Ralph: Welcome everyone. Today's event, organized by the Initiative on Global Markets and maybe, first, a word of thanks to Alyssa and Peggy for organizing the event on such short notice, to put all this together.
So my name is Ralph Koijen, I'm a professor of finance here at Booth, and I'm delighted to introduce our main guests for today. So to the right of me, first, Anil Kashyap, he’s the Distinguished Service Professor of Finance and Economics here at Booth. His research covers macroeconomics,
monetary policy, financial regulation, and banking. Also, relevant for today's conversation, starting in 2016, Anil was also an external member of the financial policy committee at the Bank of England, until recently. And, so he also has a lot of life, policy experience. Then we have Raghu Rajan,
who is the Katherine Dusak Miller Distinguished Service Professor of Finance. Raghu's research covers, also banking, monetary policy, economic development, and corporate finance. And from 2013 until 2015, Raghu was the 23rd governor of the Reserve Bank of India.
So, in short, we’re very lucky to have such world-leading experts on the topic here at Booth. Try to figure out what's going on, what happened in the last couple of weeks, what's maybe still in store for us, and more broadly what can we think about in order to make it stable, that the system
may be a bit more stable going forward. So please join me in welcoming Anil and Raghu.
So the game plan is going to be the following. So we're going to have 40 minutes or so of conversation mostly among Anil and Raghu. And then I'm sure, by then, you'll have lots of questions of your own, then we'll open it up [inaudible 00:01:46]. Okay. So maybe just to kick it off, maybe Raghu,
maybe you can tell us a little bit about your perspective in terms of what happened to Silicon Valley Bank, why did they get into trouble, and what sort of was done to resolve this.
Raghu: So, well—hello everyone. Silicon Valley Bank, the immediate causes are pretty obvious. It got a ton of deposits over the last couple of years, especially after the Fed went into overdrive mode with quantitative easing during the pandemic. So, it was getting in the
order of 20, 30 billion dollars of deposits a quarter in some quarters. And what did they do with that money? Basically they parked it. And you know, they were paying some interest on some of that money, but they parked it in essentially longer term bonds. And the sense was, they were making a
spread, that was a good thing, and in the meantime they were focusing on their main business, which servicing all their VC clients and so on. So, it looked really good, and they had a pretty strong capitalization. Except, you know, when the Fed started raising interest rates, the long bonds that
they held plummeted in value, present discounted value, to raise the interest rates, the discounted value falls.
While on the liability side, yeah, so long as the large deposits were staying—were you know, sitting around and earning that interest rate, they were being paid, that's fine, you were still making the spread. But then people started paying attention to the quality of their bond portfolio; at
some point they had to sell. Now you can put your bonds in one of the boxes, held to maturity and available for sale. It's the available for sale that typically is marked to market and the held to maturity, you put it in that suspense account; and only if somebody pays close attention, do they
figure out how much it's really worth. Well, what happened was, they had to sell some of the available for sales securities, and then it came out that they had big losses on those assets and then people put two and two together and said you're sitting on significant losses.
Now again, if the depositors stayed quiet and were willing to accept relatively low interest rates, that would be fine. And this is what many banks look for a stable depositor base. It's typically the household deposits, small and medium size deposits where people don't really move that much. But
these were large depositors and then they started talking amongst each other, this is the Twitter storm that took place, and they said, look, this bank may be in trouble. Let's go find something more stable. And they [inaudible]. Basically, the Thursday before they were taken over, they were taken
over on a Friday, they lost 40 billion in deposits. That sort of was the run of it, and they were closed.
Now the problems that extend across banks is how many banks were sitting on [inaudible] came out with a number, 600 billion in losses on securities portfolios, and our colleagues, former colleagues, from the, from Chicago did a quick paper, I think it was in the works, but did a quick paper
suggesting when you also discount the mortgage-backed securities, the mortgages that are on bank balance sheets, and I think they also included commercial real estate, you come up with total of 2 trillion in losses [inaudible]. Once we start talking about 2 trillion, it basically starts approaching
the capitalization of the Bank of [inaudible], right they have about 20 billion in assets of which you take 10% in there, that's capital. Then you start getting into nervous territory. So let me stop there.
Ralph: Okay, so after these reassuring words, let's make it broader. Maybe Anil, you tell us what happened with Credit Suisse and what extent is a spill-over from what happened in the US or were there different root causes, and how was it handled there?
Anil: Okay. It's great to be in the Credit Suisse classroom. [inaudible] Credit Suisse had paid, I think, the number is 11 and a half million dollars in fines from the last 20 years. And I think the puzzle about Credit Suisse was why six months ago people were still confident
having their money in that bank. They showed just epic incompetency in managing risk. And I think it's hard to say why people freaked out exactly when they did. They tried to raise some capital but I don't think anybody believes that Credit Suisse was literally insolvent. It was more just: enough
is enough. They went to one of the bigger shareholders and tried to say, "Would you give us a little bit more capital?" They said "No, thanks, we've got enough exposure to you." There were a whole bunch of very wealthy people that had hung in with Credit Suisse for a long time, and I think
collectively just decided this is not going to end well for us and there's no reason, that they're giving us great service, they're failing to spot one after another bad client or bad risk. And they were subject to a run as well.
If there had been nothing that had happened in the US it's hard to know whether people would've pulled the plug exactly now or not. The management of Credit Suisse that's there now had nothing to do with most of the problems. They were working on a plan to try to reorganize the company, but there
was definitely something toxic in the culture of that place to repeatedly stumble over these, most of the last few times, were money laundering problems that were pointed out and they kept saying, "Oh we get it and we're going to fix it". And then you discover another shoe would drop. So they were
subject to a different set of forces than I would say was true in the US, but they ran out of time, basically.
Ralph: Yeah. So, one common theme between the two though, seems to be that risk management doesn't seem to be as good as what you would've expected it to be. So, where do you think the supervisors are in all of this, and were there failures or flags of the regulatory system, or
are these things just inherently very hard to spot?
Raghu: So, I mean, this is the big question that the Fed will have to answer, right? Where were the supervisors? Now, what they've released—nudge, nudge, wink, wink—is we were on them, and we had asked them to fix things. Now of course what happens if you're a top
supervisor is you say you fixed it yesterday, and if you haven't fixed it, you're not doing any business until you fix it. And it seems they were going in that direction, but we've had a long time in which they've built up these risks exposures. This, I keep saying is risk management 101. You have
to watch what your interest rate exposure is and see how you will be impacted by interest rates. And you can't sort of hope and pray interest rates stay within a certain bound. You have to acknowledge that it may sort of get out beyond the bounds that you were putting.
Now Anil mentioned this and I'll let him speak more about it, but whether the stress tests, if they had been applied to Silicon Valley Bank, would've caught it, perhaps not because the interest rate scenario which the Fed was putting out as what they should test for, was more like 2%. Because we had
four and a half.
And that makes a big difference in how you value some of these assets. But that said, there is no excuse for running this unhedged. Any bank with that amount of leverage has to be very careful about magic managing its risk exposure. And there are stories, itss risk officer was missing for the
last six or seven months. I mean that doesn't sound like a well governed bank. And, so yes, there is a question of supervisory failure, but it's not just these guys, and that's the problem. If it's First Republic, if it's, was it Securities Bank? No, no, the Signature Bank. I mean, what else have
we missed out? And that's the problem. Once you start seeing this, then you worry, I mean, why is it that the Fed had to intervene? Because it sees systemic risk. Everybody's exposed to the same thing because of supervisory failure, and that's the problem that we worry about at this point.
Ralph: And so how do you think this is going to end? Do you think the current interventions at that they implemented are sufficient or do you expect there to be more turmoil in the weeks or months to follow? Or, what would you be looking for in terms of fragility?
Anil: I'm usually a glass two-thirds empty guy and I thought when the largest banks put 30 billion unsecured into First Republic, that might be a backstop combined with all the stuff the Fed has done. And I'm still thinking maybe we're close enough to being there, but the fact
that people are putting out numbers like 2 trillion means that it's going to be hard. I mean I think the simplest way to end it would be for the Fed to stand up and the FDIC and all the—OCC—all the supervisors stand up and say, look, we've kicked the tires on these banks, here's the
calculation we've done. It's very transparent, it's easy, and we're going to put up spreadsheets so you can do your own version of this. And here's why you should have confidence in the system. The problem is they're going to have to be doing that at the same time that they said, right in front of
our face was Silicon Valley Bank, and we wouldn't have said that about them, they were clearly insolvent, but trust us on the other thing.
So I think the problem they're going to have is they have to have credibility to say that here's a back of the envelope calculation you can do to convince yourself your money is safe even if it's not insured, at the same time that they're going to have to admit to these kind of epic failures. And
I'm not sure they're going to be positioned to be able to do that. It may be the case that Congress should set up an independent look at all of this and have the independent body say it, because I'm not sure that the Fed at this point's got enough credibility to do that; but I think they have to
be utterly transparent about how they somehow missed this, but trust us, we're not missing it again.
Raghu: There's another way, Here's the problem. Typically, we think liquidity problems turn into solvency problems because of fire sales and so on. Somebody runs for their money and you have to sell assets. There's a different way the liquidity problem is turning into a solvency
problem here. And that's because the way you have assets which are underwater because of higher interest rates, but still survive, is if your liabilities don't demand higher interest rates over time. So you can decide depositors, we're not asking to be repriced. Okay?
Now this is where the liquidity problem can turn into a solvency problem. If your depositors start saying, Hey, we were asleep, so not only is our bank risky but we're getting really low interest rates, and they start demanding higher interest rates, and this becomes a wider phenomenon. Then what
happens, if everybody's saying, "My money market is giving me four and half percent, you're giving me half percent". Let me start upping the rate that I demand, then you start getting banks having to pay that out and that's when those 2 trillion of losses become realized effectively, because you
don't have a spread. You really have to discount them at the market interest rate rather than that low deposit interest rate that you had earlier. And that's when becomes real.
So take First Republic. What is its problem? Its problem is its depositors. The low return deposits have sort of left, and now it's borrowing from the Federal Home Loan Bank. It's borrowing from the discount window. All of that is at 4, 4.5%. And so the economics that made sense when it was
borrowing at 1% no longer makes sense when it's borrowing at four and half percent and overnight, it's got, it’s a 200 billion bank approximately, it's got 150 billion of financing coming at that kind of rate.
So when the Fed says we will provide you financing, it's not cheap financing. And so what that does is it converts a liquidity problem into a solvency problem. The only way—so, when the Fed sort of offers you financing against the full value of your collateral, it still is the case that it's
going to be at a high cost. And so you're not dealing with the fact, you may be providing them liquidity, but they have to find some business which generates income to make the payments that they have.
Anil: So, it sounds like you think they need somebody coming and putting capital and include that there's enough of franchise value that owning this bank and running its loan book going forward is going to be attractive enough to take on this risk.
Raghu: Which is—the broader question across banks is how many of them have sticky deposits? Because they have business relationships, they put their money in because they expect lending down the line, and how many of them are really a little more mobile and can leave?
And so I don't think we will know for sure whether we've stabilized the system. We've had a back and forth from Janet Yellen: Yes, we're going to insure all the deposits. No, we are not going to insure all the deposits yesterday. I don't know where we will stand on that, but it is going to be the
case until people feel confident that either the deposits are sticky or there is a serious business in the bank that is going to be generating income.
And what if we have widespread panic? Let's go there. What if we have widespread panic? You have to do what we've always done, which is insure everybody for a few weeks, go monitor every bank, go do a—investigate every bank, and then open only the ones that you think are solvent under that
situation. And basically say we will back up capital for these guys if necessary and then over time let them survive on their own. But it has to be a big helping out. But I don't think we're there yet. We just have to see if this stops First Republic, but there are more entities that go bang over
the next few weeks.
Ralph: So do you think the assessment to coal is potentially systemically rescue was driven by the linkages of like SUB to venture capital firms or because there's not a 2 trillion out there and willing to make sure that we don't have those other 2 trillion panic? It's hard to
tell, but what is your...
Anil: I think it was over a weekend, and they weren't confident enough to say. that we can give some assurance that we know this stops here. I think the critics would say you should have slaughtered the weakest antelope in the pack just to make a point. You might have still had
to back up everybody else, but the fact that it wasn't a complete blowout for everybody associated with Silicon Valley Bank is I think the relevant counterfactual. I mean it's clear that there would've been some of these other banks that had the same set of assets that would've been in the same
position. And so I think we would've gotten here pretty quickly to where you were going to have to do some sort of grand rescue. Would've been better if it was temporary and the rules of the game were understood and there was an exit strategy and the way you build confidence is you say, "This is
what I'm going to do", then you come out the next week, "I'm doing it. I'm following through on this."
And then you come out and say, "Okay, I've done it and now you should be confident that we've got a fix." We're kind of making it up as we go. They clearly didn't see this coming back to the regulatory failure. So it wasn't like they had a big playbook, they were going to run out, but at some point
we're going to get into that mode where they're going to have to say, "Here's a marker, this is what we see the size of the problems are. Here's how we’re gonna—here’s how we got there, here's why you should be comfortable assuming that we're going to be able to get out from under
this. Here's the plan," and then we execute it. I think it's, as Raghu said, it's too early tell.
Ralph: Yeah. And so if you think about the nature of liquidity risk can, you mentioned also it started with a Twitter storm. To what extent do you think the whole dynamic has changed in terms of social media and things like that that coordinated? We've seen the whole main stocks
of stirring up lots of turmoil and financial markets. To what extent are bank regulators underestimating how much coordination there is among depositors now and someone can start, okay, I can earn four and a half percent somewhere else and suddenly poof, all the deposits are gone. Is there a
concern like that? That like, the nature of liquidity risk has changed or bank runs are of all times and it's really no different than what we've seen before?
Raghu: I mean, look, Silicon Valley Bank is a special case because all those guys talk in the—meet in the same restaurant in Palo Alto or wherever and they talk with each other and so on. I think that's a more close-knit group and they follow each other. I also think, to
your point, whether it was systemic, it was made out to be systemic.
Raghu: All these very well-connected donors calling their friends in Congress and saying we better do something about this and so on. So one of the things that you must remember that Lehman bought for us was political room; that Hank Paulson could say this system is going to help
and Congress has to step up to save the system and look, we let Lehman go and see what's happened. So I think that letting Silicon Valley Bank go could have started some turmoil but would have bought political room for the Fed and the treasury to say, okay, we can't let this go. We have to stop.
Now, they're sort of caught in between. They want to keep saying there's no taxpayer money involved, there's no bailout, but they need to do a little bit of that to get us out. So let's see how this proceeds. But it may be you need, as you said, a serious sacrificial vote where...
Anil: Look over here.
Raghu: Let these deposits go and you see what happens. Maybe we don't reach there. I'm hopeful we don't, but that's why I went off on a tangent.
Ralph: No, no, no. About social media. What extent liquidity, the nature of liquidity risk has changed...
Raghu: It may have in some quarters, but it may be that your large depositors in the small community bank, they may not—it's hard to say. I think it depends from bank to bank. They could be some...
Anil: If you go back to the 1800s when we used to have panics back then, it was the same kind of thing. Everybody knew each other. There'd be a rumor that so-and-so couldn't get their money, or got it out of the discount. So I don't think this is anywhere close to unprecedented.
It's just that you know…I think the thing is, to go back to his point about supervision, you just—I couldn't imagine that this could have happened. I mean I was clearly on team Fed, I just closed. So I worked there, I told the Chicago Fed. To think that this could have happened in
plain daylight, just shakes your confidence. You don't know what else could happen.
Ralph: But to what extent, also if you talk about the stress test, you mentioned before that there wasn't a real scenario where interest rates would rise; and coming out of a period where interest rates were very low maybe in part because of unconventional monetary policy. To
what extent do you think that what kind of like—to what extent was the Fed sort of, in part, in on this, selling these like, this environment where all of a sudden banks are—
Anil: It shouldn't have taken the Fed. These guys should be doing their own risk management. I mean let's not lose the picture. I mean Silicon Valley governance was like an F minus. I mean you can't understate how incompetent these people were. And so—
Ralph: 2 trillion of—
Anil: Yeah, so it turns out there may be others, but the Fed flunks too. But if you're sitting on that board looking at this business model saying, "How do we earn our business?" and somebody explains, "We just took this massive levered bet on interest rates and oh by the way, we
stopped hedging, and blah blah blah."
This is not as complicated as 2007 and 8. When that was going on, people on the fifth floor of this building running from office to office, "You know what this is? You know what that is? How do we understand this?" That was complicated. This was like 101— actually econ one, risk management
one, not even 101. So, to screw that up, you just didn't think was possible.
Ralph: Raghu, what are your thoughts on this?
Raghu: So, actually I had a conversation with a CEO of a money center bank in October. It was interesting because we were trying to push him, where do you think the risks are? He said, "I don't know where the risks are, but something is going to blow up." This was very
interesting. I mean, this is a really smart CEO. You know him, but he was saying, "I have no idea but it's going to happen. Why? Because the Fed is going to keep raising interest rates until something breaks. And something's going to break somewhere. And we always think the system is secure, it's
not.” And this guy, Feroli from JP Morgan said something like, "When the Fed presses on the brakes, somebody's going to go out of the windshield." And we saw who went out of the windshield.
So, the problem, to some extent, is really the seeds of all this are laid in the prior period when things really seem very, very smooth; the great moderation. That was before the global financial crisis. We had a similar kind of great moderation before this event, which was interest rates really
low, plenty of liquidity. What do people do there? They search for yield, they search for risk, and they take on those risks, and they don't manage them well, and most of them hopefully get it right, but some don't. And those are the guys who go out of the windshield. That's what we've seen. Again,
I think, to Ralph's point, we also need to think about the systemic factors leading to this and the Fed, Anil and I have different opinions on this, but I think the Fed is much more culpable in the sequence of really easy money, quantitative easing, and then switching around, than it ever admits.
I would say right from the early 2000s, we've been in the cycle of really easy money, things blow up. Then again, really easy money, things blow up, again, really easy money. There is a third cycle, there's a third part of it. And so we need to start thinking, is it the role of monetary policy to do
as much as it has been doing, or should it step back a little bit and say: we can do some, but we can't really go to the point where we're trying to lift the economy on our own, because it creates these problems which eventually blow up.
Anil: I mean, look, I think they botched their first primary job, which was controlling inflation. And they did it on the heels of a review that said, it's been a mistake to be preemptive and worried about inflation until it comes, so we're going to wait till we see the whites of
the eyes, and we're paying for that mistake. So there's no doubt that they're very culpable this time, and you know, they're going to get into a position where inflation's going to level off. If it levels off at three and a half, they're going to have a really difficult time. It levels off at two
and a half, they'll declare victory, and then maybe they'll go back to easy money or not. But I think the jury's very much out as to whether they're going to stick with it. I think it was good that they did 25 basis points yesterday. But, I mean, the disconnect between what the market expects them
to do and what they say they're going to do is about as big as it's been. And I don't know, I think it was remarkable that there were no dissents yesterday.
Raghu: Even our friend Austan.
Anil: Yeah, Jay, Jay's very good at keeping the team on side, but at some point the more dovish members of that committee are going to start saying “enough,” and then it's going to get really, really ugly. So they're in a terrible position.
Ralph: So you think at this point, so like, monetary policy goals are really conflicting with financial stability given in fact that stuff started breaking already and...
Anil: But they don't have a financial stability mandate. They don't have money for capital. I mean I think his point about needing headroom is a big deal. I mean, Congress doesn't seem to think this is in their camp; um, you know, I think, I hope they're going to just say, "Look,
there's a limit to what we can do. We can deal with the inflation problem. If the banking sector needs capital, we can't do that. We can give them liquidity. We can't give them capital. If we need to do something to force them to raise capital and we need money for a backstop, that's not us.
That's you." And if it gets really ugly, that's where we'll wind up.
Raghu: Well, so, so yes, if supposing there are a couple more failures, right, between now and the next market policy meeting, I don't think they can, they will feel comfortable in raising rates at that point, they—
Anil: Yeah, but that's not going to fix the problem.
Raghu: I agree entirely. But all I'm saying is that, that's when the conflict really comes, because there would be a sense, even though long rates aren't going up with the short rates, and that’s the tension the Fed has. Desperately, is trying to say, "We're trying to slow
the economy", but markets are basically saying, "Oh you're going to cut from July. In fact, that's what is being priced in. You're going to start cutting in July." And so the Fed is not having traction, in, at least to its monitoring policy instrument, because the short rates are going up, but
long rates aren't even, and market's pricing for a cut. So, in that sense, the financial stuff is also going to weigh on them. And, "How much do I keep raising rates in the face of all this?" And I don't think they will have the stomach.
Anil: The other thing is their theory of inflation is going to get a serious test, I mean for—you talk about the great moderation. From about 1990 till now, we've had this trundling down of inflation leveled off for about 20 years, and they kept saying, "We deserve the
credit. We've got inflation expectations anchored, that's keeping inflation under control." But if you did a regression, you couldn't tell PII E from PII T minus one. So if people had no idea what the Fed's target was or what they were trying to do and you just looked out and said there was no
inflation, so you just expect no inflation, that model PII T minus one wins the regression race. Ok, but now there's everybody in this room, except maybe the faculty, have never seen inflation, right? So you wake up and you thought 3% rate, it's a good deal. And now you say, oh they just cut my
salary by 2% because inflation's five, you don't know what's going to get unleashed once that's out there.
And so, this idea that it's just going to come back kind of on its own, which was baked into their policy, is getting a real stress right now. And I think Powell's a very pragmatic guy and so fortunately he hasn't written papers that you know, face his whole self felt self-esteem on that Phillips
curve being right. He's just going to look and see whether or not it's going well. But the staff has bet its future on that model, and they may have to kind of eat a lot of humble pie saying our theory of the case was just basically wrong, and that's not going to be comfortable either.
Raghu: But I mean there's a sense in which the tightening financial conditions can do some of the Fed’s work for it. And if you have a loss of evidence, and some of that four and a half percent, 4.75 as of yesterday is starting to show up, right; you’re starting to
see—I mean, Accenture just said it's laying off 19,000 people. That's a big number, and thus far obviously there are really tight areas, which is: places like hospitality, hard to find workers there. But the upper end is starting to feel the pain tag for sure.
Anil: Morale booster for the MBA students.
Raghu: No, I'm very hopeful.
Anil: Hope is not a plan.
Raghu: The reality is this is what the Fed is trying to do. The Fed is trying to slow the economy somewhat, doesn't want to slow it too much. It doesn't want to slow it such that you guys don't have jobs, but it does want to slow it somewhat, and you're starting to see some of
that happen. So one hope is really this combination of uncertainty about the financial sector combined with what it's already done will start slowing sentiments somewhat.
Anil: I mean I give Powell credit for not promising a soft landing. The Fed's never managed to do this. I don't see why they're going to be able to do it this time. And so I think the moment of truth is going to come. Inflation's leveled out at whatever it is. Let's say it's
three and a half, the unemployment rate is up to four and a quarter let's say. And then they've got to make a choice. Do they just tolerate it, in which case it gets kind of entrenched and we have to live with inflation for a while or do they say, full steam ahead, we're going to get back to two,
and if we have to suffer a recession for a little while, we'll deal with that, but we just don't want to relive the seventies or we don't want to live the 80s. People forget in the 80s, the bond market didn't believe Volker. I mean there was a big period where actual inflation was running well
below what interest rates were because people's expectations were, ok, he squeezed it out, the guy could be gone, we don't know if the Fed's going to have its credibility.
I think all the people that are down in the weeds of monetary policy look back and saying that that's a bad trade. It's worth it to take the pain to get it back down to two and just say we screwed up once, but we're not going to keep doing this. Whether or not that'll be the judgment of that
committee when the time comes, I don't know. But I think that's kind of my nightmare scenario is they're faced with this trade off. I mean the full nightmare scenario is the financial system is broke, and they're faced with this trade off, but let's hope that the financial system's got, there's
some way to recapitalize whoever needs to get recapitalized. And then we just go back to the macro tension.
Ralph: So one question, both of you talk a lot about the financial system, yet most of the discussion is on banks now. Yeah. So what is your sense? Even if you say okay it was a risk management failure, maybe they should have hedged well or someone else on the other side, which
are other long-term investors like pension funds and insurance companies. We've seen in the UK pension funds also not being particularly good at risk management at times. And so you wonder is there much sort of oversight across these different parts of the financial sector between insurance
companies, open-ended funds, shadow banking, and are there other issues there potentially we should be worried about, or do you feel like oversight is well-coordinated along these different parts of the sector?
Raghu: Well if it wasn't well done at the bank level, which is the most scrutinized and supervised area, you worry a little bit about the other areas. The whole, however, is, I mean there's a lot of reasonably capitalized entities with plenty of firepower waiting on the
sidelines, and hopefully your private equity accumulated a huge amount of money. Of course there are concerns there that they haven't taken their marks appropriately at this point. But there, there's private equity. The leverage loans were a big concern. But of course one of the things that
happened in that market is maturities have gotten pushed out during this time of relatively easy money. And so the kind of cliff where you have to roll over this stuff is a little further down the lines.
So, it may be that we are in a little better position in other areas now with the insurance, with pension funds, it's both the assets and the liabilities that have to be revalued at the higher interest rate, and to the extent that they're reasonably hedged in the, or any kind of derivatives
positions that they have, and they can make up whatever margins, unlike the people who are doing LD five in the UK, maybe they can survive this period of rising interest rates.
So I mean broadly speaking, I think I'm in that camp of the Money Center Bank CEO. There may be stuff waiting to explode. It's not obvious where it is. We may have seen all that there is to see, but we don't know.
Anil: Well, you and I were on this group that the IGM sponsored looking at all the cases and regulations. So I don't feel comfortable at all about a bunch of the risks that are unattended to. I mean thank God Frankel had the theory that it was all about too big to fail, not about
runs and liquidity problems that could show up in various parts of the financial system, there's still a bunch of unattended business there. Whether that's going to be the second passenger through the windshield, I don't know. But I think that the possibility of problems popping up there are still
an issue. And there’s, the fortunate thing is it's been 10 years, so there are playbooks out there saying, "Here's the legislation you should do, here's some of the reforms we should undertake," that maybe this was as Rahm Emmanuel said, "A crisis is a terrible thing to waste."
So maybe we can get some legislative reform or energy back into this discussion, just out of fear that there's things that need to be done. But I don't know, I don't think people should have a lot of confidence in the financial regulatory structure of the United States. It's pretty terrible. And
there's things like, take the money funds, we've been complaining about that 15 years, and they can't even get up [inaudible] deal with that. And so if you can't fix the stuff that's standing right in front of you, the possibility of something you haven't thought of could go wrong is something that,
you know, you should be worried about.
Ralph: Okay. Well with that, let me open it up for questions. So also for those attending on Zoom, I can still see the questions here, so I'll monitor that as well, andso, thanks.
Speaker 4: You talked a lot about Fed policy, and it sounds like this point of view is for raising interest rates at least a little bit further. I mean what's the case against the wait-and-see approach? We've already seen inflation metrics, basically every inflation metric comedown for the last
three to four months at this point. We've seen a bank collapse. Is inflation of three and a half percent really so terrible compared to negative impacts of labor dynamics?
Raghu: Well, so one of the issues, really, is once you have three and a half, is it going to stay at three and a half, or is it going to climb up? One of the advantages of bringing it within your target zone is then people have a sense that yeah, if it starts climbing out, that's
what you're going to, you're tackle. If you say three and a half and we are done, then is three and a half the new floor, and how confident are they that you will tackle it if it starts going up once again. So it's very hard to change your implicit inflation target in the middle, especially when
you're failing on your explicit inflation target and then say we're done.
That said, I think what they will do is try and give themselves as much time as they can to see that things are moving in the right direction. Now before this bank sort of—these bank failures, it was clear they were still behind the curve a little bit with core inflation at 50 basis points
month on month. They really needed to do a little more to slow down the economy. Yes, there are things which are moving in the right direction. You're not seeing wages keep up with inflation by some metrics. You're also seeing the housing component of inflation may well start coming down soon,
even next month.
Speaker 4: Say it did last month, for the first time, housing prices [inaudible].
Raghu: Well as inflation it went up. But yeah, so we're agreed that it's going to probably come down. So I mean you could let all that sort of play out. The sense though is that it will still take us down to three or four on an annualized basis. So whether it comes down to this
is the point, whether it's say the three and a half or comes down for that last line, that last line might may be the hardest.
Anil: And the other point is if they pause, you're going to have risk on, and that's the mechanism by which it stops falling and starts reversing is people say, oh well they're going to tolerate this and there’s, we're going to go back to spending and investing and taking
these gambles consistent with easy peasy policy. So it's not like it's a free lunch that you just stopped, and you count on inflation continuing to trundle down. If they stop and people think they, they're really going to tolerate this, it's not going to keep falling, it's going to level off and
maybe take up. And that's the case at hand, is you don't want to put yourself in a position where, I mean there must be a thousand Fed speeches saying two is our target and if they declare victory at three and a half, they're going to have some 'splainin' to do. That's not going to be something
they can easily just give one talk and say, "Okay we're done with that. Next question."
Raghu: [inaudible] So I think you are right that if stuff goes south in the financial sector, between now and the next meeting, they might say, "We're not paused, but we'll watch a little more." So two at 25 every two meetings rather than 25 every meeting. So they will find ways
without declaring pause and then seeing the stock market—
Anil: But it will rocket the day they try to say, "Oh trust us, we're going to keep going," you know, it's going to go against them.
Raghu: And yesterday if Powell had said pause, I have no doubt it would've done what it's doing today perhaps more. And I don't know why it's doing what it's doing today.
Ralph: So talk about the stock market, so there's a question on Zoom from Adil ask about, we talked about internal risk management of firms, stress test from the Fed and those potentially failing or simply failing. What about the market? Shouldn't stock market investors and
analysts who are scrutinizing these firms...
Anil: Yeah, remember all the structural bears have been blown out of the market. If you were a glass even one fifth empty, you're not working on a trading floor, because you've been on the wrong side of this for 20 years. The right bet for 20 years of Fed's got your back. And so
the people that are more balanced in all this don't have huge amounts of money, lots of funds of have closed saying, "We don't understand stuff like this." So it's going to take some reckoning for the people that are flush with funds to come round to this view. And that's a consequence of every
time there's a choice, choosing easy, is—it's got consequences.
Stephan: Up on a question that Ralph raised about the stickiness of deposits. I agree with Ralph that it seems hard to imagine that in the future deposits will be as sticky as they were in the past, and it seems dangerous to build a financial system on the assumption that deposits are somehow
sticky and some depositors are asleep at the wheel. And so doesn't this necessitate that we need to think about a more radical solution, like, for example, some sort of narrow banking for demandable deposits or something?
Raghu: So this is the question of the ages. Why do we have banks at all. Has that time come? I mean the whole idea was to some extent there is a need to finance longer term assets with shorter term liability, either because it's a more efficient way to do it, and that's been sort
of the line that Doug Diamond and I have, or that there is really a mismatch in the economy between preferences of investors who want more liquidity and the media firms who want more stability and something has to intermediate that difference, and that's the banking system. So pick whichever
theory, actually Doug's written on both, but that would suggest that it's going to be hard to move to that narrow banking system without some sort of mismatch. If you said strictly narrow banks, if you fund your deposits, if you fund, you invest your deposits only in short-term assets, maybe there
are not enough assets available for the kind of short-term claims that people want to hold, they want more liquidity than that, who's going to make the balance? And it may be that some other entity shows up and their take on this maturity mismatched risk.
And the question is how are they protected? So I think this is a very good question which we have to answer. It comes up every time we have a crisis. Post-Depression, we had the Chicago school proposing narrow banking, but it's been proposed many, many times in the past. It hasn't stuck. Partly
because we haven't answered these questions, and we do need to answer these questions. Are there ways that we can provide what the market wants? Almost invariably the tendency of the market is to go towards higher leverage of this kind, which suggests there's a market need which needs to be
fulfilled by somebody.
Anil: Well I think regulatory arbitrage is a very, very powerful force. So even if you permitted narrow banks, I bet on somebody else creating a version of the thing that's unstable.
Speaker 8: So you brought up Silicon Valley Bank and how it got on the wrong side of these interest rate rises and didn't kind of adjust as they kept on climbing. And as you also mentioned, for most of us in this room, this is the first time we've seen interest rates rise pretty rapidly and
consistently in our lifetime. But it's not the first time that it’s happened. Are there similar analogs from the seventies and eighties where interest rates were going up and banks were failing to adjust interest rates that you can think of?
Raghu: Well the most obvious one is the SNL crisis. That's where they really had a lot of long-term assets funded with short term deposits and then Wilker took rates really up and we had a real serious crisis on our hands. Are they stopping previously?
Anil: Now this is pretty unprecedented to move at 400 basis points in a year, but that NPF paper kind of points out that to get inflation down that there are no immaculate disinflation. So if you look at history, the big mistakes have come from declaring victory too soon and
easing off and then inflation takes back up and then you have to really hit the brakes even harder. So I think there is pretty good empirical evidence about what it takes to get inflation back down, and there's no simple way to do it. You have to get the real interest rate positive, and it's still
not right now.
Speaker 7: Circling back to the deposits a bit, could you speak to some of these bank debt covenants and maybe some room for reform? My understanding is that clients of SVB which received loans, most of them were required to keep all of their assets there. I don't know if I'm missing something,
and I get that the business model necessitates that to a certain extent, but it seems like some sort of cap there is reasonable.
Raghu: You're talking about enforcing a certain kind of risk management on the clients or giving them the freedom. So one of the things I wasn't aware of, I thought this had to be done manually, but there are now some instruments by which you can put your money in that structure
and that will spread it across many banks each under 250,000. So you can get millions into that kind of structure, everything insured. So a lot of the clients of Silicon Valley Bank would probably have been better off with some structure like that, makes it much harder to make a payroll every
week. It's not one account, but you can imagine things emerging where you force the diversification on the clients and then make them less prone to run because they've got it in 50 different accounts. It's not one account and all of them—
Anil: He's not a paid advisor for IntraFi, which is the name of the firm does this.
Raghu: You can imagine structures like that emerging and there's no reason why they can't, because at that point the government will say, "This defeats the purpose. We really wanted to ensure small deposits. Now we ensuring everybody because everything's become small. It's
diversified across all the banks," but then you get the deposit diversification, which is a little more stability. So I can imagine that there will be a lot more innovation on these, on this side over the next few years.
Speaker 7: And I guess just to make sure I'm understanding you though, does that really get to this point, right, with SVB giving these loans and requiring those assets to stay in-house, I don't understand how that connects—
Anil: They wouldn't have been able to grow their deposits nearly as quickly if his model of how deposit...
Raghu: The question is, did they have legal right to write that into the contract?
Speaker 7: Yeah.
Raghu: Or whether it was an understanding, look, you want the loan you keep your money here, or we think about or find ways to pull back the loan.
Anil: They didn't have horrific interest rate risk a year and a half ago. So I mean they really put it all on 22 black and rolled the roulette wheel over the last year and a half. But they grew from 50 billion to 200 billion over that time. So there was an explosion of deposits.
Raghu: So one of the things that we—we presented a paper yesterday is, think of the Fed's balance sheet expanding from 4 trillion to 9 trillion in the pandemic. The question is who was funding it? Or when the fed expands the balance sheet, and you don't need to worry about
the details, commercial banks also expand their balance sheet. There's a lot of money coming into the commercial banks, and so this happens really quickly. We're talking about everything happening really quickly.
What do they do? It's like they've got a fire hose to their mouth. What do they do with all the money that's coming in? Well let's take a little spread, because we can't make serious loans with this amount of money. Let's invest it in treasury. Very liquid, gives us 100 basis points. That's what
a lot of them were doing. So this is why I say it's not unconnected with what the Fed was doing before, because the Fed was expanding its balance sheet, usually during Covid, somebody had to be taking the other side. That was the commercial banks.
Stephan: So I had a question regarding the comment regarding Silicon Valley Bank being mismanaged. If we go back two years before, nobody had anticipated a 400, 450 basis point Fed environment and at that time, this is not like the '08 crisis where they've invested in junk assets. These are all
G-SEC or very high quality assets where they had to generally take a markdown due to the interest rate environment. Is this an error if everyone is doing it at that time, did they have that onus for their shareholders to maximize returns during those boom times.
Anil: Well, they still should have been managing interest rate risk, and you know, they hired BlackRock—just reading the press, but they hired BlackRock and said, "We evaluate you on 11 dimensions of risk management. You get a gentleman's C because you flunked all of them."
And then they say, "We'd be willing to do a little bit more consulting for you." And they said, "No, thanks. We got the message. Back to your regular programming."
So, they, they—there's no benign interpretations. They were incompetently managed, they should have seen this. They had plenty of time to raise capital. They would have had no problem raising capital to absorb these losses if they'd done it last September before the CEO said somebody's
going to fail. They didn't even have a chief risk officer. I mean they deserve to have their posters in Wikipedia, like here were the rogues that ran this organization. [inaudible] I mean we've got to hold these people responsible. They're not going to go to jail, they didn't do anything illegal,
but they were epically incompetent. None of them should ever be on a corporate board anywhere for the rest of their lives.
Speaker 8: Hi, yes, I'm from Argentina, [inaudible] so I know what it is to live with high inflation. What is your perspective regarding the role of Fed? Because we're speaking on the root cause of this. There's high rates because of high inflation, and this come from printing so much money. What
do you think, is this a scenario better than having or facing the crisis of coronavirus without printing that much money? I mean, what is your perspective regarding the Fed's responsibility in this moment?
Raghu: Look, I mean, if you look at the response, right, in hindsight, and I don't want to say we're all smarter than...those guys are plenty smart at the Fed, or [inaudible]. All I want to say is, all we can do is look for the benefit of hindsight. Could the fiscal stimulus
packages have been much more targeted than they were? The first, probably not. Everything's going south. We need to help the system. Yeah, the only way to get it through Congress is, you do a deal for my constituencies, the poor, I do a due deal for your constituencies, small and medium banks,
small and medium firms, and in the process, the banks benefit. I mean, think about the fact we had really much lower loan losses during the pandemic than we have in normal times. We had much fewer bankruptcies. There was a flood of money going into the system such that the system was actually
better off in some ways. How can you have a catastrophe where you've borrowed from the future to pay people, such that you are actually better off in the catastrophe than without?
That to my mind suggests that we did spend a lot, and of course the Fed already was sort of reversing quantitative tightening, and it's flooded the system with money.
What we are realizing is these don't come without costs and now we are seeing the costs of both actions, the enormous spending as well as the enormous infusion of liquidity. It's not easy withdrawing liquidity. The system gets used to it. And then if you withdraw from that high level, it starts
reacting, because it wants all that liquidity up there. I mean talking anthropomorphic, but you get the sense, that there is [inaudible] the system. And so I would say when we look back at this, we will ask, did we have to do so much? Could less be actually more?
Anil: I mean, and it's not like there wasn't a debate. I mean Larry Summers has a pretty big megaphone, and he was sounding alarms in February of 2021. Yes, anybody that took my advanced macro class that year's graduated, but I had Larry come to class and lay out his case, and it
was pretty compelling. There were a lot of us that were on that side, that they'd gone too far. People didn't want to make the mistake of 2009 and do too little. And I think it's pretty simple, they overdid it and we’re paying for the costs.
We're probably going to have to stop, so I want to put in an ad for the IGM, the sponsor of this thing. You go to IGMchicago.org, you can get a lot of good content. Lots of you seem to be economic junkies, but we find our expert panels that poll experts, economists on lots of issues. We want a good
place to look for what conventional wisdom is amongst economists. That's kind of our job. Ralph's one of the directors. I'm one of the directors, right, who's a frequent contributor. Stefan runs one of the polls, Maryanne's one of the panelists. So the faculty are very much in this game. We'd love
to engage students more.
Ralph: So let's conclude it here. Please join me in thanking Anil and Raghu.