The barn door

Kevin Warsh has a nice WSJ oped warning of financial problems to come.  The major point of this essay: "countercyclical capital buffers" are another bright regulatory idea of the 2010s that now has fallen flat. 

As in previous posts, a lot of banks have lost asset value equal or greater than their entire equity due to plain vanilla interest rate risk. The ones that haven't run are now staying afloat only because you and me keep our deposits there at ridiculously low interest rates. Commercial real estate may be next. Perhaps I'm over-influenced by the zombie-apocalypse goings on in San Francisco -- $755 million default on the Hilton and Parc 55, $558 million default on the whole Westfield mall after Nordstrom departed and on and on. How much of this debt is parked in regional banks? I would have assumed that the Fed's regulatory army could see something so obvious coming, but since they completely missed plain vanilla interest rate risk, and the fact that you don't have to stand in line any more to run on your bank, who knows?

So, banks are at risk; the Fed now knows it, and is reportedly worried that more interest rates to lower inflation will cause more problems. To some extent that's a feature not a bug -- the whole theory behind the Fed lowering inflation is that higher interest rates "cool economic activity," i.e. make banks hesitant to lend, people lose their jobs, and through the Phillips curve (?) inflation comes down. But the Fed wants a minor contraction, not full-on 2008. (That did bring inflation down though!) 

I don't agree with all of Kevin's essay, but I always cherry pick wisdom where I find it, and there is plenty. On what to do: 

Ms. Yellen and the other policy makers on the Financial Stability Oversight Council should take immediate action to mitigate these risks. They should promote the private recapitalization of small and midsize banks so they survive and thrive.

Yes! But. I'm a capital hawk -- my answer is always "more." But we shouldn't be here in the first place. 

Repeating a complaint I've been making for a while, everything since the great treasury market bailout of March 2020 reveals how utterly broken the premises and promises of post-2008 financial regulation are. One of the most popular ideas was "countercyclical capital buffers." A nice explainer from Kaitlyn Hoevelmann at the St. Louis Fed (picked because it came up first on a Google search), 

"A countercyclical capital buffer would raise banks’ capital requirements during economic expansions, with banks required to maintain a higher capital-to-asset ratio when the economy is performing well and loan volumes are growing rapidly.  " 

Well, that makes sense, doesn't it? Buy insurance on a clear day, not when the forest fire is half a mile upwind. 

More deeply, remember "capital" is not "reserves" or "liquid assets." "Capital" is one way banks have of getting money, by selling stock, rather than selling bonds or taking deposits. (There is lots of confusion on this point. If someone says "hold" capital that's a sign of confusion.) It has the unique advantage that equity holders can't run to get their money out at any time. In bad times, the stock price goes down and there's nothing they can do about it. But also obviously, it's a lot easier to sell bank stock for a high price in good times than it is just after it has been revealed that the bank has lost a huge amount of money, i.e. like now.  

Why don't banks naturally issue more equity in good times? Well, because buying insurance is expensive, and most of all there is no deposit insurance or too big to fail guarantee subsidizing stock. So banks always leverage as much as they can. Behavioralists will add that bankers get over enthusiastic and happy to take risks in good times. Why don't regulators demand more capital in good times, so banks are ready for the bad times ahead? That's the natural idea of "countercyclical capital buffers." And after 2008, all worthy opinion said regulators should do that. Only some cynical types like me opined that the regulators will be just as human, just as behavioral, just as procyclically risk averse, just as prey to political pressures in the future as they were in the past. 

And so it has turned out. Despite 15 years of writing about procyclical capital, of "managing the credit cycle," here we are again -- no great amounts of capital issued in the good times, and now we want banks to do it when they're already in trouble, and anyone buying bank stock will be providing money that first of all goes to bail out depositors and other debt holders. As the ship is sinking, go on amazon to buy lifeboats. Just as in 2008, regulators will be demanding capital in bad times, after the horse has left the barn. So, the answer has to be, more capital always! 

Kevin has more good points:  

Bank regulators have long looked askance at capital from asset managers and private equity firms, among others. But this is no time for luxury beliefs.

Capital is capital, even from disparaged sources. 

Policy makers should also green-light consolidation among small, midsize and even larger regional banks. I recognize concerns about market power. But the largest banks have already secured a privileged position with their “too big to fail” status. Hundreds of banks need larger, stronger franchises to compete against them, especially in an uncertain economy. Banks need prompt regulatory approval to be confident that proposed mergers will close. Better to allow bank mergers before weak institutions approach the clutches of the Federal Deposit Insurance Corp.’s resolution process. Voluntary mergers at market prices are preferable to rushed government auctions that involve large taxpayer losses and destruction of significant franchise value.

It is a bit funny to see the Administration against all mergers, and then when a bank fails, Chase gets to swallow up failing banks with government sweeteners. Big is bad is another luxury belief. 

Yes, banks are uncompetitive. Look at the interest on your deposits (mine, Chase, 0.01%) and you'll see it just as clearly as you can see lack of competition in a medical bill. But most of that competition comes from regulation, not evil behavior. As per Kevin: 

The past decade’s regulatory policies have undermined competition and weakened resiliency in the banking business. 

A final nice point: 

The Fed’s flawed inflation forecasts in the past couple of years are a lesson in risk management. Policy makers shouldn’t bet all their chips on hopes for low prices or anything else. Better to evaluate the likely costs if the forecast turns out to be wrong.

Maybe the lesson of the massive failure to forecast inflation is that inflation is just bloody hard to forecast. Rather than spend a lot of effort improving the forecast, spend effort recognizing the uncertainty of any forecast, and being ready to react to contingencies as they arise. (I'm repeating myself, but that's the blogger's prerogative.)  

Cost Benefit Comments

The Biden Administration is proposing major changes to cost-benefit analysis used in all regulations. The preamble here, and the full text here. It is open for public comments until June 20. 

Economists don't often comment on proposed regulations. We should do so more often. Agencies take such comments seriously. And they can have an afterlife. I have seen comments cited in litigation and by judicial decisions. Even if you doubt the Biden Administration's desire to hear you on cost-benefit analysis, a comment is a marker that the inevitable eventual Supreme Court case might well consider. Comments tend only to come from interested parties and lawyers. Regular economists really should comment more often. I don't do it enough either. 

You can see existing comments:  Search for Circular A-4 updates to get to https://www.regulations.gov/docket/OMB-2022-0014, then select “browse all comments.” (Thanks to a good friend who sent this tip.) 

Take a look at comments from an MIT team led by Deborah Lucas here and by Josh Rauh. These are great models of comments. You don't have to review everything.   Make one good point. 

Cost benefit analysis is useful even if imprecise. Lots of bright ideas in Washington (and Sacramento!) would struggle to document any net benefits at all. Yes, these exercises can lie, cheat, and steal, but having to come up with a quantitative lie can lay bare just how hare-brained many regulations are. 

Both Josh and the MIT response focus on the draft proposal's use of ultra-low discount rates, ranging from historic TIPS yields to arguments for zero or negative "social" discount rates. Josh emphasizes a beautiful compromise: always show the annual stream of costs and benefits. Then it's easy enough to apply different discount rates. No Black Boxes. 

Discount rates seem like a technical issue. But they matter a lot for climate policies, or for policies with substantial cost but putatively permanent benefits, because of the long horizons. For example, climate change is alleged to create costs of 5% of GDP in 100 years. So, let's assume a 0% discount rate -- treat the future just like the present. How much is it worth spending this year to eliminate additional climate change in 2100? Spend means real spending, real reductions in everyone's standard of living, not just funny money billions on twitter. 

If you answered "5% of GDP" (roughly $3,500 per person) that's wrong, for two crucial reasons. First, the economy grows over time. At a modest 2% real growth, US GDP will be 7.4 times as large in 100 years as it is today, or 640% greater. (e^2=7.4). Thus, 5% of GDP in 100 years, discounted at 0%,  is 7.4 x 5% or 37% of today's GDP, or $17,500 per person today. Second, the gain is forever -- 5% of 2123 GDP, but 5% of 2124 GDP, and so on. Discounted at a zero rate, 5% of 2123 forever after that is worth... an infinite amount today. But GDP keeps growing after 2123. If you discount at anything less than the growth rate of GDP -- 2% in my example -- 5% of (growing) GDP forever is worth an infinite amount!  So what if $250 billion subsidizing huge battery long range electric cars made by union labor in the USA from hypothetical US made lithium mines might, all in, save a thimbleful of carbon per car (is it even positive?), if the benefits are infinite, go for it. 

If you discount by a low, but somewhat more reasonable number like 7%, then a dollar in 100 years is worth 0.09 cents today (100 x e^-7). Now you know where to put your thumb on the climate scales! 

You might be wondering, if our great grandchildren are going to be so fantastically better off than we are, let them deal with it. Or you may be wondering that maybe there are other things we could do with money today that might speed up this magical growth process and do 5% better. For an infinite amount of money, is there nothing we can do to raise the growth rate from 2% to 2.05%? 

The latter opportunity cost question is, I think, a good way to think of discount rates. The average real return on stocks is something like 5%, at least. The average pre-tax marginal product of capital is higher; pick you number but it's in the range of 10% not 1%. The right "discount rate" is the rate of return on alternative uses of money. Josh and the MIT team are exactly right to point out that using the rate of return on risk free government bonds is a completely mistaken way to discount the very risky costs of climate damage -- that 5% is a very poorly known number -- and the even riskier benefits of the government's shifting climate policy passions. But I think phrasing the experiment in terms of opportunity costs rather than proper discounting of risky streams makes it more salient, despite the decades I have spent (and an entire book!) on the latter approach. Businesses can take $1 today and turn it in to, on average, $1.07 next year. Why take away that money for a project that yields $1.00 or $1.01 next year? 

The former question has a deeper consequence. Why should we suffer to help people, even our grandchildren, who will be on average 7.4 times better off than we are? How much would you ask your great grandparents to sacrifice to make you 5% better off than you are today? 

Here the low discount rate clashes interestingly with another part of the proposal: equity and transfers. 

From the preamble p. 12: 

A standard assumption in economics, informed by empirical evidence (as discussed below), is that an additional $100 given to a low-income individual increases the welfare of that individual more than an additional $100 given to a wealthy individual. Traditional benefit-cost analysis, which applies unitary weights to measures of willingness to pay, does not usually take into account how distributional effects may affect aggregate welfare because of differences in individuals’ marginal utility of income. Related to the topic of distributional analysis is the question of whether agencies should be permitted or encouraged to develop estimates of net benefits using weights that take account of these differences.26 The proposed revisions to Circular A-4 suggest that agencies may wish to consider weights for each income group affected by a regulation that equal the median income of the group divided by median U.S. income, raised to the power of the elasticity of marginal utility times negative one.

Now wait a darn-tootin' minute. The "standard" doctrine in economics is that you cannot make intra-personal utility comparisons. Utility is ordinal, not cardinal. Here cardinal-utility utilitarianism with equal Pareto-weights is about to be carved into federal stone. (To decide social benefit of taking from A and giving to B, you construct a social welfare function \(u(c_A) + \lambda u(c_B)\). This needs you to use the same \(u()\) for A and B, and agree on a Pareto-weight \(\lambda\) implicitly one here.) 

Imagine a simple regulation: take a dollar from Joe ($100,000 income) and give it to Kathy ($50,000 income). By this standard such a straightforward transfer passes a cost-benefit test.  

But this does not get applied over time. Taking a dollar from you and me, and at a discount rate of 0% giving it to our great grandchildren who will be 7.4 times better off should set off massive inequity alarm bells. Nope. 

Indeed, you can deduce a discount rate from the inequality goal. Pure undiscounted intergenerational equity requires a discount rate proportional to the economic growth rate. 

(With power utility, an intervention that costs A $1 to give B $\(e^{rt}\) just passes a cost-benefit test if \[c_A^{-\gamma} = e^{rt} (c_B)^{-\gamma}.\]  If B is \(e^{gt}\) times as well off as A, \(c_B=e^{gt} \times c_A\) then we need  \(r=\gamma g\). \( \gamma\) is usually a number a bit bigger than one.  The preamble's discussion of \(\gamma\) values is pretty good, settling on a number between one and two. However, they haven't really heard of the finance literature: 

Evidence on risk aversion can be used to estimate the elasticity of marginal utility. In a constant-elasticity utility specification, the coefficient of relative risk aversion is the elasticity of marginal utility. There are numerous different estimates of the coefficient of relative risk aversion (CRRA), using data from a variety of different markets, including labor supply markets,29 the stock market,30 and insurance markets.31 Relevant estimates vary widely, though assumed values of the CRRA between 1 and 2 are common.32

30 Robert S. Pindyck, “Risk Aversion and Determinants of Stock Market Behavior,” The Review of Economics and Statistics 70, no. 2 (1988): 183-90 uses stock market data and estimates the CRRA to be “in the range of 3 to 4"

Since then, of course, the whole equity premium literature sprang up with coefficients 10 to 50. Shh. That would justify insane levels of equity. 

The draft also encourages all sorts of unquantifiable non-economic "benefits," but I'll leave that for another day. 

Read and comment. 

BTW, despite my negative tone and picking on these elements, much of the draft is quite good. Here is a particularly nice piece, from p. 26 of the full text 

j. A Note Regarding Certain Types of Economic Regulation

In light of both economic theory and actual experience, it is particularly difficult to demonstrate positive net benefits for any of the following types of regulations:

 price controls in well-functioning competitive markets;

 production or sales quotas in well-functioning competitive markets;

 mandatory uniform quality standards for goods or services, if the potential problem can be adequately dealt with through voluntary standards or by disclosing information of the hazard to buyers or users; or

 controls on entry into employment or production, except (a) where needed to protect health and safety (e.g., Federal Aviation Administration tests for commercial pilots) or (b) to manage the use of common property resources (e.g., fisheries, airwaves, Federal lands, and offshore areas).

Well, FAA tests and rules for commercial pilots is not actually quite so obvious and really needs a cost benefit test. "Commercial pilot" does not mean "airline pilot," it means can you do anything in an airplane and get money for it. But leave that for another day, these principles if applied could clean out a lot of mischief. Well, I guess many on the progressive left or nascent national-conservative right would deny there is such a thing as a "well-functioning competitive market." 

Update: 

I should have added: It's insane to make a once and for all cost benefit analysis, especially for projects with 100 year horizons. All regs should be re evaluated every 5 to 10 years, and use experience to update costs and benefits. 

 

   

Hoover Monetary Policy Conference Videos

The videos from the Hoover Monetary Policy Conference are now online here.  See my previous post for a summary of the conference. 

The big picture is now clearer to me. Phil Jefferson rightly asked, what do you mean off track? Monetary policy is doing fine. Interest rates are, in his view, where they should be. He argued the case well. 

But now I have an answer: The Fed has had three significant institutional failures: 1) Its inflation target is 2%, yet inflation exploded to 8%. The Fed did not forecast it, and did not see it even as it was happening. (Nor did many other forecasters, pointing to deeper conceptual problems.) 2) In the SVB and subsequent mess, the Fed's regulatory apparatus did not see or do anything about plain vanilla interest-rate risk combined with uninsured deposits. 3) I add a third, that nobody else seems to complain about: In 2020 starting with treasury markets, moving on to money market funds, state and local financing,  and then an astonishing "whatever it takes" that corporate bond prices shall not fall, the Fed already revealed that the Dodd-Frank machinery was broken. (Will commercial real estate be next?) 

Yet there is very little appetite for self-examination or even external examination. How did a good institution, filled with good, honest, smart and devoted public servants fail so badly? That's not "off-track" that's a derailment. 

Well, two sessions at the conference begin to ask those questions, and the others aimed at the same issues. Hopefully they will prod the Fed to do so as well, or at least to be interested in other's answers to those questions. 

(My minor contributions: on why the Taylor rule is important here, where I think I did a pretty good job; and comments on why inflation forecasts went so wrong at  1:00:16 here.)

Hoover Monetary Policy Conference

Friday May 12 we had the annual Hoover monetary policy conference. Hoover twitter stream here.  Conference webpage and schedule here (update 5/24 now contains videos.) As before, the talks, panels, and comments will eventually be written and published. 

The Fed has experienced two dramatic institutional failures: Inflation peaking at 8%, and a rash of bank failures. There were panels focused on each, and much surrounding discussion.  

We started with a little celebration of the 30th anniversary of Taylor (1993), which put the Taylor rule on the map. As Andy Levin pointed out in the discussion, academic immortality comes when they omit the number after your name. Rich Clarida, Volker Weiland and I quickly outlined some academic influence. John Lipsky added some very interesting commentary on how the Taylor rule was important on Wall Street, and specifically from his experience at Salomon Bros. 

The second panel on financial regulation was a smash. Anat Admati chaired, with presentations by Darrell Duffie, Randy Quarles, and Amit Seru. 

Duffie showed how online banking has taken over, and the combination of twitter and online banking makes runs happen much faster than before. You don't have to stand in line, you can all push "withdraw" at once. He also showed a glaring hole in liquidity regulations: A bank cannot count as liquidity its ability to use the discount window at the Fed. 

Seru covered some of his recent work, showing just how many banks have lost 10% or more of their asset value, and thus the value of their equity. (Nobody mentioned commercial real estate, the next shoe to drop.) They gently disagreed, Darrel viewing more liquidity and better liquidity rules as the main solution, and Amit more equity. All seemed to agree that the current regulatory mechanism is fundamentally broken. 

Randy gave a thoughtful, eloquent, and impassioned talk laying to rest the common notion that "deregulation" caused SVB to fail. It would have passed all the stress tests. This will be important to read when the papers are all available. I take the implication that the regulatory structure is, again, fundamentally broken. No, more of the current regulations would not have helped. But Randy didn't say that. 

Peter Henry next presented "Disinflation and the Stock Market: Third World Lessons for First World Monetary Policy" (a paper with Anusha Chari), discussed by Josh Rauh and Chaired by Bill Nelson. A key innovation, they use stock market reactions to measure whether disinflations are a success on a cost/benefit basis. Large inflations seem to end with stock market expansions. Moderate disinflations don't really do much for stock markets. Most disinflationary reforms fail.

Over lunch, Haruhiko Kuroda, Former Governor, Bank of Japan updated us on the Japanese situation. He is confident 2% inflation will return soon. 

Niall Ferguson and Paul Schmelzing presented "The Safety Net: Central Bank Balance Sheets and Financial Crises 1587-2020," (with Martin Kornejew and Moritz Schularick), with Barry Eichengreen discussing and Michael Bordo chair. A taste: 

The paper concludes that lender of last resort operations do work, and also create moral hazard. Barry had an eloquent discussion, noting among other things that not all balance sheet expansions are the same. Look for those in the written versions. 

Next, Mickey Levy presented The Fed: Bad Forecasts and Misguided Monetary Policy, Steve Davis discussing and  Jim Wilcox chair. The Fed -- and most industry analysts -- completely missed 8% inflation, both ahead of time and as it was happening. Why? How can the Fed do better? (And why is the Fed not asking this question?) 

To me, it looks like the forecast is not much more than an AR(1) reversion to 2% inflation. The paper has a good summary of how Fed forecasts are made, along with recommendations for institutional improvement.  

Steve Davis had an excellent discussion, pointing to a central incentive problem. The Fed uses forecasts to try to shape expectations. Like pubic health authorities, it can be afraid to reveal actual fears. I also see conceptual flaws -- not much attention to supply or fiscal policy, using the Phillips curve as a causal model and as a model in itself, too much attention to the one-period link from expected inflation to inflation, and too much attention to the forecast rather than risk management; what do we do if things come out differently. 

The conference day ended with the traditional policy panel, with Jim Bullard (talk here), Philip Jefferson (talk here), Jeff Lacker, and Charlie Plosser, Chaired by John Taylor. 

Bullard pointed to the huge fiscal stimulus as a source of inflation, warming my heart. He opined that this stimulus is fading, making him hopeful for a soft landing. He presented the following chart. 

This is a very interesting measure of how much "stimulus" is sitting out there in the economy. The government did write a lot of checks, that went straight to people's bank accounts, and eventually were spent, driving up inflation. On the other hand, I am still a bit shocked that we're running $1 trillion deficit despite beyond-full employment and output revving at every bit that the "supply" side of the economy can produce. What's your measure of fiscal stimulus? Which forecasts inflation? This is a very provocative and interesting idea. 

Jefferson gave a great talk. He has the measured cadence of a seasoned central banker, but speaks very clearly and directly.  He started by announcing his appointment as vice-chair, which got a well deserved ovation. He then jumped right in: 

The title of the conference "How to Get Back on Track: A Policy Conference" is potent. Its intent and ambiguity are striking. First, the title presupposes that U.S. monetary policy is currently on the wrong track. Second, the webpage for this conference advances a puzzling definition of the phrase "on track." How so? According to the Hoover webpage, "A key goal of the conference is to examine how to get back on track and, thereby, how to reduce the inflation rate without slowing down economic growth" (emphasis added).1 As this audience knows, there are macroeconomic models that permit disinflation with no slowdown in economic growth, but the assumptions underlying these models are very strong. It's not clear, at least to me, why such a strict metric would be used to assess real-world monetary policymaking....

I loved this. It shows he took the time to read up on the conference, and I love seeing basic premises challenged. Later, this struck me as thoughtful: 

I want to share with you a few strategic principles that are important to me. First, policymakers should be ready to react to a wide range of economic conditions with respect to inflation, unemployment, economic growth, and financial stability. The unprecedented pandemic shock is a good reminder that under extraordinary circumstances it will be difficult to formulate precise forecasts in real time. Our dual mandate from the Congress is especially helpful here. It provides the foundation for all our policy decisions. Second, policymakers should clearly communicate monetary policy decisions to the public. Our commitment to transparency should be evident to the public, and monetary policy should be conducted in a way that anchors longer-term inflation expectations. Third—and this is where I am revealing my passion for econometrics—policymakers should continuously update their priors about how the economy works as new data become available. In other words, it is appropriate to change one's perspective as new facts emerge. In this sense, I am in favor of a Bayesian approach to information processing.

The first point brings us back to the problem that the Fed has so far been too silent about: How did it miss 8% inflation? And how to operate when such huge misses are possible? The Fed seems to have been making a forecast, then announcing a policy path that works for the forecast, and then trying to stick to it. In this first principle you see a quite different view. Let's call it data-dependent rather than time-dependent. 

This is a conference about the Taylor rule. Should the Fed look at more than inflation and employment? Well, yes and no according to these comments. And when models are not certain, distrust and update.

Plosser and Lacker previewed an upcoming paper on the Fed's deviation from rules. Stay tuned. 

The evening started with a delightful speech by Sebastian Edwards on Latin American inflation. Stay tuned for that too. 

Videos should be up soon, and written versions as fast as we can get authors to turn them in. This is just a teaser!  

Update: Videos are now up, with some more commentary here.

On marking to market and risk management

Two more thoughts:

1) In the SBV debacle, many of my colleagues and friends jump to the conclusion, we should just mark all assets to market and forget about this "hold to maturity" business.

Not so fast. Like all imperfect patches, there is some logic to it. Suppose you have a $100 payment that you have to make in 10 years. To cover that payment, you buy a $100 face value Treasury zero coupon bond. Done, zero risk. 

Now interest rates rise. The value of your asset has fallen in value! It's only worth, say, $90! Are you underwater? No, because when the time comes, you still will have exactly $100 to make the needed payment. 

You will quickly answer, well, mark both assets and liabilities to market. The $100 payment is now also worth $90, so marking both sides to market would reveal no change. But there is a lot of unneeded volatility here. And in most cases, the $100 payment is not tradeable on a market, while the $100 asset is. So now, you're going to be balancing marking to market vs. marking to model. Add the regulator's and many participant's distrust of market prices, which are always seemingly "illiquid," "distressed," in a state of "fire sale," "dysfunctional," and so forth. Add the pointlessness of it all. In this situation we all know that you can make the payment in 10 years. Lock it up and ignore it. Call the asset "hold to maturity." 

Of course, suppose the point of that asset is to make sure that depositors with $100 accounts can always get their money back by selling the asset. Well, now we have Silicon Valley Bank. 

Hence the imperfect fudge of current accounting and regulation rules. "Hold to maturity" assets don't get marked to market, and indeed there are penalties for selling them to meet current needs. Lots of "liquidity" and other rules are supposed to make sure there are adequate short run liabilities to stop a run. Those were of course completely absent in SBV's case -- a truly spectacular failure of elementary regulation. 

In short, mark to market makes sense to assess if a bank can make its payments and avoid failure tomorrow. Hold to maturity makes a bit of sense to assess if a bank can make its payments and avoid failure years from now, when both long term assets and long term liabilities come due. That is, if it survives that long. 

2) There is a lot of criticism of SBV bank management and board for being underinvested in risk management and over invested in lobbying, political connections, donations to politically popular causes, and so forth. Ex post, their choice of managerial investments looks brilliant! What brought in the millions to stem a run, I ask you? In today's highly political banking system, they made optimal choices. To an economist, many puzzling actions are just an optimal answer to a different question. 

Update: Ok, I went too far with that one. Management are out, shareholders wiped out. I'll stick with the idea that uninsured depositors did a great job of monitoring -- they monitored that the bank had the political chops to demand and get a bailout of uninsured depositors! 

From a correspondent: 

"It seems to me now that SVB was really a money market fund with the addition of a bit of equity and breaking all the SEC asset and liquidity rules that MMFs are subject to. " 

Or, it was really a mutual fund (money market funds with $1 values can't invest in long term bonds, long term bond funds must have floating NAV) that was violating rules on floating NAV! 

Small bank thoughts

 Three small thoughts. 

1) There is much commentary that bank troubles will interfere with the Fed's plan to lower inflation by raising rates. Actually, this is a feature not a bug. The main mechanism by which, in the Fed's view, raising interest rates slows the economy and lowers inflation is by "constricting credit," "tightening financial conditions," lowering borrowing that finances investment and consumer durables purchases.  The Fed didn't want runs, no, but it wants the result. If you don't like that, well, we need to think of other ways to contain inflation, like taking the fiscal gasoline off the fire. 

2) On uninsured deposits. A correspondent suggests that the Fed simply mandate that all large depositors participate in the sorts of services, there for the asking, that split large accounts into multiple $249k accounts spread over multiple banks, or sweeps into money market funds. 

I don't think that mandating this system is a good idea. If you're going to do that, of course, you might as well just insure all deposits and keep it simple. 

But the suggestion prompts doubt over the oft repeated notion that we want large sophisticated depositors to monitor banks. Anyone who was large and sophisticated enough to monitor banks had already gamed the system to make sure their accounts were insured, at some nontrivial cost in fees and trouble. The only people left with millions in checking accounts were, sort of by definition, financially unsophisticated or too busy running actual companies to bother with this sort of thing. Sort of like taxes. 

We might as well give in, that all deposits are here forth insured. If so, of course, then banks are totally gambling with the house's money. But we also have to give in that if they can't spot this elephant in the room, asset risk regulation is hopeless. The only workable answer (of course) is narrow deposit taking -- all runnable deposits invested in reserves and short term treasuries; fund portfolios of long term debt with long-term borrowing (CDs for example) and lots of equity.

3) Liquidity and fixed value are no longer necessarily tied together. I still don't quite get why better payment services are not attached to floating value funds. Then we wouldn't need run-prone bank accounts at all. 

 

How many banks are in danger?

With amazing speed and impeccable timing, Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru analyze how exposed the rest of the banking system is to an interest rate rise.

Recap: SVB failed, basically, because it funded a portfolio of long-term bonds and loans with run-prone uninsured deposits. Interest rates rose, the market value of the assets fell below the value of the deposits. When people wanted their money back, the bank would have to sell at low prices, and there would not be enough for everyone. Depositors ran to be the first to get their money out. In my previous post, I expressed astonishment that the immense bank regulatory apparatus did not notice this huge and elementary risk. It takes putting 2+2 together: lots of uninsured deposits, big interest rate risk exposure. But 2+2=4 is not advanced math. 

How widespread is this issue? And how widespread is the regulatory failure? One would think, as you put on the parachute before jumping out of a plane,  that the Fed would have checked that raising interest rates to combat inflation would not tank lots of banks. 

Banks are allowed to report the "hold to maturity" "book value" or face value of long term assets. If a bank bought a bond for $100 (book value) or if a bond promises $100 in 10 years (hold to maturity value), basically, the bank may say it's worth $100, even though the bank might only be able to sell the bond for $75 if they need to stop a run. So one way to put the issue is, how much lower are mark to market values than book values? 

The paper (abstract):  

The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. 

... 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks have lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. 

... Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. ... these calculations suggests that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

Data:

we use bank call report data capturing asset and liability composition of all US banks (over 4800 institutions) combined with market-level prices of long-duration assets. 

How big and widespread are unrecognized losses?

The average banks’ unrealized losses are around 10% after marking to market. The 5% of banks with worst unrealized losses experience asset declines of about 20%. We note that these losses amount to a stunning 96% of the pre-tightening aggregate bank capitalization.

Percentage of asset value decline when assets are mark-to- market according to market price growth from 2022Q1 to 2023Q1

Most banks operate with (to my mind) tiny slivers of capital -- 10% or less. So 10% decline in asset value is a lot! (Banks get money by issuing stock and borrowing. The capitalization ratio is how much money banks get by issuing stock/assets. Capital is not reserves, liquid assets "held" to satisfy depositors.) In the right panel, the problem is not confined to small banks and small amounts of dollars. 

But...all of this is slightly old data. How much worse will this get if the Fed raises interest rates a few more percentage points? A lot. 

To runs, it takes 2+2 to get 4. How widespread is reliance on uninsured, run-prone deposits? (Or, deposits that were run-prone until the Fed and Treasury ex-post guaranteed all deposits!) Here SVB was an outlier. 

The median bank funds 9% of their assets with equity, 65% with insured deposits, and 26% with uninsured debt comprising uninsured deposits and other debt funding....SVB did stand out from other banks in its distribution of uninsured leverage, the ratio of uninsured debt to assets...SVB was in the 1st percentile of distribution in insured leverage. Over 78 percent of its assets was funded by uninsured deposits.

But it is not totally alone 

the 95th percentile [most dangerous] bank uses 52 percent of uninsured debt. For this bank, even if only half of uninsured depositors panic, this leads to a withdrawal of one quarter of total marked to market value of the bank. 

Uninsured deposit to asset ratios calculated based on 2022Q1 balance sheets and mark-to-market values 

Overall, though, 

...we consider whether the assets in the U.S. banking system are large enough to cover all uninsured deposits. Intuitively, this situation would arise if all uninsured deposits were to run, and the FDIC did not close the bank prior to the run ending. ...virtually all banks (barring two) have enough assets to cover their uninsured deposit obligations. ... there is little reason for uninsured depositors to run.

... SVB, is [was] one of the worst banks in this regard. Its marked-to-market assets are [were] barely enough to cover its uninsured deposits.

Breathe a temporary sigh of relief. 

I am struck in the tables by the absence of wholesale funding. Banks used to get a lot of their money from repurchase agreements, commercial paper, and other uninsured and run-prone sources of funding. If that's over, so much the better. But I may be misunderstanding the tables. 

Summary: Banks were borrowing short and lending long, and not hedging their interest rate risk. As interest rates rise, bank asset values will fall. That has all sorts of ramifications. But for the moment, there is not a danger of a massive run. And the blanket guarantee on all deposits rules that out anyway. 

Their bottom line: 

There are several medium-run regulatory responses one can consider to an uninsured deposit crisis. One is to expand even more complex banking regulation on how banks account for mark to market losses. However, such rules and regulation, implemented by myriad of regulators with overlapping jurisdictions might not address the core issue at hand consistently 

I love understated prose.

There does need to be retrospective. How are 100,000 pages of rules not enough to spot plain-vanilla duration risk -- no complex derivatives here -- combined with uninsured deposits? If four authors can do this in a weekend, how does the whole Fed and state regulators miss this in a year? (Ok, four really smart and hardworking authors, but still... ) 

Alternatively, banks could face stricter capital requirement... Discussions of this nature remind us of the heated debate that occurredafter the 2007 financial crisis, which many might argue did not result in sufficient progress on bank capital requirements...

My bottom line (again) 

This debacle goes to prove that the whole architecture is hopeless: guarantee depositors and other creditors, regulators will make sure that banks don't take too many risks. If they can't see this, patching the ship again will not work. 

If banks channeled all deposits into interest-paying reserves or short-term treasury debt, and financed all long-term lending with long-term liabilities, maturity-matched long-term debt and lots of equity, we would end private sector financial crises forever. Are the benefits of the current system worth it? (Plug for "towards a run-free financial system." "Private sector" because a sovereign debt crisis is something else entirely.) 

(A few other issues stand out in the SVB debacle. Apparently SVB did try to issue equity, but the run broke out before they could do so. Apparently, the Fed tried to find a buyer, but the anti-merger sentiments of the administration plus bad memories of how buyers were treated after 2008 stopped that. Beating up on mergers and buyers of bad banks has come back to haunt our regulators.) 

Update: 

(Thanks to Jonathan Parker) It looks like the methodology does not mark to market derivatives positions. (It would be hard to see how it could do so!) Thus a bank that protects itself with swap contracts would look worse than it actually is. (Translation: Banks can enter a contract that costs nothing, in which they pay a fixed rate of interest and receive a floating rate of interest. When interest rates go up, this contract makes a lot of money! )

Amit confirms,

As we say in our note, due to data limitations, we do not account for interest rate hedges across the banks. As far as we know SVB was not using such hedges...

Of course if they are, one has to ask who is the counterparty to such hedges and be sure they won't similarly blow up. AIG comes to mind. 

He adds: 

note we don’t account for changes in credit risk on the asset side. All things equal this can make things worse for borrowers and their creditors with increases in interest rates. Think for a moment about real estate borrowers and pressures in sectors such as commercial real estate/offices etc. One could argue this number would be large.  

So don't sleep too well.  

From an email correspondent: 

Besides regulation, accountancy itself is a joke. KPMG Gave SVB, Signature Bank Clean Bill of Health Weeks Before Collapse.  

How can unrealised losses near equal to a bank's capital be ignored in the true and fair assessment of its financial condition (the core statement of an audit leaving out all the disclaimers) just because it was classified as Held to Maturity owing some nebulous past "intention" (whatever that was ever worth) not to sell?

It strikes me that both accounting and regulation have become so complicated that they blind intelligent people to obvious elephants in the room.  

Silicon Valley Bank Blinders

The Silicon Valley Bank failure strikes me as a colossal failure of bank regulation, and instructive on how rotten the whole edifice is. I write this post in an inquisitive spirit. I don't know the details of how SVB was regulated, and I hope some readers do and can chime in. 

As reported so far by media, the collapse was breathtakingly simple. SVB paid a bit higher interest rates than the measly 0.01% (yes) that Chase offers. It attracted large deposits from venture capital backed firms in the valley. Crucially, only the first $250,000 are insured, so most of those deposits are uninsured. The deposits are financially savvy customers who know they have to get in line first should anything go wrong. SVB put much of that money into long-maturity bonds, hoping to reap the difference between slightly higher long-term interest rates and what it pays on deposits.  But as we've known for hundreds of years, if interest rates rise, then the market value of those long-term bonds fall. Now if everyone comes asking for their money back, the assets are not worth enough to pay everyone back.  

In sum, you have "duration mismatch" plus run-prone uninsured depositors. We teach this in the first week of an MBA or undergraduate banking class. This isn't crypto or derivatives or special purpose vehicles or anything fancy. 

Where were the regulators? The Dodd Frank act added hundreds of thousands of pages of regulations, and an army of hundreds of regulators. The Fed enacts "stress tests" in case regular regulation fails. How can this massive architecture fail to spot basic duration mismatch and a massive run-prone deposit base? It's not hard to fix, either. Banks can quickly enter swap contracts to cheaply alter their exposure to interest rate risk without selling the whole asset portfolio. 

Michael Cembalist assembled numbers. This wasn't hard to see. 

Even Q3 2022 -- a long time ago -- SVB was a huge outlier in having next to no retail deposits (vertical axis, "sticky" because they are insured and regular people), and a huge asset base of loans and securities. 

Michael then asks 

.. how much duration risk did each bank take in its investment portfolio during the deposit surge, and how much was invested at the lows in Treasury and Agency yields? As a proxy for these questions now that rates have risen, we can examine the impact on Common Equity Tier 1 Capital ratios from an assumed immediate realization of unrealized securities losses ... That’s what is shown in the first chart: again, SVB was in a duration world of its own as of the end of 2022, which is remarkable given its funding profile shown earlier.

Again, in simpler terms. "Capital" is the value of assets (loans, securities) less debt (mostly deposits). But banks are allowed to put long-term assets into a "hold to maturity" bucket, and not count declines in the market value of those assets. That's great, unless people knock on the door and ask for their money now, in which case the bank has to sell the securities, and then it realizes the market value. Michael simply asked how much each bank was worth in Q42002 if it actually had to sell its assets. A bit less in each case -- except SVB (third from left) where the answer is essentially zero. And Michael just used public data. This is not a hard calculation for the Fed's team of dozens of regulators assigned to each large bank. 

Perhaps the rules are at fault? If a regulator allows "hold to maturity" accounting, then, as above, they might think the bank is fine. But are regulators really so blind? Are the hundreds of thousands of pages of rules stopping them from making basic duration calculations that you can do in an afternoon? If so, a bonfire is in order. 

This isn't the first time. Notice that when SBF was pillaging FTX customer funds for proprietary trading, the SEC did not say "we knew all about this but didn't have enough rules to stop it." The Bank of England just missed a collapse of pension funds who were doing exactly the same thing: borrowing against their long bonds to double up, and forgetting that occasionally markets go the wrong way and you have to sell to make margin calls. (That's week 2 of the MBA class.)  

Ben Eisen and Andrew Ackerman in WSJ ask the right question (10 minutes before I started writing this post!) Where Were the Regulators as SVB Crashed? 

“The aftermath of these two cases is evidence of a significant supervisory problem,” said Karen Petrou, managing partner of Federal Financial Analytics, a regulatory advisory firm for the banking industry. “That’s why we have fleets of bank examiners, and that’s what they’re supposed to be doing.”

The Federal Reserve was the primary federal regulator for both banks.

Notably, the risks at the two firms were lurking in plain sight. A rapid rise in assets and deposits was recorded on their balance sheets, and mounting losses on bond holdings were evident in notes to their financial statements.

moreover, 

“Rapid growth should always be at least a yellow flag for supervisors,” said Daniel Tarullo, a former Federal Reserve governor who was the central bank’s point person on regulation following the financial crisis...

In addition, nearly 90% of SVB’s deposits were uninsured, making them more prone to flight in times of trouble since the Federal Deposit Insurance Corp. doesn’t stand behind them.

90% is a big number. Hard to miss.  The article echoes some confusion about "liquidity"

SVB and Silvergate both had less onerous liquidity rules than the biggest banks. In the wake of the failures, regulators may take a fresh look at liquidity rules,...

This is absolutely not about liquidity. SBV would have been underwater if it sold all its securities at the bid prices. Also 

Silvergate and SVB may have been particularly susceptible to the change in economic conditions because they concentrated their businesses in boom-bust sectors...

That suggests the need for regulators to take a broader view of the risks in the financial system. “All the financial regulators need to start taking charge and thinking through the structural consequences of what’s happening right now,” she [Saule Omarova] said

Absolutely not! I think the problem may be that regulators are taking "big views," like climate stress tests. This is basic Finance 101 measure duration risk and hot money deposits. This needs a narrow view! 

There is a larger implication. The Fed faces many headwinds in its interest rate raising effort. For example, each point of higher real interest rates raises interest costs on the debt by about $250 billion (1 percent x 100% debt/GDP ratio). A rate rise that leads to recession will lead to more stimulus and bailout, which is what fed inflation in the first place. 

But now we have another. If the Fed has allowed duration risk to seep in to the too-big to fail banking system, then interest rate rises will induce the hard choice between yet more bailout and a financial storm. Let us hope the problem is more limited - as Michael's graphs suggest. 

Why did SVB do it? How could they be so blind to the idea that interest rates might rise? Why did Silicon Valley startups risk cash, that they now claim will force them to bankruptcy, in uninsured deposits? Well, they're already clamoring for a bailout. And given 2020, in which the Fed bailed out even money market funds, the idea that surely a bailout will rescue us should anything go wrong might have had something to do with it. 

(On the startup bailout. It is claimed that the startups who put all their cash in SVB will now be forced to close, so get going with the bailout now. It is not startups who lose money, it is their venture capital investors, and it is they who benefit from the bailout. 

Let us presume they don't suffer sunk cost fallacy. You have a great company, worth investing $10 million. The company loses $5 million of your cash before they had a chance to spend it. That loss obviously has nothing to do with the company's prospects. What do you do? Obviously, pony up another $5 million and get it going again. And tell them to put their cash in a real bank this time.) 

How could this enormous regulatory architecture miss something so simple? 

This is something we should be asking more generally. 8% inflation. Apparently simple bank failures. What went wrong? Everyone  I know at the Fed are smart, hard working, honest and dedicated public servants. It's about the least political agency in Washington. Yet how can we be seeing such simple o-ring level failures? 

I can only conclude that this overall architecture -- allow large leverage, assume regulators will spot risks -- is inherently broken. If such good people are working in a system that cannot spot something so simple, the project is hopeless. After all, a portfolio of long-term treasuries is about the safest thing on the planet -- unless it is financed by hot money deposits. Why do we have teams of regulators looking over the safest assets on the planet? And failing? Time to start over, as I argued in Towards a run free financial system

Or... back to my first question, am I missing something? 

****

Updates: 

A nice explainer thread (HT marginal revolution). VC invests in a new company. SVB offers an additional few million in debt, with one catch, the company must use SVB as the bank for deposits. SVB invests the deposits in long-term mortgage backed securities. SVB basically prints up money to use for its investment! 

"SVB goes to founders right after they raise a very, very expensive venture round from top venture firms offering:

- 10-30% of the round in debt

- 12-24 month term

- interest only with a balloon payment

- at a rate just above prime 

For investors, it also seems like a no-downside scenario for your portfolio: Give up 10-25 bps in dilution for a gigantic credit facility at functionally zero interest rate.

If your PortCo doesn't need it, the cash just sits. If they do, it might save them in a crunch. The deals typically have deposit covenants attached. Meaning: you borrow from us, you bank with us.

And everyone is broadly okay with that deal. It's a pretty easy sell! "You need somewhere to put your money. Why not put it with us and get cheap capital too?"

Update:

1) Old Eagle Eye's comment below is fascinating. I am getting the sense that the rules actually preclude putting 2+2=4 together here. Copied here in toto

SIVB did have a hedge put on during 2022, but it was limited to its available-for-sale securities ("AFS"). It was precluded from hedging its interest rate risk in held-to-maturity securities ("HTM") by U.S. GAAP rules. [My emphasis] Here is the explanation found at PwC:

[PWC Viewpoint Commentary: "The notion of hedging the interest rate risk in a security classified as held to maturity is inconsistent with the held-to-maturity classification under ASC 320, which requires the reporting entity to hold the security until maturity regardless of changes in market interest rates. For this reason, ASC 815-20-25-43(c)(2) indicates that interest rate risk may not be the hedged risk in a fair value hedge of held-to-maturity debt securities." "ASC 815-20-25-12(d) provides guidance on the eligibility of held-to-maturity debt securities for designation as a hedged item in a fair value hedge."]

[Extracted subsection:

"Chapter 6: Hedges of financial assets and liabilities. 

"6.4 Hedging fixed-rate instruments

"6.4.3.4 Hedging held-to-maturity debt securities

"ASC 815-20-25-12(d)

"If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is classified as held to maturity in accordance with Topic 320, the designated risk being hedged is the risk of changes in its fair value attributable to credit risk, foreign exchange risk, or both. If the hedged item is an option component of a held-to-maturity security that permits its prepayment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. If the hedged item is other than an option component of a held-to-maturity security that permits its prepayment, the designated hedged risk also shall not be the risk of changes in its overall fair value."]

Source: PWC Viewpoint (viewpoint.pwc.com) Publication date: 31 Jul 2022

https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/derivatives_and_hedg/derivatives_and_hedg_US/chapter_6_hedges_of__US/64_hedging_fixedrate_US.html

Update 2: Thanks to anonymous below for a pointer to a good New York Times article about SVB, what the Fed knew and when. Apparently the bank's supervisors knew about problems for a long time before the bank failed. Whether this is good or bad news for the regulatory project I leave to you.