We're coming up to the one-year anniversary of the collapse of Silicon Valley Bank, which sparked a fresh conversation about the role of banks in the wider economy. Last year's banking drama culminated in the Federal Reserve unveiling a new liquidity facility for lenders and the US government made bank customers whole even beyond the $250,000 limit on guaranteed deposit insurance. So what did we learn from the March banking crisis? And what could we be doing differently now? In this episode, we speak with Anat Admati, professor at Stanford Graduate School of Business, about why bank bailouts (in all their different varieties) persist and what can be done about it. Anat became a major advocate of banking reform following the 2008 financial crisis, and has continued to lobby regulators and government officials for fundamental change. She discusses why banks are structurally disincentivized to behave like other types of companies, the impact of new capital requirements including the Basel Endgame proposal, and competition with other types of lenders including private credit. This transcript has been lightly edited for clarity.
Key insights from the pod:
Do banks hold capital? — 3:15
Why banks hate equity — 5:54
Why banks focus on ROE — 9:10
On Silicon Valley Bank — 11:22
Will higher capital requirements reduce lending? — 14:37
What motivates Anat Admati — 17:40
Competition with shadow banks — 22:43
The Basel Endgame proposals — 24:41
How bank rules get made — 27:35
Demand for bank credit assets — 30:45
Previous banking systems — 34:30
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Tracy Alloway (00:17):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal (00:22):
And I'm Joe Weisenthal.
Tracy (00:23):
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 like a crisis at the time.
Joe (00:35):
But it went away so fast. You know what the funny thing was? And I've probably mentioned it, is there was that cliche, like ‘Oh, the Fed is going to keep hiking rates until something breaks.’ It's like ‘Oh, here's the break. It happened,’ and then it was like a blip. It was nothing. And then the Fed kept hiking and stocks kept going up and everyone forgot about it. So it was kind of weird that something that dramatic could happen and seemingly then just sort of get forgotten about quickly.
Tracy (00:59):
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. So we know at this point that you are supposed to have up to $250,000 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. But 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.
Joe (01:40):
We talked about it at the time. And I think 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 US 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? That 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.
Tracy (02:12):
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 Steven 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. Let's just avoid this problem altogether.
And I'm very pleased to say that with us now we have Anat Admati. 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 Odd Lots.
Anat Admati (02:59):
Thank you so much for having me.
Tracy (03:01):
You know, we needled Steven a little bit when he was on the show by just throwing out...
Anat (03:06):
Yes, liquidity of solvency?
Tracy (03:08):
Yes! So I'm going to do the equivalent for you and say, how do banks hold capital?
Anat (03:15):
Oh 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 [a] 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. What we're talking about is just like deposits on the funding side.
We're talking about equity funding for banks — an 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.
Joe (04:16):
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.’
Anat (04:24):
Right. That's what they say.
Joe (04:26):
But for actual people who understand banking, the idea of having more capital means that more of their funding needs to come from
equity.
Anat (04:33):
Exactly. 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 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 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.
In 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 are always taking risks.
Tracy (05:31):
Well, 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...
Anat (05:49):
It’s a leverage business.
Tracy (05:49):
Right. It's a leverage business. So like, what exactly are we talking about if it doesn't look like that?
Anat (05:54):
Okay, so banks are a leveraged 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 all equity firm as a kind of a starting point where you are kind of investing 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 will 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, you know, they might get paid or not, but the bank walks 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 phenomena. 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 borrowing.
Now what's the business of the bank? There isn't 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 from their perspective. Any bit of it, you know, is too much. From society's perspective, having 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 digits, you know, depending on all their 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 that 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. And that's really it, because the conservation physics of finance that I'm talking about, physics of money, is that 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.
Joe (08:26):
So 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, etc. What else encourages the demand for further leverage or the prioritization of debt financing versus equity financing?
Anat (08:54):
It's the compensation of the bankers. It's 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 are less negative. So if your actual realized returns are below your funding costs...
Joe (09:07):
Wait, where does the fixation of return on equity come from?
Anat (09:10):
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 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.
That's a part of that. The bailouts, by the way, [are] a really complicated system. And you even touched on the FHLBs or 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, giving for a while, higher interest on reserves, which is crazy, as well as the FDIC, which has started guaranteeing all deposits, [an] extraordinary, dangerous situations.
And sometimes guaranteeing other debt after 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 – 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.
Tracy (10:56):
I 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 there's a reason why banks typically don't like to do that...
Anat (11:22):
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. It just so happened that both in the financial crisis and last spring and now, banks are considered well-capitalized. A lot of the banks that failed, including First Republic, got great CAMELS 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 hold-to 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. So a Treasury needs no equity backing. So even if you buy a Treasury, and you can do it a hundred percent with deposit money, well, the Treasury can lose in value.
What happened in Silicon Valley Bank was the following – in banking in general, being a zombie, you know, being insolvent, is Monday morning. What they're showing is symptoms – to a corporate doctor like myself – is every day the symptoms of the more they hate equity with a passion, 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. So this hold-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 their long-term have big duration risks and interest rates went down. So when they sold, they had to realize the losses. So all of a sudden accounting rules that usually allow you to hide the losses, are forcing you to recognize the losses.
So that was the first hit. Then basically, how would they survive? They were beginning to be obviously, more visibly insolvent. So the next thing that happens is they try to raise equity, as you said, and they couldn't. Now if you can raise equity — 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 deep in the water.
So the not raising equity is like the ultimate nail in the coffin. In other words, you are definitely insolvent. At that point the run was inevitable because of course, maybe by now that they've guaranteed effectively everything, maybe people won't run. And maybe we consider that kicking the can down the road as a good financial stability measure. But that is extraordinarily dangerous because in the eighties we allowed all these zombie savings and loans to persist and raise money — guaranteed by the taxpayers – until, you know, we have to pay for it.
Joe (14:22):
One of the arguments obviously against higher capital ratios or more equity is like ‘Oh, this will lead to an austerity of credit,’ and that banks won't be able to do lending. And this is a big part of the push against some of these rules, that there's going to be less lending etc. Why is that wrong in your view?
Anat (14:37):
Well, first of all, they can make any loan. My first measure, and my first emergency measure since the financial crisis, and you know, 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? Just 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 — they'll die? You know, if they die, if they can't survive, I question their business model. If the entire charter value that you 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 “ Leverage Ratchet” actually shows the waste of de-leveraging, and we show that there's a tendency to leverage through asset sales or stopping to lend, or whatever, through shrinkage, versus expansion. Well, I would 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 as conglomerates broke up in the eighties, 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. They would not exist in the 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 as well as the upside? If you don't like that price, maybe that's telling us something.
Tracy (16:34):
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….
Anat (16:42):
I remember!
Tracy (16:43)
What was it?
Anat (16:45):
This had a whole story behind it, which I won't tell you all of it, but it was by Binyamin Appelbaum, who used to be a Fed reporter, who I first met when he was a Fed reporter. And I won't go through all the details, but when he ended up writing the profile, it was entitled “ When She Talks, Banks Shudder.” And what I say to people who've noticed the headline is, oh, Jamie Dimon sleeps like a baby. In other words, the headline is cute but false.
Tracy (17:18):
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 and their business models...
Anat (17:31):
And the regulators, especially. The banks do what they get away with.
Tracy (17:34):
Yeah, for decades now, basically, I guess. What motivates you to do this?
Anat (17:40):
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 just a corporate finance, corporate governance person. And I look at those corporations, which I was teaching my students for 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 something in some other silo in economics. But 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, it’s the specialness of banks, it’s literally what they get away with. It’s then the politics of banking, that's what's special.
And then I all of a sudden realized, 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…
So 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 Haldane, 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. So there were big fierce battles at the time, post-financial crisis, about the topic. And I mobilized a lot of academics to help me, but it was very difficult work.
You were at the Financial Times at the 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, because 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, kind of almost didn't happen. It has been a decade since the book was published.
Tracy (20:35):
The book by the way, I should have said in the intro, it's The Bankers’ New Clothes and you have a new edition coming out.
Anat (20:40):
Exactly. So the book edition just came out in January, in the US, 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. So there are a few expansions of the material. The book is called The Bankers’ New Clothes: What's Wrong with Banking, and What to Do about It. The Bankers’ New Clothes refers to flawed claims. So that's the list of which we now have 44. But somebody just pointed [out to me] 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.
Joe (21:18):
So I take it, just an increase in capital requirements is probably, in your view, necessary but not sufficient to a stable financial system...
Anat (21:26):
It's the most no-brainer thing.
Joe (21:28):
But what is an actual – 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 [happen]. But what would it take or what is the basics of your prescription?
Anat (21:40):
Okay. 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 maintain, 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-weighted... they'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.
Joe (22:35):
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?
Anat (22:43):
Okay, in the 44 flawed 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 banks that are not connected as much to the, or not as obviously, to the safety net, to those bailout systems, actually fund with more equity. That was true for REITs – 30% is common sometimes.
And now one colleague and a few other people have a paper about mortgage lenders which have to disclose some things in some states and they analyze it and they show that lenders for mortgages that are not in the banking sector and are not regulated like banks have twice as much equity as the banks. So what's the problem lending with money that's raised however in markets?
And then the second point about shadow banking is most of the time, I mean the ultimate, the first incarnation of a shadow bank is the money market fund, right? So what ends up happening with shadow banking is, most of it, if you follow the money, is connected, funded by etc. the banks in the end. So when you follow the money, you'll find the safety net someplace along the way. So money market funds are just creating another layer of intermediation and then they can run on the banks, their investors can run on them. And then we opened up the spigot on them in Covid again because their reforms didn't work.
Tracy (24:12):
You mentioned the initial round of Basel rules sort of post-2008 and of course you've already touched on this as well, but we do have another effort, the Basel Endgame proposal. Now when we talked to Steve Kelly about this, he was like ‘Well why even bother talking about it? Because like for sure it's going to change from its current proposed form.’ But maybe with that caveat, can you talk a little bit about whether you think that's a useful revision of the rules?
Anat (24:41):
Well, I signed two comment letters on Basel Endgame and one on the long-term debt proposal, which also kind of triggered me a lot. And I signed one letter by 30 academics who are kind of, you know, friends of the Fed, supporting it, saying it's a step in the right direction. And then in my own letter on it, to which I attach a previous version of these 44 flawed claims and other writings and testimonies from the last 15 years – I said, ‘Well, I hope it's not Endgame because we will come back to it after another financial crisis, it has to be very spectacular. Because obviously the last one didn't affect it enough.’
In other words, it's really depressing how they always have these liquidity narratives and other things and focus on bailouts again instead of actually going – and you know Dodd-Frank said ‘No more bailouts,’ and there's plenty of authority to do anything, certainly to do even a lot more here, on both supervision, which completely failed in this case, and on the target numbers and on making them more meaningful because they're still not meaningful.
So why are we talking about it? I would say yes, these are kind of useless. Are they good? It depends how you enforce them. All of these rules end up – if you look just at the radar that shows you these ratios – you won't even know there was a financial crisis. The banks that needed the most bailout looked good all through the crisis, you know, and that's a study that was also done after the crisis.
So the bottom line is we don't like the metrics, we don't like the numbers, the range of numbers. And so I'm coming at it from completely the other side. I'm saying this continues to be poorly designed and inadequate. And in addition to this, I am not a hawk on other regulation. It's just this one is just correcting a huge distortion.
It's only on the funding side, it's liquidity regulations that put money on the sidelines. It's liquidity regulations that are costly in good times and useless in a run. You know, so that's the problem. So a lot of living wills, complicated risk weights, stress test, I gave you my stress test, market stress test. So I'm totally into just bringing the funding into markets and especially into equity markets. Start with that and the rest might look a little bit better.
Tracy (27:14):
So one of the things that comes up when talking about the Endgame proposal is the idea of, you know, ‘Well, poor Michael Barr needs to build consensus. He has to talk to all these different stakeholders about very technical and complicated things.’ Can you give us a little bit of color on your experience about how new banking rules actually come into being? I'm always curious.
Anat (27:35):
Oh, you know, the sausage making is amazing. So I was actually in DC and I met a few of the regulars including Mike Barr. I think it's on his official calendar, so I can tell you that. And yes, everybody was feeling very sorry for Michael Barr. I of course was feeling frustrated that he, you know, didn't speak more strongly. His first speech was okay, but afterwards it’s ‘Oh, we’ll change it, we'll change it,’ whatever. So anyway, I mean I told him this to his face and offered my help to argue against all these flawed claims. There's a manual of how to respond to all these.
So here's the interesting thing. With monetary policy, the Fed board is always unanimous. Like, you know, when Kevin Warsh objected to QEs, he basically had to leave, [Thomas] Hoenig would object from the regional reserve bank on monetary. On regulation, they don't have to have consensus. So he needs four out of seven. And you know, some of the support was tentative, some of the statements that the governors made were full of flawed claims and I didn't get a chance to meet all of them, but I would welcome that.
So I just think there's a great confusion and a lot of politics and sort of ways of thinking in banking that are very entrenched. And so, I don't know, I think what this proposal ultimately is doing is not changing the top head[line] numbers, but tweaking risk weights a little bit. And by increasing the risk weight a little bit, that's a little bit more equity you have to have against a particular asset out of millions. Nevermind that they don't take care about correlations and interest rate risk and other things, but just on the credit risk part.
And so the banks are weaponizing this extremely disingenuously to make threats that you and you and you and you won't make a loan. Which of course, once they get the cheap funding, they'll do what they'll do. They'll maximize ROE, whatever. So the politics of it are really ugly.
When I was in DC a couple of weeks ago, it was oozing from everywhere. The bombardment of lobbying was really shocking. It was never in the popular, on billboards and ads on your podcast, I mean, you know, I heard their ads on your podcast, ‘Stop Basel Endgame.’ They have explainers on that website that are wrong. You know, students coming into my course, just out of the corporate finance course, it's like you’re saying that equity is expensive because it's risky? What's wrong with all these companies that have plenty of equity and they don't choose to borrow even though there's no regulation? What are you talking about? This is absolute bread and butter finance: leverage and risk, risk and return, required return, is completely bread and butter. And so that's when you are even on the right side of the balance sheet and not on the cash reserve thing. It's crazy stuff.
Joe (30:17):
So we could say, okay, banks could be safer in a world in which, yep, they're much more equity financed. What about coming from the perspective of creditors to the bank? So there's certain capital that exists in the world that seeks out bank bonds, insurance companies, pensions, things like that may have a lot of demand for bank credit assets. Where does that money go in a different world?
Anat (30:41):
So are you talking now about the people who are customers who are borrowing from the bank?
Joe (30:45):
No, I'm talking lenders to the bank.
Anat (30:45):
Oh, okay, great subject. So here's the thing. Here's what's amazing about banks and here's the real abnormality of the bank. The deposits, of which, by the way, JPMorgan Chase now has two and a half trillion dollars. That is money that is a very unusual debt. Because it has no collateral. This is important to understand. No collateral, but has insurance, which effectively is now almost unbounded.
So what happens is that the depositors are almost all the time completely passive. I mean, if they'll panic one day, but they're always just telling them not to panic and just go about their business. So they sit there. Now, once you have this funding, it's a good time. It's a good life because you can use the assets as collateral for the other lenders. And the other lenders come in and they have collateral to their name, short-term lending. So they feel they can almost like depositors take the money out, withdraw it, and they have safe harbor laws that in a bankruptcy they can actually walk away with a collateral.
So if they, including the Federal Home Loan Banks, including even the Fed, they are safe. So in the ratcheting of leverage and in the sort of rat race to maturity – so there's another related paper saying that there's a race to shorten maturity, and then of course there's collateral races – what you have is the ability to keep shortening maturity and to keep giving collateral as a way to favor new lenders over old lenders. And the most passive lenders to take advantage of are the depositors and those who back them. So that's what actually happens in the economics of it.
Your ability to ratchet up your borrowing and the ability of your lenders to both chase their own returns — and we can talk about returns offered on CoCos and all of that, which in the end, wink wink ,nudge nudge, are not actually absorbing losses. And we didn't mention Credit Suisse in last year's events in the spring, which happened a week or nine days after Silicon Valley Bank. And that was a spectacular event in the world of banking, of big systemic institutions, that requires a lot of a whole discussion we may not have time for.
But all the talk in the same couple of years that I went to Davos, about how we're going to have bail ins instead of bailouts, and all these TLACs and long-term debt proposals, which completely triggered me over the Martin Luther King weekend when I was preparing these comment letters – once again, extraordinarily exasperated that I even have to do this – totally Groundhog Day.
As Tom Hoenig likes to say, why are we solving a problem of too much debt with more debt? If you have equity instead of long-term debt, instead of this total loss absorbing capacity, you would not get to that level. If Silicon Valley Bank had 20% equity, it would absorb those losses from interest rate decreases. If Credit Suisse had more meaningful, I'm saying better measured equity, we wouldn't be here.
Tracy (33:38):
I was just remembering the first time I ever wrote about contingent capital, it was on FT Alphaville. And even then, you're right, there was this discussion about like whether or not it would actually get used in an emergency. But maybe just to help us understand the argument – it's so hard, even for me, and I've been covering financials for a long time, to imagine a banking business model where they're not borrowing and lending and highly leveraged. So I want to ask like, is there–
Anat (34:07):
Having 20% equity and 70% or 80% debt allows you to do all the borrowing and lending you need to do. It allows you to take all the deposits, allows you to make all the loans you make.
Tracy (34:17):
I take the point, but what I want to ask is like if you think about your ideal banking system, what does it look like? Does it exist somewhere in the world already or has it existed in the past?
Anat (34:30):
Has it existed in the past? Definitely. Before safety nets – first of all, when banks were partnerships, not even limited liability corporations, they had 50% equity and unlimited liability for the Jamie Dimons of the world. In other words, they had their own money and they had to be the ones ensuring depositors back in the 19th century. You know, the depositors won't trust them otherwise – somebody had to back it up.
We go into a world in which we introduce, after runs and panics and all of that, we introduce deposit insurance. We introduce the central banks before that. So, equity, for example, when they started FDIC, banks in Kansas for example, they didn't want FDIC insurance and they had 20% equity. So in the history of banking, you know, in the start of the 20th century, banks had 20%, 30% equity.
So it's not unheard of. The equity markets are more developed – if they have a business model, there are investors who will give to them at their appropriate prices. They just don't like those prices because what they're telling equity investors is to take on risks that’s right now on other people, including governments and taxpayers.
So the point is my banking system would look a lot safer and all the de-leveraging that would happen would happen much slower. You'd have a lot more time to intervene as you see losses mount. If you are looking, somebody should look, if it's not going to be the investors, it's going to have to be the regulators. And that's all there's to it.
It's not rocket science. So, you know, and on contingent capital, there has never been an argument, why at the point of it, you force them to issue those because they also don't like those because maybe the long-term unsecured investors might ask a question or two about the off-chance that they would lose. You know, in an interview in 2013, [John] Stumpf, the CEO of Wells Fargo said ‘We have a lot of retail deposits and therefore we don't have a lot of debt.’ And I had a deposit with him so he even forgot, like you can't make up the nonsense they say. So the bottom line is get the equity, retain the earnings and come back later.
Tracy (36:25):
Alright Anat Admati, it was so great to finally speak to you on this podcast and the new edition of the book, The Bankers’ New Clothes, is out now. So thank you so much.
Anat (36:35):
Thank you.
Joe (36:35):
Thank you. That was great. It was a lot of fun. Thank you so much.
Tracy (36:50):
Joe. I'm glad we did that conversation. Because obviously there is still a lot more to say about banks, not just about how we bail them out, but maybe getting to that place, as Anat mentioned, where they don't need to be bailed out on a regular basis.
Joe (37:04):
I thought that was really interesting. I mean there are a few things that stuck out to me. One is just sort of this idea of examining banks as if they're regular businesses and starting from the premise that okay, this is a business and we have all these successful businesses in the world that do not, especially in Silicon Valley, that do not have particularly much credit financing and yet they work.
And so the question is like, starting from that standpoint, why are banks so much different and how does that contribute to the risks? I also thought it was interesting, her point that actually shadow banks or things that we call shadow banks, lenders that aren't necessarily part of the regulated bank system, in fact do hold more equity. That was very intriguing to me. And so the idea that not only do they naturally hold more equity, but also presumably they wouldn't be as systemically important because of the lack of depositors. That's an interesting observation about how banks or financial institutions outside the regulated system work.
Tracy (37:58):
Well, and they seem to be doing reasonably well right now, right? I haven't looked at a publicly traded BDC share price lately. So don't at me if this is completely untrue, but we talk about the golden age of private credit all the time and how quickly that industry is expanding. And in many ways they're doing the same thing that banks are just without, I guess, the regulatory requirements attached to that, but also the funding benefits.
Joe (38:24):
This idea of the obsession with return on equity. It almost sounds like, you know, a conspiracy between bank executives and the shareholders, right? Which is obviously, the shareholders don't want to get diluted by having more equity, and the executives want their salary to be tied to how much profits they can make on the equity, etc., but not necessarily being in the best interest of society and taxpayers.
Tracy (38:50):
And depositors who just want their money back.
Joe (38:52):
Yeah, exactly. No, there are a lot of interesting ideas there. I'm glad we had her on.
Tracy (38:55):
Alright, shall we leave it there?
Joe (38:56):
Let's leave it there.
You can follow Anat Admati at
@anatadmati
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