Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2: Hello and welcome to another episode of the Odd Thoughts podcast.
Speaker 2: I'm Tracy Alloway.
Speaker 3: And I'm Joe. Wasn't all Joe.
Speaker 2: It is coming up to the one year anniversary of
Speaker 2: last year's banking drama. I'm still not sure if we
Speaker 2: can call it at crisis or not. Uh, it kind
Speaker 2: of felt crisis at the time, but.
Speaker 3: It went away so fast. You know what the funny
Speaker 3: thing was, and I've mentioned it is it is that
Speaker 3: cliche or I don't know a thing that people say
Speaker 3: the FED is going to keep hiking rates until something breaks.
Speaker 3: He's like, here's the break. It happened, and then it
Speaker 3: was like a blip. It's like nothing. And then the
Speaker 3: Fed kept hiking and stocks kept going up, and everyone
Speaker 3: forgot about it. So it's kind of weird that something
Speaker 3: that dramatic could happen and seemingly then just sort of
Speaker 3: get forgotten about kind of quickly.
Speaker 2: Well, one of the most dramatic things that happened out
Speaker 2: of all of that, I thought, was when they basically
Speaker 2: just guaranteed everyone's deposits, right, So we know at this
Speaker 2: point that you are supposed to have up to two
Speaker 2: hundred and fifty thousand dollars of your deposits at any
Speaker 2: bank or any bank that's FDIC guaranteed. Basically those are safe.
Speaker 2: If the bank goes under, you get that money back.
Speaker 2: But then we saw that Silicon Valley Bank went under
Speaker 2: and people had more than two hundred and fifty thousand
Speaker 2: dollars in their accounts and they got bailed out, which
Speaker 2: is kind of phenomenal. I don't think we talk about
Speaker 2: the deposit guarantee the aspect of that whole thing enough.
Speaker 3: We talked about it at the time, and I think
Speaker 3: this was the interesting thing, and you're right, this is
Speaker 3: the sort of the bigger thing that has been swipped
Speaker 3: under the rug, which is if all deposits and all
Speaker 3: US banks are implicitly federally backed, then do we need
Speaker 3: to rethink the business of banking? If this huge source
Speaker 3: of finance, if it's all guaranteed in the end, then
Speaker 3: it's like, why do we allow these banks to operate
Speaker 3: as there? That was a big question. We talked about
Speaker 3: it in March and April and May, and that's still unresolved.
Speaker 3: But people have really moved on from that question. But
Speaker 3: it really is fundamental.
Speaker 4: Not us.
Speaker 2: We are still living in spring of twenty twenty three,
Speaker 2: so I'm very pleased to say we do, in fact
Speaker 2: have the perfect guest to discuss this. You might remember
Speaker 2: we spoke with Stephen Kelly a couple weeks ago about
Speaker 2: how the way we're bailing out banks or supporting them
Speaker 2: with various liquidity facilities is changing. In this episode, we
Speaker 2: are going to be focusing on getting to a point
Speaker 2: where you don't actually have to bail out the banks.
Speaker 2: Let's just avoid this problem altogether. And I'm very pleased
Speaker 2: to say with us now we have a not at Madie.
Speaker 2: She is, of course an economist and professor at the
Speaker 2: Stanford Graduate School of Business. She has written prolifically on
Speaker 2: this topic for at least as long as I can
Speaker 2: remember at this point, certainly since the two thousand and
Speaker 2: eight financial crisis. And thank you so much for coming
Speaker 2: on all.
Speaker 4: Thoughts, Thank you so much for having me.
Speaker 2: You know, we needled Stephen a little bit when he
Speaker 2: was on the show by just throwing out the yes.
Speaker 2: So I'm going to do the equivalent for you and say,
Speaker 2: how do banks hold capital?
Speaker 4: Oh my god, that word is a trigger because because
Speaker 4: that word leads to so much confusion. So I'm glad
Speaker 4: you started with that. A senator would say it's money
Speaker 4: on the sideline. Newspaper articles explain it as cash like asset,
Speaker 4: and it's not true. What we're talking about this hold
Speaker 4: capital is not something that actually the banks hold. It's
Speaker 4: something that investors hold. In fact, what they do hold
Speaker 4: is those reserves in the Central Bank on which they
Speaker 4: get five point four percent. That's what they hold. That's
Speaker 4: what's out of the economy set aside. What we're talking
Speaker 4: about is just like deposits. On the funding side, we're
Speaker 4: talking about equity funding for banks, an amazing idea in
Speaker 4: banking that you would actually need any of it. And
Speaker 4: guess what they live like no corporation lives, and no
Speaker 4: corporation needs to live. But they're there because you know,
Speaker 4: I have a lot of research on leverage and leverage addiction,
Speaker 4: and it's just there at the point of such heavy
Speaker 4: indebtedness that they hate coming out.
Speaker 3: So when people think banks need to have more capital
Speaker 3: or hold more capital, in their mind, what they hear is, well,
Speaker 3: banks just need to have more cash set aside.
Speaker 4: That's what they say.
Speaker 3: But in the actual people who understand bank the idea
Speaker 3: of having more capital means that more of their funding
Speaker 3: needs to come from equity exactly.
Speaker 4: So it's all about whether you get your money by
Speaker 4: promising to pay back or not and your equity investors.
Speaker 4: I mean, I come from Silicon Valley, so you know
Speaker 4: who needs to borrow to have a thriving business. Lots
Speaker 4: of companies don't pay dividends, just grow and grow and
Speaker 4: grow and market value. And you know you don't need
Speaker 4: to borrow as much. And in banking, if you just say, hey,
Speaker 4: why don't you do something good with your earnings, such
Speaker 4: as you know, make loans instead, they're I want to
Speaker 4: take the money out, and they will threaten not to
Speaker 4: make a loan in the ridiculous campaign they're making right
Speaker 4: now about this buzzle endgame, where in fact, what they're displaying,
Speaker 4: and I like to talk about it that way, is
Speaker 4: every single symptom of extraordinary overhang or even insolvency at
Speaker 4: all times. In other words, these are the classic zombie
Speaker 4: symptoms that in another sector would lead you to a
Speaker 4: fraudulent conveyance in bankruptcy or something. You know that you're
Speaker 4: taking the money out, that you're always taking a risk.
Speaker 2: Maybe that's a good point to back up a little
Speaker 2: bit and talk about how you understand the banking business,
Speaker 2: because a lot of people will hear a statement like, oh,
Speaker 2: banks should hold more equity, they should have less leverage,
Speaker 2: and they would think, well, that's what a bank is.
Speaker 2: You borrow and then you leverage a business. Right, it's
Speaker 2: a leverage business. So like, what exactly are we talking
Speaker 2: about if it doesn't look like that.
Speaker 4: Okay, So banks are leverage business in the sense if
Speaker 4: we start from the basics that deposits put them in
Speaker 4: a leverage position right away. So by the time you
Speaker 4: take the positis, if we're talking about the posit taking banks,
Speaker 4: they already start with that, unlike a company, like in
Speaker 4: a corporate finance course, where we stuck with their own
Speaker 4: equity firm as a kind of a starting point where
Speaker 4: you're kind of investing your own money or your own
Speaker 4: shareholders money. So now you're already in an area in
Speaker 4: which the people managing the bank, so the extent or not,
Speaker 4: depositors are immediately conflicted with depositors over how much equity
Speaker 4: they would have, how much risk they would take. Because
Speaker 4: of the fact that the positors, ultimately if the bank
Speaker 4: defaults or if the bank goes into resolution or whatever,
Speaker 4: you know, they might get paid or not, but the
Speaker 4: bank walked away with the upside in any case. So
Speaker 4: from that point on, the banks hate equity. The bank
Speaker 4: er hates equity. So any leveraged equity holder has a
Speaker 4: resistance to leverage reduction. That's a pervasive phenomenon. And in fact,
Speaker 4: if you let them adjust leverage just once, it's not
Speaker 4: like we go to an optimal capital structure. Always up,
Speaker 4: always up. So that's the addictiveness of boring. Now, what's
Speaker 4: the business of bank There isn't a basic conservation in
Speaker 4: the world. It's not an irrelevancy. It's not that it's irrelevant,
Speaker 4: it's just relevant in different ways to society and to
Speaker 4: the banker. The banker hates equity. From their perspective, any
Speaker 4: bit of it, you know, is too much. From society's perspective,
Speaker 4: having a huge more equity funding is only good and
Speaker 4: not bad. And in fifteen years of asking the question,
Speaker 4: why are we even here? Why do they have single
Speaker 4: digit you know, depending on all their risk or its,
Speaker 4: we can get into that. Why are we here? You know,
Speaker 4: they didn't in the history of banking, and certainly relative
Speaker 4: to other corporations that are not regulated for leverage. Even
Speaker 4: though we subsidize that in the tax code, you don't
Speaker 4: see corporations like that. How do they ever get away
Speaker 4: with that? Oh? How they get away with it is
Speaker 4: the safety nets all these bailouts all the time and
Speaker 4: place it an explicity. And that's really it, because the
Speaker 4: conservation physics of finance that I'm talking about, of physics
Speaker 4: of money is there is risk to be born and
Speaker 4: taxes to be paid, and if you bear less of it,
Speaker 4: somebody else bears more of it. If you pay less
Speaker 4: of it, somebody else pays more of it. So the
Speaker 4: whole thing we're talking about is whether banks are subsidized
Speaker 4: to be leveraged, not just want to be leveraged, but
Speaker 4: encouraged to be leveraged by the system of taxes and subsidence.
Speaker 4: And therefore they're telling us that they should be getting
Speaker 4: all these subsidies blanket to their funding and then they'll
Speaker 4: do something good with it.
Speaker 3: So sometimes bailouts are explicit, like such as what we
Speaker 3: saw in two and eight, two thousand and nine with
Speaker 3: TARP and various programs. Sometimes I guess they're sort of
Speaker 3: implicit or the idea that well, we just sort of
Speaker 3: expect that something like that will come. What else, other
Speaker 3: than what we call bailouts, you say, through taxes, et cetera.
Speaker 3: What else encourages the demand for further leverage or the
Speaker 3: prioritization of debt financing versus equity financing.
Speaker 4: It's the compensation of the bankers. It's any this fixation
Speaker 4: with return on equity, which is only return on the upside,
Speaker 4: because on the downslide, when you have less leverage, you're protected,
Speaker 4: you're less negative. So if your actual realize returns are
Speaker 4: below your funding costs.
Speaker 3: Where does the fixation of return on equity come from?
Speaker 4: That? You know, I think that it's a proxy for subsidies.
Speaker 4: I think it basically means that if you compensate somebody
Speaker 4: based on return on equity metrics where you know it's
Speaker 4: always on the upside where its juices up returns, then
Speaker 4: by doing that, by going after the return on equity,
Speaker 4: they are basically doing what you know, maybe sharelders one
Speaker 4: to some extent, but certainly works well for the bankers,
Speaker 4: which is to maximize the subsidy, to maximize the leverage,
Speaker 4: because through the leverage you get more subsidies. That's part
Speaker 4: of that. The bailouts, by the way, is a really
Speaker 4: complicated system, and you even touched on the flobs on
Speaker 4: the federal home loan banks. It's basically an interlocking set
Speaker 4: of institutions that are either providing guarantees or investing lending.
Speaker 4: So it's either the central banks that would make these
Speaker 4: excessive loans that we should get into the bank lending
Speaker 4: programs and at the same time, you know, giving for
Speaker 4: a while higher interest on reserves, which is crazy, as
Speaker 4: well as the FDIC, which has started guaranteeing all deposits
Speaker 4: with extraordinarly dangerous situation and sometimes guaranteeing other debt. After
Speaker 4: the financial crisis, they let even newly created bank holding
Speaker 4: companies that were investment banks the previous day, like Goldman
Speaker 4: Sachs and Morgan Stanley guarantees on all debt. Now, of
Speaker 4: course they could go and raise money from investors guaranteed
Speaker 4: by the FDIC, which they can do cheaply, no strings attached,
Speaker 4: and return the top money the Treasury gave them with
Speaker 4: tiny bit of strengths attached. So it's basically a system
Speaker 4: between the FED, the FDIC and Treasury and fhlbs where
Speaker 4: there are sort of investments made in the so basically
Speaker 4: the prevention of default, that's a bailout. The third party
Speaker 4: comes in. You made a promise and somebody comes in
Speaker 4: and swoops in and prevents your default.
Speaker 2: I want to talk a little bit more specifically about
Speaker 2: the events of last year, because I think they're a
Speaker 2: good prism to view some of the things you were
Speaker 2: talking about through. But one of the interesting things is
Speaker 2: Silicon Valley Bank got in trouble. I don't want to
Speaker 2: say for doing the right thing, but they did go
Speaker 2: out into the market and say we're raising equity, and
Speaker 2: as you put it, you know, there's a reason why
Speaker 2: banks typically don't like to do that.
Speaker 4: So this is a great question, and it's a great
Speaker 4: way in fact to see what I'm saying. So what
Speaker 4: happens is they have definitions these days in the regulatory
Speaker 4: community of what a well capitalized bank is. It just
Speaker 4: so happened that both in the financial crisis and last
Speaker 4: spring and now banks are considered well capitalized by a
Speaker 4: lot of the banks that failed, including First Republic, got
Speaker 4: great camel ratings just before they failed, so they can
Speaker 4: say it's well capitalized. Now, why is that because the
Speaker 4: metrics are so bad, and the metrics include not recognizing
Speaker 4: fair market value on hultimaturity assets. So the bank is
Speaker 4: pretending to have these assets that they bought at power
Speaker 4: value even though they're losing value like treasuries. In addition,
Speaker 4: capital ratios depend on risk weights, and the risk weights
Speaker 4: ignore interest rate risk entirely, only credit risk. So a
Speaker 4: treasury needs no equity backing. So even if you buy
Speaker 4: you buy a treasury and you can do it, and
Speaker 4: one hundred percent of deposit money, well, the treasury can
Speaker 4: lose in value. What happened in Silicon Valley Bank was
Speaker 4: the following in banking in general. You know, being a zombie,
Speaker 4: being insolvent is Monday morning, Okay. What they're showing is
Speaker 4: symptoms to a corporate doctor like myself is every day,
Speaker 4: the symptoms of the more they hate equity with the
Speaker 4: passion they hate equity, the more things they have way
Speaker 4: too little of it. So that's that. Now, what happened
Speaker 4: in Silicon Valley Bank two things. First of all, they
Speaker 4: had to sell some assets, so this whole two maturity
Speaker 4: might not actually work out for you, and the assets
Speaker 4: are worth less as you have to pay more on deposits.
Speaker 4: The assets are worth less because their long term have
Speaker 4: big duration risks, and interest rates went down, so when
Speaker 4: they sold, they had to realize the losses. Sudden accounting
Speaker 4: rules that usually can allow you to hide the losses
Speaker 4: are forcing you to recognize the losses. So that was
Speaker 4: the first thing. Then basically, how would they survive. They
Speaker 4: were beginning to be more obviously more visibly insolvent. So
Speaker 4: the next thing that happens is they try to raise equity,
Speaker 4: as you said, and they couldn't. Now, if you can
Speaker 4: raise equity, if somebody not at the price you like,
Speaker 4: but at the price a penny a dime for your equity,
Speaker 4: then you might still be insolvent because there's only the upside.
Speaker 4: It's just an option on the upside because you can
Speaker 4: always walk away as equity. But if you cannot raise equity,
Speaker 4: then you're really deep in the water. So they're not
Speaker 4: raising equities like the ultimate nail in the coffin. In
Speaker 4: other words, you're definitely sold. At that point, the run
Speaker 4: was unavoidable because you know, of course, maybe by now
Speaker 4: that they've guaranteed effectively everything, maybe people won't run. And
Speaker 4: maybe we consider that kicking the can down the road
Speaker 4: as a good financial stability measures. But that is extraordinary
Speaker 4: dangerous because in the eighties we allowed all these zombie
Speaker 4: savings and loans to persist and raise money guaranteed by
Speaker 4: the taxpayers until you know, we have to pay for it.
Speaker 3: One of the arguments obviously against higher capital ratios or
Speaker 3: more equity is like, oh, this will be lead to
Speaker 3: an austerity of credit, that banks won't be able to
Speaker 3: do lending. And this is a big part of the
Speaker 3: push again to some of these rules that there's going
Speaker 3: to be less lending, etcetera. Why is that wrong? Interview?
Speaker 4: Well, first of all, they can make any loan. My
Speaker 4: first measure and my first emergency measure since the financial crisis,
Speaker 4: and you know I said this with twenty academics and
Speaker 4: lots of people is to retain them earnings and use
Speaker 4: them for loans. So what's the problem now? So I've
Speaker 4: been asking for fifteen years, tell me again what would
Speaker 4: go wrong if they retain their earnings? Just go take
Speaker 4: me through an argument and economic argument of how the
Speaker 4: economy would suffer. In other words, is their subsidies so
Speaker 4: big that God forbid, you know, they'll die? You know,
Speaker 4: if they'll die, you know, or they can't survive. I
Speaker 4: question their business model. If the busy, if the entire
Speaker 4: charter value that you like to talk about subsidies, then
Speaker 4: we have to question the business model. Just you started
Speaker 4: by saying, so my point is the following. If you
Speaker 4: tell them not a ratio, Actually I am against giving
Speaker 4: them ratios from where we are right now. You take
Speaker 4: them by the hand through issuance and retentions, because then
Speaker 4: they won't shrink inefficiently. Because a paper I wrote called
Speaker 4: leverg Bratchet actually shows the ways of deleveraging, and we
Speaker 4: show that there is a tendency to level as it
Speaker 4: saves or stopping to lend or whatever to through shrinkage
Speaker 4: versus expansion. Well, I will expand. These are monstrous banks,
Speaker 4: which I'm saying to expand only because I believe that
Speaker 4: once they live in markets, once they're in equity markets,
Speaker 4: they will break up on their own inefficient weight, because
Speaker 4: as conglomerates broke up in the AD, because we don't
Speaker 4: need such complicated institutions. I was, you know, back in
Speaker 4: doubles in twenty fourteen with Paul Singer of Everybody, and
Speaker 4: he says these are two opake. I cannot put my
Speaker 4: analysts on it and understand their risk. They would not
Speaker 4: exist in market as they are right now. Once you
Speaker 4: push them more and more into equity markets, it's equity
Speaker 4: marketer will give them the stress test. That's my stress test.
Speaker 4: My stress test is raised equity. Let's see at what price?
Speaker 4: What will investors say when they have to bear the downside?
Speaker 2: Is?
Speaker 4: Where is the upside? If you don't like that price,
Speaker 4: maybe that's telling us something.
Speaker 2: Since you mentioned twenty fourteen, I think that was the
Speaker 2: year when there was a New York Times profile about you,
Speaker 2: and I cannot remember the exact headline, but why is
Speaker 2: it in?
Speaker 4: This said? The whole story behind it, which I won't
Speaker 4: tell you all of it, but it was by ben
Speaker 4: in Minneapplebaum, who used to be a feder reporter who
Speaker 4: I first met when he was a federal reporter, and
Speaker 4: I won't go through all the details, but when he
Speaker 4: ended up writing the profile, it was entitled when she
Speaker 4: talks banks shutter Yeah, and what I say, So, I've
Speaker 4: asked a few times about that with people who've noticed
Speaker 4: the headline, and I say, oh, Jamie Damon slips like
Speaker 4: a baby. In other words, the headline is cute but false.
Speaker 2: But this leads into something I wanted to ask you.
Speaker 2: And I'm trying to think how to phrase this question
Speaker 2: without sounding hokey. But you know, you've been criticizing the
Speaker 2: banks and the regulators, models.
Speaker 4: And the regulators, especially for the banks do what they
Speaker 4: get away with.
Speaker 2: Yeah, for decades now, basically, and I guess it I
Speaker 2: have yet what motivates you to do this?
Speaker 4: Oh? Good, Such a good question because I often wonder
Speaker 4: that myself. Okay, so what motivated me in the beginning
Speaker 4: was you know, I sort of fell in a rabbit
Speaker 4: hole when I started looking into banking. I'm not just
Speaker 4: a corporate finance corporate governance person. And I look at
Speaker 4: those corporations which I was teaching my students for you know,
Speaker 4: twenty five years, what a wonderful market we have, and
Speaker 4: all of a sudden that market like what just happened?
Speaker 4: And then I look at them and I say, okay,
Speaker 4: I understand about corporations. We don't talk specifically about banks
Speaker 4: because that's something some other silo in economics, but if
Speaker 4: I look at them as a corporate finance person, and
Speaker 4: I say, what's the same and what's different about them,
Speaker 4: And all of a sudden, what's different about them is
Speaker 4: all bad. And what's different about them is what they
Speaker 4: get away with more than anything, you know, the specialness
Speaker 4: of banks is literally what they get away with. And
Speaker 4: then the politics of banking, that's what's special. And then
Speaker 4: I all of a sudden realized, you know, if nobody
Speaker 4: understands what the word means, if the regulators are standing by,
Speaker 4: if the politicians want banks to make some loans or
Speaker 4: some campaign donations or whatever else, and nobody is exposing
Speaker 4: the nonsense that we have in this space that pervades
Speaker 4: this space, that maintains and enables this to continue. So
Speaker 4: I was basically alarmed by people inside the FED that
Speaker 4: terrible things are happening in Basil when they were negotiating
Speaker 4: that agreement. And I was encouraged by people both inside
Speaker 4: some places in the FED and in the Bank of
Speaker 4: England at the time where I had most of my
Speaker 4: friends at the time when Mervin King was there, to
Speaker 4: get involved. And I truly didn't know what I was
Speaker 4: getting into when I agreed to do this. I was
Speaker 4: joking that I'm working for and the hell dying, you know,
Speaker 4: that kind of thing. So he was at the Bank
Speaker 4: of England at the time, and so was Mervin King,
Speaker 4: who gave us a blurb for the book, and while
Speaker 4: the governor of the bank. So there were big, fierce
Speaker 4: battles at the time post financial crisis about the topic,
Speaker 4: and I felt and I mobilized a lot of academics
Speaker 4: to help me, but it was very difficult work. You
Speaker 4: were at Financial Times at the time, Tracy, and getting
Speaker 4: through even the opinion pages against bankers is impossible, and
Speaker 4: that's the opinion pages now in the politics like forget it.
Speaker 4: So I began to really see the politics something I
Speaker 4: was not aware is so important in finance and how
Speaker 4: much it plays in banking. So I stayed in this
Speaker 4: debate just basically hating to be worn out more than anything,
Speaker 4: just not wanting for them, with the resources that they have,
Speaker 4: with the amount of lobbying and the amount of money
Speaker 4: that they spend across the political system and the regulation
Speaker 4: system and global institutions and all that, to kind of
Speaker 4: give up because I felt a sense of duty basically
Speaker 4: to society that I actually know something that's useful and
Speaker 4: it's my job to say. But anyway, I worked on
Speaker 4: it for five six years, and then I essentially wrote
Speaker 4: a few essays that were kind of putting it to
Speaker 4: bed around twenty fifteen sixteen, and that I'm back here
Speaker 4: is kind of almost didn't happen. It was a decade
Speaker 4: since the book was published.
Speaker 2: This book, the book, by the way, I should have
Speaker 2: said in the intro, it's the Banker's New Clothes, and
Speaker 2: you have a new edition coming up exactly.
Speaker 4: So the book edition just came out in January in
Speaker 4: the US, and the book got fat because of because
Speaker 4: we had to vamp a lot of stuff and take
Speaker 4: a lot of stuff out of the editing floor to
Speaker 4: explain more about central banks. So there are a few
Speaker 4: expansions of the material. The book is called The Banker's
Speaker 4: New Clothes. Was wrong with banking to do about it?
Speaker 4: The Banker's New Clothes refers to flood claims. So that's
Speaker 4: the list of which we now have forty four. But
Speaker 4: somebody just pointed me out to an add that was
Speaker 4: apparently in the football games, saying that grocery prices will
Speaker 4: go up and their mother won't be able to buy
Speaker 4: lollipop if you increase capital requirements.
Speaker 3: So I take it just an increase in capital requirement
Speaker 3: is probably in your view, necessary but not sufficient to
Speaker 3: a stable financy.
Speaker 4: It is the most no brainer thing.
Speaker 3: But what is an actual you know, we sort of
Speaker 3: tease Tracy said in the beginning, well, could we ever
Speaker 3: have a world where we don't have to have bailouts?
Speaker 3: And I'm kind of skeptical that that'll have? What would
Speaker 3: what would it take? Or what is the what is
Speaker 3: the basics of your prescription?
Speaker 4: So the basics of our prescriptions and we go through
Speaker 4: them extensively in the book. What to aim for, What
Speaker 4: to watch for as you do this, you know, is
Speaker 4: basically to maintain to aim at equity ratios that fluctuate
Speaker 4: between twenty and thirty percent of total assets. It's important
Speaker 4: because the risk weights are really the ones that reduce
Speaker 4: their assets by like a half or more in our
Speaker 4: gamed continuously and actually add to fragility because you give
Speaker 4: zero weight to government bond, you give zero risk wed it.
Speaker 4: They're actually anti lending the risk weights themselves. So that's
Speaker 4: a whole other can of worms. But we're against the
Speaker 4: risk weights, except maybe as a backup right now, it's
Speaker 4: the leverage ratio that is a three percent or maybe
Speaker 4: five percent ridiculous numbers that are missing a digit is
Speaker 4: we're not there, We're not close to where we need
Speaker 4: to be. And if people say the industry will shrink,
Speaker 4: I say, fine, that's maybe a feature not a bug.
Speaker 4: In other words, maybe the industry is two bloaded and
Speaker 4: two big.
Speaker 3: I mean, we talk about it on the show all
Speaker 3: the time. What if it's not a matter of the
Speaker 3: industry shrinking but migrating to what people call shadow Okay.
Speaker 4: And the forty four flood claims, all of it is there.
Speaker 4: You'll find the grab bag of them that they use.
Speaker 4: So what sort of not just people a little bit
Speaker 4: is the fact that all along two things are true
Speaker 4: about the shadow banking system. Number One, institutions in the
Speaker 4: shadow bankings that are not connected as much to the
Speaker 4: or not as obviously to the safety net to those
Speaker 4: bailout system actually fund with more equity. That was true
Speaker 4: for reads, and that was true for like thirty percent
Speaker 4: is common sometimes. And then now one colleague and a
Speaker 4: few other people have a paper about mortgage lenders which
Speaker 4: have to disclose some things in some states, and they
Speaker 4: analyze it and they show that lenders for mortgages that
Speaker 4: are not in the banking sector and are not regulated
Speaker 4: like banks have twice as much equity as the banks,
Speaker 4: So what's the problem lending with money that's raised however
Speaker 4: in markets? So and then the second point about shadow
Speaker 4: banking is most of the time, I mean, the ultimately
Speaker 4: the first incarnation of a shadow bank is money market
Speaker 4: fund right, So what ends up happening with shadow banking
Speaker 4: is most of it if you follow the money, is
Speaker 4: connected funded by et cetera, the banks in the end,
Speaker 4: So when you follow the money, you'll find the safety
Speaker 4: net someplace along the way. So money market funds are
Speaker 4: just creating another leg of intermediation. And then they can
Speaker 4: run on the banks, their investors can run on them,
Speaker 4: and then we couldn't you know, we opened up this
Speaker 4: bigot on them in COVID again because their reforms didn't work.
Speaker 2: You mentioned the initial round of Basil rules sort of
Speaker 2: posts two thousand and eight, and of course you've already
Speaker 2: touched on this as well. But we do have another effort,
Speaker 2: the Basil endgame proposal. Now, when we talked to Steve
Speaker 2: Kelly about this, he was like, well, why even bother
Speaker 2: talking about it, because like, for sure it's going to
Speaker 2: change from its current proposed form, but maybe with that caveat,
Speaker 2: can you talk a little bit about whether you think
Speaker 2: that's a useful revision of the rules.
Speaker 4: Well, I signed two comment letters on basil endgame and
Speaker 4: one on the long term debt proposal, which also kind
Speaker 4: of triggered me a lot. And I signed one letter
Speaker 4: by thirty academics who are kind of you know, friends
Speaker 4: of the FED supporting it, saying it's a step in
Speaker 4: the right the right And then in my own letter
Speaker 4: on it, to which I attached the previous version of
Speaker 4: these forty four flood claims and other writings and testimonies
Speaker 4: from the last fifteen years, I said, well, you know,
Speaker 4: I hope it's not endgame, because we will come back
Speaker 4: to it after another financial crisis, if not a bigger
Speaker 4: you know, it has to be very spectacular because obviously
Speaker 4: the last one didn't you know, affect it enough. In
Speaker 4: other words, it's really depressing how they always have these
Speaker 4: liquidity narratives and other things and focus on bailouts again
Speaker 4: instead of actually going and you know, DoD Frank said
Speaker 4: no more bailouts, and there's plenty of authority to do anything,
Speaker 4: certainly to do even a lot more here both the provision,
Speaker 4: which completely failed in this case, and on the target
Speaker 4: numbers and on making them more meaningful, because they're still
Speaker 4: not meaningful. So why are we talking about it? I
Speaker 4: would say, yes, these are kind of useless. Are they good?
Speaker 4: It depends how you enforce them. All of these rules
Speaker 4: end up not you know, if you look just at
Speaker 4: the radar that shows you these issues, you won't even
Speaker 4: know there was a financial crisis. The banks that needed
Speaker 4: the most bailout looked good all through the crisis, you know.
Speaker 4: And that's a study that was also done after the crisis.
Speaker 4: So the bottom line is, we don't like the metrics,
Speaker 4: we don't like the numbers, the range of numbers. And
Speaker 4: so I'm coming at it from completely the other side.
Speaker 4: I'm saying this continues to be poorly designed and inadequate.
Speaker 4: And in addition to this, I am not a hawk
Speaker 4: or other regulations. It's just this one is just correcting
Speaker 4: a huge distortion. It's only on the funding side. It's
Speaker 4: liquidity regulations that put money on the sidelines. It's the
Speaker 4: liquidity regulations that are costly in good times and useless
Speaker 4: in Iran, you know. So that's the problem. So a
Speaker 4: lot of living wills, complicated risk weits, stress tests like
Speaker 4: ever my stress test market stress test. So I'm totally
Speaker 4: into just bringing the funding into markets, and especially into
Speaker 4: equity markets. Start with that and the rest might look
Speaker 4: a little bit better.
Speaker 2: So one of the things that comes up when talking
Speaker 2: about the endgame proposal is the idea of you know, well,
Speaker 2: poor Michael Barr needs to build consensus. He has to
Speaker 2: talk to all these different stakeholders about like very technical
Speaker 2: and complicated things. Can you give us a little bit
Speaker 2: of color on your experience about how new banking rules
Speaker 2: actually come into being. I'm always curious.
Speaker 4: Oh, you know, the sausage making is amazing. So I
Speaker 4: was actually in DC and I met a few of
Speaker 4: the regulars, including Mike Barr. I think it's on his
Speaker 4: official calendar, so I can tell you that. And yes,
Speaker 4: and everybody was feeling very sorry for Michael Barr. I
Speaker 4: of course was feeling frustrated that he, you know, didn't
Speaker 4: speak more strongly. His first speech was okay, but afterwards, oh,
Speaker 4: we'll change it, will change it whatever. So anyway, I mean,
Speaker 4: I told him this to his face, you know, and
Speaker 4: offered my help to argue against all these flood claims.
Speaker 4: There's a manual of how to respond to all these.
Speaker 4: So here's the interesting things for monitory policy. The FED
Speaker 4: Board is always unanimous. Like you know, when Kevin Warsh
Speaker 4: objected to QAES, he basically had to leave. Honig would
Speaker 4: object from the Regional Reserve Bank on monitoring on regulation,
Speaker 4: they don't have to be consensus, so he needs four
Speaker 4: out of seven. And you know, some of the support
Speaker 4: was tentative. Some of the statements that the governors made
Speaker 4: were full of flood claims, and I didn't get a
Speaker 4: chance to meet all of them, but I would welcome that.
Speaker 4: So I just think there's a great confusion and a
Speaker 4: lot of politics and sort of ways of thinking and
Speaker 4: banking that are very entrenched, and so I don't know.
Speaker 4: I think you know, what this proposal ultimately is doing
Speaker 4: is not changing the top head numbers, but tweaking risk.
Speaker 4: Weits a little bit. And by increasing the risk, wait
Speaker 4: a little bit, that's a little bit or equity you
Speaker 4: have to have against a particular edset out of millions.
Speaker 4: Never mind that they don't take care of correlations and
Speaker 4: interest rate risk and other things, but just on the
Speaker 4: credit risk part. And so the banks are weaponizing this
Speaker 4: extremely disingenuously to make threats that you and you and
Speaker 4: you and you won't make it loan, which, of course,
Speaker 4: once they get the cheap funding, they'll do what they'll do,
Speaker 4: they'll maximize our e whatever. So the politics of it
Speaker 4: is really ugly. When I was in DC a couple
Speaker 4: of weeks ago, it was oozing from everywhere. The bombardment
Speaker 4: of lobbying was really shocking. It was never in the
Speaker 4: popular you know, on billboards and ads on your podcast.
Speaker 4: I mean, you know, I heard the ads on your podcast,
Speaker 4: Stop Basile Endgame. They have explainers on that website that
Speaker 4: are wrong. You know, students coming into my course just
Speaker 4: out of the corporate finance course, it's like you're saying
Speaker 4: that equity is expensive because it's risky. What's wrong with
Speaker 4: all these companies that have plenty of equity and I
Speaker 4: don't choose to borrow even though there's no regulation. What
Speaker 4: are you talking about? This is absolute bread and butter finance.
Speaker 4: Leverage and risk risk and return required return is completely
Speaker 4: bread and butter. And so that's when you're even in
Speaker 4: the right side of the balance sheet and not on
Speaker 4: the cash reserve thing. It's crazy stuff.
Speaker 3: So we could say, okay, banks could be safer in
Speaker 3: a world in which they're much more equity finance. What
Speaker 3: about coming from the perspective of creditors to the bank.
Speaker 3: So there's certain capital that exists in the world that
Speaker 3: seeks out bank ponds, insurance companies, pensions, things like that
Speaker 3: may have a lot of demand for bank credit assets.
Speaker 3: Where does that money go in different world?
Speaker 4: So are you talking now about the people who are
Speaker 4: customers who are boring front them? Okay, great, great subject. Okay,
Speaker 4: So here's the thing. Here's what's amazing about banks, and
Speaker 4: here's the real abnormality of the bank the deposits of which,
Speaker 4: by the way, JP Morgan Chase now has two and
Speaker 4: a half trillion dollars. Okay, that is money that is
Speaker 4: a very unusual debt because it has no collateral. This
Speaker 4: is important to understand, no collateral, but has insurance, which
Speaker 4: effectively is now almost unbounded. So what happens is that
Speaker 4: the depositors are almost all the time completely passive. I mean,
Speaker 4: if they'll panic one day, but they are always just
Speaker 4: telling them not to panic and just go about their business.
Speaker 4: So they sit there. Now, once you have this funding,
Speaker 4: it's a good time. It's a good life because you
Speaker 4: can use the assets collateral for the other lenders. And
Speaker 4: the other lenders come in and they have collateral to
Speaker 4: their name short term lending, so they feel they can
Speaker 4: almost like depositors, take the money out with droid and
Speaker 4: they have safe harbor laws that in a bankruptcy they
Speaker 4: can actually walk away with a collateral. So if they
Speaker 4: including the federal home loan banks, including even if they've fed,
Speaker 4: they are safe. So in the ratcheting of leverage and
Speaker 4: in the sort of race toy. So there's another related
Speaker 4: paper saying that there's a race to shorten maturity, and
Speaker 4: then of course there's collateral races. What you have is
Speaker 4: the ability to keep shortening maturity and to keep giving
Speaker 4: collateral as a way to favor new lenders over old lenders.
Speaker 4: And the most passive lenders to take advantage of are
Speaker 4: the depositors and those who back them. So that's what
Speaker 4: actually happens in the economics of it. Your ability to
Speaker 4: ratchet up your boring and the ability of your lenders
Speaker 4: to both chase their own returns, and we can talk
Speaker 4: about you know, returns offered on cocoas and all of
Speaker 4: that which in the end wink wink not and not
Speaker 4: actually absorbing lostsses. And we didn't mention credit twists in
Speaker 4: last year's events in the spring, which happened a week
Speaker 4: or nine days after Silicon Valley Bank, and that was
Speaker 4: a spectacular event in the world of banking of big
Speaker 4: systemic institutions, that requires a lot of a whole discussion,
Speaker 4: and we might not have time for. But all the
Speaker 4: talk in the same you know a couple of years
Speaker 4: that I went to Davos about how we and have
Speaker 4: bail ins instead of bailouts and all these teal action
Speaker 4: long term debt proposal, which completely triggered me over the
Speaker 4: Martin Luther King Weiken when I was preparing these comment
Speaker 4: letters once again extraordinarily exacerbated that I even have to
Speaker 4: do this totally groundhog They they don't, they don't. As
Speaker 4: Tom Honing likes to say, why are we solving a
Speaker 4: problem of too much debt with more debt? If you
Speaker 4: have equity instead of the long term debt, instead of
Speaker 4: this title loss absorbing capacity, you would not get to
Speaker 4: that level. If Silicon Valley Bank had twenty percent equity,
Speaker 4: would absorb those losses from interest rate decreases. If credits wiss,
Speaker 4: you know, more meaningful, I'm saying, better measured equity, we
Speaker 4: wouldn't be here.
Speaker 2: I just remember in the first time I ever wrote
Speaker 2: about contingent capital, it was on FT alphavel and even that,
Speaker 2: you're right, there was this discussion about like whether or
Speaker 2: not it would actually get used in an emergency. But
Speaker 2: maybe just to help us understand the argument, you know,
Speaker 2: it's so hard even for me and I've been covering
Speaker 2: financials for a long time, to imagine a banking business
Speaker 2: model where they're not borrowing and lending and highly leveraged.
Speaker 2: So I want to ask, like, is.
Speaker 4: Heaven twenty percent equity and seven seventy or eighty percent
Speaker 4: debt allows you to do all the boring and lending
Speaker 4: you need to do. Is it allows you to take
Speaker 4: all the deposits, allow you to make all the loans
Speaker 4: you make?
Speaker 2: I take the point, But what I want to ask
Speaker 2: is like, if you think about your ideal banking system,
Speaker 2: what does it look like. Does it exist somewhere in
Speaker 2: the world already or has it existed in the past.
Speaker 4: Has it existed in the past. Definitely before safety in
Speaker 4: it first of all, when banks were partnerships, not even
Speaker 4: limited ability corporations. They had fifty percent equity and unlimited
Speaker 4: liability for the Jamie Diamonds the of the world. In
Speaker 4: other words, there was the all money and they had
Speaker 4: to be the ones ensuring depositors. Back in the nineteenth century.
Speaker 4: You know, the depositors won't trust them, otherwise somebody had
Speaker 4: to back it up. We go into a world in
Speaker 4: which we introduce after runs and panics and all of that,
Speaker 4: we introduce the posit insurance, we introduce its central banks
Speaker 4: for that so so equity for example, you know when
Speaker 4: they started FDAC banks in Kansas, for example, they didn't
Speaker 4: want FDS insurance and they had twenty percent equity. So
Speaker 4: in the history of banking, you know, in the start
Speaker 4: of the twentieth century banks that twenty thirty percent equity.
Speaker 4: So it's not unheard of. The equity markets are more developed.
Speaker 4: If they have a business model, there are investors who
Speaker 4: will give to them at their appropriate prices. They just
Speaker 4: don't like those prices because what they're telling equity investors
Speaker 4: is to take on risks right now on other people,
Speaker 4: including governments and taxpayers. So the point is, you know,
Speaker 4: my banking system would look a lot safer, and all
Speaker 4: the de leveraging that would happen would happen much lower.
Speaker 4: You'd have a lot more time to intervene as you
Speaker 4: see losses mountop. If you're looking, somebody should look. If
Speaker 4: it's not going to be the investors, it's going to
Speaker 4: have to be the regulators. And that's all these to it.
Speaker 4: It's not rocket science, so you know, and on on
Speaker 4: contingent capital. There has never been an argument why at
Speaker 4: the point of the you force them to issue those
Speaker 4: because they also don't like those because maybe the long term,
Speaker 4: you know, unsecuredy investors might ask a question or two
Speaker 4: about the off chance that they would lose they you know.
Speaker 4: In an interview in twenty thirteen, Stump, the SEAO of
Speaker 4: Wells Fargo, said, we have a lot of retail deposits
Speaker 4: and therefore we don't have a lot of death And
Speaker 4: I had a deposit with him, so he even forgot, Like,
Speaker 4: you can't make up the nonsense they say. So bottom
Speaker 4: line is, you know, get the equity, retain the earnings,
Speaker 4: and come back you know later.
Speaker 2: All right, and not at MADI. It was so great
Speaker 2: to finally speak to you on this podcast and the
Speaker 2: new edition of the book, The Banker's New Clothes is
Speaker 2: out now, So thank you so much.
Speaker 3: Thank you, thank you.
Speaker 4: That was great.
Speaker 3: It was a lot of fun. Thank you so much, Joe.
Speaker 2: I'm glad we did that conversation. Yeah, obviously there is
Speaker 2: still a lot more to say about banks, not just
Speaker 2: about how we bail them out, but maybe getting to
Speaker 2: that place, as a not mentioned, where they don't need
Speaker 2: to be bailed out on a regular basis.
Speaker 3: I thought that was really interesting. I mean, there are
Speaker 3: a few things that stuck out to me. One is
Speaker 3: just sort of this idea of examining banks is if
Speaker 3: the regular businesses is starting from the premise that, okay,
Speaker 3: this is a business, and we have all these successful
Speaker 3: businesses in the world that do not especially you know
Speaker 3: in Silicon Valley, that do not have particularly much credit financing,
Speaker 3: and yet they work, and so the question is like,
Speaker 3: starting from that standpoint, wire bank so much different, and
Speaker 3: how does that contribute to the risks? I also thought
Speaker 3: it was interesting her point that actually shadow banks are
Speaker 3: things that we call shadow banks, lenders that aren't necessarily
Speaker 3: part of the regulated bank system, in fact do hold
Speaker 3: more equity was very intriguing to me and to the
Speaker 3: idea that not only did they naturally hold more equity,
Speaker 3: but also presumably they wouldn't be as systemically important because
Speaker 3: of the lack of depositors. That's an interesting observation about
Speaker 3: how banks or financial institutions outside the regulated system work well.
Speaker 2: And they seem to be doing reasonably well right now.
Speaker 4: Right.
Speaker 2: I haven't looked at like a publicly traded BDC share
Speaker 2: price lately, so you know, don't at me if this
Speaker 2: is completely untrue. But we talk about the golden age
Speaker 2: of private credit all the time and how quickly that
Speaker 2: industry is expanding, and in many ways they're doing the
Speaker 2: same thing that banks are, just without I guess the
Speaker 2: regulatory requirements attached to that, but also the funding benefits.
Speaker 3: This idea of the obsession with return on equity, it
Speaker 3: almost sounds like, you know, a conspiracy between bank executives
Speaker 3: and the shareholders, right, which is obviously the shareholders don't
Speaker 3: want to get diluted by having more equity, and the
Speaker 3: executives want their salary to be tied to how much
Speaker 3: can they how much profits can they make on the equity,
Speaker 3: et cetera, but not necessarily being in the best interests
Speaker 3: of society and.
Speaker 2: Techpositors who just want their money back.
Speaker 3: Yeah, exactly, Now, a lot of interesting ideas there. I'm
Speaker 3: glad we had her on.
Speaker 2: All right, shall we leave it there?
Speaker 3: Let's leave it there.
Speaker 2: This has been another episode of the Odd Thoughts Post podcast.
Speaker 2: I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 3: And I'm Jill Wisenthal. You can follow me at The Stalwart.
Speaker 3: Follow our guest ant Admodi at a not Admati, and
Speaker 3: check out the new edition of her book, The Banker's
Speaker 3: New Clothes. Follow our producers Kerman Rodriguez at Kerman Erman,
Speaker 3: Dashel Bennett at Dashbot and Kilbrooks at Keilbrooks. And for
Speaker 3: more odd Laws content go to Bloomberg dot com slash
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