Much Money, Little Capital, and Few Reforms: The 2023 Banking Turmoil

>> Steve Haber: Welcome everybody, I'm Steve Haber from the Hoover Institution and the Department of Political Science at Stanford. It is my distinct pleasure to share this session today on Much Money, Little Capital and fewer forms the 2023 banking turmoil Geneva Reports on the World Economy. So the Geneva Reports on the World Economy are a series of policy focused publications produced by the Center for Economic Policy Research in collaboration with the International Center for Monetary and Banking Studies.

The reports address pressing global economic issues with an emphasis on providing actionable policy insights. They're authored by leading economists and the reports are widely regarded as influential in shaping debates amongst academic policymakers and petitioners. Today we're very honored to have Stijn Claessens, who's going to be talking about a report that he played a key role and drafting.

Along with Ignazio Angeloni, Amit Seru, Sascha Steffen and Beatrice Weder di Mauro. This report, Much Money, Little Capital and Few Reforms, focuses on the state of global banking and financial markets 15 years after the 2008 financial crisis. It explores how the abundance of liquidity, low capital buffers and limited structural reforms have shaped vulnerabilities in the global financial system.

Focusing on the recent financial turmoil in the US And Europe that led to the failure of Silicon Valley Bank, First Republic and others in the US. Just as an aside here, I should have read your report before it even existed because I did have a lot of money in First Republic bank.

But as I short my wife just short, which is part of the problem, I think we're going to get to.

>> John Cochrane: Hey, you got bailed out and I got bailed out.

>> Steve Haber: Yes, that's what I thought I told my wife.

>> John Cochrane: Perfectly rational.

>> Steve Haber: Exactly, that's what I told her.

>> John Cochrane: And you knew you were gonna get bailed.

>> Steve Haber: Yes, exactly. Which is part of the problem coming out of the 2008 financial crisis. It's why in some sense that crisis didn't really fully end. Rather, it generated a set of responses that continues to make financial systems extremely vulnerable.

That's the subject of Much Money, Little Capital, Few Reforms. So the book has a, or the report has a policy-oriented perspective and the authors make recommendations to increase financial stability. We're going to have three speakers. So first, Stijn Claessens, former Senior Advisor of the Bank of International Settlements, who will present the findings and provide insights into global banking vulnerabilities and discuss some policy implications of the report.

Amit Seru, another author of the report and senior fellow at the Hoover Institution and professor at the Stanford Graduate School of Business. Who's going to discuss the factors that explain why the turmoil in the United States, what it was due to and what the policy implications might be.

And here I'm simply going to point out that before the Silicon Valley Bank and First Republic and other banks started to collapse, Amit had done some fundamental work showing the vulnerabilities of those banks and others. That became, I don't wana embarrass Amit here, but I believe it's the most downloaded paper ever in the history of SSRN.

So to say that it's had an impact would be to grossly understate the idea. Ross Levine, senior Fellow at the Hoover Institution, is going to provide remarks on the report. Ross is someone who needs no introduction other than to say that A, he's one of the world's most cited economists and B, a very good friend.

So here's how we're going to go. Stijn's going to start out and that he's going to talk for about 10, 15 minutes or so. Then Amit's going to speak, then Ross is going to speak. And before we give sign the floor, let me say that this program today is organized by the Hoover Prosperity Program, which is a new program that's sort of come into existence in the last year or so.

It is led by a group of senior fellows across, across many disciplines because Prosperity is something which many disciplines are interested in. So it includes colleagues from political science, economics, finance and classics. Ross and Amit play lead roles, as does Dan Kessler, Peter Henry, Josh Ober, Paola Sapienza and myself.

And thanks in particular to the team that supports this effort, Isabella Ismael at my left, Jovan Hammerquist and Sue Thompson. Stijn, the floor is yours.

>> Stijn Claessens: Thanks very much, Steven. Thanks very much for hosting us here, the Hoover crowd, it's a pleasure to present this report. I will speak to for a few minutes and then I'll hand it over to Amit basically to introduce the report.

So it's about the five authors that you already were told and it's the 27th version of this series. Now we also address an issue that has been tackled in many other ways. So when we started structuring the report, we really had to think hard about what added value it could give.

And really want to look a little bit more the underlying issues that were driving the problems that we saw in March 2023. So then stepping back and also being a little more quantitative, there was a lot of tal and a lot of laundry list of what went wrong and what were the causes.

We want to pinpoint a little bit more accurately where actually the trouble was coming from. So that, as a motivation we ended up with the title Much Money, Little Ccapital and Few Reform. That gives a little bit of a sense already where the problems are taking from a holistic point of view those worthy issues.

Too much money, too little capital and too much too little reforms. I should also remind you that this was a crisis that was not so small. I mean it went by and we were now still living through the aftermath of it. But if you look at the first little chart there, and it will give some more detail, in dollar terms 2023 adjusted inflation the crisis was large, maybe even as large as the SNL.

There was a lot more banks going on there but in dollar it was less than a GFC in 2008 but even not that different. So a big event in the US. Switzerland was the epicenter in Europe and a big event there. You see here some dignitaries as well as a banker sitting there on the Sunday after.

Afternoon for the crisis that was hitting that country. What I will do now is the report covers a lot, so we have quite a few that we could present. We're not gonna do all of that. So I hope you have a chance to read it later, but this is a big outline.

I'm gonna give you just a summary of what I will do in red, which is talk a little bit about a reminder of defense and I will talk about what we call failing to integrate monitoring and financial stability policy. So two elements that I will present, Amit in blue.

Color coding doesn't mean anything. Talking about the weaknesses in the US particular sense and why also supervision was a problem there and all both of us will talk about lessons and recommendations. So with that, we're skipping things, but that's for you to hopefully read. Reminder, very brief, you were here.

Actually, you were much closer than anybody of us. So you know very well what happened in the US and the high outflow speed. I wanna stress the contagion part, that was the risk that was really necessary. The interventions, that was very high. The European case is the Swiss credit, Swiss going under.

That was a debt that was long forewarned but never coming. If you look at the prices here in red and in gray is the price to book ratio. They start to deviate from the banking system in general in Europe somewhere in 2020, and then it really became a downward trajectory very rapidly and still a sudden debt in that March week.

Both large scale interventions were needed. We can talk about the numbers, but the Swiss case easier was about 20% of GDP in the US, of course, is systemic intervention.

>> John Cochrane: Could you comment? The risk of contagion was large, what do you mean by that?

>> Steve Haber: Risk of contagion in the sense that if the Sunday measures were not taken, there were a bunch of other banks that were at risk.

Amit will give you the more detail of who that might have been. Individual bank is not so much our focus, but there were a number that could have gone on there and that necessitated the intervention, at least in the eyes of the policymakers. Now, the outcome was the last two on this chart.

This is all indexed as of the weekend when things happened in terms of market prices or banks in US and Europe. The bottom two lines, the dotted lines, the very bottom one is the US above that is Europe recovered relatively within a year. So back to then, actually, the European banks recovered faster than the US banks and declined also less.

The economy, we don't have a good measure. I'm looking at the S&P and the Europe equivalent measure, we know the index has gone up and even more so. So you could argue low economic cost in the short run. The short one is not always the long one, of course.

And this is also the more so and this will finish a little bit that the banking reforms, while there were a head of other areas of finance, we're still having quite a few delays. And if you think of Europe where you combine the EU as a common rule book for the whole continent and then the UK and Switzerland kinda follow in step and compare that also with US, there were some delays.

The one way to show that easily is to take this dashboard that the Basel Committee puts out every September. September 23rd was still more or less the pre-crisis situation. Not much has caught up at that time. If you look at the four columns on the right and blanking out Turkey, you basically talk about Europe, Switzerland, UK, US, and the EU.

They were all in yellow. It's a traffic light system, right? So they were in the middle. They had published regulations, but not yet adopted them. They were still in draft. So that was not a good sign at that point, it was particularly on the capital, very weak. That's where the most yellow was.

Fast forward, last fall 2024, this after report came out, we got this update. The US is now in some sense falling behind. They have more things in yellow still than all the other countries that have adopted now regulations and published them. So none of them is perfect, the four would be the score you want.

So we have some questions here still on the reform side as well. With that as an introduction, we're gonna pass to Amit and I'll come back on the world of monetary policy after Amit has spoken.

>> Amit Seru: Thank you, Stijn. So I think the way we are doing this because it's recorded live is we're gonna give the whole overview and then there's gonna be a Q&A, because otherwise it's all live.

And so in case I am rushing, that's the reason, all right? So thanks Stijn. And so he'll talk more about the monetary policy part of the recommendation. I'm gonna focus more on the US side and some recommendations that might emerge from this. So everybody remembers March 2023, Silicon Valley Bank fails.

High interest rates lead to large unrealized losses. Depositors line up, unrealized losses become realized. And the question is, is SVB unique? Is it an outlier like regulators said then? Maybe some still say, turns out if you look at the entire banking system, there's a lot of similarity. What's the entire banking system look like?

Here is what it looks like. Very similar to what SVB is, but at a much larger scale. So on the asset side, at the time when interest rates hiked, we are talking about $24 trillion of assets spread across securities, loans and so on. And on the liability side, you have deposits, not just insured deposits, that's 9 trillion of them, but $9 trillion of uninsured deposits and equity of 2 trillion, which I'll come to many times in this talk.

So as the rates rose, value of long dated securities fell and long dated assets fell. So much so that the unrealized losses in the banking system were of the order of 2 trillion. And we call this turbulence, because it was not just affecting one bank. These were 2 trillion, and this number is interesting for two reasons.

One, I told you that the total equity in the system was 2 trillion. So that tells you it can't be just SVB, right, off the bat. But also, if you look at where this was and which assets these losses was in, it was very peculiar, because if you looked at the 2007, 8 crisis, it was mainly in illiquid assets.

Here, 60% of the losses are in liquid securities, treasuries, RMBS, backed by Freddie Fannie and so on. Yes, there are loans, which we could actually reprice based on the interest schedule and so on. And we do that, and that's those $2 trillion of losses. But this is 60% in liquid securities and this is no credit risk.

So was SVB unique in terms of losses? You can already tell the answer is no. But if you really wanted a visual picture, this is the distribution of losses, x axis, how many losses relative to assets. And all the banks in the system, there is 4,800 of them, the dotted vertical line is SVB.

You can see that there are about 500 banks which are more affected in terms of unrealized losses than svb. So SVB is not unique on this margin. Maybe it's the case that SVB decided not to hedge and others were quite hedged. Turns out you can look at hedging in the system, there are two snapshots here.

The lighter picture is before monetary tightening and the darker picture is after monetary tightening. On the x axis is duration. That's a short form of saying, are you exposed to interest rate risk? If this number is close to zero, you are hedging and you're not. But if this number is positive, you are taking a huge amount of interest rate risk and you're not hedged.

Turned out that SVV was somewhere in the middle. Interestingly, banks decided to hedge less as the interest rates rose. I'll come back to this later, but clearly it was not that SPV was unique because some banks were hedging and they didn't care about the losses. Maybe it was because other banks had a lot of equity capital which would absorb the losses and that's why SVB stood out.

Well, that's not it either because as I will show you, if you look at the equity in the system, all the banks pretty much have the same leverage, which means they have the same kind of equity. And if you just looked at equity, SVB doesn't stand apart. So that's not it either.

So what is it now, after the fact? This is something that many people have commented on, but we were looking into this for some time, which is you need to understand the structure of the liabilities here. And what matters really is how many uninsured deposits do you have as a proportion of total liability that you have.

So how much is your uninsured leverage? Why? Because uninsured deposits, well, have the maximal incentives to run because they are not insured. So we call this the flight risk. And the question was, how much of this is in the system? A reminder, we have $9 trillion of uninsured deposits in the system.

So was SVB unique on this margin? Well, we can again plot the distribution of the entire 4,800 banks. And you can see the vertical line is where SVB is. So, yes, it was an outlier when it came to uninsured leverage, but also not the only one. So what did we then do?

We combined this flight risk, which is how much spooky depositors you have, with turbulence, which is how much mark to market losses you have. And put it all out there and try to understand when is it that we are gonna see some kind of losses and runs like SVB.

So our insight really was when the interest rates are high, as a result you will have a lot of uninsured mark to market unrealized losses. If you have long dated assets, if you don't have enough equity in your system, in a bank because you can't absorb losses then.

And if you have a lot of spooky depositors, uninsured deposits, you might end up with a bad equilibrium or run equilibrium which is different than the other equilibrium that people usually talk about, the good equilibrium. What is the good equilibrium? Well, depositors, there's a franchise value, depositors are sleepy.

So if there are losses in banks, they just absorb it because they're sleepy. In this case, if you have spooky depositors, we posited that you might end up with a solvency run equilibrium where enough uninsured depositors will force you to liquidate your assets and as a result unrealized losses become realized losses and trigger a self fulfilling prophecy.

So what did we do with this? We said, okay, SVB is clearly not unique. We can get a sense, but can we be a bit more precise on how much of the banking system might be affected? So here is what we then did. We took this idea and we put turbulence, which is mark to market losses, low versus high on one axis.

And spookiness, which is how many uninsured depositors you have on the x axis, and ask the question how many potentially insolvent banks might be there? Now that's going to be a function of how many uninsured depositors we think are going to run. So there are going to be different scenarios one can simulate.

And in each of these scenarios we can ask, given some losses, mark to market losses, if we were to pay the uninsured depositors that we are choosing to in that scenario, would we make payments available for all of our insured depositors? And if we wouldn't, we call that as potentially insolvent bank.

Remember, there are 4,800 banks. So what I'm gonna show you is each dot which is potentially insolvent bank under a certain scenario of uninsured depositors running. Each size of the bank is going to be represented by the size of the dot, okay? So these are the potentially insolvent banks in the system.

There is SVB, high losses, high risk, but it's not alone. Under the scenario simulated here, there is a bunch of other banks in there. The largest blob that you see is a G sip by the way, it's bank of America, which still continues to be in the news.

If you saw yesterday, it's still doing what we said it would do. So SVB is not unique again. So yes, there is SVB, but there are so many others. This is all just taking interest rate risk into account. And we are talking about roughly 300 banks which are potentially insolvent or at risk of runs that we found.

This was before we decided to backstop everything, and I'll get to that shortly. Now, I haven't talked at all about credit risk. If you think about 2000, 2007 crisis that was all about subprime housing assets, credit risk mattering, we could easily do it. And we do that in the report, we sort of figure what is the additional insolvency you would get if you had some credit losses as well.

And the asset class that has been talked about quite a bit is commercial real estate. Why? Because a lot of it is facing refinancing risk, rates are high. They had financed earlier a low rate, they are gonna face huge pressure. The value of the office buildings and such is down because people are working from home.

Interest rates are high, so value of these properties is low. All of these things are pushing us towards a reasonably high delinquency level. And then given some recovery estimates from the previous crisis, we can ask how many additional banks would go insolvent over and above the 300 that I showed you?

And we kind of do that under that scenario. So on the X axis is different scenarios of CRE default, commercial real estate default. And ask what is the additional number of banks that would go under? So we are talking about the 50 banks in the middle part of the distribution in the US which would also be all insolvent.

So that's the situation, and you can ask, so what about regulators? The problem is that there's a way in which we fight the last war always, we have hammers. Everything looks like nail. Last crisis was about credit risk driven by liquidity. So we went after that, how do I know?

You can look at reports after reports after report. And they mentioned liquidity as the reason why we were seeing SVB and other things. And if liquidity is the reason, that's the wrong diagnosis. So not a surprise you have wrong policies. After SVB, we decided to give more money to First Republic to other banks.

But yet the banks kept failing because the fundamental problem was insolvency, not liquidity. Was there anything else going on? Of course there is the issue of bad management, board of directors and so on. We don't do a lot in the report, but there is a little bit which suggests that banks and their management, and their governance was probably responding to whatever incentives we posed for them.

Here is one way of looking at it. I already spoke a little bit about hedging, that banks were not hedging enough. If you look into the data, there is a lot more going on, which is quite interesting. We allow banks in the US to classify their securities as for sale.

If we think this is pretty liquid and something that we are going to buy and sell versus hold to maturity, which is kind of illiquid, kind of something that we are going to hold for a long duration. And why do we allow that? Because if there are market forces and market volatility is there, we want to shield the banks from that and that seems very reasonable.

Turns out if you look at what the banks were doing over the years on the Y axis and on the X axis is in amounts. You can look at the proportion of securities they had in for sale, red and hold to maturity blue. And as monetary tightening happened around 2022 down, you can see that the red bars are becoming smaller and the blue bars are becoming more.

Maybe you're saying, well, I'm not exactly seeing it. Okay, so here is one other way of doing it, which is let's just talk about total money that securities that were getting transferred from AFS bucket to HTM bucket. And you can see a huge change, almost a trillion dollars worth of securities moving from one bucket to the other.

You might say, well, does this matter? Well, we can do the same kind of loss calculation for these things. And if you do that and compare it, what amount of equity capital do these banks have? It's a pretty big number. Okay, so here is one simple way of doing it.

On the left y-axis is how many losses are in securities which are transferred from AFS to HTM category. And the y-axis on the right hand side is how much equity capital do I have in these banks? Maroon line. So Maroon line is telling you, well, okay, equity capital is what it is.

But the losses as I tighten my monetary policy spiked, went quite high, 160, 170 billion. That's about 20% of equity capital wiped off just with these securities. I'm not even talking about other assets. So there was a lot of issues with this going on. Is that it? Well, there is also the political economy of regulation and the design of regulation that we sort of speak about in the report.

So what is that? Well, the idea that if you have a lot of fragmentation in regulation or supervision, where you have multiple regulators looking at the same thing with different incentives, that injects sluggishness and inconsistency in the system. Now turns out one of the big things regulators do for banks, from First Republic to SVB to Citibank to JP Morgan is this thing called Camel's rating that they give them.

What is Camel's rating on each of these dimensions? You give a score one to five, one is great, five not so good. And you can see some of these will have more discretion with the regulator, some less like management quality. What does that really mean? But we construct a composite score out of it called Camels and give a score 1 to 5.

This gives you everything as a bank from how much deposit insurance you will pay to whether you'll be allowed to expand what you are allowed to do, what you're not allowed to do. And why am I sort of mentioning this? Because for a large number of banks in the US system, almost 80%, they are regulated by state regulators and federal regulators in rotation.

So fragmented responsibilities, potentially different incentives, leads to a lot of sluggishness and inconsistency. And we have an experiment to sort of demonstrate this. A bunch of banks in rotation regulated by states and fed. So we have Camel's ratings for these banks. We can look at the Camels rating for the same bank virtually at the same time.

What are states versus Fed doing to these things? So that's what I'm sort of showing you here. On the x-axis is when states and Fed come in, states are white, Fed are gray, one after the other, that's how rotation works. On the y-axis is Camel's rating. Remember, a higher score means tougher.

So what happens when states come in white spells? They lower the Camels rating, they are nice to banks. When Feds come in the gray bars, they are tougher to the same bank. Camels rating go up and when states come in, they again lower the ratings. And especially so if the local economy is not doing very well.

Now, does this really matter, all of this stuff? Well, we could ask this in the context of the picture that I showed you before with some different color coding of potentially insolvent banks in the system. I showed you this before, now I have color coded it. And the red here is all the rotating banks.

And I can't tell, but visually it seems to me there's a lot of rotating stuff which is leading to a lot of problems from SBB to First Republic and so on. That doesn't mean Bank of America doesn't have a problem. But that's a separate story that I'm not sure we get into in this report.

All right, so now what? Because this connects with some of the policy, Stijn is gonna talk about, monetary policy. But let me just say a few things that we talk about in terms of policy. If you look at what we did in the US we gave a bunch of explicit and implicit support from the government, but losses remain.

There's a lot of insolvency, which means equity is underwater. What happens when equity is underwater, and you give a free amount of money? We teach this to our MBA students five times the week and five times on the weekend. Here is what we teach them. We talk about the S&L crisis.

What happened? During then, interest rates went up, a lot of banks became underwater. That is the lower part of this picture, but that's when we look back and look at the entire losses. That's not where all the losses were. The big part of the losses were when banks started getting free money or government support from mid-80s, early-80s, they started gambling for resurrection and taking risky bets, bad assets, which is where we are.

So what do we do? Well, there are two things we talk about. One in the short run, medium run, and one in the long run. So if you remember the bank balance sheet, it looks like this. The issue is right now that we have a bunch of insolvent banks which should be closed.

And then there is a bunch of illiquid but potentially solvent banks, but they are all clubbed together. So what do you do? Well, we need some kind of a market test. And one market test to do it is to ask banks to go out and raise some private money.

One thing could be equity. So with a bunch of colleagues mentioned in the report, some at the GSB, we sort of did some calculation. If you look at the amount of private money in the system versus how much would be needed to recapitalize banks, which are illiquid but solvent.

The answer is we are talking about about 200 billion to 400 billion to get the banks out of this mess in the short to medium run. Now, that's something that's always politically challenging and we'll talk about why, but that's clearly a recommendation that we sort of talk about.

The bigger issue is what about the longer run? I think in the longer run, we keep revisiting this because the fundamental issue in. All of this is the issue of bank leverage, the fact that banks have a high leverage. So this is size of the banks, 4,800 of them on the x-axis and the leverage debt to assets on the y-axis.

I don't know what you see, but it just seems like everyone has the same leverage and it's pretty high. So not a surprise if there are small shocks, credit shocks, interest rate shocks, you see a lot of runs. What's the way out? Like I said, with solvency run, for any run you need more equity capital to absorb losses.

So in the longer run that's where we need to go. But we keep hearing that if we have a lot of equity capital, maybe banking services will not be provided. We have a natural experiment now in private credit and even before in the consumer and other credit space with non-banks or shadow banks, which are non depository institutions, so their entire funding is uninsured debt.

What kind of capital structure do they have? Here is a $12 trillion mortgage market and non banks in the space and what kind of leverage they have. You can see this is line is well below the banks. So that tells you it has more equity, especially in this range which is where all the potentially insolvent banks are by the way, which I sort of mentioned earlier.

So non-banks are already providing services at a much higher equity, which is where I think we need to go if we need to sort of come out of this. So let me end, we have a way to keep regulation simple here towards financial stability. Banks need to eventually have high equity, we know they can provide banking services with this change.

Why do I say this? Because a substantial part of the private market, non-bank is already doing so. So thank you, back to you Stijn.

>> Stijn Claessens: Thanks Amit. So we're gonna go back to the monetary policy. So the title has three elements, like I said, money, and we just talked about too little capital and I mentioned there was too little reforms.

I'm gonna expand a little bit on monetary policy, what the role was in creating this crisis. And by the way, monetary policy was not mentioned in the report that Michael Barr wrote at all. So capital solvency was mentioned once, but monetary policy not at all. And we do think there is an causal relationship here.

If you just look at the US in terms of the old-fashioned monetary aggregates this year, M1 and M2, the US doesn't produce M3 anymore, doesn't publish M3 anymore. And you see that the period of the shock when there was a lot of QE and a lot of asset purchases was very much an outlier in terms of the monetary aggregates.

So the total amount of M1 grew at a rate of 70% in that period. And it was QE infinity of course during the March to at the end of the year period in 2020. So a big shock in quantities wise and just to compare, the US stood out.

We do the comparison here with Europe where we didn't have the same asset purchases. We did have an increase there as well, but not of the same magnitude in the euro context. So a big shock for the US monetary system was justified arguably for the COVID problem, but it did create a lot of problems for the banks the same time.

And just again, to make the comparison, the interest rate policies between the US and euro area also varied a little bit. So let's look at euro first. The euro area had continuously a declining rate because they were still on the negative and continuously lowering the negative rate below zero.

In some sense, the depositor in euro land did not know where the rate was gonna go even eventually. They never had a formal statement that we're gonna bound it at some point to minus whatever. Now, look at the US. The US in some sense had more volatility because there was a period between 17 and 19 where the rates were being raised.

And there was always an explicit lower bound because the US always said because of the money market funds and otherwise that we're not gonna go below zero. Why I'm making these points on the interest rate, well, it affected money demand to some extent. So in your area, money demand was becoming less because you had the negative rates, whereas in the US you still had the potential for an upside on the interest rate.

So that kept monies to some extent in the bank from the depositors point of view. Nevertheless, there was a large shock, as I mentioned, to all of the aggregates. I had M1, M3, with both demand and supply components. And so QE was increasing, as I said, the reserves and deposits because the purchases were from non-banks, which means that the banks have to end up with more deposits when the Fed buys these securities.

That also meant more liquidity dependence among the banks. So dependence means that they were less actively managing their liquidity, because they had lots of them floating around. It also meant that they could not in some sense manage the demand towards longer dated deposits because the term spread was simply too low.

Take your own case, whether you are putting money away for six months or a year or zero, there was no difference because you didn't get any interest regardless. So both effects were arguably stronger in the US given what I mentioned on the ELB as well. And the banks on aggregate could not control in some sense the flows.

This is basic monetary aggregate, how you do monetary policy. The system has to absorb all the reserves that are being created by the central bank and somebody has to hold them in the sense of a bank. And the banks could not, as I said, determine the funding structure.

So for many banks it ended up being basically the question where do I park the funds that have been thrown at me, to use that term. Now this is a very simple comparison. You take the flow of funds, the financial accounts of the US and you ask yourself, going from left to right, where the deposits that were growing so fast because of QE ended up.

They were accompanied by a slight increase higher than total assets. So maybe equity went up a little bit, but that wasn't very much. In the end a lot went to securities of which treasury and agency were the majority of it. So that's where the point of Amit, in the individual balance sheets of the banks that shows up in the aggregate, of course as well.

A little bit or a lot of it in cash, central bank reserves, that was not a problem. It was liquid and of course redeemable easily. But in terms of overall magnitudes, the relative percentage increases, which is the line here that I'm highlighting in the yellow bars in the yellow circles, was very, very high on both the security side.

So this is the 50% increase for the system as a whole in that two year period from 19 to 21 when we had the COVID expansion a lot absorbed for the banking system. The tide turns around moving into the period of not QT yet, but an increase in interest rate in 2122.

We see then consequently also somewhat of a decline in deposits not yet a QT period. And we see the decline on the treasury side to some extent. But that was the shock that had to be absorbed. It was a lot smaller shock as a percentage wise than the earlier shock that we had seen for the banking system as well.

Banking system as well is not individual banks. Then we go to the three banks that have been highlighted in the report and let me discuss as well. One thing to add here, they grew very fast too. It was both that had risky structures, which is the deposit ratio, uninsured ones and the security portfolio losses that they end up with.

But the growth also was a big concern for these individual banks given that they simply couldn't manage that very well. So what we then ended up here on the policy side, we're basically saying we need to integrate, particularly as a central bank that does both monetary policy and supervision.

The financial stability dimensions of monetary policy. You can use monetary records, we sometimes tend to discard them post-inflation targeting and the like. But they're still useful to inform us about those risks. And you need to coordinate better with financial stability. And coordinating is sometimes a loaded word, it really doesn't mean that monetary policy and financial stability should make these decisions jointly.

They should let each other know of what they're doing, obviously. But they should also integrate analysis accordingly. So here we have a number of specific recommendations. Analyzer spillovers better, you say that's a basic thing. Well, it doesn't happen necessarily on a high frequency or an intense enough basis.

That means improving the staffing and rotating people between various divisions. Think hard, but conventional but also unconventional monetary policy does to financial stability. An easy thing that could have been done is the interest rate risk scenarios. For most of the stress tests in the US, actually for all, there was never an increase in interest rate.

Assumed with the philosophy that if we were to have stresses, that would always lead us to lower the interest rate. So we would never have a situation in which we have stress and ended up raising the interest rates. The Europeans were doing somewhat better, but still it needs to be done more frequently, more often.

And this is maybe the more controversial part of it. You can think of how you adjust your monetary policy strategy and even your path keeping consistent with price stability in mind, given those financial stability risks. So those are the policy recommendations, there's a lot more, I mean we can talk about it in the discussion.

We have things on resolution, we have a lot on the European banking system. This is not performing well in a more structural franchise sense. The market value of those banks are much below what you can find in the US. And as I said, we're talking also about resolution in terms of what needs to be done post-credit Suisse, what could have been done and what should be done going forward.

But let me stop here.

>> Steve Haber: Ross Levine, the floor is yours.

>> Ross Levine: So this is an extraordinary report. It fully accomplishes its goals, which is to analyze the 2023 turmoil in the banking system, mostly in the US, but in Europe as well. And to dig deep, not just on the superficial issues, and to then come up with actionable policy recommendations.

It provides enormous amount of empirical evidence, and I really don't have any issues with the analyses in the report or its recommendations. It's hard hitting, it's diplomatic, and I'll come back to that. But it offers a very critical assessment of authorities in the United States and Europe. So the report is both comprehensive and substantive.

And so I'm gonna tell three stories, one a comedy, one a tragedy, and one a horror story. And raise some questions for the authors that I've spoken with them about, for Hofstein, over the 30 years, and Amit, over 30 months. So the first story goes back to November 2021, when I came here for a recruiting dinner and presentation and I was out to dinner with Amit.

So again, this is November 2021, and we got into a discussion of, somebody asked me, so what do you think is gonna happen to monetary policy? And I said, well, by then it had been six, nine months and Larry Summers had said they had to increase rates. And it's, yeah, they have to increase rates cuz inflation is picking up.

And Amit, who's doing a variety of detailed work on banking said, no way, they raise interest rates because of duration risk. They raise interest rates, the value of the bank's liabilities and Treasury securities is gonna go down and they'll be insolvent. And I said, no, the central bankers are defined in terms of inflation, they're gonna raise interest rates.

And of course, we were both right. For an economist, that's comedy. So one lesson from this is that, and the one that they take in their report is, and I'm gonna redo this. Because it says, competencies of committee members and other decision-makers need to include skills in both monetary policy and financial stability and their interactions.

Now, when I read this, I cracked up because the competencies that we're talking about is the understanding that if you increase interest rates, the value of bonds goes down. And then it says, also we need greater integration, which means that the people doing monetary policy and financial policy need to communicate with each other.

Well, these happen to be the same people on the same floor of a single building. And so the question is that, well, one, recommendation is we can train the authorities in terms of duration risk. Which when I taught money in banking, you had to know by the fourth week, or you literally, you couldn't continue with the class.

And maybe we have to have box lunches for the people on the Federal Open Market Committee and the other authorities to talk to each other. Now, again, it's funny and it's sarcastic and it's not the tone that one should take in a report, but it makes me concerned.

And the question is, can we really expect this institution to deal with anything more complicated? Like cryptocurrencies, non-bank financial intermediaries, the links with all of the things that can come up more politely. How does supervisory and regulatory capacity affect your recommendations, if I'm trying to put on my inner diplomat?

Okay, the next one is more of a tragedy. So when I worked at the World Bank, one of the things that I did was I had to read through the history of banking missions to many countries. And one would get the following type of tragic story. There would be a banking crisis.

World Bank team would go in, there would be a report on strengthening supervision and regulation. This would typically come with a checklist of the supervisors and regulators to do. There would be a follow-up analysis suggesting that they implemented many but not all of the checklist. There would be a crisis, another World Bank team would go in.

Another, more complicated checklist would be designed. Now, this report, I truly believe if these recommendations had been implemented, the probability of a crisis in the US and the failure credit system would have been diminished. The analyses are incredibly impressive. I guess the question is, is this whole tragic fragility, is it fragile by design?

Purposely using the title of a book by Steve Haber and Charlie Calamiris where this system of a fragile fragility is there for a purpose because it benefits certain constituencies that ultimately make these policies. And so, I guess it's definitely outside the scope, the paper accomplishes its goal. But there is an element of given the political economy, are things going to be improved?

Is there any capacity to deal with something that doesn't reflect what happened and the general risks that might ensue? And my next story is horror. And the story here is a paper written by the former head of bank supervision regulation in Spain. And he wrote a paper that's sort of a cult piece for people of my demographic.

And it was a guy named Aristobulo the One, and he has the title of the paper, which is maybe one of the great titles of financial regulatory paper, which is From Good Bankers to Bad. And the story here is that, it's not so much that you have good bankers and bad bankers.

Is what you have are incentives, and you could have a great banker. And then, if you change the incentives that they face because of insolvency, the incentives will then turn to taking on excessive risk. Or if you have very, very large insurance of liabilities, you will have incentives to take on a lot of risk.

If you give them options contracts for a variety of reasons to take on excessive risks, those really good bankers will do exactly that. And so, one view of the need to avoid the horror of this transformative Frankensteinian transformation to excessive risk taking is capital. And it's hard to argue, except I'm going to raise a question, is that is capital enough to shape incentives?

And so do we also need to focus on governance and ownership structure? And so I think that it's a natural response is that if you have large enough equity base, then the equity holders will put pressure on the board of directors in order to alter the incentives of the bankers.

My concern is, especially in the US we have incredibly diffuse shareholdings in banks, oftentimes running through money market or mutual funds, is there really going to be that type of governance? So to put it differently, when I've spoken to regulators over the years since the crisis, and I ask.

So if a banker, I say a decision maker, you can choose whoever you want to name as the decision maker in a bank. If this decision maker takes on excessive risk and the bank fails, will the decision maker in that bank lose his or her house? And I don't mean that his or her house, but lose a lot of their personal wealth?

And the answer is for all major banks in the US, no, you could ask another question. Has any supervisor or regulator lost their jobs? For what happened in SVB, and these are the level of incompetency is simply staggering. And again, I think the answer is no. And so this raises a question of going forward, will the increase in capital, regulations and other things be enough to prevent or reduce excessive risk taking in a world where I think it's really unlikely that governments can credibly reduce the safety net?

So if you can't reduce the safety net, what is going to be the mechanism to reduce moral hazard in the banking system? That's really my ultimate question. And just as a final note of concern, I think we're about to start 2008 all over again. We are going to deregulate banking without changing the incentives of bankers.

And it could become very, very ugly in the next five years. That's it.

>> Steve Haber: Let me give the floor back to Stijn and Amit, if they would like to say some words in response to Ross's comments.

>> Stijn Claessens: Thanks very much Ross, very good points, not easy. So let me take a few and then pass it back to Amit.

Time horizons play a big role in terms of making this integration of monetary financial stability more difficult, right? So in the short run, you're always better off prioritizing monetary policy and then economic and price stability. And then that leads financials stability to be like okay, every quarter they come to the board of the bank, central bank and then may discuss it.

But then, it's we put aside, and then we go back to it. And then the techniques also that we have, they're still fuzzier on the financial stability side. So for better or worse, we have a certain paradigm in mind, inflation targeting, etc. And people can debate on the base of numbers where you want to go, but on financial stability it's a lot less obvious.

So our point is to try to reduce those tensions that exist inherently. I think some tools have been developed like growth at risk is something where the monetary policy guys can also sometimes think about risk in a more integrated fashion if you include financial stability. I think skill sets are not irrelevant.

Now you can say, okay, the monetary policy people can learn financial stability and duration. They only need to know the basics, you'll be surprised. I've had discussions with people who you know very well, and who were directors in international institutions as well, about basic finance things that are intended to push aside, right?

You were at the World Bank. Stan Fisher was presented with a proposal for a world development report a minute long and Stan said, yeah, why would we talk about finance? We don't have any crisis in emerging markets. And then, mid-Neil Long, who was a big name in finance, if you don't know him, said, listen, this is my list of 30 crisis in emerging markets the last 10 years.

And this is the cost that came along with it. I think we should write something on this. So this concept, some people are stuck. I'm not going to go into the DSG world because that's even more difficult constraint on this. Let me skip maybe this the second one, fragile by design.

I think fragility is not necessarily given for every country forever, right? So, is Canada perfect? No, but it has how many crisis has it had? Very few if any. So it can be done. What's the secret sauce? Steve will tell us maybe again what he wrote in his book with Charlie.

On your last point, I think the two forms of government, internal governance. How do you manage the manager so to speak, and then what the shareholders and other stakeholders can do to overall change the firm. I think we need to do a lot more on the, call it internal governance, but that kind of agency issues where the manager can get away with murder, not in that little sense.

But in the other sense and doesn't lose his house but doesn't even get claw backs on his compensation, there's no penalty whatsoever. So, if you don't tackle those kind of issues, we're not gonna get to the core of the risk taking which is behind it. But it's a risk taking a more complicated way cuz it's also sometimes systemic, right?

So we need to think of the complementarities between bank A and bank B taking the same risk because they have some group thinking or some other forms. I don't know the answer, it's not easy. But yes, the zombie banks or the good to bad banking is still a major problem.

>> Amit Seru: All right, thank you Ross for these comments. All well received. I think I'll make a couple of points. One is the overarching message hopefully got through which is financial stability, if it's tied to interest rates because of the asset composition of banks. It puts a constraint on monetary policy and we've seen that in the US in various ways.

So that's one point which at least we try to push for and therefore these things need to be integrated. I think to your points on regulators there is a political economy there as well. I don't think the issue is that people can't do simple math that interest rates go up, value of assets goes down.

It's again a matter of incentives. And that's the reason, I don't think the answer is we need to train regulators, coordinate, yes, all of those things. But if you personally ask me, having more capital substitutes for all of that because we let the markets decide what the right number is and what it should be because we see this with private credit and non bank.

So there's nothing to be afraid. No one is saying there should be zero regulation, there are externalities, but I don't think the answer is getting away from capital. Capital will substitute for some of these problems as well. So that's one thing. Second thing which is related is your point on talent indirectly.

Because when you say governance, let me have clawback policies, let's remove limited liability and so on. I think that's again a political economy issue because do we really want best talent not to work in banking? I don't know the answer to that. To say that more equity capital means there will be diffused shareholders and therefore we don't know and we need something more in terms of skin in the game.

I'm not 100% sure about that because if you look at public companies, they have diffused ownership. If they underperform and we let the markets run, there are activists, there is takeover markets. Takeover markets in fact work because some firm wants to take over a target endogenously goes and acquires a toehold.

So people do all kinds of stuff when they find problems, issue is safety net. You started with saying we are not gonna get rid of the safety net and let's do stuff. I think that has been the major problem because once we go there, we are in third, fourth, fifth best world and then we are talking about band aids.

And I don't know any bandit that can fix the problem that we are introducing with letting the moral hazard run wild like we have. So I think that would be my sort of view.

>> Steve Haber: So here is what I'd like to do. We have both a very large audience online on Zoom, and we have the audience here in the room also quite sizable.

I'd like to start by taking questions from within the room, and rather than take one question and give three people a chance to respond, which will limit the number of questions we can take. I'd like to take three at a time from within the room after taking some questions from in the room, then open things up to people are online who are communicating with Isabel Ismail who will be passing me questions.

So, floor is open to people in the room to pose questions. And I'm gonna just make the point that this is like jeopardy. Your statement should come in the form of a question. I have Harold Ulugh, John Cochrane in the queue. Harold and Pascal Paul.

>> Harold Ulugh: So great report.

And it seems with banking we always try to go back to the same model where heads you win, tails taxpayer loses. And we keep on finding out that that doesn't work. So, now the interesting thing is if you look at the bank run literature building on Diamond Dipvik, we've created the core model for thinking about bank runs.

There's a huge number of proposals of how to get around this problem and what to do there. And so why don't we embrace these solutions, that's one thing. So if you're an uninsured depositor, you are an uninsured depositor and you shouldn't be bailed out afterwards. Why don't we take that seriously?

Now the flip side to that is that some people say well we need these information insensitive deposits that you can withdraw at any time that you won't find. But then why not allow narrow banks? Right, that's the other proposal on the table where bank has access to the master account of the Fed and just all that they do is just take deposits and put them in the master account of the Fed.

That's totally safe. There was such a proposal and after applying for master account in 2024 in February, it was final denied. So I'm coming back to your fine book. I think it's all politics has nothing to do with the banking system.

>> Steve Haber: John Cochrane.

>> John Cochrane: I will violate the rule on question.

Maybe you can tack on, well, what do you think of that? First, your title you say there are a few reforms. There's Dodd Frank, there's Basel, 1, 2, 3, there's scope 1, 2, 3, 4, 5. Emissions in Europe, there's too many reforms. None of them work to the point that we couldn't see the elephant in the room.

Your multiple regulators is kind of interesting, but I'm not totally confused. There were multiple regulators, but they were all asleep. The Feds were not saying it wasn't. The Fed wasn't saying interest rates are going up. You gotta manage this, and the local camels guys were saying no, nobody was sleep.

And there's actually a case competition. It just takes one person to pull the fire alarm. More people in the room might be someday better. And discretion isn't terrible. The central problem is that in the hundred thousand pages of Dodd Frank rules there was no rule that said your duration and your uninsured deposits can't coexist in the same bank.

It needed just the tiniest bit of awakeness and discretion and they were too busy filling out the 100,000 pages of rules to even notice that. Similarly, you sort of say, we need stress tests for duration. This is duration. It's the one thing where we understand and can calculate it and you don't need to do some magic stress test.

That that ought to be pretty simple. Was monetary policy the blame? I'm a little bit. Monetary policy dumped a lot of reserves in there and banks could have easily taken the deposits and funneled them into the reserves, and they just wanted to make more money than that. I'm not sure that is to blame.

There is on this fourth floor of the Fed, I think whatever floor of the Fed it is, there's an interesting wilful disconnect almost an ethical. We're not allowed to think about monetary policy when we set regulation and vice versa that they don't talk to. But it is astounding that we all know interest rates are going up and the regulators saying what if interest rates are going down.

But maybe you guys who know the banking system can know why they think it's terrible. And finally, I just wanna echo Ross's view of the future. What we need is less rules and more capital. What we're likely to get from an industry led deregulation is more rules cuz they love it as a barrier entry, and much less capital.

And the reason is cuz most people use the word hold capital and they have no idea what capital really is when they're doing it. What do you think of that.

>> Steve Haber: Can end with that, Pascal Paul.

>> Pascal Paul: So I wanted to ask a question about politically, and now asking for more capital for everyone.

But I want to make it more specific to banks that are problems account. Kind of leverage can be unrealized losses that are creating problems. We wanna create capital requirement rules to basically a function of those things, and then we basically manage the back-ends of government, necessarily. As an aside, very largest banks which have this pass through of unrealized losses on their securities into AOCI and capital that's one way of getting at that, but I think design other ways, as well.

>> Steve Haber: Let me give any one of the three an opportunity to respond to the three comments or questions.

>> Stijn Claessens: So the last one Pascal was a more explicit question, so that's easier. So I think have some sympathy for linking more explicitly the capital requirements with the funding structures.

Now, we have the liquidity regulation is the LCR and NFSR for banks liquidity cover ratio, net stable funding ratio. I think there are issues with those in the first place, and they clearly didn't serve to stop the problem to begin with. I think there actually may be a little bit of a constraint on banking without much return.

What you're suggesting could rectify that. Of course, we have to calibrate it properly. And I think this is where the subjective, or whatever you want to call it, discretionary part comes in. Good supervisors will do a better job than any regulation can ever achieve that. So in a Basel context, you have pillar one is the regulations.

Pillar two is more the supervisory role. I would give them more credit that requires governance change at the supervisory agency level that they feel more willing to take actions without compliance. So that gets a little bit to what John was asking, less regulation. Is that not better? Yes, if you can see instead of regulation, a better supervisory structure.

Are we gonna be willing to pay for the right supervisors? Are we gonna be willing to give them the laws that they need in order to intervene? If that's part of the bargain, yes, I sign up for it. So that's the answer to what John, I think, was suggesting.

Harold, yeah, I don't disagree. I think narrow banking, but then you might as well do a money market fund. Mean you can put your money there and it's safer, it's treasury fund. So I have a bank then in the first place. Rather than having what we have now of a banking system that we understand to some extent, and the money market system that we understand to some extent having the narrow banks in between.

I'm not sure it adds that much value but.

>> John Cochrane: Money market funds can't have reserve accounts at the Fed and thereby can't give instant transactions. So there's a big difference between a narrow bank and a money market fund.

>> Stijn Claessens: But to encourage the ten people that held or institutions that held $15 billion at SVB, say, well, you should have held maybe 1 billion and the rest could have been at a money market fund.

You don't need it on an instantaneous overnight basis. Could have been one answer.

>> Amit Seru: Okay, so I'll start with Harold. Harold, I think, yeah, like Stijn, I agree with what you're saying. I think one thing that you usually hear people when they talk about narrow banks and why that might not work fully is, there is a view that if you look at deposits.

A lot of that is serving some liquidity demand from corporates, from retail borrowers. We need to estimate what this is. We really don't know what this really is, except knowing that treasury corporate treasuries do invest a lot in these deposits. You can see in SVB, where was the chunk of the money it was corporate deposits, portfolio companies of venture capitalists.

So if that is something that can be managed to a money market fund for example or something else, I think it's the time to decide what type of financial inter-mediation system do we need all this non banks, private credit and money market funds. If we can come together and figure out some ways of satisfying liquidity demand, I don't see what other function we need to have through the system which has all these flaws and all of these model hazard built in which we just can't get around.

So that's my view on what what you said. John, I think if you look at the reports that Fed and state folks wrote, all the postmortem, you can see that Fed actually did, Fed supervisors did find the problems well in advance. Now remember like Stijn showed, there was a huge amount of growth for example, well before monetary tightening.

When that happens, all kinds of nonsense is going on in the bank. So they found all of that, deposits were coming, they had no idea where the hell they were doing. They were throwing it in securities, hedging was not there, no one was paying it, all of that was pointed out.

But when it got to states because the rotation happens, remember this was post COVID. Every state wanted their economy to do well. And how do you get the economy to do well? You need the banks to pump money. So I don't think it's not an issue. We just think that that may not be the central thing, I agree, but I think it's kind of important.

I agree with you, less rules, more capital. If we can get there, that will solve a lot of problems. And Pascal, I'm very sympathetic to your view about focusing on the subset of banks which are problematic. That's the reason for the short to medium run approach rather than just thinking long term, short to medium is exactly that, really.

They're looking at the problematic banks and saying, hey, let's just give these guys some equity capital if they're solvent and otherwise. If you can't raise the money from anyone, maybe you should be shut down or consolidated. But there might be easier ways of doing it through AOCI, and I know that you have some work which gets at that so agree.

>> Steve Haber: Let me pose a question, taking prerogative of chair before I open things up to questions that have come from our colleagues on Zoom. So Ross, I think, had this wonderful metaphor of comedy, tragedy and horror. And it got me thinking as well. Is there yet a fourth version of this?

And I would say, well, sort of nightmare. And Abbott just made the point that governments always like banks to make lots of loans because it pumps the economy. And who could be against that? And this segues into something Ross said, which is that how we're going to regulate banks, what requirements will be put in place in terms of capital requirements as a political decision?

So here's the nightmare. And my question is, is this nightmare a complete hallucination of mine or is this a real risk? So right now we have a banking system that's very highly regulated in which as John and I were going back and forth about before, basically all deposits are insured, de facto and we have low capital requirements.

And then we have a non bank sector that's growing very large in which the market is basically doing the regulation by setting equity ratios at about 10% or higher.

>> Amit Seru: Higher.

>> Steve Haber: Higher, yeah, so here's the nightmare. Regulators always like to keep regulating. And as the non banks grow, the impulse is going to be we need to regulate them too.

And once we regulate them too, they should have the same equity ratios as the banks. And so we should just push down those equity ratios cuz the banks are gonna lobby like crazy. Everybody's got to have the same equity ratios, right. And we're going to only compound the problem.

So, is my nightmare a realistic portrayal? Is it reasonable to think that this could unfold or are there countervailing forces that will push the other way for a more stable system?

>> John Cochrane: I can just add the other part of your nightmare is these guys go under and the government says well, we can't let them go under boom.

>> Amit Seru: I was about to answer that no, it's exactly. If we are in that world where the government is gonna bail these folks out, then all, all bets are off. I think the key in the non bank sector so far is the following. If you look at the non banks I showed you, they have all uninsured debt.

Uninsured debt is not a problem, it's runnable. So what does the market say? Well, if you have uninsured debt, you better have a lot of equity capital. That's the way to run the business, and they're running it. So far we have not bailed them, they are doing a good job.

You look at private equity which is doing a lot of private credit. How does private equity fund itself? It goes and asks limited partners, Stanfords of the world, hey, give me money, give me money for 10 years. It's gonna be high risk, high return, but the duration is 10 years.

And then I will go out and invest in projects which are also long duration. So I do duration matching and that's their business model. Now if we introduce safety and bailout then of course they are gonna shorten the maturity and say, you've heard this, private equity right now wants a lot of retail money.

Well, retail money is gonna be flippant and short term. And if we are gonna then bail out because we don't let retailers go under, your nightmare might happen. And here I just woke up no.

>> Stijn Claessens: There's one issue however that we need to think because this is this bailout that comes from a systemic problem in the non banks.

And I think we can't ignore it forever because we've done it now too many times that it did bail out. So I don't wanna take the regulation from the banks and apply it to the non banks and then create a monster over there. I want specific regulation on the non banks that deals with that risk of a systemic meltdown on them and that's much more difficult.

I don't think we have the paradigm, so I'm very reluctant to go there with a book now. But let's keep that in mind.

>> Steve Haber: I'm going to take three questions that have come through via Zoom. I'm gonna take all three of them and then I'm gonna let our panelists respond.

So first, can you comment on a solution to the problem that the mark to market on a government security should be a matter of indifference to a depositor whose likelihood of withdrawing the money before the maturity of the security is low? But lack of information about the mark to market losses are not available in real time to depositors.

Second question, I would be interested to hear if the US is adopting IRRBB rules similar to the EU. Would it be helpful to do so such as outlier tests using EVE and NII? Third question, do you suggest that an IRBB risk should be moved to pillar one? Would it be helpful as a tool to increase capital for IRBB risks?

Floors open to our three panelists.

>> Stijn Claessens: Let me start with the last one. This IRB and pillar 1 versus pillar 2 has been debated for a long time. The BAS committee discussed about interface risk in the banking book, decided not to have a pillar one because there was an agreement globally and the US was one of the outliers.

Didn't want to go that way. If there is no scope for doing it, I would still not think that pillar one is the way to go because you tie yourself down in some mechanical formula that really is much more judgement thing. You need to have proper risk management on this very essential part of your business.

It typically is gonna be governance failure if you can't do that. I think it's more pillar two in that sense. That also answers a little bit of a second question. Should you give the US as an outlier? I think it hurt the supervisory system not to have any rule that they could refer to any principles in a formal sense.

Having said that, the principles are so basic that if you can't get that going then I think there's something else wrong.

>> Amit Seru: I think the first question, if I understood correctly was, should we be disclosing the mark to market losses to depositors? Maybe it's better that depositors remain sleepy because then they can eat losses.

Well, that's what leads to zombies. So if we really believe in all the theories out there where depositors and shareholders are supposed to be monitoring disclosure, you don't say that let's hide the problems. You say that you make the problems known so that you can solve the governance issues and get the misallocation sorted sooner rather than later.

So I'm not sure that I would advocate that one way of solving this is just not disclosing. I mean, we have solved it in another pretty bad way, which is we bailed everyone. So you could make the argument that let's just insure $20 trillion of deposits, insured and uninsured.

Why? Because that's what we do. Then we don't even need to worry about disclosure or anything else. We can insure everything, but everything has a cost. And where the cost is gonna come is gonna be in credit that's offered, the price that it's offered at and misallocation. So I think I would be against not disclosing early enough.

>> Steve Haber: Let me give the three panelists an opportunity. I'm mindful of the time to say any final words and one, we go in the order in which they presented so Stijn, Amit, and Ross.

>> Stijn Claessens: So here's some skepticism on the reform side and this is not the direction of the reform, but more the details in terms of.

And I'm sympathetic to that because we have a long list of rules in place at the moment and to the extent, at least, to compliance and check you don't get what you achieve. Having said that, so I'm pretty much more into pillar two, the supervisory. And I think we've seen in Europe, we didn't discuss very much, but the 10 years of the Single Supervisory Mechanism in Europe has led to a big increase in capitalization of banks around Europe.

It doesn't mean that the European banking system is sound as one would like it to be on the franchise side, but on the capital side. So this is where I would put my money a little bit more, let's get good supervisors to do their job better.

>> Amit Seru: Thanks, so let me just say two things.

One, I want to thank again the Hoover Prosperity Program and the Financial Regulation Working Group and the CEPR for hosting this, all of you for coming in and giving us comments both in person and online. The second thing I'll say is of course this report is not gonna solve everything.

I think fundamentally as we have discussed, we are in a world in an equilibrium where we have given these bailout expectations and safety nets are all built in and ultimately you want to start out. If we had to start out, these are not expectations we want to start out in a clean system.

So that's the equilibrium, and how we get to that equilibrium, there are different ways in which people posit we get to that. We don't have great theories, we don't have great ways of figuring out how you move from one equilibrium to the other. There is the band aid approach which is, we'll tweak a few things and we might get there.

Seems like that has been our approach for the last 15, 20 years. I'm not sure that is useful. So maybe it's time to try something drastic and see if we might go there. And that would be my plea for future work going in this direction.

>> Ross Levine: Yeah, I just wanna come back to the goal of the report.

I mean, the goal of the report was to assess whether the post ESE reforms were sufficient to identify structural causes and to provide actionable policy recommendations. The goal of the report was not to design the optimal financial regulatory system over the next 20 years. And I think, it's a slam dunk accomplishment of the goals.

There's better integration of monetary and fiscal policy, structural improvements in US supervision, because of the can be the back and forth with different regulators. Further steps in European bank integration. There's detailed recommendations about recovery regimes, binding triggers, enhanced lender of last resort mechanisms and market tests for raising capital.

And it provides an enormous amount of empirical evidence, including evidence that raising the capital necessary to do so would not necessarily be disrupted to the allocation of credit and growth in the economy. I think that's an enormous success. And although I spent a lot of time telling stories, I learned an immense amount from the report.

And if these policies are implemented, it would have reduced the probability of the turmoil in 2023. And I think it will reduce the probability of turmoil going forward. And then there are the issues of these bigger systemic themes that I think there's a lot of agreement about and need for more work and commentary.

>> Steve Haber: Thank everyone for their active participation and for stimulating session. Let me in particular thank Stijn for coming all the way out to the west coast to join us and look forward to the next time that we see all of you at another event of the Hoover Prosperity Program.

Thank you very much.

>> Stijn Claessens: Thank you, Steve.

>> Amit Seru: Thank you.