Arnold Kling: We Just Nationalized the Banking System—Now What?
2023-03-20 · Guest: Arnold Kling (Economist) · 52:49
Silicon Valley Bank Collapse and Banking Nationalization
Bob Zadek interviews economist Arnold Kling about the collapse of Silicon Valley Bank and the subsequent government intervention. Kling argues that by guaranteeing all deposits and providing liquidity facilities, the U.S. government has effectively nationalized the banking system, leading to increased regulation and moral hazard.
Topics: Silicon Valley Bank, Banking Failure, Nationalization, FDIC, Moral Hazard, Interest Rate Risk, Federal Reserve, Economic Policy
Speakers: Bob Zadek, Arnold Kling
Introduction [00:00]
Bob Zadek: Hello friends, I’m Bob Zadek, host of the country’s longest-running libertarian broadcast, nationally streamed at 8:00 AM Pacific Time Sundays on the 860 AM app. The archive of my Bob Zadek Show podcasts holds 15 years of major issue discussion, and it’s the ideal resource to revisit our country’s prior missteps with so many continuing to reappear. I promise you in-depth content on social, political, and economic issues that really matter, always with the ideal guest, accessible and entertaining. Our standard: ideas, not attitudes.
Today’s guest, Arnold Kling, exceeds those standards. Arnold earned his PhD in economics from MIT in 1980. He has worked at the Fed and later at Freddie Mac. He started a web-based business in 1994—Arnold, I didn’t even know they had electricity then, let alone the web—and Arnold continues his web-based life. He has blogged at EconLog and now writes at arnoldkling.substack.com. Arnold, welcome to the show.
Arnold Kling: Thanks, Bob.
The Sudden Collapse of Silicon Valley Bank [01:53]
Bob Zadek: Arnold, tell us about the debacle, the inappropriate goings-on in my backyard up in Silicon Valley with Silicon Valley Bank. A relatively newly formed bank—it goes back about 40 or 50 years, relatively new in the lifespan of banks, considering our first bank was formed by Alexander Hamilton, if I am not mistaken, the Bank of New York, around the time of the founding of our country. So Silicon Valley Bank, a relative newcomer, it has failed. Now, so far there has not been a run on other banks, maybe because the Feds have intervened. We will discuss that in the show. But Silicon Valley Bank was doing just fine. It was the 16th largest bank in the country. It had robust funds on deposit. It had public shareholders. It was one of the leading, if not the leading bank active in startups in Silicon Valley. It specialized in lots of biotech companies, but in tech companies writ large. It was the favorite bank for startups. It was a favorite of the venture capitalists in and around Silicon Valley. And then one day, it seems very suddenly, it’s no longer around. Arnold, tell us how a bank could go from alive and well to a corpse in one sunrise and sunset.
Arnold Kling: Well, I think it was Ernest Hemingway who said, “I went bankrupt gradually, then suddenly,” and I think that’s the story here. They gradually lost money because they had a huge portfolio of long-term mortgage-backed securities and Treasury securities that they put on the books a couple years ago before interest rates went up. And so the value of that portfolio went down. And then they went bankrupt suddenly because over 95% of their deposit money was not insured because the typical customer was a business that had, let’s say, $3 million, $4 million—they’re using that to make payroll and whatever—and that’s way above the insurance limit of $250,000. So those people saw that the bank was underwater, and no one wanted to be the last one to leave, and so they started a run.
The Nature of Bank Deposits and FDIC Insurance [03:48]
Bob Zadek: Arnold, when we talk about depositors, I want to expand that concept because the word “depositor” is, in my opinion, the public misunderstands that relationship. The public believes when you deposit money in the bank, the bank is somehow holding in a shoebox under the counter your stuff, and when you want your stuff back, you go and pick it up like clothing at the dry cleaner. But nothing could be farther from the truth. And in fact, when you deposit money in the bank, you, the depositor, you are making, number one, a loan to the bank. Number two, you’re making an unsecured loan to the bank. Unlike a bank which lends you money on the collateral of your home or of your car, you make a loan to the bank unsecured. You’re just the lowest form of creditor; you’re an unsecured creditor.
Now, the qualification which Arnold mentioned, and we’re going to drill down on, is Arnold referred to deposits not covered by the FDIC. Well, since depositors are making loans to the bank, we don’t want all of the depositors asking for all of their money back at the same time. The words are—I think Jimmy Stewart might have been the first one to mention that phrase—it creates a run on the bank. Like anybody who owes lots of money but doesn’t have all of the money sitting there to pay it back, if everybody you owe money to demands their money back at the same time, even though you have assets, they’re not cash, and therefore you’re going to default. That’s a run on the bank.
So, starting in the time of the Great Depression, the government decided—the federal government—that in order to avoid a panic, a run on the bank, creditors, aka depositors, demanding their money back at the same time, the government said, “If we tell depositors, ‘Yes, you’re a creditor, but we will guarantee that debt, and we’re the federal government, so don’t worry,’ now the fact that your debtor, the bank, is failing is not going to make you feel you better get your money back lest the music stops and you have no chair.” So that’s deposit insurance. But as Arnold pointed out, and we’re going to expand upon this, the deposit insurance is not unlimited—or at least it didn’t used to be. It is, as Arnold will explain. But it’s limited, and it’s now limited after Dodd-Frank to $250,000. So if you have money on deposit at or below $250,000, don’t worry, no rush to get your money back, you can’t lose it, so says the federal government. But as Arnold then explained, the problem was that we had lenders, big companies in Silicon Valley, that had buckets of money, millions and millions of dollars lent to Silicon Valley Bank in the form of deposits. And then bad things started to happen that caused these depositors to have the very run on the bank that deposit insurance is supposed to partially protect.
Interest Rate Risk and the Savings and Loan Parallel [09:12]
Bob Zadek: So tell us about the run on the bank and the federal securities, because the listeners to this show may not fully understand exactly why the federal securities caused a problem. People are accustomed to thinking that if you have money tied up in federal securities, that ought to be pretty safe. So where’s the disconnect that caused depositors to pull back their money?
Arnold Kling: Okay, in a way, this is a rerun of something that you and I remember, but maybe a lot of your listeners don’t, which is the savings and loan crisis of the ’70s and ’80s. If your assets that you have as a financial institution are long-term assets, like a mortgage—so let’s say you lent me mortgage money a few years ago at 3% because you thought that was good. Now mortgage rates are closer to 6%, they’re at least 5%. So you probably are not so happy collecting the 3% from me, and I’m really happy; I’m not going to sell my house now because only paying 3% is great and I don’t want to sell my house and then get a new one and have to pay 5%. So what’s good for me is bad for you as a lender.
Silicon Valley Bank was a big lender when interest rates were low. And so the mortgage securities and the long-term bonds that they bought lost value. So even though there’s no risk of default—there’s no way that I would refuse to pay back my 3% mortgage, I’m happy to have it, and there’s no way that the federal government is going to default on these 20-year bonds that are paying 1.5% interest—that’s the least of your worries. You don’t have to worry about default, and that’s the sense in which you believe that it’s safe. But they have lost value. And if you had to resell them to someone else today, you might get 50 cents, 60 cents on the dollar. And that’s exactly the problem that Silicon Valley Bank faced. That is, when people—when just ordinary, there was some ordinary deposit runoff because the tech boom was fading, and so some of these companies were starting to spend their money. And so instead of having $3 million in their account, they might have taken it down to $2 million. So they’re asking for a million dollars back, and the bank, to meet that, has to sell some of its portfolio. And with its portfolio being worth 50 cents, 60 cents on the dollar, it starts to book losses, and then these depositors start to worry, like, “What happens when it’s my turn and I need the money? Are they still going to have it?”
Insolvency vs. Illiquidity [11:45]
Bob Zadek: Arnold, it’s so easy to imagine what Arnold has explained if you just think of your own personal financial affairs. Imagine you own a house worth a million dollars. That’s its value. Imagine you have a mortgage on that house for $500,000. That’s your only debt. You have positive net worth of $500,000. You are solvent; your personal financial statement is strong. You have $500,000 of value that you own, which is the amount by which your assets exceed your debt. And you’re fine. Now, and you go to bed feeling financially secure. Imagine if the holder of your mortgage had the right to the next morning demand repayment. You couldn’t pay it. You would tell that holder of your mortgage, “I cannot pay you.” So that’s what being insolvent means.
Arnold Kling: I would call that illiquid, but not insolvent. And I think the thing about Silicon Valley Bank is it was definitely insolvent in that if you said, “Okay, insolvent means that if you just had to liquidate everything today, sell your house and pay off your mortgage…” Okay, you’re not insolvent because if you sold your house for a million dollars, you could pay your mortgage for half a million and you’d have half a million free and clear. So you’re not insolvent. So in your example, you’re not insolvent. Now, you’re insolvent if your house is worth $400,000 and your mortgage is $500,000, because then if you have to sort of close your books today, sell the house and pay off the mortgage, you sell the house for $400,000, pay it off for $500,000—yeah, you still can’t pay off for the $500,000. So Silicon Valley Bank was also illiquid in that they didn’t have the cash to meet the depositors who were coming in and asking for their money back, but they were also insolvent in that if they had tried to meet that by selling the bonds in their portfolio, they would not have come up with enough money to pay all the depositors. So they were both insolvent and illiquid.
The Failure of Regulators and Rating Agencies [14:24]
Bob Zadek: What’s interesting is one of the maybe underreported, maybe reported appropriately, but I just think it’s more important—but I couldn’t help but notice, Arnold, and I’m sure you did as well, how the Moody’s rating changed for Silicon Valley Bank from an A to a C rating overnight. And that was a news story that was just mentioned in passing. And Arnold, I couldn’t help but flash back to the role that the rating agencies played during the—shall I call it the era of the Big Short, where it was the rating agencies which are the one thing that the 2008 financial crisis had with Silicon Valley Bank, and maybe First Republic, and with related banks, is the rating agencies again were asleep at the switch. They were not there sounding the clarion call that they are theoretically supposed to be playing. Watch The Big Short if you want the details, but the rating agencies are paid by the companies they rate, not paid by the people who rely upon them.
Arnold Kling: But it’s interesting, there are all these people that are in some sense either private sector or government regulators. So you have the California Home Loan Bank Board, you have the FDIC, you have the auditor—whatever their Big Four auditor was, which signed off on everything—and you have the rating agencies. And none of these people did anything until the crisis was over, even though there were short sellers who could see this happening. I think the Home Loan Bank Board sent some examiners in about a year ago, and they said, “This is a problem.” And everybody who’s been a bank regulator knows that banks are not supposed to just organically triple in size. SVB had $60 billion in deposits in early 2020, and they had closer to three times that amount by the end of 2022. If you’re running a bank, you cannot keep your management controls operating with a growth rate like that. You’re going to have junior managers who’ve never managed more than a certain amount of money managing four or five times as much. You’re going to be hiring new staff and throwing them in there kind of the way Putin’s throwing untrained soldiers at Ukraine. You’re going to have systems problems. And the bank examiners saw that. And that’s even without the—and they also saw the interest rate risk. But they did nothing. We think, “Well, all we need is enough regulation. If there’s enough regulation, these things won’t happen.” But I’ve never seen—I mean, maybe these regulators have stopped a lot of things and we haven’t seen it because when they stop it, it doesn’t make headlines, but they sure don’t stop everything.
The Nationalization of the Banking System [20:45]
Bob Zadek: Arnold, you focused on the extraordinary and atypical growth. As my audience knows, I’ve spent my life in commercial credit as a lawyer and as a lender; that’s my world. And often I have those who seek loans, and they present themselves with unusual growth, how well we are doing, we’ve grown so fast. And just as you have pointed out, Arnold, my response is: there is a natural growth that one would expect in whether it’s in companies or in biological beings and in animals. But one can have extraordinary growth; the word for it is cancer. That’s the biological word for it, or else it’s steroid-induced, which is another artificiality. In summary, it’s not good for you. It’s a predictor of bad health, not good health, whether it’s financial or sickness. And therefore, I couldn’t agree with you more that that factor alone should have at least raised a question, unless you’re looking for reasons to encourage the enterprise rather than the skepticism necessary to regulate them. So it’s interesting, Arnold, you have pointed that out. Most other commentators haven’t specifically mentioned that as one of those red flags, but you did; they should have been listening to you, Arnold, and not to themselves.
Arnold Kling: I’m actually surprised that there wasn’t a veteran regulator—one of the things I joke is that it would be fun to do a Freedom of Information request to get all the memoranda that were written about Silicon Valley Bank within the FDIC, because I’ll bet there’s some old cranky guy there who was writing memos like, “Why don’t we shut this bank down? Why don’t we tell them that they need to hedge their interest rate risk? Why don’t we do this? Why don’t we do that?” And somebody higher up said, “No, we don’t need to do that.” I’m sure that there’s got to be somebody around there on the inside of the FDIC who could see that there was a problem.
Bob Zadek: The danger was, we know and we’ll get into what action the federal regulators took to perform what they vehemently deny is a bailout. Arnold, you and I will have our own opinion on that, and we will examine that. But putting aside the label, they stepped in over a weekend and they avoided and prevented the obvious. The obvious was: oh well, let the bank fail. There’s nothing wrong with the bank failing. There is no victim in the bank’s failing. There is no yet suggestion of fraud. All that happened was depositors as lenders put a bunch of money into a bank, presumably on an informed basis. They made a cautious decision to give the bank money. They don’t qualify as victims. The small depositors, a tiny minority of their cohort of depositors, are protected by deposit insurance. Just let the bank fail. Let the companies who were unwise enough to leave their money with the bank lose the money because they should have—they made a bad bet, they made a bad loan. But they didn’t. So tell us why you think the regulators didn’t just let nature take its course, what their claimed reason for not letting nature take its course, and walk us through, if you will, the headlines of what the regulators did to defer or prevent nature, at least financial nature, from taking its course.
Arnold Kling: I’ll start by saying something that’ll probably be pretty striking: what happened over the last weekend is that the banking system of the United States was nationalized. We now have a banking system that is like the Chinese banking system; the government controls it. So why did they do it? Well, it wasn’t so much a bailout of SVB; it was a bailout of every other bank. Because there are about a quarter of banks roughly—I mean, I could be off, but it’s a significant number—that are in this bad condition relative to long-term bonds. They’ve got too many long-term bonds on their portfolio, and so they’re borderline insolvent. But whether they’re insolvent or not, a lot of them have these uninsured deposits, these large deposits. And so if SVB had been allowed to fail, it’s not just whatever consequences to SVB’s creditors that you worry about; it’s that Monday morning, First Republic and all these other banks would have suffered runs, and probably even small depositors, the people who are insured, would have been scared just because there would have been a general atmosphere of fear. So I think if they had done nothing, Monday morning would have been chaos; it could have been a complete collapse of the financial system. I don’t think they had a choice—well, they had other choices for dealing with the problem. But if nature had taken its course, there’s a good chance there would have been widespread financial collapse, and you could go and take your apple cart and go out on the street and sell apples because that might be the only way you can make a living.
So I think they had to do that. But they didn’t just say, “Okay, we’re going to make sure that these uninsured depositors are going to be made whole at SVB.” They said at every bank from now on, the uninsured depositors are going to be made whole. We are going to make a lending facility available that will allow any other bank to borrow to meet any liquidity needs so that if you try to run on the bank, they’ll be able to pay your deposit. They effectively said they’re going to protect everything. So what follows from that as night follows day is tighter regulation. They’re going to exert more control over what the banks do, in some ways legitimately, because they have become the ultimate backstop for every bank. And so they can legitimately come in and say, “Hey, since you’re playing with our money, with house money, we should control what kind of risks you take and what kind of lending you do.” So that’s why I say in effect we have nationalized the banking system because, again, as night follows day, once the kind of it sinks in how much new risk the FDIC and the Fed have taken on with their backstopping of all these banks, they’re going to realize that they need to regulate more closely. And so we’re going to have a highly regulated banking system where government regulators are going to tell banks what kind of loans they can—who they can lend to and who they cannot lend to, and that gets back to something that’s like the system in China.
Government-Directed Credit and Social Policy [26:38]
Bob Zadek: I would just like to modify the tense that you used. You said we are going to have a highly regulated banking system. I’m sure you could have just as comfortably said we have a highly regulated banking system, and now you ain’t seen nothing yet. Because of my professional life, I have lots of contact with banks and bankers in many capacities. And therefore, I’m an informed observer. And it’s clear to me—in fact, it would be clear to anybody who had my experiences—that so many of the decisions that bankers as an occupation seem to make, they explain it somewhat apologetically: “Well, we’re doing what the regulators require.”
Arnold Kling: Well, and SVB is an example of that. Why did they buy long-term bonds and mortgage-backed securities? Because the government says that’s how you minimize your capital requirements. That’s how you can grow without continually going out to the capital market and asking shareholders to put up more money, is you buy these kinds of securities. So yeah, we’re already doing that, we’re already regulating that way. It’s just that, like you say, it’s going to be “you ain’t seen nothing yet.” There’s going to be less and less room within the regulations for banks to do private sector type lending, and it’s going to be more and more of a focus on lending to the government.
Bob Zadek: If any of our listeners need proof, I don’t think they do, but one can easily rattle off the examples of the shotgun marriage between government and banking. We all are at least vaguely familiar with one set of regulations been around since the late 1970s, started in Chicago, called the Community Reinvestment Act, where government, which had a social problem—housing—it was part of our national ethos that it’s more American if you live in a private house than if you’re a renter; you’re not as American as if you lived in a private house. So government set about getting people who couldn’t necessarily afford it to get mortgages to live in private houses, and they did so by coercing banks to make mortgage loans to people who otherwise might not deserve it—might not, I’m not indicting any group, but banks were told, “You are regulated. You will need favors from us, the regulator, and if you expect favors from us, you better—one hand washes the other—you better help us carry out social policies.” Think back to a show I did, it was much in the news, where the banking regulators were suggesting to banks by way of guidance—but guidance from government has a powerful meaning—to stop giving bank accounts to people who operate lawful businesses like gun shops. Gun shops are lawful business activities; government didn’t like it, they said, “Don’t give them bank accounts,” and banks were discouraged from making loans to gun shops and other lawful businesses. So the examples are legion where there is this relationship where bankers carry out social governmental policies, not because they necessarily want to, but because they are regulated. And Arnold is now saying it’s only going to continue, but now more so as the separation—talk about separation between church and state, how about between private business and government? That separation becomes more blurred. Arnold, I think you were going to either correct me or support me, I couldn’t tell which.
Arnold Kling: No, I would support. I just like—I would say up until 2008, government likes to channel credit to its preferred uses, mostly its own spending, and keep it away from things like the gun shops and whatever. Up until 2008, housing in general was a preferred thing. It was all sorts of subsidies given to home buyers. But I think since 2008, a lot of that has been dialed back in the form of much tighter credit requirements. I think that we’ve gone from having credit requirements for borrowers that were too loose to requirements now that are too tight. And the consequence has been since 2008, over the last 15 years, we have not had one year in which housing starts have been sufficient to keep up with population. And so we’re seeing rents and house prices go up because the government no longer favors housing in the financial market. So the question is sort of who will suffer next as the government channels more and more credit to its preferred uses? Is it going to still support venture capital? Is it still going to support private sector investments in energy or—anyway, it’ll just be more and more directed from government. And again, I go back to: that’s how China operates. The banks are technically private, but the government tells them exactly where to put their money.
The Myth of “No Cost to Taxpayers” [32:54]
Bob Zadek: One of the more cynical aspects—I think Janet Yellen is guilty of this, and Arnold, I’d like you to speak to this issue. The government has announced that it is now going to insure deposits in excess of $250,000. Okay, as Arnold has explained. Now, obviously, any kind of insurance has a cost, because if there is insurance, then there’s a likelihood of claims. And therefore, Janet Yellen and President Biden says, “This is at no cost to consumers,” and that’s the cynical part that I’d like you to address. So Janet Yellen explains not to worry because consumers aren’t going to pay. We charge a fee for deposit insurance, and all banks are required to pay a fee which is based upon their size. So the banks will have to contribute to the Federal Deposit Insurance fund, so if we have to pay claims, don’t worry, the banks will pay. Speak to the utter cynicism, if not dishonesty, of that explanation of how “don’t worry, taxpayers, it will not cost us.”
Arnold Kling: That’s a classic thing of when politicians levy taxes at a business level to say, “Don’t worry, it’s a business tax, you won’t pay it,” not realizing that who patronizes businesses, who owns businesses? They’re people. Ultimately, there’s no “business” thing that’s not a person that pays taxes. All taxes ultimately are paid by people. That’s just a classic demagogic—I’ll use the term lie—to say that no people will pay for a tax. Any tax you see—you can call it a corporate tax, you can call it a payroll tax—any tax you see is paid by people. And there’s no sort of thing out there sitting out in the ocean that you can just pull money out of and say I haven’t taxed any people.
Bob Zadek: I did—it was certainly at least 10 years ago, and I even remember who was the guest; it was somebody from the CEI, Competitive Enterprise Institute, and the topic of the show was we spent an entire hour discussing who pays corporate income tax. And it was clear, data-driven response: the lowest 25th percentile of the earning public bears the brunt of all corporate taxes because they spend all of their money on the consumption of consumer goods in which the price of taxation is passed into the product.
Arnold Kling: And they’re also workers, and the corporate income tax reduces investment, and the investment is what raises the productivity of workers and raises their wages. So it’s a classic difference in economics between where you place the tax and who bears the burden of the tax. I mean, a simple example of that difference is the payroll tax. So half of the payroll tax is levied on employers and half of it is levied on employees, just as a legal matter. But as an economic matter, the employee pays all of it. Because if I’m an employer and I know that hiring you, I’m going to have to pay X percent of your salary to the government, then that money is less money that I can afford to pay you. So in the end, you pay the entire payroll tax even though for legal and accounting and phony purposes, it’s supposedly split between you and the business.
Moral Hazard and the Future of Banking [37:21]
Bob Zadek: Another concept that was in the news every night during the last alleged financial crisis, 2008 et al., the era of The Big Short, my favorite economics financial motion picture, bears watching once a year. The concept is Moral Hazard. And that doesn’t sound like an economic concept, but Arnold, of course it is. Tell us what the concept of moral hazard is and what it has to do as a concept with the bailout of Silicon Valley Bank—yes, Janet Yellen, it is a bailout—with the bailout of Silicon Valley Bank, Signature Bank, and perhaps First Republic Bank and other banks which may follow.
Arnold Kling: Okay, so it’s a concept that originates in the insurance industry. So let’s say you’re going to build a house somewhere in, let’s say, Western Florida. And you have a choice between building your house right down near the Gulf there, or you can build it a mile, two miles inland. And if you have flood insurance, and you know you’re going to have flood insurance, you might as well build it on the coast; it’s much nicer there. And that is the moral hazard of having insurance. I mean, it’s a good idea to have insurance on your house, it’s a good idea to have flood insurance, but the one issue with flood insurance is it creates this incentive for you to overlook or downplay a risk, a risk of your house flooding. So it’s a very common thing that happens. We still need insurance, but when we have insurance, we need to be aware of this moral hazard that you all of a sudden have reduced the disincentive to take risks.
And where that shows up in banking is in deposit insurance, which is insurance. If I have the choice as the owner of a bank between being very low risk, very prudent, very careful, not trying to pay too much to depositors to lure money away, not trying to invest in the riskiest loans, versus another bank that says, “I’m just going to gamble. I’m going to make risky loans, and in order to grow, I’m going to lure other depositors away from other banks with higher interest rates and so on.” That risky bank is in some sense subsidized by having deposit insurance. It’s sort of a “heads I win, tails the FDIC loses” situation. So what follows from that is it becomes incumbent on the insurance company to regulate. In this case, the FDIC has to regulate banks, just as a company that’s going to insure your business is going to give you fire insurance, it’s going to make sure that you follow building codes, that you have the right amount of—you have a sprinkler system if you’re supposed to have it, and so on. And you see that with car insurance; you’ll pay different rates depending on what kind of safety features you put in place.
So that kind of insurer always wants to regulate to some degree the person they’re insuring. And so the moral hazard problem in this case gets exacerbated because now, as I mentioned before, there are a lot of banks that are not in as extreme position as SVB, but they’re in a milder version of it where their portfolios are a little underwater and they have a lot of these what were formerly uninsured deposits. And now that they’ve got their insurance backing, there’s in theory nothing stopping them from luring in billions of dollars of deposits and sort of taking them to Las Vegas, so to speak, making a big bet. And if it wins, the shareholders get a lot of money and the executives get to pay big bonuses to themselves. And if it loses, well, maybe it doesn’t really hurt them because if they’re in a dicey situation right now, maybe they can’t pay big dividends or have big bonuses now anyway, so they haven’t really lost much if they lose. So the moral hazard in the whole system has just gone way up, and it’ll mostly be exploited by the owners and managers of banks that are not in good shape. In the 1980s, we used to call them “zombie banks.” That was a term for a bank that didn’t really have much profit on its own.
Bob Zadek: Texas was ground zero for the S&L crisis, and that was because the Speaker of the House was a guy named Wright from Texas, who had a lot to say about banking regulation and he took care of his banks in Texas. One of the less reported upon moral hazards is not focused on the bankers, but focused on the depositors. I believe that the corporate treasurers who kept large sums, uninsured sums with Silicon Valley Bank truly believed that, yes, they were uninsured, but who cares? The government will step in and under some version of “too big to fail,” although Silicon Valley was not too big to fail, but on the assumption that the government simply will not let depositors with deposits lose money. On that assumption, they didn’t pay attention to whether Silicon Valley Bank was good for the money. So the other version, in my view, underreported on moral hazard is: if it were assured that if the bank where you had your money failed, you would lose the money, corporate treasurers would, in my judgment, be more prudent where to spread the money around so it’s not uninsured. So that’s the other version of distorting market behavior. Therefore, banks were able to get deposits when perhaps their balance sheet didn’t deserve it.
Private Insurance and Contingent Capital Solutions [44:55]
Arnold Kling: Well, yeah, you could have a banking system where you teach them a lesson and you say, “Okay, we’re going to let these corporate treasurers sit and wait until we’ve liquidated SVB and we’ll see how much they get—80 cents on the dollar, 60 cents on the dollar.” I think the problem with that is that, at least as banking is conducted today, it’s really difficult to expect even a professional corporate treasurer to walk into a bank and examine everything and figure out how risky it is. I couldn’t do it. I certainly don’t have the know-how. And you just look at things like the really complicated banks with derivative books and so on, or just a bank even like SVB, to understand that they were risky, you have to understand that they’re not hedging their portfolios well. Because there are other banks that have just as many long-term bonds, but they do things like interest rate swaps and so on. So I don’t want to have—if I’m a corporate treasurer, I don’t want to have to go into every bank that I’m doing business with and say, “Okay, what does your derivative book look like, and what would it look like under this scenario, and what would it look like under that scenario?” I don’t think we can organize the banking system that way. I think we do need to organize it in a way that there are people in the private sector who have the skin in the game. I don’t want it just to be the FDIC on the one hand and everybody else is risk-free on the other. But it requires a different direction in the banking system. The proposal that I like the best that I’ve seen is to have what are called contingent capital, which is a long-term bonds that are in the bank, but if the net worth of the bank falls below a certain level, the ownership of the bank gets transferred from the shareholders to the bondholders. So those bondholders would then be the ones that have to evaluate the risk and monitor the bank. I think that’s about the only way you can transfer it to the private sector. I think it’s pretty hard to transfer it to depositors.
Bob Zadek: Arnold, I’m going to give you first rights to my better solution. We only have a few minutes left; you’re not going to have a chance to tear it to pieces, maybe you’ll spend some time on your Substack blog to discuss it. My plan would be, just as there is commercial credit insurance, that a private insurance policy to insure deposits. The insurance company has the wherewithal and the incentive to do the deep dive that you say a treasurer cannot do. So I propose privatized deposit insurance, have treasurers buy the premiums—the premiums would be tiny, and the premiums would be rated based upon the bank where you want to deposit the money. So banks would then have to compete on credit quality to get deposits. So I say I have already invented, unfortunately, I need your support to promote my plan so we can go into business together. So you can privatize it.
Now, Arnold, before we close and we tell the audience how to follow your writings, what do you think will be the aftermath? After all, this is not the end of the story; this is the prologue of the story. So tell us what in your view we can expect, and then tell us how our friends can follow your writings on Substack and what your blog attempts to cover.
Arnold Kling: Okay, first of all, the private insurance has worked before. Banks even can get together and do a mutual insurance. In fact, that’s sort of what’s going on with First Republic as we speak, although I don’t know how the banks that are providing liquidity to First Republic are being compensated. So that’s been workable in the past. Just because it’s workable doesn’t mean it’ll ever happen here; it’s not politically what’s going to happen. But I think I’ve already said what I think is happening, is that our banking system has been at least ratcheted up the amount of nationalization.
As far as following me, just the last name is spelled K-L-I-N-G, Arnold Kling. It’s hard to miss on the web because I’ve been on the web for so long. And if you do a Google for “Arnold Kling Substack,” you’ll find it. I post about once a day; I’ve been posting twice a day since the SVB crisis. I’m going to try to dial that back. I have one more long post on SVB tomorrow, and I hope I’ll be able to back off and talk about the other things that I like to talk about on the Substack.
Bob Zadek: What are the types of topics you like to cover? What can our audience expect if they follow your writings on Substack?
Arnold Kling: Some of it’s just abstract stuff about libertarianism and about the challenges of trying to do libertarian things. That’s probably what I try to do most. I try to stay out of what people call “the current thing,” you know, whatever’s high on Twitter or in the mainstream media. It just happened that with SVB, because I’ve got a long background in working at finance, financial regulation, interest rate risk, and so on, I felt like this was in my wheelhouse. And so even though it’s the current thing that I usually try to stay away from, I got into it.
Bob Zadek: You provide a lot of wisdom on a tough subject. Most people, their eyes glaze over. To me, this is all fascinating stuff, and it affects every single listener, every single American, and it is a predictor of what might be our future political and economic life. So please keep an eye on it for all of us. Arnold’s Substack is arnoldkling.substack.com. Be sure to follow Arnold. Arnold, thank you so much for giving us an hour of your time. We sure have found it valuable. And thank you so much to my listeners out there for giving Arnold and myself an hour of your time, which is equally valuable. We hope you have found the time to be well spent. Thank you so much to Arnold, and thank you so much to my friends out there.
Arnold Kling: Thanks, Bob.