The Quiet Revolution in How We Rescue Banks

24:34SVB was running on negative accounting equity for months and investors had discounted it. It's not just the SVB case. There has yet to be a case study where Twitter can come out or Bill Ackman can just take down Goldman Sachs because it goes back to what saying about Warren Buffett or the capital raise it if the franchise is strong and you have if you have contingent capital you don't have to worry if you don't have contingent capital the capital structure breaks down this is the thing Tracy that I still like to this day I don't quite understand which is that you know there was no question that they were running like negative equity and it was right there in like probably the 10q or like some sec filing but you know like all of these startups like supposedly love the bank.

25:18They target it. They understood they had like these special products so that founders could get mortgages by posting their RSUs as collateral, which other banks didn't. Like, I don't understand why they couldn't have monetized that franchise value, which now seems to be gone. So they did for so long. I mean, that's how they could afford running at negative accounting equity. It's like Amazon, right? How long did they take to turn a profit? But you had long-term viability. And the thing with SVB is like, okay, you can have the most loyalist depositors in the world, like every bank thinks they have.

25:51And SVB probably did. But what happened, what Tracy was observing with her article and what was happening before the run is they had to spend their money. The deposit balance at SVB was dependent on new IPOs that just weren't happening. So these venture capitalists are as loyal as can be, but they're just spending down their cash balances. And so the balance sheet unwinds. How much of the banking fragility that we've seen over the past year is basically an interest rate story? So, you know, setting aside IPOs, which dried up when interest rates increased, you also just have the losses on the bond portfolio.

26:29And to me, this is kind of it's kind of a non-issue, but it's also kind of a fundamental tension in the banking system, which is that you've built all the rules around the idea that like the best type of collateral is either cash or government bonds, which is fine when government bonds are really boring and not very volatile and there's not a lot happening. But when inflation starts to go up and the primary tool the central bank has to manage that is to affect the price of bonds, then we seem to have this like tension enter the system. For sure. That's how you end up with the BTFP, which, you know, sort of fits in this long trend, particularly at the Fed of like, what is a treasury and how much do we want to monetize it?

27:16Like, how often do we want to be intervening? How, you know, what different lending facilities do we have to set up? Who do we let? So it does sort of sit within that post 2008 tension of like, you know, we're really building the system on top of these safe assets and we kind of have to keep them money like. But yeah, that is the key vulnerability. But also there's so many banks who have that same vulnerability as SVU that didn't fail. So that's sort of the built in macro vulnerability. but the interest rate risk, you know, was also in tech and in innovation and in crypto. And so that's why we've seen like banks like Schwab, banks like Bank of America, like huge unrealized losses, but less concern about the franchise.

27:55Yeah. It seems like when I say non-issue, like it seems like there's a tension, but also I find it hard to believe that like the banking system is going to come down because banks have bought too many U.S. treasuries. Like that doesn't seem realistic. This was always the nuclear option that the Fed had is like the second you're worried about JP Morgan going down because of too many treasuries, the Fed's going to cut rates and just recapitalize the whole system. So it was also sitting in this tension of the Fed was tightening and didn't want to ease up on tightening. So that made it a harder dance, too.

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30:47And so, you know, they re-expanded the balance sheet. You know, some Twitter people thought that was QE or it wasn't. But like, what is like, talk to us about that tension of if the Fed, you know, it's like, You mentioned it's like, OK, let's say JP Morgan, we're getting into trouble. But, you know, that could happen at a time of high inflation. And as Tracy mentioned, you it could happen that some bank through the Treasury channel literally did. How do central bankers think about this tension or how do you resolve that? Well, central bankers might not. I mean, at the absolute limit, this is why crisis interventions are capital injections and guarantees and fiscal, you know, it's sort of all these things at once and why the discount, again, going back to the discount, why it's not always enough and why it doesn't solve every crisis.

31:27But that's exactly why you have to see, quote unquote, innovative things like valuing collateral at par. And the BTFP and the arbitrage and sort of the terming out losses is a little unique because all the losses really built up just in treasuries at the time. You know, if you're thinking about something like commercial real estate to pick a random asset class, the credit risk is endogenous to the Fed. Right. So it's not it's not a case where the losses necessarily materialize over time. The Fed can come along and write, you know, basically a put option on credit risk in a way that even valuing collateral at par, it sort of couldn't with the BTFP.

32:04So I mentioned at the beginning that we are seeing various attempts to tweak and in some cases like change significantly the way these various facilities are used. If you were Michael Su at the OCC or if you were Michael Barr, the vice chair of supervision at the Fed, if you were like the ultimate Michael, basically, how would you be arranging this constellation of facilities? Yeah, there's a few things. I mean, one, we can talk about the standing repo facility, but I might pop a blood vessel if we do that. I want to see that. OK, talk. No, no, we'll get to that. The biggest thing is you have to have some carrot at the window because the Fed.

32:45So it used to be, even in recent history, that there was a premium to go to the discount window, right? You want banks to be evaluated by the market when they're getting funding, and you don't want haircuts at the discount window being your effective collateral requirements. So there is a reason to not run everything out of the Fed, right? They're not asset managers. But at the same time, you have this tension where you want them to come when the time is right. So you have to have some incentive for the banks to go because the Fed can't go any lower on price. It used to be 100 basis point premium.

33:15We've seen the Fed lower this in crisis. They lowered it to zero over Fed funds in COVID, and it's been there since. So it's clear that they are keeping the discount window right at top of Fed funds. So they really can't go any lower because then we're in the BTFP problem where They're taking in less than you can pay on interest on reserves. So you have to have some regulatory carrot and stick, basically, for the discount window. So that's a big piece. Second thing is get the FHLBs out of the lender of last resort game. We sort of got a unique political moment in that the FHFA put out a report a few months back kind of saying this thing, right?

33:52Like, you know, my sense is Sandra Thompson, the head of the FHFA, cares about affordable housing, right? She doesn't want to be in this world of bankers just lending to each other, and it goes to a trillion dollars in a crisis. It's just sort of so far from where those institutions started. It's so far from the goal of housing. Get them out of the lender last resort game. Don't let them pay dividends based on who borrows. Pay dividends based on who does affordable housing or something along those lines. And basically write up a bunch of term sheets for all these different potential 13-3 facilities that you're going to have to roll out.

34:24because the other piece of this is like going back to your rates question, Joe. All we talk about now is central bank intervention. Like anytime a market blows up, it's where's the ECB? Where's the BOJ? Like buy equities now, bail out this bank, like especially since 2008. And where was all this before? It's like, well, they just cut rates. When we didn't have to worry about the zero lower bound, they just cut rates. And, you know, that was sort of the Greenspan playbook, right? Just like let some financial froth come out and then clean up the mess with rates. So that's sort of the other reason that we're talking about this more and more and more is we're worried about the zero lower bound.

34:58Talk to us about the standing repo facility. It seems like a good idea, you know, just always be there. Whoa, his head just exploded. Oh, shoot. Oh, shoot. It was nice knowing you, Stephen. It's okay. What's the downside? It always seemed like a good idea. So the standing repo facility is, so first of all, it's basically the discount window for treasuries and agencies. The nice thing about it is that it adds primary dealers. You hear the Fed talk about it and they want to add all these banks to it, but it's just the discount window. You can bring treasuries to the discount window. So that whole piece of it of like, let's get banks involved, it would really only be valuable if you as a bank, like the depository subsidiary, had collateral in the tri-party repo market.

35:40Because the Fed runs this program out of the tri-party repo market. It's not like the discount window in that sense. So that part's sort of goofy. It's nice to have it for the primary dealers. but there's two problems we have with it one and zoltan has talked about this on this podcast at length which is you're relying on the primary dealer's balance sheet to sort of on lend it to everybody you know repurpose the liquidity for every hedge fund that needs it in a time of crisis and that just doesn't work because balance sheets get pinched and then the alternative is like okay you let every hedge fund come directly to the fed and there are political and legal issues with that the other thing is again it's not like it takes a matched book right the same repo facility is not going to take your treasury and your future.

36:19So if you look at something like the basis trade and the risks we have around the basis trade, I take very little comfort in the standing repo facility, even though some folks do, because when the basis blows out, you basically have the cash price falls and the futures tighten, right? And that's what we saw in March 2020. And all the standing repo facility can do is replace your repo funding at that new market value. So it goes back to this issue of like, where do you value the collateral? It's not going to to recognize, oh, you have a future and you have a treasury. So I'm going to lend at the collective value of that portfolio.

36:53It's going to lend at the cash value of your dash to cash treasury that everybody's trying to get rid of. And so you're just going to get caught in that spiral. What does a bank do? No, seriously, what is the main product that a bank offers? Deposits. Can you explain it? And like when I think it's like, oh, I want to go to the bank, I want a loan. If a bank offers mostly deposits, why are they all so bad at actually matching the benchmark interest rate. Because deposits are a service. That's exactly why. I disagree. I got nothing from my bank. This is my argument. We should be paying the bank for deposits.

37:26I love easy online banking services and free ATM withdrawals. Why aren't I paying them? Well, not only that, it's the ledger, Tracy. It's the ledger of the whole economy. You cannot make a payment that isn't a deposit transfer happening somewhere at the back end. And that is a service that banks offer. And that is exactly why the franchise value can erode so quickly. Because if you say, oh, we have all the liquidity we need at the discount window because we're highly capitalized, which failed banks always have great capital ratios, right? So they can take their collateral to the window, haircut it, whatever.

37:58But you have no deposit franchise left. And the deposit franchise is what was allowing you to borrow at zero and lend at three. So that's your whole franchise value. I realize we've made it through this entire conversation without even touching the Basel endgame proposals. Should we do it? Yeah, let's go for it. All right, Basil. I mean, it's almost not worth it because it's not going to look anything like it does now. I mean, I don't even know. What does that mean? Well, there's a lot of places in it that look like easy fixes. You know, there's like weird charges that show up for like climate financing or like random distortions that happen in housing.

38:33So the Fed's going to look very responsive. It's going to look like it changed a lot of things. The other thing is they've sort of signaled that they want more consensus than they had putting out the proposal. and they had two dissents putting out the proposal. They had Mickey Bowman, who they're never going to get. She hates everything the Fed has done on the regulatory front in the last year. And it's Chris Waller, who has really talked about the operational piece, which is a little bit distorted. So the proposal sort of looks at charging for operational risk based on the size of a business.

39:04So the size of an asset management business would cause you to need to hold more capital. But those businesses tend to be very stabilizing. Like, look at what we've seen happen to Morgan Stanley. Like, it's a diversifying business. It's sort of an all-seasons business. So I think we'll probably see a lot of changes on the operational risk charges as well. Prior to SVB, I believe there were a lot of fights around the regulatory limits and whether stress tests about, like, banks that weren't the mega, too-big-to-fail banks, but weren't necessarily, like, the little tiny community banks out in the middle of nowhere.

39:37And I think like SVB and some of these others sort of like fell in that middle and in a way like probably harmed themselves because in retrospect, they probably just would have been better off taking a little bit of hit to profitability for a sort of like tighter regulatory requirement. What is happening with regulation for some of these more mid-sized banks? Well, I mean, the goal is to bring them all into sort of recognize them as big banks, which you know it seems why not do that there are like maybe legal reasons and blah blah blah and but i'm really not convinced but i'm also like fundamentally like if we take a step back from the capital regulation debate like we're talking about changing ratios from like 12 percent to 13 and a half like i get why a bank is annoyed i get why there's all these interest groups involved but like from a systemic perspective that's just not that interesting that's not gonna be the difference between 2008 and not and it's also not gonna be the difference between a profitable banking system that beats Europe and China and not.

40:32I mean, it is true that SVB had a carve out as a smaller bank. And there is discussion about whether or not those carve outs should exist. But just backing up for a second, big picture. I feel like in the U.S. we have yet to decide what we want the banking system to actually look like. So there's this sort of it's a wonderful life vision where you have all these local banks, community banks, even in New York, and they know you and they build up that relationship and, you know, you get those benefits. But on the other hand, there also, you know, our experience of last year is that maybe there is a benefit to being extremely large and efficient and having a funding advantage and things like that.

41:15And it feels to me like the regulators, politicians, basically everyone involved in this equation has yet to figure out exactly what they want. Yeah. And it's a hard thing to talk about because, you know, you can't go out as like Jay Powell and be like, I think we should have less banks because you'll have less banks by Friday, right? So it's a hard thing to talk about. And they've pushed back on this idea of like a barbell banking system, which is sort of the midsize ones get hollowed out, they either downsize or upsize, and you're left with community banks and bigger banks. And that is sort of the verdict of 2023 is you would say, okay, big banks did well, small banks did well, let's just get rid of the mid-sized banks.

41:56But, you know, there's small banks that are very dependent on the local economy. I will say, big picture, you cannot be a niche bank that is also under the pressure of financial markets. Like, you can't be focused on Silicon Valley and also, you know, need to raise equity and have attentive, you know, headlines. If you're a community bank, you can probably run on negative equity longer than, you know, a mid-sized bank that has to go to market and things like that. All right, Stephen Kelly, thank you so much for coming on All Thoughts and letting us trigger you for basically 40 minutes. I really appreciate it.

42:29That was great. Yeah, thanks, Stephen. Thanks, guys.

42:44So, Joe, I really enjoyed that conversation. I have a feeling it's going to be a very relevant one in 2024 as we start to see more movement on these various issues, including, you know, maybe reforming the discount window, whatever the Basel endgame actually ends up looking like. There are a few interesting things that I would pick out there. So one of them was Stephen's emphasis of how important the actual banking franchise, the deposit franchise is to funding. And, you know, if the franchise starts to go like that's when you do get the deposit issues and then you can't actually raise capital.

43:20And I think some of that did get lost in the conversation around SVB and Signature and First Republic, where it was more like, oh, these banks kind of got unlucky, like they bought too many bonds or whatever. No, that really connects some dots and crystallized a lot of things. And I had forgotten with SVB that prior to the run that did happen on the bank, there was the deposit shrinkage that was simply as a result of Silicon Valley financial conditions at the time, which is that there was no IPO window for a while there. And there was no new fundraising. So you didn't have these startups and stuff did not have fresh cash coming in.

44:01And they were in survival mode. And they're like spending down their money all the time. So there was this sort of like natural, it was not a run. It wasn't even about the treasuries. It was not about the report on the substack in January of that year. That's like, uh, Bern Hobart, the author of the diff, uh, newsletter. Uh, he's like, by the way, uh, Silicon Valley bank is insolvent. You guys should check this out. And like, people like ignored it for about four weeks. Um, it was not about that. It was just about the fact that, uh, the deposits were going down. Yeah. However, Joe, I really, I remain reluctant to pay my bank a fee.

44:33I don't want to. No, I, I mean, I don't, I, I like having free banking and I like having free access to ATMs and the website and a nice app and stuff like that, but it does really make sense and sort of like crystallize this point, which is that that is the only sub market rate borrowing in the world, right? Like basically for the banks. And there's a reason that they can get sub market rate because they also throw in this service for you. But you know, there was like that chart we had at our recent odd lots trivia night that Josh Younger showed, which was like the Fed funds rate. And then it's like, what is this rate below it?

45:07And there really is only one rate in the world that's going to ever be below the Fed funds rate. And that's like the special rate that banks can borrow at from their own customers. Deposits. Yeah. You did mention, I think, earlier in the intro that around this time last year, so in addition to the Bill Nelson on the discount window episode that we did in January, I think in February, probably, we spoke to Joe Abate over at Barclays about exactly this issue. So deposit rates, the beta to benchmark interest rates. So, yeah, I think we're pretty on the ball. We're pretty on the ball. And that talking, Stephen, that like put a bunch of things together, like a lot of like light bulbs went up.

45:49It's like, oh, I get why this is the case or I get why that's not really an ultimate fix, et cetera. So I really enjoyed that conversation. OK, on that self-congratulatory note. And the flubs. That's a good one. I'm going to start calling it that. That's so much easier to say than FHLB. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guest, Stephen Kelly, at StephenKelly49. Follow our producers, Carmen Rodriguez at CarmenArmin, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks.

46:24Thank you to our producer, Moses Andam. For more OddLots content, go to Bloomberg.com slash OddLots, where we post transcripts. We have a blog and a weekly newsletter that Tracy and I write. And you can talk about all of these topics with fellow listeners 24-7 in the Discord, discord.gg slash oddlots. And if you enjoy Oddlots, if you like it when we do deep dives on emergency lending facilities for banks, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account to Apple Podcasts.

47:05Thanks for listening.

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