Innovative Strategies for Strengthening U.S. Banks

>> Amit Seru: All right, so let's open it up for Q&A, and hopefully, everybody was still awake. Please go ahead, yeah, yes.

>> Audience 1: Hi, professor. I am really excited to finally meet you in person, because one of my professors this past semester named Jeremy Stein at Harvard, he's super passionate about this.

I read your March paper the Monday after it came out after spring break, and with your colleague Jiang and the other two. So this is fantastic. So nice to meet you in person finally. So you mentioned some of the things we can do about this. First of all, definitely have the banks become more transparent about their liquidity risks and such.

Second of all, we could definitely raise the liquidity ratio requirements. And third of all, really, is just to raise the FDIC insured amount. But I wonder, how should we go about it for the rest of this year? Are we looking for a more dovish or hawkish approach especially because we know that.

So, when your March paper came out, federal funds rose about 4.5% ish, and now it's 5.3%, and we expect the Fed to actually hike again in December, right? How should we go about it? I think on one hand, we know that, for instance, right after SBB happened, and the government was able to ensure everyone's deposit, all the uninsured one, we knew that, okay, we're safe now.

And then we knew, of course, JP Morgan acquired first Republic, and so we know, okay, so we're more safe. So I think, on one hand, the public may think, everyone's just not your spooky, equilibrium, I guess, like results. But on the other hand, interest rate risk is still very much a thing, and now it's even higher than before.

So how should we go about, I guess, policy for the rest of this year?

>> Amit Seru: Yeah, so you summarized all the conundrums, but you also mentioned some of the things which I think are bad diagnosis and bad policies. To be honest, with due respect to Jeremy, I think he and I may disagree a little bit on some of these points.

Which is liquidity is not gonna solve this problem because interest rates are high and we have insolvent banks in the system. The question is, how do we separate out solvent but illiquid from insolvent ones? So one way of doing this could be to essentially have regulators go in and do a stress test on the entire banking system and come out very clearly that these are solvent banks.

And these are not solvent banks, and we are going to consolidate them or sell them or close them. Because unless that happens, there is going to be no equity that's going to be flowing in a PAC West looks the same as any other solvent bank because we don't know anything.

So regulators have to go in and help the market. If the issue is that the market can't tell, that's the way I sort of interpreted your question. That maybe, you know, one issue is that will the market be able to tell, which one is solvent and which one is not solvent, because till then, otherwise we have to fix liquidity and transparency.

Well, we got to come out of this, we got to raise equity. How do we do that? Well, someone who has information has to come out and do this. Or we need someone like a Warren Buffett to come out and say, I'm investing 5% in Goldman. And then everybody says, okay, solve it.

But without that, this uninhibited line of credit that we have given to banks is not going to lead to good outcomes. Best example is first republic. We gave liquidity to first Republic for a month and a half. I don't know if you all remember, but big banks decided to put deposits into them.

We gave FDIC line of credit, we gave loans from FHLB. And what happened? All of it went down because the assets are not gonna be revalued up, not in the short run. So we've got to consolidate, separate out, but we got to make sure that the good ones are able to thrive.

And they're not going to thrive till the regulators give a clear signal by saying that there is one idiosyncratic and everybody else is the same wrong message. But we can talk more.

>> Audience 2: All right, so I have two questions, if I could. First, it seemed when we applied criminal penalties to miss stated financials, a lot of the nonsense went away going back to Enron and Sarbanes Oxley.

And so I'm curious as to whether you think there's an opportunity for something similar here. And secondarily, did you look at all at the Silicon Valley seemed to have a uniquely weak board and a consolidated CEO and chairman. Have you looked at all on the governance structure and its relationship to risk?

>> Amit Seru: Yeah, these are excellent questions. I think so, the short answer is no, we've not looked at it. Someone is looking at it. I'm pretty sure. I think it's true that the governance needs to be fixed and compensation and we can go back and talk about it. It's also true that after Enron maybe we did something good but let's not forget the costs that came with it as well.

So many of you might have noticed that there were about 3000 missing US public firms over the time period over which we implemented Sarbanes Oxley pretty aggressively. One of the reasons why we are backpedaled and allowed direct listings and spacs and so on is because we felt we went too much on that direction.

We can try it, but one cost that one worries about is that maybe the talent will leave and you won't have good bankers available because they'll do something else where there is less regulation. So you got to balance that a little bit. It's definitely important, don't get me wrong, but I just feel if you had equity, you solve this problem.

I would rather have a dumb management which puts in a lot of equity than a smart management which is gambling on government money. That's the way I think about it. But this debate has been going on for ten, 15 years. I don't know if we'll make huge amount of progress when it comes to clawback and this and that, because, on both sides of the aisle, I don't think there is a huge amount of appetite to really do this.

But that's my short answer. Lots of hands, yeah. And then Mike over here would be.

>> Audience 3: Professor, very interesting presentation. I really enjoyed learning so much new information. So my question is, does more equity actually provide a self insurance kind of thing? And if that is the case, what is that number, that sweet number that the Fed should mandate so as to make sure that these kind of situations might be prevented in the future.

>> Amit Seru: So when it comes to solvency equilibrium and solvency run equilibrium, yes. That's the simple way of thinking about it, that equity provides a buffer. Another way of thinking about it is that if someone is doing this calculation and there are unrealized losses, the unrealized losses are first going to go to equity, right?

So if you have a high enough buffer, I don't get spooked because, yeah, you have your equity capital and that will get wiped out. I am fine. So that's what one is thinking about. Now, for this situation, we can compute this number, it's 20, 25% equity. But remember, every situation is different, right?

So what should the right equity ratio be? Is difficult to tell you, but it's definitely more than ten. We know that shadow banks operate in many lending activities exactly the same way with almost two and a half times the equity of banks where that number is something to be discussed.

Because sometimes what people say is deposits have some other roles as well. Bank deposits, because they're insured, have some other roles as well. For example, people used to think that if a household needs liquidity, which means I want to put some money in a safe way, not in my mattress, but I also want to have the convenience of withdrawing at any point of time.

Where can I do it? Well, deposits are the thing. So if they are providing that convenience back in the day, then we do want to have a little bit of deposits over and above what just a stability concern might tell you what I'm talking about. But fast forward right now we have many other ways in which we can provide liquidity to households.

It seems going through deposits is not the best way of doing it. But that's the debate, okay? But definitely my preferred number is 25%, please.

>> Audience 4: Hello? And then. Can you hear me?

>> Amit Seru: Yes.

>> Audience 4: All right, yeah fascinating presentation. I'm actually really new to banking, so it's been wonderful being able to learn all this new stuff.

>> Amit Seru: You're ready to be a banker, yes.

>> Audience 4: Yep and my question is a two parter. So my question is, how might the absence of subsidized deposits encourage banks to innovate in terms of services and risk management strategies? And does such a direction necessitate a shift in the way regulators oversee banks and risk management?

>> Amit Seru: Yeah, so it's a very good question. But remember, you could ask the same question to Google's and apples and any firm out there in the Silicon Valley that's innovating. We don't ask them, do you innovate because you have only your equity and your venture capital, which is also putting in equity.

In fact, you could argue that you innovate a lot if you have equity and you absorb the losses. Because if you look around us in the ecosystem here, nine out of ten investments that a venture fund makes fail, or eight out of ten fail. But we don't have crises happening all the time because this is equity.

And yeah, you take risk and you innovate. Now when it comes to regulators and risk management, that's exactly my point. So to the gentleman there when he talked about compensation and governance, I'm not undermining it, that's definitely required. But if you have your skin in the game and a buffer which is your own capital, you'll automatically be a little bit more careful.

So that will necessitate less amount of work for regulators because regulators are not gods, right? We treat regulators as if they are scientists and physicists and chemists and they know the exact formula, and then we see them, they can't even divide the assets by two. So when the interest rates have risen.

So one's got to be a little bit careful and have the right approach. There was a question here as well. Okay, so everybody knows what they're doing, yes. Okay, there's a queue. All right, Mike in the middle go ahead.

>> Audience 5: So, quick question.

>> Amit Seru: Yeah.

>> Audience 5: So, one, do you have any opinions on the Department of Defense coming into bailout Silicon Valley bank?

And that's just on the side. And then my understanding of the banking institution and the business is they borrow short and they run long, and so they have this implicit, explicit systemic risk for yield curve, right? And so the way to fix that yield curve control, if you change the Basel requirements, you change marginal deposits.

So, one, the yield curve control is its own issue. But so you're talking about this rising of equity. You're talking about taking a lot of capital out of the system. And so banks do fail all the time. And is there any study of the economic cost of reducing the amount of capital in the system versus just letting these risks run where they may?

>> Amit Seru: Yeah, so look, you're telling me things that I fully agree with. So I don't think there is any disagreement. I have, I agree with you that when banks fail, are there massive costs? Back in the day, and remember, when I say back in the day, it's important, because we didn't have alternative sources of financing.

We didn't have venture capital, we didn't have private equity, we didn't have fintechs, we didn't have shadow banks. Back in the day, when banks fell, there was a local systemic effect in terms of unemployment going down, lending going down, vibrancy going down. And that's why people thought that, well, these are pretty important institutions, and we got to somehow make sure they stay alive because they're important for local economy.

I'm not sure that that's the case right now, but those stories perpetuate when we bail out again, we are taking capital from somewhere and putting it into the banks. We just don't do that calculation and we should. The whole point is, when Silicon Valley bank's scenario happened, it was pretty bad, because when we uninsured depositors, we said that, this is only for Silicon Valley, but really we insured $9 trillion instantly.

None of that is free. As we saw during the pandemic, when MMT and other arguments were being made that, what's the problem? Let's just keep printing there is no issue. Inflation is just a think of the economic history when it comes back. It comes back very quickly. And $9 trillion of uninsured deposits becoming insured.

We don't even know how to think about it and what kind of incentive effects it might have. And I worry about it. But I'm in agreement with you. We should let some banks fail and see what happens, last question.

>> Audience 6: Yes, hello, professor. Hello, Professor Saro, thank you so much.

The main idea I took away from your presentation is that a lot of times people take more risks when they know there is someone watching in them and they will protect them in a way. I was wondering if you believe that this principle applies to human nature in general.

So, for example, football players, they have head injuries. Do you think that if you take the helmets off, they are less likely to have head injuries?

>> Amit Seru: It depends, if you took off the helmets, very few would want to go and play football, right? And those who would want to play football, my view is they better know what they're doing and then it's on them.

We don't do that with banks. We decide to let them play and say, you're on your own, but really, on taxpayers dime. Sorry you lost out, good, thank you.