[00:04:23] Joseph Wang: But if everyone comes and asks for their money back at the same time, now that’s not expected. But if they did, the bank would be expected to have enough cash to meet those withdrawals. But in practice, that doesn’t happen. So, banks usually don’t keep a whole lot of cash on hand. Their assets tend to be longer-dated assets, say a mortgage or a corporate loan that eventually will get repaid, but obviously, they’re not going to keep a whole bunch of cash on hand because in practice, not everyone asks for their money back at the same time.

[00:05:03] Joseph Wang: When everyone does ask for their money back at the same time, well, that’s a huge problem for the bank. In practice, banks just don’t keep that much cash on hand. If they’re in a pinch, they can ultimately borrow, as you suggested from the Fed, who is the lender of last resort for commercial banks and the Fed.

[00:05:27] Joseph Wang: Well, that’s the whole purpose of the Fed, is to be that lender of last resort, but they also have a lot of restrictions as well. The Fed is not in the business of supporting banks that are insolvent, so they also want to make sure that the banks that they lend to are in good financial condition and to protect the Fed.

[00:05:43] Joseph Wang: The Fed will also ask for good collateral to make loans against what we’ve seen over the past few years. Is the failure of some banks that were badly run. Now remember, the core problem of a bank is that they don’t want to, they want to make sure that, well, first of all, when everyone asks for their money back, they have enough cash on hand.

[00:06:00] Joseph Wang: There are two ways to do this. The first way is to manage the deposits. So that not everyone asks for their money back at the same time. And I’ll get into how this can be done. And the second part is to make sure that just in case that everyone does ask for all their money back at the same time, they have enough assets that they can use to raise cash to repay those depositors.

[00:06:24] Joseph Wang: And as we get to Shirley, we’ll see that Silicon Valley Bank basically failed very badly on both those measures.

[00:06:31] Rebecca Hotsko: Right. Okay. So let’s unpack what happened with them, because it’s my understanding that they failed just because they were very poorly run. They exposed themselves to risks that maybe not other banks are facing, and so talk about what they did wrong.

[00:06:48] Rebecca Hotsko: How did they run their business differently and ultimately expose themselves to risk though these other banks perhaps aren’t facing.

[00:06:57] Joseph Wang: So as an overview, the US has about over 4,000 banks and a few thousand credit unions. So, if you have several thousand of these bank-like businesses, some of them are going to fail. It’s like any other business. Some of them are not going to be very well run. So, I don’t think it’s a surprise that we see banks fail every now and then. What’s been surprising is that we’ve had very few bank failures over the past few years, but historically, for the past 20 years, we’ve had a few hundred banks fail.

[00:07:23] Joseph Wang: Silicon Valley Bank was unusual in that it’s relatively well, it’s not a big bank. It’s a medium-size bank. And medium-size banks usually don’t fail as badly as Silicon Valley. So, let’s get into how they did not manage their risks properly. Now, let’s start with looking at deposit risk. So a bank doesn’t want all their depositors to ask for their money back at the same time. At the same time, the way that they can prevent this is, well, there are many ways actually, but a common way is to issue things like a CD. So, we think of a CD as a deposit that can give you a higher interest rate, but in return, your money’s locked up in the bank for say three months or 12 months, and so forth.

[00:08:17] Joseph Wang: That’s a way for the bank to make sure that not everyone will ask for their money back at the same time because a portion of it is locked in CDs and can’t be redeemed until the CD expires. But for a bank like Silicon Valley Bank, the more common way to manage deposit outflows is to have a diversified retail-based deposit base. So, in the US, deposits are protected up to $250,000 in FDIC insurance. For most retail investors, there’s really no reason to ever worry that you’ll lose your deposits. But if you are a wealthier investor, an institutional investor, or a corporation, you have to worry a bit more since not all of your money is covered by FDIC insurance.

[00:09:06] Joseph Wang: So larger accounts are more volatile; they’re flightier. If they sense that a bank is in bad condition, they get their money out asap. Because they know they’re not protected, usually banks want to have a large deposit base of insured depositors because insured deposits don’t run. So, you don’t have this problem of everyone asking for their money back at the same time. Silicon Valley Bank was unusual in that almost all of its deposits were uninsured. So, they were a company that focused basically on wealthy individuals and companies. In contrast, in the US, usually, banks usually have about half of their deposits uninsured. So Silicon Valley Bank, with over 90% uninsured, was an extreme outlier.

[00:09:54] Joseph Wang: Another way they were an outlier is that they focused heavily on tech and VC and crypto and things like that. So usually, a bank also tries to manage the deposits by having a diversified industry base, so just in case one segment of the economy doesn’t do well, they won’t take too big of a loss, right? Classic diversification, which I’m sure we’ve discussed about as an investor, but Silicon Valley Bank was basically all in on the tech space. And as we’ve heard, tech has not been doing that well over the past year. So, they were in a position where they were very vulnerable to everyone asking for their money back or not being able to put more money into the bank. And if you have everyone asking for their money, well, that’s fine if you have a lot of assets that you can use to raise cash and meet those withdrawals. But as you noted, Rebecca, they didn’t manage their interest rate very well, and so when the time came, they actually didn’t have enough good assets that they could use to raise cash to meet those withdrawals.

[00:11:11] Joseph Wang: So we’ll pause here. Does everything follow so far?

[00:11:15] Rebecca Hotsko: Yeah. That was such a helpful explanation and I think you’re stopping there. It kind of segues into the next thing I wanted to ask you, which is on how the inverted yield curve. Impacted or played a role in their failure because this is a risk that all banks face this interest rate risk.

[00:11:34] Rebecca Hotsko: And so, what are other banks doing differently that I guess Silicon Valley Bank failed to do to manage this interest rate risk with this inverted yield curve?

[00:11:44] Joseph Wang: That’s one of the things that Silicon Valley Bank did not do well, so they had tremendous amounts of interest rate risk. So Silicon Valley Bank had a balance sheet of about 210 billion in assets, and almost half of that was in long-dated securities. So, treasuries and agency mortgage-backed securities, those long-dated securities, are very sensitive to interest rates. So, when interest rates go up, the market value of those securities declines. Silicon Valley Bank held $120 billion worth of securities, and because of the Fed rate hikes, interest rates went higher, and the market value of those securities decreased to $100 billion.

[00:12:26] Joseph Wang: So, they were sitting on unrealized losses of 20 billion. That’s a problem. Well, that’s a problem if you need cash, right? If you just hold those securities, they’re guaranteed by the US government, so there’s no credit risk. Eventually that $100 million. We’ll appreciate one $20 million as the security matures, but if you need cash right away, you have to raise cash against the market value of securities.

[00:12:52] Joseph Wang: So that means that if you have an unrealized loss, you have less money you can raise based on those securities at that point in time, even if Silicon Valley Bank was able to borrow against all those securities, they probably still wouldn’t have enough money to meet the. Outflows. A well-managed bank would try to take away some of that interest rate risk through something called interest rate derivatives.

[00:13:13] Joseph Wang: What a derivative does is that it would offset the losses on the securities. So, for example, when interest rates went higher, Silicon Valley Bank could have lost money on the securities it held, but it could have offset those losses with gains. Properly executed interest rate derivatives. That’s common practice for a bank.

[00:13:32] Joseph Wang: But Silicon Valley Bank did not do that. So, at the end of the day, they didn’t have anything to offset the losses on their securities. They didn’t have enough assets they could use to raise money to capture all the outflows usually. Now, your point about the inverted yield curve is important when it comes to the profitability of a bank.

[00:13:51] Joseph Wang: So, banks have to pay interest on their deposit. But they earn interest on the longer dated securities, longer dated securities. They trade in line with let’s say the 10-year treasury, whereas short, dated deposit rates usually track short, dated interest rates. So, when you have an inverted curve, let’s say if the two year is 4% and the 10 year is 3%, then possibly you could be not making a lot of money or even.

[00:14:20] Joseph Wang: Making some losses because your assets, say your mortgages are yielding 3%, but you have to pay 4% in interest. That would be a negative interest rate margin. That’s a potential concern, but it’s not very serious right now. The reason is, I guess we all know the reason if you, if I go to my bank, I will earn 0% on my deposits, and I think that’s the common story for most people.

[00:14:40] Joseph Wang: So, banks have a lot of pricing power when it comes to deposits because they don’t purely compete on price. When you go to a bank, they offer a whole bunch of services. Very nice. Branch offices and a whole bunch of technology. For example, you could deposit your check on your phone these days. These are all things that are valuable to customers.

[00:14:58] Joseph Wang: So, customers don’t really judge a bank purely by how much interest they can earn on their deposits. So even though the curve is inverted so far, I think banks, because they cannot pay a lot of money on their deposits, they can still make healthy net interest margins.

[00:15:15] Rebecca Hotsko: Okay, and I want to get more into the net interest margins in a bit.

[00:15:19] Rebecca Hotsko: I want to kind of discuss more about these failures first and get into this, because I guess in hindsight, it’s clear now that there was this very poor risk management happening and maybe the risks were unique to this bank. And then signature, who was also very. To certain niche industries. I guess I’m just wondering what warning signs, if any, should have investors and public notice about a Silicon Valley bank, because it seems obvious now that they had this very large asset liability mismatch.

[00:15:50] Rebecca Hotsko: Why wasn’t that noticed before?

[00:15:54] Joseph Wang: That’s a good question and it should be an especially important question for the regulators because this should have been very obvious that it was a risk, and the regulators should have done something about it. And I think there is some soul searching that they have to do.

[00:16:07] Joseph Wang: Now, when it comes to investors though, in my experience, most investors don’t really look very closely at the financial statements of a bank. And to be fair, banks are difficult to understand. There were some vocal short sellers who. Warning about Silicon Valley Bank, but most people, I don’t think they invest according to what they see in the financial statements.

[00:16:27] Joseph Wang: A lot of times it has to do with where the s and p is, where sentiment is, and maybe technical indicators. So it was a, I think it was a very obvious risk. It’s surprising that the market did not find out, but you know, eventually it did. So sometimes it just takes a while.

[00:16:43] Rebecca Hotsko: And I guess, what do you think are the most important takeaways for investors from this situation?

[00:16:48] Rebecca Hotsko: If someone invests in bank stocks, what do you think should have been learned from this that now investors know to look out for, to make sure banks are properly managing their risks?

[00:16:59] Joseph Wang: No, strangely, I think this incident made all banks much, much safer because what happened after Silicon Valley Bank? No, we all, the assumption always was that there.

[00:17:11] Joseph Wang: A $250,000 insurance limit for your deposits. So if you are depositing in a bank, well, you want to be careful, and if you have a lot of money and the bank is in trouble, you gotta run, which in turn causes the bank to be in distress. But the authorities guaranteed all the deposits of Silicon Valley Bank and Chair Powell and Treasury Secretary Yellen have made very strong indications that they’re willing to go.

[00:17:36] Joseph Wang: All deposits in the US Now, this can only be done by an act of Congress. However, if a bank were to go in, if a bank were to fail, the government has a whole bunch of special emergency powers that can allow them to ensure deposits, as in the case of Silicon Valley Bank and Signature Bank. So now the going assumption for the entire public.

[00:17:57] Joseph Wang: Is that all your deposits insured? And if all your deposits are insured, then there’s never any reason to run. And if no one runs, there’s much less likely for a bank to fail. So, strangely I think it honestly makes investments in the banking sector safer so that you don’t have this failure risk going forward.

[00:18:14] Joseph Wang: So I, I think that on one hand that is constructive and in addition to that, The Fed has also rolled out this special emergency lending facility, which allows banks to borrow against the face value of securities rather than the market value. So going back to our earlier discussion, Silicon Valley Bank bought 120 billion worth of securities that had declined in value to 100 billion.

[00:18:37] Joseph Wang: They had unrealized losses. This new facility would allow a bank like Silicon Valley Bank to borrow, not just against the market value, which is what the market convention would be, but to borrow against face value. So in the case of Silicon Valley Bank, that would’ve been about 120 billion. This, in a sense, takes away interest rate risk for a bank, so you wouldn’t have to worry that you were Silicon Valley Bank mismanaging interest rates because in a sense, the Fed has this facility that will fakely bail you out.

[00:19:06] Joseph Wang: So the risk in the baking sector is a lot less today than I think it was a few weeks ago.

[00:19:13] Rebecca Hotsko: Okay, and I guess I was going to ask you if you think there is a big risk for this contagion to spread, because then a few days later we heard of the failure of Credit Suisse. And so it’s my understanding though that when.

[00:19:28] Rebecca Hotsko: Led to the problems at Credit Suisse , it’s been long standing. They’ve had a history of kind of issues of their own, and so the issues that brought it down were perhaps even different from Silicon Valley Bank, but do you think that the measures taken by the Fed are enough to contain this from future bank rents happening because Credit Suisse.

[00:19:49] Rebecca Hotsko: Systemically important bank compared to Silicon Valley Bank, which was not considered systemically important at the time. And so when the fall of Credit Suisse happened, I think that caused some investors and depositors to be worried that, okay, is this the start of a more global contagion? And this could actually spread to more than just these regional niche banks.

[00:20:12] Joseph Wang: Yeah, that’s the question on everyone’s mind right now. So the market is very nervous because what looked like a regional bank problem and suddenly erupted into what may potentially be a more global problem. Now, I’ll touch upon the regional problem first, and then I’ll talk about Credit Su, and then I’ll talk about the potential implications for the global banking sector.

[00:20:32] Joseph Wang: Now going back to the regional. Now for some perspective, Silicon Valley Bank is not even a 10th. The size of JP Morgan, the largest bank in the U.S. So Silicon Valley Bank it’s really not a big deal. It’s kind of like a giant local bank. Its failure doesn’t have any global repercussions, but it did lead to some panic that we can see now in recent data.

[00:20:54] Joseph Wang: So when I look at the most recent official data on bank deposit flows, what I saw is  that in one week, between March 8th and March 15th, so covering the time that Silicon Valley Bank failed, we saw about a hundred billion of deposits leave. These small banks move to the big banks. So right off the bat, that can tell you that more and more people are concerned that their small bank might not be safe, and so they’re moving money outside of the small banks and into the larger banks.

[00:21:22] Joseph Wang: Now the next thing I will note is that you’ve also have large inflows into US Money market funds. A money market fund is an investment fund that only invests in very safe assets like treasury. So it’s basically even safer than a commercial bank. In that one week we saw a hundred billion leave the banking sector into money market funds.

[00:21:44] Joseph Wang: So you can think of small banks, some of the money from small banks going to money market funds and going into big banks and some of the money in big banks going to money market funds. So there is a little bit of it. In the US banking sector where everyone is trying to get to where they  think is safer.

[00:22:01] Joseph Wang: But overall, the US banking sector is very big and in my view, much stronger than it was before compared to pre-gfc. So I don’t think there’s any problems there. Now. All this was happening and then suddenly halfway across the world we saw Credit Suisse fail. And Credit Suisse, as you noted, is systemically.

[00:22:19] Joseph Wang: It’s not just a regional bank like Silicon Valley Bank, it is legitimately too big to Phil Bank that is globally interconnected with the entire financial system. So its bankruptcy would have tremendous implications that could be comparable to Lehman Brothers back in 2008. So, The reasons for Credit Suisse’s failures are many, and it was almost always on death’s row if you look at it, so I encourage everyone to look at a chart of the soft price of Credit Suisse, and you’ll know that it’s a bank that had a lot of trouble over the past year.

[00:22:51] Joseph Wang: It looks like it’s been going down every day. For those of you who remember Archegos, Credit Suisse lost billions of dollars by lending into this investment fund Archegos, who bought a whole bunch of meme stocks. So Credit Suisse is a bank that has made a long history of very bad investments, was poorly run, and was always just at death’s door for whatever reason.

[00:23:11] Joseph Wang: Silicon Valley banks seem to panic. The depositors in Credit Suisse. Forced them to run, and that in a sense, collapsed Credit Suisse. The Swiss authorities stepped in and forced UBS to buy them, and the Swiss authorities also sweetened the deal by offering all sorts of, I guess, loan guarantees and liquidity and so forth.

[00:23:31] Joseph Wang: So it was actually a pretty good deal for UBS. What I take away from this episode is that it’s very difficult to have a big systemic banking crisis today because the authorities are willing to do whatever it takes . To make it stop. Now everyone who is a policy maker. Grew up in the shadow of Lehman Brothers in 2008, when Lehman Brothers failed, that really shook the world’s financial system.

[00:23:55] Joseph Wang: Many banks went under, soft market tanked. A lot of people lost their jobs.  That was a very bad experience, and so everyone has been working hard and were willing to do whatever it takes to avoid that. So it’s very unlikely we have a big banking crisis because the government is willing to do everything it can to stop.

[00:24:12] Joseph Wang: But, and that leads me to the most interesting part. There are things that are beyond the government’s power. Now, we talk about in the US in Silicon Valley Bank, for example, a lot of uninsured depositors ran because they were afraid that they would lose money. And that led to the fall of Silicon Valley Bank.

[00:24:29] Joseph Wang: What people don’t often appreciate is that the US dollar is a global system. People take dollar deposits in the US but because the US. Global reserve currency. People all throughout the world use dollars from Asia to Europe, to Africa and so forth. Everyone uses US dollars and banks across the world take U.S dollar deposits and make US dollar loans.

[00:24:52] Joseph Wang: Insurance on US dollar deposits only happens within the US. It’s within the jurisdiction of the us. But outside of the US there are several trillion dollars in dollar deposits being held in foreign banks that are not insured by the US government. And if you are a foreign government, let’s say for example, you are the French government, you have a lot of banks in France who have dollar deposits, you don’t guarantee those either because you don’t have any dollars.

[00:25:19] Joseph Wang: So you can’t print dollars yourself. So obviously you don’t have the part to guarantee that the potential threat to the global banking system, in my view, and this is a potential threat, not something that will necessarily happen, is just as many people realize that it’s not safe having your money uninsured in a bank.

[00:25:37] Joseph Wang: So many people outside of the US will realize that their dollars are not safe in a foreign bank because it’s not guaranteed by the US government, and that should move it to a US bank at the end of the. The US government has strongly suggested that everything will be insured.

[00:25:54] Rebecca Hotsko: So you said that you don’t think this could be as bad as 2008 because the government will do what’s necessary to stop it.

[00:26:04] Rebecca Hotsko: But I guess I’m wondering what vulnerabilities or problems do you think that these, this recent crisis highlighted in the banking system that just wasn’t fixed in 08′ and all the regulations that followed after that?

[00:26:18] Joseph Wang: Well, you know, I think that’s what’s interesting and so just focusing first on the US.

[00:26:24] Joseph Wang: So in the US, we had this panic in the regional banks, but the big banks were fine. A big difference is that the big banks were actually under the big regulations set forth since the great financial crisis. So they were highly regulated, almost socialized in the. But in the US regulations on banks depend on how big the bank is.

[00:26:49] Joseph Wang: If you are a big bank, the book gets thrown at you. But if you are a medium-sized bank, like Silicon Valley Bank, like First Republic, you fall under the radar of a lot of regulations. And so there’s more potential for banks to, you know, get themselves into trouble. I think what will happen going forward is that regulators will change the rules to make sure that even medium-sized banks are under very stringent rules to make sure that this kind of thing can’t happen anymore.

[00:27:24] Rebecca Hotsko: And so I guess in general, we have seen some buyout happen of the banks as well as measures put in place by the Fed. And so do you think that what’s been done so far is sufficient to contain this or do you think that there is still a risk of possibly more smaller banks failing that are still in that smaller category that maybe fell through the cracks of regulation?

[00:27:50] Joseph Wang: That’s the problem for these smaller banks. So if you are a bank, you know, you have asked what you hold, what you invested in. But from the outside, if you are a depositor, you can possibly know if your bank is well-managed or not well-managed. If you look on the website for Silicon Valley Bank, it’s beautifully done. They have a great PR team. Everything looks like it was well managed and shiny, but it was rotten inside. So from a depositor’s perspective, it’s very difficult to know. So I think it’s understandable that smaller, let’s say the people who deposit in smaller banks would try to go to a JP Morgan because they know that JP Morgan is under very strict regulations and is better run.

[00:28:41] Joseph Wang: And that is going to be a big problem for the small. Because small banks are already at a competitive disadvantage versus the big banks, for example, they don’t have huge marketing budgets. They don’t have huge technology platforms, and you know, they just don’t have  the resources of a big bank.

[00:29:02] Joseph Wang: In the US, we actually have been hemorrhaging small banks for over the past few decades, pre-degree financial crisis. I believe we have about 6,000 banks, and today we have a lot less, about 4,000, and that’s in part due to consolidation and mergers and so forth. I think that it’s very good to have small banks in the US because when you have a small bank, you can have a bank that’s a bit more responsive to local conditions. Now there’s more of a relationship side to it, and they can, they’re more willing to help the community. So I hope that we can address this panic through official full deposit guarantees so that people have no reason to move money out of the small banks.

[00:29:53] Joseph Wang: Right now, it’s only strongly hinted at by Fed Chair Powell, but we should make that into law through Congress.

[00:30:00] Rebecca Hotsko: And I do want to get your thoughts on the Fed too, because given this current economic climate, the Federal Reserve is facing difficulties between reaching their inflation target and then raising interest rates, which could

[00:30:15] Rebecca Hotsko: pose a threat to the bank. So we just had the meeting on March 22nd where they raised rates by 25 basis points, but I guess at the same time, these further rate increases may exacerbate problems in the banking sector. And so I wanted to ask you what. You took away from the most recent Fed meeting and what you think the path forward looks like is it seems like we are at a breaking point in the economy, but yet the Fed communicated that they’re still going to do what it takes to get us back to 2%.

[00:30:49] Joseph Wang: Yeah, the Fed is facing a tough choice right now. As you noted. On the one hand, inflation bio measures continues to be a big problem. On the other hand, it  seems like if you raised rates too quickly, you might have some financial stability concerns. Now, the Fed wants to get rid of inflation, but they don’t really want to tank the financial system.

[00:31:10] Joseph Wang: So I think their approach right now so far has been successful because it’s been very targeted. Now, I’ll give you an example actually. If you remember last year, there was some excitement in the UK sovereign bond market. The guilt market was in a crisis, and the gilt yields shot up very strongly. The Bank of England undertook an emergency targeted, measured.

[00:31:34] Joseph Wang: To provide liquidity in their bond market, solve that problem. Turned around and went right back to hiking rates because they are also very concerned with inflation. Now the Fed is basically doing something very similar. So the Fed saw that there is some stress in the banking sector and they rolled out this.

[00:31:50] Joseph Wang: Emergency lending facility to the banks to try to address this in a targeted fashion. You can think of it as basically duct taping the financial system together so that the  weak points in it don’t fall apart, allowing the Fed to continue to have enough policy flexibility to continue to hike rates and fight inflation.

[00:32:08] Joseph Wang: So when you move interest rates, especially when you move them very quickly, like the Fed is, It has huge impacts across markets and across the world. Some segments of the markets will be more fragile than others. If the Fed has these special facilities that can address these weaknesses in a targeted way, then that means they could continue to raise the overall interest rate without being afraid of financial instability. That’s what they’re doing right now.

[00:32:33] Joseph Wang: Now, the big change right now is that the market is pretty, That the Fed is going to be cutting rates later this year. In fact, the markets are thinking that pricing is pretty aggressively not the same as what the Fed is saying. The Fed is saying that we’re going to hike rates maybe one more time. Maybe this is the final hike, but we’re going to hold them throughout the year.

[00:32:53] Joseph Wang: The reason that the Fed, so the Fed was going to hike it a bit higher, but now they’re thinking that this is, might be the end of the cycle because they see that the  impact in the banking sector might have some effect of dampening the economy. So you can think of maybe the stress in the regional banks as equivalent to maybe one or two rate hikes.

[00:33:09] Joseph Wang: So because there’s some stress in the banking sector, Maybe the Fed doesn’t need to hike as much, and so maybe they’re close to done. The big difference is, of course the Fed thinks they’re going to hold it here at around 5%, but the market thinks they’re going to cut. What’s going to happen with the markets in the coming months is largely going to depend on which, who’s right.

[00:33:26] Joseph Wang: Is it the Fed or is it the market? Interest rates have a huge impact on risk assets. So if the market is, if the stock market is going up because it thinks the Fed is cutting rates, well that makes sense. But if the market is wrong, the Fed won’t actually be cutting rates, then I think the equity market could have some downside risk here.

[00:33:45] Joseph Wang: Now, when you think about how accurate the market is, I think you need to realize that the market has a very bad track record when it comes to predicting the Fed. So there’s actually a very good chart on Twitter about this. So the market always thinks that the future looks like the past. So let’s go back to 2009.

[00:34:03] Joseph Wang: So right after the financial crisis, right after the financial crisis, the market was always thinking that the Fed is going to hike rates in a year or a couple years, and they’re going to hike to say three or four. And it thought that for almost 10 years. But as we know now, in retrospect, the Fed kept rates at zero for many years until 2016.

[00:34:24] Joseph Wang: So the market was thinking that after the great financial crisis, things were just like they were before the great financial crisis. When the Fed was inclined to hike rates, but the market failed to understand that the world had changed. Now, today, the market thinks that the world we live in now is the same as pre covid.

[00:34:41] Joseph Wang: The pre covid, the Fed was always eager to cut rates, and so the market is eager to price in rate cuts. But my own view is that the market, the world have fundamentally changed because we have persistent inflation. And as long as that’s the case, the market is going to. I think it’s going to be wrong again because they miss, they’re not very good at catching these regime changes where now the Fed can’t easily cut and they really do have to stay higher for longer.

[00:35:08] Rebecca Hotsko: Okay. So with that view in mind then that the Fed could have these higher rates for longer. You just talked about what that means for the stock market. What about the banking sector? Do you think that poses any systemic risks to bank stocks? Because on one hand, higher rates typically are good for banks profitability, if they can lend for more than they need to pay an interest.

[00:35:31] Rebecca Hotsko: But at what point would higher rates actually pose a big threat to banks?

[00:35:36] Joseph Wang: That’s a good point. So intuitively, we think that high rates are helpful for. And there’s good reason to think that, as you mentioned, if interest rates today are 5% and they were 2% last year, well, obviously if you’re a bank and you’re making a 5% loan, you’re earning more interesting income, so that should be good for our bank.

[00:35:55] Joseph Wang: That’s true. But we also have to keep in mind that a lot of the loans. The bank’s books were made in the past when interest rates were low. Now, suppose that a bank made a whole bunch of mortgages when mortgage rates were 3%. Now interest rates have risen and they’re forced to pay their depositors, let’s say 1% or 2% on their deposits.

[00:36:14] Joseph Wang: In this case, what’s happening is that the bank is actually making less money because of its interest. Expenses are. So banks that don’t have a lot of loans stuck in low interest rates, or maybe have loans that are variable floating rates, they’re going to do fine and they’re going to be able to capitalize on higher interest rates and make those loans and earn more money.

[00:36:34] Joseph Wang: But if you are a bank, Such as Silicon Valley Bank that has a whole lot of securities and loans locked in, low interest rates, then you’re not going to do well. Another point is that banks make money, not just through interest income, but in a lot of services as well. For example if you are a bank, you could make money by providing advice to investors, advisory services.

[00:36:56] Joseph Wang: You could also make money by helping banks raise money by doing an IPO or issuing corporate bonds when interest rates are. That’s usually stressful for financial markets, so you can see that the equity markets tanked. Last year, the bond market tanked as well. Now, if you’re a bank who has a big business in providing wealth advice or some kind of investment management, then you would’ve seen that your assets under management decline, and so your fees decline as well.

[00:37:23] Joseph Wang: In the same way, if you are a bank that has a big business, helping companies raise money, well, companies don’t want to raise money when interest rates are high because, well, that’s expensive. When interest rates are low, they want a lot of cheap and cheap money. But money is, when money is expensive, you don’t want to borrow as much.

[00:37:40] Joseph Wang: So if you’re a bank that has a business mix that has a lot of these more cyclical businesses, you’re not going to do well in a world with high interest rates. So the picture that I’m trying to convey is that high interest rates have many impacts on a. And it really depends on the bank’s business model. So some banks are going to be okay and some banks who are not going to do as well.

[00:38:00] Joseph Wang: So you’re going to have to go into the underlying, I guess, financials or the annual reports of a bank and try to figure out just what the bank is exposed to, what its business model is to try to figure out which banks are going to do better than others. Now that’s in general, and right now I would emphasize.

[00:38:17] Joseph Wang: We just had a panic in the regional banks, and some regional banks are going to be oversold because some regional banks actually manage their interest rate risk very well and are well run. There’s some research from people suggesting that one of these banks, let’s say it has been telling you that they actually manage their interest rate risk very well.

[00:38:36] Joseph Wang: When interest introduced her low, they did not load up on long dated securities. They were buying Sured dated securities, so they’re not subject to all this panic. So basically there, it may be that some banks, some good banks will earn, banks were thrown out in the panic and maybe worth a look.

[00:38:52] Rebecca Hotsko: And I guess in general then, in terms of what could impact bank’s, future profitability.

[00:38:59] Rebecca Hotsko: Powell’s speech in the most recent meeting, he was talking about the banking sector. He addressed it in the measures that are going to be put in place. And so what do you think it’s going to do to the bank’s profitability going forward, as he alluded to, increased regulation or cash requirements may need to be set in place?

[00:39:20] Joseph Wang: Wow, that’s a really hard question. So if we go to the path where the government is going to ensure all deposits, well, Deposit insurance actually isn’t free. It’s paid for by banks. So just like you and I, let’s say pay monthly fees on our home insurance or auto insurance, so banks also pay fees to the FDIC to ensure their deposits.

[00:39:43] Joseph Wang: Now, if more deposits are being insured, that means more money is needed. The insurance premiums are going to go higher, and that could impact a bank’s profitability, but that also has to be balanced by the fact that now that deposits are safer, maybe banks don’t need to pay as much interest for them because people are happy keeping their money in the bank.

[00:40:01] Joseph Wang: They’re not worried about default risk. And you also have to keep in mind that there’s going to be assumption that the Fed is going to. Take away interest risk for banks. So again, that takes away some of the left and left tail risk failure risk for banks. So far, I think it’s a bit muddy. We’re going to have to wait and see.

[00:40:19] Rebecca Hotsko: It does seem quite muddy because you talked about in the beginning of the episode how deposits have been declining, and I’ve heard other people talk about how there’s been kind of a silent bank run even before the crisis happened. Customers have been moving deposits away from banks to higher yielding markets like money market securities because banks haven’t been increasing the interest on deposits, so customers are moving elsewhere, and so we’ve been seeing this decline in deposits that seems like it would directly impact a bank’s profitability too.

[00:40:54] Rebecca Hotsko: So what impact, if we keep seeing this decline in deposits, what does this mean for the banking sector and then even the economy?

[00:41:03] Joseph Wang: So you’re exactly right that bank deposits have been declining, but I think it’s helpful to understand why. And in part it is because there are people moving money out of banks into higher yielding alternatives like the money market.

[00:41:18] Joseph Wang: But another part of it is simply Fed policy. So the Fed has been conducting quantitative tightening over the past several months, and when the Fed does quantitative tightening, it decreases the level of deposits in the banking sector. The Fed is taking money out of the banking sector, just like quantitative easing, pushing a whole bunch of money printed and pushing a whole bunch of money into the banking sector.

[00:41:39] Joseph Wang: And so quantitative tightening reverses that. So what you’re seeing. In part it is a movement of banks into money market funds, but from what I see, the much bigger reason is that the Fed is conducting quantitative tightening, and that is going to continue for the next several months. Now, it’s a really good point that this may potentially affect a bank’s profitability because if there are fewer deposits, maybe the banks will have to pay higher.

[00:42:05] Joseph Wang: To attract those depositors and when their interest expense increases, that’s going to hurt their profitability. But then before we make too many, we jump to too many conclusions. We have to also think just how many deposits does a bank need? How much cash does a bank need? So the Fed through this tremendous amount of quantitative easing that they did over the past two years really stuffed the banks with cash.

[00:42:29] Joseph Wang: So, You know, trillions of dollars. So the, one of the reasons why the banks don’t have to pay a lot of interest on their deposit, It’s simply because they have too much, the Fed just put a lot of cash in the banking sector, and the banks don’t have any need to pay higher interest to attract depositors.

[00:42:46] Joseph Wang: One day they will. Eventually they will, as quantitative easing continues, and as more money leaves the banking sector into money market funds. But I think that’s sometime in the future, maybe a few months into the future. So, so far it doesn’t seem like this will have a big impact on the interest rate margin of banks.

[00:43:04] Rebecca Hotsko: I also wanted to get your thoughts on a more general question on the future of banking. What this looks like following the crisis and how you see banking evolving in the long term and competing with the desire for more decentralization. Systems, some proponents of crypto and decentralized finance use this development as a reason to further highlight the need for change.

[00:43:31] Rebecca Hotsko: And so I’m wondering what you think the future of banking looks like and could we ever see a bankless future?

[00:43:39] Joseph Wang: I think it’s difficult to see a bankless future, and that’s because banks play a very important role in. By creating money. So there’s often a conception that banks are just a place to store your money, and then they take that money and they lend it out to someone.

[00:43:54] Joseph Wang: That’s actually not what a bank does. When a bank makes a loan, it creates money out of thin air. And so the bank has a very important job of deciding who to give money to. The bank looks at it. So if you go and you try to borrow from a bank, the bank will look at your proposed project or maybe look at your income and try to make a decision whether or not to give you money.

[00:44:15] Joseph Wang: Ultimately, that’s going to be a very qualitative decision, and it’s a decision the bank is incentivized to do well because if you, if the bank makes a loan that doesn’t get re. The owners of the bank take the loss. So a bankless future is very difficult because where would the money come from? You need banks to be able to create money.

[00:44:33] Joseph Wang: That being said, you can easily have a world where banks can exist, but you can also have other more decentralized ways of distributing money that the bank has already created. We can think of this as the capital markets. So for example, if I go and I issue a stock or issue a bond, what I’m doing is I’m.

[00:44:51] Joseph Wang: The cash that someone else has. I’m not borrowing from a bank. So you could have a world where people may be able to lend and borrow in decentralized fashions away from capital markets through these crypto algorithms and so forth. I think that’s a possibility, especially as we have more data available.

[00:45:10] Joseph Wang: For example, you can easily think about a world where maybe this decentralized software has access to your credit score and employment data and so forth, and is able. Make, help make a judgment as to whether or not to lend money to you. And to be fair, a lot of people already do that, including banks.

[00:45:26] Joseph Wang: I think what’s more interesting about what’s happening now is that if you are willing to completely guarantee all deposits in a bank, I think the next step would be some kind of central bank digital currency where instead of depositing money at a bank that’s guaranteed, maybe you just deposit money directly at the Federal Reserve since you know, even if a bank goes bust, the government is guaranteeing it so the government’s on a hook anyway, minus as well, just all deposit at the Fed.

[00:45:55] Joseph Wang: And that has tremendous implications. Because that would make the government ultimately a major creator of money and they could decide that who gets money and who doesn’t. The difference between that and the bank of course, is that if a government makes a bad loan, it doesn’t really matter because the government can’t go bankrupt.

[00:46:12] Joseph Wang: So they’re incentivized to create loans, not because they’re getting repaid, but because of political interests. And I think that’s a dangerous precedent. We shouldn’t want to move towards it.

[00:46:23] Rebecca Hotsko: Yeah, I’m really glad you brought up the Central Bank digital currency because I am wondering how that would compete with the other crypto and decentralized finance in general, where a lot of people want it to be separate from the government or the state.

[00:46:41] Rebecca Hotsko: How do you see those two competing in that space?

[00:46:45] Joseph Wang: So, I think the government doesn’t like to have competition. If they have a central bank digital currency, they probably won’t want other people to have digital currencies. For example, we have very good private payment platforms like Venmo or PayPal where you can send money instantly.

[00:47:01] Joseph Wang: Now the government is coming out with something called Fed Now, which directly competes with these payment processors. So, Fed basically allows you to make instant payments for retail between each other in the same way that Venmo and PayPal can. Now, if we had a bank for digital currency, I would imagine that the government would want everyone to use it and so they would not want people to use other currencies.

[00:47:22] Joseph Wang: For example, when we buy stuff in the store, we all use dollars. There’s no state of Texas dollars or there’s no state of Nevada dollars and so forth. It’s just US dollars. If some state suddenly wanted to issue dollars for their own use, I imagine that the government would not be happy. So, it seems likely to me that the government would not want to have competing cryptocurrencies.

[00:47:45] Joseph Wang: And I’d also note that it seems like the banks that I’ve been going under, are those that have been strongly associated with crypto, like Signature Bank, like Silver Gate and so forth. And you know, I think that would send a strong signal to other banks to probably not sponsor these activities.

[00:48:01] Rebecca Hotsko: I wasn’t going to get into that, but I read an article that talked about how they didn’t want to back the crypto asset, so when the buyouts were happening, they were allowed to buy everything.

[00:48:13] Rebecca Hotsko: But the crypto asset. So, it seems like that’s sending a strong message that they don’t want crypto to be bailed out or involved in any way. And so, it just really makes me wonder what the future of crypto looks like when many proponents are like, this is the time, this is why we need it. But on the other hand, it could just be, I guess, completely wiped out by regulation.

[00:48:36] Joseph Wang: Rebecca, that’s exactly the fact that I was alluding to, they seemed to be, the regulators seemed to be putting their thought on the scale and discouraging people from participating banks, from participating in crypto. So yeah, that’s definitely a very big concern. You know, if you look at other countries, let’s say China, they effectively banned crypto.

[00:48:55] Joseph Wang: And of course, maybe they won’t be able to enforce it perfectly. But if you have the government against you, it’s a huge headwind.

[00:49:03] Rebecca Hotsko: Yeah, that seems like a major risk. Going forward, how would you suggest that people involved in the crypto space navigate this, and what information should they be looking for?

[00:49:15] Rebecca Hotsko: I guess to stay up to date, because lots of people believe in it wholeheartedly, but. What should they be listening to on the other end of the spectrum as well?

[00:49:26] Joseph Wang: I would pay attention to any hints by the SCC and other government authorities as to how they view crypto. The government acts very slowly, and so before they do something, they’ll start making speeches.

[00:49:37] Joseph Wang: They’ll have a regulation, proposed regulation for comments and so forth. So I would follow them closely to see what they’re thinking.

[00:49:45] Rebecca Hotsko: Well, thank you so much for coming on today, Joseph, this was such a wonderful discussion. I really appreciate your time today. Before I let you go, where can the listeners go to learn more about you and all of the work that you do?

[00:49:59] Joseph Wang: First of all, thanks so much for inviting me, Rebecca. It was great to be here again. So my name is Joseph. I have a website called fedeye.com where I write and teach about the markets. I have a bestselling book on Amazon called Central Banking 101 that teaches you about the financial system, and I also teach about markets from the perspective of a macro investor with my course Markets 101, also available on my website.

[00:50:30] Rebecca Hotsko: Perfect. I will make sure to have all of those in the show notes. Thank you so much again for coming on.

[00:50:36] Joseph Wang: See you later.

[00:50:37] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you [00:50:00] never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven’t already, make sure to sign up for our free newsletter, We Study Markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So, with that all said, I will see you again next time.

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