Bloomberg Audio Studios, Podcasts, radio News.
Hello and welcome to another episode of the ad Blots podcast. I'm Tracy Alloway.
And I'm Joe.
Why isn't thal Joe?
Do you remember what we were doing this time last year?
Uh?
Nope, not really.
I should say around this time last year. But yes, I can't really even remember last week at this point. But in the middle of January we recorded an episode on the discount Yeah.
Oh, on the discount window, Yes, I do. Why were we talking about the discount window?
No, because borrowing was going up, right, Yes? Yeah?
Right?
Yes, okay, yes, so in like February or Sunday or maybe early January of last year. No, no, February March of last year. Like, we did that episode about like deposit rates, and then that turned out to be very relevant. But even before that, you started writing about the rise in discount window borrowing.
Yes, that's right. I think I wrote something in December. I think the headline was like billions in discount window borrowing suggests all is not well with banks, which turned out to be fairly true come March because we did see a mini banking crisis, banking drama, whatever you want to call it the collapse of three banks, including Silicon
Valley Bank. But since then there has been this massive discussion about how to tweak all these emergency financing programs for banks, what they should actually look like, how do we want the lender of last resort system to operate, and what does it mean for banks? You know, if they have to hold back additional collateral in order to access these programs, then what does it mean for them from you know, a capital or a revenue to point. So many things going on in the space right now.
It's a little bit under the radar, but I think we should talk about it totally.
It always is like there's like this inherent challenge, right and even with Silicon Valley Bank, even setting aside like emergency borrowing. You know, the thing I guess like that people get anxious about is as soon as any financial institution makes moves to shore up liquidity, show up finances, et cetera, that becomes a signal right to investors or depositors whoever, it's like, Okay, why do they feel the
need to shore up their finances? And then you become a target and you start worry about the share price and equity et cetera. And it feels like this is like an inherent challenge for regulators, which is, of course, you want banks to be proactive, you want banks to have plenty of liquidity, you want them to have equity cushions. But if the act of doing so invites suspicions, then how do you get.
Out of that puzzle?
Well, exactly, And I think this is most apparent with the discount window, where people talk about the stigma of accessing the discunt window, and you know, when you access it, it's supposed to be anonymous. The FED doesn't publish who's actually tapping it until I think two years later. But
you start to see rumors swirl. In the case of last year, when we saw the discount window borrowing start to go up in December, I think that was the proximate time when people started to ask questions about like, well, wait a second, what's going on with Signature, what's going on with Silicon Valley Bank. That might have contributed to
some of the deposit withdrawals that we eventually saw. So the super interesting thing now is that people are talking about reforming the discount window as well as some other facilities.
We saw the acting Comptroller of the Currency Michael Sue, also a former All Blots guest, talk about the idea of like, well, maybe we're going to require banks to tap the discount window every once in a while, just so the stigma maybe reduces, but also they have the operational readiness to do it when they really need to.
Can I say it's almost inappropriate? For no, it's it's it's borderline.
Are you gonna make the discount window inappropriate? I'm curious?
So you know what I think whenever, like I hear this idea of like, well, if you just get everyone to do it, there's no there's no stock.
Oh, I know exactly what you're gonna say.
I tweeted this one.
I always think about the scene in the movie Billy Madison where like the kid is really embarrassed because everyone can see that he pat his pants and so wait, who's that actor who's in it?
That fit the comedian Adam Sandler.
Adam Sandler's like, oh, he like splashes a bunch of water on his own pants, and so he's like, oh, everyone and everyone around has water on their own pants. There's nothing embarrassing about it. And in my mind that's I'm Sorry, maybe I have a juvenile humor. That's always where my mind goes. If you have everyone do it, no one can be embarrassed about doing it.
Okay, Well, on today's episode, why requiring banks to tap the discount window is the equivalent of splashing your pants with water?
That's gonna be the title of this episode.
Excellent. We really do have the perfect guest. It's someone we've wanted to get on the podcast for a long time, and I don't think he's been on before.
Though.
We're going to be speaking with Stephen Kelly, Associate director of Research at the Yale Program on Financial Stability. So, Steven, thank you so much for coming on all.
Thoughts, happy to be here and talk about Billy Madison.
So how much did the banking drama of last year change attitudes towards emergency lending facilities? I guess another way of asking the question is do we think that all these lender of last resort type things actually stood up to the test last year?
Yeah? So it's a tricky question because obviously what comes after these crises is you go, why didn't it work? Right? It's there, the Fed can mint money. Why doesn't it work? You know? Why didn't SVB just post everything at the window. And we can get into the various reasons about that, but basically it's hopeless to say, oh, the discount window is going to work once you have name that's in the headlines, and that's sort of the pressure we put
on it. Sometimes what the discount window is great for is sort of a macro story. It's great for contagion. It's great for maybe a community bank that it isn't facing the same kind of headline risks. It's never gonna save that bank that's in the headlines, and we can go into all the reasons about why, but so much of the franchise value just gets destroyed so fast. And when you're talking about replacing all your depositors, well, what is a bank but you know a collection of its depositors.
So you know, you can put all the money you want in the window, but it's never gonna save that bank. And that's just too much pressure on the window.
Can good banks fail by taking on these counter signals to the market, So, whether it's going to the FED and trying to get additional liquidity, whether it's doing an equity sale at some point just to create that greater equity cushion. If the bank is fundamentally sound, can simply expressing consarn be enough to bring it down because it does seem like, you know, people don't want to send that signals. Or ultimately, if the bank is good, then these are good moves to take and they'll survive it.
Yeah. The biggest thing is if you can't get capital. I mean capital is what protects the deposit layer of the balance sheet. So if you can't get capital as a bank, you're out of business. So SVB comes out March eighth last year with an eight K that says, oh, you know, we were kind of looking at raising two point twenty five billion. We have five hundred million of commitment. Like that was enough to say, Okay, they gave an inside look at the balance sheet and nobody wanted it.
So it wasn't that they were raising capital. It was that they announced that there was this gap.
Yeah, if they had come out on March eight and said Warren Buffett is investing two point five billion, we would still have SVB today, got it.
Maybe this is a good place to sort of back up and dive into what exactly happened with SVB. So there seems to have been a reluctance or an inability to tap the discount window soon enough. But we also know in retrospect, with the benefit of hindsight, that they were tapping another emergency. Well, oh, I should be careful here. It's not really supposed to be an emergency lending facility. I'm talking about the fhlb's, the Federal Home Loan banks.
We used to call these, by the way, we used to joke in like two thousand and nine that fhlb stood for free Hubris loans for banks or find huge lumps of bucks.
Like I love to find huge lumps of bucks.
But anyway, I mean, this is a facility. It was supposed to facilitate home ownership and help banks do mortgages for people, but it sort of transformed to become an alternate emergency lending facility, and we should definitely talk about why. But SVB was basically tapping that instead of the discount window. So walk us through like what we saw from that particular bank in terms of the choices they made to access different types of liquidity.
Yeah, so we call the fhlb's the flubs, which they don't love, but we'll deal it anyways, So I think it's not unique to SVB that they sort of relied on the fhlbs. You know, there was an SNL sketch after two thousand and eight during the original stress test where they they sort of did a bit like the stress test was an actual exam that banks had to take, and you know, City Group kept answering government bailout to
all the questions and that's never saw that. That's sort of what happened with the fhlbs, particularly prior to March and prior to you know, the supervisory pressure we've seen since where if you asked the bank, hey, what do you do if you really get pinched to go, well, we'll go to the FLUB. You know, we have a great relationship with the fhlbs. I mean that's another piece is that these fhlbs are a lot more commercial in
nature than the FED. But so that was sort of the contingency funding plan written large across the system, and you know, it sort of works if you need a billion or five billion if you're SVB. It doesn't work if you need forty billion because the fhlb's they take government collateral, they take mortgage collateral. If you need to start posting, you know, commercial and industrial loans, something like
corporate bonds. You got to go to the FED. And if you're not set up at the FED, because it's annoying to do that, it's too expensive, you don't want to leave collateral there, whatever the reason, you run out of time.
So some things just aren't set up with the FED, like it's too annoying.
Exactly what if that's the operational readiness argument for making them splash water on their pants, slash go to the discount window.
Right, So SPB literally couldn't get collateral to the FED in time before the run is out. Again, the SVB story was over, so it didn't matter. But it's useful to be ready to go at the FED because they can take effectively your whole balance sheet. Basically any asset a bank will have you can put to the window. I mean, that's why it exists. And the FHLBS, you know, because of this sort of housing origin and whatever other reasons, they just don't have that range.
The same thing happened at Signature, by the way, and I think there was a really good speech by a FED official. I can't remember who it was, but they were talking about how it had basically been five years since Signature tapped the discount window, and when it came time to tap again, you know, things are blowing up. You need to access emergency liquidity. The Signature staff didn't really understand the rules around collateral eligibility and what they had to do in order to actually go to the
window and borrow money. So I can see the argument for why you would want people to like practice it.
Hey, what happened to Signature who took over their assets again? Well, I'm making a bit of a joke there that I'm aware that.
I'll have to check my Bloomberg. I think there's some sleepy bank. No one's ever heard of it.
Yeah, and why c b Okay, So no, this really, I mean that sort of blew my mind at the time, that like, here are these institutions, and I guess that weekend, obviously, I guess the Fed or the Treasury determined that there was some sort of emergency aspect of it. And we all know that, like there was the sort of rescue and they opened up this new program, the BTFP, which we'll talk about. But it sort of blew my mind that you could have this crisis and part of it
is like, well, what time is it? What time is like the window actually open? Can we reopen the window? Like that sort of blew my mind. So what happened immediately or maybe not immediately, but in the wake of all of this. So we've sort of talked about the run up and how they're like, what changes did we see regulatory wise in the wake of the SVB and signature disaster.
So the biggest change, which is long overdue, is you got to post more collateral at the window. It's this term prepositioning that we're starting to hear more and more of. And you know, you got to practice, and we're hearing more from regulators that they would like a little more practice than this, you know, and this is probably the direction that supervision needs to go of, like, Hey, if
you're not practicing, we're gonna we're gonna docu. If you can't show that you can show up at the window and get liquidity when you need it, we're going to docu from a supervisory perspective. But really, it's been a lot of pressure to send more collateral to the FED. There is something like three trillion dollars of collateral at the FED. We don't get like daily updates on this, but it's in that vicinity and we know what's been growing.
And we're also hearing from regulators that there's maybe some reforms to be had and some new liquidity measures to take.
Is pre positioning a synonym basically for encumbrance. So the idea that I have a certain number of assets on my balance sheet, I'm going to have to use more of those or set more of those aside at the Central Bank in order to satisfy these new requirements, and therefore they're going to be less available to me to do stuff, do you know, creative and hopefully revenue generating things with them, like repo them out or something like that.
So yes, that's that's part of the story. And the other thing I think about is like banks have a lot of loans, so those are just sitting there, goes to the FED. You get over the hurdles of moving up, Like it's not like you're repolling out your loans necessarily as a community bank. Just house them at the FED, don't leave them at the fhlb's send them to the FED. And so that's gonna be a piece of it. The other thing that may come here is some sort of
carrot with that stick. So the hardest thing about the discount window is that it really can't be any cheaper. And that's the stigma, is that it's really expensive. So if you have a deposit which is yielding zero and you've got to go to the window, the Fed can say, oh, look it's just the top of the Fed funds rate, but that's still you know, right now, it's five hundred BIPs more than more than deposit.
I see.
So even if it's just like it's just you're just borrowing, even if it's just at the Fed funds raids, yeah, like really banks are borrowing from their deposits. That's way more or you know, whatever it is now it's not zero anymore, but whatever the typical deposit is.
Right, So it's it's incredibly expensive. It would be great if you were Coca Cola and you could go to the discount window, but you can't. So the way to destigmatize is to offer some sort of caret and if you can say, hey, if you preposition collateral, we'll give you some credit towards your LCR, or we'll give you some credit towards these other things. So you can self ensure less and do more profitable things with your balance sheet.
That's maybe a viable route, and that's why preposition is sort of coming in vogue.
Wait, can you talk a little bit more about the rates available at I guess specifically the discount window versus the Fhlb's ye, because this is something I never like quite understood. So if you go to the FHLB the FLUB, I think they actually like they do something where they do look at unrealized gains and losses on your securities in order to see whether or not you're a viable entity to be lending money too. So if you are like super stressed, they might not actually lend you money.
But on the other hand, it seems like everyone kept going to them, and I'm assuming it's because like the rate of borrowing is more attractive than the discount rate.
Yeah, so that's a big piece of it. And it's the confidentiality. So the valuation thing you're thinking of is only unavailable for sales. So that's part of the story is you can still hide the losses and help the maturity to some degree, but the pricing is definitely advantageous and nobody can write that story that you wrote last February, Tracy, where you're saying, okay, it looks like.
There's December, please sorry, give me my extra two months.
I think you told these banks to borrow. You know, nobody can write that story because the data is not it's not public data. We don't get a weekly balanced sheet from the Fed.
Why isn't it public.
Because you don't want to run on the bank.
Because the fhlb's are a private entity, they're cooperative basically put together by the banks, and so that's a piece of the stigma. And the funding is really good because this is you know, it's a GSC, it's a government sponsored enterprise. So when you have a crisis and there's a flight into money market government money market funds, what can they buy? They can buy treasuries and they can buy FHLB debt and so you really have you have
cheap issuance. And the FHLB pays out their earnings to members. They don't pay it out based on you know, the biggest bank it's the biggest or you know, everybody gets an eqal share. Whoever borrows is who gets the earnings back. So it's it's literally you know, a rebate to anybody who borrows. And so what we see as the fhlbs are always competitive with the FED, often cheaper, and you know that drives part of the story too, is that they just have this built in discount.
So one other thing that's happened recently is the FED has basically said they're going to end the BTFP program, I think in March, which was when it was supposed to end. And I was kind of amazed at some of the arbitrage story that came out a little while ago, the idea that banks could basically get free money from the FED because of the way the rates were set on the BTFP versus other financing sources. How big of an issue was that, How much did that play into
the decision to end it? And then I guess lastly, given what we're seeing now with one particularler New York based bank and the troubles, there is there a possibility that the BTFP gets extended.
So I would say it's unlikely absent a wider crisis. The arbitrage story isn't really it's not likely that that's why it was ended. It was ended because things you know, NYCB notwithstanding and things have been calmer. There's not really the unusual and exigen circumstances the FED looks for. I think it's probably why we found out in January that it was going to end in March and why they announced the rate change. Yeah. So the way the rate
thing worked is the BTFP is for one year. The FED charged one year OIS plus ten basis points, So that was sort of the penalty built in. But what they're lending is reserves, and if you are a bank, you can leave those reserves at the FED, not do anything with them, and earn interest on reserves. So this is sort of a new post two thousand and eight thing that actually weighs into the expenses of the FED.
So when OIS plus ten BIPs drops below ior, you know, you could just run that trade infinitely as long as you have the collateral and just sort of harvest the carry basically.
For listeners and for myself. Remind me again, so what exactly the BTFP stipulated. It was rolled out as part of the SVB emergency. I get, you know, there were all these concerns about these losses on the whold to market book, But remind me what the actual design of that program was.
So the biggest thing about the BTFP is that it took collateral at par value.
Right par and so there was a lot of these treasuries in particularly in SVB cases were like way off parwer because rates.
And China right. And so the critique at the time was, oh, my gosh, this is not how central banking works. You can't just lend it whatever value, blah blah blah. And that was pretty overblown because the BTFP still charges a market rate. So just like we were talking about before, they're not charging the deposit rate. They're charging five hundred
BIPs at the time. So all it did was turn out a bank's losses because you know, a mark to market loss on a health to maturity security from interest rates is representative of your funding cost over time to hold that security. Banks typically don't pay that actual rate, right if they're paying cheaper deposits, and that's why we
ignore the accounting. But once you take that security to the FED, if you take a thirty year treasure to the FED for thirty years, just keep rolling that discount window alone, you're going to pay the market rate, and so those losses are you're going to realize them over time. So it solved the liquidity problem, but it didn't ignore these losses. Banks still had to deal with them.
You just alluded to something that I wanted to ask you. This is sort of a provocative question. I know it's going to get you going. But liquidity versus solvency, that's not even a question, that's just a statement. What's the difference? Does it matter?
So this is a common versus framing for basically synonyms in banking, Like every time a bank fails, it's either one political party, it's definitely the executive who ran the bank. We just had a liquidity problem. We just needed more liquidity from the Fed. People freaked out. The question they can answer is why your bank? Right? We don't have a panic that takes down JP Morgan right. The idea that something can be a liquidity issue alone, it doesn't exist.
These banks aren't chosen at random, and every bank at the very end looks like a liquidity issue because the last thing they do is either fail to make a payment or look like they're about to fail to make a payment and the regulators show up.
Well, can you have like a pure self fulfilling prophecy, like couldn't someone start a false rumor or misunderstand social media. And I remember in the wake of SVB as like, oh, social media caused the bank run or all of these people on his ski trip in Aspen, I think was like one of the stories, like they were all like whatsapping with each other and that's what caused the bank run. Like could that is that a real thing? Like where like a bank could go down? You say like, well, yeah,
but why are they targeting you? But maybe everyone just on the WhatsApp group says this is the bank that's in trouble.
They could, but we just don't see that as really happening. You know, SVB was running on negative accounting equity for months and investors had discounted it. It's not just the SVB case, Like there has yet to be a case study where Twitter can come out or you know, Bill Ackman can just like take down Goldman Sachs. Because it goes back to what we're saying about Warren Buffett or the capital raise. It if the franchise is strong and you have if you have contingent capital, you don't have
to worry. If you don't have contingent capital, the capital structure breaks down.
This is the thing Tracy that I still like to this day, I don't quite understand, which is that, you know, there was no question that they were running like negative equity and was right there in like probably the ten Q or like some SEC filing. But you know, like all of these startups like supposedly loved the bank they targeted. They understood they had like these special products so that founders could get mortgages by posting their RSUs as collateral,
which other banks didn't like. I don't understand why they couldn't have monetized that franchise value, which now seems to be gone.
So they did for so long. I mean, that's how they could afford running at negative accounting equity. It's like Amazon, right, how long did they take to turn profit? But you had long term viability. And the thing with SVB is like, Okay, you can have the mostest loyalist depositors in the world, like every bank thinks they have, and SVB probably did. But what happened, you know what Tracy was observing with her article and what was happening before the run is
they had to spend their money. Like the deposit balance at SVV was dependent on new IPOs that just weren't happening. So these venture capitalists are as loyal as can be, but they're just spending down their cash balances, and so the balance sheet.
Unlines how much of the banking fragility that we've seen over the past year is basically an interest rate story. So you know, setting aside IPOs which dried up when interest rates increased, you also just have the losses on
the bond portfolio. And to me, this is kind of it's kind of a non issue, but it's also kind of a fundamental tension in the banking system, which is that you've built all the rules around the idea that, like the best type of collateral is either cash or government bonds, which is fine when government bonds are really boring and not very volatile and there's not a lot happening.
But when inflation starts to go up and the primary tool the central bank has to manage that is to affect the price of bonds, then we seem to have this like tension enter the system.
For sure. That's how you end up with the BTFP, which you know sort of fits in this long trend, particularly the FED of like what is a treasury and how much do we want to monetize it, Like how often do we want to be intervening? How you know, what different lending facilities do we have to set up? Who do we let? So it does sort of sit within that post two thousand and eight tension of like, you know, we're really building the system on top of these safe assets, so we kind of have to keep
them money. Like, but yeah, that is the key vulnerability. But also there's so many banks who have that same vulnerability as su that didn't fail. So that's sort of the built in macro vulnerability. But the interest rate risk, you know, was also in tech and in innovation and in crypto and so that's why we've seen like banks like Schwab, banks like Bank of America, like huge unrealized losses, but less concerned about the franchise.
Yeah, it seems like when I say non issue, like it seems like there's a tension. But also I find it hard to believe that like the banking system is going to come down because banks have bought too many US treasuries, Like that doesn't seem right, and this doesn't seem realistic.
This was always the nuclear option that the FED had is like, the second you're worried about JP Morgan going down because of too many treasuries, the Fed's going to cut rates and just recapitalize the whole system. So it was also sitting in this tension of the FED was tightening and didn't want to ease up on tightening, So that made it a harder dance too.
You wrote about this a little bit at this time, and I think, even like before SVB, what happened if we get into this situation in which the FED is trying to put out a financial fire at the same time that it's trying to fight inflation, which was certainly the case in March twenty twenty three because at that point the hiking cycle had not yet reached its peak, and so the you know, they re expanded the balance sheet.
You know, some Twitter people thought that was QI or it wasn't, But like, what is like talk to us about that tension of if the Fed. You know, it's like you mentioned, it's like, okay, let's say JP Morgan, we're getting into trouble. But you know that could happen at a time of high inflation, and as Tracy mentioned, you it could happen that some bank through the treasury channel literally did how do central bankers think about this tension or how do you resolve that?
Well, central bankers might not, I mean at the absolute limit. This is why crisis interventions are you know, capital injections and guarantees and physically you know, it's sort of all these things at once. And why this kind can't go back to this, i't know why it's not always enough
and why it doesn't solve every crisis. But that's exactly why you see have to see you know, quote unquote innovative things like valuing collateral at par and the BTFP and the arbitrage and sort of the turning out losses is a little unique because all the loss is really built up just in treasuries at the time. You know, if you're thinking about something like commercial real estate to pick a random ass set class, the credit risk is indogenous to the FED, right, so it's not a case
where the losses necessarily materialized over time. The FED can come along and write, you know, basically a put option on credit risk in a way that even valuing collateral at par it sort of couldn't with the BTFP.
So I mentioned at the beginning that we are seeing various attempts to tweak and in some cases like change significantly the way these various facilities are used. If you were Michael Sue at the OCC or if you were Michael Barr, the Vice Chair of Supervision at the FED, if you were like the ultimate Michael, basically, how would you be arranging this constellation of facilities.
Yeah, there's a few things. I mean, one we can talk about the standing repo facility, but I might pop a blood vessel if we do that.
I want to see that.
Okay, no, no, we'll get to that.
The biggest thing is you have to have some carrot at the window because the FED, so it used to be even in recent history, that there was a premium to go to this kind wind to Right, you want banks to like be evaluated by the market when they're getting funding, and you don't want like haircuts at the discount window being your effective collateral requirements. So like there is a reason to not run everything out of the FED. Right,
they're not asset managers. But at the same time you have this tension where you want them to come when the time is right, So you have to have something send there for the banks go because the Fed can't go any lower on price. It used to be one hundred basis point premium. We've seen the Fed lower this in crisis. They lowered it to zero over FED funds in COVID and it's been there since. So it's clear
that they are keeping it. You know, they're keeping the discount window right at top of FED funds, so they really can't go any lower because then you know, we're in the BTFP problem where they're they're taking in less and then you can pay on interest on reserves. So you have to have some regulatory carrot and stick basically for the discount windows. So that's a big piece. Second thing is get the FHLBS out of the lender of
last resort game. We sort of got a unique political moment in that the FAHFA put out a report a few months back kind is saying this thing right, like, you know, my sense is Sandra Thompson, the head of the FAHFA, cares about affordable housing, right, she doesn't want to be in this world of like bankers just lending to each other and it goes to a trillion dollars in a crisis, and it's just sort of so far from where those institutions started and so far from the
goal of housing, Like get them out of the lender of last resort game, don't let them pay dividends based on who borrows, pay dividends based on who does affordable housing or something, you know, something along those lines, and basically write up a bunch of term sheets for all these different potential thirteen three facilities that you're going to have to roll out. Because the other piece of this is, like going back to your rates question, Joe, all we
talk about now is central bank intervention. Like anytime a market blows up, it's where's the ECB, where's the boj like buy equities now, bail out this bank, Like especially since two thousand and eight, and where was all this before. It's like, well, they just cut rates when we didn't have to worry about the zero lower bound. They just cut rates, And you know that was sort of the green Span playbook, right, just like let some financial froth come out and then clean up the mess with rates.
So that's sort of the other reason that we're talking about this more and more and more is we're worried about the zero lower bound.
Talk to us about the standing repot facilities.
It seems like a.
Good idea, you know, just always be.
There and well his head just exploded.
Shoot, shoot, it's nice knowing you, Steven.
It's okay.
What's the downside? Always seemed like a good idea.
So the standing repol facility is so first of all, it's basically they just got window for treasuries and agencies. The nice thing about it is that it adds primary dealers. You hear the FED talk about it and they like want to add all these to it, but it's just the discount window. You can bring treasuries to the discount window, so that whole piece of it of like, let's get banks involved. It would really only be valuable if you, as a bank, like the depository subsidiary, had collateral in
the tri party repol market. Because the FED runs this program out of the triparty repo market. It's not like the discount window in that sense, so that part's sort of goofy. It's nice to have it for the primary dealers,
but there's two problems we have with it. One, and Zultan has talked about this on this podcast at length, which is you're relying on the primary dealer's balance sheet to sort of on lend it to everybody, you know, repurpose the liquidity for every hedge fund that needs it in a time of crisis, and that just doesn't work because balance sheets get pinched. And then the alternative is like, okay, you let every hedge fund come directly to the FED,
and there are political and legal issues with that. The other thing is, again, it's not like it takes a matched book, right. The Sandry po facility is not going to take your treasury and your future. So if you look at something like the basis trade and the risks we have around the basis trade, I take very little comfort in the standing repel facility, even though some folks do, because when the basis blows out, you basically have the cash price falls and the futures tightened, right, And that's
that's what we saw in March twenty twenty. And all the standing repel facility can do is replace your repot funding at that new market value. So it goes back to this issue of like where do you value the Collaterally, it's not going to recognize, oh, you have a future and you have a treasury, so I'm going to lend
you know, at the collective value of that portfolio. It's gonna lend at the cash value of your dash to cash treasury that everybody's trying to get rid of, and so you're just gonna get caught in that spiral.
What does a bank do?
No, seriously, what is the main product that a bank offers?
Deposits?
Can you explain it? And like when I think it's like, oh, I want to go to the bank, I want to loan.
If a bank offers mostly deposits, why are they all so bad at actually matching the benchmark interest rate?
Because deposits are a service. That's exactly what I disagree.
This is my saying, this is my this is my our We should be paying the bank for deposits. I love easy online banking services and free ATM withdrawals. Why aren't I paying them?
Well, not only that, it's the ledger tracy, that it's the ledger of the whole economy. You cannot make a payment that isn't a deposit transfer, you know, happening somewhere at the back end, And that is a service that
banks offer. And that is exactly why the franchise value can erode so quickly, because if you say, oh, we have all the quity we need at the discount window because we're highly capitalized, which failed banks always have great capital ratios, right, so they can take their collateral to the window, haircut it whatever. But you have no deposit franchise left. And the deposit franchise is what was allowing you to borrow at zero, you know, and and lend it three. So that's your franchise value.
I realized we've made it through this entire conversation without even touching the basil endgame proposals. Should we do it? Yeah, let's go for it, all right, Basil.
I mean, it's almost not worth it because it's not going to look anything like it does now. I mean, I don't even know.
What doesn't mean.
Well, there's a lot of places in it that look like easy fixes. You know, there's like weird charges that show up for like climate financing, or like random distortions that happen in housing. So the Fed's going to look very responsive. It's going to look like it changed a lot of things. The other thing is they've sort of signaled that they want more consensus than they had putting out the proposal, and they had two descents putting out
the proposal. They had Mickey Bowman, who they're never going to get. She hates everything the FED has done on
the regulatory front in the last year. And it's Chris Waller who has really talked about the operational piece, which is a little bit distortive, so that the proposal sort of looks at charging for operational risk based on like the size of a business, So like the size of an asset management business would cause you to need to hold, you know, more capital, but those businesses tend to be very stabilizing, Like look at what we've seen that happened
to Morgan Stanley, Like it's a diversifying business, it's sort of a all seasons business. So I think we'll probably see a lot of changes on the operational risk charges as well.
Prior to SVB, I believe a lot of fights around the regulatory limits and whether stress tests about like banks that weren't the mega, too big defail banks, but weren't necessarily like the little tiny community banks out in the
middle of nowhere. And I think like SVB and some of these other sort of like fell in that middle and in a way like probably harmed themselves because in retrospect, they probably just would have been better off taking a little bit of hit to profitability for a sort of like tighter regulatory requirement.
What is happening with regulation for some of these more mid sized.
Banks, Well, I mean the goal is to bring them all into into to sort of recognize them as big banks, which you know.
It, why not do that?
There are like maybe legal reasons and blah blah blah, But I'm really not convinced. But I'm also like fundamentally, like, will we take a step back from the capital regulation debate? Like we're talking about changing ratios from like twelve percent to thirteen and a half. Like, I get why a bank is annoyed. I get why there's all these interest groups involved, but like from a systemic perspective, that's just not that interesting. That's not gonna be the difference between
two thousand and eight and not. And it's also not gonna be difference between a profitable banking system that beats Europe in China and not.
I mean, it is true that Sphoebe had a carve out as a smaller bank, and there is discussion about whether or not those carve outs should exist, but just backing up for a second big picture, I feel like in the US we have yet to decide what we want the banking system to actually look like. So there's this sort of it's a wonderful life vision where you have all these local banks, community banks, even in New York, and they know you and they build up that relationship
and you know, you get those benefits. But on the other hand, they're also you know, our experience of last year is that maybe there is a benefit to being extremely large and efficient and having a funding advantage and things like that.
And it feels.
To me like the regulators, politicians, basically everyone involved in this equation has yet to figure out exactly what they want.
Yeah, and it's a hard thing to talk about because you know, you can't go out as like Japol and be like, I think we should have less banks, because you'll have less banks by Friday, right, So.
Yeah, it's a good way to do it.
It's a hard thing to talk about. And you know, they've pushed back on this idea of like a Barbell banking system, which is sort of the mid sized ones get hollowed out, either downsize or upsize, and you're left with community banks. And bigger banks, and that is sort of the verdict of twenty twenty threes. You would say, okay, big banks did well, small banks did well. Let's just get rid of the mid size banks. But you know, there's small banks that are very dependent on the local economy.
I will say, big picture, you cannot be a niche bank that is also under the pressure of financial markets, like you can't be focused on Silicon Valley and also, you know, need to raise equity and have attentive you know, headlines. If you're a community bank, you can probably run on negative equity longer than you know, a mid size bank that has to go to market and things like that.
All right, Steven Kelly, thank you so much for coming on all thoughts and letting us trigger you for basically forty minutes. I really appreciate it. That was great.
Yeah, thanks, thanks guys.
So Joe, I really enjoyed that conversation. I have a feeling it's going to be a very relevant one in twenty twenty four as we start to see more movement on these various issues, including you know, maybe reforming the discount window whatever. The basil end game actually ends up looking like there are a few interesting things that I would pick out there. So one of them was Steven's emphasis of how important the actual banking franchise, the deposit
franchise is to funding. And you know, if the franchise starts to go like that's when you do get the deposit issues and then you can't actually raise capital. And I think some of that did get lost in the conf around SVB and Signature and First Republic, where it was more like, oh, these banks kind of got unlucky, like they bought too many bonds or whatever.
No, that really connects some dots and crystallized a lot of things.
And I had forgotten with SVB that prior to the.
Run that did happen on the bank, there was the deposit shrinkage that was simply as a result of Silicon Valley financial conditions at the time, which is that there was no IPO window for a while there, and there was no new fundraising, right, so you didn't have these these startups and stuff did not have fresh cash coming in, and they were in survival mode and you know, they're like spending down their money all the time. So there was this sort of like natural it was not a run.
It had it wasn't even about the treasuries. It was not about the report on the sub stack in January of that year. That's like Burn Hobart, the author of the newsletter.
It's like, by the.
Way, Silicon Valley Bank is insolvent, you guys should check this out, and like people like ignored it for about four weeks. It was not about that. It was just about the fact that the deposits were going down.
Yeah, however, Joe, I really I remain reluctant to pay my bank a fee. I don't want to.
No, I mean I don't.
I like having free banking and I like having free access to ATMs and the website and a nice app and stuff like that. But it does really make sense and sort of like crystallize this point, which is that that is the only sub market rate borrowing in the world right like basically for the banks, and there's a reason that they can get submarket rate because they also
throw in this service for you. But you know, there was like that chart we had it at our recent odd lotch trivia night that Josh Younger showed, which is like the Fed funds rate and then is like what is this rate below it? And there really is only one rate in the world that's going to ever like be below the Fed funds rate, and that's like the special rate that banks can borrow at from their own customers deposits.
Yeah, you did mention I think earlier in the intro that around this time last year. So in addition to the Bill Nelson on the Disco episode that we did in January, I think in February probably, Yeah, we spoke to Joe aboute over at Barkley's about exactly this issue, so deposit rates, the beta Joe benchmark interest rates. So yeah, I think we're pretty on the ball.
We're pretty on the ball. And that talking Stephen that like at put a bunch of things ye together like a lot of like light bulbs. Enough it's like, oh, I get why this is the case, or I get why that's not really an ultimate fix, et cetera.
So I really enjoyed that conversation.
Okay, on that self congratulatory.
The slubs, I'm gonna start calling it that. That's so much easier to say than fhlb's.
Shall we leave it there, Let's leave it there.
This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway and.
I'm Joe Wisenthal. You can follow me at the Stalwart. Follow our guest Stephen Kelly at Stephen Kelly forty nine. Follow our producers Carman Rodriguez at Krman Arman Dashel Bennett at Dashbot and kel Brooks at kel Brooks. Thank you to our producer Moses Ondam from our oddlotscontent. Go to Bloomberg dot com slash odd Lots, where we post transcripts.
We have a blog and a weekly newsletter that Tracy and I write, and you can talk about all of these topics with fellow listeners twenty four seven in the discord Discord dot gg slash odlocks.
And if you enjoy Oddlots, if you like it when we do deep dives on emergency lending facilities for banks, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is connect your Bloomberg account to Apple Podcasts. Thanks for listening, Bead