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A
Hey Fidelity, what's it cost to invest with the Fidelity app?
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B
Start with as little as $1 with no account fees or trade commissions on US stocks and ETFs.
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A
That's music to my ears.
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B
I can only talk
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C
Investing involves risk, including risk of loss. Zero Account fees apply to retail brokerage accounts only. Sell order assessment fee not included. A limited number of ETFs are subject to a transaction based service fee of $100. See full list of Fidelity.com commissions Fidelity Brokerage Services LLC Member NYSE SIPC
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B
thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask Alexa. Play the podcast Odd Lots on Amazon Music
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A
Bloomberg Audio Studios Podcasts Radio News.
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B
Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.
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C
And I'm Joe Weisenthal.
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B
Joe, it is coming up to the one year anniversary of last year's banking drama. I'm still not sure if we can call it a crisis or not. It kind of felt crisis y at
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C
the time, but it went away so fast. You know what the funny thing was, and I probably mentioned it, is there was that cliche or I don't know thing that people say the Fed is gonna keep hiking rates until something breaks.
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B
Oh yeah.
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C
Like here's the break. It happened and then it was like a blip is like nothing. And then the Fed kept hiking and stocks kept going up and everyone forgot about it. So it's kind of weird that something that dramatic could happen and seemingly then just sort of get forgotten about kind of quickly.
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B
Well, one of the most dramatic things that happened out of all of that, I thought, was when they basically just guaranteed everyone's deposits, right? So we know at this point that you are supposed to have up to $250,000 of your deposits at any bank or any bank that's FDIC guaranteed. Basically. Those are safe. If the bank goes under, you get that money back. But then we saw that Silicon Valley bank went under and people had more than $250,000 in their accounts and they got bailed out, which is kind of phenomenal. I don't think we talk about the deposit guarantee aspect of that whole thing enough.
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C
We talked about it at the time and I think this was the, this was the interesting thing. And you're right, this is the sort of the bigger thing that has been slipped under the rug, which is if all deposits in all US Banks are implicitly federally backed, then do we need to rethink the business of banking? If this huge source of Finance, if it's all guaranteed in the end, then it's like, why do we allow these banks to operate as they are? That was a big question. We talked about it in March and April and May and that's still unresolved. But people have really moved on from that question. But it really is fundamental.
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B
Not us. We are still living in spring of 2023. So I'm very pleased to say we do in fact have the perfect guest to discuss this. You might remember we spoke with Stephen Kelly a couple weeks ago about how the way we're bailing out banks or supporting them with various liquidity facilities is changing. In this episode, we are going to be focusing on getting to a point where you don't actually have to bail out you the banks. Let's just avoid this problem altogether. And I'm very pleased to say with us now we have Anat Edmadi. She is of course, an economist and professor at the Stanford Graduate School of Business. She has written prolifically on this topic for at least as long as I can remember at this point, certainly since the 2008 financial crisis. Anant, thank you so much for coming on. All thoughts.
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A
Thank you so much for having me.
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B
You know, we needled so Stephen a little bit when he was on the show by just throwing out liquidity insolvency. Yes. So I'm gonna do the equivalent for you and say, how do banks hold capital?
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A
Oh, my God, that word is a trigger. Because that word leads to so much confusion. So I'm glad you started with that. A senator would say it's money on the sideline. Newspaper articles explain it as cash like asset. And it's not true. What we're talking about, this hold capital is not something that actually the banks hold. It's something that investors hold. In fact, what they do hold is those reserves in the central bank on which they get 5.4%. That's what they hold. That's what's out of the economy set aside. What we're talking about is just like deposits on the funding side. We're talking about equity funding for banks. An amazing idea in banking that you would actually need any of it. And guess what? They live like no corporation lives and no corporation needs to live. But they're there because, you know, I have a lot of research on leverage and leverage addiction. And it's just they are at the point of such heavy indebtedness that they hate coming out.
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C
So when people think banks need to have more capital or hold more capital in their mind, what they Hear is, oh, banks just need to have more cash set aside for an emergency.
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A
That's what they say.
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C
But in the actual people who understand banking, the idea of having more capital means that more of their funding needs to come from equity.
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A
Exactly. So it's all about whether you get your money by promising to pay back or not. And your equity investors. I mean, I come from Silicon Valley, so, you know, who needs to borrow to have a thriving business? Lots of companies don't pay dividends, just grow and grow and grow in market value and, you know, you don't need to borrow as much. And in banking, if you just say, hey, why don't you do something good with your earnings? Such as, you know, make loans instead, they want to take the money out and they will threaten not to make a loan. In the ridiculous campaign they're making right now about this Basel endgame, where in fact, what they're displaying, and I like to talk about it that way, is every single symptom of extraordinary overhang or even insolvency at all times. In other words, these are the classic zombie symptoms that in another sector would lead you to fraudulent conveyance in bankruptcy or something. You know, that you're taking the money out, that you're always taking risk.
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B
Maybe that's a good point to back up a little bit and talk about how you understand the banking business. Because a lot of people will hear a statement like, oh, banks should hold more equity, they should have less leverage. And they would think, well, that's what a bank is. You borrow and then you lend.
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A
It's a leverage business.
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B
Right, It's a leverage business. So, like, what exactly are we talking about if it doesn't look like that?
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A
Okay, so banks are a leveraged business in the sense, if we start from the basics, that deposits put them in a leverage position right away. So by the time you take deposits, if we're talking about deposit taking banks, they already start with debt. Unlike a company like in a corporate finance course, where we stuck with the oil equity firm as kind of a starting point where you're kind of investing your own money or your own shareholders money. So now you are already in an area in which the people managing the bank, to the extent they're not depositors, are immediately conflicted with depositors over how much equity they would have, how much risk they would take because of the fact that depositors ultimately, if the bank defaults or if the bank goes into resolution or whatever, they might get paid or not, but the bank walked away with the upside in any case. So from that point on, the banks hate equity, the banker hates equity. So any leveraged equity holder has a resistance to leverage reduction. That's a pervasive phenomenon. And in fact, if you let them adjust leverage just once, it's not like we go to an optimal capital structure. Always up, always up. So that's the addictiveness of, of boring. Now, what's the business of bank? There is a basic conservation in the world. It's not an irrelevancy, it's not that it's irrelevant, it's just relevant in different ways to society and to the banker. The banker hates equity. From their perspective, any bit of it is too much. From society's perspective, having huge more equity funding is only good and not bad. And in 15 years of asking the question, what? Why are we even here? Why do they have single digit, depending on all their risk weights, we can get into that. Why are we here? They didn't. In the history of banking, and certainly relative to other corporations that are not regulated for leverage, even though we subsidized that in the tax code, you don't see corporations like that. How do they ever get away with that? How they get away with it is the safety nets, all these bailouts, all the time, implicit and explicit. And that's really it. Because the conservation physics of finance that I'm talking about, the physics of money, is there is risk to be born and taxes to be paid, and if you bear less of it, somebody else bears more of it. If you pay less of it, somebody else pays more of it. So the whole thing we're talking about is whether banks are subsidized to be leveraged, not just want to be leveraged, but encouraged to be leveraged by the system of taxes and subsidies. And therefore they're telling us that they should be getting all these subsidies blanket to their funding and then they'll do something good with it.
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C
So sometimes bailouts are explicit, like, such as what we saw in 2008, 2009 with TARP and various programs. Sometimes I guess they're sort of implicit or the idea that, well, we just sort of expect that something like that will come. What else, other than what we call bailouts, you say, through taxes, et cetera, what else encourages the demand for further leverage or the prioritization of debt financing versus equity financing?
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A
It's the compensation of the bankers. It's any this fixation with return on equity, which is only return on equity on the upside, because on the downside, when you have less leverage, you're protected you're less negative. So if your actual realized returns are below your funding costs, where does the
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C
fixation of return on equity come from?
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A
That, you know, I think that it's a proxy for subsidies. I think it basically means that if you compensate somebody based on return on equity metrics, where it's always on the upside, where it juices up returns, then by doing that, by going after the return on equity, they are basically doing what maybe shareholders want to some extent, but certainly works well for the bankers, which is to maximize the subsidy, to maximize the leverage. Because through the leverage you get more subsidies. That's part of that. The bailouts, by the way, is a really complicated system. And you even touched on the flubs on the federal home loan banks. It's basically an interlocking set of institutions that are either providing guarantees or investing lending. So it's either the central banks that would make these excessive loans that we should get into the bank lending programs and at the same time giving for a while higher interest on reserves, which is crazy. As well as the FDIC which has started guaranteeing all deposits with extraordinary dangerous situation and sometimes guaranteeing other debt. After the financial crisis, they let even newly created bank holding companies that were investment banks the previous day, like Goldman Sachs and Morgan Stanley, guarantees on all debt. Now of course they could go and raise money from investors guaranteed by the fdic, which they can do cheaply, no strings attached, and return the top money that treasury gave them with tiny bit of strings attached. So it's basically a system between the Fed, the FDIC and treasury and FHLBs where there are sort of investments made in the. So basically the prevention of default, that's a bailout, a third party comes in, you made a promise and somebody comes in and swoops in and prevents your default.
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B
I want to talk a little bit more specifically about the events of last year because I think they're a good prism to view some of the things you're talking about through. But one of the interesting things is Silicon Valley bank got in trouble, I don't want to say for doing the right thing. But they did go out into the market and say we're raising equity. And as you put it, there's a reason why banks typically don't like to do that.
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A
So this is a great question and it's a great way, in fact, to see what I'm saying. So what happens is they have definitions these days in the regulatory community of what a well capitalized bank is. It just so happened that both in the financial crisis and last spring. And now banks are considered well capitalized by a lot of the banks that failed, including First Republic got great Camel ratings just before they failed. So they can say it's well capitalized now. Why is that? Because the metrics are so bad. And the metrics include not recognizing fair market value on whole to maturity assets. So the bank is pretending to have these assets that they bought at par value even though they're losing value, like Treasuries. In addition, capital ratios depend on risk weights and the risk weights ignore interest rate risk entirely, only credit risk. So a Treasury needs no equity backing. So even if you buy a Treasury and you can do it 100% with deposit money, well, the treasury can lose in value. What happened in Silicon Valley bank was the following. In banking in general, being a zombie, being insolvent is Monday morning, okay? What they're showing is symptoms to a corporate doctor like myself is every day the symptoms of the more they hate equity, with the passion they hate equity, the more I think they have way too little of it. So that's that. Now what happened in Silicon Valley Bank? Two things. First of all, they had to sell some assets. So this whole to maturity might not actually work out for you. And the assets are worth less as you have to pay more on deposits. The assets are worth less because they're long term, have big duration risk and interest rates went down. So when they sold, they had to realize the losses. So all of a sudden accounting rules that usually can allow you to hide the losses are forcing you to recognize the losses. So that was the first state. Then basically how would they survive? They were beginning to be more obviously more visibly insolvent. So the next thing that happens is they try to raise equity, as you said, and they couldn't. Now if you can raise equity, if somebody not at a price you like, but at a price a penny a dime for your equity, then you might still be insolvent because there's only the upside. It's just an option on the upside because you can always walk away as equity. But if you cannot raise equity, then you're really deep in the water. So the not raising equity is like the ultimate nail in the coffin. In other words, you're definitely insolvent. At that point the run was unavoidable because of course maybe by now that they've guaranteed effectively everything, maybe people won't run and maybe we consider that kicking the can down the road as a good financial stability measures. But that is extraordinarily dangerous because in the 80s we allowed all these zombie savings and loans to persist and raise money guaranteed by the taxpayers until you know, we had to pay for it. Hey Fidelity, what's it cost to invest with the Fidelity app?
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B
Start with as little as $1 with no account fees or trade commissions on US stocks and ETFs.
- [15:14]
A
Hmm, that's music to my ears.
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B
I can only talk
- [15:20]
C
Investing involves risk, including risk of loss. Zero Account fees apply to retail brokerage accounts only. Sell order assessment fee not included. A limited number of ETFs are subject to a transaction based service fee of $100. See full list of Fidelity.com commissions Fidelity Brokerage Services LLC member NYSE SIPC
- [15:33]
A
one
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C
of the arguments obviously against higher capital ratios or more equity is like oh, this will lead to an austerity of credit that banks won't be able to do lending. And this is a big part of the push. Again, some of these rules that there's going to be less lending, etc. Why is that wrong in your view?
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A
Well, first of all, they can make any loan. My first measure and my first emergency measure since the financial crisis, and I said this with 20 academics and lots of people, is to retain them earnings and use them for loans. So what's the problem now? So I've been asking for 15 years. Tell me again what would go wrong if they retain their earnings? Just go. Take me through an argument, an economic argument of how the economy would suffer. In other words, is their subsidy so big that God forbid they'll die? If they'll die or they can't survive, I question their business model. If the entire charter value that you like to talk about is subsidies, then we have to question the business model just like you started by saying. So my point is the following. If you tell them not a ratio, actually I am against giving them ratios from where we are right now. You take them by the hand through issuance and retentions because then they won't shrink inefficiently. Because a paper I wrote called Leverage Ratchet actually shows the ways of deleveraging and we show that there is a tendency to leverage through asset sales or stopping to lend or whatever to through shrinkage versus expansion. Well I will expand. These are monstrous banks, which I'm saying to expand only because I believe that once they live in markets, once they're in equity markets, they will break up on their own inefficient weight because as conglomerates broke up in the 80s because we don't need such complicated institutions. I was back in Davos in 2014 with Paul Singer of Everybody. And he says, these are too opaque. I cannot put my analysts on it and understand their risk. They would not exist in market as they are right now. Once you push them more and more into equity markets, it's equity markets that will give them the stress test. That's my stress test. My stress test is raise equity. Let's see, at what price? What will investors say when they have to bear? The downside is where is the upside? If you don't like that price, maybe that's telling us something.
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B
Since you mentioned 2014, I think that was the year when there was a New York Times profile about you. And I cannot remember the exact headline, but it was something I remember. What was it? It was like the woman.
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A
This had a whole story behind it, which I won't tell you all of it, but it was by Benjamin Appelbaum, who used to be a Fed reporter, who I first met when he was a Fed reporter. And I won't go through all the details, but when he ended up writing the profile, it was entit. When she talks, banks shudder. Yeah, and what I say. So I've asked a few times about that with people who noticed the headline, and I say, oh, Jamie Dimon sleeps like a baby. In other words, the headline is cute but false.
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B
But this leads into something I wanted to ask you, and I'm trying to think how to phrase this question without sounding hokey, but, you know, you've been criticizing the banks and the regulators models
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A
and the regulators, especially for the banks do what they get away with.
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B
Yeah. For decades now, basically.
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A
And I guess, and a half. Yeah.
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B
What motivates you to do this?
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A
Oh, good. Such a good question. Because I often wonder that myself. Okay, so what motivated me in the beginning was, you know, I sort of fell in a rabbit hole when I started looking into banking. I'm not just a corporate finance, corporate governance person. And I look at those corporations, which I was teaching my students for 25 years, what a wonderful market we have. And all of a sudden that market, like what just happened. And then I look at them and I say, okay, I understand about corporations. We don't talk specifically about banks because that's in some other silo in economics. But if I look at them as a corporate finance person and I say, what's the same and what's different about them? And all of a sudden what's different about them is all bad. And what's different about them is what they get away with more than anything. You know, the spirit specialness of banks. Is literally what they get away with, then the politics of banking, that's what's special. And then I all of a sudden realized, if nobody understands what the word means, if the regulators are standing by, if the politicians want banks to make some loans or some campaign donations or whatever else, and nobody's exposing the nonsense that we have in this space that pervades this space that maintains and enables this to continue. So I was basically alarmed by people inside the Fed that terrible things are happening in Basel when they were negotiating that agreement. And I was encouraged by people both inside some places in the Fed and in the bank of England at the time, where I had most of my friends, at the time when Marvin King was there to get involved. And I truly didn't know what I was getting into when I agreed to do this. I was joking that I'm working for Andy Haldine, you know, that kind of thing. So he was at the bank of England at the time, and so was Mervyn King, who gave us a blurb for the book while the governor of the bank. So there were big, fierce battles at the time, post financial crisis, about the topic. And I felt, and I mobilized a lot of academics to help me, but it was very difficult work. You were at Financial Times at Tom Tracey, and getting through even the opinion pages against bankers is impossible. And that's the opinion pages now in the politics, like, forget it. So I began to really see the politics, something I was not aware is so important in finance and how it plays in banking. So I stayed in this debate, just basically hating to be worn out more than anything, just not wanting for them, with the resources that they have, with the amount of lobbying and the amount of money that they spend across the political system and the regulation system and global institutions and all of that to kind of give up. Because I felt a sense of duty basically to society, that I actually know something that's useful and it's my job to say. But anyway, I worked on it for five, six years, and then I essentially wrote a few essays that were kind of putting it to bed around 20, 15, 16. And that I'm back here is kind of almost didn't happen. It was a decade since the book was published.
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B
This book, the book, by the way, I should have said in the intro, it's the Banker's New Clothes and you have a new edition coming out.
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A
Exactly. So the book edition just came out in January in the US and the book got fat because we had to revamp a lot of stuff and take a lot of stuff out of the editing floor to explain more about central bank. So there are a few expenses of the material. The book is called the Banker's New what's wrong with banking? What to do about it. The Banker's New Clothes refers to flood claims. So that's the list of which we now have 44. But somebody just pointed me out to an ad that was apparently in football games saying that grocery prices will go up and their mother won't be able to buy a lollipop if you increase capital requirements.
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C
So I take it just an increase in capital requirements is probably in your view necessary but not sufficient to a stable financial.
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A
The most no brainer thing.
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C
But what is an actual. You know, we sort of tease Tracy said in the beginning well could we ever have a world where we don't have to have bailouts? And I'm kind of skeptical that that'll. What would that. What would it take? Or what is the. What is the basics of your prescription?
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A
So. So the basics of our prescriptions and we go through them extensively in the book what to aim for, what to watch for as you do this, you know, is basically to maintain to aim at equity ratios that fluctuate between 20 and 30% of total assets. It's important because the risk weights are really the ones that reduce the assets by like a half or more and are gamed continuously and actually add to fragility because you give zero weight to government bonds, you give zero weight to risk weighted. They're actually anti lending the risk weights themselves. So that's a whole other can of worms. But we're against the risk weights except maybe as a backup right now it's the leverage ratio that is at 3% or maybe 5%. Ridiculous number they are missing a digit is we're not there. We're not close to where we need to be. And if people say the industry will shrink, I say fine. That's maybe a feature, not a bug. In other words, maybe the industry is too bloated and too big.
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C
I mean we talk about it on this show all the time. What if it's not a matter of the industry shrinking but migrating to what people call shadow banks or something like that?
- [23:55]
A
Okay, in the 44 flood claims all of it is there. You'll find the grab bag of them that they use. So what sort of nudges people a little bit is the fact that all along two things are true about the shadow banking system. Number one, institutions in the shadow bankings that are not connected as much to the or not as obviously to the safety net, to those bailout system actually fund with more equity. That was true for REITs and that was true like 30% is common sometimes. And then now one colleague and a few other people have a paper about mortgage lenders which have to disclose some things in some states and they analyze it and they show that lenders for mortgages that are not in the banking sector and are not regulated like banks have twice as much equity as the banks. So what's the problem? Lending with money that's raised, however, in markets. So there's. And then the second point about shadow banking is most of the time, I mean, the ultimate, the first incarnation of a shadow bank is money market fund, right? So what ends up happening with shadow banking is most of it, if you follow the money is connected, funded by, et cetera, the banks in the end. So when you follow the money, you'll find the safety net someplace along the way. So money market funds are just creating another layer of intermediation. And then they can run on the banks, their investors can run on them. And then we couldn't, you know, we opened up the spigot on them in Covid again because their reforms didn't work.
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B
You mentioned the initial round of Basel rules sort of post 2008, and of course you've already touched on this as well. But we do have another effort, the Basel endgame proposal. Now when we talked to Steve Kelly about this, he was like, well, why even bother talking about it? Because like, for sure it's going to change from its current proposed form. But maybe with that caveat, can you talk a little bit about whether you think that's a useful revision of the rules?
- [25:52]
A
Well, I signed two comment letters on Basel endgame and one on the long term debt proposal, which also kind of triggered me a lot. And I signed One letter by 30 academics who are kind of, you know, friends of the Fed, supporting it, saying it's a step in the right direction. And then in my own letter on it, to which I attach a previous version of these 44 flawed claims and other writings and testimonies from the last 15 years, I said, well, you know, I hope it's not endgame because we will come back to it after another financial crisis, if not a big, you know, it has to be very spectacular because obviously the last one didn't, you know, affect it enough. In other words, it's really depressing how they always have these liquidity narratives and other things and focus on bailouts again instead of actually going. And you know, Dodd Frank said no more bailouts. And there's plenty of authority to do anything, certainly to do even a lot more here on both supervision, which completely failed in this case, and on the target numbers and on making them more meaningful, because they're still not meaningful. So why are we talking about it? I would say yes, these are kind of useless. Are they good? It depends how you enforce them. All of these rules end up not, you know, if you look just at the radar that shows you these ratios, you won't even know there was a financial crisis. The banks that needed the most bailout looked good all through the crisis. And that's a study that was also done after the crisis. So the bottom line is we don't like the metrics, we don't like the numbers, the range of numbers. And so I'm coming at it from completely the other side. I'm saying this continues to be poorly designed and inadequate. And in addition to this, I am not a hawk on other regulations. It's just this one is just correcting a huge distortion. It's only on the funding side. It's liquidity regulations that put money on the sidelines. It's liquidity regulations that are costly in good times and useless in Iran. So that's the problem. So a lot of living wills, complicated risk weights, stress tests. I gave you my stress test. Market stress test. So I'm totally into just bringing the funding into markets and especially into equity markets. Start with that, and the rest might look a little bit better.
- [28:25]
B
So one of the things that comes up when talking about the endgame proposal is the idea of, you know, well, poor Michael Barr needs to build consensus. He has to talk to all these different stakeholders about, like, very technical and complicated things. Can you give us a little bit of color on your experience about how new banking rules actually come into being? I'm always curious.
- [28:46]
A
Oh, you know, the sausage making is amazing. So I was actually in D.C. and I met a few of the regulars, including Mike Barr. I think it's on his official calendar, so I can tell you that. And yes, and everybody was feeling very sorry for Michael Barr. I, of course, was feeling frustrated that he, you know, didn't speak more strongly. His first speech was, okay, but afterwards, oh, we'll change it, we'll change it, whatever. So anyway, I mean, I told him this to his face and offered my help to argue against all these flood claims. There's a manual of how to respond to all these. So here's the interesting things. For monetary policy, the Fed board is always unanimous. Like when Kevin Wash objected to qes, he basically had to leave. Honing would object from the regional Reserve bank on monetary, on regulation, they don't have to be. So he needs four out of seven. And you know, some of the support was tentative. Some of the statements that the governors made were full of flawed claims. And I didn't get a chance to meet all of them, but I would welcome that. So I just think there's great confusion and a lot of politics and sort of ways of thinking in banking that are very entrenched. And so I don't know, I think, you know, what this proposal ultimately is doing is not changing the top head numbers, but tweaking risk weights a little bit and by increasing the risk weight a little bit, that's a little bit more equity you have to have against a particular asset out of millions. Never mind that they don't take care of correlations and interest rate risk and other things, but just on the credit risk part. And so the banks are weaponizing this extremely disingenuously to make threats that you and you and you and you won't make a loan. Which of course, once they get the cheap funding, they'll do what they'll do, they'll maximize Roe, whatever. So the politics of it is really, when I was in D.C. a couple of weeks ago, it was oozing from everywhere. The bombardment of lobbying was really shocking. It was never in the popular billboards and ads on your podcast. I mean, I heard the ads on your podcast Stop Basel Endgame. They have explainers on that website that are wrong. Students coming into my course just out of the corporate finance course. It's like you're saying that equity is expensive because it's risky. What's wrong with all these companies that have plenty of equity and they don't choose to borrow even though there's no regulation? What are you talking about? This is absolute bread and butter finance. Leverage and risk. Risk and return required return is completely bread and butter. And so that's when you're even on the right side of the balance sheet and not on the cash reserve thing. It's crazy stuff.
- [31:28]
C
So we could say, okay, banks could be safer in a world in which they're much more equity finance. What about coming from the perspective of creditors to the bank? So there's certain capital that exists in the world that seeks out bank bonds, insurance companies, pensions, things like that may have a lot of demand for bank credit assets. Where does that money go in a different world?
- [31:52]
A
So are you talking now about the people who are customers who Are borrowing from the bank?
- [31:55]
C
No, I'm talking to lenders, to the bank.
- [31:58]
A
Oh, okay, great, great subject. Okay, so here's the thing. Here's what's amazing about banks and here's the real abnormality of the bank. The deposit of which by the way, JPMorgan Chase now has two and a half trillion dollars. Okay, that is money that is a very unusual debt because it has no collateral. This is important to understand. No collateral, but has insurance, which effectively is now almost unbounded. So what happens is that the depositors are almost all the time completely passive. I mean, if they'll panic one day, but they are always just telling them not to panic and just go about their business. So they sit there. Now, once you have this funding, it's a good time, it's a good life because you can use the assets as collateral for the other lenders. And the other lenders come in and they have collateral to their name, short term lending. So they feel they can almost like depositors, take the money out, withdraw it. And they have safe harbor laws that in bankruptcy they can actually walk away with a collateral. So if they, including the federal Home loan banks, including even the Fed, they are safe. So in the ratcheting of leverage and in the sort of race to maturity. So there's another related paper saying that there's a race to shorten maturity and then of course there's collateral races. What you have is the ability to keep shortening maturity and to keep giving collateral and as a way to favor new lenders over old lenders. And the most passive lenders to take advantage of are the depositors and those who back them. So that's what actually happens in the economics of it. Your ability to ratchet up your borrowing and the ability of your lenders to both chase their own returns. And we can talk about returns offered on Cocos and all of that, which in the end, wink, wink, are not actually absorbing losses. And we didn't mention Credit Suisse in last year's events in the spring, which happened a week or nine days after Silicon Valley Bank. And that was a spectacular event in the world of banking, of big systemic institutions, that requires a lot of a whole discussion we may not have time for, but all the talk in the same couple of years that I went to Davos about how we're going to have bail ins instead of bailouts and all these TLAX and long term debt proposals, which completely triggered me over the Martin Luther King weekend when I was preparing these comment letters. Once again, extraordinarily exacerbated that I even have to do this. Totally Groundhog Day. They don't. They don't. As Tom Honing likes to say, why are we solving a problem of too much debt with more debt? If you have equity instead of the long term debt, instead of these title loss absorbing capacity, you would not get to that level. If Silicon Valley bank had 20% equity, it would absorb those losses from interest rate decreases. If Credit Suisse, you know, more meaningful, I'm saying, better measured equity, we wouldn't be here.
- [34:49]
B
I was just remembering the first time I ever wrote about contingent capital. It was on FT Alphaville and even that, you're right. There was this discussion about like whether or not it would actually get used in an emergency. But maybe just to help us understand the argument, you know, it's so hard even for me and I've been covering financials for a long time to imagine being a banking business model where they're not borrowing and lending and highly leveraged. So I want to ask, like is
- [35:18]
A
having 20% equity and 70 or 80% debt allows you to do all the borrowing and lending you need to do. It allows you to take all the deposits, allow you to make all the loans you make.
- [35:28]
B
I take the point. But what I want to ask is like, if you think about your like ideal banking system, what does it look like? Does it exist somewhere in the world already or has it existed in the past?
- [35:41]
A
Has it existed in the past? Definitely before safety Net, first of all, when banks were partnerships, not even limited liability corporations, they had 50% equity and unlimited liability for the Jamie Dimons of the world. In other words, there was their own money and they had to be the ones insuring depositors back in the 19th century. The depositors won't trust them otherwise somebody had to back it up. We go into a world in which we introduce after runs and panics and all of that, we introduced deposit insurance, we introduced central banks before that. So equity, for example, when they started FDIC banks in Kansas, for example, they didn't want FDIC insurance and they had 20% equity. So in the history of banking in the start of the 20th century, banks had 20, 30% equity. So it's not unheard of. The equity markets are more developed. If they have a business model, there are investors who will give to them at the appropriate prices. They just don't like those prices because what they're telling equity investors is to take on risk that's right now on other people, including governments and taxpayers. So the point is, my banking system would look a lot safer and all the deleveraging that would happen would happen much slower. You'd have a lot more time to intervene as you see losses mount up. If you're looking, somebody should look. If it's not going to be the investors, it's going to have to be the regulators. And that's all there's to it. It's not rocket science. So. And on contingent capital, there has never been an argument why at the point of that, you force them to issue those because they also don't like those, because maybe the long term unsecured investors might ask a question or two about the off chance that they would lose. In an interview in 2013, Stumpf, the CEO of Wells Fargo, said, we have a lot of retail deposits and therefore we don't have a lot of debt. And I had a deposit with. So he even forgot, like, you can't make up the nonsense they say. So bottom line is, you know, get the equity, retain the earnings and come back, you know, later.
- [37:36]
B
All right, Ednat Admadi, it was so great to finally speak to you on this podcast and the new edition of the book the Banker's New Clothes is out now. So thank you so much.
- [37:46]
C
Thank you, thank you. That was great. It was a lot of fun. Thank you so
- [37:51]
B
much, Joe. I'm glad we did that conversation because obviously there is still a lot more to say about banks, not just about how we bail them out, but maybe getting to that place, as Anat mentioned, where they don't need to be bailed out on a regular basis.
- [38:14]
C
I thought that was really interesting. I mean, there are a few things that stuck out to me. One is just sort of this idea of examining banks as if they're regular businesses. Starting from the premise that, okay, this is a business and we have all these successful businesses in the world that do not especially, you know, in Silicon Valley that do not have particularly much credit financing, and yet they work. And so the question is like, starting from that standpoint, why are banks so much different and how does that contribute to the risks? I also thought it was interesting, her point that actually shadow banks, or things that we call shadow banks, lenders that aren't necessarily part of the regulated bank system, in fact, do hold more equity, was very intriguing to me. And so the idea that not only did they naturally hold more equity, but also presumably they wouldn't be as systemically important because of the lack of depositors. That's an interesting observation about how banks or financial institutions outside the regulated system
- [39:09]
B
work well and they seem to be doing reasonably well right now. Right. I haven't looked at like a publicly traded BDC share price lately, so, you know, don't me if this is completely untrue, but we talk about the golden age of price private credit all the time and how quickly that industry is expanding. And in many ways they're doing the same thing that banks are, just without, I guess, the regulatory requirements attached to that, but also the funding benefits.
- [39:36]
C
This idea of the obsession with return on equity, it almost sounds like, you know, a conspiracy between bank executives and the shareholders. Right. Which is obviously the shareholders don't want to get diluted by having more equity and the executives want their salary to be tied to how much can they, how much profits can they make on the equity, et cetera, but not necessarily being in the best interest of society and taxpayers.
- [40:01]
B
Depositors who just want their money back.
- [40:03]
C
Yeah, exactly. No, a lot of interesting ideas there. I'm glad we had her on.
- [40:06]
B
All right, shall we leave it there?
- [40:07]
C
Let's leave it there.
- [40:08]
B
This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at tracyalloway.
- [40:14]
C
And I'm Jill Wiesenthal. You can follow me at the Stalwart, follow our guest Anat Admadi, Nat Admadi and check out the new edition of her book the Banker's New Clothes. Follow our producers Kerman Rodriguez at Kerman, Ermine Dashiell Bennett at dashbot and Kale Brooks at Kale Brooks. And for more Odd Lots content, go to bloomberg.com oddlods we have transcripts, a blog and a newsletter and check out the Discord Discord ggod.
- [40:41]
B
And if you enjoy Odd Lots, if you like it when we do deep dives into the business of being a bank, 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. Sam.