Fixing Banks. It’s Not That Complicated!

Authored by Axel Merk via MerkInvestments.com,

When you’re in a hole, stop digging. Seriously. It’s frustrating to see policy makers make the same mistakes as in 2008. There are real solutions on the table.

They are not that complicated. Yet, as in 2008, we are barking up the wrong trees.

In 2008, we missed a major opportunity to fix some core issues. To get a more robust financial system, we must set the right incentives. Let’s not waste another crisis, please join me in speaking up.

FDIC further erodes discipline

One reason expanded FDIC insurance is a bad idea is because it takes yet another market-based measure of the health of banks away. That is, aside from the share price, we are then entirely dependent on the wisdom of regulators to keep the banking system safe. It should be apparent that this is a poor approach, but for some reason it is not; and regulators will always fight the last war. In contrast, markets are forward looking. I’m not suggesting we don’t need regulations, but we need a healthy mix, and the pendulum has swung way too far. Notably, all but eliminating intra-bank lending in 2008 (by paying interest on deposits at the Federal Reserve (“Fed”)) has taken away an important market-based metric to assess bank health. What happens when we eliminate the market from telling us how healthy banks are? In my assessment, it will suggest that everyone will feel safe until a dam breaks, then all hell breaks loose. Sound familiar?

FDIC expansion is very expensive and creates political pitfalls, international challenges

There are other reasons dramatically expanded FDIC insurance is a bad idea; the price tag being one of them – you penalize banks through large contributions for the bad apples. Another is that it amplifies the politicization of the FDIC, as we can see unfolding. With the large unrealized losses in the banking system, odds are Congress will need to step in to enhance funding in a bigger crisis. Then there’s the small detail that while banks pay into the FDIC fund, the fund is only partially funded. Treasury transferred $40bn to the FDIC the day after SVB was seized to honor the wire transfers initiated before SVB’s seizure. (When a bank fails outbound transfers are honored up to the moment the FDIC seizes the bank.) This may be normal operating procedure in a bank failure, but it poses its own set of political risks.

Rounding broadly to illustrate the order of magnitude, at the end of last year, the FDIC fund had approximately $120bn. Unrealized losses in the banking system were a bit over $600bn and deposits were almost $20tn. $20tn is a good chunk of change. Somewhat related, in some countries, bank deposits are greater than the GDP of the respective country. There’s a risk that you suck money out of European banks to the U.S. should the U.S. pursue dramatically higher depositor insurance. (The Eurozone currently has EUR 100,000, Switzerland CHF 100,000 in depositor insurance.)

Emergency tools can contribute to confusion, capital flight

Expanding FDIC insurance would take an act of Congress due to a 1991 law that requires just that. Except there’s a carveout for emergencies allowing expanded coverage for a limited time. It’s in this context that Treasury Secretary Yellen has been rather technical in her answers. A side effect of this has been confusion when her precision of what Treasury can do collided with Fed Chair Powell’s talk. Powell appears much more at east at using emergency tools, more on that below. As far as Yellen is concerned, when grilled by Oklahoma Senator James Lankford on March 16th, she appeared surprised when confronted that the current practice encourages depositors to pull money out of regional banks because of the implicit deposit guarantee at ‘too big to fail’ banks versus smaller, regional banks.

Staggered sub-ordinated debt is part of the solution

So how does one square the circle? The answer is not in blanket FDIC insurance, but in making the banking system more robust in a credible way while at the same time also exposing large banks more to market forces. Instead, Dodd Frank cemented too big to fail. The answer is hiding in plain sight: a 2001 paper on the Fed’s website calling banks to hold subordinate debt, https://www.federalreserve.gov/econres/feds/using-subordinated-debt-to-monitor-bank-holding-companies-is-it-feasible.htm. Dr. Bill Poole, Merk’s Senior Economic Adviser since 2008, better known as the former St. Louis Fed President, was a strong advocate for banks hold 10-year staggered subordinate debt, so that they would need to refinance 10% of their funding each year. If banks can’t refinance at acceptable costs, they shrink by 10%. Ten percent shrinkage is absorbable, 50% is not. Dr. Poole reminded me of this the other day. His point is as valid as ever.

The Fed’s BTFP program is part of the problem

While Fed Chair Powell is eager to help, the Fed is (and has been) part of the problem rather the solution. The Fed’s Bank Term Funding Program (“BTFP”) converts an acute crisis into a chronic one. Banks with unrealized losses can get liquidity for bonds they deposit with the Fed at par. That’s like 100%. These are securities that are underwater and have unrealized losses. The Fed has become more creative in bending the rules; Bernanke would be proud. But the Fed exacerbates rather than solves the problem because it all but assures banks banking (pun intended) on this liquidity facility will be impaired. They are impaired because they still have unrealized losses on their books. Banks that are weak financially will be reluctant to lend, especially now with the increased scrutiny.

It’s capital, stupid

The solution is, of course, capital. Let me take that back, why do I write “of course?” Excuse me for applying common sense, as that does not appear to be the forte of policy makers. To address this banking crisis, banks with holes in their balance sheet must raise more capital, duh! Except the perception that the FDIC won’t allow further banks to fail, and the Fed’s liquidity provision are major disincentives to banks to raise more capital. To illustrate why, take the example of a bank I shall not name that has a market capitalization of a little over $2bn as of this writing; JP Morgan and others deposited $30bn in that bank and are now in discussion to have that deposit converted into equity. Banking 101 stipulates that equity is substantially more powerful than deposits because of the multiplier effect in a fractional reserve world. Except, if you do the math, the bank receiving the injection would have its shareholders dramatically diluted. That of course is what must happen, but the incentive for management and shareholders is to limp along and hope for higher valuations down the road. Not sure how to be clearer, but it is bad policy to provide disincentives to raise capital when it is capital that’s needed.

Mark-to-market accounting is part of the solution

The big elephant in the room that policy makers, for whatever reason, are not talking about is the lack of mark-to-market accounting with a requirement to account for unrealized losses. In any other area of the financial industry, we have mark-to-market accounting with margin calls. Not in banks. That’s the mother of all weaknesses. Insurance giant AIG went bust in 2008 because they thought they could hold securities to maturity and ignore unrealized losses. Banks are correct that if they only held their securities to maturity, they don’t need to worry about interest rate risk. But the current crisis shows that this is the wrong way to think about it because, um, you could have a depositor flight. If, instead, there were a threat of margin calls (which is what this is the equivalent of, induced by depositors), you have an incentive for good risk management and a disincentive to use excess leverage. That’s precisely what we want!
To make this less abstract, let me cite an example I used in 2008 when the price of oil went from approximately $80 per barrel up to ~$140, then down to ~$40. If, when the price of oil was at ~$80, you bet that the price of oil would decline, you would ultimately be proven right, but you would have had margin calls while the price of oil was first heading higher. If you had substantial leverage, you would have been wiped out. With no or only modest leverage, you would have earned money. Banks are like the over-levered speculator crying foul because he “would have been right” had everyone given him a break. But that misses the point of what a robust banking system is supposed to be about: a regulators’ job is not to protect participants from mistakes, but prevent the participants mistakes from wrecking the system.

Principles, not a litany of complex rules that are changed ad hoc, are part of the solution

Instead, what we get is a litany of rules; or worse, we change the rules when the sh*t hits the fan. There’s now talk of increasing regulation for smaller banks. We need to move to sound principles, not to more red tape. Smaller banks scramble to keep up with the red tape; then some pencil-pusher determines all is good. In the meantime, they miss the forest for the trees.

The non-bank private sector is part of the solution

Finally, private markets worked. The weekend of the SVB collapse, I was at a dinner party (I live in Silicon Valley) where a guest was late because her firm was arranging private funding for startups to meet payroll; similar efforts were reported in the financial media. Also, FDIC receivership certificates can be used to get a loan. There would have potentially been some losses at uninsured SVB depositors and the downturn in the startup world would have been painful. As a reminder, Silicon Valley is a history of booms and busts. Already a decade ago, I scratched my head how SVB ran its business as they ran it more like a venture capital (VC) firm. There’s nothing wrong with VC firms, but they should not get access to the Fed or FDIC insurance. I very much doubt whomever buys what’s left of SVB (or its pieces) will pursue the same business model. The change in how startups are served may take some time, but there will be private sector solutions. There will still be those providing loans to startups, but that funding is more likely to come from sources outside the banking system. That’s a good thing.

Did someone say, oh, depositors were bailed out to prevent a run? Already back in 2008, I advocated that the best short-term solution is a good long-term solution. The above suggestions would go a long way to making the banking system more robust. They are common sense solutions. As alluded to earlier, a capital shortfall is a big part of the problem. There’s a fix to that, namely capital; or you force sales or wind-downs of these solutions. You ring fence the problem by tackling the problem, not with the illusion of protection and dragging the problems along. We should have learned something from the banking crisis in Japan in the 1990s.

Help spread the word

It’s extremely frustrating to have just almost no one in government focus on most of these issues. Post 2008, people wondered why growth was so lackluster. I am convinced this was in no small part due to how Dodd-Frank missed the mark. To repeat myself, it is not about having regulation, it’s about incentives with policy goals. On that note, I let the Fed off the hook too easily here. Their actions are not fixing inflation and instead are contributing to market volatility. But that’s a Merk Insight for another day.