The Fragility of Finance

>> Ross Levine: Banks are extremely important for defining people's economic opportunities and hence politicians essentially find it irresistible to regulate banks, because by regulating banks, they can shape who gets to use society's resources. It's a pleasure to be here in looking over your impressive CVs. There's a pretty broad diversity of backgrounds when it comes to finance.

So I'm going to spend a little bit of time going over what are banks, how does it fit into the financial system? And then we'll get into some of the details of regulation and I'll try to leave lots of questions, lots of time for questions. So who cares about banks?

We'll start out with that. Why do we regulate banks? What are some of the common regulations of banks and what are the problems? And then as an example, we'll go through last year's debacle with SVB and some other banks. So who cares about banks? So let's just start a little bit broader.

Rather than just focusing on banks, think about the entire financial system. And you might ask yourself a question. What happens if you had a good idea? I don't know, you had a good idea for frozen yogurt, you had a good idea for a software firm, what would you do?

So I have a colleague here, Eric Hannaschak, he's gonna talk to you later. And he said to me all this stuff about finance. It's like, what could you actually do with finance if you didn't have a good idea? And the question I was posing to you is, what could you actually do with a good idea unless you could get finance?

So the financial system plays a huge role in determining who gets to start a business and who doesn't. Who gets to expand a business and who doesn't? Who gets to try to realize their economic dreams and who doesn't? The financial system decides whether, for example, you might be able to borrow to live in a community that's conducive to the cognitive and non-cognitive development of your children.

So the financial system plays a huge role in shaping the contours of everyone's economic horizons. Just click through some of this. Oops. And by financial horizons, I don't just mean people who are going to go and get a loan from a bank to start a business. And I don't just mean people who are gonna go raise money from a venture capital fund.

Let's say you're a worker, let's say you're a software engineer, let's say you're a plumber, let's say you're any sort of a business person. And you're going to look for work. Do you go through and look for a work where there are lots of companies that are rising to compete for your services, or do you go for work in an environment in which is essentially one firm, and so you don't look for work in a competitive environment?

The financial system has this impact on the entire way and the entire environment in which you go and look for work as well, even if you never engage with the financial system at all, except for maybe student loans. So the financial system is extremely important for people's economic opportunities and because it's going to affect innovation for economic growth as well.

So how do banks fit into all of this? Well, banks are simply one entity within this big financial system that we're not gonna talk about all the elements of the financial system, we're just gonna talk about banks. Banks are one institution. They happen to be a gigantic multi-trillion dollar institution, but they're one institution and what they primarily do, at least in a traditional sense, is they collect deposits from all of us.

And the deal with those deposits is we give our deposits to the bank, or we lend our deposits to the bank and the bank promises to give us back our deposits if we want them. They can raise money through other ways as well, but we'll focus on deposits.

So these deposits are short term, short term, meaning you can go and demand them whenever you want. You don't have to wait a year. You put it in, you can take it out. They're liquid, you can take it out whenever you want. At least that's the promise. And if you've ever checked the interest rate on those deposits, the banks tend to pay a pretty low interest rate.

Then they turn around and they make loans or they buy securities. So they may make loans to this plumbing firm that I talked about. They may make loans to a venture capital firm that then buys equity in other firms. They may do all sorts of things with this money that you lend to them, but those loans tend to be of a longer-term duration.

And when you make a loan to Exxon, you can't go and demand the loan from Exxon the next day, so that's what I mean by illiquid. Exxon has some time to pay back the loan. It also tends to be a higher interest rate than what they're giving on deposits.

So they tend to have these liabilities, what they owe to you, the depositors, those are short-term, low interest rates. And then they tend to make longer-term loans and then they Keep the gap between the high interest rates and the low interest rates and that's how they make a lot of money.

Good. Okay, so that's this pivot, they are very, very important. And that's sort of the general nature of their balance sheets. They borrow short-term deposits and they lend longer-term and make a higher interest rate. Okay, so the way I've shaped it like this, there's this inherent liquidity problem.

There's sort of an inherent. Sorry, I have to go back here. An inherent fragility that if you, the depositors go and want a lot of your deposits back, the bank may have invested a lot of those funds in these firms or other investments and they can't get cash back quickly enough to give it to you, the depositors unless they've been good at managing their liquidity and keeping some cash on hand.

Good, so that's the inherent liquidity problem of banks. And if they do their job well, they keep enough liquid assets on hand to satisfy the demands of depositors while at the same time investing enough both to facilitate economic growth and expand economic opportunities and to make a lot of money for the bankers.

Good. Okay, so that's the problem. Okay, I would just wanna make it everybody difference between solvency and illiquid. So let me give the following example. So let's say we have to go back in time. Let's say I'm sitting on my couch, I'm watching television, it's Sunday afternoon, my daughter comes in and she wants her allowance and I have no cash.

Now I'm solvent, I do have assets, I have a house, I have savings, I have retirement, I just have no cash. Okay, now you've never, maybe you haven't been in this situation, but this is not a good situation to be in with your daughter. But this is a liquidity problem.

Now I still may go bankrupt in some sense of the word because I disappointed my daughter, but I'm not insolvent. Good, we can also have the scenario in reverse. We could have a situation where I'm lying on my couch and I'm depressed because I'm bankrupt because the value of my assets are less than what I owe to everybody.

So I know that they're gonna come take my house and my car. I'm insolvent. My daughter comes in, she demands her allowance and I happen to have the cash on hand to pay her. So I'm not illiquid, but I am insolvent. So those are these two differences. And in some sense, in economic terms, if an entity is bankrupt, then there's an argument for why they would then go out of business.

Liquidity is a different issue because this is a sound institution. It's just somehow mismatched the liquidity of its assets that it needs to finance a particular set of liabilities. Good on the difference. Okay, so now why regulate banks? So there's a couple of answers for this. The first is this, you've probably heard this expression Willy Sutton is.

Willie Sutton was a famous bank robber and they asked him, why do you rob banks? Because that's where the money is. So why regulate banks? Because that's where the money is. So if we go back to the argument that I made in the beginning when I pointed out that, look, banks play this huge role in deciding who can start a business, who can't, who can borrow to buy a house, who can't.

Banks are extremely important for defining people's economic opportunities and hence politicians essentially find it irresistible to regulate banks because by regulating banks they can shape who gets to use society's resources. So there's very much of a political economy element of why regulate banks that exists outside of any economics.

Okay, now we'll go to a textbook economic answer of why regulate banks. Well, we just showed or explained why the banking system can be fragile for economic reasons. Long-term illiquid assets, short-term liquid deposits. We can have a liquidity problem unless the banks manage this. Well, that's an argument about an individual bank.

An individual bank, the depositors may come in and they don't have liquid assets to satisfy the deposits. But that doesn't necessarily mean that the whole system is fragile. To get the whole system fragile, you need something else. You need opacity and contagion. What I mean by opacity is that it's difficult.

Like if you were to say, like go in, tell me how Citibank is doing. Solvent. Not solvent, liquid, illiquid. Probably impossible, right, for us to figure that out in any reasonable frame of time because it is so complex. That's what I mean by opacity. What this can mean is that if I see another bank fail and I have my money in Citibank, I may get nervous about Citibank.

Even though there's nothing wrong about Citibank because I see this other bank can't pay its depositors. So then what do I do? I say I'll go take my money out of Citibank. And if enough people do that, Citibank will fail, okay? Because it doesn't have enough liquid assets to satisfy all depositors so that's this notion of contagion.

One bank fails, people in other banks get nervous, they withdraw their deposits, those banks fail. That's the systemic risk, the systemic fragility that people talk about in the context of banks. Good, Sure, okay. Okay, so that's the textbook rationale. Textbook rationale is this systemic fragility provides a rationale for regulators to come in and they say, look, the financial system is extremely important for economic growth, decides who gets to lend, borrow and all that.

The financial system is very important for economic opportunities. Who actually gets to borrow? Is it the people with the best ideas? Is it the people who are best connected? The banking system is very, very, very important. It affects what type of labor markets we're in. So we don't want the entire banking system failing and the entire banking system may be fragile because of this liquidity problem.

Okay, so this then becomes the economic rationale, okay? Okay, so that's that. So two common regulations that are used in order to deal with this problem. Okay, capital regulation, sorry, capital regulations, and then the insurance of deposits. So, capital regulations. And I'm going to use this in a very, very broad context and if there are questions about details, we can get into that.

By capital regulations, I mean, hey, let's make sure that the banks invest in safe assets and in liquid assets. They invest in safe assets so that the public is confident that they're not going to go insolvent and therefore run to take out their bank, their funds. And we're going to make sure they invest enough in liquid assets.

So that is depositors, through their, the fluctuations go in, they take money out, they put money in. The banks have enough liquid assets to pay the depositors when the depositors come. Good, so we can get into this capital regulations can become very, very complicated. But the essence is to make sure that the banks invest in safe stuff.

People are not nervous about them failing, and they invest enough in liquid stuff so they can satisfy deposits. Good. Okay, another element and this is gonna come up with the example, and this relates back to what John Cochran was saying, is that one of the ways in which you can ensure or reduce the possibility that the bank is insolvent or that the bank is illiquid is to have less of the bank be funded with depositors with deposits.

Because if you're a depositor, you come in, you demand your money, the bank is legally obligated to give you the money and instead have people finance the bank as equity holders. As an equity holder, you can't come and demand a certain amount of equity back. You can just take your share and sell it in the market, which means that the price can adjust, and it means that it won't cause a liquidity problem for the bank.

Good. Okay, so that's capital regulations. And if you're not involved in econ very much and you're looking at the newspaper, you'll hear capital regulations a lot. The other is to insure the depositors. Remember, one of the big issues that we talked about in terms of a systemic banking risk is that one bank perhaps fails for whatever reason, we have our deposits in another bank.

We get nervous that our bank is going to fail and we won't be able to get our deposits out. So we rush out to take our deposits out, and that's what causes the systemic failure. The government comes in and it says, look, don't worry. Even if the bank fails, we, the government will give you your deposits back.

Then you're less likely to get panicked if a bank fails because you know the government will give it to you one way or the other. Good. So those are the two key regulations that are used in order to deal with this issue of the systemic risk of banks.