More Subsidies, More Problems: The Real Cost of Cheap Deposits

>> Amit Seru: Now what about regulators? Okay, so when it comes to regulators, we have thousand pages of Dodd Frank, thousand regulators implementing it, so what happened? Well, if you have wrong diagnosis, you'll have wrong policies, is my feeling, okay, here is the simplest way of seeing this. When you look at regulators, right from the start they kept saying, this is liquidity, what does liquidity mean?

That this is just a short term thing, if we just give money to the banks, it will become fine. Remember, this happened because interest rates rose and assets fell. Interest rates are not going to go to zero immediately, these are assets are low in value, there's nothing about liquidity.

But if you look at the Fed diagnosis, if you look at the regulated diagnosis, they came up with a bunch of reports. They talk about liquidity 320 times as being the reason why Silicon Valley bank went down. Solvency is mentioned once, I like to joke and say that this was a typo in the report, someone just left it.

Why do I say that liquidity is a bad thing? We have seen, now there is no debate on this, because if you look at liquidity, we addressed it. We had this line of credit, we gave a lot of liquidity to PacWest, we gave a lot of liquidity to first republic, what happened?

They went under, they are insolvent, this has nothing to do with liquidity, these are all liquid assets, these are treasury bonds. What illiquidity are we talking about, what else did they blame? Well, of course they had to blame the bad management, and there was no mention of regulators, of course, because they obviously did their job, is this it?

I think there is one other thing that's missing in this story, which is if you think about the banking system, it comprises of state and federal regulators regulating in tandem. And there is a political economy between them which leads to inconsistency and sluggishness. What do I have in mind?

That essentially one simple way of seeing this is what regulators do is they go inside the bank, look at it and give you a rating. Are you good, bad, ugly? Okay, one, two, three, four, five, if you're five, you're a disaster, one, you're amazing, that's how you want to think about it.

And the state and federal regulators do that in tandem for 80% of the banking system, why? Because there's political economy behind it, now, Fed has different incentives, state have different incentives. States have an incentive to be lax because banks are too big to fail for them. And if they have incentives to be lax, they're going to undo everything.

And as a result there's gonna be inconsistency in implementing regulation, as well as how quick the system is going to respond to things like what we saw when it comes to interest rate risk. So we actually did a study back in the day with some collaborators where we kind of showed this.

What is plotted here in the black solid line is something known as Camel's rating, one, two, three, four, five. Higher the number, worse off the bank, what are the vertical lines here? The white line is when the federal regulator is looking at a bank, sorry, white line is when the state regulator is looking at the bank.

And the gray line is when the federal regulator is looking at the bank in rotation. So state, fed, state, fed, state, fed, that's how it's going, and you can see what's happening to the same bank. State gives it a low rating, Fed gives it a high rating, state gives it a low rating, Fed gives it a high rating, and so on, so this leads to sluggishness, this leads to inconsistency.

And that's not something that was not happening in Silicon Valley bank, and a bunch of these banks, so political economy, which has not even been mentioned, was kind of important. Last point is now what? We already talked about, a bunch of things that have been done. And here is the worry that all of this is fine, but losses remain, which means equity is underwater.

And when you do bailouts, which you give government guarantee, and equity is underwater, what do you worry about? You might have heard of the term gambling for resurrection. What is the idea that equity holders have nothing to lose? If I gamble and it pays off, amazing, if it doesn't, I will make zero, anyway, it's government's problem, by the way, the indicators of this are already there.

I told you before that they were selling hedges, as interest rates increased, as their equity fell, they realized that, my God, let's just sell the hedges, what's the point? So instead of hedging interest rate risk, you were selling hedges. That tells you they were gambling already, and they are gonna gamble even more.

In fact, you all are too young to remember this, but back in the day, there was this thing called a saving and loans crisis, where this exact same thing has happened. So we don't learn from the past, but here is what happened during the 1980s in the saving and loans crisis.

So the first hump is, here is, these are years you can see well before many of you were born. But the first hump is when interest rates increased back in that time period, institutions had losses similar to what we had before. At some point in mid eighties, early mid eighties, we decided we were gonna bail out the banks, the institutions, so similar to what we are doing right now.

And then that's where the big losses happen, so this yellow piece is all what happened when banks which were insolvent decided to take a undue risks. So we exactly did this before we saw this happen, and now this is at a much larger scale, that's the only difference.

So what should we do in the long run, in the short run? It's a policy Bootcamp, so what about policy? So in the short run, if you think about this situation, we have equity which is underwater, we are giving government support. And essentially me and some of my colleagues, we decided that one way to address this is to do somewhat of a market test.

What's the idea that yes, we will give you government support, but you got to tell us that you are actually solvent, why? Because we want to separate out insolvent banks from solvent but illiquid banks. So solvent but illiquid means there is some franchise value in the bank. And if there is franchise value, some external financier, equity holder, debt holder should be willing to fund.

If you remember 2007- 8 crisis when Goldman went Warren Buffett decided to invest, that's a market test. So we want a market test and not an open line of credit from taxpayers to banks, which is happening right now. So this is a proposal, if you're interested, which addresses this issue of equity in the short run, and I can send you a link about this.

Now you might say really like market test markets, tell us something. Well, this is Hoover Institution, not only do we believe in it, but we also have data to show you. Here is what happened when SVB turbulence happened. Market immediately told you there's a bunch of banks out there who have high flight risk and huge amount of turbulence.

First Republic, PacWest, you can see all of them, but what did we do? We decided to give them liquidity support, so First Republic went under in mid May. For all that time we gave it liquidity support when the market was already telling you there is no value, these are insolvent banks, that's what we want.

In the long run, what do we want to do? Well, here, if you look at where we are going already, we are going in the direction of more regulations already. And that's a typical response, because we think about regulators as these physicists and chemists who will just figure out the right mixture and right way of running the experiment and everything will work out.

If you look at what they are talking about, what happened recently, they're saying that well, this was unprecedented and unanticipated. Yet if you look at any banking or any finance textbook, interest rate risk is chapter number one. Okay, so this is not unprecedented and this is certainly not unanticipated.

So my view, and I sort of have some op-eds on this where I argue that, like, we got to move away from subsidized deposits. The big issue here is subsidized deposits, if you don't have enough skin in the game, you are not going to internalize all the actions you take.

Pretty simple, and you might say, really, so you want more equity, have we seen this experiment? Yeah, we have seen this before, FDIC, more equity in banks as soon as we went to FDIC, equity went down, what a surprise. We have actually seen this experiment play out. Josh mentioned, I look at Fintech and shadow banks in my research, and post 2007 eight crisis, when we did a lot of regulation.

What ended up happening was a lot of lending activity moved to these entities called shadow banks or fintech banks. They're called banks, but really they don't take any deposits, they don't take any subsidized deposits. So they are taking lending from the market, and they are taking loans from the market and then making loans like a bank.

So why do I say this is an interesting experiment? Because we can ask the question that really, like, if you have a lot of equity, can you do a lot of lending? Well, here is the best way to sort of show it, it's again from a study that we did.

This is in the US, in the mortgage market, mortgage market is about $12 trillion in the US on the x axis is how much lending a given institution is doing. And then there are two lines here, the orange line is telling you what the equity to assets of a bank is, I already told you, it's pretty low in the entire banking system.

So that line is just telling you across the spectrum, equity to assets for banks is pretty low. What's the black line? Black line is telling you for equivalent shadow fintech banks who don't take deposits, who don't have any subsidies, what's their equity? So where do they get funding from?

Uninsured depositors, uninsured lending and equity. So if you look at their equity, it's much, much higher than banks, and they are doing as much activity as your banks. So more equity is possible and you can replicate the lending and other activities that banks do. So that's what I mean by in the long run, we want to move toward a system which has more equity easier said than done, but that's the story.

So four questions that we started with, what happened at Silicon Valley bank? Hopefully everybody's clear mismatch, interest rate risk. Was it an outlier? No, there are hundreds of banks in the same boat, they continue to this date. What about regulators and regulation? They were inconsistent late and there was an incorrect diagnosis.

And what about short and long run? I think in the short run you have to have a market test without that, this is not going to work. And in the long run, we just need more equity.