going back to the evolution
Speaker 1: of bank capital rules. So one of the big things
Speaker 1: that happened, and you sort of outlined it in the
Speaker 1: lead up to the two thousand and eight crisis, but
Speaker 1: like it definitely hardened after two thousand and eight. Is
Speaker 1: this idea that banks should be holding more bonds in general,
Speaker 1: the safest bonds, so, you know, US treasuries in the
Speaker 1: case of US banks, maybe agency mortgage backed securities that
Speaker 1: are implicitly guaranteed by the US government, things like that
Speaker 1: for their regulatory capital and liquidity buffers. And it seems
Speaker 1: to me like that probably made a lot of sense
Speaker 1: in the low inflation environment of two thousand and eight,
Speaker 1: But now that you have the FED raising rates, you
Speaker 1: have a lot of volatility. It seems like these bonds
Speaker 1: might not be I don't think safe is the right word,
Speaker 1: but not as unproblematic as maybe we imagine them to
Speaker 1: once be. Could you talk a little bit more about
Speaker 1: basically how we built the modern banking system on top
Speaker 1: of a bedrock of bonds that are presumed to be
Speaker 1: somewhat stable in price. So I think that you're right
Speaker 1: to sort of highlight the appeal of treasuries and agencies
Speaker 1: to both bankers and supervisors in the wake of two
Speaker 1: and eight. Bank that loads up on treasury, that's, like,
Speaker 1: you know, very wholesome. It seems very wholesome for a
Speaker 1: bank to do right. The government likes that. The government
Speaker 1: is like banks that buy treasuries since the Civil War,
Speaker 1: and so it's gonna cut against even the most ambitious
Speaker 1: and confident, you know, safety and soundness overseas. It's going
Speaker 1: to cut against their their impulses to to sort of
Speaker 1: fault a bank for loading up on treasuries. I mean,
Speaker 1: that's that seems that seems that's a good thing, right,
Speaker 1: And so it's it that helps to explain part of
Speaker 1: what's happening here. And it's also true that banks do
Speaker 1: have the ability to weather usually a fair amount of
Speaker 1: interest rate losses on their assets. So many banks think
Speaker 1: of themselves as structurally hedged against interest rate increases because
Speaker 1: while their assets, if they have law assets like long
Speaker 1: dated treasuries, that's those are going to lose value when
Speaker 1: the interest interest rates rise, their liabilities or deposits, and
Speaker 1: their deposits are sticky, they don't pass through, and so
Speaker 1: actually their deposit funding becomes much more valuable when interest
Speaker 1: rates rise. So if in a zero interest rate environment,
Speaker 1: interest rates or zero deposit rates or zero deposits aren't
Speaker 1: that useful. You're getting a little benefit that you have
Speaker 1: deposit funding. But if interest rates go way up, you're
Speaker 1: not gonna if you're the bank, you're not actually going
Speaker 1: to be forced to raise your extracting rents right from
Speaker 1: the deposit public. But you're not going to be forced
Speaker 1: to raise your deposit rates. And this is actually strengthening
Speaker 1: your business. And Silicon Valley Bank is going to think, yeah, okay,
Speaker 1: so we take some we take some hits on our
Speaker 1: long assets, but actually our net interest margin is going
Speaker 1: to position, is going to main strong, our deposits are
Speaker 1: going to be much more valuable, and we're just gonna
Speaker 1: we're gonna work through, you know, year to eighteen month
Speaker 1: period and be totally fine, right, which it seems like
Speaker 1: they lose was sort of the assumption that they had,
Speaker 1: like they knew they it wasn't great and maybe even
Speaker 1: technical and solvent, but I mean, I think it was
Speaker 1: in this leek one of matt Leview's news and letters,
Speaker 1: he's like, this was actually like a very profitable time
Speaker 1: for them, like it did. It would have been fine
Speaker 1: if everyone's did. And presumably their expectation was, well, we're
Speaker 1: just making a lot of income right now. So the
Speaker 1: fact that we took it a hit on the asset
Speaker 1: side is not really well. They had they had a
Speaker 1: specific estimate in one of those internal documents where they said,
Speaker 1: we could shorten duration, but that would mean an eighteen
Speaker 1: million dollar hit to our net interest margin in one
Speaker 1: year alone, going up to like thirty six million over
Speaker 1: the next three years. So they knew that if they
Speaker 1: reduced duration, they would be sacrificing earnings to some extent. Yeah,
Speaker 1: I mean, I think it's fair to say that in
Speaker 1: twenty twenty one they were making huge profits because this
Speaker 1: strategy was really working. Interest rates went way up, and
Speaker 1: I think it would have impaired their profitability, but they
Speaker 1: were They weren't wrong to think that they were what
Speaker 1: structurally hedge, even though they had no interest rate hedges
Speaker 1: or anything, by virtue of the fact that they would
Speaker 1: slowly be able to replace their treasuries with much higher
Speaker 1: yielding treasuries while being able to pay depositors very little.
Speaker 1: And we also, you know, we talked about this deposit
Speaker 1: betas on a recent episode with Joe Batte and why
Speaker 1: they're off at low and what if His points was like, well,
Speaker 1: you know, you have a bank, you have an individual
Speaker 1: has an account at Chase or something like that they're
Speaker 1: providing a lot of services along with that. People are
Speaker 1: not that inclined to move their checker account just because
Speaker 1: the interest rate doesn't bump up a little bit. And
Speaker 1: I imagine for Silicon Valley depositors these companies, the whole
Speaker 1: story about Silicon Valley Bank was all of the products,
Speaker 1: the startup specific products that they are that they offered,
Speaker 1: which presumably to their mind, insulated them to some extent
Speaker 1: against losing deposits. Absolutely, and I mean in the case
Speaker 1: of SVB, there was also what an antitrust law we
Speaker 1: call tying, where accompany ties one product to another product. Yeah,
Speaker 1: so the bank would require that if you wanted to
Speaker 1: borrow from the bank, that you would have Is that
Speaker 1: unusual because people some people obviously some people are like, oh,
Speaker 1: that's weird, and some people are like no, of course,
Speaker 1: like any commercial loan. But is that unusual in your view?
Speaker 1: I don't think it is unusual. There are strict rules
Speaker 1: about bank tying in other areas. But my understanding is
Speaker 1: that banks are explicitly permitted to tie deposit account services
Speaker 1: to lending services. And historically it was core to the
Speaker 1: banking business that you were the depository institution for the
Speaker 1: for your borrowers that that went together, and you know,
Speaker 1: we've moved away from that technology lots of things have
Speaker 1: allowed people to borrow from banks that aren't the banks
Speaker 1: where they bank at. But a long time, the idea
Speaker 1: was that there's a lot of synergies between that no
Speaker 1: one's going to be in a better position to determine
Speaker 1: how much to lend to you than your own banker.
Speaker 1: I imagine like there was also a bit of a
Speaker 1: prestige element to banking at SVOB as well, given that,
Speaker 1: you know, it was so popular among a particular type
Speaker 1: of tech slash VC person. But you know, Joe touched
Speaker 1: on the episode we did on deposit betas with Joe Abode.
Speaker 1: But I'd love to hear from you, like why didn't
Speaker 1: people pull more deposits from a bank that was essentially
Speaker 1: paying them nothing? Because to some extent, this is the
Speaker 1: big question, like why did SVB have so many deposits?
Speaker 1: Well into twenty twenty two, at which point we started
Speaker 1: to see some of the I guess most interest rate
Speaker 1: sensitive parts of the economy, ie the tech industry lose
Speaker 1: a bunch of money and have to pull funds. But
Speaker 1: why why were people accepting of that for so long.
Speaker 1: So we mentioned a couple of the sort of rational
Speaker 1: explanations that you know, there's a strong brand, you want
Speaker 1: to they're they're lending to you, they've required you to
Speaker 1: keep deposit there. But you can't discount the fact here
Speaker 1: that a big piece of this was a lack of
Speaker 1: sophisticated financial management on the part of startup companies that
Speaker 1: maybe didn't have CFOs, didn't have anybody on their teams
Speaker 1: with any experience in managing cash. They're focused on their
Speaker 1: their business and it's very hard to justify five hundred
Speaker 1: million dollar bank account balance, and I think we have
Speaker 1: one example of that that just there's there's no reason
Speaker 1: for that's that's very bad management. No well run, mature
Speaker 1: company would operate in that way. Among other things, you
Speaker 1: you you have a huge uninsured deposit risk that we
Speaker 1: that we saw, but you're also just giving up lots
Speaker 1: of return. You could have that money invested in laddered
Speaker 1: treasury bills or something. And significantly more so, there's a
Speaker 1: huge amount of money that's just been left on the
Speaker 1: floor here there, and it's you know, it doesn't it
Speaker 1: doesn't really make sense. So we have to understand that
Speaker 1: these that these customers, despite having lots of money, are
Speaker 1: not actually very sophisticated. So I want to go back
Speaker 1: to the supervisory question and ask about it, kind of
Speaker 1: come at it from a different angle. You know. Obviously
Speaker 1: the two thousand and eight two thousand and nine crisis
Speaker 1: was very focused on the asset side of the business
Speaker 1: and were these really high quality assets? And then part
Speaker 1: of the reasonable bunch of banks failed is because the
Speaker 1: assets like weren't very good that they held. And as
Speaker 1: people have discussed with Silicon Value Bank, a lot of
Speaker 1: the issues. Yes, maybe they made a wrong bet on
Speaker 1: treasuries or they put too much, but is the flightiness
Speaker 1: of the deposits? Can you talk a little bit more.
Speaker 1: I know that regulators do bucket deposits from the most
Speaker 1: sticky to the least sticky, but could you talk a
Speaker 1: little bit about like how good supervisory in a sort
Speaker 1: of like active pre nineties way might have approached the
Speaker 1: uniformity of SVB deposits and the risk of them all
Speaker 1: leaving at once. Yeah, I mean I think that if
Speaker 1: you showed svb's balance sheet to supervisor brought up during
Speaker 1: the new deal system. So let's say it's nineteen seventy five,
Speaker 1: they would be horrified at the enormous concentration of uninsured
Speaker 1: deposits controlled by a group of businesses with very similar
Speaker 1: risks to their business and so all of your depositors,
Speaker 1: and this is something that and this is something that
Speaker 1: a new deal era supervisor would be familiar with from
Speaker 1: press experience. Well, I think I think it would have been.
Speaker 1: They would have been unfamiliar with it in the sense
Speaker 1: that it would have been so unusual back then everyone
Speaker 1: would have looked at it and said, WHOA, this bank
Speaker 1: has a very unstable deposit base. It would not have
Speaker 1: been novel to view this with concern. It would be
Speaker 1: it would be even more concerning because of how risk
Speaker 1: it would have been to operate a bank in this
Speaker 1: way at that point in time, when when, of course,
Speaker 1: people still remembered the bank runs of the thirties much
Speaker 1: more than they do than they do today. And you know,
Speaker 1: part of what went wrong at SVP is it's not
Speaker 1: just that they had ninety seven percent or something in
Speaker 1: uninsured deposits, but that all of their depositors were going
Speaker 1: to withdraw at the same time. And so there's sort
Speaker 1: of a classic issue in the banking business always is
Speaker 1: in what circumstances am I going to be subject to
Speaker 1: a deposit train? You know, you get to model your
Speaker 1: deposits as sticky if you're a bank, because over time,
Speaker 1: for the banking system, the deposit base is always sort
Speaker 1: of growing. I mean, with the exception of over the
Speaker 1: last year where monetary policy is trying to shrink the
Speaker 1: money supply, but you know, over time it's a constant
Speaker 1: growing base, and so deposits are really, in some simes
Speaker 1: a very long duration asset, except if you're the one
Speaker 1: bank that experiences a drain to the rest of the
Speaker 1: system where everyone withdraws from you, and so if your
Speaker 1: customers are all going to face hardship your depositories or
Speaker 1: depot it was hard. The same time, you really can't
Speaker 1: treat yourself as structurally hedged. You're the opposite of structurally
Speaker 1: head And that's what that's what Silicon Valley Bank found out,
Speaker 1: is it thought that, oh, you know, when when my
Speaker 1: assets lose value, my deposits will become more valuable. But
Speaker 1: actually all their depositors started to draw down their accounts
Speaker 1: and the opposite happened, and so they were just very
Speaker 1: very long low interest rates, silicon valuing. The whole business
Speaker 1: model was tied to low interest rates, I think to
Speaker 1: an extent that they did not appreciate, and to an
Speaker 1: extent supervisors clearly didn't depreciate, but maybe weren't even thinking
Speaker 1: as hard about as they might have in an earlier
Speaker 1: period where they were more empowered to make those sorts
Speaker 1: of judgments. Yeah, this is exactly what I said on
Speaker 1: our episode with Dan Davies. It was interest rate exposure
Speaker 1: kind of squared, but just on the deposit side. Because
Speaker 1: to me, this is kind of the most novel or
Speaker 1: interesting thing about all of this, because we know that
Speaker 1: a lot of banks have unrealized losses on bonds, and
Speaker 1: you know too. Seems like broadly they've been managing their
Speaker 1: interest rate risk so far. But with SVB, the big
Speaker 1: difference was that group of highly concentrated, extremely unreliable depositors
Speaker 1: who themselves had significant interest rate exposure. And we're pulling
Speaker 1: money over the past years. So what could regulation do
Speaker 1: on that front? So I guess instead of the asset side,
Speaker 1: looking more at the liability side. Yeah, So what you
Speaker 1: want to see is a coherent asset liability management strategy
Speaker 1: for a bank, and so a bank that anticipates deposit
Speaker 1: trains for a bank that has flighty deposits, and there
Speaker 1: are many banks that can fall into this category. This
Speaker 1: is something that regulator supervisors do think a lot about.
Speaker 1: If you're in that category, then you need to hold
Speaker 1: liquid assets that you can sell and that at their
Speaker 1: fair market value to cover the withdrawals. And so part
Speaker 1: of the problem here is that Silicon Valley Bank did
Speaker 1: not actually have available for sale securities at fair market
Speaker 1: values sufficient to cover the withdrawals, and so the fix
Speaker 1: for this would have been to have much less duration
Speaker 1: in the in the in the asset portfolio, or many
Speaker 1: many more reserves. This is the same problem, by the way,
Speaker 1: that took down silver Gate Bank and to some extent,
Speaker 1: Signature Bank. They had deposit bases that were flighty, that
Speaker 1: their depositors suffered and their deposit the banks experienced deposit
Speaker 1: drains because they were concentrated in a group of people
Speaker 1: that were exposed to interest rate hiking. I just realized
Speaker 1: I promised to ask about discount lending and the fhlb's
Speaker 1: the Federal Home Loan Bank. So you know, in theory,
Speaker 1: when you have this type of banking crisis or you know,
Speaker 1: some sort of liquidity issue with the financial institution. You
Speaker 1: would expect them to either go to the FED, to
Speaker 1: the discount window and for all blots listeners, we recorded
Speaker 1: an episode on this a month or two ago, or
Speaker 1: they can borrow from the FHLBS. And some of the
Speaker 1: talk out there is that SVB got cut off by FHLB.
Speaker 1: Why would that have happened and why wouldn't those two
Speaker 1: lenders of last resort do everything they can in order
Speaker 1: to step in and support the bank. Or is it
Speaker 1: the case that at some point, you know, maybe they're
Speaker 1: talking to the FDIC and they just say this is
Speaker 1: untenable and no matter how much money we provide, like
Speaker 1: the bank is not going to be able to get
Speaker 1: up and running again. So I'm speculating a bid here,
Speaker 1: and you might want to talk to the FHLB expert
Speaker 1: in the legal academy, K Judge, who's my colleague. But
Speaker 1: the FHLBS are not a lender of last resort in
Speaker 1: the way that the FRBs are. Right, the FHLBS they
Speaker 1: do provide sort of lender of second to last resort
Speaker 1: services to their members, but they are much more operated
Speaker 1: by their members, and they pay dividends to their members
Speaker 1: than the FRBs. So the FRBs were set up in
Speaker 1: a similar model, but today basically function as public banks,
Speaker 1: so they have no interest in profits or anything like that,
Speaker 1: and they're willing to sort of take one for the
Speaker 1: team in a way that the fhlbs are not. So
Speaker 1: I think it's a mistake to look at the FHLBS
Speaker 1: and say, oh, well, you really ought to have lent
Speaker 1: into an insolvent institution and took on that potential. Rik k.
Speaker 1: The FRBs are are are are wary of that for
Speaker 1: various reasons we could get into. But the flhol bes
Speaker 1: have even more reason to sort of to pull back.
Speaker 1: We definitely have to do an FHLB episode at some
Speaker 1: point with k Judge, because I don't know much about
Speaker 1: them at all, and it definitely it's been too long
Speaker 1: or it's far too long without having yeout having her on.
Speaker 1: I want to ask another dimension. You know, people pointing
Speaker 1: to the twenty eighteen law change to Dodd Frank that
Speaker 1: seemed to exempt banks like Silicon Valley Bank from some
Speaker 1: of these liquidity requirements that you were talking about, like
Speaker 1: do you have enough liquid assets? Hey? Could you sort
Speaker 1: of characterize the change that was made there in b
Speaker 1: had that not been in place, like is that is
Speaker 1: that change that was made in twenty eighteen? Does does
Speaker 1: that tell the story of the demise? Had the old
Speaker 1: Dodd Frank laws remained in place for a bank the
Speaker 1: size of Silicon Valley Bank, would they have been able
Speaker 1: to weather the storm? You can never know for sure,
Speaker 1: but I would suggests yes, that is decisive. And so
Speaker 1: this brings us back to how the government responded to
Speaker 1: the two thousand and eight failure of supervision regulation. And
Speaker 1: they responded with a set of tiered new requirements. And
Speaker 1: for the very biggest banks you had the CCR stress
Speaker 1: testing regime, and for all of the banks with more
Speaker 1: than fifty billion dollars of assets, you had stress testing
Speaker 1: as well as collection of other enhanced prudential standards. And
Speaker 1: this new cocktail of regulation and supervision was geared towards
Speaker 1: preventing a repeat of something on the scale of two
Speaker 1: thousand and eight. And so we weren't going to impose
Speaker 1: this on the whole banking system, on all of the
Speaker 1: sort of smaller banks. But the thinking was, if we
Speaker 1: could just really get back to serious government oversight of
Speaker 1: banks over fifty billion dollars that would really go a
Speaker 1: long way towards preventing another another calamity like two thousand
Speaker 1: and eight. And what happened was immediately there was litigation
Speaker 1: over the threshold for this new regulatory supervisory cocktail. And
Speaker 1: so this fifty billion dollars threshold came under a lot
Speaker 1: of political pressure from the banking agencies and from various
Speaker 1: people in Washington, and the bank lobby fought a battle
Speaker 1: over many years to raise the threshold. One of the
Speaker 1: important figures lobbying for raising the threshold was the CEO
Speaker 1: of Silicon Valley Bank. He was growing his bank and
Speaker 1: he did not want to grow his bank into additional
Speaker 1: regulatory and supervisory requirements. And in twenty eighteen, after winning
Speaker 1: over people in both parties to this cause of raising
Speaker 1: the threshold, Congress changed the law and the threshold moved up.
Speaker 1: A bunch of thresholds moved around, but the relevant threshold,
Speaker 1: I think, moved up to two hundred and fifty billion dollars.
Speaker 1: And the result was Silicon Valley Bank and its peers
Speaker 1: had successfully exempted themselves from the enhanced prudential standards that
Speaker 1: Congress had created. After two thousand and eight, and the
Speaker 1: result was you didn't have the stress testing, which is
Speaker 1: the primary means by which supervisors now exercise substantive judgment
Speaker 1: about risks, and so you had a much more I
Speaker 1: think light touch process focused oversight that allowed rule compliant
Speaker 1: balance sheet configurations like svbs to go relatively unchallenged. But
Speaker 1: if you had been in the in the Enhanced Prudential
Speaker 1: Standards bucket, I think that they would have been challenged.
Speaker 1: They would have been challenged through all of these additional
Speaker 1: rules and also supervisory programs. And it's unlikely. You can
Speaker 1: never know, but it's unlikely that they could have taken
Speaker 1: so much duration risk and not raised capital earlier, been
Speaker 1: permitted to go for so long in a position where
Speaker 1: their liquidation value was possibly negative. Yeah, since we're on
Speaker 1: the topic of the blame game, I mean, one of
Speaker 1: the things that you see people saying now is that, well,
Speaker 1: it's the Fed's fault. The FED kept interest rate slow
Speaker 1: for too long, and it basically forced people to assume
Speaker 1: additional duration risk in order to seek out yield. And
Speaker 1: I think, you know, financial repression is a real thing.
Speaker 1: But on the other hand, you cannot ignore the individual
Speaker 1: actions of one or a few specific banks, their managers,
Speaker 1: their shareholders, and their depositors. But how would you describe
Speaker 1: the overall monetary policies role in the current predicament. So
Speaker 1: overall monetary policy is of course central to the current predicament.
Speaker 1: But there's a sort of false dichotomy underline, the view
Speaker 1: that somehow it's like monetary policy happening up here at
Speaker 1: the FED that's then causing problems down here at the
Speaker 1: banking system. The whole thing is monetary policy. The whole
Speaker 1: reason we have banks is monetary policy. Banks are creating
Speaker 1: the money supply, and the question is how much money
Speaker 1: do we want to be created. So it would be
Speaker 1: the tail wagging the dog if we had to change
Speaker 1: our judgment about how much money should be created because
Speaker 1: like somehow the system couldn't create that amount of money
Speaker 1: safely and stably. We have a broken system if it
Speaker 1: can't create the amount of money that the FMC says
Speaker 1: is appropriate for macroeconomic conditions. And so I would not
Speaker 1: blame the FOMC for thinking that we need to adjust
Speaker 1: the amount of money that the banking system and the
Speaker 1: financial system are creating. I would blame the banking and
Speaker 1: financial system and the banking and financial laws. If they're
Speaker 1: incapable producing the amount of money and changing the amount
Speaker 1: of money they're producing overtime consistent with the fomc's directives
Speaker 1: and the needs of the economy, that's a really big problem.
Speaker 1: And it does look like we're facing that problem now,
Speaker 1: where in the coming months we could be in quite
Speaker 1: a predicament where the FOMC may make the judgment and
Speaker 1: we can brack it whether it would be the correct
Speaker 1: judgment that the economy needs less money and the banking
Speaker 1: system may be incapable of functioning properly under that directive.
Speaker 1: And that's the flip side of, you know, the suggestion
Speaker 1: that the banking system should also be able to function
Speaker 1: under the judgment that interest rate should be zero and
Speaker 1: function in a way that is sustainable over time. And
Speaker 1: so to the extent that is what's going on, I
Speaker 1: think it's a real indictment not of monetary policy, like
Speaker 1: the high level decision about how much money we need,
Speaker 1: but the structure being unable to follow through to execute
Speaker 1: on those decisions. Leveman on that was an amazing answer,
Speaker 1: That was an amazing conversation that was so helpful that
Speaker 1: was so helpful and so clear. I've said it every
Speaker 1: time we talked to I'm like, oh, I've finally had
Speaker 1: There's been a few more, but I so that was
Speaker 1: a that was very good. I'll just leave it there.
Speaker 1: I really I really appreciate that. So thank you so
Speaker 1: much for coming back on up. Thank you so much
Speaker 1: for having me that, Tracy. I love that whole conversation,
Speaker 1: starting from the very end, which I think is a
Speaker 1: really excellent way to sort of reconceptualize the monetary policy problem,
Speaker 1: which is that if the FED is going to be
Speaker 1: tasked with like the sort of like big sweep macro management, right,
Speaker 1: getting employment inflation at its targets and so forth, in theory,
Speaker 1: we want to have a financial system that can operate
Speaker 1: under any you know, operate relatively safely under whatever rates
Speaker 1: the FED deems to be appropriate. Absolutely, I mean, I
Speaker 1: do think there is a fundamental tension between monetary policy,
Speaker 1: which you know, like the big thing monetary policy does
Speaker 1: is basically impact the price of bonds and then having
Speaker 1: the financial system and banks specifically have to hold a
Speaker 1: bunch of bonds as part of their capital and liquidity mandates.
Speaker 1: Like that tension is there, but there are way is
Speaker 1: to manage it such that we can avoid failures and
Speaker 1: also provide for the effective implementation of monetary policy as
Speaker 1: a whole. The other thing that really struck me is
Speaker 1: this is kind of an incentives episode, right, And I
Speaker 1: thought Lev's point about basically outsourcing a lot of bank
Speaker 1: supervision to private shareholders and expecting them to you maybe
Speaker 1: press the brakes on risk when things start to get
Speaker 1: out of hand, that was a really interesting one. And SVB,
Speaker 1: I think, is going to end up as a classic
Speaker 1: case where you know, there was an acknowledgement that there
Speaker 1: was an issue here. There was the asset liability duration mismatch,
Speaker 1: and there was too much exposure to long bonds and
Speaker 1: too much of an assumption that deposits would be around
Speaker 1: forever or that they might even return or start growing again,
Speaker 1: and it was a conscious decision to pick up net
Speaker 1: interest margin, or at least it looks like that. I'm
Speaker 1: sure more will come out over the course of all
Speaker 1: of this, but for now, it certainly seems like it
Speaker 1: was a decision to do that. That's really interesting, like
Speaker 1: thinking about like, it's pretty fascinating that a lot of
Speaker 1: these like capital requirements and ratios and regulations that we
Speaker 1: think of as courtA how we manage the banking system
Speaker 1: are all pretty young, and that for the most part,
Speaker 1: for a long time in history it was like active
Speaker 1: super advisory people making judgments based on the operations of
Speaker 1: the bank, whether their decisions on loans and deposits were healthy.
Speaker 1: But it does make total sense that it is sort
Speaker 1: of like you know, I hate usually where it's like neoliberal,
Speaker 1: but that like that the role of supervisors would essentially
Speaker 1: transform to making sure that shareholders were getting adequate information.
Speaker 1: That you start with the assumption that the market is
Speaker 1: the best regulator, and then what is the role of
Speaker 1: the government well, and the role of the government, and
Speaker 1: that point is to make sure that market regulators get
Speaker 1: good information. Like that seems like a very like big
Speaker 1: theme that like you could like characterize across a lot
Speaker 1: of different industries, a lot of different government and then
Speaker 1: the failure of just like well, the problem is like
Speaker 1: shareholders can lose everything and not be accountable for the
Speaker 1: spill over when a bank fails. And so yeah, the
Speaker 1: need perhaps to get back to a type of supervisory
Speaker 1: that actually takes decisions into own hands and rather than
Speaker 1: just outsourcing it. You know, I realized we didn't even
Speaker 1: get into FED checking accounts, which is one of them.
Speaker 1: Now that's the next step. So then I think the
Speaker 1: series is if all deposits post SVB are presumed to
Speaker 1: be ensured, which almost seems like implicitly the case, now
Speaker 1: why do we have private deposit taking institution? So I
Speaker 1: kind of think that's the next one in this series
Speaker 1: to look at, Well, what does this tell us now
Speaker 1: about even the point of private deposit taking institutions? And
Speaker 1: should there be a point? I mean, that is what
Speaker 1: I was kind of hinting at in the intro. But
Speaker 1: we'll just have to leave that. You know, it was
Speaker 1: a trailer not for this episode but for the next one,
Speaker 1: so plenty more to come, but shall we leave it there?
Speaker 1: Let's leave it there. This has been another episode of
Speaker 1: the Odd Thoughts podcast. I'm Tracy Alloway. You can follow
Speaker 1: me on Twitter at Tracy Alloway and I'm Joe wisn't All.
Speaker 1: You can follow me on Twitter at the Stalwart, follow
Speaker 1: our guest Levmnond on Twitter at levmanand follow our producers
Speaker 1: Carmen Rodriguez at Carmen Arman and Dash Bennett at dashbot
Speaker 1: Check out Bloomberg's podcast son to the handle at podcasts,
Speaker 1: and for more Odd Lots content, go to bloomberg dot
Speaker 1: com slash odd Lots, where we post all the transcripts.
Speaker 1: Tracy and I have a blog and weekly newsletter that
Speaker 1: comes out every Friday. Go there and sign up. Thanks
Speaker 1: for listening.