20VC: First Republic; Management Responsibility or Result of Contagion in the System, The Future of Regional Banks, Will Interest Rates Go Higher | Net Zero, Where Are We? The Best and the Worst Actors with Mark Carney, Former Governor of The Bank of Engl

0:00No, this turmoil isn't over. We see it as we're talking today. FRB is under great strain. It is the case that almost one in 10 US regional banks would fall below their minimum capital levels if all of their assets were marked to market. I think there's going to be really a wave of consolidation. I would say go smaller, go home. This is 20 VC with me, Harry Stubbings. And as we speak, the banking turmoil continues. And there is no better guest to answer some the most pressing questions of the day, he spent over a decade as a central bank governor, first as governor of the Bank of Canada and then as governor of the Bank of England.

0:37Today, he is vice chair and head of transition investing at Brookfield Asset Management, one of the world's leading asset managers with over 800 billion in AUM. He's also a United Nations special envoy on climate action and finance and if all of this wasn't enough, he's also on the board of Stripe, PIMCO and the world economic forum. Yes, I'm thrilled to welcome back to the hot seat, the main man, Mr. Mark Carney, and I want to say huge thank you to Mark Evans for making this one happen to stay huge science for that mark. But before we dive into the show's day, are you building enough conviction to outpace other investors in this changing ecosystem?

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3:04Mark, I am so excited for this. We had so much to discuss in our first episode that we simply couldn't fit it into one. And so first thank you so much for joining me for a second time today. Harry, thanks for having me back. I wasn't sure you would ask me back, but yeah, there's lots to cover. I think this is the perfect time to have you back, Blondley. I have so many open questions before we dive into the core of the show though. I just want to do a cliff notes, which is really unfair, especially given your career. But what is the cliff notes on your career and the core highlights you dive into?

3:34Okay, quick cliff notes. I guess I'd say I've worked pretty much at the intersection of private markets and public policy most of my careers. I started in the city just before the fall of the Berlin Wall, so probably before you were born, rode the globalization boom from the in Asia, New York, a bit in Canada with Goldman. Then I became a central bank governor in search of a quiet life. I figured eight interest rate meetings a year and I could spend time with my family and my time was a bit off because I started a few weeks before Bear Sterns failed and then obviously that cascaded into the subprime crisis and and so I got involved with the financial reforms after that to picked up from where Mario Draghi left off on leading the financial reforms went to the Bank of England during the Euro crisis, Brexit referendum focused a bit on climate when I was there, given the responsibilities and now I'm back more on the private sides.

4:24That was a long period on the public side, but a public side where working a lot obviously trying to fix and reform private markets and now I'm back on the private side, focusing in a couple areas, most of which relate to climate. So I work with Brookfield, we have big transition fund, we focus on going to where the emissions are and funding companies to get them down. I'm on the board of Stripe, a great FinTech company and more. I work with companies like Watershed, which help with the mechanics, the ERP, if you will, of climate to help companies get down. And I do spend just back on the public side, I spend about half of my time as a special envoy for the United Nations.

5:00It sounds great. For which they owe me, I get a dollar a year and they owe me $3. They're in the bad debt category. I've been doing it for three years. And in that regard, I worked to organize the private financial sector to address climate change. But in a way, and last point, which is, I guess, the theme of my career, in a way that gets the power of markets to deliver the things that people want. First of, maybe I wouldn't be single if I had the title of special envoy. This could be the secret on my luck. I'm very envious of that. The second is well done for Somizing an incredible career in about 150 second But I want to start today on a cool which is in the last show I said Mark I haven't seen a boom and I haven't seen a bust and I haven't worked through that cycle I feel like that is changing and so help me Mark.

5:47Where are we now and what follows a bust? Yeah, exactly so I guess in the last time we were in the middle of a boom are probably towards the end of a boom and for students of economic and financial history, they'd be familiar with something called the Minsk cycles. It starts with something fundamentally good, some big innovation. It could have been the productivity miracle in the US at the start of the 2000. The first bits of financial innovation that helped to develop some prime lending as an example, blockchain and DeFi as another example. So these are fundamentally good innovations, but ultimately the growth turns to boom turns to Euphoria, and it turns to the phase that we were pretty close to, I think we were just on the cusp of last time we spoke, which is what this guy Minsky, the economic historian called the Ponzi phase, which is a phase that you recognize is a phase where you're lending against the asset that's at the center of the boom on the assumption that the asset is going to continue to rise.

6:45And so it's asset -based lending with price appreciation absolutely built in. And of course, at some point, there's Binsky moment, you turn to panic because the assumptions are removed and you lead into despair. We're at that phase, certainly, I think, in the DeFi crypto universe. And what's interesting about that phase is provided, you'd avoided getting overlevered in the Ponzi phase. What it brings is tremendous opportunity because the underlying innovation was real. it's still there. You've seen what works and what works less well. There are some assets that can be picked up and there's much much less capital available to that's competing with you.

7:27And so this is the time after the boom we've had the bust and this is where opportunity comes really into play. Can I ask can you provide me with an example of an innovation that went through this cycle experienced this Ponzi realization moment but had underlying value to the innovation that then was reborn efficiently. Because in my mind, it's just like people realize it's a Ponzi scheme and never come back. I'll give you an example of a financial innovation where that's the case. A collateralized loan market, CNBS, a collateralized mortgage -backed securities, the assumptions underlying them about taking to a ridiculous extremes, Ponzi extremes, the price appreciation built into those structures in 2006, 2007, and brought the whole, literally, the House of Cards crashing down.

8:12But the core innovation there lives on, and I think it served the market quite well. And we've ended up actually with a much more robust, it's not totally robust to be clear, but a much more robust, what some would call shadow banking system, I would call non -bank finance, that providing a different channel of credit and actually giving what's going on the banking sector, a very welcome example of credit. I think you're also asking, though, about a fundamental innovation that was going up and down through the boom bus cycle. And I think the example a little closer to home for me would be in hydrogen, where we've had a couple of those euphoric cycles.

8:52The last one was early 2000s. We're entering another. And I think a much more solidly grounded one. Time will tell, though. I can't actually give you the example of hydrogen fully deployed in a way that's mainstream commercial. I think it's coming, I think it's coming in next few years. So maybe if you have me back in a few years, I'll be able to nail that question. And I will have a special envoy as entitled by Dan. So we'll both have won. I already want to say you mentioned that you touched on the banking situation. Let's put it that way. We were talking before about FRB being in turmoil. I just wanted to understand where we are there, Mark.

9:24Is the banking crisis over? So you were always careful with your words, and you started with situation, you ended with crisis. I'd put it more in turmoil. I guess the quick answer to your question is no, this turmoil isn't over. We see it as we're talking today. FRB is under great strain. It is the case that almost one in ten US regional banks would fall below their minimum capital levels if all of their assets were marked to market. So I think it's increasingly well understood that one of the challenges the number of the regional banks, the extreme being Silicon Valley Bank, One of the challenges they have is they have a lot of actually quite high quality assets, but very low yielding assets, and they have in some cases massive franchise problems because of that, because they're just, unless we go back to a low for long world, which I think is extremely unlikely, unless we go back to that world, they're just going to have very large earnings headwinds going forward.

10:22So there are a large number of institutions, regional institutions in the US that have varying degrees of this problem and the longer higher rates go on and the more deposits move to safer places, shall we say, perceive safer places. We're going to see more at a minimum, but it politely, we're going to see more consolidation in that sector. But, and here's the big but. This is a very different situation than what we went through 10 years ago. The system is a whole has more than six times the loss of absorbency it had than it has much higher liquidity across the system, central banks are providing much faster support as needed for those who are impaired.

11:02There are many fewer, I should say, many fewer interconnections between the institutions. In 2008, everybody was connected to everybody else and nobody knew who was going to fall down next, but everybody was convinced that if somebody failed, it would bring others down. Those were reasonable assumptions, certainly during the panic. That's just not the case now. We're seeing individual problems. The contagion in the system is because of similar business models as opposed to interconnections that to cascade through the system. So the turmoil, I would say it's turmoil not crisis. No, it's not over because we're in a higher rate environment.

11:39We're going to have a tougher credit environment coming as the economy slows, but it's seen it absolutely different order of magnitude of what we experienced in the past. That's quite refreshing in some ways. My question is, I have Bill Atman on the show and he presented the view that, essentially, we need to guarantee all deposits in banks. And once you do that, you'll reinsert consumer confidence and turmoil will really be quashed in many ways. Do we need to guarantee all deposits in banks, Mark? I'll say a couple of things. One is that what we're seeing is that the current structure which does not guarantee all deposits in banks is proving time inconsistent.

12:16So under pressure, authorities are coming in and on a case -by -case basis effectively guaranteeing all deposits and banks. So after you have a few of those, you ask the questions of a question whether, well, should you just jump to the end state, which is to guaranteeing all deposits and banks. At first point, second point, there is a bit of an issue, which is somebody has to take that decision, it has to be duly authorized in the US that requires an act of Congress. So the effective way to guarantee all those deposits is not going to happen quickly. Third, there is a bigger argument, and maybe we'll get into this, but I'll just put it on the table, which is something, Andrew Bailey, the current governor of the Bank of England, appoint.

12:58You made a seemingly esoteric point, but quite an important point, around the nature of money. And his point was, in effect, most people don't realize that there's a difference between money that's created by a bank, a private bank, inside money, versus the money that when people used to use cash, they would see the manifestation of money created by the central bank, but core outside money. Most people think they're absolutely interchangeable, which they are in transactions, but they assume they are in deposits, or implicitly assume, and shouldn't we, the authorities, make that clear. Okay. Last point I'd make, whether, let's say we take the the Ackman plan, I'll call it the Ackman plan.

13:38And when the UK and the US elsewhere, we say, you know what, it's just not realistic that Harry VC and people like you, or somebody running the corner shop who has their deposit in a bank is going to take time out to monitor the health of the bank and move that deposit when you start to get concerned about the credit worthiness. I think that is actually a realistic assumption. It's certainly totally unrealistic that individuals do that. Now, what we would have to do if we changed the system so that all deposits were backstop is to make sure that there is substantial capital at risk in the system.

14:15So somebody other than the supervisors and the central banks are monitoring those institutions. And that's why you need to have senior debt, that it non -deposit debt, not recharacterized as deposit in backstop, and contingent capital or AT1 capital different words for roughly the same thing, which is capital that is subordinated and would be bailed in once the equity holders are wiped out. And it's those pools of capital and the institutions behind them that's going to discipline the system or help discipline the system on top of what the boards and the management are supposed to be doing. So you need all of those components.

14:50So help me out here in terms of that contingent group that's external to like the core savior, which would obviously be government led. Is that like a contingent of JP Morgan Goldman Sachs, the biggest institutions who collectively come to rescue the banking system together with this guarantee? What does that look like? I'm sorry for being so naive. No, no, it's something we put in place after the financial crisis. So I said a few more minutes ago that the system as a whole has six times as much loss absorbency as it had going into the financial crisis. So that's a big multiple. A little less than half of that is contingent debt.

15:26So it's actually, there's various structures for this, but in effect, it's subordinated debt, which is owned by institutions, not other banks actually. You don't want other banks to own it because that brings contagion. Let's say I'll take an extreme example, JP Morgan fails, and Goldman Sachs owned a bunch of their contingent debt. Then Goldman Sachs is going to be called into question because they'll take loss on that. So what you want is a different source of capital for it and that to be an insurance company, its pension funds, they're the big buyers, straight -asset managers as well. They're the big buyers of, I'll call them 81 securities, which is a number of people on the pod will recognize.

16:04They're the big owners of that and they are very sophisticated and they do recognize that there are scenarios where they're going to end up owning equity in a stricken institution because it's failed. And in one extreme, which we saw with Credit Suisse, they discovered that they owned nothing, at least on the current version of what the Swiss authorities have done. So that's the way you have discipline in the system and you have an additional level of protection before you get back to the state because you don't want the taxpayer to be second in line after the equity holder to prop up these institutions.

16:37That was the case, by the way, the taxpayer being second in line back in 2008. Mark, can I ask you mentioned regional banks earlier? What's the future of regional banks in the US? Yeah, I would say go smaller, go home. It was always the US banking system, relatively very large number of institutions by number in the US. Barbell strategy was it was dangerous to be in that awkward middle where you're a large regional and therefore you have a lot of corporate deposits above the minimum. They turn out to be much more flighty what we saw with Silicon Valley, what we're seeing with first Republic. Like, that's an awkward place to be.

17:12If you're a narrow regional small, literally close to your customers, largely insured deposits, more stable funding base. You're okay, it's an okay business. You don't have a lot of growth opportunities or you're gonna get consolidated up into some of those very large institutions. I think there's going to be really a wave of consolidation. Another wave has happened over time, but we'll accelerate. And in part, it's accelerating because the competition, not just for the regionals, but also for the large institutions is very much coming from Fintech and is a bigger picture point. The system is moving towards a form of narrow banking as a core competitor to fractional reserve banks, in other words banks that create their own money and leverage up.

17:56And it's able to do that, the system's able to do that because of technological changes, which make things very easy to take customer money and back -to -back it quite efficiently into the money markets and provide better returns. Okay, so we see consolidation there within regional banking in the US. You mentioned credit sweet earlier. I do have to ask, I have to find Mark for this one, but he asked, how do you assess the balance of regulatory and bank management responsibility in the case of SVB in credit's whist? Yeah, it's a great question. You start with management responsibility in both management and boards of the first lines of defense.

18:31I would say in the case of SVB, the pains me to say this as a former regulator and supervisor, but much higher regulatory and supervisory responsibility in the case of Silicon Valley Bank because of a couple of things. One is they changed the rules in the US in 2018 and did away with some very basic protections that we apply everywhere else in the world. Stress tests, we in the Bank of England when I was there and subsequently we We stress test the banks to a 4 % increase within 12 months of interest rates all the way across the curve. Now it seemed quite extreme at the time. It's more or less what has happened because of this inflation.

19:10But we stress tested everybody. In the US, they said, well, now people under token 250 billion, which is a very large number, don't have to do things as severe as that. So that's the first thing. So they weren't doing that. Then they also lessened responsibilities around what are called liquidity rules or liquidity standards and buffers and some of those actually protect against having the extreme mismatches that places like Silicon Valley had. And then thirdly, in the actual practice of supervision, so even if you don't have those rules, even if you don't do the stress test, you just have to look at the books and the mismatches of that bank and say, this is, you know, irresponsible, clearly was, and that was noticed but not acted on.

19:52So I would say in In that case, apart from management, it's more supervisory. I would say in case of Credit Suisse, the challenge, it's been a stricken institution for a number of years. It's had cultural issues. It's had real risk management issues. The authorities there have been spending time, and when I was at the Bank of England, we spend time on this as well, putting in place as best as possible ways to minimize the risk to everybody else of Credit Suisse and maximize the ability that if Credit Suisse couldn't make it, so to speak, that it could be wound down in a relatively orderly fashion.

20:31And it wasn't perfect, but the fact is that when it hit the wall, the Swiss authorities, the international authorities had many more options than they would have had even a few years before to manage that situation. and wasn't a great day for credits -wee shareholders or the contingent capital holders who absorbed the losses, but it meant that the depositors, the debt holders, and the franchises of the whole could be, the first two could be protected, and the franchise could be folded into UBS, which would not have been the case, as I say, just even a few years prior to that. Incredibly unfair question.

21:08Is FR be a stricken asset with a damaged business book, or is it a consequence of a wider macro banking turmoil situation where really it's being pulled into something that it doesn't deserve to be? On the balance it bears more responsibility for the situation it is than the macro. And let me make a macro point which is that if we go back to where we were, whenever it was we spoke last time, 12, 15 months ago. We're just rolling into this period where the world's moving out of low for long interest rate environment, low volatility environment, which some had interpreted as low forever, including low -volve forever, and had built up books of business and in the case of FRB and SVB very large books of business that were low yielding, assumed low volatility for a very long period of time.

22:01And it wasn't proven risk management, that you should have been able to see that at the time. And now that we've moved into a different regime, it is a huge headwind on the franchise. Nobody has an incentive to reprice their own loan. It might as well keep the terms that they have. They're certainly not going to get them again. It's more a victim of its own situation. You could say, I guess, that the macro situation has changed quite dramatically. But one of the things you're supposed to do is a risk manager. You're certainly supposed to do this as a central banker, as a regulator, is think about the tail risks that others are not thinking about and what is possible, not what's most likely.

22:37And it was always the case that one of the very likely possibilities, one of the fat tails, was we would eventually get out of the liquidity trap this low for long interest rate world. And to assume otherwise is irresponsible, just like now, to assume that we're going back to that world after we get through this bout of inflation is also, in my view, an unrealistic assumption, you're just gambling for redemption on that one. That's what I wanted to ask you, which is that when you think about what's to come and the consequences, when you think about the consequences of the banking crisis on monetary policy, how do you think that will look in the next 12 months?

23:14So I distinguish between a crisis and turmoil, so I'm still going to cling to that turmoil term, but it's nonetheless serious. I get serious enough that But it's going to, let's say in the US, it'll probably slow growth by half to three quarters of a percentage point. It's probably enough if people felt that the US economy was on the cusp of this narrow path between avoiding recession and having a recession. It's probably enough of a headwind that there will be a recession in the US. So that's material. In terms of monetary policy, I think what the central banks have done is to try to differentiate between what they need to do to keep the financial system functioning reasonably well and what they need to do to address inflation.

23:58So they provide liquidity to the banks, particularly in the United States, and that keeps those who have healthy enough business models to keep going, but they continue to raise interest rates. But the next point is that the degree to which they raise interest rates has changed. And if we had been talking at the end of February, early March, before Silicon Valley Bank, I would have said something to the effective, I think the Fed may have to go to 6 % Fed funds. Now I think they'll probably stop at 5 .5 and a quarter. That's 75 basis points at a minimum of shift in the stance of monetary policy.

24:33And of course the reason for that is that there is a headwind from what's happening in the regional banking system. It is half of consumer lending, plus it's three quarters of the lending into commercial real estate. its material for commercial and industrial lending as well. And the price of that lending has changed, but actually the very availability of that lending is, in many cases, coming to a stop, and the Fed has to react to that. Mark, was the speed of rate hike? Was it irresponsible? It was unpowered out to any other rate height, supposedly, you know, in recent times. I think it was necessary.

25:09It has consequences. I think one of the assumptions that economists, Not always financiers, but economists often make is that things move in a linear fashion, whereas a certain technologist knows that things get disruptive, there's quantum moves. And in finance, there are situations where it isn't the case that when you move from, certainly in this case, when you move from zero interest rates to 5 % interest rates in a short period of time, it doesn't mean the cost of credit moves up, lock step with each of those moves. you get to positions where the availability of credit just stops from certain channels.

25:46We're seeing that in the regional banking sector. We'll see that in other leverage parts of the system. I guess we saw it at the very start of this move. We saw it in leverage crypto, which wasn't macro -significant. So I think the responsibility of the authorities is to recognize that the faster things go, the more likely there are to be these, to put it politely non -linearities or sudden stops. and that needs to be taken into account. Mark, if I put you in charge of the Fed, what would you have done differently? Well, so what the Fed did when we're in the depths of the pandemic, it effectively tied its hands.