First Republic Bank has become the second largest bank failure in US history.
Another Bay Area bank goes down.
We're back with some breaking news this morning.
First Republic Bank has been taken over by federal regulators and sold to JP Morgan.
Chase as America's bank and crisis flares up again. In a statement this.
Morning, Hello Stephanomics, here the podcast that brings you the global economy. We're back a few weeks later than expected, but just in time to talk about the collapse of First Republic, the fourth US bank to hit the rails since we went off air at the end of January. Why are these smaller lenders under pressure and if they stop lending, is that going to be enough to tank
the economy? I found myself asking these questions in Los Angeles this week at the Milklin Institute's big annual conference. It's not a bad place to get expert answers. Some of the biggest names in US finance were here, along with some senior US politicians and the Managing Director of the International Monetary Fund, Chris Selina Gorgieva. I'll play you my chat with her and with Milkin's chief economist William
Lee in a few minutes. But with the best will in the world, these movers and shakers aren't going to be able to tell you how it feels to be at the sharp end of this slow moving US credit crunch. For that, we ask Bloomberg's Mike Sasso to go to Florida.
Pickleball has exploded in popularity across the country at.
Kickleball and now Picklebob, popularity has exploded, with an estimated more than four point eight million players nationwide.
If a pickleball business is having trouble getting alone these days, then you know the credit crunch sweeping the US must be syric. In Nakatie, Florida, a suburb in the fast growing Jacksonville area, Lauren Garvey and her husband are eager to open a new bar and grill with quartz for pickleball, the popular paddle sport that's kind of like tennis for
the everyman. They want to combine it with a restaurant, either by creating their own spot or buying a franchise of Chicken and pickle where you can gobble down some wings with a beer then hit the quartz.
When I started noticing pickleball was when you know maybe five seven years back, when my grandmother was in her retirement community and she was playing pickleball and she was raving about it, and it sounded like such a funny term until we started noticing more and more people playing in our community in Nokti, and there were multiple pickleball
courts and they're constantly full in the mornings. When I take walks past there, I'll see people playing pick a ball, you know, as early as seven am, and they're there until the sun goes down. So we just realized what kind of opportunity was there.
But like so many other lately, the Garvey's entrepreneurial dreams are a little more remote than they were just a few weeks ago. Getting a two and a half million dollar loan from their bank once looked all but certain, but when the best rate they could get was around nine percent or ten percent, the Garvey's put the brakes on.
You know.
It got to that point where when we were told that the interest rates were going to be at ten plus percent, we realized that's just higher than what we could afford or what made sense. And there's a high probability that you know, they wouldn't approved the concept or the loan anyway, and obviously it doesn't support our financial model. We you know, it would make it difficult for us to even break even, let alone make money time soon, so you know, we had to cut that off.
It was expected over the weekend as well.
Let's get a little bit more insight on the collapse of Silicon Valley Banks is rapid.
How quickly this bank went into total collapse. It was just a couple of days, and it happened.
In the middle.
The banking turmoil that sunk Silicon Valley Bank in rattled markets worldwide. So far hasn't led to the wholesale crisis that some feared. Yet it's causing banks in other lenders to think harder about making loans, and it's reducing the size of the loans they do make. This credit crunch is more than a little worrying for the world's biggest economy, especially as the US Federal Reserve met this week in raised interest rates for their tenth and possibly final time
of the current cycle. Those higher borrowing costs played a role in stoking today's banking trouble. A year ago, the US Central Bank launched an aggressive campaign to squelch the worst inflation America had seen in forty years. Suddenly, new car loans that once had low four point four percent interest rates now carry burdensome seven percent rates. And for a min America's mom and pop shops, the average loan backed by the US Small Business Administration has nearly doubled
to more than eleven percent interest. It was too much to stomach for the Garvey's.
Yeah, we kind of got to the point where we just realized it was too high for us.
Only about twenty percent of the money in the United States is in currency and coin. The other eighty percent is check with money, and that check with money is in the form of deposits in our commercial banking system commercial banks.
Americans have generally parked their money in banks for a long time without moving it, but they started to withdraw when the FED began raising rates last year. When svb's troubles made headlines in March. In First Republic and Signature Bank soon followed, depositors got spooted and yanked their cash out calls all three to.
Fail, and as those deposits flow out of the bank, that severely cuts down on their ability to make new loans.
Here's Ben Johnston Enough Capitis a lender to small businesses.
And in fact many cases, these banks are needing to shed assets and courtail lending in the future in order to make sure that they can supply that outflow of deposits.
Eventually, bank regulators in a coalition of large banks stepped in to quell the crisis, but many see troubling signs for the bank loans and the companies that depend on them. Just this week, JP Morgan agreed to acquire First Republic Bank after it was seized by authorities. John Tuhig works for the investment bank Raymond James Financial, overseeing a unit
that packages up loans and trades them. He normally surveyed about two hundred regional banks recently and found that about a quarter had toughened their lending standards after svb's collapse.
They're charging higher rates, so that again that comes back to liquidity, right, their cost of funds is going up. It's not necessarily credit, but I mean if they have to do a borrowing or have to do a CD special, they're borrowing costs or four or five percent today, they have to charge something north of that, right, But you're starting to see lending slow because of those higher rates.
Meantime, the amount of corporate debt trading at distress levels has soared by twenty eight percent since SVB collapsed in March, and bankruptcies are climbing, especially among small firms with money harder to get at traditional banks. More firms likely will turn to high interest alternative lenders like Cappitis. The New York based company offers loans in other forms of credit with interest rates starting in the teens and going up from there. Despite its priceier loans, the companies saw loan
applications spike to their highest level ever in March. Here's chief operating Officer Ben Johnston again, and.
We expect that volume to continue to be at quite high levels for the foreseeable future.
Back in Florida, the Garvey's are going to wait out the high interest rates and credit crunch, hopefully returning to their pickleball, grill and bar concept when things settle down.
No doubt that it would be profitable and that the demand is there, and it's something that we would love to pursue down the line, especially if the interest rates come down. It's not going to come off of our radar. We're going to continue to proactically pursue it. There's just so much demand for it, especially in this area.
So we're sitting in a crowded hall at the Milkin Institute's big annual shindig in LA at the kind of charmingly old fashioned Beverly Hilton, and I'm delighted to be joined by William Lee, who's the Milcan Institute's chief economist and often helps us explain what's going on in the global economy. So I appreciate William.
Well, I've had the privilege of being on Bloomberg Radio in Asia, so I visit almost every Bloomberg office in places where I've worked my entire professional life.
And somehow we've not had you on Stephanomics. So I'm glad we finally resolved that problem. I want to talk to you about lots of things, but let's get into the all this talk of credit crunch. And you know, obviously this conference this week began with the resolution of the First Republic situation, the JP Morgan buying this bank.
We've had four US banks fail in the last few years for a few months, and not all of them big, but certainly raising questions about mistakes being made in their business model, but also the impact of this big increase in interest rates that we've had in the US. So I guess I should ask you how concerned are you by the state of the US banking system, which of course lends to a lot of households and a lot of companies, and if they can't lend, then the economy might be affected.
You know, when you bump into anybody here at Milkin as an icebreaker, they always ask you. In fact, they've been asking me all morning, what do you think of happened in the First Republic? Is this the start of something really big in the banking is just them? Will the banking system be in trouble? And I think if you're given answer of the sort that says, oh gee, the credit crunch might lead to a recession, they shake your hand and they leave because they know. The professionals
here are capital markets people. They know that corporate America raises most of its money through debt and equity, and bank lending right now has become much less important source of capital for major corporations. Where banks are still very important would be among the smaller and medium sized businesses and in certain sectors like real estate. They're the local banks, the small and medium sized regional banks are incredibly important
in supplying money to these particular businesses. So if indeed there were a banking credit crunch, and there's a banking crisis that prevented banks from lending, you'll see the impact mainly in those areas. Now, when I say it's only eleven percent of total corporate borrowing, do you think, oh my god, that's such a small number. Why are we
so worried about it? Well, small businesses account for the bulk of the employment, and the real estate market is absolutely vital to a lot of people, because, let's face it, we didn't want to go through two thousand and eight again. But as far as tanking the entire use economy is concerned, that's unlikely to happen unless we really have a very severe banking crisis that spreads into the capital markets that prevents companies from raising money there.
So what we're basically saying is that you know, a mum and pop store or a small business can't go and issue debt, issue a bond from mom and pop. They have to go to their local bank. And so whether or not that bank is feeling able to lend, and how tough requirements that are is going to make a difference on whether or not they can get that loan. But I guess if you're the FED, that's kind of why you're raising interest rates.
Right exactly.
One of the reasons why the FED is so worried about the efficacy and the power of mantrap policy these days is that they have been raising rates really almost at an unprecedented rate, from zero to now near five percent, and they still see the economy chudging along fairly strongly, and more importantly, the unemployment rate it's three and a half percent. So they're asking themselves, is has the transmission
of monetary policy change It somehow has become less powerful. Well, it may have, but certainly the indicator they want to see change is consumers spending easing off. And we heard in today's session Jane Fraser, the head of City Banks, say the top two quintiles of people still have a lot of spending power. And it really struck me to say, yeah, you're right, it's the top two quintiles, But what about
the rest of the population. They're going to paycheck to paycheck, they're using their credit cards, So we have two Americas. In America where the very rich are comfortably spending and going on vacation and filling up all the airplane going to Europe, but we have the bulk of US population still suffering from not having enough money to meet their daily needs because prices keep going up faster than their income.
So when the Fed wants to ease inflation, the first thing they want to do is start to get the economy to slow down so that people don't demand as much goods and services and so that the price pressures are eased off.
And I think that is starting to work now.
In the latest GDP numbers, we're starting to see income gross domestic income has actually turned down, and that's a good sign that maybe we will have something that will restrain the economy. And if the banks start to ease off on lending to specifically to businesses that hire a lot of people, more people will get frightened that, my god, my job really is at risk.
Maybe I shouldn't be going on that vacation. I can maybe delayed till next year.
It's an uncomfortable conversation, though, isn't it, Because we tend to we talk about higher interest rates in the abstract, and maybe we encourage the idea that it's you know, going to just at the edges make people cut their spending. And you talk about holidays, some people think of the holidays a pretty essential item in their basket. But you know, the uncomfortable truth is you the whole point of the policy is to make it harder for people to get alone, right.
So I'd rather have the money in my plucket now rather than spending it and then worry that I will get laid off for six months after I come back from my vacation. So I think those are the social issues that I think the FED is well aware of. But there is really only one policy instrument they have to control inflation, and that's by raising interest rates.
I guess the only upside of this for people who don't like the sound of working Americans being hurt is that it's pretty tough for banks in the US at the moment for lots of reasons. But this increase in interest rates actually has turned out to be a bit of a problem for them. You know, normally they can make a lot of money from having a big gap between what you can get in a savings account and what they're lending out for but it hasn't quite worked out like.
That well it so definitely I'm not sympathetic. I'm sorry.
My former boss, Jane Frasier at City is doing quite well because they have a very diversified business model.
So those banks that are able.
To manage their businesses and manage their risks are doing quite well. What we have seen is that banks that go on the fringes and into fringe markets, like trying to service the venture capitalists in Silicon Valley, are going to really high net worth people and saying come do business with me, and offering very very specialized services to them. Those business models that are less diversified are also more risky.
And what we've discovered is that as interest rates went up, they could no longer fund these special services as they did before with cheap money, and once funding became expensive, suddenly their customers noticed, oh gee, I can get better services or better return someplace else. And guess what rich people do. They really move their money fast when they see higher returns now. Silicon Valley also operated with no chief risk officer for nine months.
They didn't have the kind.
Of corporate governance that held them accountable for making management mistakes similarly, but First Republic also was subject to not enough corporate governance that said, hey, you should divorse by your business model. So the fact that individual banks like that they are not well run, failed is a good thing. What we actually do have, which we haven't talked about enough, is a crisis in.
Supervision, not regulation.
But supervision regulation is for everyone out there is having a lot of bunch of rules and having very stiff rules or less stiff.
Rules applying to various banks.
But a supervisor supposed to come in and actually say, hey, you're not following the rules. And the vice chairman Barre testified, we gave these banks three notices saying you've got to correct what you're doing. That's like saying when I was in grade school, my teacher said, this is going to go on your permanent record if you don't correct yourself.
Well, these guys just said, well, so what now?
From where you come from the Bank of England, the worst fear of every banker is to be invited to tea at the Bank of England.
Back in the day, anyway, I'm not sure not just because the quality of the t we should say.
Well, that could be true.
But here the supervisors allowed these banks to continue, and that was the sin that really cannot be forgiven. And the fact that the FED on internal review said, oh gee, you know, this era of deregulation from Trump has caused our supervisory staff to feel that they really shouldn't be enforcing regulations.
I'm sorry. That is not a reasonable excuse for supervisors pointing out in their jobs.
But there is something that is not specific to those banks that you've talked about, or even the band supervision which we saw in these crises, all these failures of
these banks. There's, as you mentioned, the sort of digital bank run that can happen overnight billions of dollars in twenty four hours going out of senecon valid bank example, which feels like a game changer, but also now a pretty large gap between where short term interest rates are and still where most banks are, you know, off what
are offering in terms of savings rates. Now you look at a back that is one of the main ways they make money by having that gap and hoping that kind of people won't notice, or they talk about the deposits being sticky. You know, it does seem to be relevant to every bank if it's going to be harder to do to make money from that in the future.
Absolutely, And so you have a business model.
Every bank does what the fancy term in business school they call it maturity transformation, right, which means, you know, you're ripping the consumer up, you rip off the depositors, and you give you know, very expensive loans to to your to your clients. What they did instead was, in the case of first of Public, they gave very cheap loans to these very rich people to attract them to
come to their to their bank. And while the amount of deposits they were paying off were also low, the fact that they could fund these very low interest mortgages and very large size mortgages was really at the heart of their business model, aside from the touch aphead, you know, you can call your bank or any time stuff. So when interest rates rose, what's the first thing a banker knows that? You have to match your assets and liabilities.
Maturity matching is something that every risk manager learns from the first day.
Why didn't they do that?
I'm sorry, it wasn't a surprise that the FED started raising rates four or five maybe even six percent interest rates. Not to have that as part of a contingency plan is a failure of bank management.
Fascinating Well, William Lee, thank you very much.
Well Seth, It's been a pleasure to talk to you, and I really feel privileged to be in your presence.
Now.
He's not the only one saying I told you so to First Republic and to the US supervisors who were asleep at the wheel. Crystallina Gorgieva said more or less the same thing when I spoke to her in the opening session of this milk and conference. So, Crystallina, you have the great and good of American finance, well at least the great of American finance arrayed in front of you as head of the IMF. What do you wake up thinking about in the morning that you want them to think about more.
The unthinkable.
What we have lived through in the last years has been series of unthinkable events, the pandemic, the war in Ukraine, the rapid jump of interest rates after many, many, many years of staying Lowell. And it is upon all of us to anticipate shocks and be ready to act when they occur, because they will be coming. So if your risk officers are only thinking about the predictable and well known from history. Risks, they're falling a little short, so give them a little push to think of what.
Is so impossible to think.
We're clearly still seeing continued strength on the consumer side of the economy in the US and indeed other places in response to this massive increase in interest rates, But there are building concerns of a credit crunch, a sort of slow motion credit crunch. Do you think we're underestimating the impact of those rate rises? Where are you looking?
Well?
The first we need to accept that we have handled incredibly significant challenges, actually not so badly. In twenty twenty, we were anticipating depression.
Did not happen.
Yes, the world economy is shrank by three point one percent, but that was far from our worst fears.
So resiliency is for real.
And actually, since it is morning and we need to all wake up, I'm gonna ask you to give a big round of applause to yourself because we have.
Lived through these events.
Shameless pandering to the audience, but of course there is a bud here and the bodies.
They have not been without consequences.
We still have the scarring from the pandemic, the geo political tensions that have been fueled by a Russia's invasion of Ukraine. Are accelerating something that has been already happening, more fragmentation in the world economy that has causing consequences. And as you pointed out to Stephanie, this rapid transition from low interest rates to high interest rates did what should be expected to do. It exposed vulnerabilities in the
financial sector. I want to say that this should not be a surprise because it is just not possible to have that jump in interest rates and to find that everybody has matched the liabilities and assets and looked into the interest rates.
In a responsible manner.
What was a surprise, though, was that it happened in the banking sector, not in the non banking institutions, where we feared that may occur. So what should we be thinking, Well, it hasn't happened in the non banking sector. It doesn't mean that we have a free pass. It doesn't mean that there wouldn't be more vulnerabilities to come.
And here is our reality.
Growth is slowing down, but inflation is not going down as fast as we wanted to go. And unfortunately, with more protectionism, we are trying cold water on what is an anemic growth to begin with. You want me to finish on a positive site.
Sure, well.
The positive site is that we have proven to be incredibly resourceful, and I think it is now time to do that to prove it again resourceful.
But as you pointed out, also kind of a bit stupid in the sense that we were worried about hidden risks and the non banking sector, and yet right there in plain sight was potential interest rate risks in a
digitized world. When you think about the un thinkable, we certainly haven't seen nominal rates at four or five, six percent whatever in a world where money can immediately come out of billions could come out of deposits instantly, and banks have made a lot of money over the years from years of rising interest rates and not passing on those short term interest rate rises. Should that completely change the way we think about financial stability risk?
Well, let's first recognize that since the global financial crisis, a lot has been done to strengthen banking sector, to strengthen our financial system. Banks are better regulated, they're better capitalized, and very important decision makers.
Policy makers are very fast.
This being said, now I'm going to say something that I avoid saying we told you so, the IMF, the IMF rot.
The IMF, always saying we told you so.
Well in this particular case, read the books.
In the In the financial sector assessment we have done for the United States in twenty one and twenty two, we zero in on the problem that blew up the bank here in California.
It's there.
So there is a bit of complacency and now we saw the price to pay. We saw that you provision has not been quite up to par sol. There are things that can be done to reduce these risks. But you put your finger on something that for all of us is novelty and we are all going to be wrestling with it. It is the speed money can move from one place to another and the role of social media.
Again, it goes.
Into the into the territory of the unthinkable. But I am pretty confident we will see quite a lot of new regulatory and disclosure thinking around how we deal with this.
Christina, good yeav Thank you so much. This has been a great start to the week.
Thank you. Thanks, You'll be back much, jem Bag.
Well, that's it for this episode of Stephanomics. We'll be back next week. In the meantime, as ever, you can get a lot more economic insight and news from the Bloomberg Terminal website or app. This episode was produced by Magnus Henrickson with help from Yang Yang and Summer Sadi. The new executive producer of Stephanomics is Molly Smith and the head of Bloomberg Podcasts is Sage Bowman.
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