Banking Systems and Crises from Deposit Insurance to Stablecoins

- This is The Capitalism and Freedom in the 21st Century Podcast, an official podcast of the Hoover Institution Economic Policy Working Group where we talk about economics, markets, and public policy. I'm Jon Harley, your host Today. My guest is Charlie Calomiris, who is an emeritus professor of finance at the Columbia Business School, and a legendary authority on all things banking. His research spans the years of banking, corporate finance, financial history, and monetary economics. He's also for his 2014 book on global banking history, fragile by Design, the Political Origins of Banking Crises and Scarce Credit written with Steven Haber. Charlie also sits on the Shadow Open Markets committee as well, where he often gives his thoughts on monetary policy and and finished regulatory policy. Welcome, Charlie. Thanks so much for joining.

- It's great to be with you, John. Very much so. By the way, I should mention I'm also now at the Anderson Institute for Finance and Economics, my new job, which I'm enjoying very much.

- Well, terrific. That, that's so great to hear. And I know a number of your colleagues as well who are doing great things there as well. I want to start with your personal origins and where did you grow up and how did you first get interested in economics and finance, and when did you sort of realize that you would be spending and dedicating much of your life to studying banking?

- That's a great question. I grew up in Washington, dc My father was a prominent civic leader, real estate developer and owner of apartment houses in the DC area. And so it was part of the family business to be tracking banking credit and also interest rates very much so. My dad was on the Board of Rigs National Bank in Washington. He was also on the board of a savings and loan. And so it was just, I had a very close relationship with my father. I admired him very much and he educated me from almost as, as, as far as I can remember, age five maybe. I don't know, to think about finance and banking and monetary policy. I remember very well, even as a, I guess I must have been about 13 or 14 at the time when Arthur Burns was creating havoc in the Federal Reserve, how much trouble that was creating for real estate people. So I saw most of these topics originally through the lens of a real estate developer.

- Wow. That, that's what a great introduction to banking. And, and no wonder, you know, you're an expert very young, no wonder, you know, I suppose it's not surprising at all that, you know, you, you grow to become, you know, one of the greatest living experts on banking. You know, just to really, I guess start, so like, I guess tell, tell us a little bit about you, you know, I guess becoming an academic, your, your dad was sort of a, a practitioner. I mean, what, what made you think that joining academia would, would be a good way to, I mean, explore these sorts of issues? And I'm, I'm curious how, how that sort of transformation becoming a professor, how that came about.

- You know, I think John, a lot of times when we tell tell answers to questions like that, we sort of make them up. That is, I don't really know, and I doubt whether anybody really knows how they get into the academic business exactly why. But at the best I can figure out, I didn't have much choice. I just was very curious about things and just wanted to study things more and more. And it wasn't, you know, something that my family was particularly excited about. I think my dad was expecting that I would get a law degree or do something more useful from his perspective, and it took a while for him to warm to the idea that I was gonna be an academic. So I think I just never got enough is, is really what it came down to. I just, it was almost a personal, just yearning honestly, to just study. That's all I can say.

- That's terrific. Well, I wanna dive deep. I, I, I guess just in the banking straight away and really want to start with deposit insurance theory of bank runs. I mean, we could get into sort of banking history, but I, I feel like especially given the recent Nobel Prize given, you know, toward, you know, Doug Diamond and Phil Dibb big, and you know, it's also that same prize was also given Ben Bernanke as well. You know, the, the, this is a big topic, you know, the what causes bank runs in the first place. You know, we think, you know, these long lines maybe in the late 1920s, 1929 crash, we think, you know, more recently, you know, you could argue that in 2008 was a, you know, run on, you know, some people call it the shadow banking system or run on the money fund system. You know, what causes these is I think a, a a big question. And, you know, one justification that they've given, you know, the, the, the Diamond Dig big model gives is that, you know, that there's a coordination failure amongst depositors and that there's sort of a, a self-fulfilling prophecy with, you know, if, if if there's enough, you know, even a small number of depositors are, are afraid it can trigger a panic and, and can sort of leap this bad equilibrium outcome. Now you are, you've been a long sort of time critic of, of that framework. I'm curious where you, you know, what you think that model gets wrong about why banking crises occur and and tell us a little bit more about what your theory of, sort of the cause of, of bank runs are and, and whether deposit insurance is an effective policy tool to mitigate bank crisis.

- Well, let me start off just by saying I was a whole wholehearted supporter of giving the prize to all three of those people the Nobel Prize and in fact wrote some things to the Nobel Committee suggesting that it was a good idea. But the way I would describe my relationship with the Diamond Divi model is that it was the things that were unsettling about the diamond divi model and seemed to me wrong. That really were my main motivation in getting into banking theory and the theory article that Charles Cann and I wrote. And when I met Gary Gorton after a conference where we had both presented bank theory papers, he presented his 1990 paper with George Panke and I presented mine with, with Charles Can. We met in the airport and we found that both of us had to a very large extent, been driven to do banking theory, mainly because of how much we disliked the diamond DG model. But that doesn't mean that the diamond divi model didn't contribute. I think its main contribution was this coordination failure idea that you could have Nash equilibrium where you had runs coming just out of the expectation by depositors that others might run. So I think that's the main contribution of the paper. But I do want to emphasize there are no loans that banks are making. There's no loan risk in the Diamond DI model. The claims on the bank are not transactable, and since there's no risk runs can't be a response to anything that's a problem. So all of those are big problems. If you want to have a kind of historically informed understanding of banking trouble, I would say that actual bank failures, and I think runs are a little over-emphasized to be honest, but bank failures and waves of bank failures clearly reflect fundamental problems in the economy that hurt banks. And the the key things you need to have an empirically realistic model of bank runs or bank withdrawals that is deposit withdrawals is two things. First, that there's gotta be an observable shock that scares depositors about the value of the bank loan portfolio. And secondly, depositors don't wait for banks to become insolvent. Depositors are risk intolerant, and as soon as the banks get risky, they start to withdraw their money. And when depositors usually begin that process, it happens in a kind of smooth and continuous way. So that what's happening is the depositors are withdrawing gradually, not all at once, not suddenly. And that, that discipline actually leverages banks and in most cases leads the banks to restore their stability through a reduction in leverage and a kind of forced increase in cash assets that the banks have. So when banks experience that disciplinary pressure, most of the time they respond to it favorably reduce their risk and continue. And then of course, there's some extreme cases when it happens very suddenly, especially if there's some whiff of fraud or other kind of very sudden kind of news, then you can get very quick responses. But the key is any model, and by the way, very few models of of banking have these features. They, a lot of 'em have the feature of, of responding to bad news. But I would say that one of the kind of consistent flaws in a lot of the models is that they assume that depositors care about whether the bank is insolvent, actually depositors care about whether the bank is safe and long before it's insolvent, they start to withdraw their money if they're concerned about its safety deposit is pretty much wanted in the uninsured banking days, an investment grade risk or better.

- Interesting. So I guess, you know, translate for us what this I guess means for deposit insurance because, because I guess there's, there's a story that's told that, you know, essentially FDIC insurance ended bank runs that, you know, you had the 1929 crash, you had all these people lined up outside the banks. We've all seen this in these, you know, famous photos of, of Wall Street. And during the panic of of 1929, you had deposit insurance that FDR created with the FDIC in the 1930s, and we hadn't had a traditional systemic set of bank runs since then. You know, there's obviously the odd, you know, rare instance. I mean, you think about Silicon Valley Bank in 2023, there were a lot of uninsured deposits. It's sort of unclear right now what exactly the level of deposit insurance is. But, but the theory is that the FDIC sort of stopped deposit insurance, sorry, stopped bank runs from, from happening. Do you sort of buy that?

- No, it's that, that is a popular misconception. So the most obvious reason, it's a misconception is federal deposit insurance doesn't even go effect until the beginning of 1934. The banking problems were resolved with the bank holiday of March, 1933. And then what happened was, and partly because the FDIC was being created, the supervisory process of doing due diligence to see which banks were, were well enough to reopen starts at that point. Some banks reopened right away in the, the spring of 1933, others get some assistance in terms of preferred stock purchases by the government through the Reconstruction finance corporation later, and then they reopened several months later and still other banks just were shut down. And partly the reason for that was to actually resolve the problems prior to the creation of deposit insurance. So no, there was no connection between bank instability and the 19 early 1930s and deposit insurance. Certainly not that deposit insurance solved any problems. Also, deposit insurance at that time was passed only as a temporary measure. Of course, it, it became permanent and it only applied to its small deposits. And that's because it was really lobbied for by small banks that were very versified typically in rural areas. Henry Stegel from Alabama was the one who really pushed for it. And so it was really a protection that mainly benefited small banks because they had small deposit accounts. Large banks like the New York City banks were not very much affected by a deposit insurance when it was first brought in because they had a lot of deposits that weren't insured.

- Fascinating. So I wanna start short talking about your book. I mean, some of these issues are, are talked about in your book, fragile by Design with Steven Haber. And you wanna just talk about, I guess, the history of banking crises a little bit and how sort of political economy feeds into this? So, so one, you know, I think you, you may get a strong case that, you know, banking is important for economic growth. You know, credit's an important mechanism, you know, for economic growth that banks and, and banking can't really exist without a state, without some level of regulations, some sort of property rights that are really set forth and, and, you know, to prevent expropriation and so forth. But you know what, what's interesting, you know, I know the evidence from Reiner Roff is that banking crises tend to be recessions that are very bad in terms of GDP growth. Interestingly, over time, and this is something that, you know in your book, is that over time this sort of, those who take those who bear the losses of banking crises has really shifted from those who are taking risk, you know, bankers to really the taxpayer explain to us like how that that political transition has happened over time. And, you know, is deposit insurance maybe part of that, or certainly bank bailouts are, are, are part of that which have become increasingly common I think in the us I, I'm just curious like which, you know, how have the political coalitions sort of changed over time? You know, give us the sort of full history of how banking, the, you know, how the politics of banking have, have changed since the founding of the US 250 years ago.

- Well, I th I think the, the right starting point is to, once you realize that when big shocks from the macro economy occur, there's gonna have to be some allocation of loss. Okay, so somebody is going to experience some loss. That could be it when you're looking at the banking sector because banks are making loans and some of those loans aren't gonna work out. Now that is, they're gonna have loan losses. That means the stockholders in the banks are gonna be the sort of first line of defense and they're gonna be the first ones experiencing loss. And that continues to happen to today as well. The difference is, it used to be that because that was true, bankers had a lot of incentive to manage their risks. By the way, you know, most, most bank closures that happened, let's say during the Great Depression were actually voluntary liquidations because banks had extended liability, they had double liability for their paid in capital, meaning they could lose more than what they had already invested in the bank. And so bankers often shut down their banks if they, if they thought that things were going to get worse for their banks. So bank stockholders bore the losses depositors, and those voluntary liquidated banks didn't suffer any losses typically. And, and many banks shut themselves down long before depositors were at risk. But then some banks didn't do that. That's an interesting question why I'm exploring that right now in some research. But they, the bankers who didn't do that despite their extended liability, maybe because they didn't have that much wealth that they could lose as a result of the extended liability that is the extended liability would come ask them to give more of their wealth. So I think that's a reasonable guess. And so those bankers let the depositors be the ones who decided what to shut down the bank. So some banks were shut down by the bank stockholders, typically very wealthy people who didn't wanna lose anymore. The ones that weren't shut down that way were shut down by the depositors. The depositors in the 1930s lost more than they did in previous periods, but still depositor losses were actually fairly small as a percentage of of deposits. Now that was one loss allocation, but notice that that loss allocation created a lot of risk management. Banks were under very heavy incentives to manage their risks and when things weren't going well, they got hit with a lot of withdrawal pressure. And part of that withdrawal pressure was designed to force banks to manage their risks during the recessions too, to limit the losses. Now the negative part of that is that banks curtail credit supply during these recessions, even more so that if you think about how the predeep deposit insurance system works, bankers are, stockholders are the first line of defense depositors because they exercise. A lot of discipline tend to lose a little, but not very much. But the big losers are borrowers because borrowers, because of the bank's engaging in risk management, tend to curtail credit dramatically. So I see deposit insurance as an international movement and bank bailouts as mainly a government decision to subsidize the supply of credit. That is to actually try to make sure that credit crunches are less severe and that this kind of risk management system doesn't go into operation that you can certainly see that that has a benefit, which is if you have an A negative rece, a recession shock, you're gonna have less of a contraction of credit to magnify that shock. So from a macro standpoint, it sounds like a good idea from a micro standpoint, the bad news is that means all of the why's credit contraction, that was part of a risk management system, the incentives for that have been substantially reduced. And when that happens, when you get less good risk management, you get bigger losses eventually, only this time they're gonna be losses of banks that are now the loss allocation shared with the FDIC and with taxpayers because ultimately taxpayers and depositors are the ones who fund the, the FDIC and who fund the bank bailouts that go beyond the FDIC. So to summarize, if you think about shocks hitting from a recession and then being transferred in terms of loss allocation through the banking system, it used to be the banks shareholders, because they were incentivized to sort of wrap manage risks, they tended to cause much of the loss coming from the recession to take the form of reduced supply of credit for borrowers. Whereas with deposit insurance, basically that was mitigated to, to some extent, and now the losses become the bad incentive structures of banks coming from the bailout risks are now leading the banks to, to be more lax in their risk management and now leading to larger losses for society. So I, I would say if I, if you look at the balance between those and, and I think a lot of people agree with me about this, Jerry Caprio at the World Bank I know was advising countries on deposit insurance in the 1990s and trying to prevent the widespread, I'm putting words in his mouth, but I think I'm accurate that he saw it, I think correctly as protection wasn't worth it. That his protection tends to create larger social losses through this sort of subsidization of risk. And I think the lack of discipline has turned out to be a bad idea, but it's, you could see why it's motivated. I think people don't understand this. The real motive, I would say for deposit insurance, going back to Henry Stegel and those bankers, was to protect banks so that they could have, they could avoid the costly aspects to them of risk management. But that means that might sound like a good short term thing for the macro economy. But longer term for the macro economy, it does tend to mean more aggravated risks so that the history of deposit insurance has been, has meant that banking crises, that used to be situations where depositors suffered small losses and governments suffered no losses. Now we have situations where governments that are protecting banks sometimes suffer huge losses. You know, if you look at the 1990s in the E East Asian economies, I think Indonesia's cost to its government from its banking crisis in 19 97, 98 for something like 60% of GDP. And in Mexico it was 25% of GDP in 1995 in Chile, a similar number. So this is where if you looked at the, the depositor losses during the Great Depression in the us it's a number, like a couple percentage points of GDP, so that you got a huge credit crutch happening during the Great Depression. But the actual experienced losses from bank failures to depositors were very small as a percentage for GDP. But once you have the government protecting banks, those losses become much bigger. And that's what we've really seen that since the 1970s, we've had a pandemic, a banking crisis all over the world with extremely high losses. And I think that basically it's not worth it. The protection of banks is not ultimately the right answer. It's very hard to give it up politically, but because you just try to get rid of deposit insurance or you know, other kinds of bank bailout policies, it's very difficult to do politically. Politicians don't want to experience very sharp contractions of credit for one thing. And secondly, they tend to have a lot of borrowers as well as bankers are lobbying them for this kind of protection. So I think people have the, the politics of deposit insurance completely backwards. They think that it's all about depositors, actually I would say it's all about borrowers and bankers. That's why we've really got it. And it's, I think, not ultimately a good bark.

- So I, I would, I guess then just to ask, I, I mean, what, what does the optional banking system look like? You know, if we could sort of start from scratch, we, obviously, it's hard to remove politics from these things, but you know, I, I think there's obviously there, there's, there are trade-offs that, that are inherent in, in all of this. And you know, to some degree there's, you know, a desire to have what some might call riskless capitalism. We, we don't have any any bailouts, but at, at, sorry, we, we, we don't have any crises, any banking crises, but we, we essentially have all these, you know, sort of things like fed puts, you know, the almost a blanketed sort of insurance, even right now sort of post Silicon Valley Bank. It's not even clear sort of what the levels of deposit insurance really are. And so I'm just cu sort of curious, like, you know, at some level we, we could have a system where there's essentially no banking crises where the government sort of backstops the banking system, but you know, there's obviously a cost to that as well. And I mean, in your mind is an optimal banking system, sort of have some crises, you know, the odd banking failure here and there, you know, like I think Silicon Valley Bank certainly a preventable banking crisis in the sense that you had some risk managers that didn't know how to manage interest rate risk and you know, they had all these uninsured deposits. If, if they maybe understood how to manage interest rate risk that maybe wouldn't have happened. But at some level, you know, there's just inherent in lending, there's, there's always risk. And so, you know, obviously, you know, a systemic banking crisis is something I think that's, it's more desirable to be able to prevent, given that, you know, certainly how bad banking crises can be for the economy. But I'm curious, like what exactly does an optimal banking system look like with regard to its role in relationship to the state?

- Well, that's a a lot of difficult questions you're asking me. I guess the first thing I would say is you don't ever get rid of banking crises. You just postpone them So that if, if we decide, remember we had deposit insurance, pretty much a hundred percent deposit insurance for most savings and loans in the 1970s. And when interest rates go up, savings and loans initially become insolvent because of the interest rate increase because they had long duration assets. So they experienced very large losses on their mortgages and other assets, but then they became zombies because of deposit insurance. They weren't forced to shut down. So we had, we were living in a banking system of zombie savings and loans through the 1980s, and they, so yes, you could say there was no banking crisis, or you could say it there, the banking crisis had already happened and the banks were, those banks were insolvent. And then it wasn't until after the 1988 election that we got in the beginning of 1989, we finally dealt with the problem. So we got, we finally caused the savings loans to fail when we passed legislation in early 1989 to kind of, you know, deal with the whole problem. So we didn't avoid a banking crisis, we just took it from being something that was, would've been a kind of sudden thing that would've been observed at the time that interest rates went up. And we made it much worse because what did those banks do when they had that extra time after they were already insolvent? They took new risks to try to get a resurrection sort of strategy going, that is, okay, we're currently insolvent, the regulators aren't intervening. We'll take some risk on oil fields and shopping centers, f funding and other kinds of things. And then of course, that made the losses ultimately much bigger. So we, we did f finally end up shutting down a huge number of savings loans. We, so we did have a banking crisis that was revealed with lots of failures, but it happened, you know, a decade beyond when it should have, and the losses were much bigger as a result. So my first answer would be, you never get rid of these banking crises. What people find is that that phy pattern is actually quite typical. Din wrote some papers where he showed that after elections, that's when these unresolved overhang of failed zombie banks tend to be dealt with. And I want to emphasize the politicians are watching those banks doing continuing risk behavior, opting for resurrection, risk taking, taking on new risks. And ultimately they, they have to discipline them. By the way, I found that this pattern is true throughout the world, that when you increase the generosity of deposit insurance, it causes banks to take on more risk on their asset side and also to lever up as much as they can on their liability side. And that combination, of course tends to make the banking system much riskier. So actually you get more banking crises as a result of more generous deposit insurance. So what's the ideal banking system look like? Well, I, let me start with democracies because it's, you know, talking about autocracies, it's hard to have an ideal banking system in an autocracy because everything's kind of distorted and perverse in an autocracy. And the banking system is all part of that same perverse power allocation in, in the democracy. I think we could look at a country like Canada, certainly prior to Canada's decision to have some deposit insurance. It was an extremely stable banking system, very diversified portfolios of nationwide branch banks. They never had a banking crisis. They did have a few bank failures in their history, but Canada still has never had a banking crisis. That's quite interesting. I would say that they made a mistake in going for deposit insurance in the 1960s, I believe it was, but I don't think that it has undermined their overall stability, which I think is a testimony to the, the regulatory structure in Canada. But I would say that nationwide branch banking in a competitive model where there's a sufficient number of banks to compete with one another is really an ideal kind of banking system. You have to have good protections for the property rights of bank stockholders that allow bank to get their money back when they lend it. Those kinds of things really are very helpful, but free entry as much as possible. Competition and discipline.

- Just, I guess one, one quick question on, I guess on just Ken in the us so I guess your diagnosis, and I think this is, I think pretty, I think SAB well established, but the difference between why Canada had virtually no banking crises. There were a few bank failures, I think in the 18, early to mid 18 hundreds or something like that, before Canada was before Canada Federation in the 1860s. But the US had many banking crises throughout this time. And the argument there is that the US had very severe branching restrictions nationwide branch banking basically didn't exist, and so banks couldn't diversify risk across regions. And because of this, there were just more banking crises that were, were likely to happen. So you're that's you, you're on board with that?

- Oh yes. Well, if it wasn't just that you couldn't branch across state lines, which is true, you couldn't, but also in most states you couldn't branch even within states, which meant that banks had very local, single office banks with very local concentration of risk. So if you were in a place like Champagne or Bann Illinois, where if you go there today, you'll see pretty much two things, corn and soybeans as well as the university, but mainly corn and soybeans. And if you were in business in Champaign-Urbana, even if you were, let's say a mechanic or a plumber, you were basically still in the corn and soybean business because if corn and soybeans tanked, that meant the whole local economy tanked and the banks were lending effectively against corn and soybeans, even if they were lending to a merchant or whoever. And so what that means is that the bank portfolio was very versified, and of course the US was primarily an agricultural economy in the 19th century and early 20th century. So if you're looking at, you know, what, what is the riskiness of a banking system that has that kind of lack of diversification? It's, it's quite, quite great. But it wasn't just the lack of diversification, you know, we had tens of thousands sometimes at, at its peak of banks in the US and it was very hard for them to coordinate their behavior. That's another element of the Canadian system. So if you have just, let's say a dozen nationwide branching banks, then when a a, a problem arises where sometimes it's advantageous for the banks to coordinate. That happened in the early part of the 20th century. Twice the banks got together and said, well, here we are. We're all operating coincidentally through the whole country. What are we gonna do about the fact that there's been a market scare that's leading to the failure of one of our brother banks? And so in both of those cases, the Bank of Montreal led, believe it or not, a takeover of the failing bank with the costs being shared proportionally among the, the surviving banks. And the idea of this was by taking on the costs and sharing them, they basically made it clear that none of them would be insolvent as a result. So this was a great systemic risk resolution. So when the Canadian banks experienced some systemic risk, they were able to coordinate because there were only a dozen of them or less they could operate. They operated in the same territory, they watched each other, they knew each other's business practices, and they were willing to work together to solve problems. It's worth remembering, Canada didn't even get a central bank till 1935. So a lot of economists would say, well, you can't have a stable banking system without a central bank and deposit insurance and lots of other things. Canada, you know, it was very late to the game of those kinds of government interventions in the banking system. But the Bank of Montreal in coordinating with the other banks, was able to solve problems when they arose pretty well. Now, of course, that doesn't mean there weren't credit crunches in Canada. There were big credit crunches because when a recession shock at can Canada was even more of an agricultural economy than the us. So when, when macro shocks happened, that meant that there were contractions of credit precisely because the banks were managing their risks. So the Canadian banking system was very successful as a banking system, but it did it, that doesn't mean that it could avoid macroeconomic shocks affecting the supply of loans. So I think that this is something people really don't, don't get that a properly managed risk managing banking system is going to necessarily aggravate macroeconomic downturns. And if you try to prevent that, you'll make the losses bigger.

- So, so, okay, so, so I'm I'm with you. So like Bank Montreal sort of played this like def facto central banking role for a lot of Canada's history before the Bank of Canada was created in the 1930s. I, I guess similar to what jp, the role that JP Morgan played, I guess is sort of a private lender last resort, like it did in 1907, the 1907 crash, but it

- Was much more limited, John, because, you know, really what Morgan was able to do was mainly to prevent the, the failure of the New York Stock Exchange to coordinate bank behavior to keep the New York Stock Exchange running New York City banks. But New York City banks were small potatoes compared to the size of the overall banking system. They, they had to suspend convertibility in 1907. They couldn't coordinate to deal with a nationwide shock. They just were too small. But what they could do, what JP Morgan did manage to do was to help work together the New York City banks to, to keep the New York Stock Exchange going. But I think a lot of people think that, you know, have a misconception about how far reaching JP Morgan's influence was. He certainly was, you know, a very influential person in many, many ways. However, the US banking system at that time consisted of, gosh, I can't remember the amount, but there's more than 10,000 banks all located in a different location. You know, JP Morgan's one guy at the tip of the point of the pyramid of reserves in New York City, but he, he couldn't, through force of nature or great coordinating abilities, he couldn't prevent the nationwide suspension of convertibility.

- I, I guess even, even more recently, I guess you have, you know, the, the banks in 1997 got together and, and basically, you know, bailed out LTCM, long-term capital management. I mean, they met in the New York Fed headquarters, but I don't think there was any government assistance in involved in that. So I guess it's a, a bit similar sort of banks acting to, you know, promote stability in in the system. I, I just so you know, in the US Canada distinction, before we jump off that, you know, in 2008, the king banking system sort of did fair, I think, much better than the us What features there, institutional features do you think put Canada in better stead? Is it really more just this arc of history? The US still has tons of smaller banks because of this history of severe sort of branching restrictions that,

- But by, I mean, I think the difference was that the US of course, the US created the crisis through the subsidizing risk in real estate, in housing risk. And that was a politically driven subsidy where you just had a lot of mortgages that were just crappy and were crappy on purpose. If you tell people that you're not going to investigate the veracity of their mortgage application, you're gonna attract some fairly dodgy people to the mortgage market. And then you tell them they don't have to put down much of a down payment, if at all, some some zero down payment. So imagine if I told you, John, you look like a handsome young man. I'm gonna give you a mortgage wherever you'd like with zero down payment, and I'm not gonna check up on your income. That doesn't happen as a result of spontaneous greed that happens as a result of government interventions into the mortgage market that are driven by politics. And again, notice a common denominator, the politics of borrowers, the political influence of borrowers, in this case, housing borrowers, and this has now happened all over the world. Housing finance is extremely politically powerful all over the world, and we're getting a lot more risk taking, coming from the subsidization of housing finance all over the world. So I think the, you know, the US was in a different position because we were the source of the problem. Canada managed to avoid the worst of it because they weren't taking on these huge risks. So I think, you know, certainly two of our largest banks, bank of American, Citi Bank were insolvent, or, or in case of Citi, clearly it was insolvent, bank of America borderline insolvent, but this was related to fundamentals. There was no like panic, you know, out of the blue we get back to the diamond dimo, there was no, you know, like random co co coordination problem. No, it was that things were getting very bad and the banks were exposed to that risk. And if you had looked, if you just tracked the equity value of the banks for the year and a half prior to the crisis, you would've seen Citibank declining from about a 13% equity to asset ratio in market value terms to about a 2% by the time you get to 2%, which includes the value of the deposit insurance. By the way, that means the bank's effectively in solvent, even though on a book value of tangible asset basis, Citibank was showing almost a 12% capital ratio. So, so it, you know, again, you know, these aren't the mystical things. I mean, Canada was in a better position. It wasn't making all these mistakes. It wasn't the, the political bargain in Canada wasn't driving its largest banks to this, to the brink of disaster. Now, not all the US banks did it. JP Morgan Chase managed to avoid it. Wells managed to avoid it. So I think that's a also a really interesting question, and I think that what you're looking at there is also quality of management differences. So there's a lot to be said about why the US experienced this problem in Canada, didn't, but I I would come down to a combination of government incentives for extreme risk-taking, and in the worst cases, also bad managers. And what bad management means is they love to go on onto the sort of risk-taking bid because they, they don't have a, a inherently valuable franchise.

- So I wanna talk about, so, so I think we've covered sort of the cause of the 2008 financial crisis. I wanna talk, I guess just for a few minutes here about sort of the post 2008 aftermath, and what do you think about the financial reforms, St. Dodd-Frank and around the world, sort of Basel three tighter capital standards, you know, banks have to hold more equity on their balance sheet. Would you say that that's a good reform, something that you, you think is good? I mean, I'm curious what you think about some of the other pieces, like, you know, that sort of other balance sheet features, you know, the, I guess you could think about things like, for instance, central clearing of, of swaps, derivatives. Any thoughts on sort of SLR or some, some of the specifics of some of these capital standards that, that are now sort of being changed a little bit? Any, any thoughts, any thoughts on things that should have been done that, that weren't achieved? You know, I know John Taylor for a long time talked about reforming the bankruptcy act or the, the bankruptcy code in introducing sort of a chapter 14, a special sort of bankruptcy, chapter four bank, specifically, there's early liquidation authority, which is something introduced through Dodd-Frank. I'm curious, what do you think about the whole suite of financial regulatory reforms that came in after, after Dodd-Frank and, and after the gold financial crisis, the us

- Well, I, I wrote a, a small, a short book, sir, going through all of those reforms and pointing out why they were so bad and what would've been a, a serious alternative. So I, I guess what I would say is I was very much in favor of some reform. Let, let's start by just putting some things aside, like the Volker Act or a lot of the discussion about swaps. Some of those reforms might've made sense, but they had nothing to do with the crisis, and I didn't think most of them made sense on the Prudential side, really trying to bolster banks' condition by increasing capital and increasing cash assets. Now that made sense, but it wasn't done effectively. And again, as we point out in fragile by design, it was ineffective on purpose. So you have to kind of understand that what the political bargain of Dodd-Frank was all about was pretending to do something while doing exactly what you had done before. So it, it, it was a very ineffective set of reforms, as we've seen since then. I mean, imagine that we had Silicon Valley Bank that was borderline in solvent on, on a, if you just looked at their 10 K report, their public public document, you knew they were borderline insolvent, and yet the regulators were pretending that they were very well capitalized. So that just doesn't make any sense, right? If you wouldn't, if you're serious about bank prudential stability, you wouldn't act that way. So we know that our whole regulatory and supervisory system is unserious. So I, I could go through a lot of reforms that that would be much more effective. But what they would do is they would be more rules-based in using objective information about banks. So for example, banks wouldn't be able to have a market value of their equity that's close to zero and pretend that they had a very high ratio of equity to assets so that you'd use market information also about the loan portfolio. If the loan portfolio is charging huge high interest rates, let's just agree that that's probably because it, they're making a lot of risky loans, but we don't want to use the interest rates on loans as a measure of their riskiness. How crazy is that, right? We don't want to use the actual financial position of the bank in terms of its equity to asset ratio as information in the supervisory process. So these are not random mistakes. These are done on purpose to achieve the protection of banks and their borrowers and depends on the circumstances, which borrowers are being protected, which bankers are being protected. But, and I say that also, I had a year at the OCC as chief economist, by the way, I'm the last chief economist of the OCC, because after i, the experience of having me as chief economist, they abolished the position of chief economist because I guess they decided that having someone around who was constantly pointing out that the emperor has no clothes and you know, you guys are pretending this bank is fine, but you know, it isn't. And by the way, that's the truth. They know it isn't. And then behind closed doors, you'll, I'll say to them, you know, that bank's in trouble. Yes, but that bank's very politically powerful. That's the fact. Nobody likes to talk about it. The supervisors hate it. When I, when I speak the truth about it, by the way, I was on the, an advisory committee of the systemic risk board for the eu, probably even worse, right? The amount of political haggling and compromising, that's part of the supervisory process. So what we really need to do is figure out how to make the market kinds of information that's, that's really dependable and has proven itself to be dependable. How to bring that into the regulatory and supervisory process. And the reason the politicians don't wanna do it, and the supervisors and regulators don't wanna do it, is because they would lose control of the process. That is, the process might actually work. That's the last thing the politicians want. They wanna control the process. Why do we pretend that the book value of tangible capital is the measure of the health of a bank? Why do we pretend that? Because that's something we can control. So when we get that, we, we, we can control that and feel good about the fact that market pricing or perceptions or it gonna disturb our equilibrium. And I think this is, so whenever you, you hear someone like me, or like most financial economists actually who work on banking saying that we need to get market discipline back into the regulatory and supervisory process. Bankers are horrified, regulators are horrified, politicians are horrified because it might actually work. And so I'll be honest, and I'm sorry to depress everyone, I don't think there's much chance that this is gonna happen. The reason is because you'd need voters to be conscious of this and to care about it enough to push for it. If they actually created accountability for politicians, then it could happen. But voters are not that informed about this and they have other priorities. And so that is of course why special interests can get away with murder. And they do.

- So we've talked a bit about, you know, Dodd-Frank, fin reg on, you know, post gold financial crisis. I think it's hard not to talk about post financial crisis banking without talking about quantitative easing in some way. 'cause quantitative easing, you know, fundamentally changed the banking system in that, you know, we've shifted from a scarce reserve system to an ample reserve system. So much of the bank's assets now are no longer in things like, you know, treasury bills are now are reserves at, you know, the central bank or at the Fed, you know, certainly post COVID, many other central banks in the Bank of Canada sort of made that leap to expanded their balance sheets a lot with long-term asset SS some people, you know, and obviously the goal is, you know, and it makes sense, you know, certainly when you're at maybe the, the zero lower bound on short-term interest rates that you wanna lower long-term interest rates. And so central banks are, are you buying up long-term assets? Now, we're no longer at the zero lower bound and, and, you know, short-term interest rates have been above 0% for, for a good number of years now. Now I, I'm curious what you think about, you know, this ample reserve system that, that we're in. Certainly, you know, the Fed chair and nominee Ken Warsh has spoken quite a bit over the past 15 years about ending the ample reserve system and going back to, you know, pre 2008 scar system. What do you think about that idea? And

- I'm in support of it. I, I think it would be a very good idea and I wish we would do it, but I'm very skeptical that we're going to do it. So why aren't we gonna do it? First of all, the main, so, so what would it look take to make it happen? Basically announce that you're going to reduce the interest paid on reserves to zero over let's say a two or three year period. So you, you just take that interest rate down from its current market rate down to a zero rate forecastable slow, nice and gradual over three years, that will get you back to a scarce reserve system and a much smaller Fed balance sheet because banks will start laying off all of these excess reserves once they're not being remunerated, right? So it's not hard. What's the problem? Well, the problem is once banks start laying off all these treasuries, that that is not holding them at the Fed, not only the Fed balance sheet shrinks, but bank holdings of treasuries are going to go down as those bank and fed holdings of treasuries go down, that's gonna force up the yields on treasuries and the mortgage market will be the first place where you'll see higher interest rates. So the, the main political reason why this won't happen is the mortgage market, and it's pretty simple. So I would predict very, very boldly that Kevin Walsh will do very little, despite the fact that I like Kevin very much and I wish him well. And I know he's sincere. I think he'll end up doing little, because the political costs will be too great for the Fed to really push very hard. There. There's another point that makes it not, it's not a coincidence that we're standing at the precipice of a US fiscal crisis and our central bank is holding huge amounts of long-term government debt. That is, nobody wants to start seeing how the market, if the market non fed and non-banks who are kind of being pushed into it have to actually start buying government debt on a massive scale at a time when the US is at the, the precipice of a fiscal crisis. What's that gonna look like? So I, I don't think it's a coincidence either, that this is happening at a time when, if you look at the last 15 or 20 years, it's a time when the US government debt is B is, is is ballooning as a fraction of GDP. And we're on a binge, by the way, so is France, so are several other countries. We are looking at some very serious consequences of deficit spending that have accumulated over decades now. So I think the possibility that the Fed is going to shrink its balance sheet, driving up mortgage rates, forcing the private sector to have to evaluate whether it really wants to hold so much government debt at this particular moment, almost, IM impossible I think for the Fed to pull this off. And then of course, within five years, I'd say we'll be in a new equilibrium, the so-called fiscal dominance equilibrium, where as a result of the arithmetic, the Fed will, will be forced to monetize government deficits simply to avoid a government default on debt. And that will lead to a high inflation. So unless we curtail entitlement expenditures and defense expenditures or some combination of them, which are the elements that are growing Medicare, most importantly also social security and defense spending, unless we find a way to pull some or all of those back, we're looking at inflation rates that I would say will be at least 10% a year starting, let's say about five years from now. So for people your age, not my age, you guys are paying the bills, you're gonna pay the bills in terms of smaller benefits and hi and or higher inflation, people my age have been taking advantage of the entitlements and postponing the day of reckoning. And it's, it's really unconscionable. So I I'm, I'm sorry to be so pessimistic, but I, so far, I'm, I'm, I'm batting a thousand on pessimism. You're not gonna get any reforms of prudential bank regulation. You're gonna have a fiscal crisis, you're gonna have high inflation. You poor young people are gonna get fewer benefits and likely some inflation.

- Well, you know, it's, I I'm, I share your view. I think it's gonna, it's extremely difficult, I think to move back to a system of obs scarce reserves to move away from ample reserves. I mean, even when the fed's balance sheet was, you know, being decreased in 2019, we had the repo crisis, you know, the, the banking system is just dependent, heavily dependent on a system of, of, of interest paying reserves. That, and, and the whole sort of financial plumbing, the repo system and so forth is, is is dependent on it. I, I'm curious like, because this word gets thrown out a a lot and it's a term that's coined by Ron McKinnon in the late international economist who's a professor at Stanford. This is the, the term of financial repression, I think it gets thrown around a lot. I don't think there's actually a very good definition, but I think in general it's used to refer to when the sort of government represses interest rates for some reason. And certainly, you know, there are I think very clear instances of it in history, you know, regulation q you know, where that the governments have basically, you know, said the interest rates, the positive pay are gonna be zero. And and in part I think this is a subsidy of banks. Some people have called quantitative easing and I guess central bank, the existence of central bank intervention in the, you know, true term interest rate market. I in general, I guess you could maybe think of as, as financial repression, you know, yield curve control on the long end the Bank of Japan has been doing in recent years. I mean, what, what do you think, I mean you've studied, you know, global banking history over centuries. What do you think about financial repression? It's a term that comes up a lot now and is it important, is it something that we should still pay attention to? I mean, they ended req a long time ago, but are these things like QE and you know, maybe excessive central bank intervention in short term rates? Certainly, I guess if, if it's the case that we're in a new fiscally dominant equilibrium are is in your mind, is financial repression newly relevant in some way?

- Yes, it is. It is. So actually Ron McKinnon was a mentor of mine when I got my PhD at Stanford. And I think one of the great and maybe underappreciated economists of the 20th century and his focus on financial repression, I think was not just useful then, but useful now. So you raised one aspect of it having to do with the distorting interest rates. Often the in, in the interest of some political objective. I wanna mention another aspect of it. And that is requiring banks to maintain very high reserve ratios at zero interest against their deposits. So currently the, in the US we have a zero reserve requirement, but as I pointed out in a paper I wrote three years ago, which was published in the St. Louis Fed Review, once we hit the fiscal dominance point where the Fed has to monetize if we, if we don't get rid of do we have to do two things, both of which are in the power of the Federal Reserve Board, we need to get rid of all interest paid on reserves and we need to require banks to hold a lot of reserves. Now that means we're taxing the banking system because we're gonna require them to hold maybe 20%, let's say, of their deposits as reserves. That's not that unusual throughout the world. That would be unusual in the US though. But so what's the, why is that financial repression, because you're taxing the banks by telling them that 20% of the deposit funds are taking in they can't get any interest on. But the reason that will be irresistible to the Federal Reserve Board is simple arithmetic. If you don't do that, if you don't raise reserve requirements and get rid of interest payments on reserves, the implied inflation rate, if you don't change entitlements or defense spending at all the implied inflation rate in the us I know you're gonna think I'm smoking something is greater than 30% a year. If you tax the banking system and require the banks to hold something like 20% of their deposits as reserves, you, you cut that inflation rate by more than half. So you get the inflation rate down around 10 to 15%. Now that may sound horrible, but the point is the American public's gonna be very angry about inflation, but they'd be a lot angrier if the inflation rate were 30% than if it were 10%. So that the, where financial repression is McKinnon realized, where it always comes from is fiscal dominance always. It comes from the fact that governments who are looking for money look to the banking system because it's one of the easiest things to tax often because people don't even realize they're paying the tax, the depositors are paying the tax, but they don't realize it. So it'll, it'll trash our banking system to do it, but it's the political sort of path of least resistance. So I'm also worried that we're gonna have this kind of a shock to the banking system of financial repression once we hit the fiscal wall. And then we're going to have a, you know, an interesting moment where we have to figure out, do we want to have a chartered banking system that delivers for our economy, all the good features of, of financial intermediaries do, do we wanna do that? Do we wanna push everything into shadow banks that if you do, then that reduces even the reserve tax, right? It reserve reduces the tax base you get from repression. So it's gonna be a really tricky moment there because the path of least resistance is doing a little bit of back of the envelope arithmetic. You're looking at really high steady state inflation rates and combined with financial repression, combined with a sort of debilitating banking system, debilitating the banking system. So I wish I could be more positive, but I, I can't be, because this is what happens when a democracy loses its intergenerational balance where instead of planning on a balanced basis for current and future generations, the myopia of our political system has focused just on getting through to the next election. And it, it's, it's, I never would've guessed if you had asked me in the 1990s would the US go this far to basically, you know, a Ron McKinnon kind of remember Ron McKinnon's financial repression. Well, that was intended for Banana Republics as an analysis of Banana Republics. It's turning out that we're a Banana Republic. We can't plan for future generations.

- Well, I, and I'm, I'm with you. I mean, I, I sell you a lot of physical issues and, and a lot of my work is, is, and, and a lot of the work of many scholars at Ubers is very, very much focused on, on fiscal right now. I, before just, I guess one last question for you, and, and this is just on a very big topic right now in finra, and that's the issue of stable coins and whether they can offer yield or not. I mean, I guess you could in part see this as a fi repression sort of issue as well. You know, right now there's stable coin legislation that's going through Congress. There's the Genius Act that has passed last year. Basically the, the big point of contention right now that's being fought between the crypto firms and the banks are whether or not stable coins can offer yield or not. And the banks argue that stable coins will disintermediate the banking system. Stable coins argue that, you know, this is not a level of playing field or the firms argue it's not a level of playing field. What's your take on all this? I mean, at some level, I mean, do the banks sort of similarly like launch the same complaints when money market funds came around in the eighties and nineties and

- Exactly.

- Questions about whether they, they clearly didn't dis the banks. They're so round

- The incumbent banks will be disintermediated because they're, they're buggy whips, right? I mean they're, they're, they're a business model based on rent seeking and rent sharing of a regulated entity. That's part of a political bargain. And what's interesting about stable coins is that they are coming in and from the payment system standpoint, skimming the cream off off the incumbent banks and say, we can provide a better payment system, pay higher interest, clear, faster, clear and more interesting ways like combined messaging with, with clearing, we can do all this without any need for a systemic risk problem. There's a lot of, you know, what, what do the politicians say? Oh, this sounds so risky, risky, risky. It's risky to them because it could undermine their political bargain. And of course it's gonna disintermediate the banks. But what that might lead to, if, if we were doing this the right way, is modernizing bank charters to allow these narrow banks focusing just on payments without deposits using stable coins, focusing on bank lending funded mainly by market sources and starting to think about the unbundling of the banking system, which it's, there's no longer a need for these archaic structures that we're used to and the centralized clearing through fed wire and all that. This is not really needed anymore. It's not where we should be going. Of course, the political resistance is great, whether we can do it, and of course we should pay interest on stable coins. It was a, a ridiculous thing that the Genius Act prohibited it. And of course, even at the time they passed it, they already had designed this get around by paying the interest on the platforms instead, which I hope they'll continue. And yes, that will disintermediate the banks, but the solution is to get stable coins, to be banks, to get other kinds of banks to come into existence that will be part of a modern efficient consumer serving financial system. Now, of course, that's not very likely because you can't just re rescind the laws of politics. And these people are meeting in Washington. These bankers are meeting with your elected officials and other people's elected officials and trying to strike bargains every day. And the consumers whose, whose have so much at stake in this, are not sitting at that table. And that's the problem. So I hope that, you know, in the future we can solve all these problems somehow. You know, there, there was so much hope in the 1990s that the information age would make democracy smarter, would make voters smarter and more effective. Hasn't worked out that way.

- It's interesting. Yeah, just how, I guess I've long argued that I, I think stable coins should be treated like banks. So I I agree with you. I mean, it's interesting, I guess, you know, at some level, stable coins, narrow banks, which, you know, regulators have in, you know, in, in the banking industry have, have wanted to outlaw for and, and ban for quite some time. You know, I think Jimmy Macres tried to start the narrow bank a few years ago, and he's the former research director of the New York Fed, and he was sort of, you know, there was a massive regulatory barrier there. I mean, you also think back to like the, you know, the Chicago plan ideas, you know, of fully backed banks and, and narrow banks. I think the, the concept of it maybe comes out of that the Chicago plan or the idea that the banks should maybe hold, you know, a hundred percent treasuries or, or should only issue equity. I'm curious, I mean, if you have any other thoughts on, I guess reinventing.

- So in the, in the old days, you know, I I I have argued that this was a bad idea for a, for a traditional banking system because there really are synergies from bundling deposit taking and lending. But I don't think that's true anymore, or at least it's much, much reduced because of changes in technology. And I think that's why you're seeing FinTech firms are taking the form either of payment systems, stable coins especially, or new ideas and lending and those le and, and have very skinny balance sheets if they're lenders. They're not trying to, they can't, as non-banks, they can't fund themselves with deposits, but they can still operate, you know, so I think this is where we're heading, we're heading toward, yes, this stable coins will be basically narrow banks and then lenders are going to be entities that fund themselves with market debt primarily, and some equity. I think that's the system of the future. It's not what the banks want to hear.

- So it'll be just stable coins and non-bank lenders out there.

- No banks, I would say banks. No banks because, yeah, so I don't think you can get a, get rid of the idea that these need to be chartered banks, partly because even if a bank is operating without deposit accounts, it still will, there's going to be some advantage from being able to manage its risks by having access to the Fed. And so I think you're gonna see chartered lenders and chartered stablecoin providers who will both be new kinds of bank charters and, and especially on the lender side as they have to. So how, how are they gonna manage their business? They're gonna have working capital and securitization maybe. So the working capital needs to be funded with short-term debts, like commercial paper kind of things. And that means it's subject to rollover risks that can be very disruptive. So just like we had, remember we had a commercial paper crisis in 1970, the Penn Central Crisis, which the Fed intervened in. So the, the important thing to kind of realize is deposits aren't the only kind of short-term debt. And as we move to banks that are doing lending based on working capital to fund securitization, let's say, if that's the model, they'll pick that working capital will still create some systemic liquidity risk. And in fact, what we're seeing is the shadow banks right now are still relying hugely on the banks for lines of credit. Why? Because the banks have access to the Fed. So actually, you know, in terms of managing systemic liquidity risk, we're, we're still, I think, going to need chartered banks where the charter is basically making sure that the examination of what's going on is consistent with having access to ultimately a taxpayer funded discount window. So I think this is where it gets really interesting is the whole future of, of the charting of banks should change moving away from the incumbent bundled banks to allowing banks to be much more specialized.

- This has really been a fascinating conversation, Charlie, a real honor to have you on. Really fantastic talking about all things banking and your amazing career in contributions and finance and economics. Really wanna thank you for coming on.

- Thanks so much, John. Thanks for your great questions and for your patience.

- This is the Capital and Freedom the Train First Century podcast, an official podcast with the Hoover Institution Economic Policy working group where we talk about economics, markets, and public policy. I'm John Trevor, your host. Thanks so much for joining us.