The Libertarian Podcast: Too Big To Fail? Don’t Bank On It | Richard Epstein | Hoover Institution

>> Tom Church: This is the libertarian podcast from the Hoover Institution. I'm your host, Tom Church. And I'm joined, as always, by the libertarian, Professor Richard Epstein. Richard is the Peter and Kirsten Bedford Senior Fellow here at the Hoover Institution. He's the Lawrence A Tisch professor of law at NYU and is a senior lecturer at the University of Chicago.

And Richard, it's been an eventful week here in Silicon Valley, home of Stanford University, the Hoover Institution, and formerly Silicon Valley Bank. That's because we're one week past the second largest bank failure in us history. Now, late last week, Silicon Valley bank started to fold. It went very, very quickly.

And over the weekend, the FDIC, treasury department, the federal government had to step in and to ensure that a wider bank run wouldn't occur. And Richard, I'm hoping before we get into a lot of the political responses. You could maybe walk us through what happened with SVB, and then later Signature Bank.

And then the actions that the FDIC and the Treasury Department had to do over the weekend to step in to make sure that depositors would be made whole.

>> Richard Epstein: Yes, well, I mean, they had to do, it's gonna be a disputed point.

>> Tom Church: But, yeah, I thought-

>> Richard Epstein: I think what the best way to try to do this is to sort of go back and explain why it is that banking is such a perilous business.

And it's a technical point, but it's one which seems to be absolutely immovable, and it's the problem of the mismatch maturity. So what you do as a bank is essentially you're in the middle of a two sided market. And on the depositor side, the people who put their money in are typically putting in paychecks or other kinds of periodic payments.

And the only way in which they can survive is to have a right to immediate access to all the funds that they put in there at will. It would be utterly impossible for you to say to put in your $10,000 a month paycheck, and then when you wanna take it out, the bank says, are you gonna use this to pay rent or something else?

No, you just want to be able to take it out, no questions asked, so long as the balance is available. So what happens is the bank has to keep a certain amount of cash liquid. Then what you do is you turn around and you have the money. And in order to make money, what you have to do is you have to be able to lend it out at a higher rate than you're paying to your particular deposits to get some kind of a spread.

And most of your customers say, are going to be businesses that are needing long term finance, or they're going to be residents who are trying to buy home mortgages. And they have another set of imperatives, which is that they basically be able to keep their money from the bank and pay off an ordinary period.

So you cannot go to a bank and say, here, give me a mortgage for $250,000. And the bank says, yes, and by the way, we could call it at any time that we want. And nobody will borrow under those circumstances. The whole point of a home mortgage is that you have to make a lump sum payment to the front when you don't have the cash, and then you pay it off slowly.

So that what happens is you can enjoy the fruits of your money, pay it back, and not have to defer moving into an apartment or into a house until you've managed to accumulate the capital to buy it outright. So everybody's in this particular kind of market. So what happens is suppose people start getting some sense that things are a little bit uneasy.

The question then is how much money does the bank keep in free cash in order to take its deposits back? And one of the things you could do is you could keep, say, 70% of your money that way. So you're never going to be vulnerable to a bank run.

But you're not going to have enough money to rent out at a premium so as to be able to make some kind of a profit. So what happens is banks, in order to make profits, always want to have a relatively small amount of cash liquid to pay their accounts and want to put a fairly large chunk of it into long term obligations.

There's obviously a limit to all of this. But suppose you're dealing with a typical bank. What happens is, if it keeps 10% of its money in cash, and people are constantly putting money in and out on deposits and so forth. It's in a normal time. What's going to happen is all these events will be basically independent of one another.

And in the end, therefore, you may vary. So you'll have 100,000 million dollars in the bank in cash, or 120 or 80 and so forth. But then let's suppose that there's somebody who gets wind of the fact that this bank may not have enough assets because something has gone wrong.

And so everybody arrives at the bank at the same time. The way the modern banking laws work is they do have cash. In many cases, you're required to have securities that could be easily liquidated, like treasury bonds and so forth, in order to cover other excesses in addition to your loan.

But if, in fact, there is a real mismatch in maturity, it could easily be that the run in the bank will exhaust the free cash that you do up. So something like the Silicon Valley pass, there was a very elementary blunder that had been made. What happened is they wanted to soak the yield.

They got a huge amount of cash coming in. The home mortgage market was not large enough for them to absorb it all. So what they did is they invested in long term corporate bonds. The problem is, when you invest in long term bonds, is that you're subject to interest rates fluctuation.

And if, in fact, what you do is you invest in those bonds and say you're gonna get 4%, and then the Fed starts to tighten the money up and so forth. And all of a sudden, new securities are paying 6%. The guy who has that 4% bond, if he wants to sell it or otherwise realize it, is going to have to take a haircut.

Because people are going to pay him that sum of money, which is going to be small, so as to give them a return equal to the 6% return they could get on the new situation. And what they didn't do is they didn't hedge that risk. They didn't buy some kind of a derivative which said that if it turns out that the value of the long term bonds go down, then the value of our hedge will start to go up so as to create stability.

And once this information becomes out, then the whole thing just collapses like a house of cards. Well, the government then has to figure out, what are we supposed to do? And one of the things you do is you try to require larger down payments, but in this case, you didn't do it.

Another thing you could do is you could have different kinds of banks enter into various kinds of reinsurance arrangements with each other. So I commit myself to lend to you if there's a run on your bank, and you will do the same thing for me. That's going to work if it's only one bank, it's not going to work if they're all being hit together.

If you looked at what happened, for example, with First Republic, which was a relatively sound bank, I think quite. I banked there, I think it's an exceptional bank. What happened is people got very nervous about that bank because it has a similar clientele, though quite different in other ways from that of the SVC.

And so there was a talk that people would want to take their money out of that bank. The stock of the company went way down. But just today, I got a notice which indicated that there was a consortium of seven or eight banks which essentially gave a $50 billion line of credit to make sure that Firsr Republic didn't fail.

So that's another solution that can happen. And so when you teach the banking course, as I do, from time to time, what happens is everything is designed to do this. You know the mismatched maturities are set in stone. Exactly what institutional arrangements do you put into place so as to deal with the stress that's going to happen in the event of a run?

And it seemed as though the folks at SVC and the folks at the Fed were all a little bit sloppy because they allowed the situation to become fundamentally unglued. The usual rule is it's a $250,000 protection cap given by the government, just another device on the run. And the theory is that larger depositors can figure out ways to get the protection for themselves.

It turns out, as often as the case, it's very inconvenient for you if you have $2 million in the bank to set up eight separate accounts and try to figure out which bills you're going to pay over which account on which days. So people get a little bit sloppy, and they put it all in one big account, because, remember, they're churning this thing much more rapidly than the typical depositor, like myself.

You put the money and you could use multiple accounts, because these are not business accounts in exactly the same way. So they keep it all in the one account, and then the thing is about to go, and then the president says, well, we're going to guarantee this, too.

Now, it's not a trivial guarantee. When the bank here decided to liquidate some of its long term bond, it took a haircut of about 15%, a couple billion dollars here and a couple billion dollars there. And it's not at all clear exactly how all this is going to be made up.

But it shows you once again that eternal vigilance is the price of liberty. It's also the price of bank soundness, and there's a lot of blame that can go around. But there's very little confidence that we could come up with an ideal set of arrangements which will stop a repetition sometime in the future.

It is extremely difficult to let the whole system go to pieces when the bank is bad, because it's not just the bank that fails, it's all of its customers to fail, all their employees, all their suppliers. So that you're worried about mass contagion, which goes far beyond the bank and brings down a lot of innocent parties.

>> Tom Church: Richard, there's two lines of thought I want to follow up on, and we can do them one at a time. One is the Treasury Department's and the FDIC's reaction to swoop in and make sure that all depositors secured or unsecured or insured, pardon me, insured or unsecured or uninsured, were covered.

And then there's also much has been made of Dodd Frank maybe not applying to SVB. I mean, the question is, why was this allowed to happen? Why was SVB allowed to have 90% uninsured deposits looking very, very different from almost every other large bank that's out there? Dodd Frank, the argument there is there were onerous requirements put on big banks to make sure big bank runs and failures didn't happen again.

But those requirements are expensive, and so small banks shouldn't have to follow them because small banks would never be able to compete and grow with larger banks. And so, I guess, twofold question for you, Richard. One, should we have actually had the Treasury Department step in and guarantee these banks?

And two, what can we do in the light of Dodd Frank, not even applying the regulator is missing this.

>> Richard Epstein: Okay, well, let's start with the first of the question. This is a debate which takes place every time. The basic view is you are big boys, you get this stuff wrong, we're going to let you fail, because that means the next time around you're going to actually get better kinds of protections in the private market.

You'll hire, take guarantees, you'll get some auditors to look at the various kinds of books that give you the right to withdraw money, a whole variety of things. The problem is that these things are rarely done because any individual borrower doesn't quite have enough money coming into this particular bank to make it worthwhile for that person to put the whole apparatus in place.

So there tends to be a kind of prisoner's dilemma game. Everybody thinks that somebody else ought to institute the kinds of protections, but there's nobody who has a large enough stake that they're willing to do it. So day to day operational convenience tends to dominate. Then the government comes along and say, there, we're going to basically make sure that you fail.

The problem about that is it's not only that you fail, but there are a lot of innocent people who fail with you. So what you say is, okay, then we'll do this. If, in fact, what you do is you say, look, if you fail, we're gonna guarantee you at any amount, then the $250,000 guarantee is worthless, our limit is worthless.

And so you're going to increase the probability of a failure the next time. And so there's this constant question of, can we figure out how to save you this time and then start to reinsure things on the next time? And it's just an open question. You start looking at any of these disputes in banking and so forth, there's just a huge amount of difference on the way in which this thing starts to work.

And you could say, well, let's wipe out the shareholders of these banks and keep the depositors protected. But it turns out there may not be enough shareholder equity in this thing to make good all the particular losses in question. You can say, what we have to do is to find some personal liability on the part of the members of the board of directors and so forth.

But those sums would dwarf any salary that they're going to receive and would scare away talent. So it's just a constant second best type situation. I think the practice that what you do is you save them. Back in 2008, they saved most of the banks. I think they let one of them go under.

I can't remember which one, Lehman Brothers, I guess it was. And what you did see was a massive kind of social dislocation. So everybody spooked on both sides of this particular question. So then the question you asked at the second half is, what do we do about Dodd Frank?

Well, the relaxation in 2018 was bipartisan, and the argument was these small banks could not possibly be big enough to be systematic risk. And the cost of compliance is so grea, given the smallness of their financial base that everything is going to go bad. But look, the thing to understand is you're getting rid of certain kinds of Dodd Frank protection.

The kinds of mistakes that were made in this particular case were so elementary in terms of having this unhedged risk and interest rate risk at a time when inflation is a serious sort of risk and doing nothing about it. You don't need to have Dodd Frank in place to say that this kind of thing is just a terrible mishap.

What you have to do is to ask the question, how did they get such a miserable board in terms of doing it inside the company? And then the other question is, how do you get such miserable oversight by going to the Federal Reserve Banks in San Francisco or wherever it is?

And that's the key question that you have. And one of the things I think that is really important to understand is there is a constant tendency on the part of people today. Particularly with the movement towards diversity and so forth, to starting to say, well, we really have to have a board which represents or looks like America.

And the implicit assumption about that is that a board that looks like America is gonna have an ability roughly equivalent to that of a bank whose officials and board of directors are chosen. Only for the technical skills that they have either in managing accounts of one kind or another, or rich strategies and so forth.

And one of the things that I've always been opposed to in the diversity movement. Is the implicit assumption that there isn't much of a discount that you're gonna take when you get rid of the experts and you put in somebody who has these other qualifications. In my experience, no matter what profession that you're in, the gradation is always steeper.

And insiders understand the difference in the ability of the people who are working. And so if you start putting in second tier people, you're going to get second tier problems out of this. And I think, in effect the hardest thing to regulate, but the most important thing to deal with is in fact the question of how it is you start to appoint the members to both the private boards and to the public board.

And if you appoint a bunch of people who really do not understand the nature of the mismatched maturity problem and all the various devices that have to be used to counter it, this system is going to be toast. And I don't think that we do that in the United States enough.

I think that the move away from merit has led to the appointment of weak boards and the appointment of weak boards has led to before performance. If the Federal Reserve and its local banks follow the same kind of strategy, its going to be mediocre managing mediocre. This is very similar to what happened with Pacific Gas and Electric, whatever it is.

They spend so much time worrying about diversity, they don't spend enough Time worrying about the fire risk associated with their pipelines and all the rest of the stuff. So I think, in effect, what we really have to do is to understand that personnel really matters, that differences in merit really count.

And I think there's so much of the prevailing ideology that we have today which says that these things are fictive, that we don't want to take them into account. So I think, in effect, the first reform, which you cannot legislate, has to be cultural. It has to be a return to a set of norms about how people are selected both to be regulators and officials based upon their achievements and their expertise, not upon various other kinds of collateral, political considerations.

>> Tom Church: Well, Richard, I will say management is out at SVB, shareholders wiped out. We'll see how much bondholders take a haircut. And so it seems like there have been consequences for not following what you say are these elementary risks that are there for banks.

>> Richard Epstein: But remember, their losses are trivial compared to the social losses.

And so the issue is not that you're going to take retribution on shareholders and boards of members after the loss. The issue is how you prevent the loss, because the social losses are far greater than the losses that are being visited upon these individuals. These are non trivial concerns, and I think that they have to be imposed.

But I do think, in effect, that the nature of this game is not to try to run salvage operations, which always are costly and imperfect, is to try to prevent the occurrence from happening in the first place. And I don't think there is enough attention paid to that in the way in which we sort of run American businesses today.

This is an argument about, you have to be very careful. Being woke, in one sense or another, is often very expensive. Traditional standards of merit are the only thing that will protect you from major sorts of dislocations in all of these very complex financial and other business markets.

>> Tom Church: All right, one last question for you, Richard. Treasury Secretary Janet Yellen has just testified to Congress that the banking system is sound and that not all uninsured depositors in the future would be protected from future failures. I guess this question we've talked about a little bit before is one of moral hazard, right?

Our colleague David Henderson at Hoover has written a column called bailing out is a bad idea. And I'm looking at this, Richard. I'm saying I'm seeing too big to fail seems to be the de facto policy of the United States. And I'm just wondering to you, is this an issue in which libertarians and maybe Elizabeth Warren and Bernie Sanders can agree upon that the banking system isn't regulated the way we should probably regulate it?

>> Richard Epstein: I regard this as a nonpartisan, particular question, as you start to say, but it's not at all clear what the ideal form of regulation ought to be. I mean, one of the problems that you have, for example, is can we survive a system of small banks? And so if you look at canadian system, they tend to have four very, very big banks, and you start talking about systematic risk.

The basic idea was that the amount of money that the bank had would be a rough proxy as to whether or not the risk was systematic. Nobody discussed or really thought about the SVB Bank situation, where, in fact, you have a relatively small bank. But it has an absolutely dominant position in a particular kind of market, ie, the market for venture capital and for high tech.

So that it was a huge portion of a small market, which, in fact, is extremely critical to the rest of the country. So these things always have a way of kind of coming up with a very terrible hypothetical one way or another. And as I already mentioned, the private sector did move in to protect first Republic.

It has a similar clientele in the sense that they're relatively well heeled, but they certainly don't have the same amount of BC expertise and so forth, and didn't have the same kind of risk profile. But one of the dangers of not rescuing the first bank is some second bank is going to go down, because the rumor of a bank weakness is enough to send everybody to the door and to shut the thing over.

And so the problem that you have in taking the hard libertarian line is that it's not only the bank that deserves to fail that fails. Is given the confusion and the misinformation, it's the banks that deserve to succeed, who've taken all the steps, who are nonetheless subject to these runs.

And then when you say, well, let's protect them, it turns out you've used a lot of your resources up to protect the first bank, which did fail. So you don't have enough back to going through these other banks. It's just a very, very tricky kind of situation. So, as I said, I don't want to be a pessimist about all this.

I think you can do better or worse, but I tend to believe in, as I get older, that the right people in the right places is much more important than the right rules. Or to put it another way, when I teach the law of contracts with my students, I said, you could have one of two things.

You could have a reliable contracting partner and a crappy contract with a lot of gaps. Or you could have a terrific contract with all sorts of contingencies covered and allows contracting party. Which of the two would you want if put to the extremes? And the answer, as I've gotten older, is I want to take the good businessman and the bad contract.

I don't want to take the good contract and the bad businessman.

>> Tom Church: You've been listening to the Libertarian Podcast with Richard Epstein. If you'd like to learn more, make sure to read Richard's column, The Libertarian, published on Defining Ideas at hoover.org. If you found our conversation thought provoking, please share it with your friends and rate the show on Apple Podcasts or wherever you're tuning in.

For Richard Epstein, I'm Tom Church. We'll talk to you next time.

>> Presenter: This podcast is a production of the Hoover institution, where we advance ideas that define a free society and improve the human condition. For more information about our work, or to listen to more of our podcast or watch our videos, please visit hoover.org.