By now we have a decent understanding of the business choices that caused Silicon Valley Bank to fail. It made a bad bet on interest rates. Its depositors were not as sticky as they might have assumed. But of course, banks also have regulations, and supervisors intended to avoid such errors. So what went wrong on the regulatory side? On this episode, we speak with Columbia Law School professor Lev Menand about the history of banking regulations and the choices that lead up to this disaster. The transcript has been lightly edited for clarity.
Key insights from the pod:
How is financial regulation structured in the US? — 4:45
How our current system of financial regulation is broken — 7:12
How regulations started changing in the 1990s — 11:40
Why supervisors stopped supervising — 15:50
Who are the bank supervisors? — 18:50
Why do banks load up on Treasuries? — 21:40
What good regulators should have seen in SVB’s books — 30:37
Would SVB have survived under the original Dodd-Frank rules? — 37:58
Is monetary policy to blame for SVB’s failure? — 41:38
Joe Weisenthal: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway: (00:15)
And I'm Tracy Alloway.
Joe: (00:17)
So Tracy, we obviously have a sense of why Silicon Valley Bank failed. We just published a really good episode with Dan Davies, talking about where things went wrong on the deposit side and failing to balance assets and liabilities, as well as the strengths and weaknesses of the business model. But there are many more questions beyond just why they failed.
Tracy: (00:42)
Yes, some of the big ones emerging are: Where were the regulators? People were already analyzing SVB's balance sheet the week before it collapsed and for some time before that, and you could see these vulnerabilities when it comes to duration exposure. That's something we talked about with Dan Davies.
And then, it's not like bank failures are that unusual throughout history. This is the first big one since the 2008 financial crisis, so it's garnering a lot of attention, but we do have bank failures from time to time. It kind of raises the question of, if we're going to keep having them in different ways, and if the government or the Federal Reserve are going to keep coming in and rescuing them in various ways, should we maybe do something to the system to make it different?
Joe: (01:45)
What were the failures? And can we at least learn from them? We're always going to be fighting the last war, obviously, but what does it tell us about weaknesses in the system? There may be things that we could do.
Of course, there are things people are talking about on the written law side, like maybe we need more banks to have greater liquidity, ability to meet withdrawals. Some of the smaller, more regional banks don't have as stringent requirements on that front as the really large banks.
And then people are talking about supervision, which doesn't get as much attention as the written laws, but it's essentially, why did the supervisors, the bank regulators, allow the bank to create this confluence of risks, this big mismatch between the nature of its assets and the nature of its deposit base, that allowed it to unravel really quickly?
Tracy: (02:40)
Absolutely.
And with the Fed announcing this new facility, which is quite dramatic, you have a question of, if we're just going to guarantee all the US bank deposits out there, then should we maybe make a more fundamental change to the banking industry itself?
Matt Klein over at The Overshoot tweeted about how banks are these private investment funds that are grafted on top of critical infrastructure, designed to extract subsidies from the rest of society by basically threatening people with banking crises whenever one of them is allowed to fail.
We saw that last week, especially with a bunch of VCs coming out and saying, if you don't rescue all the SVB depositors right now, this is going to happen to all the banks. And so you kick off that privatization of profits versus publicization of losses argument over and over again.
Joe: (03:47)
That's been really clear in this particular episode. There's something about this story that raises uncomfortable questions because it's not coming in a wholesale financial collapse related to the collapse of the economy, like in 2008 or 2009. It's this very specific industry that got in trouble.
Anyway, we could go on and on, but I'm excited we have the perfect guest for us to talk about the role of regulators, the role of regulatory failure, the role of the Fed in all of this, and the history of banking and how we got here. We're going to be speaking to Lev Menand, a professor at Columbia Law School who has written a lot about the Fed and regulation. So, Lev, thank you so much for joining us.
Lev Menand (4:30):
Thank you so much for having me.
Joe (4:31:
Just to give a top-line view, what would you say was the main regulatory failure with SVB?
Lev (4:45):
We can distinguish between regulation, which are bright line rules put down in advance, and supervision, which is discretionary safety and soundness oversight by examiners and federal officials. Both the bright line rules and supervision failed here. There was an overreliance on the bright line rules and a failure to do the discretionary oversight effectively.
On the bright line rules side, SVB figured out a way to take additional risk without holding additional capital because of risk-weighted capital rules. Treasury securities are risk-weighted at zero, meaning that a bank has to hold zero equity against their Treasury positions. So, SVB was able to buy a lot of long-dated Treasuries and build up quite a bit of interest-rate risk without that being reflected in the capital required of them under the regulatory framework.
Now, we have a whole supervisory framework designed to deal with these sorts of holes in the rules. Everybody knows that the rules are insufficiently precise. We used to just do discretionary safety and soundness oversight. The real question here is how come the supervisors didn't pick up on the fact that SVB had gamed the rules to take on a lot of interest-rate risk without holding an adequate amount of capital against it. It's a pretty obvious maneuver and not a novel one. You would think any seasoned supervisor looking at the balance sheet could pick up on this quickly. So, what happened? I think the answer requires maybe 20 or 30 years worth of history to understand because contemporary supervision is broken in some sense, and this is a manifestation of that.
Tracy (7:03):
Ok, I’ll bite. Please give us the 30 or 40 years of banking history building up to this.
Lev (7:12):
I'll say why I think it's broken and then tell you how it got so broken. Supervision is broken because, outside of the stress testing framework, supervisors primarily now focus on process and procedures. Our insight into what actually goes on in supervision is very limited due to confidentiality. But it's fairly obvious that what supervisors today tend to focus on is the process.
They will look to see if the bank has a good risk management process, the right board committees, the right management committees looking at risk decisions, and three lines of defense. If the supervisors see the requisite process, they are very reluctant to make judgments about the actual decisions coming out of that process. They don't want to impose their own view on what is excessive risk. The process approach is born of the view that the best way to address risk is to make sure that the procedures are good. If the procedures are good, the problem will take care of itself.
Tracy (9:16):
So as long as you see the bank debating its risk exposure internally, which seems to have been the case at SVB, the regulators are just going to look at that and take it on face value because the process is there, and they assume that the bank is doing what it should be doing?
Lev (9:54):
Exactly. If you're not one of the big G-SIBs, the global systemically important banks, and you're not in the stress testing regime, I think that is what tends to happen. It doesn't have to happen, but there is a tendency in the supervisory process to look at compliance with the rules and check for processes. If you see compliance with the rules and processes in place, you give the bank a clean bill of health as it were.
And so the question is, how did we get to this place? Because actually this was an innovation, At one point we used to do safety and soundness, substantive supervision, without much bright line rules at all. Capital rules date only to the mid eighties.
And this focus on process is really an innovation from the 1990s. And so it's part of what I think is the toxic brew of regulatory supervisory policies that brought us the 2008 crisis. And we still sort of have supervision guided by this nineties approach. And I think the SVB failure is one of several really significant examples of post-2008 supervisory failure where the supervisors are still focused on process and unwilling to make substantive judgments reflecting the sort of approaches that were developed by primarily the Greenspan Fed, but also the Ludwig OCC in the 90s.
Joe: (11:29)
Can you explain what happened in the nineties? Was it a directive that came down? What caused this philosophical or mechanical shift in the approach to supervisory?
Lev: (11:40)
Let me start with the eighties, actually, with the birth of the capital rules. So, what's the baseline? Supervision, safety, and soundness supervision date all the way back to the 19th century. The way that the government managed the incentive misalignment between bank shareholders and managers and bank depositors and the public has been through discretionary supervisory oversight safety and soundness oversight. That's been the byword of federal law since the 1930s.
The way that supervisors would do their job is they would make judgments about the riskiness of the bank's assets and the riskiness of bank's leverage and the amount of capital. They would write letters and jawbone, and they would take enforcement actions. They would issue cease and desist orders if they thought banks were undercapitalized or, like in the case of Silicon Valley Bank, they would tell Silicon Valley Bank that it had to shorten its duration risk. That's what supervisors would do.
In the 80s, you have a moment that's quite similar to today in that the banking system's business model comes under a lot of pressure for macroeconomic reasons. Inflation goes up, and then interest rates go way up because of the Volcker shock. This causes the yield curve to change in a way that's very ugly for a bank because a bank's business is a positive net interest margin. You earn more on your assets than you pay on your liabilities, and your liabilities are short duration.
And so if interest rates go way up quickly, you can end up in a position where you are paying more on your liabilities than you are on your assets, which is going to run right through your capital. It's not a profitable business model. This happened in the eighties, and a lot of banks became undercapitalized, and supervisors were swamped with cease and desist orders and supervisory directives to banks all over the place to raise more capital.
Some banks sued, one bank was able to prevail in the Fifth Circuit, and Congress intervened and passed a new law authorizing ex-ante, bright-line capital rules for the first time and saying that capital judgments of supervisors can't be second-guessed by courts. And so in an accidental way, you have the birth of capital regulation. The supervisors are overwhelmed, and there are lawsuits, and you have Congress saying, actually, just write a rule that the banks all have to comply with so that you don't have to get into litigation over whether this bank or that bank is undercapitalized. Fast forward a few years, you get these rules, and you get Basel I, you get an effort to align these rules internationally, and you get Alan Greenspan as Fed chair going into the nineties.
The banking system starts to transform. You have the emergence of large complex banking institutions, and you have a lot of soul-searching in Washington and the Federal Reserve and the OCC about whether supervisors are really up to the task of assessing the risk-taking of these new large complex financial institutions — these large complex banking organizations that we never had in this country before — through traditional means or whether we should actually embrace these new rules that have developed, and rely primarily on the rules, and shift supervisors to a task that they're more capable of performing. This is very self-conscious for the policymakers of the time.
You can go back and read some of Alan Greenspan's speeches about the changes that he's making. And he basically thinks that especially for large banks, supervisors are just not going to be able to do it the way they used to. What we need are capital rules that require shareholders to have enough skin in the game, and then the shareholders will do it. The shareholders were supervised banks. And so Alan Greenspan says it's not about needing net less regulation, it's about whether it should be public-sector regulation or private-sector regulation. And we need to reorient the banking system so that we have more private regulation. So that obviously goes terribly wrong in 2008.
Tracy: (15:47)
It's not funny, but this happens over and over and over, doesn't it?
Lev: (15:50)
It does. And so by 2008, supervisors have more or less unilaterally disarmed. They have shifted to enforcing the capital rules. The banking agencies are relying almost entirely on the capital rules for making judgments about whether a bank has adequate capital for the risks it's taking. Instead, they are looking at processes. There's a real theory behind this.
The theory is that in order for market regulation to work, private regulation must work, and there has to be disclosure. A bank has to be transparent about the risks it's taking. A bank can't be transparent about the risks it's taking if it doesn't have processes to monitor and disclose those risks. The job for supervisors is to make sure banks are monitoring their risks and disclosing them to the shareholders so that the shareholders can discipline the banks.
By 2008, supervisors have stopped bringing cease and desist orders. There are no safety and soundness enforcement actions against any of the major banks, any of the major banks that take TARP, for years running up to 2008. If they're in compliance with the rules and they're disclosing to the market, the judgment is that the system is going to work.
What goes wrong is that bank shareholders have an incentive to take much more risk than is in the interest of the government or depositors. Shareholders have an incentive to extract wealth from the depositors and from the public. They can be much more comfortable with a lot more risk than the public should be. If you're going to rely on them to monitor risk, you're going to get a much riskier bank, and this is Silicon Valley Bank's story.
So you get 2008, and you get a modification after 2008, which is stress tests. But a lot of ordinary supervision continues to be procedurally-oriented. You see this with the London Whale and the fake-account scandal at Wells Fargo, both of which are really important data points for outside observers to think about how much we fixed supervision after 2008 and how much we moved away from the Greenspan nineties cocktail of bright line capital rules and procedural oversight-oriented to shareholder discipline. I think the answer is that for the small banks that are not subject to stress tests, and even for the big banks that are subject to stress tests, outside of the stress-testing regime, we still have a lot of procedural oversight.
Joe: (18:23)
This is actually a very quick mechanical question, but for a bank like Silicon Valley Bank, is it supervised by a panel? Like, how many people are involved? Because it's someone at the SF Fed, presumably, and I assume there are thousands of banks in California, probably at least hundreds. What kind of human resources could even currently go to paying attention to a bank like Silicon Valley Bank?
Lev: (18:51)
There are thousands of supervisors across the federal system. They're split across three agencies: the Federal Reserve, the Federal Deposit Insurance Corporation, and the Comptroller of the Currency. They split up responsibility for supervising banks. Silicon Valley Bank is a state-chartered bank and a member of the Federal Reserve System. So, as a result, it's the Fed that has responsibility at the federal level for primary responsibility for supervision, although there's always overlap.
The FDIC has some ability to come in because it's insuring the deposits, and it's very involved now. The day-to-day job here is for the Fed personnel in San Francisco, who are actually exercising delegated authority of the Board of Governors, which is the federal agency with the power to supervise member banks. The reserve bank of San Francisco is actually a federal corporation, And so it's helping the board. And the board has supervisory staff that are supposed to sort of oversee what is going on at the reserve bank. So is San Francisco doing a good job? And obviously at the top of that is Michael Barr, the vice chair for supervision.
Tracy: (20:24)
I am going to have some more questions on the San Francisco Fed and the FOMC as well. But just going back to the evolution of bank capital rules. So one of the big things that happened, and you sort of outlined it in the lead up to the 2008 crisis, but it definitely hardened after 2008, is this idea that banks should be holding more bonds in general, the safest bonds.
So, you know, US Treasuries, in the case of US banks, maybe agency mortgage-backed securities that are implicitly guaranteed by the US government, things like that, for their regulatory capital and liquidity buffers. And it seems to me like that probably made a lot of sense in the low-inflation environment of 2008. But now that you have the Fed raising rates, you have a lot of volatility.
It seems like these bonds might not be, I don't think safe is the right word, but not as unproblematic as maybe we imagined them to once be. Could you talk a little bit more about basically how we built the modern banking system on top of a bedrock of bonds that are presumed to be somewhat stable in price?
Lev: (21:44)
So I think that you're right to highlight the appeal of Treasuries and agencies to both bankers and supervisors in the wake of 2008. A bank that loads up on Treasuries is seen as very wholesome for a bank to do. The government likes that, the government has liked banks that buy Treasuries since the Civil War.
And so it's going to cut against even the most ambitious and confident safety and soundness overseers' impulses to fault a bank for loading up on Treasuries. That seems like a good thing, right? And so it helps to explain part of what's happening here. And it's also true that banks do have the ability to weather usually a fair amount of interest-rate losses on their assets.
So many banks think of themselves as structurally hedged against interest-rate increases because while their assets — if they have long assets, like long-dated Treasuries — those are going to lose value when interest rates rise. Their liabilities are deposits, and their deposits are sticky, they don't pass through. And so actually, their deposit funding becomes much more valuable when interest rates rise.
So if in a zero-interest rate environment, interest rates are zero, deposit rates are zero, deposits aren't that useful, you're getting a little benefit that you have deposit funding. But if interest rates go way up, you're not going to, if you're the bank, you're not actually going to be forced to raise your deposit rates, and this is actually strengthening your business.
And Silicon Valley Bank is going to think, yeah, okay, so we take some hits on our long assets, but actually, our net interest margin is going to remain strong, our deposits are going to be much more valuable, and we're just going to work through a year to 18-month period and be totally fine.
Joe: (23:57)
Right. Which it seems like that was sort of the assumption that they had, like they knew it wasn't great and maybe even technically insolvent, but I mean, I think it was this week in one of Matt Levine's newsletters, that this was actually a very profitable time for them. It would've been fine if everyone stayed. And presumably their expectation was, well, we're just making a lot in income right now. So the fact that we took a hit on the asset side is not really long-term.
Tracy: (24:21)
Well, they had a specific estimate in one of those internal documents where they said we could shorten duration, but that would mean an 18 million hit to our net interest margin in one year alone, going up to like 36 million over the next three years. So they knew that if they reduced duration, they would be sacrificing earnings to some extent.
Lev: (24:44)
Yeah, I think it's fair to say that in 2021, they were making huge profits because this strategy was really working. Interest rates went way up. And I think it would've impaired their profitability. But they were wrong to think that they were somewhat structurally hedged even though they had no interest-rate hedges or anything, right, by virtue of the fact that they would slowly be able to replace their Treasuries with much higher yielding Treasuries while being able to pay depositors very little.
Joe: (25:12)
Also, we talked about deposit betas on a recent episode with Joe Abate, and why they're often low. One of his points was like, well, you have a bank, an individual has an account at Chase or something like that. They're providing a lot of services along with that. People are not that inclined to move their checking account just because the interest rate doesn't bump up a little bit.
And I imagine for Silicon Valley Bank depositors, these companies, the whole story about Silicon Valley Bank was all of the products, the startup-specific products that they offered, which presumably insulated them to some extent against losing deposits.
Lev: (25:52)
In the case of SVB, there was also what in antitrust law we call “tying,” where a company ties one product to another product. So the bank would require that if you wanted to borrow from the bank, you would have to also have a deposit account.
Joe: (26:09)
Is that unusual?
Lev: (26:17)
I don't think it is unusual. There are strict rules about bank tying in other areas, but my understanding is that banks are explicitly permitted to tie deposit-account services to lending services.
Historically, it was core to the banking business that you were the depository institution for your borrowers. That went together. We've moved away from that due to technology and other factors, but for a long time, the idea was that there's a lot of synergies between the two.
Joe: (26:59)
Right.
Tracy: (27:00)
I imagine there was also a bit of a prestige element to banking at SVB as well, given that it was so popular among a particular type of tech/VC person. Joe touched on the episode we did on deposit betas with Joe Abate, but Lev, I'd love to hear from you: why didn't people pull more deposits from a bank that was essentially paying them nothing?
To some extent, this is the big question: Why did SVB have so many deposits well into 2022, at which point we started to see some of the most interest rate-sensitive parts of the economy, i.e., the tech industry, lose a bunch of money and have to pull funds? Why were people accepting of that for so long?
Lev: (27:51)
We mentioned a couple of the rational explanations, like a strong brand, wanting to bank there, and lending requirements. But you can't discount the fact that a big piece of this was a lack of sophisticated financial management on the part of startup companies that maybe didn't have CFOs or anyone with experience in managing cash.
They were focused on their business. It's hard to justify a $500 million bank account balance, and we have one example. There's just no reason for that. That's very bad management. No well run mature company would operate in that way. Among other things you have the huge uninsured deposit risk that we saw, but you're also just giving up lots of return. You could have that money invested in laddered Treasury bills or something and be earning...
Joe: (28:55)
You’re getting 4% now!
Lev: (28:57)
...significantly more money. So there's a huge amount of money that's just being left on the floor here, and it doesn't really make sense. We have to understand that these customers, despite having lots of money, are not actually very sophisticated.
Joe: (29:11)
I want to go back to the supervisory question and ask about it, coming at it from a different angle.
Obviously, the 2008-2009 crisis was very focused on the asset side of the business and whether these were high-quality assets. Part of the reason a bunch of banks failed is because the assets they held weren't very good. As people have discussed with Silicon Valley Bank, a lot of the issue is — yes, maybe they made a wrong bet on Treasuries or they put too much — but it’s the flightiness of the deposits. Can you talk a little bit more about how good supervision in an active pre-nineties way might have approached the uniformity of SVB deposits and the risk of them all leaving at once?
Lev: (30:07)
Yeah, I mean, I think that if you showed SVB's balance sheet to a supervisor brought up during the New Deal system — let's say it's 1975 — they would be horrified at the enormous concentration of uninsured deposits controlled by a group of businesses with very similar risks to their business. All of your depositors are going to run into this.
Joe: (30:31)
Something that a New Deal-era supervisor would be familiar with from previous experience, right?
Lev: (30:37)
I think it would have been unfamiliar in the sense that it would have been so unusual back then. Everyone would have looked at it and said, "Whoa, this bank has a very unstable deposit base." It would not have been novel to view this with concern. It would be even more concerning because of how risky it would have been to operate a bank in this way at that point in time when people still remembered the bank runs of the thirties much more than they do today.
Part of what went wrong with SVB is that they had, say, 97% of uninsured deposits, and all of their depositors were going to withdraw at the same time. This is a classic issue in the banking business: Under what circumstances am I going to be subject to a deposit drain?
You get to model your deposits as sticky if you are a bank because, over time, for the banking system, the deposit base is always growing. I mean, with the exception of over the last year, where monetary policy is trying to shrink the money supply. But over time, it's a constantly growing base. Deposits are really, in some sense, a very long-duration asset, except if you are the one bank that experiences a drain to the rest of the system where everyone withdraws from you. If your customers are all going to face hardship at the same time, you can't treat yourself as structurally hedged. You're the opposite of structurally hedged. That's what Silicon Valley Bank found out: They thought that when their assets lost value, their deposits would become more valuable. But actually, all their depositors started to draw down their accounts, and the opposite happened.
They were just very long low-interest rates. Silicon Valley Bank's whole business model was tied to low interest rates, to an extent that they did not appreciate. And to an extent, supervisors clearly didn't appreciate but maybe weren't even thinking as hard about as they might have in an earlier period where they were more empowered to make those sorts of judgments.
Tracy: (32:41)
Yeah, this is exactly what I said on our episode with Dan Davies. It was about interest-rate exposure, kind of squared, but just on the deposit side. To me, this is the most novel or interesting thing about all of this because we know that a lot of banks have unrealized losses on bonds, and it seems like, broadly, they've been managing their interest-rate risk so far.
But with SVB, the big difference was that group of highly concentrated, extremely unreliable depositors who themselves had significant interest rate exposure and were pulling money over the past years. So, what could regulation do on that front? I guess instead of the asset side, looking more at the liability side.
Lev: (33:30)
Yeah, what you want to see is a coherent asset-liability management strategy for a bank. A bank that anticipates deposit drain, especially if it has flighty deposits, needs to hold liquid assets that can be sold at their fair market value to cover the withdrawals. Part of the problem here is that Silicon Valley Bank did not actually have available-for-sale securities at fair market values sufficient to cover the withdrawals.
The fix for this would have been to have much less duration in the asset portfolio or many more reserves. This is the same problem, by the way, that took down Silvergate Bank and, to some extent, Signature Bank. They had deposit bases that were flighty, and their depositors suffered as the banks experienced deposit drains because they were concentrated in a group of people exposed to interest-rate hikes.
Tracy: (35:06)
I just realized I promised to ask about discount lending and the FHLBs (Federal Home Loan Banks). In theory, when you have this type of banking crisis or a liquidity issue with a financial institution, you would expect them to either go to the Fed, to the discount window, or they can borrow from the FHLBs. Some of the talk out there is that SVB got cut off by FHLB.
Why would that have happened, and why wouldn't those two lenders of last resort do everything they can to step in and support the bank? Or is it the case that, at some point, they're talking to the FDIC and they just say this is untenable and no matter how much money we provide, the bank is not going to be able to get up and running again?
Lev: (36:02)
So I'm speculating a bit here, and you might want to talk to the FHLB expert in the legal academy, Kate Judge, who's my colleague. But the FHLBs are not a lender of last resort in the way that the Fed is. The FHLBs do provide sort of lender of second-to-last resort services to their members, but they are much more operated by their members and they pay dividends to their members than the Fed.
The Fed basically functions as a public bank with no interest in profits, and they're willing to take one for the team in a way that the FHLBs are not. So I think it's a mistake to look at the FHLBs and say, "Oh, well, you really ought to have lent to an insolvent institution and took on that potential risk." The FHLBs have even more reason to pull back.
Joe: (37:09)
We definitely have to do an FHLB episode at some point with Kate Judge.
I want to ask another dimension. People point to the 2018 law change to Dodd-Frank that seems to exempt banks like Silicon Valley Bank from some of these liquidity requirements that you were talking about. Like, do you have enough liquid assets? A, could you sort of characterize the change that was made there, and B, had that not been in place? Is that change that was made in 2018 the story of the demise? Had the old Dodd-Frank laws remained in place for a bank the size of Silicon Valley Bank, would they have been able to weather the storm?
Lev: (37:58)
You can never know for sure, but I would suggest yes. That is decisive. This brings us back to how the government responded to the 2008 failure of supervision and regulation. They responded with a set of tiered new requirements. For the very biggest banks, you had the CCAR stress testing regime, and for all of the banks with more than $50 billion of assets, you had stress testing as well as a collection of other enhanced prudential standards.
This new cocktail of regulation and supervision was geared towards preventing a repeat of something on the scale of 2008. We weren't going to impose this on the whole banking system, but the thinking was if we could get back to serious government oversight of banks over $50 billion, that would go a long way towards preventing another calamity like 2008.
What happened was, immediately there was litigation over the threshold for this new regulatory supervisory cocktail. The $50 billion threshold came under a lot of political pressure from the banking agencies and various people in Washington. The bank lobby fought a battle over many years to raise the threshold. One of the important figures lobbying for raising the threshold was the CEO of Silicon Valley Bank. He was growing his bank and did not want to grow into additional regulatory and supervisory requirements. In 2018, after winning over people in both parties to raise the threshold, Congress changed the law and the relevant threshold moved up to $250 billion. As a result, Silicon Valley Bank and its peers had successfully exempted themselves from the enhanced prudential standards that Congress had created after 2008.
The result was that they didn't have stress testing, which is the primary means by which supervisors now exercise substantive judgment about risks. You had a much more light touch, process-focused oversight that allowed rule-compliant balance sheet configurations like SVB's to go relatively unchallenged. If they had been in the enhanced prudential standards bucket, they would have been challenged through additional rules and supervisory programs. It's unlikely, though you can never know, that they could have taken so much duration risk and not raised capital earlier or been permitted to go for so long in a position where their liquidation value is possibly negative.
Tracy: (40:57)
Since we're on the topic of the blame game, one of the things you see people saying now is that it's the Fed's fault. The Fed kept interest rates low for too long, and it basically forced people to assume additional duration risk in order to seek out yield. Financial repression is a real thing, but on the other hand, you cannot ignore the individual actions of one or a few specific banks, their managers, their shareholders, and their depositors. How would you describe overall monetary policy's role in the current predicament?
Lev: (41:38)
So overall, monetary policy is, of course, central to the current predicament, but there's a sort of false dichotomy underlying the view that somehow it's like monetary policy happening up here at the Fed that's then causing problems down here at the banking system. The whole thing is monetary policy. The whole reason we have banks is monetary policy. Banks are creating the money supply. And the question is, how much money do we want to be created?
So it would be the tail wagging the dog if we had to change our judgment about how much money should be created because somehow the system couldn't create that amount of money safely and stably. We have a broken system if it can't create the amount of money that the FOMC says is appropriate for macroeconomic conditions. And so I would not blame the FOMC for thinking that we need to adjust the amount of money that the banking system and the financial system are creating.
I would blame the banking and financial system and the banking and financial laws if they're incapable of producing the amount of money and changing the amount of money they're producing over time, consistent with the FOMC's directives and the needs of the economy. That's a really big problem. And it does look like we're facing that problem now, where in the coming months, we could be in quite a predicament where the FOMC may make the judgment, and we can bracket whether it would be the correct judgment, that the economy needs less money and the banking system may be incapable of functioning properly under that directive.
And that's the flip side of the suggestion that the banking system should also be able to function under the judgment that interest rates should be zero and function in a way that is sustainable over time. And so, to the extent that is what's going on, I think it's a real indictment, not of monetary policy, like the high-level decision about how much money we need, but the structure being unable to follow through to execute on those decisions.
Joe: (43:29)
Lev Menand, that was an amazing answer. That was an amazing conversation. That was so helpful and so clear. I've said it every time we talk to you, I'm like, "Oh, I finally had, there's been a few more, but that was very good." I'll just leave it at that. I really appreciate that. So, thank you so much for coming back on.
Lev: (43:50)
Thank you so much for having me back.
Tracy: (43:51)
Thanks.
Joe: (44:04)
Tracy, I loved that whole conversation, starting from the very end, which I think is a really excellent way to reconceptualize the monetary policy problem, which is that if the Fed is going to be tasked with the sort of big sweep macro management, right? Getting employment and inflation at its targets and so forth. In theory, we want to have a financial system that can operate under any, you know, operate relatively safely under whatever rates the Fed deems to be appropriate.
Tracy: (44:36)
Absolutely. I mean, I do think there is a fundamental tension between monetary policy, which, you know, like the big thing monetary policy does is basically impact the price of bonds, and then having the financial system and banks specifically have to hold a bunch of bonds as part of their capital and liquidity mandates. Like that tension is there, but there are ways to manage it such that we can avoid failures and also provide for the effective implementation of monetary policy as a whole. The other thing that really struck me is this is kind of an incentives episode. And I thought Lev's point about basically outsourcing a lot of bank supervision to private shareholders and expecting them to, you know, maybe press the brakes on risk when things start to get out of hand, that was a really interesting one.
And SVB, I think, is going to end up as a classic case where, you know, there was an acknowledgement that there was an issue here. There was the asset-liability duration mismatch, and there was too much exposure to long bonds, and too much of an assumption that deposits would be around forever or that they might even, you know, return or start growing again. And it was a conscious decision to pick up net interest margin, or at least it looks like that. I'm sure more will come out over the course of all of this. But for now it certainly seems like it was a decision to do that.
Joe: (46:08)
That's really interesting. Thinking about it, it's fascinating that a lot of these capital requirements, ratios, and regulations that we think of as core to how we manage the banking system are all pretty young. For a long time in history, it was more about active supervisory people making judgments based on the operations of the bank, whether their decisions on loans and deposits were healthy.
I hate to use words like “neoliberal,” but that the role of supervisors would essentially transform them into making sure that shareholders were getting adequate information — you start with the assumption that the market is the best regulator, and then the role of the government is to make sure that market regulators get good information.
This seems like a big theme that you could characterize across different industries and governments. The problem is that shareholders can lose everything and not be accountable for the spillover when a bank fails. So there's a need to get back to a type of supervisory role that actually takes decisions into its own hands, rather than just outsourcing it.
Tracy: (47:24)
You know, I realized we didn't even get into Fed checking accounts...
Joe: (47:28)
Yeah, so I think the next episode in this series should be if all deposits post-SVB are presumed to be insured, which almost seems like implicitly the case now, why do we have private deposit-taking in private banks?
Tracy: (47:43)
Yeah.
Joe: (47:44)
I think that's the next topic in this series to look at — what this tells us now about the point of private deposit-taking institutions and whether there should be a public option.
Tracy: (47:53)
I mean, that is what I was kind of hinting at in the intro. But we'll just have to leave that for the next episode. It was a trailer, not for this episode, but for the next one. So, plenty more to come, but shall we leave it there?
Joe: (48:04)
Let's leave it there.
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