Fixing the Banking System

>> Ross Levine: Everything is complicated and I always keep coming back to one thing. If the bank fails, who loses their house?

>> Speaker 2: Hi, thanks for speaking. I just wondered what you thought about what needs to be done following Silicon Valley bank basically now ensuring deposits in those firms. What regulation now needs to be put in place to fix that moral hazard that exists?

>> Ross Levine: So I'm going to, if you give me, I'm going to give you three interrelated answers. So this problem of gambling, most commonly known as a moral hazard problem, again, I don't know people's economic backgrounds, but that's this issue of you ensure the deposits that create its incentives for risk-taking.

This is a very typical moral example of moral hazard. So the, the standard way to do this would be to increase the amount that bankers have to finance a bank with equity. So you would prohibit or limit the amount that banks could borrow relative to the amount that they have to finance with equity.

In the example that I gave with the gambling, the more that you induce the banker to put in this case her money on the line, the less incentives she has to take on excessive risk. So this would be sort of the standard argument for how to approach this problem.

All good. I'm gonna go on a little bit more as long as we got that one down. Okay, there's a problem with that standard argument though. The problem is the following is that there's two elements to it. One is that to the extent that more of the bank is financed with equity and less with borrowing, like in depositors, the more that is financed with equity.

If the value of the assets goes down, the equity goes down, but you can still pay the depositors. That's just standard accounting. That's like a cushion. Assets go down, equity goes down, she loses her money, okay, that's going to prevent her from taking on too much gambling. You can still finance the depositors.

There are no runs, less systemic risk, fair. The other part of the argument we said is like, we're going to force her to have more of her personal wealth in the bank and therefore she has more to lose. And so it's going to affect how she allocates the banks' assets.

More stay stuff, less Las Vegas, okay? The issue there is that, and this is a difference. The issue there is that many of the largest banks, in fact I think all of the largest banks in the US don't have one owner who has an enormous amount of their personal wealth on the line.

Most of the banks in the US are made up of owners like us. Lots and lots and lots of little people with owning a few dollars, a few thousand dollars, a few tens of thousands of dollars in a bank worth a trillion dollars. Most of the owners in the bank have very little of their wealth on the line and they have very little influence over the bank.

So if you increase the amount that has to be financed by equity, this could simply mean that you force the bank to fund itself with more little depositors, none of whom has much skin in the game and none of whom has much wealth has influence over the decisions of the bank.

So in that context, if you increase the amount that has to be financed by equity, you have that cushion. If the assets falls, the equity holders lose, you can still pay the depositors, but you don't have the incentive effect of the owner having a lot of her wealth in the bank and a lot of influence in the bank.

My own sense is that, yes, capital regulations, the amount that has to be financed with equity should be increased, but the focus should be on having the decision makers in banks have more of their personal wealth invested in the bank. SVB bank, the CEO, he made, I'm not gonna get this exactly right, but I think in the year leading up to the failure, made something like $20 million in that year, not counting the tens of millions in previous years.

When SVB failed, he did not lose anything, okay? So if you want him to be very careful with the risk-taking in the bank, he needs to have more of his personal wealth. The other issue is the U.S. faces difficulty compared to Europe. So in the U.S. what you have is the banks.

The US you have a situation in which you have the insurance of the depositors to a big scale.. So you create this immense moral hazard problem. If you create this immense moral hazard problem, you have to do something to counteract the incentives. Because with the immense moral hazard problem the decision makers in the bank have this huge incentive to take on risk.

So then the question is, what are you going to do about that? You can reduce the deposit insurance. Maybe not clear to me whether that's politically feasible, or you have to really regulate the bank either in having the owners put more of their wealth on the line or restrictions on what banks can invest in.

In Europe, they sort of treat the bank in some sense like a public utility. We're gonna insure everything. There's going to be this moral hazard problem, but then we're going to put so many shackles on what you do, we're going to try to prohibit you from going to Las Vegas.

This might prevent systemic crises. They can't go to Las Vegas. But it also strangles the economy in the sense of investing in the people with the best ideas and the most innovation, right? Because those are going to be riskier. So what happens in Europe you force the bankers to invest in things that the government approves of.

The US hasn't resolved what it wants to do. My concern is that the US is caught in this schizophrenic state in which it, for political reasons, always has shown that it will insure all of the investors in the banks, the depositors, bondholders, hedge funds, etc. It creates this moral hazard problem.

It creates the incentives to go to Las Vegas and yet the US still wants the efficiency that comes from having a free market and relatively unregulated banks, okay? And that inconsistency is very, very unstable, okay? So given how important finance is, I prefer one route, right, which is less insurance of the deposits, maybe taking a move toward what John Cochran says, having more competitive allocation of capital, cuz that's gonna finance growth.

But the worst setup might be where we're at, okay? We have to make that choice, I think. I'm happy to. Yeah, they're choosing, right?

>> Speaker 3: Yeah. So one thing you just mentioned is, is that one solution could be telling the partners of a big bank that they have to put their own personal equity into the bank.

But I mean, if you're like say a partner at Goldman Sachs and you have $100 million of capital and now you're forced to put 50 million of it into Goldman, then isn't that limiting, like the flow of capital where if he personally wanted to invest that into other sources, but the rest of the partners at Goldman say we want this to be put into this investment.

Does that limit where capital can flow freely and is that a problem for free markets?

>> Ross Levine: So it's a good question. An economist is typically going to start with what is the reason for any sort of government intervention. And so if we go back to, if we go back, I could envisage a happy situation where the government just doesn't get involved in this and at all, except to make sure that the dissemination of information is accurate and not fraudulent, sort of what it does in other parts of the financial sector.

And if we go back in history when governments got involved less with banks, the banks still face this liquidity problem that I talked about and they got together to sort of resolve it says, if you have a run on your deposits, I'll help you. But then since I'm gonna help you if you have a run on your deposits, I gotta sort of check you out continuously to make sure that you're gonna be solvent.

So that if you have a run on your deposits and I lend to you, I'm not going to lose my money. That you'll be able to figure this out over the course of a year or two and pay me back because your solvent is just a little bit illiquid.

So the market will respond. So we could have a discussion of might that be a better solution to the situation in which we're in now. And that is a perfectly reasonable discussion. You sort of asked where I'm at. My own view now is that we're not going there.

If Citibank fails, the political pressure to bail out investors in Citibank would overwhelm any economist talking about the long-run implications of bailing out Citibank and the moral hazard problem, okay? So we're in an environment I think in which what can we do, in my view, given various political constraints?

In my view, right now we rely to an extraordinary degree on regulators. In my research I see failing again and again and again for a variety of reasons. And that one way to partially mimic the market is by having the decision-makers, whether it's a partner in Goldman or whether it's the C suite at Citibank, have more of their wealth invested in the bank and allow other conduits of finance to firms as well.

So that's. Yeah.

>> Speaker 4: Hi. So you talked about the opacity of information when it comes to the fragility of the banking sector. So you kind of touched on this already. But what would you say to. As a part of fixing the banking system is going back to sound financial reporting.

As you may be Familiar, in the 1980s the Financial Accounting Standards Board, the successor to the Accounting Principles Board, which the SEC got rid of and took away, the accounting professions regulator allowed banks to not mark certain securities to market certain securities that were held to maturity, which is a big problem in svb.

So what would you say to the importance of self-regulation or conservatism of financial reporting?

>> Ross Levine: So there's maybe I'm wrong, but I think there's two parts to the question if I have it right. Tell me if I didn't if I'm not answering it. So one is sort of the question of do we want market-to-market accounting and banking and assets and any other types of financial institutions?

I couldn't make the argument for why not. So that's one part is yes, there's greater transparency and clarity, absolutely, yes. If I heard correctly, part of the question was would you need that in a self-regulatory environment or would you just leave it up to the banks themselves to self-report and monitor the dissemination of information?

So that part, I'm not sure if that was part of the question. I think there have to be standards and I'm not an expert on accounting. So the focus on transparency and clarity and marking to market seems like a good way. It seems like the only reasonable way to go.

The issue of whether this is best done through an official regulatory agency of accounting or whether this is best done through self-regulation, I'm not sure.

>> Speaker 5: The SVB case really represents a disconnect between banks and the Fed. How would you advocate for bridging that gap and how would you decrease the risk that banks face at the hands of actions from the Fed?

>> Ross Levine: So I guess I'm not sure I view it as a disconnect between the Fed and the SVB as a colossal failure of the Fed. For those of you who took money in banking or when I used to teach money in banking, I would say by four weeks in this notion of this liquidity mismatch and how this could show up with different maturity bonds would be clear.

The Fed has all of the information about the basics of asset allocation and liabilities of banks. So the dinner argument I was having with Amhed Saroo, okay, Amhed doesn't work for the Fed. He doesn't have access to proprietary information and yet in November of 2022 he knew which banks had a lot, a lot of long-term securities and which ones didn't.

And therefore he could tell me which banks were most vulnerable to an interest rate hike. So it's simply not conceivable that the Fed didn't know. One of the arguments by the way that's made for why the Fed didn't do well with SVB is that SVB was now under the limit that would require these stress tests.

So Elizabeth Warren, for example, said, well actually it was the deregulation under Trump that meant that SVB was no longer subject to this more intense regulation that would have required the stress tests. So I don't wanna talk about whether the deregulation was good or bad, I just wanna talk about the statement.

Because we know what went into the stress tests and the one thing we know that didn't go into the stress test is that the stress test did not consider the possibility that interest rates would go up. They considered the possibility that interest rates would go down, which again is sort of inconceivable given that they were at their lowest rates historically.

But they didn't consider the possibility that they would go up, which clearly was on the horizon cuz people are arguing about inflation being high. So there's something either grossly incompetent or grossly corrupt about what happened. So this disconnect, I'm not sure it was a disconnect as much, it is the question what was going on at the Fed?

I don't think we know. I mean, they take credit now for saving the world from a systemic banking crisis, or at least the US From a systemic banking crisis. But they're not willing to answer the question of how did we get there? I used to work at the Fed, but they don't love me anymore.

>> Speaker 6: Thank you so much. You mentioned how in European banking, it's more treated like a public good. In European and now American banking, we have central synthetic risk transfers which basically let equity investors get access to the credit risk that banks are exposed to. And so I was wondering, do you think that that's kind of a way to pseudo equity finance banks or.

Because it's still kind of undercutting regulations, it's like a little bit too complex and it's not really meeting the goal of equity financing the banks.

>> Ross Levine: So I'm going to, so there I'm going to answer the way I answer when I have the opportunity to talk at Feds and other central banks.

And that is everything can be complicated, everything in finance is complicated. I've been studying banking regulation for a very long time and there's always this thing, and they do this thing and there's this secured, everything is complicated. And I keep coming back to one thing, if the bank fails, who loses their house?

And in all the major US Banks, who loses their house in the sense of what decision maker in the bank loses their house? And all the US major banks, it's nobody. And that is at the core of the problem. And so everything is complicated, however it fits in, I would keep coming back to that.

What decision maker in the bank that's shaping risk-taking loses their house? Figuratively speaking, if the bank fails because of the decisions that they're making? And I would say that basically all banks in the US, nobody, that's a problem.

>> Speaker 7: Thank you very much, Ross.

>> Ross Levine: Thank you very much.