Odd Lots - The Regulatory Blunder That Gave Us the Silicon Valley Bank Disaster

Episode Date: March 16, 2023

Whenever a major financial institution collapses and needs a bailout, it's easy to say, "Where were the regulators?" But that's only a useful question if you can pinpoint the specific regulatory choices that led to any particular situation. So what caused Silicon Valley Bank to implode? On this episode of the podcast, we speak with Columbia Law School professor Lev Menand, who discusses the defanging of bank supervisors in the run-up to this fiasco. With proper oversight, someone might have caught and put a stop to the unique set of risks the bank was taking. But without proper oversight, they were encouraged to go for all-out growth, regardless of the ultimate social cost. We also discuss legislative changes over time that led to this buildup of risk.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa play the Odd Lots podcast on Amazon Music. You have the desire to help a real difference? The College, LaCity, you offer the program Dependance and Sentental. Acquare the competences essential for accompany and support the people confronted to health mental and dependence. Construise a career enrichinger, to service of the community francophone of all the country.

Don't the soin of quality in French, it's possible, with LaCite.com.C.A. right now. An initiative of the Consortium National of Formation in Health Sautenu, supported by Santee Canada.

Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. So Tracy, we obviously

I think have a sense of why Silicon Valley Bank failed. We just published a really good episode with Dan Davies like sort of like talk about where things

went wrong on the sort of deposit side and failing to bail assets and liabilities and the issues of strengths and weaknesses of the business model. But then the other question, there are many, many more questions beyond just like why they failed. Yes. I mean, some of the big ones that are emerging are where were the regulators, right? It, you know, people were already analyzing SVB's balance sheet, you know, certainly the week before it collapsed

and for some time before that. And you could see these vulnerabilities when it comes to duration exposure. And again, that's something we talked about with Dan Davies. And then the other thing, I guess just in general, is it's not like bank failures are that unusual over the course of history. So this is the first big one, I guess, since the 2008 financial crisis. And so it's obviously garnering a lot of attention. But we do have bank failures throughout history from time to time. And it kind of begs the question of, well, 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? What were the failures and can we at least, you know, we're always going to be fighting the last war, cliche, obviously. But what does it tell us about weaknesses in the system?

And there may be things that we could do. And of course, there's things that people are talking about on the sort of written law side, which is like, okay, maybe we need more banks to have greater liquidity, ability to meet withdrawals, et cetera. I think 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. And I don't think supervision gets as much attention as the sort of written laws. but it's essentially, well, why did the supervisors, the bank regulators, allow the bank to, like, create this confluence of risks, this big, like, sort of very specific mismatch between the nature of its assets, the nature of its deposit base that allowed it to unravel really quickly. Absolutely.

And then, of course, with the Fed announcing this new facility, which is quite a dramatic one, you have a question of, okay, if we're just going to guarantee all the U.S. bank deposits out there, then, should we maybe make a more fundamental change to the banking industry itself, right? And actually, Matt Klein over at the overshoot, I think you tweeted this, but he had that great first line in his most recent newsletter about how basically banks are these private investment funds that are grafted on top of critical infrastructure. And that structure is designed to extract subsidies from the rest of society by basically threatening people with banking crises whenever one of them is allowed to fail. And we saw that last week, right? We saw especially 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, you know, privatization of profits versus publicization of losses argument over and over and over again. No, that's been like really clear in this particular. episode. Like, there's something about this story really raises some, like, uncomfortable things, because it's not coming in, like, a wholesale financial collapse that's related to the collapse of the economy, like in 2008 or 2009. It's like, it's this very specific industry that sort of got it in trouble. Anyway, we could go on and on. But I'm excited we do 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. in the history of banking and how we got here.

We're going to be speaking to Lev Menand. He is a professor at Columbia Law School, written a lot about the Fed and regulation. So, Lev, thank you so much for joining us. Thank you so much for having me. So just, you know, very top line view, you know, what would you say was the main regulatory failure with SIVB? So can distinguish. SIV must be a Freudian. Oh, yes.

We can distinguish between maybe regulation, right-line rules that we put down in advance and sort of supervision, which is discretionary, safety and soundness oversight by examiners and federal regulators, federal officials. Both the sort of bright-line rules and the sort of supervision failed here. There was an over-reliance on the bright-line rules and a failure to do the discretionary oversight, the safety and soundness oversight effectively. So on the bright-line rules side, SVB figured out a way to take additional risk without holding additional capital because of what's called the risk-weight capital rules.

Treasury securities are risk-weighted zero. That means that a bank has to hold zero equity against their treasury positions. And so, SBB was able to go and buy a lot of long-dated treasuries and actually build up quite a bit of interest rate risk without that being reflected in the capital that was required of them under the bright line rules, under the regulatory framework. Now, we have a whole supervisory framework that's designed to deal with these sorts of holes in the rules. Everybody knows that the rules are insufficiently precise. And in fact, we didn't even have the rules until the 1980s in meaningful sense.

We used to just do discretionary safety and soundness oversight. And so the real question here in some sense 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, it's a pretty obvious maneuver. It's not nearly as complex as some of the maneuvers, the gaming. And it's not novel. It's not novel. Yeah, this is an old move. It's not like they camp with something new. You would think any, any seasoned supervisor looking at the balance sheet could pick up on this pretty quickly. So what happened? I think is exactly the right question to be

asking. And I think the answer requires maybe, and this might just be my approach to these issues, 20, 30 years worth of history to understand. Because basically, I think contemporary supervision is broken in some sense. And this is a manifestation of that. Okay. Well, I'm just going to go ahead and bite and say, please, please give us the, you know, 30 or 40 years of banking history building up to those. Yeah, so I'll say why I think it's broken, and then I'll tell you how we got, how it got so broken. So it's broken because outside of the stress testing framework, which I think we should

definitely talk more about, supervisors primarily now focus on process and procedures. Our insight into what actually goes on in supervision is very limited, and that's because supervisory materials are all confidential and can't be disclosed by the bank and aren't disclosed by the regulators and often never made public. So there's a lot of opacity into what supervisors are actually doing, but it's fairly obvious. And I'll go through a few examples that what supervisors today tend to focus on is the process. And so they will look to see, does the bank have a good risk management process? Does it have the right board committees? Does it have the right board committees? Does that have the right management committees looking at its risk decisions.

Are there three lines of defense? And if the supervisor see the requisite process, they are very reluctant to make judgments about the actual decisions that are coming out of that process. And so they don't want to impose. They are reluctant to impose their own view. Oh, that is excessive risk. That is too much interest rate risk, as opposed to, we like, the procedures that you set up to manage interest rate rate.

Just to be clear, though, they certainly could under current law. Like, they're not, they're allowed to say that. They're supposed to, arguably, that's what current law is about. And the process approach being grafted onto this is an innovation. The purpose of safety and soundness law is really very much to address risk. And the process angle is born of the view that the best way to do that, the most efficient way to do that across a massive banking system is just to make sure that the procedures are good. If the procedures are good, the problem will sort of take care of itself.

So as long as you see the bank kind of debating its risk exposure internally, which seems to have been the case at SVB, and I know I brought this up in the previous episode, but, you know, there were some internal documents, which I've seen, where they're talking about interest rate exposure and they're debating it, you know, with their asset liability committee and presumably with their risk specialists. But if they come to the conclusion that actually we're okay, the regulators are just going to look at that and take it on face value because the process is there and they assume that, you know, the bank is kind of doing what it should be doing. Yeah, 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, as Joe said, there are certainly going to be examples where supervisors there's exercise of independent judgment, but there is a tendency still in the supervisory process to look at compliance with the rules, to check for processes. And if you see compliance with the rules and you see processes in place to 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-80s. 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 2000-Nate crisis. And we still sort of have supervision guided by this 90s 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 too 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. Can you explain what it was or what happened in the 90s? Was it a directive that came down? What caused this philosophical shift or just maybe mechanical shift in the approach to supervisory? Let me start with the 80s, actually, just with the birth of the capital rules. So what's the baseline? So supervision, safety and sound of supervision, dates all the way back to the 19th century.

And so the way that the governments manage 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 bywords of federal law since the 1930s. And the way that supervisors would do their job is they would make judgments about the riskiness of banks' assets and the riskiness of banks' leverage and the amount of capital. And they would write letters and they would 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 business model comes under a lot of pressure for macroeconomic reasons. Inflation goes up and then interest rates go way up because of the Volker 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 80s, 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 bank sued. One bank was able to prevail in the Fifth Circuit, and Congress intervened and passed a new law, authorizing a forward-looking

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 a sort of accidental way, you have the birth of capital regulation. The supervisors are overwhelmed, and there are low, there are low, 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, you get Basel 1.

You get an effort to align these rules internationally and you get Alan Greenspan as FedShare. Going into the 90s, 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 at 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 the traditional means. Or whether we should actually embrace these new rules that have developed up and rely primarily. on the rules and shift supervisors to a task that they're 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 Green spent 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 Green Span 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. It's not funny, but this happens over and over and over, doesn't it?

Go ahead. It does. And so by 2008, you have 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 that it's taking. And instead, they are looking at processes, and there's a real theory behind this. The theory is, in order for market regulation to work, private regulation to work, there has to be disclosure. And so a bank has to be

transparent about the risks that it's taken. A bank can't be transparent about the risks that it's taking if it doesn't have processes to monitor and disclose those risks. And so 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. And by 2008, supervisors have stopped bringing cease and desist. There's 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. Because if they're in compliance with the rules and they're disclosing to the market, the judgment is that 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. It's sort of basic economic stuff. The shareholders have an incentive to extract wealth from the depositors and from the public. And so the shareholders are going to be much more comfortable with a lot more risk than the public should be. And so if you're going to rely on them to monitor risk taking, you're going to get a much riskier bank. And this is Silicon Valley Bank story. I mean, it's very much Silicon Valley Bank story. So you get 2008, and you get a modification after 2008, which is stress tests. But a lot of ordinary day-to-day supervision continues to be, I think, procedurally oriented. And you see this with the London Whale. And you see this with the fake account scandal at Wells Fargo, both of which I think are really

important data points for outside observers to think about how much did we fix supervision after 2008. How much do we move away from the Greenspan 90s cocktail of bright line capital rules and procedural oversight oriented to shareholder discipline? And I think the answer is 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. So this is actually a very quick mechanical question. But for a bank like Silicon Valley Bank. Is it as supervisor? Is it a panel? Like how, like, what do you know, do you have a sense of like how many people, I mean, because it's someone at the SFFED,

presumably. And I assume there's thousands of banks in California, probably, or at least hundreds. Like what kind of just like human resources could even go currently to paying attention to Silicon Valley, a bank like Silicon Valley Bank? So there are thousands of supervisors across the federal system. Okay. 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 it's a member of the Federal Reserve System. So as a result, as you say, it's the Fed that would have responsibility at the federal level for primary responsibility

for supervision. There's always overlap, so the FDIC has some ability to come in because it's insuring the deposits, obviously, and then it's very involved now. But the day-to-day job here is fed personnel in San Francisco who are really actually exercising delegated authority of the Board of Governors, which is the federal agency with the power to supervise member banks. And the Reserve Bank of San Francisco is actually a federal bank, a federal corporation. And so it's facilitated. It's helping the board.

And the board has supervisory staff that are supposed to sort of over-referiorated. see 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. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value in fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But on Vanguard, at Vanguard, institutional quality isn't a tagline. to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders.

These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Renno mishap? That's embarrassing. You know what's not embarrassing? Using FIG for Home Improvement Loan.

A quick, simple, and transparent offer in minutes. Borrow Better with FIG. Visit fig.ca. I'm going to have some more questions on the San Francisco Fed and the FHLBs 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 like it definitely hardened after 2008, is this idea that banks should be holding more bonds in general, the safest bonds. So, you know, U.S. treasuries in the case of U.S. banks, maybe agency mortgage-backed

securities that are implicitly guaranteed by the U.S. 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 imagine them to once be. Could you talk a little bit more about basically how we built the modern banks? system on top of a bedrock of bonds that are presumed to be somewhat stable in price. So I think that you're right to sort of highlight the appeal of treasuries and agencies

to both bankers and supervisors in the wake of 2008. Bank that loads up on treasuries, that's like, you know, very wholesome. Seems very wholesome for a bank to do, right? The government likes that. The government is like banks that buy treasuries since the Civil War. And so it's going to cut against even the most ambitious and confident, you know, safety and soundness oversea. It's going to cut against their impulses to sort of fault a bank for loading up on treasuries. I mean, that's, that seems, that seems, that's a good thing, right? And so it's, it, it, it, that 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, that's those are going to lose value when the interest 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 in a zero interest rate environment, interest rates are zero, deposit rates are zero.

Deposit 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, you're extracting rent. right, from the deposit public, but you're not 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. Right, which it seems like

was sort of the assumption that they had. Like they knew it wasn't great. And, and maybe even technical and solvent. But, I mean, I think it was in this week, one of Matt LeVue's newsletters is like, this was actually like a very profitable time for them. Like it did, it would have 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. Well, they had, they had a specific estimate in one of those internal documents where they said,

we could, 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. Yeah, I mean, 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 have impaired their profitability, but they were, they weren't wrong to think that they were somewhat structurally hedge, even though they had no interest rate hedges or anything 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.

And we also, you know, we talked about this on a deposit beta on a recent episode with Joe Bate and why they're off and low. And one of his points was like, well, you know, you have a you have an individual has an account that 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 depositors, these companies, the whole story about Silicon Valley Bank was all of the products, the startup specific products that they offered, which presumably to their mind insulated them to some extent against losing deposits. Absolutely. And I mean, in the case of SVB,

there was also what an antitrust law we call tying, where a company ties, one product to another product. And so the bank would require that if you wanted to borrow from the bank, that you would have your deposits there. Is that unusual? Because people, some people, I've seen some people like, oh, that's weird. And some people's like, no, of course,

like any commercial loan. But is that unusual in your view? 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, and historically, it was core to the banking business that you were the depository institution for your borrowers, that that went together. And we've moved away from that technology. Lots of things have allowed people to borrow from banks that aren't the banks where they bank at. But a long time, the idea was that there's a lot of synergies between that. No one's going to be in a better position to determine how much to lend to you than your own banker. I imagine like there was also a bit of a prestige element to banking at SVB as well,

given that, you know, it was so popular among a particular type of tech slash VC person. But, you know, Joe touched on the episode we did on deposit betas with Joe Abate. But I'd love to hear from you, like, why didn't people pull more deposits from a bank that was essentially paying them nothing. Because to some extent, this is the big question. Like, why did SVB have so many deposits well into 2022, at which point we started to see some of the, I guess, most interest rate-sensitive parts of the economy, i.e. the tech industry, lose a bunch of money and have to pull funds. But why were people accepting of that for so long? So we mentioned a couple of the sort of rational explanations that, you know, there's a strong

brand, you want to bank there, they're lending to you, they've required you to keep deposit there, but you can't discount the fact here 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, didn't have anybody on their teams with any experience in managing cash. they're focused on their business, and it's very hard to justify a $500 million bank account balance. And I think we have one example of that. There's 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 ladder treasury bills or something and be earning. Or cheap bills that are paying 4% now. Significantly more money. So there's huge amount of money that's just being left on the floor here. And it's, you know, it doesn't really make sense. So we have to understand that these customers, despite having lots of money, are not actually very sophisticated.

So I want to go back to the supervisory question and ask about it, kind of come at it from a different angle. You know, obviously the 2008-2009 crisis was very focused on the asset side of the business and were these really high-quality assets and then part of the reason a bunch of banks failed is because the assets like weren't very good that they held. And as people have discussed with Silicon Valley Bank, a lot of the issues, yes, maybe they made a wrong bet on treasuries or they put too much, but is the flightiness of the deposits. Can you talk a little bit more? I know that regulators do bucket deposits from the most sticky to the least sticky.

But could you talk a little bit about like how good supervisory in a sort of like active pre-90s way might have approached the uniformity of SVB deposits and the risk of them all leaving at once? Yeah. I mean, I think that if you showed SVB's balance sheet to a supervisor brought up during the New Deal system. So let's say it's 1975, they would be hard. at the enormous concentration of uninsured deposits controlled by a group of businesses with very similar risks to their business. And so all of your depositors are going to run into- And this is something that a New Deal era supervisor would be familiar with from

past experience. It's not novel. I think it would have been, they would have been unfamiliar with it 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, of course, people still remembered the bankruns of the 30s much more than they do today.

And part of what went wrong at SVP is it's not just that they had 97% or something in uninsured deposits, but that all of their depositors were going to withdraw at the same time. And so there's sort of a classic issue in the banking business always is, in what circumstances am I going to be subject to a deposit drain? You know, you get to model your deposits as sticky if you're a bank, because over time for the banking system, the deposit base is always sort of growing. I mean, with the exception of over the last year, where monetary policy is trying to shrink the money supply.

But, you know, over time, it's a constant. and growing base. And so deposits are really, in some sense, a very long duration asset, except if you're the one bank that experiences a drain to the rest of the system where everyone withdraws from you. And so if your customers are all going to face hardship, your depositories are all going to face hardship at the same time, you really can't treat yourself as structurally hedged. You're the opposite of structurally hedger. And that's what Silicon Valley Bank found out. is it thought that, oh, you know, when my assets lose value, my deposits will become more valuable, but actually all their depositors started to draw down their accounts, and the opposite happened.

And so they were just very, very long, low interest rates, Silicon Valley. Their whole business model was tied to low interest rates, I think 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. Howard to make those sorts of judgments. Yeah, this is exactly what I said on our episode with Dan Davies. It was interest rate exposure kind of squared. But just on the deposit side, because to me, this is kind of 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 year. So what could regulation do on that front? So I guess instead of the asset side, looking more at the liability side. So what you want to see is a coherent asset liability management strategy for a bank. And so a bank that anticipates deposit drain, for a bank that has flighty deposits, and there are many banks that can fall into this category. This is something that regulators and supervisors do think a lot about. If you're in that category, then you need to hold liquid assets that you can sell and that at their fair market value to cover the withdrawals. And so part of the problem here is that Silicon Valley Bank did not actually have,

available for sale securities at fair market value, sufficient to cover the withdrawals. And so 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, that their deposition. depositors suffered and their deposit, the banks experienced deposit drains because they were concentrated in a group of people that were exposed to interest rate hiking. Renno mishap?

That's embarrassing. You know what's not embarrassing? Using FIG for Home Improvement Loan. A quick, simple, and transparent offer in minutes. Borrow Better with FIG. Visit fig.ca. On April 4, 2023, around 2 in the morning, a man was, was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, we did this to you.

What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. I just realized I promised to ask about discount lending and the FHLBs, the federal home loan bank. So, you know, in theory, when you have this type of banking crisis or, you know, some sort of liquidity issue with a financial institution, you would expect them to either go to the Fed, to the discount window. And for Obot's listeners, we recorded an episode on this a month or two ago, or they can borrow from the FHLBs. And 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 in order to step in and support the bank?

Or is it the case that at some point, you know, maybe they're talking to the FDIC and they just say this is untenable and no matter how much money we provide, like the bank is not going to be able to get up and running again? So I'm speculating a bit here and you might want to talk to the FHLB expert in the Legal Academy, Kate Judge, who is my colleague. but the FHLBs are not a lender of last resort in the way that the FRBs are, right? The FHLBs, they 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 FRBs. So the FRBs were set up in a similar model, but today basically, function as public banks. So they have no interest in profits or anything like that. And they're willing

to sort of 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 into an insolvent institution and took on that potential risk. The FRBs are wary of that for various reasons we could get into, but the FHLBs have even more reason to sort of to pull back. We definitely have to do it. We definitely have to do it. a FHLB episode at some point with K Judge because I don't know much about them at all. And it definitely has been too long or it's far too long without having. No one's had to think about them for many years. Yeah, without having her on.

I want to ask another dimension, you know, people pointing to the 2018 law change to Dodd-Frank that seem 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, can you sort of characterize the change that was made there? And B, had that not been in place, like, is that change that was made in 2018? Does that tell 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?

You can never know for sure, but I would suggest yes. That is decisive. And so this brings us back to how the government responded to the 2008 failure of superiors. and regulation. And they responded with a set of tiered new requirements. And for the very biggest banks, you had the C-Car stress testing regime. And for all of the banks with more than $50 billion of assets, you had stress testing as well as collection of other enhanced prudential standards. And this new cocktail of regulation and supervision was geared towards preventing a repeat of something on the scale of 2008. And so we weren't going to impose this on the whole banking system

on all the sort of smaller banks, but the thinking was, if we could just really get back to serious government oversight of banks over $50 billion, that would really go a long way towards preventing another calamity like 2008. And what happened was immediately there was litigation over the threshold for this new regulatory supervisory cocktail. And so this $50 billion threshold came under a lot of political pressure from the banking agencies and from various people in Washington. And 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 he did not want to grow his bank. into additional regulatory and supervisory requirements. And in 2018, after winning over people in both parties to this cause of raising the threshold, Congress changed the law. And the threshold moved up, a bunch of thresholds moved around, but the relevant threshold, I think, moved up to $250 billion. And the result was Silicon Valley Bank and its peers had successfully exempted themselves from the enhanced prudential standards that Congress had created after 2008.

And the result was you didn't have the stress testing, which is the primary means by which supervisors now exercise substantive judgment about risks. And so you had a much more, I think, light touch process-focused oversight that allowed rule-compliant balance sheet configurations like SVBs to go relatively unchallenged. But if you had been in the enhanced prudential standards bucket, I think that they would have been challenged. They would have been challenged through all of these additional rules and also supervisory programs. And it's unlikely, you can never know, but it's unlikely that they could have taken so much duration risk and not raised capital earlier, been permitted to go for so long in a position where their liquidation value is possibly negative.

Yeah, since we're on the topic of the blame game, I mean, one of the things that you see people saying now is that, well, 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. And I think, you know, 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, but how would you describe the overall monetary policy's role in the current predicament? 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 rate 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. Love Manon, that was an amazing answer. That was an amazing conversation.

That was so helpful. That was so helpful and so clear. I've said it every time we talk to, I'm like, oh, I finally had, there's been a few more, but I, so that was a, that was very good. I'll just leave it in a day. I really, I really appreciate that. So thank you so much for coming back on the upload. Thank you so much for having me back. Thanks, Lab.

Tracy, I love that whole conversation, starting from the very end, which I think is a really excellent way to sort of reconceptualize the monetary policy problem, which is that if the Fed is going to be tasked with the sort of like big sweep macro management, right, getting employment, 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. 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 all. 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, right? 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. That's really interesting. Like thinking about, like, it's pretty fascinating that a lot of these like capital requirements and ratios and regulations that we think of as core to how we manage the banking system are all pretty young. And that for the most part, for a long time in history, it was like active supervisory. People,

making judgments based on the operations of the bank whether their decisions on loans and deposits were healthy. But it does make total sense that is sort of like, you know, I hate to use words like neoliberal, but that like that the role of supervisors would essentially transform to making sure that shareholders were getting adequate information. That you start with the assumption that the market is the best regulator. And then what is the role of the government? Well, and the role of the government in that point is to make sure that market regulators get good information. Like, that seems like a very, like, big theme that, like, you could, like, characterize across a lot of different industries, a lot of different government. And then the failure of just, like, well, the problem is, like, shareholders can lose everything and not be accountable for the spillover when the bank fails.

And so, yeah, the need, perhaps, to get back to a type of supervisory that actually takes decisions into its own hands rather than just outsourcing it. You know, I realized we didn't even get into Fed checking accounts, which is one of those. So then I think the next episode we have to do in this series is 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 institutions? So I kind of think that's the next one in this series to look at, well, what does this tell us now about even the point of private deposit taking institutions and should there be a public option? That is what I was kind of hinting at in the intro, but we'll just have to leave that. It was a trailer, not for this episode, but for the next one. So plenty more to come. But shall we leave it there?

Let's leave it there. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. Follow our guest Lev Menand on Twitter at Lev Menand. follow our producers Carmen Rodriguez at Carmen Armin and Dash Bennett at Dashbot.

Check out Bloomberg's podcasts under the handle at podcasts. And for more Oddlots content, go to Bloomberg.com slash oddlots, where we post all the transcripts. Tracy and I have a blog and a weekly newsletter that comes out every Friday. Go there and sign out. Thanks for listening. June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets.

From corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our day. podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of leading by example,

we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example, executives making an impact on the IHeart radio app, Apple podcast, or wherever you get your podcasts.