Anat Admati on How to Never Bail Out Banks Again

0:00You're being sold an AI future where you're obsolete or irrelevant. That vision is wrong. At Palantir, they're building AI that helps workers and unlocks their full potential. American workers are our nation's greatest strength. AI shouldn't eliminate them. It should elevate them. Palantir is here to tell their stories. From factories to hospitals, AI is freeing people from drudgery, letting them do what humans do best. Create. Solve. Build. Palantir, making Americans irreplaceable.

1:11Hello and welcome to another episode of the Odd Lots podcast. I'm Tracey Alloway. And I'm Joe Weisendahl. Joe, it is coming up to the one year anniversary of last year's banking drama. I'm still not sure if we can call it a crisis or not. It kind of felt crisis-y at the time. But it went away so fast. You know what the funny thing was? And I probably mentioned it is there was that cliche or I don't know, thing that people say, oh, the Fed is going to keep hiking rates until something breaks. Oh, yeah. It's like, oh, here's the break. It happened. And then it was like a blip. It's like nothing.

1:43And then the Fed kept hiking and stocks kept going up and everyone forgot about it. So it's kind of weird that something that dramatic could happen and seemingly then just sort of get forgotten about kind of quickly. Well, one of the most dramatic things that happened out of all of that, I thought, was when they basically just guaranteed everyone's deposits. Right. So we know at this point that you are supposed to have up to two hundred fifty thousand dollars of your deposits at any bank or any bank that's FDIC guaranteed. Basically, those are safe. If the bank goes under, you get that money back.

2:17But then we saw that Silicon Valley Bank went under and people had more than$250 ,000 in their accounts and they got bailed out, which is kind of phenomenal. I don't think we talk about the deposit guarantee aspect of that whole thing enough. We talked about it at the time. And I think this was the this was the interesting thing. And you're right. This is the sort of the bigger thing that has been swept under the rug, which is if all deposits in all U.S. banks are implicitly federally backed, then do we need to rethink the business of banking? If this huge source of finance, if it's all guaranteed in the end, then it's like, why do we allow these banks to operate as they are?

2:57That was a big question. We talked about it in March and April and May, and that's still unresolved. But people have really moved on from that question. But it really is fundamental. Not us. We are still living in spring of 2023. So I'm very pleased to say we do, in fact, have the perfect guest to discuss this. You might remember we spoke with Stephen Kelly a couple weeks ago about how the way we're bailing out banks or supporting them with various liquidity facilities is changing. In this episode, we are going to be focusing on getting to a point where you don't actually have to bail out the banks.

3:30Let's just avoid this problem altogether. And I'm very pleased to say with us now we have Anat Edmadi. She is, of course, an economist and professor at the Stanford Graduate School of Business. She has written prolifically on this topic for at least as long as I can remember at this point, certainly since the 2008 financial crisis. Anat, thank you so much for coming on All Thoughts. Thank you so much for having me. You know, we needled Stephen a little bit when he was on the show by just throwing out. Liquidity or solvency. Yes. So I'm going to do the equivalent for you and say, how do banks hold capital?

4:08Oh, my God. That word is a trigger because that word leads to so much confusion. So I'm glad you started with that. A senator would say it's money on the sideline. Newspaper articles explain it as cash-like asset. And it's not true. What we're talking about, this hold capital, is not something that actually the banks hold. it's something that investors hold. In fact, what they do hold is those reserves in the central bank on which they get 5.4%. That's what they hold. That's what's out of the economy set aside. What we're talking about is just like deposits on the funding side. We're talking about equity funding for banks.

4:48An amazing idea in banking that you would actually need any of it. And guess what? They live like no corporation lives and no corporation needs to live. But they're there because, you know, I have a lot of research on leverage and leverage addiction. And it's just they are at the point of such heavy indebtedness that they hate coming out. So when people think banks need to have more capital or hold more capital, in their mind, what they hear is, oh, banks just need to have more cash set aside for an emergency. That's what they say. But in the actual people who understand banking, the idea of having more capital means that more of their funding needs to come from equity.

5:27Exactly. So it's all about whether you get your money by promising to pay back or not. And your equity investors, I mean, I come from Silicon Valley, so, you know, who needs to borrow to have a thriving business? Lots of companies don't pay dividends, just grow and grow and grow in market value. And, you know, you don't need to borrow as much. And in banking, if you just say, hey, why don't you do something good with your earnings, such as, you know, make loans, instead they want to take the money out and they will threaten not to make a loan in the ridiculous campaign they're making right now about this Basel endgame, where, in fact, what they're displaying, and I like to talk about it that way, is every single symptom of extraordinary overhang or even insolvency at all times.

6:13In other words, these are the classic zombie symptoms that in another sector would lead you to fraudulent conveyance in bankruptcy or something, you know, that you're taking the money out, that you're always taking risk. Maybe that's a good point to back up a little bit and talk about how you understand the banking business, because a lot of people will hear a statement like, oh, banks should hold more equity. They should have less leverage. And they would think, well, that's what a bank is. You borrow and then you lend. It's a leverage business. Right. It's a leverage business. So like what exactly are we talking about if it doesn't look like that?

6:48Okay. So banks are a leverage business in the sense, if we start from the basics, that deposits put them in a leverage position right away. So by the time you take deposits, if we're talking about deposit taking banks, they already start with debt. Unlike a company like in a corporate finance course where we start with the oil equity firm as a kind of a starting point where you kind of invest in your own money or your own shareholders money. So now you are already in an area in which the people managing the bank, to the extent they're not depositors, are immediately conflicted with depositors over how much equity they would have, how much risk they would take, because of the fact that depositors ultimately, if the bank defaults or if the bank goes into resolution or whatever, they might get paid or not.

7:31But the bank walked away with the upside in any case. So from that point on, the banks hate equity. The banker hates equity. So any leveraged equity holder has a resistance to leverage reduction. That's a pervasive phenomenon. And in fact, if you let them adjust leverage just once, it's not like we go to an optimal capital structure. Always up, always up. So that's the addictiveness of boring. Now, what's the business of bank? There is a basic conservation in the world. It's not an irrelevancy. It's not that it's irrelevant. It's just relevant in different ways to society and to the banker. The banker hates equity.

8:08from their perspective, any bit of it, you know, is too much. From society's perspective, having a huge more equity funding is only good and not bad. And in 15 years of asking the question, why are we even here? Why do they have single digit, you know, depending on all the risk rates, we can get into that. Why are we here? You know, they didn't in the history of banking and certainly relative to other corporations that are not regulated for leverage, even though we subsidized debt in the tax code, you don't see corporations like that. How do they ever get away with that? Oh, how they get away with it is the safety nets, all these bailouts all the time, implicit and explicit.

8:45And that's really it because the conservation physics of finance that I'm talking about, the physics of money is there is risk to be born and taxes to be paid. And if you bear less of it, somebody else bears more of it. If you pay less of it, somebody else pays more of it. So the whole thing we're talking about is whether banks are subsidized to be leveraged, not just want to be leveraged, but encouraged to be leveraged by the system of taxes and subsidies. And therefore, they're telling us that they should be getting all these subsidies blanket to their funding, and then they'll do something good with it.

9:20So sometimes bailouts are explicit, like such as what we saw in 2008, 2009 with TARP and various programs. Sometimes I guess they're sort of implicit or the idea that, well, we just sort of expect that something like that will come. What else, other than what we call bailouts, you say through taxes, et cetera, what else encourages the demand for further leverage or the prioritization of debt financing versus equity financing? It's the compensation of the bankers. It's any, this fixation with return on equity, which is only return on equity on the upside, because on the downside, when you have less leverage, you're protected, you're less negative.

9:58So if your actual realized returns are below your funding costs. Where does the fixation of return on equity come from? That, you know, I think that it's a proxy for subsidies. I think it basically means that if you compensate somebody based on return on equity metrics, where, you know, it's always on the upside where it juices up returns, then by doing that, by going after the return on equity, they are basically doing what, you know, maybe shareholders want to some extent, but certainly works well for the bankers, which is to maximize the subsidy, to maximize the leverage, because through the leverage, you get more subsidies.

10:34That's part of that. The bailouts, by the way, is a really complicated system, and you even touched on the flubs on the federal home loan banks. It's basically an interlocking set of institutions that are either providing guarantees or investing lending. So it's either the central banks that would make these excessive loans that we should get into, the bank lending programs, And at the same time, you know, giving for a while higher interest on reserves, which is crazy, as well as the FDIC, which has started guaranteeing all deposits with extraordinarily dangerous situation and sometimes guaranteeing other debt.

11:10After the financial crisis, they let even newly created bank holding companies that were investment banks the previous day, like Goldman Sachs and Morgan Stanley, guarantees on all debt. Now, of course, they could go and raise money from investors guaranteed by the FDIC, which they can do cheaply, no strings attached, and return the top money the Treasury gave them with a tiny bit of strings attached. So it's basically a system between the Fed, the FDIC, and Treasury and FHLBs where there are sort of investments made in the – so basically the prevention of default. That's a bailout. A third party comes in, you made a promise, and somebody comes in and swoops in and prevents your default.

11:50I want to talk a little bit more specifically about the events of last year, because I think they're a good prism to view some of the things you're talking about through. But one of the interesting things is Silicon Valley Bank got in trouble, I don't want to say for doing the right thing, but they did go out into the market and say, we're raising equity. And as you put it, you know, there's a reason why banks typically don't like to do that. So this is a great question. And it's a great way, in fact, to see what I'm saying. So what happens is they have definitions these days in the regulatory community of what a well-capitalized bank is.

12:27It just so happened that both in the financial crisis and last spring and now, banks are considered well-capitalized by a lot of the banks that failed, including First Republic, got great camel ratings just before they failed. So they can say it's well-capitalized. Now, why is that? Because the metrics are so bad. And the metrics include not recognizing fair market value on halting maturity assets. So the bank is pretending to have these assets that they bought at par value, even though they're losing value, like treasuries. In addition, capital ratios depend on risk weights, and the risk weights ignore interest rate risk entirely, only credit risk.

13:03So a treasury needs no equity backing. So even if you buy a treasury and you can do it 100 % with deposit money, well, the treasury can lose in value. What happened in Silicon Valley Bank was the following. in banking in general, you know, being a zombie, being insolvent is Monday morning. Okay. What they're showing is symptoms to a corporate doctor like myself is every day the symptoms of, of the more they hate equity with a passion, they hate equity, the more I think they have way too little of it. So that's that. Now what happened in Silicon Valley bank, two things. First of all, they had to sell some assets.

13:40So this whole to maturity might not actually work out for you. and the assets are worth less as you have to pay more on deposits. The assets are worth less because they're long-term, have big duration risk and interest rates went down. So when they sold, they had to realize the losses. So all of a sudden accounting rules that usually can allow you to hide the losses are forcing you to recognize the losses. So that was the first thing. Then basically, how would they survive? They were beginning to be more obviously, more visibly insolvent. So the next thing that happens is they try to raise equity, as you said, and they couldn't.

14:11Now, if you can raise equity, if somebody, not at a price you like, but at a price, a penny, a dime for your equity, then you might still be insolvent because there's only the upside. It's just an option on the upside because you can always walk away as equity. But if you cannot raise equity, then you're really deeply in the water. So, the not raising equity is like the ultimate nail in the coffin. In other words, you're definitely insolvent. At that point, the run was unavoidable because, you know, of course, maybe by now that they've guaranteed effectively everything, maybe people won't run.

14:45And maybe we consider that kicking the can down the road as a good financial stability measures. But that is extraordinarily dangerous because in the 80s, we allowed all these zombie savings and loans to persist and raise money guaranteed by the taxpayers until, you know, we had to pay for it.

15:15Silicon Valley is selling you a future where you're obsolete, or worse, identical. At Palantir, they're witnessing something different and revolutionary. From re-industrializing the nation's defense base, to shipyard workers building faster, and frontline workers boosting productivity, AI is transforming work across the nation. AI is not replacing American workers or flattening them into conformity. It's unleashing what makes each one irreplaceable, their judgment, their craft, their creativity. When American workers become more powerfully themselves, they own the future. Palantir, making Americans irreplaceable.

15:56Hey, Ryan Reynolds here for Mint Mobile. You know, one of the perks about having four kids that you know about is actually getting a direct line to the big man up north. And this year, he wants you to know the best gift that you can give someone is the gift of Mint Mobile's unlimited wireless for$15 a month. Now, you don't even need to wrap it. Give it a try at mintmobile.com slash switch. Upfront payment of$45 for three-month plan equivalent to$15 per month required. New customer offer for first three months only. Speed slow after 35 gigabytes if network's busy. Taxes and fees extra. See mintmobile.com.

16:27One of the arguments, obviously, against higher capital ratios or more equity is like, oh, this will lead to an austerity of credit. Banks won't be able to do lending. And this is a big part of the push, again, to some of these rules that there's going to be less lending, et cetera. Why is that wrong in your view? Well, first of all, they can make any loan. My first measure and my first emergency measure since the financial crisis, and I said this with 20 academics and lots of people, is to retain their earnings and use them for loans. So what's the problem now? So I've been asking for 15 years, tell me again what would go wrong if they retain their earnings?

17:02Just go take me through an argument, an economic argument of how the economy would suffer. In other words, is their subsidy so big that, God forbid, you know, they'll die? You know, if they'll die, you know, or they can't survive, I question their business model. If the entire charter value that you'd like to talk about is subsidies, then we have to question the business model, just like you started by saying. So my point is the following. If you tell them not a ratio, actually, I am against giving them ratios from where we are right now. You take them by the hand through issuance and retentions because then they won't shrink inefficiently because a paper I wrote called Levered Ratchet actually shows the ways of deleveraging.

17:43And we show that there is a tendency to leverage to asset sales or stopping to lend or whatever to shrinkage versus expansion. Well, I will expand. These are monstrous banks, which I'm saying to expand only because I believe that once they live in markets, once they're in equity markets, they will break up on their own inefficient weight. Because those conglomerates broke up in the 80s because we don't need such complicated institutions. I was, you know, back in Davos in 2014 with Paul Singer of everybody, and he says these are too opaque. I cannot put my analysts on it and understand their risk.

18:19They would not exist in market as they are right now. Once you push them more and more into equity markets, it's equity markets that will give them the stress test. That's my stress test. My stress test is raise equity. Let's see at what price. What will investors say when they have to bear? The downside is where is the upside? If you don't like that price, maybe that's telling us something. Since you mentioned 2014, I think that was the year when there was a New York Times profile about you. And I cannot remember the exact headline, but it was something like, what was it? I remember this had a whole story behind it, which I won't tell you all of it, but it was by Benjamin Applebaum, who used to be a Fed reporter who I first met when he was a Fed reporter.

18:59And I won't go through all the details, but when he ended up writing the profile, it was entitled, When She Talks, Banks Shutter. Yeah. And what I say, so I've asked a few times about that with people who notice the headline and I say, oh, Jamie Dimon sleeps like a baby. In other words, the headline is cute but false. But this leads into something I wanted to ask you. And I'm trying to think how to phrase this question without sounding hokey. But, you know, you've been criticizing the banks and their business models. and the regulators. Especially. The banks do what they get away with. Yeah, for decades now, basically.

19:41A decade and a half, yeah. What motivates you to do this? Oh, good. Such a good question because I often wonder that myself. Okay. So what motivated me in the beginning was, you know, I sort of fell in a rabbit hole when I started looking into banking. I'm not just a corporate finance, corporate governance person. And I look at those corporations, which I was teaching my students for, you know, 25 years, what a wonderful market we have. and all of a sudden that market, like what just happened? And then I look at them and I say, okay, I understand about corporations. We don't talk specifically about banks because that's in some other silo in economics.

20:14But if I look at them as a corporate finance person and I say, what's the same and what's different about them? And all of a sudden, what's different about them is all bad. And what's different about them is what they get away with more than anything, you know, the specialness of banks is literally what they get away with. And then the politics of banking, that's what's special. And then I all of a sudden realized, you know, if nobody understands what the word means, if the regulators are standing by, if the politicians want banks to make some loans or some campaign donations or whatever else, and nobody's exposing the nonsense that we have in this space that pervades this space that maintains and enables this to continue.

20:53So I was basically alarmed by people inside the Fed that terrible things are happening in Basel when they were negotiating that agreement. And I was encouraged by people both inside some places in the Fed and in the Bank of England at the time where I had most of my friends at the time when Mervyn King was there to get involved. And I truly didn't know what I was getting into when I agreed to do this. I was joking that I'm working for Andy Heldine, you know, that kind of thing. So he was at the Bank of England at the time. And so was Mervyn King, who gave us a blurb for the book while the governor of the bank.

21:30So there were big, fierce battles at the time, post-financial crisis about the topic. And I felt and I mobilized a lot of academics to help me. But it was very difficult work. You were at Financial Times at Time, Tracy. And getting through even the opinion pages against bankers is impossible. And that's the opinion pages now in the politics, like forget it. So I began to really see the politics, something I was not aware is so important in finance and how much it plays in banking. So I stayed in this debate just basically hating to be worn out more than anything. Just not wanting for them with the resources that they have, with the amount of lobbying and the amount of money that they spend across the political system and the regulation system and global institutions and all of that to kind of give up.

22:18because I felt a sense of duty, basically, to society that I actually know something that's useful. And it's my job to say. But anyway, I worked on it for five, six years. And then I essentially wrote a few essays that were kind of putting it to bed around 2015, 16. And that I'm back here is kind of almost didn't happen. It was a decade since the book was published. This book, by the way, I should have said in the intro, it's The Banker's New Clothes, and you have a new edition coming out. Exactly. So the book edition just came out in January in the U.S. and the book got fat because we had to revamp a lot of stuff and take a lot of stuff out of the editing floor to explain more about central banks.

23:00So there are a few expansions of the material. The book is called The Banker's New Clothes. What's wrong with banking? What to do about it? The Banker's New Clothes refers to flood claims. So that's the list of which we now have 44. But somebody just pointed me out to an ad that was apparently in the football games saying that grocery prices will go up and their mother won't be able to buy a lollipop if you increase capital requirements. So I take it just an increase in capital requirements is probably, in your view, necessary but not sufficient to a stable financial system. It's the most no-brainer thing.

23:33But what is an actual, you know, we sort of teased, Tracy said in the beginning, well, could we ever have a world where we don't have to have bailouts? And I'm kind of skeptical that that'll have, what would it take or what is the basics of your prescription? So the basics of our prescriptions, and we go through them extensively in the book, what to aim for, what to watch for as you do this, is basically to aim at equity ratios that fluctuate between 20 and 30 % of total assets. It's important because the risk weights are really the ones that reduce the assets by like a half or more, and are gamed continuously and actually add to fragility because you give zero weight to government bonds, you give zero weight to risk weight.

24:13They're actually anti-lending the risk weights themselves. So that's a whole other can of worms. But we're against the risk weights, except maybe as a backup. Right now, it's the leverage ratio that is at 3 % or maybe 5%. Ridiculous numbers. They are missing a digit. We're not there. We're not close to where we need to be. And if people say the industry will shrink, I say, fine, that's maybe a feature, not a bug. In other words, maybe the industry is too bloated and too big. I mean, we talk about it on the show all the time. What if it's not a matter of the industry shrinking, but migrating to what people call shadow banks or something like that?

24:49Okay. That's all in the 44 flood claims. All of it is there. You'll find the grab bag of them that they use. So what sort of nudges people a little bit is the fact that all along, two things are true about the shadow banking system. Number one, institutions in the shadow bankings that are not connected as much to the, or not as obviously to the safety net, to those bailout system, actually fund with more equity. That was true for REITs, and that was true for like 30 % is common sometimes. And then now one colleague and a few other people have a paper about mortgage lenders, which have to disclose some things in some states.