MI266: Banks on the Run: Insights into the Banking Crisis & the Future of Banking w/ Joseph Wang

26:15Everyone uses US dollars and banks across the world take US dollar deposits and make U.S. dollar loans. Insurance on U.S. dollar deposits only happens within the U.S. It's within the jurisdiction of the U.S. But outside of the U.S., there are several trillion dollars in dollar deposits being held in foreign banks that are not insured by the U.S. government. And if you are a foreign government, let's say, for example, you're the French government, you have a lot of banks in France who have dollar deposits. You don't guarantee those either because you don't have any dollars. So you can't print dollars yourself.

26:51So obviously, you don't have the power to guarantee that. The potential threat to the global banking system, in my view, and this is a potential threat, not something that will necessarily happen, is just as many people realize that it's not safe having your money uninsured in a bank, so many people outside of the US will realize that their dollars are not safe in a foreign bank because it's not guaranteed by the US government. And they should move it to a US bank, where at the end of the day, the US government has strongly suggested that everything will be insured. So you said that you don't think this could be or is bad as 2008, because the government will do what's necessary to stop it.

27:33But I guess I'm wondering what vulnerabilities or problems do you think that this recent crisis highlighted in the banking system that just wasn't fixed in 08 and all the regulations that followed after that? Well, you know, I think that what's interesting in terms of focusing first on the US. So in the US, we had these panic in the regional banks, but the big banks were fine. A big difference is that the big banks were actually under the big regulations set forth since the great financial crisis. So they were highly regulated, almost socialized in a sense. But in the US, regulations on banks depend on how big the bank is.

28:14If you're a big bank, the book gets thrown at you. But if you are a medium-sized bank, like Silicon Valley Bank, like First Republic, you fall under the radar of a lot of regulations. And so there's more potential for banks to get themselves into trouble. I think what will happen going forward is that the regulators will change the rules to make sure that even medium-sized banks are under very stringent rules to make sure that this kind of thing can't happen anymore. And so I guess in general, we have seen some buyout happen of the banks, as well as measures put in place by the Fed. And so do you think that what's been done so far is sufficient to contain this?

28:55Or do you think that there is still a risk that of possibly more smaller banks failing that are still in that smaller category that maybe fell through the cracks of regulation? That's the problem for these smaller banks. So if you are a bank, you know you have asked what you hold, what you invested in. But from the outside, if you are a depositor, you can't possibly know if your bank is well-managed or not well-managed. If you look on the website for Silicon Valley Bank, it's beautifully done. They have a great PR team. Everything looks like it was well-managed and shiny, but it was rotten inside.

29:32So from a depositor's perspective, it's very difficult to know. So I think it's understandable that smaller, let's say, the people who deposit in smaller banks would try to go to a JP Morgan because they know that JP Morgan is under very, very strict regulations and is better run. And that is going to be a big problem for the small banks because small banks are already at a competitive disadvantage versus the big banks. For example, they don't have huge marketing budgets, they don't have huge technology platforms, and they just don't have the resources of a big bank. In the US, we actually have been hemorrhaging small banks for over the past few decades.

30:09Pre-degree financial crisis, I believe we have about 6 ,000 banks, and today we have a lot less, about 4 ,000. And that's in part due to consolidation and mergers and so forth. think that it's very good to have small banks in the US because when you have a small bank, you can have a bank that's a bit more responsive to local conditions. There's more of a relationship side to it and they're more willing to help the community. So I hope that we can address this panic through official full deposit guarantees so that people have no reason to move money out of the small banks. Right now, it's only strongly hinted by Fed Chair Powell, but we should make that into law through Congress.

30:50And I do want to get your thoughts on the Fed too, because given this current economic climate, the Federal Reserve is facing difficulties between reaching their inflation target and then raising interest rates, which could, I guess, pose a threat for the banks. So we just had the meeting on March 22nd, where they raised rates by 25 basis points. But I guess at the same time, these further rate increases may exasperate problems in the banking sector. And so I wanted to ask you what you took away from the most recent Fed meeting and what you think the path forward looks like, because it seems like we are at a breaking point in the economy, but yet the Fed communicated that they're still going to do what it takes to get us back to 2%.

31:40Yeah, the Fed is facing a tough choice right now, as you noted. On the one hand, inflation, by all measures, continues to be a big problem. On the other hand, it seems like if you raise rates too quickly, you might have some financial stability concerns. Now, the Fed wants to get rid of inflation, but they don't really want to tank the financial system. So, I think their approach right now so far has been successful because it's been very targeted. Now, I'll give you an example, actually. If you remember last year, there was some excitement in the UK sovereign bond market. The gilt market was in a crisis and the gilt yields shot up very strongly.

32:20The Bank of England undertook an emergency, targeted measure to provide liquidity in their bond market, solved that problem, turned around and went right back to hiking rates because they are also very concerned with inflation. Now, the Fed is basically doing something very similar. So, The Fed saw that there was some stress in the banking sector, and they rolled out this emergency lending facility to the banks to try to address this in a targeted fashion. You can think of it as basically duct taping the financial system together so that the weak points in it don't fall apart, allowing the Fed to continue to have enough policy flexibility to continue to hike rates and fight inflation.

32:59So when you move interest rates, especially when you move them very quickly like the Fed is doing, it has huge impacts across markets and across the world. Some segments of the markets will be more fragile than others. If the Fed has these special facilities that can address these weaknesses in a targeted way, then that means they could continue to raise the overall interest rate without being afraid of financial instability. And that's what they're doing right now. Now, the big change right now is that the market is pretty convinced that the Fed is going to be cutting rates later this year. In fact, the markets are thinking that pricing is pretty aggressively.

33:34That's not the same as what the Fed is saying. The Fed is saying that we're going to hike rates maybe one more time, maybe this is the final hike, but we're going to hold them throughout the year. The reason that the Fed, so the Fed was going to hike it a bit higher, but now they're thinking that this might be the end of the cycle because they see that the impact in the banking sector might have some effect of dampening the economy. So you can think of maybe the stress in the regional banks as equivalent to maybe one or two rate hikes. So because there's some stress in the banking sector, maybe the Fed doesn't need to hike as much and so maybe they're close to done.

34:06The big difference is, of course, the Fed thinks they're going to hold it here at around 5%, but the market thinks they're going to cut. What's going to happen with the markets in the coming months is largely going to depend on which was right. Is it the Fed or is it the market? interest rates have a huge impact on risk assets. So if the stock market is going up because it thinks the Fed is cutting rates, well, that makes sense. But if the market is wrong, the Fed won't actually be cutting rates, then I think the equity market could have some downside risk here. Now, when you think about how accurate the market is, I think you need to realize that the market has a very, very bad track record when it comes to predicting the Fed.

34:45So there's actually a very good chart on Twitter about this. So the market always thinks that the future looks like the past. So let's go back to 2009. So right after the financial crises, right after the financial crises, the market was always thinking that the Fed is going to hike rates in a year or a couple years, and they're going to hike to say three or 4%. And it thought that for almost 10 years. But as we know now, in retrospect, the Fed kept rates at zero for many years until 2016. So the market was thinking that after the great financial crisis, things were just like they were before the great financial crisis when the Fed was inclined to hike rates.

35:25But the market failed to understand that the world had changed. Now, today, the market thinks that the world we live in now is the same as pre-COVID. Pre-COVID, the Fed was always eager to cut rates. And so the market is eager to price in rate cuts. But my own view is that the market, the world has fundamentally changed because we have persistent inflation. And as long as that's the case, the market is going to be, I think it's going to be wrong again, because they're not very good at catching these regime changes where now the Fed can't easily cut and they really do have to stay higher for longer.

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39:17That's theinvestorspodcast.com slash tip-finance. All right, back to the show. Okay. So with that view in mind then that the Fed could have these higher rates for longer, you just talked about what that means for the stock market. What about the banking sector? Do you think that poses any systemic risks to bank stocks? Because on one hand, higher rates typically are good for banks' profitability if they can lend for more than they need to pay in interest. But at what point would higher rates actually pose a big threat to banks? That's a good point. So intuitively, we think that higher rates is helpful for banks.

39:59And there's good reason to think that. As you mentioned, if interest rates today are 5 % and they were 2 % last year, well, obviously, if you're a bank and you're making a 5 % loan, you're earning more interest income. So that should be good for a bank. That's true. But we also have to keep in mind that a lot of the loans on the bank's books were made in the past when interest rates were low. Now, suppose that a bank made a whole bunch of mortgages when mortgage rates were 3%. Now interest rates have risen and they're forced to pay their depositors, let's say 1 % or 2 % on their deposits. In this case, what's happening is that the bank is actually making less money because its interest expenses are rising.

40:38So banks that don't have a lot of loans stuck in low interest rates or maybe have loans that are variable floating rates, they're going to do fine and they're going to be able to capitalize on higher interest rates and make those loans and earn more money. But if you're a bank such as Silicon Valley Bank that have a whole lot of securities and loans locked in low interest rates, then you're not going to do well. Another point is that banks make money not just through interest income, but in a lot of services as well. For example, if you are a bank, you could make money by providing advice to investors, advisory services.

41:14You could also make money by helping banks raise money by doing an IPO or issuing corporate bonds. When interest rates are high, that's usually stressful for financial markets. So you can see that the equity markets tanked last year, the bond market tanked as well. Now, if you're a bank who has a big business in providing wealth advice or some kind of investment management, then you would have seen that your assets under management decline and so your fees decline as well. In the same way, if you are a bank that had a big business helping companies raise money, well, companies don't want to raise money when interest rates are high because, well, that's expensive for them.

41:51When interest rates are low, they want a lot of cheap and cheap money. But when money is expensive, you don't want to borrow as much. So if you're a bank that has a business mix that has a lot of these more cyclical businesses, you're not going to do well in a world with high interest rates. So the picture that I'm trying to convey is that high interest rates have many impacts on a bank and it really depends on the bank's business model. So some banks are going to be okay and some banks who are not going to do as well. So you're going to have to go into the underlying, I guess, financials or the annual reports of a bank and try to figure out just what the bank is exposed to, what its business motto is to try to figure out which banks are going to do better than others.

42:32Now, that's in general. And right now, I would emphasize though that we just had a panic in the regional banks. And some regional banks are going to be oversold because some regional banks actually manage their interest rate risk very well and are well run. There's some research from people suggesting that one of these banks, let's say a mentee, has been telling you that they actually manage their interest rate risk very well. When interest rates were low, they did not load up on long-dated securities. They were buying short-dated securities, so they're not subject to all this panic. So basically, it may be that some banks, some good banks, Warren banks, were thrown out in the panic and maybe worth a look.

43:10And I guess in general then, in terms of what could impact banks' future profitability in Powell's speech in the most recent meeting, he was talking about the banking sector. He addressed it in the measures that are going to be put in place. And so what do you think it's going to do to banks' profitability going forward as he alluded to increased regulation or cash requirements maybe need to set in place? Wow, that's a really hard question. So if we go to the path where the government is going to insure all deposits? Well, deposit insurance actually isn't free. It's paid for by banks. So just like you and I, let's say, pay monthly fees on our home insurance or auto insurance, so banks also pay fees to the FDIC to insure their deposits.

44:01Now, if more deposits are being insured, that means more money, the insurance premiums are going to go higher, and that could impact a bank's profitability. But that also has to be balanced by the fact that now that deposits are safer, maybe banks don't need to pay as much interest for them because people are happy keeping their money in the bank. They're not worried about default risk. And you also have to keep in mind that there's going to be assumption that the Fed is going to take away interest risk for banks. So again, that takes away some of the left-to-end, the tail risk, failure risk for banks.

44:32So far, I think it's a bit muddy. We're going to have to wait and see. It does seem quite muddy because you talked about in the beginning of the episode, how deposits have been declining. And I've heard other people talk about how there's been kind of a silent bank run even before the crisis happened, where customers have been moving deposits away from banks to higher yielding markets like money market securities, because banks haven't been increasing the interest on deposits. So customers are moving elsewhere. And so we've been seeing this decline in deposits. That seems like it would directly impact banks' profitability too.

45:12So what impact, if we keep seeing this decline in deposits, what does this mean for the banking sector and then even the economy? So you're exactly right that bank deposits have been declining, but I think it's helpful to understand why. And part of it is because there are people moving money out of banks into higher yielding alternatives like money market funds. But another part of it is simply Fed policy. So the Fed has been conducting quantitative tightening over the past several months. And when the Fed does quantitative tightening, it decreases the level of deposits in the banking sector.

45:49The Fed is taking money out of the banking sector. Just like quantitative easing pushed a whole bunch of money, printed and pushed a whole bunch of money into the banking sector. And so quantitative tightening reverses that. So what you're seeing in part is a movement out of banks into money market funds. But from what I see, the much bigger reason is that the Fed is conducting quantitative tightening and that was going to continue for the next several months. Now, it's a really good point that this may potentially affect a bank's profitability because if there are fewer deposits, maybe the banks will have to pay higher interest to attract those depositors.

46:25And when their interest expense increases, that's going to hurt their profitability. But then before we jump to too many conclusions, we have to also think just how many deposits does a bank need? How much cash does a bank need? So the Fed, through the tremendous amount of quantitative easing that they did over the past two years, really, really stuffed the banks with cash. So, you know, trillions of dollars. So one of the reasons why the banks don't have to pay a lot of interest on their deposits is simply because they have too many. The Fed just put a punch of cash in the banking sector and the banks don't have any need to pay higher interest to attract depositors.

47:04One day they will. Eventually they will as quantitative easing continues and as more money leaves the banking sector into money market funds. But I think that's sometime in the future, maybe a few months into the future. So, so far, it doesn't seem like this will have a big impact on the interest rate margins of banks. I also wanted to get your thoughts on a more general question on the future of banking, what this looks like following the crisis and how you see banking evolving in the long term and competing with the desire for more decentralized systems. Some proponents of crypto and decentralized finance use this development as a reason to further highlight the need for change.

47:49And so I'm wondering what you think the future of banking looks like. And could we ever see a bankless future? I think it's difficult to see a bankless future. And that's because banks play a very important role in the economy by creating money. So there's often a conception that banks are just a place to store your money. and then they take that money and they lend it out to someone. That's actually not what a bank does. When a bank makes a loan, it creates money out of thin air. And so the bank has a very important job of deciding who to give money to. The bank looks at, so if you go and you try to borrow from a bank, the bank will look at your proposed project or maybe look at your income and try to make a decision whether or not to give you money.

48:33Ultimately, that's going to be a very qualitative decision and it's a decision the bank is incentivized to do well because if the bank makes a loan that doesn't get repaid, the owners of the bank take the loss. So a bankless future is very difficult because where would the money come from? You need banks to be able to create money. That being said, you can easily have a world where banks can exist but you can also have other more decentralized ways of distributing money that the bank has already created. We can think of this as the capital markets. So for example, if I go and I issue a stock or issue a bond, what I'm doing is I'm borrowing the cash that someone else has.

49:12I'm not borrowing from a bank. So you could have a world where people can maybe be able to lend and borrow in decentralized fashions away from capital markets through these crypto algorithms and so forth. I think that's a possibility, especially as we have more data available. For example, you can easily think about a world where maybe this decentralized software has access to your credit score and employment data and so forth and is able to help make a judgment as to whether or not to lend money to you. And to be fair, a lot of people already do that, including banks. I think what's more interesting about what's happening now is that if you are willing to completely guarantee all deposits in a bank, I think the next step would be some kind of central bank digital currency where instead of depositing money at a bank that's guaranteed, maybe you just deposit money directly at the Federal Reserve.

50:05Since, you know, even if a bank goes bust, the government is guaranteeing it. So the government's on the hook anyway, might as well just all deposit at the Fed. And that has tremendous implications, because that would make the government ultimately a major creator of money. And they would decide that who gets money and who doesn't. Difference between that and the bank, of course, is that if a government makes a bad loan, it doesn't really matter because the government can't go bankrupt. So they're incentivized to create loans, not because they are repaid, but because of political interests. And I think that's a dangerous precedent we shouldn't want to move towards.

50:42Yeah, I'm really glad you brought up the central bank digital currency, because I am wondering how that would compete with the other crypto and decentralized finance in general, where a lot of people want it to be separate from the government or the state. How do you see those two competing in that space? So I think the government doesn't like to have competition. If they have a central bank digital currency, they probably won't want other people to have digital currencies. For example, we have very good private payment platforms like Venmo or PayPal, where you can send money instantly. Now the government is coming out with something called FedNow, which directly competes with these payment processors.

51:26So FedNow basically allows you to make instant payments for retail between each other in the same way that Venmo and PayPal can. Now, if we had a set of digital currency, I would imagine that the government would want everyone to use it, and so they would not want people to use other currencies. For example, when we buy stuff in the store, we all use dollars. There's no, say, state of Texas dollars, or there's no state of Nevada of dollars and so forth. It's just US dollars. If some state suddenly wanted to issue dollars for their own use, I imagine that the government would not be happy. So it seems likely to me that the government would not want to have competing cryptocurrencies.

52:05And I'd also note that it seems like the banks that I've been going under are those that have been strongly associated with crypto, like Signature Bank, like Silvergate and so forth. And I think that would send a strong signal to other banks to probably not sponsor these activities. I wasn't going to get into that, but I read an article that talked about how they didn't want to back the crypto assets. So when the buyouts were happening, they were allowed to buy everything out, but the crypto assets. So it seems like that's sending a strong message that they don't want crypto to be bailed out or involved in any way.

52:42And so it just really makes me wonder what the future of crypto looks like when many proponents are like, this is the time, this is why we need it. But on the other hand, it could just be, I guess, completely wiped out by regulation. Rebecca, that's exactly the fact that I was alluding to. They seemed to be, the regulators seem to be putting their thumbs on the scale and discouraging people from participating, banks from participating in crypto. So yeah, that's definitely a very big concern. And, you know, if you look at other countries, let's say China, they effectively banned crypto. And of course, maybe they won't be able to enforce it perfectly.

53:18But if you have the government against you, it's a huge headwind. Yeah, that seems like a major risk going forward. How would you suggest that people involved in the crypto space navigate this? And what information should they be looking for, I guess, to stay up to date? Because lots of people believe in it wholeheartedly. But what should they be listening to on the other end of the spectrum as well? I would pay attention to any hints by the SEC and other government authorities as to how they view crypto. The government acts very slowly. And so before they do something, they will start making speeches.

53:57They'll have a regulation, proposed regulation for comments and so forth. So I would follow them closely to see what they're thinking. Well, thank you so much for coming on today, Joseph. This was such a wonderful discussion. I really appreciate your time today. Before I let you go, where can the listeners go to learn more about you and all of the work that you do? First of all, thanks so much for inviting me, Rebecca. It was great to be here again. So my name is Joseph. I have a website called feddie.com where I write and teach about the markets. I have a bestselling book on Amazon, Concentral Banking 101, that teaches you about the financial system.

54:35And I also teach about markets from the perspective of a macro investor with my course, Markets 101, also available on my website. Perfect. I will make sure to have all of those in the show notes. Thank you so much again for coming on. See you later. All right. I hope you enjoyed today's episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you've been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven't already, make sure to sign up for our free newsletter, We Study Markets, which goes out daily and will help you understand what's going on in the markets in just a few minutes.

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