Wall Street Week Special: Banking Breakdown

There's a lot that's gone on in the banks in the last two weeks. We heard it from j Powe, the Sheriff FED yesterday, So let's talk about exactly what happened. I want to start with you, Dan. You were a colleague for several years of J. Powell. During the time you were on the Fed, you had responsibility for banks supervision. We've been told the banks were so strong we didn't have to worry about it. Were we misled what happened here?

We didn't think we still had banking problems. Well, I trust that the largest banks truly are in the much better capital and liquidity position that Jay Powell referred or two yesterday during the press conference. We don't, David obviously know yet the whole story, but I think there are some things that we do know. We know first that there was a significant supervisory failure somewhere along the way.

Was that failure in the San Francisco Fed's inability to identify problems of growth and maturity mismatches and the like early on. Was it the failure of the second San Francisco FED team, to which did identify some problems to follow up in a sufficiently robust way. Was it a supervisory failure because of the light touch approach to supervision that the Federal Reserve Board had put in place over

the last four or five years. Or was it a supervisory failure because the supervisors generally had not adjusted their method of assessing liquidity to take account of very high uninsured concentrations coexisting with the capacity of big depositors to run at warp speed rather than the way they used

to run. Those are not mutually exclusive explanations, and I also would not rule out a contributing factor being the twenty eighteen legislation in twenty nineteen FED regulation, both of which deregulated banks of under seven hundred or the regulation banks of under seven hundred billion dollars in assets, the legislation banks of under two hundred and fifty. But I think in the most immediate sense this is clearly a supervisory failure. Other factors may be uncovered as the FED

Zone investigation proceeds. Dan, do we have a sense of how big the breadbox is? If I can put it that way? What is the likelihood disc could spread to other parts of the financial system. We heard a chair Pile yesterday saying that silicon value back was an outlier. Dan, how do we know it's an outlier? I owed, that's a good question, David, And you know your correspond and Bloomberg correspond and Katarina Sareva asked a really good question.

In the press conference yesterday. She looked back at the notes from the January thirty, first February first FOMC meeting and noted that there had been a discussion of the potential financial stability implications of the rapid rise and interest rates which the FED is engineered over the last year, and she pointed to some specific areas of concern which the FOEMC had identified, one being runs on non bank institutions a little bit ironic in retrospect, but also the

position of banks with large portfolios of treasuries that had not been marked to market but had lost value obviously because of the interest rate increases. And she asked the chair for a little bit of an explanation of what that discussion had been, and he was unable to give it to her. For me, it raises the question of whether they were monitoring just those kinds of issues throughout

last year as they were increasing rates. I mean, you would think that interest rate risk would have jumped to the top of the supervisory heap, and that the FOMC would have been getting reports on the impact of the interest rate increases on deposits, deposit flows, holdings of securities, especially those that are not marked to market. So I think as a backward looking matter, it will be interesting

to find that out. As a forward looking matter, has the FED in since a week ago Friday, done the kind of assessment to be able to tell Jay Powell you can go out and say that it's an outlier in the banking system is safe. He didn't indicate that any such assessment had been done. Perhaps it has, Perhaps it hasn't. Maybe Vice Chair bar we'll talk about it next week for Congress, But right now our basis for

evaluating his statement is kind of limited. So Larry, let's put you back at the Treasury, or for that matter, at the White House. If you were looking at this situation, what questions would you be asking to make sure you understood the possible ramifications of what we've seen so far

in a broader financial context. Before I answered, Before I answer that hypothetical, let me put a question to my friend Dan, who I'll just say I think did an enormous amount to strengthen our financial system during his time at the FED. Dan, I've heard it said, and I don't know that. Even in twenty twenty two, the FED stress tests that were applied to the largest banks did not include an analysis of the stress from a major

interst rate height. If that's true, that seems kind of bizarre from the point of view of the world of early twenty twenty two, when it certainly many people, certainly me on David's show, were emphasizing that there was likely to need to be very substantial increases in interest rates. Can you say something and if the stress tests weren't considering increases in interest rates, then perhaps the exempting of Silicon Valley Bank from the stress tests was not central

to understanding the problem. Can you say something about interest

rate hikes and FED stress tests? Sure? So? First off, I think Larry, I agree with the statement you made toward the end of your question, which is, actually, if Silicon Valley had been in last year's stress test for real rather than its stress rehearsal, I don't think it would have made much difference sisily the reason you say that they weren't stressing the things that were the SVB vulnerabilities with respect to stress testing generally, over again, over

the last five or six years, the stress test has become eminently predictable. The scenario that's used is now a single scenario, which is essentially a variant on the very first one we put in some years ago. That is a severe, quite severe recession, but it follows the basic pattern of the scenario that was developed when we began doing the annual stress test. The scenario, of course includes a reduction in interest rates because of the hypothesis of

a recession and the Fed's reaction. When I was at the FED, we were using also an alternative scenario. It's called the adverse rather than severely adverse scenario, and we use that scenario to test things than the prototype of the severe recession. And indeed we used it at least one year, and I think a couple of years, to test what would happen with unusual changes and interest rates which were not then anticipated. So to some degree, the

answer to your question is like supervision. Generally, the stress test has become less rigorous over time, and I think more importantly, it's become too predictable. And the whole purpose of a stress test is that you're trying to stress against the unanticipated, not the anticipated. At the risk of preps being too tough on your former colleagues at the FED, you talk about predictable versus unpredictable. I would argue that at a very minimum, the stress tests ought to consider

what is the major risk of their moment. When you were at the FED DAN in that period, I think it was reasonable to think that the major risk was a tilt towards recession and deflation. But I don't see how anybody last spring could have thought that the major risk was anything other than a spike in interest rates. So a process that didn't consider as a risk seems

to me to be a profoundly problematic process. Even if you were to accept that you were only going to look at one scenario and all of that, it seems almost like the supervisors were mailing it in if they weren't thinking about at a moment when monetary policy was turning in a dramatic way towards tightening, and at a moment where the FED had just retired the word transitory, we're not looking at interest rate. Is there a reasonable

is there a defense? Well, I would say first, this is not by way of defense or certainly not an apologia, but just a bit of explanation. It's quite likely that the scenario development was taking place in the latter part of twenty twenty one if it was going to be the twenty twenty two stress test, And of course this is the period in which the FOMC was still figuring out that the inflation problem was not transitory. But I don't want to use that as a kind of exculpation

of the supervisors. Second thing to say is it's not the supervisors, meaning the staff who are making the policy decisions as to what kind of stress tests to have whether to have multiple scenarios, that's a decision of the Board of Governors, and so it rests with them. But I agree with the graviment of your remarks, which is not to have tried to think about something other than the same scenario is a failure of supervision in and of itself. Stephane, you've worked at the Treasury in the

United States. You also have covered financial markets and other business issues over in Europe for a good long time. One thing we're hearing from both Larry and Dan is rates were going up, and there weren't just going up here, They're going up over in Europe as well. Was what we're seeing aroun now in the banking system. Maybe not the specifics of Silicon Valley Bank, but was something like

that almost inevitable. After we've pumped so much money in the system, we start taking it out, there's going to be stress, real stress, and there's going to be some failure. Yeah, And I wish I was I was closer to you guys, because I knew I was going to struggle to get a word in with you too. But I think in this conversation, I think it is important when we're thinking

about what the implications are. You know, you have to distinguish what is an outlier about not the Silicon Valley Bank, but others that have got into trouble in this episode. What is fundamentally a regulatory stupidity, you know, a very traditional problem the interest rate risk that was just hiding in plain sight, and what is a genuinely new issue which was not being fully taken into account by anyone

looking at the risks. And I think when you look at something like Silicon Valley Bank, you know clearly it was an outlier in the speed with which deposits had been built up, in its massive exposure to uninsured deposits and reliance on that for funding. I hope it was an outlier in not having a chief risk officer for

nine months, which was an extraordinary state of affairs. Was but what was very traditional about this, and as the discussion with Larry and Dan is suggesting, was that you know, right here was a massive interest rate risk that was whether or not it was in the stress test was something that central banks should have been thinking very hard about. And I think it was sort of striking that we had a lot of the debate around this, What are

the hidden risk. You know, all the conversations that you will have had, David, when you ask regulators what's keeping you up at night, they would always talk about private equity. They'd talk about non bank shadow banking. Has been the thing that people were you know, was this worry for all these years, and in fact it was the most obvious problem sitting on bank balance sheets as a direct result of monetary policy actions by central banks that has

actually caused this issue. I would just say, though one of the reasons maybe they weren't looking at that so closely, or that I'd be interested to know what Dan and Larry think about this. You know, there is an element of this which is new, and we see in the speed with which deposits left these institutions, and that's the

non stickiness of those deposits. And I think, you know, one of the things that regulators were thinking when they looked considered interest rate risk potentially was that there was a sort of self hedging mechanism in a bank of the fact that deposits would be slow to move if they weren't being paid the higher interest rates. That is no longer the case, and I think that probably does have longer term implications for regulation and potentially longer term

implications for how much we insure deposits. Yeah, I think that's a question for either Larry or Dan. Does our entire approach to deposits change given what we've seen in the fact is they're not as stick as we thought

they were. That's what I was alluding to earlier. I'd like to have a sense of exactly what the deposit profiles of this group of banks is as a whole, because in theory, at least, the supervisor should already have been distinguishing among different kinds of uninsured deposits, some of which I've always been understood to be eminently runnable, others of which have thought to were thought to be at

least somewhat stickier than insured retail deposits. If it turns out that those and this is what Stephanie I think was suggesting that those middle categories have changed, then you're going to need a change in regular lesion, and not just in supervision. Larry, let me let mean sort of widen the frame a little bit without I agree with what Dan said, but I would put it this way. We know that the FED staff has a problem with

discontinuous change. They basically entirely missed the discontinuous change in inflation because they stuck with their model and its traditions. And I think the broad concern that someone has to put is that for the first time ever, we are now in a world of highly digital banking, with the ability to withdraw funds extremely quickly and with the ability to put them somewhere else extremely quickly and easily because

of digital account opening. So we're in this super digital world, and we're in a super digital world with five percent interest rates, and we've never been in a high interest rate, super digital world before, and large amounts of the economics of the banking industry rest on earning substantial interest premiums on deposits and whatever the traditional models are of what's

sticky and what's not. The fact that we've had the world's fastest run and the world's biggest run at one of at the sixteenth largest bank in the country managed to have the biggest bank run in history has to teach us that there's a lot of reason to be open to a much wider range of possibilities about the

risks associated with deposits. Then we thought previously, and so it seems to me that you asked me earlier what I would be thinking about if I was in the Treasury Department, and I guess I would be feeling my responsibility as the Chair of the Financial Stability Oversight Council very strongly at a moment like this, and I'd be thinking about making sure that whatever I was saying and doing, I was adding to confidence rather than subtracting from confidence

in the very short run, that if you're in an institution and that institution fails, it's gonna be okay for you if that happens right now, because if you're not sending that signal in a reasonably clear way, you'd ever

know where the runs are going to start next. I'd be thinking about this issue that I just raised of the new high interest rate digital world, and I'd be thinking about making sure that there was some broader discussion of the whole official financial community about these questions of stress testing, because I must say, doing stress testing four twenty twenty two, even if it was started in twenty twenty one, without considering unusual increases in interest rates as

a stressor, is really very problematic. So I want to pick about this speed of digital just for a moment. It's been talked about by others as well. Digital's not going away, at least not that I can see. It's not gonna We can't. We can't regulate digital out of existence.

Are there other possible rautary responses that I mean, we have circuit breakers when it comes to the stock market, right, there's too much move too quickly, Stephan, I'll ask you the question, is there a prospect of having something that's an equivalent of a circuit breaker for deposits? I think, I mean, I think there's a whole range of things

we could get into. I think one could also think about, you know, the degree of you know, how we look at liquidity ratios and liquidity buffers might have to change if you know, there is that lack of there's lack

of stickiness. If we think that those deposits could go much faster, you may even get I mean, a number of people have drawn the conclusion, that's quite a leak from here, that this is one of the biggest arguments for having a central bank digital currency, because then you can automatically have a claim on the central bank for your deposits and your your you don't face any of these issues. It's a big leak from where we are now, and it means a fundamental change to to the model

of banking that we've had. But I think you know Larry is right, and that was one of the things I was alluding to that it is it's a threat to the basic business model of model of banking and also to the way we have thought about safety nets in this area and how one provides comm David, I would just add two things. One, I think we need

to be careful about the time scale of things. It may be that it will be appropriate to fundamentally rethink the structure of our financial system, but the worst time to do that would be in a six week period while the fires were burning, And so we need to separate the what are we going to do now tactically from the longer run strategic questions. The other thing I'd say is that I agree with Stephanie about strengthening liquidity.

Dan will be very knowledgeable about exactly how you would do that, But I would dissent massively from the idea of circuit breakers on deposits. If you start saying that when certain things happen, then you're no longer going to be able to get your money out of the bank. What that's going to do is accelerate the run because people are gonna want to make sure that they get their money out before the circuit breaker comes down. So I don't think there's likely to be a circuit breaker

mechanism that works. And I think there's a lot of debate about the merits of the circuit breakers we have in equity markets, So that would not be the direction I would build. So Dan, let me accept Larry's very strong descent from circuit breakers and turn it all the way around the other way, and that's guaranteeing deposits across the board. We had the Secretary of Treasury, Janet Yell And go up to Congress this week and say, you know what, we're not really considering seriously just taking all

the limits off the guarantees. And then she came back the next day and say, I have to demand my remarks a little bit here, because we're going to do what we need to do to back deposits. Are we getting a clear message about exactly the security of deposits its secured by the federal government. Well, I mean, I let people judge for themselves whether the message is clear. Here's what I drew from what both Janet Yellen and Jay Powell have said over the last forty eight hours.

They do not have the authority without congressional action to ensure the deposits and open banks. What I think they have done is effectively to say the following, We do have the authority, along with the FDIC to ensure previously uninsured deposits in failed banks. And so what we are basically telling you is, if a bank fails, we will ensure the uninsured deposits. And I take it that that's what Jay Powell was really saying yesterday when he said all deposits are safe, and when he was asked to

elaborate on that, he just repeated the talking point. And that's when I inferred that this was the message that he was trying to give. And if you think about it, if that is indeed their position. If you think about it, it's essentially the same as ensuring uninsured deposits, because even if you said x anti, all these big deposits are insured, no one will actually drawn that insurance until the bank

had failed. So in that sense, it may be the equivalent of the ensuring of all deposits in the system, except for the fact, of course that it's presumably a policy that will not last forever, and when are they going to kind of back off of it? Is obviously

a pretty important point. The second thing one might say, and I can already I can feel Larry maybe having this reaction, is if that's what you mean, why don't you say it more clearly so that you will maximize the calming effect of whatever tool it is that you're prepared to use. And I don't know why they didn't say it more explicitly, except perhaps that they didn't want to intimate that somehow they were using the authority they do have to achieve an end that supposedly they can't

achieve without congressional approval. Dan, I think there's one other I think there's one other point, certainly, and you may

have parsed the statements more closely than I did. But some of the statements, particularly I think from the Treasury side, have talked about contagion as well, So I'm not sure the authorities have been quite as clear as you suggest in saying that if you've got money in a bank and that bank fails and it's not a source of contagion, you will nonetheless have your deposit ensured, and as I understand it, in order to payoff uninsured deposits, there need

to be some set of claims made by the government about the systemic seriousness of the moment. So I think that is also a place where there's some play. But I think I would share what I think as your instinct to be erring on the side of projecting confidence as ones choosing the way in which one talks about this. I mean the contagion of reference. Contagion sends the message that is exactly what a lot of depositors are quite reasonably doing, which is why, okay, I need to get

into a bigger bank. So just to spell out why that matters. If you make it all part of a contagion argument, you're not giving that confidence to people who are in the relatively smaller banks, although it still pretty big banks by European standards. Well, I think I think if I were at the FED now and we were trying to formulate a rationale for what I suggested a moment ago was the likely policy, even though it's not stated explicitly, I think I would probably say something like

the following. Look six weeks ago, if there had been a failure of a two billion dollar bank somewhere, ensuring uninsured depositors would be a very hard case to make on systemic risk grounds. But at this juncture, even if a two billion dollar bank fails and an uninsured depositor is not made whole, in the current circumstances, the anxiety, the nervousness, the uncertainty that itself will add fuel to the potential systemic fire. And thus in these circumstances one

could take the action there as well. You do, as a statutory matter, need to make the systemic risk argument, though that is the authority that they have, and I think Janet Yellen did make reference to small banks yesterday as well. Dan, I want to pick up on your comment if you were still to Fed. We had a decision from the Fed this week to raise another twenty five basis points. Some people had been urging that actually

they just hold given the difficulis with banking. At the same time, he Jaypole admitted that there's more uncertainty about the extent of which what's already happened with financial conditions may have essentially imposed a further rate hike already. Did they get it right? Dan? From your point of view, did Jay Pal get it right? Well? I mean it's very obviously, our ly the most difficult decisions since he's been there, although I actually think market expectations helped him.

They had sort of converged around twenty five basis points, and so then it became a communication issue. I mean, what I was struck by David In on the monetary policy side of what he said yesterday was that he said, quite explicitly, it's too soon to tell how monetary policy should respond to the anticipated credit tightening. But I actually think their actions yesterday were a fairly significant response. I mean, everybody, three or four weeks ago, people were anticipating a fifty

basis point increase, We got twenty five. Three or four weeks ago, we thought we might see the SEP suggest a ceiling of five seventy five or six percent interest, And now we're back to exactly where they were in December at last December when they did the last SEP, and of course they changed the language on the forward guidance type language. Instead of ongoing increases, we're back to may have some firming, and of course some people were reading that as the end or close to the end

of the tightening cycle. So I actually thought that they were conveying more of an assessment of the impact than Chair Powa suggested in his remarks yesterday. So, Laurie, what about you. In the past you suggested perhaps they might have to have a term of rate as high as six percent. Do you agree with Dan that what we saw from j. Powe in the Federal Reserve this week was a monetary policy reaction to what we've seen already, and if so, was it appropriate? I think what they

did was broadly appropriate. It was a time for temporizing, because there's a lot of uncertainty and a lot of cards are going to be turned over in the next several months. And the question then was just temporizing mean stopping all rate increases. And I think if they had done that, it would have sent actually a signal that they were very highly alarmed and would have been a mistake whether to continue precisely on the path that they

were on before these banking concerns arose. I think that would have seemed almost oblivious to what was a potentially gathering storm and so I think, as Dan suggests, that a middle ground path was right, and it was particularly right if the policy is going to be signaling in a clear way that even if your bank fails, you're going to be a depositor as well, And so nobody in America needs to have the kind of sweaty Palm's weekend that a large number of people had worrying about

whether they were going to meet their payroll because of Silicon Valley Bank. And I think in the context of providing those kinds of assurances that the monetary policy path they set was appropriate and appropriate doesn't mean that it will turn out to be right. Appropriate means that the errors are kind of two sided. That there's a chance that they'll need to tighten more than they're currently projecting, and there's also a chance that not all the tightening

they're currently projecting will be necessary. I think if authorities are sufficiently aggressive about adding confidence to the system, my guest best guess is that the Fed's judgment in the SEP will turn out to be considerably more accurate than the markets assessment that the FED is going to be

pushed into rate cuts very soon. But that's a a judgment that one can't have any great amount of confidence in But yes, I think what they did was broadly appropriate, particularly if we can be sending reasonably strong signals of confidence in the system. So that is going to conclude our Bloomberg Wall Street Week Brown Table, the first we've ever had. Actually, I want to thank our panelists. She's

Stephanie Flanders. She's the senior executive editor for Economics and Government for Bloomberg, dance roller, former Fed governor, and also, of course our special contrior on Wall Street Week. He's Larry Summers of Harvard. That's it for this edition of Wall Street Week. I'm David Weston. This is Bloomberg