foreign [Music] as you know it’s badly four weeks in Silicon Valley Bank abruptly collapsed it’s not even four weeks actually today and two weeks ago even while events were still unfolding and Signature Bank and First Republic Bank had come into thread Stern held a panel discussion on what we were seeing in the data in real time this and since then of course we’ve had the Credit Service event and and continued stresses in the banking sector although for the nons things look like they’ve come down a little bit um so the finance department after the panel the finance department Stern put together a white paper group and this panel discussion today is going to discuss their preliminary findings that will be reported shortly as some of you may know during the financial crisis 15 years ago the department put together a group very rapidly and came out with several books on the on the topic most of which copies of which are here if any anybody would like a history lesson the copies of the books they produced and the lessons they produced from that period are here so but with that let me turn it over to Jillian Ted one of the world’s leading Financial journalists we’re very lucky to have her here to moderate the discussion over to you Jillian well thank you very much indeed I must say I feel Roger I feel a bit like I’m trapped in Groundhog Day because it was really in a couple of years after the financial crisis that I first started coming to NYU CERN and took part in a number of seminars back then about what had happened in the great financial crisis the GFC um as they called it and of course back then there were lots of pledges that this would never happen again that Regulators would reform the system to make sure it was going to be Rock Solid going forward and that all of those bankers and financiers and investors had learned the right lesson and were going to be much more risk averse going forward well fast forward to today and it clearly didn’t work because of course we just had this dramatic explosion of panic last month the so-called March Madness now on the way here I was actually on the phone to the CEO of one of the biggest banks in America who was trying very very hard to tell me that all of what happened in March was down to quote idiosyncratic issues that’s the new buzzword or Mantra from all the big Banks who have survived and the ones who actually in some cases are actually thriving that is all down to idiosyncratic stuff Jane Fraser from the city said that again last week in Washington and it’s a way of saying it ain’t us Ain’t Us gov those people at Silicon Valley Bank massively mismanaged everything they were stupid and it should be said there’s a certain amount of Wall Street and financial tribal Prejudice going on on both sides which is that most Bankers who have grown up in Wall Street think that those techies are kind of weird Martian aliens who all look like Mark Zuckerberg and kind of had it coming to and most techies think that Wall Street Bankers are as boring as anything they can imagine and very fuddy Daddy and they’d far rather think about computer science than boring things like cash management which of course is one reason why we’re here today so lots and lots of arguments and it’s all down to quotes idiosyncratic factors a few bad apples and the system is basically fine so we have an amazing panel to tell us whether this is right or not um known to all of you the NYU all singing all dancing financial disaster team Philip Schnabel at the end we have Larry what sorry Larry white and Varela charia who are going to present their research and we’re going to start with Philip or Philippe so over to you Philippe tell us whether it is indeed just all an idiosyncratic issue or not perfect um this guy perfect so um it truly does feel like Groundhog Day I remember coming here to student 15 years ago right when the last financial crisis started I just graduated uh I’m different from PhD and it was a very exciting time to be here to learn about Banks and I think we’ve learned a lot since then and what I want to share today is talk a bit about what banks usually do when they think about interest rate and interest rate risk management so I’m not gonna talk about s3b um credit but what I’m going to think about is what the other Banks should do and I will give some Clues on whether they got it right in terms of managing the risk in the face of changing interest rates so let me start by describing what’s the problem so the problem is the following so since you know 2021 early 2022 in order to combat inflation the Federal Reserve has raised short-term rates think of the FED funds rate by 4.5 percent now when you raise short-term rates you hope that long-term rates going to go up because they reflect the expected future short rates and so they did they went up by around 2.5 percent now what’s the problem for banks well Banks hold long-term loans and securities uh roughly 17 trillion with an average duration of four years now it’s actually straightforward to calculate what’s the market value loss if interest rates go up given this duration given this size all you have to do is you multiply the change in the long-term interest rate the 2.5 percent with the duration which is four and the size of the balance sheet which is 17 trillion so that means the fair market value of the long-term assets actually declined by 1.7 trillion now two things about this number first of all it’s not hidden um you know we know what’s the duration of Bank assets it’s not complicated it just took me one line to calculate this now um second point about this number it’s large it’s actually larger than a lot of the numbers floating around the reason for that is the numbers which are floating around only look at Securities but loans are also long-term asset just because they’re not traded doesn’t mean they didn’t lose the market value because of raising interest rates and so this number is very large and it’s roughly the size of Bank equity which is 2.2 trillion so if you hear these numbers you’re going to be very void you would say well that means banks are basically bankrupt and so you know the equity value should have gone down to zero if you actually look what happened to bank stocks and here I’m plotting a bank stock index what you see is that bank stocks actually have held up pretty well as the Fed was Raising interest rates um and you know yes we had a crisis we had terminal in March and then down 25 but nothing close to what my calculation suggests so clearly there’s something else going on with these Banks such that they’re actually holding up reasonably well even though they face such a big problem with the asset side so what’s the reason well it’s the deposit franchise what’s the deposit franchise well what makes Bank Specialists they land long and the borough should it’s important to understand how the borrower should the borrower should patient deposits now people households businesses they like deposits because they’re convenient they’re safe and they need them to transact and so um you know depositors are willing to accept very low deposit rates so Banks know that when rates go up deposits become much more profitable for banks the way Banks measure that is with what they call deposit beta which is only 0.2 what’s the deposit Behavior well it tells the deposit rates only go up by 0.2 percent for every one percent increase in the FED funds rate so what that means is they’re going to keep 0.8 or 80 percent of the increase for themselves that’s what makes them profitable so it’s easy to see in this picture here in this picture you’re going to plot the deposit rates for the main categories of deposits this is checking savings and CDs or time deposits what do you see interest checking basically pays nothing even though the FED funds rate has been going up savings which is the main category of deposits now pays something like 40 basis points so 0.4 percentage points still very low and CDs pays a bit more it’s still small it’s growing but something on the order of 1.4 1.5 percentage points what that means is the difference between these colored lines and the black line that’s the profit for the bank in terms of a deposit spread now that means the deposit French is actually the Hedge against Rising interest rates on the asset side so you can easily put a number on that Banks roughly have 17.5 trillion in deposits the average deposit rate now if you kind of weigh it by the right size it’s 0.9 percentage points so what’s the spread well it’s the 4.5 percentage points which is the Fed funds rate minus the 0.9 so that’s the 3.6 deposit spread which banks on average the system of all is making right now now you said large is that small well multiply 3.6 percent with the size of the deposits and basically the increase in income from deposit is 630 billion per year so that’s what makes them profitable so if you think about the problem I described three years of that deposit income it’s enough to make up for these asset losses so deposits went from being extremely unprofitable to extremely profitable now if you use historical deposit betas and I’ve done the calculation together with my co-office it suggests that there is actually full offset now that depends on behavioral assumptions there’s uncertain exactly how you value this but that can explain what bank stocks actually have been holding up uh reasonably well now did Banks just figure that out well there’s an easy way to see whether Banks can get that right and if you looked at svb you would see that they wouldn’t get it right basically what the bank has to do is that to make sure that the change on the asset side is assets are rolling off and resetting to new interest rates that that change is the same on the deposit side so they’re matching what we have sort of an incumbent on the asset size of this deposit beta and that means the net interest margin going to stay stable as interest rate change banks have been doing this for a long time so here I’m plotting the net interest margin for the banking system of all going back to the 50s and when you see this red line it’s stable even though interest rates are moving up and down so you know we’re avoided by the rise of interest rates uh five percentage points you know if you put that in the context of History this happens all the time you know you go back to the Voca area you know raise the interest rates all the way up to 16 percentage points and so banks are used to this and if they get it right they are able to keep the net address margin stable and that means you know the banking sector would actually be fine now obviously there’s some risks um this deposit hatch only works if most of deposits stay with the bank a kind of two separate risks the first risk which is uh materialize in March is depositors may run on the bank especially if they’re uninsured well if they run on the bank that’s going to destroy the deposit franchise the Hedge going to fail it’s not going to be there anymore and you know basically the bank going to be bankrupt that’s one risk the other risk is well deposits May wake up to the fact that they’re actually paying a lot for these deposits and so they might start seeking out higher paying Alternatives like money market funds or other um you know short-term assets which pay a competitive yield so if that happens the deposit beta is going to go up and it wouldn’t be as good of a hedge at that risk it looks like it’s larger for regional Banks because they are seeing a lot of the outflows a lot of the outposts actually go to the large banks in some sense the large Banks actually might be better off that betas actually might go down because people are going there for safety but overall the key risks going forward uh is basically what’s going to happen to this deposit franchise now I don’t have the answer but I have two Clues on what has been happening so far so one thing you want to look at is what about deposit flows from small Banks to large Banks so here I’m plotting the change in deposit growth in billion for a large versus small Banks what you see is sort of this Spike here in the week after you know Silicon Valley Bank failed there was definitely a run from the a small bank so that’s in blue roughly 160 billion going to the large Banks now if that continues that might be the end for the mid-sized Banks it looks like it stopped last week presumably because of the measures the government has taken so we’ll see whether it’s going to go forward but at least for now that situation has stabilized now importantly these deposits stay within the system they’re just sort of moving around that’s going to cause some trouble for the mid-size slender lesser for the large Banks but the large Banks I’ve worried about is the deposit leave the system of all and go for example the money market funds so what happened with money market funds well what’s important to know is deposits have been flowing out to money market funds since the FED started raising so here I’m plotting uh retail money market funds so you can succeed them here in blue they’ve been going up at 35 percent since the FED started raising um here the deposit of the banking system they have been going down by like roughly five percent that’s because money market funds are much smaller than the banking system that’s normal monetary policy it’s called the deposit channel of monetary policy there’s nothing unusual about that that happens in every single cycle and I have some work sort of going back in time documenting that now the problem is for the banks this accelerated after Silicon Valley Bank failed so it went from something like 20 billion per week which you want to think of as The Benchmark uh 216 billion that’s six times as large still not much in terms of total deposit less than one percent but if that continues week after week that would be a big problem for the large Banks now it looks like last week it started to come down now it’s 60 billion still three times as large as before if it continues to come down the big Banks is only going to be fine in terms of the deposit franchise if it stays that high or gets high again you know then even the large Banks gonna be in trouble they’re gonna have to reevaluate the value of the deposit franchise the values are hedge probably means the market actually going to go down and potentially would see them lending less I wouldn’t be so worried about them going bankrupt but there could potentially be less equity and you know potentially a credit crunch okay um I will hand it over to Larry oh thank you that was an excellent masterclass in making sense of the plumbing of banks I often think these institutions a bit like some kind of Heath robinesque machine where you pull on one lever and something quite unexpected happens at the other end which takes a while to kind of see the transition mechanism but anyway now Larry is going to tell us his perspective um and he’s had a fantastically interesting background to talk about this because you were actually at not the FDIC as I thought but the head Federal home loan banking system during the Savings and Loans crisis and so that is not just groundhog day but groundhog Groundhog Day I think alas that is so um so pleased to be here pleased that you’re here and wish we weren’t talking about this uh But Here we are now like any good business school Professor I got to tell you what I’m going to say and then I’m going to say it and then I’ll tell you what I say um now um I’m not making this up when I heard Jillian talk idiosyncratic the first thing I heard was idiot okay and that’s what I think about what was going on here um the basic story is Silicon Valley Bank was borrowing short lending long in the finance World they call that the carry trade uh it’s what the snls were doing in the 1970s it’s a good way to make a living as long as interest rates stay stable or go down if they go up as they did in the late 70s and early 80s and it’s going to cause problems that’s what the snls Learned that’s what Silicon Valley Bank learned and I can’t not point out that Gap accounting makes it harder not impossible the data are there but it’s muffled uh and I’m going to come back to that other problems over 90 percent of Silicon Valley Banks uh in deposits were uninsured which meant they were highly runnable they had an undiversified lending base they had an undiversified deposit base and they had grown rapidly over the space of four years their assets grew by a factor of two and a half in the space of two years they grew who they more than doubled and here we are at a business school our management folks could tell you rapid growth is going to create stresses and strains in any organization they had inadequate capital and liquidity for the risks and as we’re unpeeling the onion we’re learning inadequate monitoring and supervision by the Federal Reserve Bank of San Francisco now the word capital is going to be used over and over again today Philip already mentioned it viral is going to be talking about it as well and so I’m going to give you a quick primer I mentioned this to Jillian alas even in the world of financial journalism one sees NIS characterizations of capital and it’s often identified with cash or money or even identified somehow with liquidity what it really is is basically owner’s equity or net worth it’s the arithmetic difference between the value of the assets and the value of the fixed liabilities and how those as values are measured is really really important and let me just go ahead here simple balance sheet okay I’ve stylized everything so that the assets are a hundred and what are those assets their primary loan primarily loans of various kinds or bonds which are basically alone and what are the primary liabilities they are deposits and notice as Philip said just a few minutes ago those loans are longer term those deposits are short-term and they are runnable the difference between the two it again measurement matters but suppose those values really are right is the owner’s net worth or uh in the banking world we call it capital and that’s what a solvent Bank looks like and just to point out what does an insolvent Bank look like it looks like that the value of the loans is no longer adequate to come cover the obligations to the depositor liability holders this is an underwater this is an insolvent in the outside of the financial world we would call this bankrupt uh that’s the nature of the problem all right so why is capital important if first we’re in a system of legal liability by the owners so those liability holders can’t go after the owners they only have a claim on those assets on the books of uh on the book of the bank it’s a cushion you know again think of what’s going on here it’s a cushion against losses if the assets go down in value at least up till a loss of eight there’s still a positive net worth there’s a cushion the bigger the capital level the bigger the cushion uh it’s a deterrent to taking risk because the owner has more foreskin in the game the bigger is the capital value lenders and again depositors are lenders to the bank should always be worried about the adequacy of the borrowers of the um uh bar right the bank is borrowing from the depositor the borrower’s capital and how do we measure this thing I’m going to come back to this it should be on a market value basis all right so are there other problems uh lurking in the financial system and the answer is yes and you’re going to see a bunch of charts I have shamelessly borrowed these from viral you’re going to be seeing some of the same um diagrams and charts in viral’s presentation first are there other banks with substantial unrecognized losses on their balance sheet yes there they are those are their stock market tickers you could uh readily look up and see where they are by the way this I’m happy to send this slide deck to anybody who would like it or I I had my email on the cover slide or you can just find me at Stern don’t look for me at George Mason University that’s the other Larry white I’m the Larry white at uh Stern I’ll be happy to send you the slide and continue in this conversation so there are other Banks where there are substantial not as bad as Silicon Valley Bank but still other banks with that in a sense their balance sheet over importantly overstates their actual uh capital and in aggregate just if we look at Securities the aggregate is a shade at the end of 2022 a shade over 600 billion dollars as Philip mentioned the aggregate net worth capital in the banking world is about 2.2 trillion so that’s over a quarter and as Philip pointed out if you looked at the real value of their other loans which are if they were marked to Market in a similar way we would be looking at not 600 billion but one 0.7 trillion dollars of um you know lost value not quite wiping out the banking net worth but coming too close all right what else other banks have high levels of uninsured deposits let me scroll through here there are these Banks again their Stock Market ticker and their percentages of uh uninsured deposits and you know here are banks with 40 and 50 percent uninsured deposits at least one thing in the Savings and Loan debacle almost all of the deposits were insured we didn’t have runs problems here you can see the potential for runs Problems by uninsured depositors and contagion when a one when a set of depositors in another bank start getting nervous when they see depositors in a First Bank starting to withdraw their money or you know I said c I still have these images of people lining up outside a bank of the 1930s or 1940s and nowadays all they have to do is see some social media with uh individuals saying hey I’m not so sure about the credit worthiness of the XYZ bank and suddenly you can have a run and then Contagion okay well what else are we talking about the overall banking system has reduced its capital to asset ratios since 2017 and here you can see those data again viral is going to show you the same slide things going downhill after 2017.
And remember this is the reported net worth it doesn’t include those embedded unrecognized losses things would be a whole lot serious more serious if those were included um contagion problems are real again in a world of social media you gotta worry about contagion uh and it’s not just the big banks in fact there probably is less of a problem with big Banks it’s those small and medium sized Banks and then the cherry on top of everything else commercial commercial mortgages lending on Commercial Real Estate historically this has been a problem for commercial Banks it was true in the 1980s it was true again around the period of the great financial crisis of 2008 what did in the commercial banks that failed uh it was commercial real estate somehow these guys keep on making too many loans and not good enough loans to Commercial Real uh to commercial real estate borrowers and we as we know it’s hard to figure out what’s going to be happening with commercial real estate but it’s probably not going to be a rising asset over the next few years all right so what needs to be done increase Bank Capital levels generally more Capital measure that Capital better Mark to Market or market value accounting the accountants would call it fair value let’s get realistic values on to bank balance sheets rather than the pretend values that current Gap accounting uh provides I’m in favor of increasing Deposit Insurance levels not because I’m all that sympathetic to people who have above 250 000 in a bank I’m primarily worried about contagion that if you have uninsured depositors there they can run and again in a social media world they’re more likely to run we have contagion problems it would expand the ability to release more what is now confidential information the camel’s rating the ratings that the bank supervisors give to particular Banks and you will hear anytime somebody like me says expand Deposit Insurance somebody will yell yeah but the moral hazard problem the moral hazard problem that’s a red herring depositors time and time again have not been good monitors of banks instead let’s get better on in addition to The Regulators better monitors uh subordinated debt or some other kind of non-runnable debt with knowledgeable holders who have some governance rights it’s longer term and can’t be run that’s the way we get better monitoring of Banks and of course we need to improve I mean just everything that’s coming out about the federal Home Loan Federal Reserve Bank of San Francisco they weren’t doing their job we need better paid better staff better trained better managed and so my conclusion how can one not quote ROM Emmanuel uh on on this don’t let a crisis go to waste thank you and again I’m happy to carry on this uh you know how to reach me happy to continue for all well thank you Larry that’s really helpful I must say I love your comment about even Financial journalists don’t understand Bank Capital um I take that as a rather flattering um backhanded compliment um I’d say many journalists should you understand banking yeah I mean why everybody else coming up I mean lots of questions there I mean one of the questions I’m dying to ask in a moment is whether you think rather than lambasting the fed that’s clearly been asleep at the wheel shouldn’t we just add the whole thing to the OCC who at least have the merits of looking at the world from a bottom-up perspective and having tracked interest rate risk rather well for many years but anyway think about that one the route over to you okay uh thank you everyone for being here uh so I think Philippe and Larry have made a couple of really excellent points one is that the real issue seems to be about the large stock of uninsured deposits that sitting around in the banking system and that uninsured depositors run they might be lousy monitors but once they they hear that there is a problem they definitely vote with their feet and switch either to money market funds or to better Banks as Philip pointed out and I think you can see this issue in data if you look at the several monetary tightening Cycles in each cycle on the x-axis you’re looking at how many months we are out as Philip pointed out Banks do lose money during the rate hikes to money market funds because they are a bit slow in raising rates for saving their franchise but this time there’s something else going on in the red line which is that the pace of losses to money market funds is anywhere a bit fast perhaps that can be explained by the pace of the rate hikes in the first place but then you see around month 11 that there is a very very further steep increase and that has something to do with the fact that now an uninsured depositors are not just talking because of just some interest rate considerations they are actually leaving the banks they are voting with their feet on banks that they are not very comfortable about so the question is do we need to think a little bit about how did this talk of uninsured deposits came about in the first place and I think it’s important to to think about that a bit right and uh my my sense based on my prior research is that there’s something to do with the scale of unprecedented monetary and perhaps to some extent fiscal expansion that we had after the pandemic uh so I’m going to do a couple of things I want to First explain to you why quantitative easing which is an expansion of the central bank balance sheet typically also lead to an expansion of bank balance sheets okay this is a somewhat underappreciated fact which is that we keep saying fed is expanding its balance sheet fed its balance sheet is now 8 trillion dollars Etc but we don’t recognize that when that expansion happens commercial bank balance sheets are expanding as well and I want to explain why that happens and importantly I want to clarify that this expansion of commercial bank balance sheets happens indeed with uninsured deposits okay which is that it’s this combination of expansion of commercial Banks and expansion with uninsured deposits which is a feature of quantitative easing as I’ll show you in fact my co-author raghuram Rajan and others but Raghu presented this in Washington DC where Megan green of the Ft actually wrote about it saying that this is going to become like a hotel California problem for for the FED because if you expand by creating uninsured deposits in Banks you know some concern about Banks runs will materialize now the FED has to start injecting liquidity all over again and you just can’t get out you are now trapped in this large balance sheet size and and the key point is that this we we did have cycles of quantitative easing and tightening over the last decade so why is this time special this time is special because it’s magnified okay it’s all about the scale of the pandemic stimulus that makes this a really serious problem in our view so let me walk through this uh in the spirit of being a bit textbookish uh just to lay this simple principle correct uh on the left hand side you have the FED balance sheet the banking sector balance sheet and the public balance sheet think of public as non-banks family offices startups corporate treasurers whatever you want okay now what happens in quantitative easing is that the FED buys treasury Securities from someone so it adds to its balance sheet it expands its balance sheet and against that it creates a reserve liability which is that it credits the account of some Commercial Bank with a reserve when this happens now where does this treasury security typically come from in our work that I presented at the Jackson Hole in August we showed that typically the expansion of the FED balance sheet happens by taking Securities from non-banks so let’s say a pension fund or a family office or a corporate Treasurer turns over their treasuries to the said so what happens to them they lose a security out of their balance sheet and when they sell it their Commercial Bank credits them with a deposit okay so what happened to the Commercial Bank in the process they expanded their deposit by a dollar in this case and on the left hand side they got a reserve from the central bank so what we generally think of quantitative easing is which is on the top and expansion of the FED balance sheet is actually an expansion of the commercial bank balance sheet and typically because this expansion happens with large parts of the non-bank system these deposits that banks are left with are uninsured deposits okay I think both of these points are somewhat underappreciated now how did this play out this time around when quantitative easing was done you can see here that the stock of uninsured deposits in Banks is essentially growing at anything at the rate of about uh here you see it’s in trillion so it’s growing at about 300 billion dollars per per quarter uh sort of very very large amount and why is that very large because it quickly adds up to two and a half three trillion dollars over the several quarters that we have seen the banking system overall grows from a very large size by two and a half to three trillion dollars if you look at it in percentages of uninsured to Total deposits you have that ratio going up from 48 to about 52 percent it doesn’t seem very large but four percent of total stock of deposits is very very large okay it’s it’s a very it’s a very large amount okay now is is this something new uh what we showed is that that isn’t the case actually every time fed has done QE this is 2009 this is 2011.
This is 2013. every time fed has done QE this blue line which is the stock of uninsured deposits in the banking system Rises okay so we have seen this in the past we know that when fed expands its balance sheet it’s the stock of uninsured deposits in the banking system that rises you can see at the time of pandemic QE this happened very fast as well the one difference is that a time of pandemic you even the in short deposits rise a lot and that’s because there was also the fiscal stimulus that was done by the government now why does all this matter this matters because it affects the scale of things okay it tells us why the problems are magnified this time so let’s look at this quantitative easing and then the quantitative tightening cycle you can see that Banks unreal size losses unrealized gains Rose then during quantitative tightening and Fed rate hikes in 1718 Banks again made losses but these problems were small these were less than 50 billion dollars of losses on the entire banking system as a whole what you have this time is 75 billion going to 750 billion or 60 billion going to 675 billion and we think there are two factors that explain this one the interest rate pace of interest rate hikes and the scale of hikes is three times magnified but the bank balance sheets are three times larger in in a rough sense okay which is that it’s it’s not exact but that’s that’s roughly one way to think about it which is that the scale of the problem is three times larger because of bank balance sheet expansion and the scale of the problem is three times larger because of interest rate hikes and then you get this 10-fold magnitude increase okay so why is this a problem the problem is because we have simultaneously relaxed Capital standards as Larry was explaining which is okay so we have stock banks with uninsured deposits through QE they are doing maturity transformation as Philip explained but because it’s being done on the back of uninsured deposits Behavior can change as we have seen very quickly losses materialize and then if capital is not where it used to be it very quickly creates doubts of solvency in the minds of depositors my sense of depositors is a little bit like a person waiting at the airport until you reach your gate and the flashing sign says the flight is on time you don’t entertain the possibility that flight is going to be late but the moment they say it’s five minutes late 10 minutes late you start calling United Global Services and or frequent flyer accounts and tell them oh this flight is late is it going to be one hour late two hours late you start looking for different options and they start running okay so I don’t know how to fix headlines but I’ll tell you a little bit about what we could do about the banking system maybe we should just fix headlines instead it might be easier okay so what should be done with banks now so one option on the table which is always an option is to backstop everything and maybe if you’re the United States government one sort of feels comfortable doing this in large quantities uh until maybe the Day of Reckoning comes at some point which perhaps hasn’t yet occurred but uh my view is that we can’t approach things in this way partly because if you do that you just socialize all risk taking in the Private Financial system and you’ve got to get them to internalize some of the risks of maturity transformation that materialize every now and then so my recommendation is that we should look back to the toolkit of 2009 to get some guidance on how we might want to proceed we can’t copy it exactly but maybe that can give us some pointers okay I won’t dwell on this but I want to make two points one that in 2008 fall after Lehman Brothers collapse we did backstop everything okay we backstop creditors bondholders we backstopped uninsured depositors we back we backstopped corporate deposits we backstopped in short deposits by raising the amount we had backstopped everything and yet implied volatility on banks was high until May of 2009 Bank credit default all SWAP spreads were high until 2009 and that’s because there was a general loss of trust and confidence in the banking system at that point so you in times entire and I’m not saying we are at a Lehman Brothers point or or even a bear Stearns Point but Regulators should prepare themselves to be to do things right if things actually get worse in the coming weeks or months I don’t like to look through the Oracle and see whether that’s going to happen or not I think it’s better to be prepared for a bad outcome rather than saying it’s going to happen or it’s not going to happen so in my view what needs to be done is that fed should prepare itself for doing a stress test and raise capital in the banking system but they need to change their stress scenario a little bit as our colleague Thomas very sharply observed that the current stress test didn’t pick up these problems because when a recession happens in the FED stressed as interest rates are cut down so the stress test did not actually factor in an interest rate hike and so therefore the FED needs to actually factor in a stagflation in some sense which is a recession but in times of high interest rates as Larry explain to do this well you have to do an honest asset quality review you have to mark to Market you have to recognize declines in commercial real estate loan values you’d have to recognize that many Securities will lose value if interest rates are high as Philip explained the problem right now is not that large so maybe this is not a bad time to ask Banks to raise Capital they actually have Market Equity of capital in their balance sheets and they can surely raise some in the market and let me explain what happens when the system as a whole raises Bank Capital someone has to buy that Equity okay so you and I will actually take out of a deposit and if the bank Equity is at an attractive price we will actually buy Equity so when you get the banking system to raise capital in the aggregate you are actually shifting deposits from the banking system into a capital claim on the banking system okay and that’s an overall stabilization of the capital structure of the economy the but last point I agree with Philip that many deposits of banks will end up being stable some concession could be considered while marking assets to Market perhaps some average duration of deposits could be considered but I being a stress test I would not extend that beyond the in short deposits of the banks I would assume everything else has to be made payable immediately so in short Banks generally get run slow at first then fast maybe they’re just Hemingway’s way of describing bankruptcy but just for banks so what’s a robust response in my view we can’t just rely on socializing the risks all the time we should have private Deposit Insurance Bank capital is a form of that we should Market honestly we should stress it plausibly and then raise its levels credibly in the system thank you well thank you very much individual that’s really really fascinating and we had a flicker of disagreement between you and Larry about how far deposit should or should not be insured which is interesting um but um I think we now have questions before we start I’d like to ask us two quick questions one is I’d love to ask Larry about the whether you think the answer is just to give everything to the OCC because America has a really nasty you know fractured picture of Regulation a lot of what happened in the last you know month with the function of regulatory Arbitrage in different states and federal levels having different Regulators but I’m curious you know the OCC in my dealings with them have always been much more tuned it seems to interest rate risks and groups like The Fed who were else just said really drop the ball on the interest rate issue I mean there’s a fascinating paper by Patrick honahan the former Central Bank governor of Ireland pointing out you know how astonishing it is that in an era of rising rates the FED wasn’t changing you get stress tests or even looking at proper interest rate Rises at all I mean absolutely shocking so I’d love to know whether you think the OCC does a better job and they should be the answer and I’m also curious for all of you about what you think the impact of social media and virality has been on this because um you know does this change things significantly is it just an acceleration of the issues is there any way to stop social media being an issue because the fed’s doing a lot of thinking about this and you know can you gate deposit accounts online in a crisis should you be prosecuting people for spreading Panic stricken messages you know should the FED window be open for more than a few hours a day to cope with this because one of the big issues with Silicon Valley Bank was that it desperately tried on the Thursday night to get the FED to give it more cash to meet deposited claims in exchange for its collateral which it had over collateral to offer um but the FED window was only open I gather until four or five o’clock New York time which meant it had you know already closed by Thursday night and that was too late so you have 20 fed using 20th century technology um in the 21st century Mobile Banking world so anyway those are my questions then we’ll Chuck it open all right very quickly the the American banking regulatory system uh Julian as you said is fragmented on the one hand that can be a good thing because then there are multiple places where good ideas can flourish on the other hand it also means there are multiple places where things can go wrong and here this was a case the uh OCC has had a reputation of being a better regulator that’s right on interest rate risk they absorbed The Regulators of the savings alone uh industry through absorbing the office of thrift soup supervision so they had some embedded human capital that had thought about interest rate risk but I you know I’m maybe put more but I’m not sure I would want a single regulator because then if things go wrong it’s really a problem that’s one of the advantages of having a diversified system you’re not putting all the eggs in one basket as far as the social media issues I don’t think we can gate stuff Professor Jeffrey Gordon at the Columbia Law School has an interesting idea that would say basically uninsured deposits ought by contract be less runnable and there would be some gates automatically you can’t impose Gates um you know suddenly that’s changing the terms of the contract but it if you beforehand say look here’s what a uninsured deposit looks like you’ve got to have at least a seven day window and if you this is all Jeffrey Gordon’s idea if you start withdrawing you’re going to pay a penalty and oh also by the way you get some Bank Equity along with the deposit it changes the terms of the arrangement I’m not sure it’s a complete idea but it’s time to be as Jeffrey says financial Innovation let’s be thinking creatively about if we’re going to have uninsured deposits how to do that felt fascinating um either of you got a view on this in terms of how you deal with you know cyber flash mobs um you know the way I think about it is you know a bank is in the business of managing liquidity risk credit risk and interest rate risk and Silicon Valley Bank clearly did not follow the prescription I put up and you could see that you know uh that the Nim was turning down they went very long in terms of their asset duration so you know as we now know they were mismatched they also had all these uninsured deposits so they didn’t do a good job you know dealing with the liquidity Risk by the time you get to the Run the game is almost over so you know I you know sure social media may have accelerated it on the margin but in some sense I think what happened is we got a front row seat out a bank run usually works uh in the old days we would line up in front of the branch maybe you know in some other times you know people just call each other here everybody could see it on Twitter how happening but I’m not sure it’s the culprit so on the same margin the FED should have stayed open and lent against these MBS it’s a little unusual that they closed too early would that have changed much we don’t know uh I think it’s unlikely that it would have saved Silicon Valley Bank but maybe they wouldn’t have had to intervene in the middle of the day so um you know I think at that point once we got there the game was effectively already over for Silicon Valley Bank right okay the real any comments uh yeah I think I’m I’m sort of with Philip a little bit that at the end the social media maybe it’s just an amplifier on the pace of things rather than being the source of the problem uh I think one thing I I would stress though is that in some sense what we are seeing to me the issue with the FED seems more that uh it’s doing sort of very big interventions uh you know we went from you know quantity of reserves in the market being a few a few scores of billions to then a trillion then 4 trillion then 8 trillion uh and I think I’m just going to use a very common sense principle which is that when you intervene on this scale there’s bound to the unintended consequences and there’s bound to be mistakes and it seems we are we are just not thinking very hard about these issues uh you know the policy is filtering into now uninsured deposits health of the banking system credit and interest rate and liquidity problems are getting intermingled because economy is slowing down rates are rising and you have this run problem so the three risks that Philip mentioned are becoming sort of all co-mingled on some balance sheets as we speak and it requires in my view a little bit of a pause that we really have to think hard about this toolkit that we seem to have embraced after the global financial crisis to do more and more do whatever it takes and then and then deal with it exposed I thought we had sort of accepted that that Greenspan Alan Greenspan approach of mopping up afterwards wasn’t the right way to go and as you pointed out we did restore Bank Capital but then we brought it down again because maybe we were far enough away from the past crisis so to me it seems to me social media is a is a factor of life not my life but for most other people’s lives but maybe maybe that the bigger issue is why are these things happening on this scale I think that seems to me to be the real problem at all right um questions I think we’re going on to 10 o’clock are we is that right uh yeah oh I can go maybe five minutes okay right anyone got any questions they want to ask this amazing Trio yep one over there if we knew we would first place our bets in the stock market and then tell you and you know I’m an optimist I hope that it is over but you know all you’ve got to do is look at those banks with over 50 percent uh uninsured deposits the banks with the unrecognated the Gap uh unrecognized losses um the fact that there are now about three or four hundred banks that are on the FDIC problem list um curiously Silicon Valley Bank appears not to have been on their problem list uh as of the third quarter what was going on there um so nobody really knows but I I you know though I’m an optimist I’m worried about contagion and that’s what makes this issue this potential crisis different from 2008 which is at that time it was all about the big guys here Silicon Valley Bank yes it was 200 billion dollars of assets much bigger bigger than anybody here can really imagine but still it was the 16th largest bank in the United States not one of the big three or four but with contagion which I think is really why the FDI the FDIC the fed and the treasury stepped in on that Sunday immediately after Silicon Valley bank was closed and said hey we’ve got to ensure all the deposits even though we’re not supposed to because we’re worried about contagion that’s the real worry even among small and medium-sized Banks that’s the word right but I should say by the way right on top of my phone is actually taking notes I’m not sort of emailing all my friends or anything yeah so I think the short answer is we don’t know uh the long answer I would say is the following so there’s something very different from 2008 to now in 2008 there was credit risk and we didn’t understand it it was in all of the bank’s balance sheet uh Banks didn’t know what was the credit risk of other Banks so there was a lot of asymmetric information they weren’t lending to each other and we had to do a very diligent asset quality review we had stress tests to figure out what is actually going on with bank assets that was about credit risk this time is about interest rate risk and I was making the point interest rate risk is very easy to assess I don’t know whether my number is exactly right but I’m pretty sure the order of magnitude is right I don’t even have to go into the bank all I need to know is the asset duration so the asset side is really simple what the uncertainty is this time around is on the deposit side we don’t know whether they’re going to be more runs it looks like that stopped but you know we’ll see so that’s the issue of contagion I think the big issue may be like how deposit is going to respond to dissolval terminal we often call them sleepy that’s why they sort of accept these low deposit rates do they’re going to go back to that world well then we’re probably back to where we were before or is to some sense that you know we’re going to see more outflows so the way I would evaluate is exactly these two metrics are put up within the banking sector do we see a migration from the mid-sized blenders to the large lenders that’s not a problem for the system but it’s a problem for the mid-sized lenders it’s a problem for their borrowers now if deposits go to JP Morgan shipping Morgan can lend to the borrowers of the mid-size lenders but that’s going to take some rearrangement there’s certain sectors like commercial real estate which heavily depend on the smaller Banks so there could be some trouble there the other issue is does the money leave the system of all gonna go to money market funds it comes back in the form of wholesale deposits but these are very different type of deposits which would also cause trouble for the large banks at that point you know the large Banks may always pull back when they’re lending and I think you could potentially see a bigger credit crunch but I think those two metrics you want to keep an eye on it will tell you how big the problem is going to be going forward I must say I find it’s fascinating as someone who trains the cultural Anthropologist because another way of encapsulating what you’re saying is it really comes down to behavioral Finance right now and you can’t really project in a model how your average consumer armed with a smartphone is going to behave that simply sorry yeah I I just want to respond that it seems you know a little surprising that we you know have to rely on all these payable assumptions now we’re kind of used to that when we model mortgage-backed Securities you know we have to deal with prepayment risk it’s all based on you know what you know you know how people make these choices and typically don’t make them optimally it’s the same here the banks have a lot of like experience doing that uh to the issue of Market to Market accounting they don’t disclose a lot about how exactly they do that uh and I think I would like to know more about it but it really comes down to trying to understand the positive behavior that’s crucial for valuing the franchise there’s no way around it and I just like say against an anthropologist you know in during the 2008 crisis became clear that one reason the models have blown up on mortgage-backed Securities was because in the early noughties Behavior shifted around mortgages in that people assumed in the old days you defaulted first on your credit card then your auto loan then your mortgage and that shifted for cultural reasons the only naughties and economists who are looking at things top down bird’s eye view didn’t see that kind of worm’s eye shift happening or you know Grassroots shift happening and so their models blew up and I’m just really curious right now about how the rise of Mobile Banking two-thirds of U.S households now have mobile bank accounts that’s you know more than double what it was eight years ago how the shifter was Mobile Banking and you know the virality of social media might be changing consumer Behavior at a time where consumers matter so deeply organ Behavior matters so deeply with deposits anyway sorry Burrell I think around you say something I think I so my sense is I think the only qualification I would have to what Philip said is I think there is more to the economy going on than just interest rate hikes uh you know Silicon Valley Bank was exposed to the tech sector which we know is having layoffs and slow down it was over stimulated and it’s slowing down uh you know silvergate and Signature Bank were also heavily exposed to crypto underlying assets that’s another asset class that was on a bubble that has corrected uh First Republic Bank which was sort of like the third or the fourth in the sequence has sort of real estate exposures in New York in Tech some commercial real estate so uh I think Larry stressed quite a bit actually that commercial real estate is probably undergoing a little bit of stress all over the country so my view is that I think it’s it’s a little bit more than just interest rate risk I think there is actually risk in the economy right now there are credit losses that could possibly arise in fact some of the deposit withdrawals out of Silicon Valley Bank were startups who weren’t getting any further loans or who weren’t who were drawing down because they wanted to make investments because their funding cycle had dried up with the rise in interest rates and so I think there’s a combination of real economy slow down and interest rate hikes in my view and so I would prefer anything one does to a stagflation risk rather than just a pure interest rate high risk I think I think the risks are intermingled in my view right now um we’ve got a couple more quite a few more questions I mean how long can we go on for we’re going to live five ten minutes I mean yeah right okay so we had a question over I think must be over yeah in fact let’s take let’s take the questions one after the other and then ask people to comment and then we’ll wrap how does that sound so your question your question and then your question first uh thanks for coming lectures um my question was actually with respect the the correlation with the economy I mean I thought that should be like a significant part of the of the analysis knowing that the economy like Grew From like 16 trillion by 2008 to um like in 25 about 25 and at the same time hope it loans in the US grew up more than 100 and they doubled the amount that they were in 2008.
So that shows upon the bubble of credit which is much broader than the specific issues that you discussed great question I agree it was not um question over there a question of that and by the way do any women want to ask questions as a having a daughter at college and who’s doing finance and economics she tells me that you know she’s often the only one who puts her hand up so anyone where women any women want to wave your hands but we’ve talked about Nebraska positives you briefly mentioned concern about commercial real estate where values of underlying assets is declining and that’s not changing unless rates come back down how to quantify that impact because it seems like it’s just a matter of time before you start seeing pretty significant losses to the banks another great question very well linked yep and then the woman in front of you who gets the prize for putting hand up yeah go on okay um right so I wonder if we dealt modern times if you’re looking for office principles there will then be a role for having disability management for these topics you just want to do that we have a contact the money they’re just directed banking for this just log into trading courses so stop messing around with the banking idiots as Larry says and instead just go straight to the central bank maybe with the cbdc yeah yeah and so we talked about it and that’s a great question because the large Bank the bank CEO I spoke to you on the way here in the taxi when I asked him do you want uninsured depositors to be protected across the system he said heck no because we’re getting loads more deposits so maybe is there another question yeah I think maybe just just two first two questions uh yeah I think uh I I didn’t use the word bubble and overheating but uh in a way one other way of thinking about the magnification of the problem is really that we had in my in my view of extremely large stimulus to the economy perhaps much larger than was required it’s also manifested in the high levels of inflation which then combined with the with you know commodity prices and supply chain problems and so on so I’m with both of you that there is probably a likely Landing for some sectors of the economy and I was alluding to some sectors which are already having it I think we have to stress those sectors in a stress test in my view to recognize if banks can withstand the losses and where they can’t what to do about them uh I’m not I’m not convinced that we need to do everything through the Central Bank you know small businesses get credit lines they get business cards there are limits to this business cards and you know they they have conditions attached to them so just the way I don’t get a credit limit of any size I want and if my credit quality is better I want to have a larger credit limit than someone else I think what the central banks can do at best is give everyone an account up to a small amount and then they can use it as a digital wallet I think that’ll be great for financial inclusion but I don’t see how the central bank can decide whether a small business or a new startup in California what what size of a credit line to give it I think that’s just impossible I think I think you you need a market economy you need Banks and institutions I think no but I think liquidity that means I I think I’ll hand it over to others but I think liquidity management is is in part a business practice I think I I don’t I think the small businesses liquidity management is far more complex than my liquidity management so that’s also a risk that they take and if they do it well they benefit from it if they don’t do it well I think there have to be some consequences in the end what was your question can you just repeat it because the fourth question so I have yeah so I I think my sense is the opportunity is in re-arranging the right hand side of your balance sheet going to the market earlier than others possibly to raise Capital no Bank wants to do it on their own because if you go the if you’re the first one it looks like the kiss of death you reveal that perhaps you have problems and that is where I think a regulatory stress test comes it marks the books and then says you need x amount of capital you need y amount of capital you need Z now when any Bank goes to the market there’s no further adverse information released beyond what The Regulators have already disclosed my sense is the opportunity is to stabilize yourself before things get worse and worst case you raise more equity in one year if nothing has gone bad return it to your shareholders you know it’ll be very easy to do yeah the cliche the best time to fix the roof is when the sun is shining you don’t wait till the thunderstorm and it’s raining heavily to fix the roof raise capital in Good Times not when you’re under severe stress so raising Capital uh has to be a really important part of the story liquidity there are already liquidity requirements that bank Regulators impose and again why wasn’t the Federal Reserve Bank of San Francisco all over Silicon Valley Bank saying you’ve gotten over 90 percent of your depositors who are uninsured and oh by the way these are pretty knowledgeable folks if things start to get a little dicey they could run on you you need to think about this they should have lined up a line with the FED in Washington so that they weren’t making telephone calls at three in the afternoon on Thursday March 9.
That was nuts okay very bright so uh stagflation so I spent the last three years of my life thinking about what happened to 60s and 70s the last time where we had significant stagflation so if you’re interested um I’ve done quite a bit of work on that the short answer is the financial system did actually pretty well during that time so that’s not to say it’s going to be the same but in some sense the troubles we have seen in March I would not pin on you know the potential for stagflation although you know it would affect the banking system but I’m happy to have a longer discussion about that you know afterwards if you’re interested um but there’s quite a bit of work on that um commercial real estate you know um that potentially going to be a big issue I’m not an expert in commercial real estate but it’s definitely going to affect the mid-sized lenders uh more um on the smaller Banks they already have been beaten down by the fact that it’s hard for them to compete in a world where you have to invest billions into the app and the large banks are pretty good at that they can you know basically Marshall those resources but it’s hard for the mid-sized finders they’ve been under pressure before that do you question what’s the opportunity well for the mid-sized lenders they have to try to differentiate themselves uh desperately because what are the large Banks going to do in the times like this well you know if they buy a field Bank the deposit is going to come to them if they don’t buy refill Bank the deposit is going to come to them I’m not surprised that large banks are sitting back and are happy about seeing these inflows because people go there for safety they don’t go for the interest rate so that means they’re deposit Payless the ones that were talking about could actually be going down because they actually have more Market power so for the large Banks you can definitely see there’s an opportunity I think for the mid-size Slanders you know it’s not obvious that their business model gonna survive over the next decade or so and the last one liquidity management um you know I think the issue there is the financial system is pretty good in dealing with the uninsured deposits which are wholesale funding so that’s those are the large time deposits I think they can do that where I think everybody had a blind spot was sort of more about this corporate checking accounts so they’re low beta but they’re also very flighty as we learned uh I don’t think a lot of people will think about that we’ll need to think hard about that it could be re-extending Deposit Insurance we had that actually up to 2012 you know after financial crisis for uh you know limited amount of time we had Deposit Insurance for transaction accounts for businesses as long as they’re not interest pairing we might bring that back I think that’s Larry’s proposal uh or maybe some sort of gates uh but you know we want to recognize that their flight I think that’s sort of where the issue is that’s on the order according to the flow of funds of 1 trillion out of 17 trillion it’s not that large uh I don’t think Vanessa needed for the others um so I think that’s a problem which can be dealt with directly right throughout last last word yeah quickly so in terms of the opportunities because we are at a business school so uh I think as Philip said when if the mid-sized lenders start pulling back on credit uh I think several I would say sub investment grade category borrowers will probably get left out large Banks typically don’t lend to them as much and there’s a lot of private debt Market that’s growing now where not just Clo’s like collateralized loan obligations but also loan mutual funds Etc are now beginning to directly lend to these players I think there will be a tremendous opportunity if the banking stress gets worse and there’s a credit crunch for the private markets to actually substitute where banks are pulling back on credit so there could be opportunities outside of banks in my view in lending to borrowers who get crowded out if if the banking stress were to get worse well therein lies the energy of entrepreneur neural American capitalism you know one person’s crisis is another person’s opportunity so there we go well listen thank you very much indeed I learned an awful lot there even as a financial journalist so thank you very much indeed and very best of luck to all of you in absorbing those incredibly important lessons um and putting it into your own careers studies wherever you’re going next so thank you thank you foreign [Music]