Capitalisn’t: Silicon Valley Bank—The End of Banking As We Know It?

Luigi: Hello, listeners. Just a note: Considering the developing nature of the story, we would like to make sure that you know that this episode was recorded on Tuesday, March 13. Thanks for listening.

We had already arranged a different episode for this Thursday when a number of our fans on Twitter started to clamor for an episode on Silicon Valley Bank, of course—the bank that failed last Friday. When Senator Sanders called the intervention of the federal government to protect all depositors “socialism for the rich,” we could not resist.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Bethany: So, in case you spent the last week skiing . . . Oops, OK, I did . . . Let’s review the basic facts. Silicon Valley Bank, the 16th-largest bank in the United States from 2020 to March of 2022, experienced an explosion in deposits, from $60 billion to $200 billion.

In order to employ those deposits, Silicon Valley Bank decided to invest them in long-term Treasury bonds. As interest rates rose, those bonds lost value. Initially, Silicon Valley Bank could pretend the loss wasn’t there because accounting rules don’t force the bank to mark to market securities that they plan to hold until those securities mature.

However, when deposits started to outflow, Silicon Valley Bank was forced to sell some of these securities, and the sale forced it to recognize $1.8 billion of the billions of dollars in losses that it had. Silicon Valley had a plan to cover for this. It planned a $2.25 billion equity offering. But last Thursday, that offering failed, even though a big private-equity firm called General Atlantic had already proposed to buy hundreds of millions of dollars of that offering.

At that point, Peter Thiel, a well-known venture capitalist, started to tell people to pull their money, and the entire venture-capital community did what VCs do: copied each other, told all their portfolio companies to start pulling their money. And so, there was a huge outflow of deposits from Silicon Valley Bank, a proverbial run on the bank.

Most of these depositors were startup firms who had accounts bigger than $250,000, so that means these deposits were uninsured. They were all terrified. In the middle of Friday, the FDIC had to intervene to take over the bank. Treasury Secretary Janet Yellen announced that equity holders and bondholders will be wiped out, but depositors, even the uninsured ones, will be paid in full.

Right now, as Luigi and I record this podcast, the regulators are trying to find a buyer for Silicon Valley Bank for the second time because the first auction failed.

Luigi: We wanted to know whether this is real capitalism in action or isn’t. To help us answer this question, today we have not one but two exceptional guests. We start with my colleague Doug Diamond, the 2022 Nobel Prize winner for his work on bank runs.

Nobody could be better for this. I did it alone because we organized it at the last minute. And since this is my week to ski, I was actually outside of a log cabin in the mountains. If you hear me trembling, it is because it was that cold.

You won the Nobel Prize for explaining how bank runs take place. So, tell us about this particular bank run. What is common about it, and what is unique?

Douglas W. Diamond: There are two things I should start with. What are banks supposed to do? They’re supposed to create some securities you can’t create on your own, and they have two technologies for doing that. One is they’re supposed to hold a diversified portfolio of assets and stay away from common systematic risks, like interest-rate risks or GDP risks, to the extent they can. That’s on the asset side.

And on the liability side, the deposit side, they’re supposed to have diversified funding sources. Not everybody needs their money at the same time; they don’t communicate with each other; they don’t share a same social network. Silicon Valley, in their risk management and just setting things up, violated both rules. They didn’t really diversify, and they were mainly exposed to interest-rate risk.

And at the same time, they had very undiversified funding sources. They basically had the money from a bunch of startups, all of whom were connected to each other through either the party that did the venture capital, or they had social networks, Y Combinator, things like that. So, they violated those rules.

Then they had this remarkably fast run, the fastest one I think I’m aware of in human history. And what happened was everybody thought Silicon Valley Bank was close to insolvent. And then once they were pretty sure they were close to insolvent, they thought, eventually the bank’s going to fail, so we’d better get out quickly.

That’s very different from the kind of run that Phil Dybvig and I thought about. Phil Dybvig and I thought about something where the bank is basically solvent if you just hold all its loans to maturity. Interest rates haven’t gone up, but if you took those loans and sold them in a hurry, you wouldn’t be able to get anything close to what they were worth. If everybody ran on the bank, they wouldn’t be able to pay everybody. But if people didn’t run on the bank, they would be able to pay everybody.

That’s only a little bit of what’s going on with Silicon Valley. They were basically going to be broke anyway, even if this run hadn’t happened. So, it was a failure of risk management at the bank, and it was a failure of the regulators for not preventing this in the first place.

Luigi: You anticipated one of my questions, which is the failure of the regulators. It seems pretty remarkable that after all the effort we made after the great financial crisis, we are still in a situation in which the regulators do not see something like that happening. What went wrong?

Douglas W. Diamond: We just were coming out of this period where short-term interest rates were very low for a long time. The Federal Reserve was making statements that they were going to be low for a very long time. The market expected them to be low for a very long time. And it turns out even bank supervisors were working under the assumption that interest rates couldn’t go above 2 percent.

How do I know that? I looked at the webpage for the stress tests of the really big banks that the Federal Reserve posted for their 2022 stress test. They haven’t posted the 2023 one yet because they don’t post it until after the test. And the highest interest rate that they measured the solvency and liquidity of these banks was 2 percent. They didn’t stress 3 percent, 4 percent, 4 ¾ percent where they are right now. I think the regulators believed their own story that interest rates weren’t going to go up. I think maybe the risk managers at Silicon Valley believed it.

If you go to who’s really at fault, it was the Fed for generating these false expectations that interest rates would stay low for a really long time. What I would have done, if I realized that there was a significant chance you’d have to increase interest rates, I would have gone and looked at the balance sheet of every single bank, large, medium, and small, and see how exposed they were to 5 percent and 6 percent interest rates, and then encouraged those banks to either use interest-rate hedging and futures or swap markets or unload their longer-term stuff so that you really could use the macroprudential regulation to keep the banks safe if you later had to raise the interest rates.

Once you realize the banks aren’t safe if you raise the interest rates, you may be on the high moral ground to raise interest rates and stop inflation. But if you stop inflation by wiping out the financial sector, you’ll stop it a little more than you mean to.

I wouldn’t be surprised if the next interest rate increase is zero percent, and I’d be shocked if it’s half a percent.

Luigi: But that will lead to more inflation down the line, but that’s a different story. Some people have blamed this failure on the fact that Trump waived the stress-test requirement for middle-size—

Douglas W. Diamond: For the middle size.

Luigi: You’re saying that that’s not true because even if they—

Douglas W. Diamond: Right.

Luigi: Go ahead.

Douglas W. Diamond: They’re only looking for risk up to 2 percent. They would have been fine up to 2 percent. The run was because they were insolvent. The high interest rates were causing funding-cost increases for them. If the interest rates that they borrowed at stayed at zero forever, then they would have been fine with having a bunch of long-term bonds with 1 percent coupon when newly issued bonds had, like, 4 percent coupons.

One narrative was that the startups needed their money, which is true. But another narrative is the startups are not stupid. If they can get 5 percent on Treasury bills or 5 percent on money-market funds, why would they leave it in at zero at Silicon Valley Bank? Once Silicon Valley’s trying to finance their 1 percent fixed-interest-rate Treasuries or US agency securities at 5 percent, they’re pretty quickly going to be insolvent.

Luigi: But you said something very interesting at the beginning, which is that in order to have a viable bank, you need to have a diversified set of depositors who are not too much in communication with each other.

Douglas W. Diamond: Yeah.

Luigi: In today’s world, in a world of social media and Twitter, everybody is in communication constantly. So, does this mean the end of banking as we know it?

Douglas W. Diamond: Well, there are two types of depositors that don’t run. The insured ones, so if you have enough insured deposits, you can predict that the run, if it’s going to occur, will only be partial. In this particular case, some really big fraction of their deposits, into the 80 percent range or something, were uninsured. And they were all not just on social media, they were all sort of on the same social media. They were all working through Y Combinator, they were working through Peter Thiel and these other people. They all dealt with the same venture-capital firms.

The fact that everybody sees the same news report makes them very prone to run. The paper of mine with Phil Dybvig imagines that everybody sees the same thing that says, “Bank run today”" which makes them all believe there’s a run, which brings them down. But if people read 10 different newspapers and only one of those 10 said, “Bank run today,” if everybody understood that, the people who read that newspaper wouldn’t worry about it. Because, hey, if 10 percent of the deposits go away, that’s not going to kill anybody.

Luigi: And so, do you think that Peter Thiel has any responsibility in triggering the run?

Douglas W. Diamond: I’m sure he has some responsibility, but also, once he realized that they were probably dead anyway, I think the responsibility he had to his people he dealt with was to tell them that they were going to be dead anyway. I don’t know. If he had a short position in the bank or something like that, then he would certainly have some explaining to do.

Luigi: Given the circumstances, do you think that the Fed and the Treasury did the right thing last weekend or not?

Douglas W. Diamond: I wasn’t so sure before they did it. I was thinking if they could have found a way to give most of the depositors, like, 90 cents on the dollar, uninsured depositors, and see if they could get 10 percent more later, that might have been the way to do it. But given that it seemed to be this was spreading to other banks, if basically every company decided to be prudent and pull out all of their checking-account deposits, demand deposits over $250,000, then that would be a disaster. If that was what was going to happen, they did the right thing.

Luigi: OK. I don’t want to take too much of your time. You’ve been very kind and very helpful, Doug. Thank you very much.

I’ve known Doug for 30 years, and he’s always been a very soft-spoken person. So, I was quite shocked by how strongly he laid all the responsibility at the feet of the Fed. We thought it would be a good idea to hear from somebody who spent all his professional life at the Fed, and until a year ago was still in charge of regulating banks.

Eric Rosengren is currently a professor at MIT, but for many years he was the chairman of the Boston Fed, somebody who played the role of the bank regulator. And since the bank regulators are on the hot seat today, we wanted to get the closest thing we could get to a current bank regulator: a former bank regulator.

Bethany: Eric, there’s always this question with a bank failure: Was it a liquidity crisis or was it an insolvency crisis? What do you think is the answer here, liquidity or insolvency?

Eric Rosengren: I would say that it is primarily a liquidity problem. Frequently many of the deposits are insured. In this case, 90 percent of the deposits were uninsured, and the firms that had uninsured deposits for the most part were firms that had venture capitalists staking them. And as a result, even though there were a lot of firms, there weren’t a lot of venture capitalists. And so, in some sense, this was a venture-capital run and over $40 billion is reported to have gone out in one day. That is very unusual for a bank the size of $200 billion. So, I would say in this case it was primarily a liquidity problem with a very unusual mismatch given the nature of its deposits.

Luigi: Sorry, Eric, they had enormous losses on their held-to-maturity assets. They invested in long-term bonds when the interest rate was at the minimum, and in the meantime, they had $16 billion in losses with $16 billion of equity. One does not need to be very sophisticated to say that they were basically insolvent. What am I missing here?

Eric Rosengren: Without getting too much into the accounting, there’s a held-to-maturity portfolio and there’s an available-for-sale portfolio. They sold the available-for-sale portfolio, which was at a market price, and they had a roughly $2 billion loss. They had more than enough capital to handle that. They were well-capitalized. The held-to-maturity, there are a lot of banks right now that have a loss on held-to-maturity.

Normally, you don’t put money into a held-to-maturity account for securities if you’re not planning on holding it all the way until they mature. The reason for that is if you sell anything out of held-to-maturity, it becomes mark to market, and you have to book the loss. If they hadn’t been forced to mark to market—if they had access, for example, to a discount window that was providing loans on par, which is what’s available now to banks—they would not have had an insolvency problem. But you’re right, on a pure mark to market they would have been insolvent. But a lot of banks might be insolvent if they were forced to mark to market for embedded losses.

Luigi: Eric, let me go back to your answer. Let me translate in a way that maybe our listeners can relate to and then tell me if I’m wrong. Because what I heard you say is, yes, they were insolvent, but if you allowed them to take advantage of depositors and basically not pay interest on deposits for a little while, they can make up the losses, which is basically what you’re saying of a lot of banks do. We know banks don’t pass the benefit of high interest rates to their customers, let’s put it this way, in a way that is pretty remarkable. If the depositors are unsophisticated enough to hold on long enough, then they are solvent.

But in this case, their depositors were sophisticated, and they moved their money out, and so they went bust. But if my interpretation is correct, what makes me nervous is that there are a lot of banks in this situation, and they were just counting on depositors being complacent.

Eric Rosengren: You’re right that sticky deposits is an advantage for a bank. And in this case, the deposits were not particularly sticky because they had highly sophisticated venture capitalists telling their firms to pull the funds en masse at one time.

An awful lot of banks have mostly insured deposits. So, it’s a little bit of an unusual model to have primarily uninsured deposits, which is one of the reasons why they were able to flee very quickly. But if you take the normal community bank, there usually aren’t very many uninsured deposits. There’s not much incentive to leave.

And yes, they don’t get a rate that’s equivalent to a Treasury rate or even a rate that you could get on a government-held money-market fund. But they choose to keep it in the bank because it’s convenient for them. Sometimes it’s a business that’s holding deposits mostly to make payroll. Sometimes it’s an individual who just finds it convenient to do all their banking services at a local place. So, there are other intangibles that are part of a banking relationship that you have to take into account besides the interest rate.

Luigi: But in a sense, the initial run was simply the fact that they started to withdraw from the bank to put it in higher-yielding assets. This was before last week. There was a significant bleeding that started to force the bank to sell some of those assets that were held-to-maturity and start to book some losses, and that’s the reason why they had to raise some equity.

Imagine that we’re now entering a world where consumers are more aware of the alternatives, and they start to pull out their money from banks that have a lot of hidden losses. If I read this correctly, there are about $600 billion in hidden losses in the banking sector. Should we expect a lot of other banks to fail like this? If you don’t give me anything in term of yield, and I find an alternative that gives me 3 percent or 4 percent, I’m incented to move even if there is no run.

And then, if a lot of those deposits started to move, then of course, you start to book losses and at the end you have the run. But even before that, you have a lot of movement of deposits, because that’s what Silicon Valley Bank experienced before last week. I can see the possibility that in a world where investors are more aware, where we are online, we can switch very fast, more people start to switch. And of course, they switch out of banks that cannot afford to pay those rates, because if they were to start to pay the market rate, they would go bankrupt.

Eric Rosengren: You’re right that many depositors have alternatives that pay higher rates. Most depositors aren’t leaving their bank. Just as a matter of fact, if you look at deposit growth, it tends to have been positive through much of this period. And so, I think there were some specifics about this bank, particularly the fact that venture-capital firms would be encouraging their firms potentially to look at alternatives. But I do think you have a point in that when something starts going wrong, the information is transmitted much more quickly than it may have been 20 or 30 years ago. And as a result, you need to be particularly good at managing your asset-liability mix to make sure that if some depositors leave, you’re not forced to sell assets at a loss.

There are plenty of banks, walking around Cambridge right now, the interest rates they have are not the interest rate you can get on a money-market fund or on a Treasury security. But as far as I know, none of those banks are having any trouble keeping their deposits. I think most depositors are pretty sticky. It’s not that everybody’s sticky. Some people do pull their funds out and put it into Treasury securities or put it into a bank or a CD. You do have other options. But the reality is that most people are pretty lethargic when it comes to responding to moving their deposits to an alternative source.

Bethany: To what extent was Silicon Valley Bank’s failure a creation of both monetary and regulatory policy? I’m seeing a lot in the press that this was the Trump administration’s fault because Silicon Valley Bank lobbied really heavily in order to skirt some of the tough rules of Dodd-Frank. And yet at the same time, at the end of December 2022, Silicon Valley Bank had a tier 1 capital ratio of 8.1 percent versus JPMorgan at 6.5 percent. So, it ties back into this question of how much of this is a failure of regulatory policy?

Eric Rosengren: Did raising the limit of what was considered a very large bank make a difference? In some cases, it did, and one of those is that they didn’t necessarily need to have a resolution plan for this bank. The expectation was . . . Most failed banks aren’t liquidated. The FDIC does a least-cost procedure, and the least-cost procedure normally is that somebody else buys the bank, or they buy at least the deposits. And when they buy the deposits, they don’t just want small depositors, they want the large depositors, too. As a result, it’s very unusual for large depositors to actually lose money in most bank failures. It’s pretty unusual for uninsured depositors to actually take a loss in most bank failures. In most bank failures, they actually just get transferred to another bank through the purchase and assumption with the FDIC.

Luigi: Going back to the exemption that Silicon Valley Bank obtained under the Trump administration, one of the things they got out of was the stress testing. However, if you look at the stress testing that was done for large banks in 2022, I think that the worst-case scenarios in terms of interest rates that the Fed put out as a guideline were not that bad, no worse than rates going up to 2 percent. Even if they had done a stress test, they would not have been exposed to this kind of losses.

Eric Rosengren: Each year they do a different stress test. Sometimes it’s a stress that’s focused on interest-rate risk. Sometimes it’s focused on real-estate risk. Sometimes it’s focused on exchange-rate risk. But in addition, any bank should be doing at least modest stress tests themselves on what their liquidity position is. And there were definitely red flags here.

For example, they were a very large borrower from the Federal Home Loan Bank. They hadn’t been a year ago. They were one of the largest borrowers at the time that they got into trouble. And that should have been a red flag telling people that there may be a liquidity issue here. So, I think there were red flags along the way. And a bank doesn’t have to go through a stress test that the largest banks go through to realize that they need to worry about interest-rate risk if they’re buying a lot of long-term securities and funding it with short-term deposits.

Bethany: Playing off that, despite the focus on what a stress test might or might not have revealed, weren’t there enough red flags that regulators should have seen this coming? It wasn’t just, as you point out, the loans from the Federal Home Loan Bank. There was the rapid growth in deposits. Rapid growth is supposed to be another red flag for regulators. This was all over the short-seller community that there were problems here. Silicon Valley Bank’s chief risk officer resigned last spring; they had no chief risk officer for a period of time. There were a lot of red flags even without stress tests that it seems to me the Fed should have caught. And so, isn’t this a mammoth failure of regulation as well as a mammoth failure of Silicon Valley Bank’s management team?

Eric Rosengren: I mean, you don’t know what actions were being taken because you don’t have exam reports; you don’t know what was being recommended to management. You would have thought that the amount of supervisory intensity would increase as some of these red flags became more and more apparent.

Unfortunately, a lot of the exam process is confidential, so you don’t know exactly what was being done or what wasn’t being done. What you do know is that they weren’t able to force enough change that they reduced the exposure so that they didn’t have this problem. I think there is work being done right as we talk at the Federal Reserve to better understand why they didn’t pick up on some of these red flags.

It’s always easier in hindsight to see a problem. And even if you knew that there might be a bank that had an issue, I’m not sure you would have anticipated that so many medium-size banks would have the same problem. And I think if they had been able to resolve it over the weekend, under a more normal process, it would have been a much better outcome now. They obviously couldn’t find enough bidders to do that, but I think there are a bunch of circumstances you might not have fully anticipated. That being said, you should never be confident that there aren’t stresses in the system that could be a problem, particularly when you’re raising rates very quickly.

Bethany: This is total speculation because I heard what you said last time about not being able to see inside the process for the auction, but isn’t it surprising that the auction failed and now they’re trying again? And I’ve wondered if there could be more surprises in Silicon Valley Bank’s portfolio than we know. For instance, half of the loans are extended to venture capital and private-equity funds to fund their capital commitments, over half of the loans. I just wonder if there’s something more here than the surface explanation that we all know that might be resulting in the failure to find a bidder. This may be too speculative a question for you to address, but I’ll ask.

Eric Rosengren: There should be franchise value in the Rolodex of having most of the venture-capital firms in the country using this bank. So, that’s why I thought there would actually have been an auction that was successful. That being said, $200 billion is a pretty big bank, and to do due diligence over a weekend is not a whole lot of time. My own view last Thursday and Friday was they were likely to find a bidder over the weekend. I don’t have a good sense of why they didn’t, but one reason to open the auction again is they do have more flexibility to actually make it a more attractive deal if somebody said, “I’m willing to do it under certain circumstances.” The fact that they’ve got more ability to actually provide sweeteners to the deal makes me pretty confident over time they’re going to find a bidder. But we’ll see how much it ends up costing the FDIC in the end.

Bethany: How worried are you about the overall stability of the banking system?

Eric Rosengren: I definitely was surprised by how much a wide variety of bank stocks reacted to the shock, and it was pretty sizable. So, at least markets are telling you, you ought to be concerned that there’s enough problems there that it could spill over to the real economy. With lots of oversight of banks and bank regulators, there’s going to be an incentive for bank management to be quite risk averse. And what that means is that the availability of credit could be impeded not only by the shock, but by additional oversight that people are thinking about.

And you might start seeing spillover to the real economy, not so much necessarily through the interest rate, but just the tightening of credit, as banks and bank regulators become more concerned about the risks, could in and of itself act like multiple rate hikes. And also, how consumers and businesses react to seeing on the news a bank failure every day. So, it does have a depressing effect on a lot of people, and that alone can have an impact on consumer behavior or a firm’s willingness to think about employment opportunities for their firm.

Luigi: So, you’re basically saying that finally the Fed has succeeded in taming inflation by creating a banking crisis that will depress our consumption and investments?

Eric Rosengren: I don’t think that was the intent, but I will say that banking crises do have spillovers to the real economy.

Bethany: So, the Biden administration has been at great pains to say this was not a bailout. What do you think? Was this a bailout or was it not a bailout?

Eric Rosengren: Well, equity and debtholders definitely took losses. Large depositors ended up being made whole. Most bank failures result in large depositors actually getting their funds back. There’s probably going to be disagreement on this call about this, but I don’t think large depositors actually provide much market discipline. The large depositors, for the most part, were probably firms focused on innovative ideas and venture capital and were not as focused on what the financial risks are. And when they do, I mean, to some extent this run was market discipline.

The problem is they waited too long and then did too much too quickly. So, that’s probably not the way I want market discipline to work. And if there had been a private-sector acquisition, the large depositors would once again have been made whole. So, it’s not as if this is an unusual circumstance that large depositors end up getting their funds. What was different was there wasn’t a private-sector acquisition to facilitate that.

Luigi: I’m actually sympathetic to the fact that as a depositor, you don’t want to spend time worrying about whether your bank fails, because you need to have a place where you pay your bills. Given that you get zero interest rate in exchange, pretty much, it would be adding insult to injury, the fact that this is even at risk.

But then the question is, is the entire structure of the banking system poorly conceived? Because what is the difference between insured and uninsured deposits, if we really think that every transaction deposit should be protected, like the Fed did after 2008? After the run on the money-market funds, they insured all transaction deposits that were basically zero-interest-rate deposits. So, why don’t we have a system where, if you have a transaction deposit, so you pay zero interest rates, then you are guaranteed? If you make an investment by parking your money there, then you face a risk. But that’s a different decision. Why is the system not organized that way?

Eric Rosengren: I mean, since most depositors in most situations get all their deposits back, I personally would have no problem saying that deposit insurance covered all transaction deposits in the bank. That puts more onus on supervisors and regulators. The quid pro quo for that ought to be that we take quite seriously the regulatory and supervisory responsibilities because otherwise you do worry about the FDIC taking larger losses. Now, given that the FDIC normally makes the depositors whole, most of the losses, with the exception of 2008, are borne by the banks who pay deposit insurance.

And so, in most circumstances, I think that the taxpayer’s not on the hook. What is a problem is if there are embedded financial-stability risks that cause all banks to fail at the same time. That is a real problem and that’s why we should have high capital requirements. We should have significant regulatory oversight. We should regularly do the kind of stress tests on liquidity so that this kind of thing does not happen. And banks of this size that have large uninsured deposits should be closely looked at and possibly have as much oversight as a bank that’s over $250 billion, because we’ve just seen that in the end, we’ve had to take extraordinary actions.

Luigi: You said that you would pay more attention—how did you say it?—to the regulatory job. Does this mean that not enough has been paid until now?

Eric Rosengren: I think that as you get to very large banks, the regulatory intensity is very different. The question is, where do you set those guidelines for where the regulatory intensity should be quite high? Fifty billion may have been too low, but $250 billion was too high.

Luigi: As I said, I’m sympathetic to the idea that transaction deposits should be insured. But at that point, if you insure all deposits and you’re providing a service that is quite cheap to the banks for them to make profit, isn’t a better alternative to provide direct access to the Federal Reserve account to provide insurance? Because we are insuring anyway. Now we are insuring with a layer that is very, very expensive. If we were to do it directly with a central-bank digital currency, we will save that money, we’ll provide security, and we’ll have no problem of competition of banks. So, why this is argument wrong?

Eric Rosengren: There are other ways that you can do it. You can directly buy Treasuries and you can buy government money-market funds that immediately give you very close to what market rates are right now. I’m not sure that you necessarily have to give people access to Federal Reserve accounts.

A digital currency . . . there are a number of ways that you can construct it. The most likely way, from my own view, would be that a digital currency would operate more like cash, which is the cash would get . . . It would be used for transactions. It wouldn’t be a savings mechanism. I think there are other ways to get the savings. And certainly, things like government money-market funds and directly purchasing government bonds are other alternatives that investors already have.

And you have to remember that for many of the depositors, there’s a whole suite of activities. If you’re a consumer, you’re probably doing bill paying; you probably have a credit card. So, switching accounts is very expensive, in part because you don’t want to deal with all the things that you are now intertwined with at the bank.

The same thing’s true for a business. If you’re doing payroll, if they’re doing a lot of other services for the business, it’s not that easy to switch from one bank to another. So, there is an inherent stickiness that a constellation of bank services provides both individuals and firms. It’s not just looking at the interest rate that determines what the full cost and the full value of a service is.

Luigi: But, sorry, the inherent stickiness is partly a result of regulation, because in Europe, where you have the open-banking directive, stickiness has gone down tremendously. So, I think we can reduce stickiness if we want to. The problem is we don’t want to because this will hurt banks.

Eric Rosengren: There certainly are mechanisms to reduce stickiness. That being said, when I look at bank balance sheets in Europe, I’m not particularly comforted, to be quite honest. So, I’m not sure that would be the leading example I would use.

Luigi: Thank you very much, Eric.

Eric Rosengren: OK. Good talking with you all.

Luigi: So, what I got very clearly from Eric’s statement is that they count on the fact that banks can get out of trouble, basically, in my book, by underpaying depositors. Look, we don’t worry about the fact that you have a big loss on your asset side, because as long as the deposits stick around, you can make it up by basically underpaying for your deposits. And so, the only problem, in this particular case, the depositors were not dumb. In general, the Fed counts on depositors being dumb. And the mistake they made is not to realize that if you have a bunch of venture capitalists, these guys aren’t dumb.

Bethany: That’s a really interesting point. I agree with that. I still think the Fed’s mistake was broader than that. Come on. In a rising interest-rate environment like the one we have, you know things are going to break. And one of the things that’s going to break is a bank. And I don’t want to reduce the Fed’s failure to not realizing that depositors aren’t dumb, although I do think that that has much broader systemic reverberations, as you pointed out.

Luigi: I’m much more scared now after talking to Eric than I was before. Because what I got is, basically, there are a lot of holes in the banking sector. There are $600 billion of losses. And you can hold unrealized losses because if you can alter the policy, blah, blah, blah, blah. But these are basically losses that are not accounted for. The Fed is not worried because they count on the fact depositors will stick around.

Bethany: Well, now that they’ve insured deposits across—

Luigi: No, no, sorry. Even insured deposits, they don’t have to stick around. Because if you pay me zero and the Treasury bill is at 4 percent, how long will it take to have somebody arbitraging and going to the depositor and saying, “Wait a minute, I’ll give you the same services and I’ll pay you 2 percent.” I still make 2 percent on the difference. That’s huge.

Bethany: Well, I think the scenario you lay out is actually happening right now as you have people pulling all their deposits out of smaller regional banks. That’s what’s causing this problem. I don’t think it’s for the reasons that you’re articulating. I don’t think it’s because they’re being offered a higher rate somewhere else. I think it’s because they’re looking at this scenario and saying, “We just don’t want to take this risk.”

I sort of agree with you and I sort of don’t, because I think that it relies on people to being less lazy than they actually are. I don’t always like my bank, but the mammoth effort required to switch just feels like it’s too much. I’m not going to take all my money and chase a higher yield. I don’t know if that’s true of businesses, but I think it’s not because they also have so many sticky relationships with their banks in other forms.

I think it’s a little more complicated than you’re laying out. I agree, the laziness of depositors is still a really big thing to be staking the safety of the US banking system on. But I think there’s some degree to which that’s true that you’re not entirely crediting.

Luigi: No, I think you’re right. But I would like to distinguish very clearly because I think that we kept going back and forth. I’d like to distinguish between taking out the money out of fear and taking out the money out of the fact that there are better opportunities out there. What I think happened in Silicon Valley Bank is first they started to take the money out because of interest rates. That started a process that led to the realization of losses and the attempt to raise equity, and at the end, the actual run. As Eric said, initially they were selling securities that were close to market. They were not realizing losses.

At some point, they had to sell some of the securities that were held-to-maturity. Held-to-maturity means I don’t want to sell them. Why they were forced to sell them is because the deposits were flowing out. And you can blame this—this is what I’m saying—you can blame the fact that the entire venture-capital industry is slowing down, blah blah. That’s what the regulators wanted to tell you, that this is a once-in-a-lifetime phenomenon, driven by the fact that this bank is too concentrated on the depositor side. But in reality, in my view, it’s simply that their depositors were not dumb.

Bethany: I’m going to disagree with you here, but with the big caveat that we don’t know why depositors were pulling their money, even before the big panic took over. I think there’s some legitimacy to the explanation out there. I do not think that it was a simple search for yield. The relationships particularly that venture capitalists had with Silicon Valley Bank were so deep that the idea that they were just going to start pulling money because they could get yield somewhere else, I just don’t think that’s true. That might be a big risk for the broader banking industry. I think you might be right about that.

I do not think that’s the story of what happened at Silicon Valley Bank. Over half of their loans were funding capital calls at venture-capital firms. That is a relationship that VCs are going to have a really hard time replacing. They extended mortgages to VC firm partners and employees at all of these startups. The relationships were so deep, the idea that they were just willy-nilly yanking their money out in search of a slightly higher yield somewhere else . . . They got too many other favors from Silicon Valley Bank, which I actually think is the real problem here.

That said, as I tried to say earlier, I agree with you that may be a really big and unaccounted-for problem with the rest of the banking industry. We don’t know, but I don’t think that’s what happened here.

Luigi: You might be right. I know for a fact that the deposits started to flow out. And maybe they’re flowing out for other reasons, but I think that as you said, there is a risk in the entire banking sector. Because even if . . . Imagine that you’re saying all money is insured; all deposits are insured. As people might start to be concerned about yield, they might take their money out and put it in money markets, put it in other places. And banks will have to start realizing losses.

Bethany: I agree.

Luigi: And we have social media. I think that this is the first run in a social-media world. Everybody knows what everybody else is thinking at the same time. And this is prone to creating bank runs. In the city of Chicago at some point, the city was monitoring social media to try to prevent riots. Because riots are like bank runs. If everybody shows up at the same time with a certain bad intention, there are not enough police to block them, so you have to start acting in advance. Shouldn’t the Fed start to monitor social media actively because this is where the bank runs might materialize?

Bethany: It’s a really good point and I think it amplifies my point about a perhaps misguided focus on stress tests, were that to be the focus, revealing everything, because there are so many other factors that a stress test wouldn’t show, including the potential for a social-media run like we had.

I mean, it started with a venture capitalist, Peter Thiel, telling people to start pulling their money, and then every VC in Silicon Valley started telling all their portfolio companies, “Get your money out, get your money out.” I mean, it becomes a self-fulfilling prophecy at that point.

I still do think . . . and I liked Eric’s answer about how there might be many things about the process that we don’t know that might have limited bidding. I still think it is a bit of a mystery as to why no buyer stepped in. And it’s going to be interesting to see with this new auction and perhaps different rules why no buyer steps in.

You would think that Silicon Valley Bank’s franchise was worth an awful lot. I mean, they have been the bank to Silicon Valley for a really long time. And again, with full appreciation for Eric’s answer that we don’t know, which I found really interesting, that we don’t know the strictures that might have been placed on the bidding process, I still think it’s a bit of a mystery. And I do wonder if there are other problems in the portfolio.

Luigi: But you are saying that a significant fraction of the loans of Silicon Valley Bank was linked to funding capital calls. These are capital calls of venture-capital firms, right? So, let me explain to the listener what this is, to get a sense of how shady this is. So, the venture capitalists are valuated on a measure called internal rate of return. The internal rate of return can be much higher if you realize the same gain over a very short period of time, because it’s a measure of speed, not the measure of how much money you make.

So, one trick the venture capital firms do is that instead of asking for their money from their investors when they make the investment, they prefund that investment with some money borrowed from the bank, and they call the capital from their own investors only later on.

Now, from a bank point of view, this seems like a super-safe loan because if you are a venture-capital firm with the ability to call capital from, let’s say, the Harvard endowment, that is as good as money. But instead of paying a very high return to their investors at Harvard, for a short period of time they pay only the borrowing rate from Silicon Valley Bank.

Now, there is a scenario in which all the big investors say, “We don’t want to fund this anymore,” and the bank collapses. So, there is a risk implicit in that. And second, these relationships, I think, are mostly personal; they’re not the bank. What I suspect is some of the big managers of Silicon Valley Bank will walk across the hall and open a new Silicon Valley Bank where the franchise value will be embedded. But if you go into the database of Silicon Valley Bank or anything like that, you don’t have something unique that is worth the franchise value.

Bethany: That might be the explanation. I do think there are two issues here that I wonder about, one of which everybody pooh-poohs, and the other of which I have not heard much discussion. But a friend of mine called me yesterday and said this was very explicit. Silicon Valley Bank would market to venture capitalists: “Here, we will offer these loans, and this will boost your IRR by two percentage points a year. Here’s how we can make it happen.” So, it was a very explicit . . . You can call it a game, it’s financial engineering, a very explicit financial engineering that Silicon Valley Bank was offering.

Luigi: I would call it manipulation because this is really not even . . . Financial engineering has at least some value to it. This is simply manipulation.

Bethany: Semantics. I happen to think financial engineering is manipulation, so whatever. Anyway, it’s semantics. A lot of people to me have pooh-poohed the idea that any of these loans at Silicon Valley Bank are going to have losses. They say, of course the LPs are going to fund. Of course, the Harvard endowment is going to continue to fund. I think there’s more of a question about that than people acknowledge, but only time will tell if that’s right, in the sense that venture capitalists’ performance last year was abysmal. It’s probably going to continue to be abysmal.

Yes, maybe people will continue to fund the really big prominent VCs like Sequoia where they don’t want to get X’d out of the next fund. But there are a lot of other venture capitalists that Silicon Valley Bank had extended these loans to, who LPs may look at this, look at the embedded losses already on their portfolio, and say, “I’m out.”

I did want to push a little bit on this notion of whether this was a bailout or not, because the bigger issue does seem to be that because of who their customers were, they were able to get the government to act in a way that it wouldn’t have acted for a different firm. And I don’t like the fact that Silicon Valley Bank does seem to show that the rules continue to be different for different players in our system.

Luigi: I completely agree with you, Bethany. I think that there was a need to stop a run, but what they could have done is to say, “I will insure all depositors from now on, but the past depositors of Silicon Valley Bank will take a 10 percent haircut.” And that would not be dramatic. I don’t think that any firm would fail because of a 10 percent of haircut. But it would show the fact that, number one, they contributed to some of the losses they have to cover up. And number two, if you make a mistake in this world, you pay. I think it would send the right signal to people.

I think the lack of willingness to do that is pervasive. And I was seeing Larry Summers saying on Twitter, “This is not the time for moral hazard and blah blah, blah, argument, et cetera.” And I was tempted to tweet back and say, “When is the time for you, Larry Summers, to actually impose some losses?”

Because I understand that during the banking crisis, that was an issue. But I never heard him outside of the banking crisis saying, “Oh, this is the moment, actually, to punish.” I am very sympathetic to the risk. So, I’m not crazy enough to say, you should be oblivious, and everybody should pay every loss, et cetera. And the uncertainty is enormous in this moment. So, instead of saying, you can get all your deposits tomorrow, actually, you can get 90 percent of your deposit tomorrow, the uninsured ones. The insured ones, I insure. I don’t see what the problem was.

Bethany: Yeah. Just two more quick points on this. Every time there’s a problem, the powerful do end up getting the safety net extended. And it’s what has to be done because if they fail, then the costs are going to be so huge. But you get tired of hearing that argument time and time again. “We can’t fail because we’re going to take you down with us; therefore, we can’t fail.” And it becomes worrisome.

And just as a second point, I do understand the argument that maybe depositors shouldn’t be required to do due diligence on their bank. At the same time, there is a question about at what size a depositor should do some due diligence. And there is something about the structure of Silicon Valley Bank and their very incestuous relationships with venture capitalists that I do see this as a bailout of the venture capitalists who encouraged their portfolio companies to put their money at Silicon Valley Bank for all the reasons we’ve enumerated, because of the perks and goodies they were also getting from Silicon Valley Bank. And there is something, given all of that, about their failure to do any due diligence on Silicon Valley Bank and their failure to diversify that I’m not thrilled to see them not bearing any losses. I’m not thrilled to see the bailout of venture capitalists.

Luigi: I think you might be right for this particular case, but in general, I think it’s a bit crazy to expect that the depositors will perform due diligence when they deposit. In the old days, bank notes were issued by banks, and you had to do the due diligence to exchange one bank note with another bank note. So, a $1 bank note from the Bank of Philadelphia was worth a different amount from a $1 bank note from the Bank of Chicago. Why? Because of the default risk. Would you want to go back to that period? Absolutely not. How did we do it? We actually had the government perform the trick of printing money, and that saved a lot of the monitoring cost.

And what I advocate is that we should do the same with all transaction deposits. You should have a central-bank digital currency where we don’t worry about it, but we don’t subsidize banks in the process. You have some transaction money that you can hold at the central bank. It yields zero rates, but it is one hundred percent safe. And then if you want to put money into more risky stuff, you can, but you should know that it does not come with any insurance, period. Because the current system is a system in which there are uninsured deposits that don’t pay for insurance, but at the end of the day, they’re insured. And so, there is somebody that benefits tremendously from this, and these somebodies are the banks.

Bethany: Well, I think we should put you—maybe not me, I might be too draconian—in charge of restructuring the US banking system.

Luigi: I don’t think so.