This post covers a new article, “Ending Bailouts, at Last,” with Amit Seru in the Journal of Law Economics and Policy, and the associated WSJ oped “Preventing Bailouts is Simple, but it Isn’t Easy.” As usual, I’ll post the full oped in 30 days.
The regulators not only “missed” the interest rate risk, they encouraged the banks to take it - first by applying lower risk-based capital charges on government and agency bonds and second by the Fed engaging in ZIRP and QE, effectively requiring the banks to extend maturities to pick up any spread while Fed forecasts reassured the banks that rates were going to stay low forever.
A huge failing by equity analysts as well- Silicon Valley was getting rewarded by the street for rapid deposit growth even though their business model was to put those deposits into long-dated agency MBS to earn 150 or 200 bp. How could the stock market apply a generous multiple to that sort of risky and plain vanilla strategy (oldest game in the book- borrow short to lend long)
As to the “solution” of banks financed with long-term debt or equity (or along the more conservative lines put forward by Mervyn King and others after the GFC)- I believe it will definitely reduce access to credit and make it more expensive.
There is investor demand for “ready cash” instruments meant to be liquid and safe but earning some return - bank deposits, money market funds, t-bills, and it is pretty clear that these funds leak into the market for credit risk via banks lending out deposits to businesses (or even buying long-dated government bonds and mortgages - bank demand allows for lower borrowing rates and tighter spreads and incents non-bank investors to look elsewhere for better spreads).
If banks can’t take deposits without holding 100 percent t-bills they will be making fewer loans and buying fewer long term agency MBS and other securities.
There is also a pool of investors who want to take credit risk to boost returns - bond funds, closed end funds, insurers, pensions, HNW, private equity, hedge funds. These are buyers of bank corporate debt now.
A bank today is essentially a CLO containing a pool of credit risk- it has the “AAA” slice of funding for the pool which are the insured deposits (a much bigger slice of the capitalization than they deserve to be, given the bank’s credit portfolio), lower rates slices which are the banks corporate bond issues, sub debt, preferred stock, and then the equity piece (bank equity).
If we remove deposits from the equation (or greatly reduce them), then the banks balance sheet of credit risks must shrink. Or they will have to pay higher rates to attract credit risk investors in their bonds and equity.
I’d love to see a banking system which is a closed-end fund. Investors fund the portfolio but can’t pull those loans- they can only sell their pro-rata share of the portfolio in the market. Then you’d have the banks competing with bond fund managers, private equity and hedge funds to see who creates better portfolios of credit risk.
Frankly, I don’t think the banks really have any special expertise in credit evaluation relative to fund managers. They have scale, and they should be good at trading credit exposure for other fee business/revenues- eg cash management, hedging products, arranger fees. primary issuance of stocks and bonds. Making loans is a stupid business model for banks without those ancillary fee revenues. Rather than having tens of thousands of employees and hundreds of branches they could simply have a couple of portfolio managers sitting in a cubicle somewhere selling CDS or buying loans - no overhead. Essentially what a bond or private equity fund has. Under the low leverage, high equity, narrow deposit model, banks would likely cease to exist as we understand them.
While that may not be a bad thing for economists or investors, it is likely to be very bad for politicians. Politicians also love easy credit, and if bank balance sheets contract, they will seek to subsidize other borrowers (not just mortgages and student loans) to address “unmet needs”.
The banking system is like a tube of toothpaste - if you squeeze one end really hard there is likely to be a big mess on the other end. Could it be fintech companies or non-bank entities taking stupid risks? Or (as is common in China and emerging markets) will large companies get into the credit game? Speculating in credit assets at the wider spreads but then “arbitraging” by funding it via issuance of short term commercial paper to allegedly “safe” ready money assets like mutual funds? We saw something like this in the GFC where SIVs issued “high rated” commercial paper against illiquid and risky credit portfolio.
Anyway, I love the idea of banks structured as closed end funds, or as high equity vehicles funded with long-term debt, but I don’t think politicians and borrowers will like what happens and their interventions might be more dangerous than today’s banking system.
Freddie is going to back second mortgages, so house owners can tap their equity in a lower than consumer loan rates. Would like to hear your thoughts on this.
They also made a lot of promises about reforming or winding down Fannie and Freddy. Now the vast majority of US mortgages are guaranteed by the federal government.
Yep, the reforming talk has been there for over a decade but that never happened (well, I wouldn’t expect it to happen while Obama was around). The winding down part was during Trump’s admin. But soon Biden admin took over FHFA and surely they want larger government. My concern is, now they entice the majority of Americans to be the slaves of debts: mortgages, credit cards, student loans, and the government tries to come behind all these debts. Now even Yellen said non-bank mortgage servicers could be too big to fail. Going forward, government is everywhere and people in this country will no longer have privacy and individuality, but just become parasites of the system and will have to live on the government. Soon these home owners who can tap their equity out will drive home prices even higher, because local governments tend to restrict housing supplies through permit restriction and zoning. It’s even harder for those who can’t own a home to own a home and they will have to rent forever. This is really the rich gets richer and the poor stays poor. I don’t know how to break this cycle unless a hard landing occurs to crash these overpriced assets
I agree with the diagnosis but question the remedy. Show me a system with risky assets financed by equity and long term debt, and I'll show you an opportunity to repackage that equity and debt into "safe" short-term claims (CDOs, CLOs, whatever). Don't expect the regulators to win the game of whack-a-mole against the financial engineers. So here's a better idea: (1) Commit to saving only the fourth and later failed institutions in a systematic run. That will make everyone more careful. (2) If your institution needs a bailout, al board members and senior management resign immediately and forfeit any deferred compensation.
I've been studying the money market layers of the repo hierarchy. Here we have securitized short term short term or overnight loans providing trillions of liquidity. Even the Fed uses the tri-party market for omo. Not all layers of the repo hierarchy are centrally cleared but the intent is to be so. About fell out of my chair first learning how primary dealers intermediate Treasury debt. Would be interested in your thoughts. Abt non centrally cleared bilateral repo, I asked David Gibbs, education director at CME, could this be a problem. After an hour convo, I commented wow the life of a primary dealer. David responded, oh it's loads of fun, until it isn't
On page 180 of your article "Ending bailouts, at last", published in the Journal of Law, Economics and Policy, vol. 19:2 2024, you state: "Banks did not routinely hedge interest rate risk and were allowed by regulators to value longterm bonds at fictitious prices, in large part based on this experience."
Per the Financial Accounting Standards Board, "FASB", securities designated as "held-to-maturity" are not hedgeable for interest rate risk. A company that does hedge its "held-to-maturity" securities against interest rate risk must re-categorize those securities as "mark-to-market" and recognize the capital loss in its income statement in the period. A company that changes the designation of "held-to-maturity" securities to "available-for-sale" securities must re-categorize all of its "held-to-maturity" securities as "available-for-sale" securities and report any un-recognized capital loss on the event in "comprehensive income" in its financial statements for the period. These are the rules set by FASB, not the Federal Reserve System Board or its regulatory staff. [n.b., "held-to-maturity" securites and "available-for-sale" securities are recorded at cost in the books of the corporation and in its financial statements; but, banks, e.g., SVB, regularly report the fair-value of those securities in their financial statements. You would have been aware of that had you read SVB's and other bank corporation's period financial statements along with the corporation's MD&A filings with the S.E.C.]
With respect to SVB, its failure is directly attributable to the bank's management and the parent firm's board of directors. Attempting to pin the failure on FRB supervisory staff may serve your narrative's purpose, but it is intellectually dishonest to put the responsibility for that bank's failure entirely or even largely on the shoulders of the FRB. It was management's decisions that led to SVB's bankruptcy--decisions that were taken during 2021-2022 and decisions that were not taken in 2022-2023.
The article is written around normative statements. That's fine, in retrospect, and we seem to have come to expect academics to pose their remedies as "do thus and thus" nowadays. But, how do your models do in the world beyond the gates of academia? As the old adage goes, "cure thyself first, doctor."
Yes, good point that they're not allowed to hedge risk of "hold to maturity" securities. Another gaping hole in the regulatory architecture. And there is no explicit rule linking interest rate risk in "hold to maturity" assets + large uninsured deposits. It just needed someone to add 2+2 and get 4. Yes, failure is due to management. And also due to depositors who put hundreds of millions in uninsured checking accounts. That's our point. When you know bailouts are coming, you are a fool not to take risks.
John, the presumption on the part of FASB is that when corporate management elects to designate certain securities as "held-to-maturity" it is because the corporation has the ability to hold those securities until the securities mature. It is not part of the regulatory architecture, per se. The accounting treatment is at the discretion of management. If management determines that the securities cannot be held to maturity then FASB requires that the securities be reclassed as "available-for-sale", or "mark to market". The penalty on management is the loss on capital is recognized immediately for all "held-to-maturity" securities -- not just one or two securities, but all of those securities so classed.
I read carefully the history of SVB and noted that on the day before the bank was seized by the FDIC (March 8th) there was no expectation of a bailout. On the 8th, the FDIC stated that uninsured deposits would not be made whole. On the 9th and the 10th (Saturday and Sunday), the uninsured depositors were scrambling to recover whatever they could, which was nothing at all as all of the bank's assets were frozen. It was not until the Monday or Tuesday following that weekend that the FDIC and the FRB announced their intention to make available lines of credit for all depositors. Proof: If the depositors were convinced on Thursday, the 7th, that they would be made whole by the FDIC/FRB on Monday the 11th, there would have been no incentive to run on the bank on Friday the 8th. Management put themselves into a bind in the lead up to March the 8th, but particularly on March the 7th when SVB's parent pulled the plug on the equity infusion they were negotiating on the 7th because the directors were concerned that they would be required to offer the same terms to existing shareholders that they were offering/agreeing to the new shareholders who expected to make an equity infusion on the 7th. Management left it too late, and then failed to complete in the 11th hour.
SVB's customer base was venture-capital funded startups and venture-capital funds that had raised cash to pay for their startup costs. The startup management teams were thin on experienced prudential financial managers and were focused on executing their business plans. They weren't thinking along the lines that you describe. Lack of perfect foresight on their part. Sometimes, hindsight is blind. Too often, everyone is a Monday morning quarterback. Rational expectations is a theoretical construct, an ideal, a method to render tractable problems in mathematical economics -- it doesn't exist in the world. (Aside: To err is human; to forgive, divine.) Your essay is a good teaching ground. It needs to be more 'graduate business school case study' than a prescriptive policy solution. During 2020 we were subjected to extreme negative government externalties imposed because Covid-19 was an unknown. The fiscal stimulus was extreme and erred on the extreme because the experience in 2008-10 was that government was too parsimonious in responding to the financial crisis and its knock-on impacts. The FOMC went to extremes and then compounded the situation by signalling a lack of commitment to inflation control (cf., the FRB's August 2020 policy change statement). Your essay brings these events into focus, and it is useful to review the circumstances and the decisions and the outcomes. We learn lessons in that way. Maybe one day we'll remember the lessons and take a different path forward, possibly a better path, maybe.
To simplify (I like simplifying things): human regulators never will be able to foresee every kind of risk, even severe risk. So restructure into a system that reduces the individual and systemic risk materially, and then let the remainders fail.
I like your approach of much higher reserves, not 5-10%, but rather 50-100%.
Questions:
1. Why would banks pay interest on deposits? If I’m a bank, and can lend out 90% of your deposit at 6%, I’m ok paying you 4%. If I can lend out none of it, why do I pay interest? Or are you suggesting that interest-bearing liquid deposits are an artifact of low fractional reserves, and shouldn’t exist? Illiquid deposits (eg CDs) that are locked can be lent out with very little risk, as long as the duration matches. But general deposits?
2. Where will banks get funds to lend? If I’m a bank and can lend out 90% of my deposits, then I’ve got funds for lending. If I can lend out none, I’ve got nothing to lend for mortgages or business loans. Longer term deposits (CDs) will provide some, equity some (I worked with a small financial firm that did exactly this 20 years ago), but that is tiny in scale compared to today’s bank lending.
Or maybe you’re putting both of those together? Deposits are zero interest bearing, a safe place to put your money and transact. Locked in deposits are interest bearing and they, along with equity funding, are sources for bank lending, as long as durations match? Bank runs become structurally nearly impossible?
Deposits flow to reserves which pay interest. So interest on deposits = interest on reserves - costs to service deposits. (In a competitive industry!) Funds to lend come from equity (retained earnings, share issues) and long-term debt. The two activities need to be separate companies, or at least isolated in bankruptcy.
Interesting. So if today, 10% of deposits pay whatever the fed is paying on reserves, and 90% pay whatever (higher) rate the banks can get by lending retail or commercial, in this system, all of it pays banks the fed rate? And banks clear some profit and pay the rest to depositors? Ok I can see that.
On the lending side, it sounds like you are saying that, since deposits just pay fed reserves rate (minus costs, profit margin, etc), then nothing is left to lend. Hence a lending company can either issue equity or bonds, and use those funds to lend. Which means it is not connected to deposits at all, which means it doesn’t need to be a bank at all.
Did you finally just solve the 1980s S&L, by detaching saving from lending?
I think it would mean a lot less lending though? Banks constantly get deposits that they lend out. Issuing debt and equity is a much less frequent process. Once they are lent out, it can do nothing until payments are made.
Do you see new kinds of “debt ETF”, where people can explicitly invest in lending, but not as equity?
I presume that you would see a tranche of preferred equity with a pay rate similar to what you would currently see in a similar deposit, but if not repaid at a certain point you would have some remedy other the suing the bank for payment, e.g. accrual at a default rate, rights to take over control of the bank (in combination with preferred shareholders in your class). Or you might see something completely different, but I think the key is that the bank doesn't become insolvent because this is not debt.
My question is does this just eventually move the bailout risk from banks to this new class of preferred equity holders? I suspect the answer is "maybe someday" (after all the desire to do bailouts is strong, e.g. GM) but at least we get some time free of bailouts in the interim.
> the bank doesn't become insolvent because this is not debt
I think the bank doesn't become insolvent, because the (deposit) bank has access to all deposits; they are reserves. Runs on the bank literally do not matter, except for time to retrieve, which may get a bit slow.
> banks to this new class of preferred equity holders?
Probably, but there is a _lot_ less political pressure to bail out the equity holders of a lender who issued too much bad debt, than to bail out the creditors of a large bank, i.e. every person who made a deposit.
one other question. If 10% of deposits as reserves currently pay x% interest, and now we go to 100% of deposits as reserves, did the Fed just need to pay 10x the amount of interest?
Excellent piece, thanks
The regulators not only “missed” the interest rate risk, they encouraged the banks to take it - first by applying lower risk-based capital charges on government and agency bonds and second by the Fed engaging in ZIRP and QE, effectively requiring the banks to extend maturities to pick up any spread while Fed forecasts reassured the banks that rates were going to stay low forever.
A huge failing by equity analysts as well- Silicon Valley was getting rewarded by the street for rapid deposit growth even though their business model was to put those deposits into long-dated agency MBS to earn 150 or 200 bp. How could the stock market apply a generous multiple to that sort of risky and plain vanilla strategy (oldest game in the book- borrow short to lend long)
As to the “solution” of banks financed with long-term debt or equity (or along the more conservative lines put forward by Mervyn King and others after the GFC)- I believe it will definitely reduce access to credit and make it more expensive.
There is investor demand for “ready cash” instruments meant to be liquid and safe but earning some return - bank deposits, money market funds, t-bills, and it is pretty clear that these funds leak into the market for credit risk via banks lending out deposits to businesses (or even buying long-dated government bonds and mortgages - bank demand allows for lower borrowing rates and tighter spreads and incents non-bank investors to look elsewhere for better spreads).
If banks can’t take deposits without holding 100 percent t-bills they will be making fewer loans and buying fewer long term agency MBS and other securities.
There is also a pool of investors who want to take credit risk to boost returns - bond funds, closed end funds, insurers, pensions, HNW, private equity, hedge funds. These are buyers of bank corporate debt now.
A bank today is essentially a CLO containing a pool of credit risk- it has the “AAA” slice of funding for the pool which are the insured deposits (a much bigger slice of the capitalization than they deserve to be, given the bank’s credit portfolio), lower rates slices which are the banks corporate bond issues, sub debt, preferred stock, and then the equity piece (bank equity).
If we remove deposits from the equation (or greatly reduce them), then the banks balance sheet of credit risks must shrink. Or they will have to pay higher rates to attract credit risk investors in their bonds and equity.
I’d love to see a banking system which is a closed-end fund. Investors fund the portfolio but can’t pull those loans- they can only sell their pro-rata share of the portfolio in the market. Then you’d have the banks competing with bond fund managers, private equity and hedge funds to see who creates better portfolios of credit risk.
Frankly, I don’t think the banks really have any special expertise in credit evaluation relative to fund managers. They have scale, and they should be good at trading credit exposure for other fee business/revenues- eg cash management, hedging products, arranger fees. primary issuance of stocks and bonds. Making loans is a stupid business model for banks without those ancillary fee revenues. Rather than having tens of thousands of employees and hundreds of branches they could simply have a couple of portfolio managers sitting in a cubicle somewhere selling CDS or buying loans - no overhead. Essentially what a bond or private equity fund has. Under the low leverage, high equity, narrow deposit model, banks would likely cease to exist as we understand them.
While that may not be a bad thing for economists or investors, it is likely to be very bad for politicians. Politicians also love easy credit, and if bank balance sheets contract, they will seek to subsidize other borrowers (not just mortgages and student loans) to address “unmet needs”.
The banking system is like a tube of toothpaste - if you squeeze one end really hard there is likely to be a big mess on the other end. Could it be fintech companies or non-bank entities taking stupid risks? Or (as is common in China and emerging markets) will large companies get into the credit game? Speculating in credit assets at the wider spreads but then “arbitraging” by funding it via issuance of short term commercial paper to allegedly “safe” ready money assets like mutual funds? We saw something like this in the GFC where SIVs issued “high rated” commercial paper against illiquid and risky credit portfolio.
Anyway, I love the idea of banks structured as closed end funds, or as high equity vehicles funded with long-term debt, but I don’t think politicians and borrowers will like what happens and their interventions might be more dangerous than today’s banking system.
Freddie is going to back second mortgages, so house owners can tap their equity in a lower than consumer loan rates. Would like to hear your thoughts on this.
They also made a lot of promises about reforming or winding down Fannie and Freddy. Now the vast majority of US mortgages are guaranteed by the federal government.
Yep, the reforming talk has been there for over a decade but that never happened (well, I wouldn’t expect it to happen while Obama was around). The winding down part was during Trump’s admin. But soon Biden admin took over FHFA and surely they want larger government. My concern is, now they entice the majority of Americans to be the slaves of debts: mortgages, credit cards, student loans, and the government tries to come behind all these debts. Now even Yellen said non-bank mortgage servicers could be too big to fail. Going forward, government is everywhere and people in this country will no longer have privacy and individuality, but just become parasites of the system and will have to live on the government. Soon these home owners who can tap their equity out will drive home prices even higher, because local governments tend to restrict housing supplies through permit restriction and zoning. It’s even harder for those who can’t own a home to own a home and they will have to rent forever. This is really the rich gets richer and the poor stays poor. I don’t know how to break this cycle unless a hard landing occurs to crash these overpriced assets
I agree with the diagnosis but question the remedy. Show me a system with risky assets financed by equity and long term debt, and I'll show you an opportunity to repackage that equity and debt into "safe" short-term claims (CDOs, CLOs, whatever). Don't expect the regulators to win the game of whack-a-mole against the financial engineers. So here's a better idea: (1) Commit to saving only the fourth and later failed institutions in a systematic run. That will make everyone more careful. (2) If your institution needs a bailout, al board members and senior management resign immediately and forfeit any deferred compensation.
I've been studying the money market layers of the repo hierarchy. Here we have securitized short term short term or overnight loans providing trillions of liquidity. Even the Fed uses the tri-party market for omo. Not all layers of the repo hierarchy are centrally cleared but the intent is to be so. About fell out of my chair first learning how primary dealers intermediate Treasury debt. Would be interested in your thoughts. Abt non centrally cleared bilateral repo, I asked David Gibbs, education director at CME, could this be a problem. After an hour convo, I commented wow the life of a primary dealer. David responded, oh it's loads of fun, until it isn't
On page 180 of your article "Ending bailouts, at last", published in the Journal of Law, Economics and Policy, vol. 19:2 2024, you state: "Banks did not routinely hedge interest rate risk and were allowed by regulators to value longterm bonds at fictitious prices, in large part based on this experience."
Per the Financial Accounting Standards Board, "FASB", securities designated as "held-to-maturity" are not hedgeable for interest rate risk. A company that does hedge its "held-to-maturity" securities against interest rate risk must re-categorize those securities as "mark-to-market" and recognize the capital loss in its income statement in the period. A company that changes the designation of "held-to-maturity" securities to "available-for-sale" securities must re-categorize all of its "held-to-maturity" securities as "available-for-sale" securities and report any un-recognized capital loss on the event in "comprehensive income" in its financial statements for the period. These are the rules set by FASB, not the Federal Reserve System Board or its regulatory staff. [n.b., "held-to-maturity" securites and "available-for-sale" securities are recorded at cost in the books of the corporation and in its financial statements; but, banks, e.g., SVB, regularly report the fair-value of those securities in their financial statements. You would have been aware of that had you read SVB's and other bank corporation's period financial statements along with the corporation's MD&A filings with the S.E.C.]
With respect to SVB, its failure is directly attributable to the bank's management and the parent firm's board of directors. Attempting to pin the failure on FRB supervisory staff may serve your narrative's purpose, but it is intellectually dishonest to put the responsibility for that bank's failure entirely or even largely on the shoulders of the FRB. It was management's decisions that led to SVB's bankruptcy--decisions that were taken during 2021-2022 and decisions that were not taken in 2022-2023.
The article is written around normative statements. That's fine, in retrospect, and we seem to have come to expect academics to pose their remedies as "do thus and thus" nowadays. But, how do your models do in the world beyond the gates of academia? As the old adage goes, "cure thyself first, doctor."
Yes, good point that they're not allowed to hedge risk of "hold to maturity" securities. Another gaping hole in the regulatory architecture. And there is no explicit rule linking interest rate risk in "hold to maturity" assets + large uninsured deposits. It just needed someone to add 2+2 and get 4. Yes, failure is due to management. And also due to depositors who put hundreds of millions in uninsured checking accounts. That's our point. When you know bailouts are coming, you are a fool not to take risks.
John, the presumption on the part of FASB is that when corporate management elects to designate certain securities as "held-to-maturity" it is because the corporation has the ability to hold those securities until the securities mature. It is not part of the regulatory architecture, per se. The accounting treatment is at the discretion of management. If management determines that the securities cannot be held to maturity then FASB requires that the securities be reclassed as "available-for-sale", or "mark to market". The penalty on management is the loss on capital is recognized immediately for all "held-to-maturity" securities -- not just one or two securities, but all of those securities so classed.
I read carefully the history of SVB and noted that on the day before the bank was seized by the FDIC (March 8th) there was no expectation of a bailout. On the 8th, the FDIC stated that uninsured deposits would not be made whole. On the 9th and the 10th (Saturday and Sunday), the uninsured depositors were scrambling to recover whatever they could, which was nothing at all as all of the bank's assets were frozen. It was not until the Monday or Tuesday following that weekend that the FDIC and the FRB announced their intention to make available lines of credit for all depositors. Proof: If the depositors were convinced on Thursday, the 7th, that they would be made whole by the FDIC/FRB on Monday the 11th, there would have been no incentive to run on the bank on Friday the 8th. Management put themselves into a bind in the lead up to March the 8th, but particularly on March the 7th when SVB's parent pulled the plug on the equity infusion they were negotiating on the 7th because the directors were concerned that they would be required to offer the same terms to existing shareholders that they were offering/agreeing to the new shareholders who expected to make an equity infusion on the 7th. Management left it too late, and then failed to complete in the 11th hour.
SVB's customer base was venture-capital funded startups and venture-capital funds that had raised cash to pay for their startup costs. The startup management teams were thin on experienced prudential financial managers and were focused on executing their business plans. They weren't thinking along the lines that you describe. Lack of perfect foresight on their part. Sometimes, hindsight is blind. Too often, everyone is a Monday morning quarterback. Rational expectations is a theoretical construct, an ideal, a method to render tractable problems in mathematical economics -- it doesn't exist in the world. (Aside: To err is human; to forgive, divine.) Your essay is a good teaching ground. It needs to be more 'graduate business school case study' than a prescriptive policy solution. During 2020 we were subjected to extreme negative government externalties imposed because Covid-19 was an unknown. The fiscal stimulus was extreme and erred on the extreme because the experience in 2008-10 was that government was too parsimonious in responding to the financial crisis and its knock-on impacts. The FOMC went to extremes and then compounded the situation by signalling a lack of commitment to inflation control (cf., the FRB's August 2020 policy change statement). Your essay brings these events into focus, and it is useful to review the circumstances and the decisions and the outcomes. We learn lessons in that way. Maybe one day we'll remember the lessons and take a different path forward, possibly a better path, maybe.
To simplify (I like simplifying things): human regulators never will be able to foresee every kind of risk, even severe risk. So restructure into a system that reduces the individual and systemic risk materially, and then let the remainders fail.
I like your approach of much higher reserves, not 5-10%, but rather 50-100%.
Questions:
1. Why would banks pay interest on deposits? If I’m a bank, and can lend out 90% of your deposit at 6%, I’m ok paying you 4%. If I can lend out none of it, why do I pay interest? Or are you suggesting that interest-bearing liquid deposits are an artifact of low fractional reserves, and shouldn’t exist? Illiquid deposits (eg CDs) that are locked can be lent out with very little risk, as long as the duration matches. But general deposits?
2. Where will banks get funds to lend? If I’m a bank and can lend out 90% of my deposits, then I’ve got funds for lending. If I can lend out none, I’ve got nothing to lend for mortgages or business loans. Longer term deposits (CDs) will provide some, equity some (I worked with a small financial firm that did exactly this 20 years ago), but that is tiny in scale compared to today’s bank lending.
Or maybe you’re putting both of those together? Deposits are zero interest bearing, a safe place to put your money and transact. Locked in deposits are interest bearing and they, along with equity funding, are sources for bank lending, as long as durations match? Bank runs become structurally nearly impossible?
Deposits flow to reserves which pay interest. So interest on deposits = interest on reserves - costs to service deposits. (In a competitive industry!) Funds to lend come from equity (retained earnings, share issues) and long-term debt. The two activities need to be separate companies, or at least isolated in bankruptcy.
Interesting. So if today, 10% of deposits pay whatever the fed is paying on reserves, and 90% pay whatever (higher) rate the banks can get by lending retail or commercial, in this system, all of it pays banks the fed rate? And banks clear some profit and pay the rest to depositors? Ok I can see that.
On the lending side, it sounds like you are saying that, since deposits just pay fed reserves rate (minus costs, profit margin, etc), then nothing is left to lend. Hence a lending company can either issue equity or bonds, and use those funds to lend. Which means it is not connected to deposits at all, which means it doesn’t need to be a bank at all.
Did you finally just solve the 1980s S&L, by detaching saving from lending?
I think it would mean a lot less lending though? Banks constantly get deposits that they lend out. Issuing debt and equity is a much less frequent process. Once they are lent out, it can do nothing until payments are made.
Do you see new kinds of “debt ETF”, where people can explicitly invest in lending, but not as equity?
I presume that you would see a tranche of preferred equity with a pay rate similar to what you would currently see in a similar deposit, but if not repaid at a certain point you would have some remedy other the suing the bank for payment, e.g. accrual at a default rate, rights to take over control of the bank (in combination with preferred shareholders in your class). Or you might see something completely different, but I think the key is that the bank doesn't become insolvent because this is not debt.
My question is does this just eventually move the bailout risk from banks to this new class of preferred equity holders? I suspect the answer is "maybe someday" (after all the desire to do bailouts is strong, e.g. GM) but at least we get some time free of bailouts in the interim.
> the bank doesn't become insolvent because this is not debt
I think the bank doesn't become insolvent, because the (deposit) bank has access to all deposits; they are reserves. Runs on the bank literally do not matter, except for time to retrieve, which may get a bit slow.
> banks to this new class of preferred equity holders?
Probably, but there is a _lot_ less political pressure to bail out the equity holders of a lender who issued too much bad debt, than to bail out the creditors of a large bank, i.e. every person who made a deposit.
one other question. If 10% of deposits as reserves currently pay x% interest, and now we go to 100% of deposits as reserves, did the Fed just need to pay 10x the amount of interest?
Unfortunately BPI lobby has greater political influence
https://www.wsj.com/finance/regulation/washingtons-pivot-on-bank-rules-could-free-up-tens-of-billions-109713c0?st=m2xmobfklidnkdt&reflink=article_copyURL_share