Financial Crashes & Policy Failures

>> Ross Levine: So getting regulation right in this context is not just about avoiding crises. It's about affecting the incentives for allocating society savings, which I view as allocating society's economic opportunities. Now, there are problems with regulation, many problems. So one problem, we talked about the example of Citibank. It's very difficult to figure out how much safe assets banks should hold, how much liquid assets banks should hold.

You could force the banks to hold only safe liquid assets, but then the banks would not be financing firms and entrepreneurship and innovation. Now, as John pointed out, other entities, other financial entities might arise to substitute for the banks, but the banks wouldn't be doing that. And that has been the source of concern among regulators or at least among the authorities.

And the insurance, if you insure the depositors, that can create very perverse incentives for the banks that could lead to higher probability of the systemic banking problems that one was trying to avert in the first place. And I'll give you examples of that, okay? Okay, so let me give you an example.

Okay, there'll be two parts. Gambling one and gambling two. Okay, so consider a banker, okay? And let's say she has a lot of personal wealth. We're gonna give her $2 million, okay? $2 million, $1 million of that is equity in the bank, okay? So she is the owner of the bank.

The other million dollars she has in cash and savings. Let's say this bank then goes and it collects. It has the 1 million in equity from the owner and it collects 9 million from depositors. So now the bank has $10 million to work with. 9 million from the owner.

Sorry, 1 million from the owner, 9 million from the depositors. It has this bundle of $10 million that it can invest. Good, like we're good on what the game is? Okay, now we give her a choice. She can play it safe, invest in something safe, or we allow her to go to Las Vegas.

Now we're gonna restrict her to the roulette wheel cuz it's gonna make the example easier. And we're just gonna have red and black on the roulette wheel and no other color. So it's 50, 50, 50% chance it's black, 50% chance it's red, good? And now, so we know if she plays it safe, we know what she's gonna get.

She starts with 2 million. She basically makes no return. She'll end up with 2 million. Now let's see what happens if she goes to Las Vegas Fair. So consider the following strategy she takes the bank's $10 million, she puts it on black. She takes the 1 million that she has on savings and she puts it in red.

So now we spin the roulette wheel. It can either come up black or it can come up red. If it turns out red, the bank loses all of its assets. And so then her equity in the bank is worthless, fair? Remember, let's just assume she's like an economist.

She's just selfish and she doesn't care about the depositors in the bank. She's lost her equity. However, sorry, go back one. If it comes out red, remember the $1 million of her own savings, she put that on red, so that now becomes $2 million, okay? So if it turns out red, she ends up with the same amount of wealth as she started.

Fair. Now, if it turns out black, all of the savings, her $1 million in savings that she put on red, she loses. But now the bank's assets double to 20 million. Fair. She still only owes the bank, still only owes the depositors 9. So now her net worth has jumped to 11.

Fair. OK, so if she goes to Las Vegas, the worst thing that happens half the time is she ends up where she started. The other half of the time, her wealth goes from 2 to 11. Not a bad gamble, if you even want to call it a gamble.

So far, so good. The issue here is, I know we don't have to worry about the numbers. The issue is to get the notion that as the owner of the bank, with only a little bit of her own wealth invested in the bank, she has incentives to take on risk.

And if possible, use her other money to hedge against that risk by betting on the opposite color, fair? Okay, now good for her, maybe not so good for society because of all of the wonderful things that banks do. Okay, so why would depositors let her do this? Okay, because they're losing.

But the purpose of the example was to show you the potentially perverse incentives of the deposit insurance. So why don't the depositors do something about it? Because they don't care too much. They're insured. They get their $9 million. It just happens to come from taxpayers, good? Okay, so again, the insurance kind of creates this opportunity for the banks and this incentives for the banker to take on these risks.

Okay, but that means that there's a regulator there. Once there's the insurance, that's supposed to stop the bank from doing that, right? So then we have to ask the question, okay, it's not the depositors, why would the regulators allow her to do this. So one argument is that they're incompetent in the sense that it's maybe not so easy as going to see that the bank is putting the money on black and red, but the bank can take on risks in many ways.

And maybe the regulators are not able to assess that the bank is taking on this risk. The other could be that they're impotent in the sense that they can actually identify what happens, that the bank is taking on this risk. But they may not have the power to stop the bank.

Power can be broadly defined. It could be that, they weren't given legal authority in order to intervene and stop the bank from doing this. And relatedly, it might mean that politicians. Very connected to the banks are putting pressures on the regulators not to intervene while the bank does this.

Okay, so there can be a variety of mechanisms why the regulators might not be able to or might not know how to stop this. So far, so good. Bottom line, deposit insurance and limited liability in the sense of the equity holder only loses her million dollars invested in the bank.

They don't come after her for more than that creates this incentive, these perverse incentives to take on risk, which could actually cause the banking system to fail. Good, okay? We have to do one more example in order to give you a little bit of the essence of why capital regulations and issues of the skin in the game of the equity holder could play a role, okay?

And this is gonna relate to what John was talking about. If banks fund themselves more with equity, the owners may have stronger incentives not to take on this risk. Is that what I wrote? Yes. Okay, so now we have to do gambling too. So gambling two, we're going to now force her to have $2 million of equity in the bank, okay?

So now she has nothing in savings. All of her net worth is tied up in the bank. So if we were going to use the colloquialisms, she has more skin in the game, right? More of her personal wealth is tied to the bank. There's more equity financing of the bank.

Before, the bank was financed with $1 million in equity. Now the bank is financed with $2 million in equity. Good, okay? So the bank collects the $2 million. Now, the banker. We're going to kind of keep it the same. The bank goes out and collects $8 million in deposits.

So the bank still has $10 million in assets to play with. 2 million financed with equity. 8 million finance with deposits. So the bank is. We can use just to use words that you may have heard. So the bank is less levered, it's borrowing less, and it's financed more with equity, okay?

Okay, so doing the same thing, she goes to Las Vegas. The banker places the $10 million on black. If it turns out red, the bank goes bankrupt, of course, and the banker loses all of her wealth. Okay, that's not good. Like before, she ended up where she started out.

Now she loses all of her wealth. Now it's not as much fun. She does not like that. Of course, if it turns out black, you know, then she does great. Her wealth goes from 2 million to 12 million. Good. But 50% of the time she goes bankrupt. It's not as clear-cut, fair.

And we could keep doing this example and increasing it till we get to John's explanation of what happens if the bank is fully financed with equity. And it's all her wealth or those of others, then you'd have fewer and fewer incentives to take on big-time risks. Good?

So this is what capital regulations is sort of focused on. Bankers have these strong incentives, especially with deposit insurance, to increase risk-taking. The other big thing is, and you see this is bankers really don't want the regulators to force them to put more of their wealth into the bank.

They really mess up the risk-taking incentives. The bankers will pay a lot of money to lobbyists to try to convince regulators and politicians not to increase capital regulations or the amount that has to be financed with equity, okay? Because here we're talking serious money, and we're not talking $2 million in equity or $10 million.

We're talking of $25 trillion of bank assets, okay? And the other thing that the bankers want is they really like the government insurance because they make it very, very comfortable for all of us to put our money in the bank at a very low interest rate because we all know that if something goes wrong, the government will protect us.

So the bankers love deposit insurance, and they really don't want any restrictions on anything else. Good, okay? So what happened at SVB? Okay, so Silicon Valley Bank. Oops. Okay, this is how they made a lot of money. So they made a lot of money in some sense in a very traditional way.

But there's one particularly interesting twist, as they collected lots of deposits. But the story I told is I told of lots of individuals putting their deposits in a bank. Grandma and grandpa, everybody else. SEV was a little bit different. It collected lots and lots of money from firms, Silicon Valley firms, they collected lots of deposits from hedge funds.

Nothing wrong with that. But when we typically think about deposit insurance, we think about it for like grandma and grandpa and people who we really don't expect to assess whether SVB is solvent or insolvent, et cetera. If we're talking about a hedge fund putting in a billion dollars of deposits, there's some notion that that's a sophisticated investor.

And you might think that it's their responsibility, along with the regulators, to assess the riskiness of the bank, its assets and its liquidity, okay? So to these firms, they paid a very low interest rate. Then they turned around and they invested primarily in treasury securities. So when the US borrows money, they go to a market, and you lend the government money, and they give you a piece of paper, a security.

And the government promises to pay the holder of that security a certain amount of interest rate and then the principal at some point in the future, okay? Generally considered pretty safe and pretty liquid. The issue, and I'm not gonna go through this now, is the issue is that these are longer-term securities, meaning that they promise to pay in say 10 years, okay?

So the government borrows and says, I'll pay you back in 10 years. I'll give you a coupon payment along the way. Basically, I'll pay you in 10 years the principal. When interest rates change, the value of those long term securities changes a lot. So keep that in mind, okay?

So SEB and the owners, they made a lot of money like this. It's the standard way. You borrow at a low interest rate and you lend at a high interest rate and you keep the difference. So then the problem with this is that as I mentioned is that this is subject to interest rate risk.

If interest rates go up, the amount that the SVB promises to depositors stays the same. They still owe that to the depositors. But their assets in these long-term treasury securities, if interest rates go up. The value of those securities goes down, the bank becomes insolvent, okay? so in 2023, interest rates rose, the value of their assets fell, and essentially SVB became insolvent.

Okay, so what happened? Well, not all of the depositors necessarily knew that they were insured because they had deposits well above the legal requirement for what the government would insure. So I mentioned that the Chinese hedge fund had a billion dollars in deposits. Many had multiple millions, which is well above what the entity insuring those deposits promised it would pay.

So those firms, including my son's firm, as soon as they got wind that SVB might be insolvent, they went and took out their money. Many went to take out their money and there wasn't the money. Hence they went bankrupt. Okay, so now then we had the contagion, First Republic Signature bank, some other banks, depositors at other banks became nervous.

It's like, well, maybe SVB is not the only bank that did this. Interest rates went up for everyone. Banks have long-term securities. The value of those long-term securities will fall. Maybe my bank is going to fail. I'm going to go get my deposits out. So regulators became extremely nervous about a systemic banking failure and so they insured essentially all depositors.

Okay, so that's what I just said. The problem now is the regulators have communicated to the financial system as a whole that I don't really care what I said about there being a limit on insurance, if you have deposits, I'm going to insure you. Which reduces, if not eliminates, the incentives for very sophisticated, very large entities with deposits in banks to monitor what's going on in the banks, okay?

So it puts enormous pressure on the regulators to then monitor the banks. So far, so good. So what were the regulators doing here? It's hard. We would go back, it's incompetence or impotence here. So if you go back 2022, interest rates are at historic lows and inflation is rapidly picking up.

It's inconceivable that you would not consider the possibility that interest rates would go up. It's hard to conceive that they would go down, okay? So indeed I always had, in the fall of 2022 is when I came for sort of my recruiting visit to Hoover. I was having dinner with Ahmed Saroo, who's a banking expert, and we got into an argument, okay?

And Ahmed said, there's absolutely no way the Fed is going to increase interest rates in order to fight inflation because it'll bankrupt the banks. And I said, no way. The Fed, the Fed chair, they're defined in terms of inflation. They will raise interest rates because that's in some sense how their career is shaped.

They are going to raise interest rates. And unfortunately, we were both right. They raised interest rates and the banks went bankrupt. The part I want to make about incompetence is that it is simply not conceivable that the Federal Reserve, which both regulates the banks and sets interest rates, could not have known about the possibility that if you increase interest rates, the value of long-term securities goes down and this might bankrupt the banks.

The possibility of this existed for years and yet there was nothing that was done in order to prevent what happened. Okay, Some argue that it's if you go to the Fed's documents, the Fed says, no, we saw this happening, we just couldn't act. Difficult to believe. Okay, So I wanted to leave time for questions.

So banks, maybe most importantly is they exert a first-order impact on economic growth. They help shape people's economic horizons, they have an impact on poverty, they have an impact on income inequality, they have an impact on innovation. If you were to take all of the economic policies that you're going to talk about today and come up with a measure for say 100 countries in 1960.

Trade, you want to talk about trade, intellectual property, finance, monetary policy, fiscal policy, take whatever you want, 1960, and then you say which one predicts how countries did from 1960 to the present. Measures of the functioning of the financial system will do the best. So getting regulation right in this context is not just about avoiding crises.

It's about affecting the incentives for allocating society savings, which I view as allocating society's economic opportunities. And then we have this problem with regulation, which may be well-intentioned, may have political motivations, but can oftentimes be a source of instability and inefficiency.