Kate Judge and Peter Conti-Brown on the Lessons Learned from the 2023 Banking Panic

Kate Judge is a professor of law at Columbia Law School and the editor of the Journal of Financial Regulation, and Peter Conti-Brown is an associate professor of financial regulation and the co-director of the Wharton Initiative on Financial Policy and Regulation at the University of Pennsylvania. Both are also returning guests to the podcast, and they rejoin Macro Musings to talk about the banking panic of 2023 and the lessons learned so far. Specifically, Kate, Peter, and David discuss how the scene was set for this recent banking crisis, the quality of the policy response, how to reform the banking system moving forward, and a lot more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Kate and Peter, welcome back to the show.

Kate Judge: Thanks for having us.

Peter Conti-Brown: Glad to be here.

Beckworth: So, Kate and Peter, let me begin with a basic question, and let me lead up to it by noting that the banking system has been through a lot these past few weeks. Three banks shut down, worries about other banks abounded, the federal government stepped in in a major way to backstop banks and calm markets. And we will get into the details of all of this in a minute, but do all of these developments amount to a banking panic as I said in my introduction? Or, is that too strong of a term and too soon to know for sure?

Judge: I think only history's going to tell. I mean, I think it started with a bank panic, but I think a lot of it's going to depend on how things evolve from here, if it's contained or if it continues to spread.

Conti-Brown: One of the things that we've seen in the first draft of history, so to speak, I wonder, which is usually in reference to journalists covering problems, there's kind of a zeroth draft of history going on on Twitter and social media, and very much in real time. And I think that that consensus, so far as I can see it, is one of very sharply divided opinions. If it's the case that Silicon Valley Bank is a victim to macro trends and flighty depositors who didn't have the right policies in place to back them up, then I think calling it a bank panic is exactly right. If it is the case that Silicon Valley Bank's uninsured depositors were running on the business model, that's Yale's Steven Kelly's diagnosis, then I don't think you call that a bank panic. I think you call that the market just beat Silicon Valley out of the business of banking, which the bank gave those depositors every reason to do.

Beckworth: So history is still being written, but it's great to have you two on. We will write the first chapter here today, if I may be so bold and daring as I say that. But it's been a great time to be engaged with folks like you. And I mentioned previously with Steven Kelly on his show, Twitter's been an amazing media through which to understand and try to grapple with these issues. So I'm fortunate to have you two on today to help us work through some of the issues.

Beckworth: So let me restate some of the developments that led to this point. So about three weeks ago, the demise of Silvergate Capital, then Silicon Valley Bank, and then Signature Bank, the last two, the state came in and closed them down, the FDIC took over. We had the Federal Reserve and Treasury step in. They made this declaration, "This is a systemic problem." So they went ahead and covered more than the normal amount of insurance on the deposits. Since then, we saw some broader stress in banking. Some other banks underwent stress. As I've checked today though, things look to be back to normal. Even interest rates on Treasury yields seem to be going back to the same direction they were in.

Beckworth: We've seen a lot of change, though, in terms of where funds are being placed. There's been a rush to money market funds. There's a great piece out in the Financial Times just yesterday titled, *Money Market Funds Swell By More Than 286 Billion Amid Deposit Flight.* So something to watch, maybe this is not over yet. Also, we have evidence from the Federal Reserve's facilities. There's been some tapping of them. The discount window, as of last week, the end of last week, $110 billion. The new bank facility that the Fed has offered, $54 billion, the banks through the FDIC that are taking over, $178 billion, for a total of $354 billion.

Beckworth: So there's still pressure, stress, in terms of people taking money and moving it to other places. Also, using the Fed's facilities. We also learned just recently that First Citizens will be buying SVB. And this morning we are recording this, just before we recorded, there's a Senate Banking Committee hearing where they brought before the Senate, the Vice Chair for Supervision, Michael Barr, from the Federal Reserve, the chairman of the FDIC, Martin Gruenberg, and then undersecretary for domestic finance, Nellie Liang. And I just caught a few minutes of it, but they got a grilling, as you can imagine. Lots of questions were asked. And as you alluded to Peter, a lot of questions and different perspectives on what went on. Now, I have you on because I really want to make sense as best we can of what has happened. So let's start there. How did we get to this place? And to do that, I want to read an excerpt from a Politico article, and this is written by Victoria Guida. Let me just read a few paragraphs here and then I'll turn it over to you two. And I thought this was great material for the show.

Beckworth: It says, "When Congress rewrote the rules for Wall Street following the 2008 financial crisis, it put the Federal Reserve at the center of oversight for the nation's wounded banks. Now the Fed is at the center of a political firestorm as Washington looks for culprits in a new banking crisis. Republicans like Senator Bill Hagerty, Thom Tillis are criticizing the central bank for failing to head off the collapse of the two lenders. Democratic Senators Tim Kaine and Michael Bennet want to know whether the Fed failed to do its job. Senator Elizabeth Warren is faulting steep interest rate hikes for fueling the problem. Even the Fed's decision to launch a review of what went wrong is being slammed by some as an investigation of itself. 'The Fed has mishandled this about seven different ways,' says Peter Conti-Brown." All right, I'll stop there. What are the different ways in which we got to this crisis? Failures, macro policy, kind of walk us through them.

The Setups for the 2023 Banking Crisis

Judge: Alright, I was going to say, [inaudible] Peter, seven different ways. I mean, clearly there's a lot of different factors going on. So you're never going to be able to have a simple narrative of, here's the one party that was at fault, or here's the one story of what went on. There were a series of missteps. And there shouldn't be a series of missteps, not only that leads to a bank failure, but leads to actually three bank failures. And with respect to two of those large bank failures, we had the federal government coming in, super majority of the FDIC, super majority of the Fed, Treasury secretary in consultation with the president, determining that it's time to invoke the systemic risk exception.

Judge: So the failure here was not that banks failed. The system should be able to handle banks occasionally failing. It was the need to invoke these emergency authorities. The Fed also went further, announced unusual and exigent circumstances, and created the special 13(3) facility. So I think the question that we need to be asking is, why is it we ended up in a situation where these emergency authorities needed to be invoked? And if that possibility was on the table, even as a low probability matter, why the heck didn't regulators and supervisors do a heck of a lot more to ward off this happening? And that's really what I think we're all trying to uncover.

Judge: So rising interest rates clearly played a huge role. It resulted in unrealized losses on SVB's balance sheet, Signature's balance sheet, and is true for a lot of other banks. But that's a necessary but not sufficient condition for everything that we've seen subsequently. And I think one of the many sources of concern are that it looks like there were probably significant supervisory failures, as well. The rules are going to be incomplete and we can talk about whether or not a more set of rules would have made this less likely, and whether we should have more robust rules for large regional banks. I personally think we should. I think the over a hundred billion dollars, you're talking about very large and potentially dangerous institutions that should be more vigorously regulated. But supervisors are always going to have to come in and fill in the gaps. And there were an array of leading indicators suggesting real problems at these institutions. So I think among the questions that we started to have answered today, but where there's still a lot more digging to do, it's just how was it more was not done earlier to ward off the situation.

Beckworth: Well, Kate and Peter, let me ask this question. You've touched on several things there, one being regulatory failure, the law itself being changed, and also supervisory failure. So let's unpack those one by one, and let's go back, Kate, to the supervisory failure. Who is the main bank supervisor in that area, and who should have been on top of the issue?

Addressing Bank Supervisory Failure

Judge: Yeah, I mean, so the current key supervisor has to be Vice Chair for Supervision Michael Barr. There is a challenge, he came into the role eight months ago, so he's been there a while. On the other hand, he wasn't there where, for an example, when the last stress test scenario was determined. And there was a lot that happened before he got on the job. So there's a little bit of attention there, but he clearly plays a key role. And then I think we also have to be looking very closely at the Federal Reserve Bank of San Francisco and the communications that happened between those two different layers. I mean, I think one of the challenges is not just when did Barr know, but what should he have known earlier?

Judge: And that's where I think, for banking folks, there were just so many red flags, aggressive growth, very often a sign that problems might ensue. Not always these are all noisy indicators, but it's an important one. Incredible concentration in a particular industry as opposed to diversified sources of activities or diversified sources of funding. Incredible concentration here. The one I'm personally always focused on, federal home loan bank borrowings, we saw no borrowings outstanding at the end of 2021. SVB was the biggest borrower from the Federal Home Loan Bank of San Francisco at the end of 2022. That was true for all of the major banks that failed in 2008. It was true of the failed thrifts back in the 1980s. So again, there's just a lot of red flags, and we're talking about a large bank. And let's be honest, these are not mid-sized banks, these are very large banks. You have to wonder why there wasn't more attention paid earlier.

Beckworth: Okay, so there's supervisory failures, and I want to try to be fair to the supervisors, to Michael Barr, to all of us, and that a big part of the story is the rapid change in macroeconomic policy. As you alluded to, interest rates rose rapidly, fast. In fact, they went faster than the Fed itself was forecasting. So everyone was kind of caught off guard. And this is reflected in the stress test. There was no interest rate risk part of that test. But should we have been expecting this? Should we have systems more robust to sudden changes in macroeconomic policy?

Conti-Brown: I think the answer to that is a resounding yes. And I'm not so sure that we should give a pass to, really, anyone in this, without really understanding who knew what and was advising whom about what. The basic architecture of bank supervision is that it's a residual category. It catches all of the risk in the system. That's not a public-only basket of responsibility, it's a public and private conversation. Sometimes it's a very hot conversation, a lot of contestation there. And sometimes it's collaboration. We on the outside, including those who are quite close to it, we almost never get glimpses into exactly how those conversations are structured and who is signing off on which kinds of decisions. But we can be quite sure that both private actors, which would be the bankers at Silicon Valley Bank, and public actors from the line examiners from the San Francisco Fed, all through the horizontal review, which is a term that's used within the system, which refers to people outside of the San Francisco Fed, all the way up to and including the Board of Governors in Washington, D.C. All of these in individuals own what happened at Silicon Valley, because bank supervision is their deed of title, so to speak. That's what bank supervision is, it's to own that residual risk.

Conti-Brown: And so the specific kind of challenge that banks face when they buy a lot of securities that are at fixed interest rates in one climate, when interest rates are going up, I think this is something that we absolutely can't simply say, "Hindsight is 20/20." Because this is the climate in banking. This is a known and knowable risk every single time interest rates budge by even 25 basis points. Every single time interest rates go up, the assets that are on banks' books, that are fixed, the value goes down. And so it's not simply the case that we've only been through this a few times in the 20th century. We've been through this a lot, most recently in 2018. And so I think it's appropriate for us to ask and scratch our heads, how could it be that bankers and bank supervisors whiffed so completely on preventing the disorderly failure of a bank that caught itself crosswise of this very phenomenon?

Beckworth: So as you know, there was a Bloomberg article that came out about the supervisory failures, and it was written about the San Francisco Fed in particular. Really interesting inside stories, but it had a certain vibe to it, that it was almost like the San Francisco Fed was trying to defend itself, put out some good PR. Was that your impression, too, Kate, when you read that article?

Judge: I think it's an accurate impression, but I think it speaks to a much deeper challenge, is that generally speaking, supervisory information is entirely confidential. And there are some good reasons. It's confidential as a default matter, but it does mean that then the information is only available precisely from the sources that are very likely, in this instance, the sources that screwed up along the way. And so I think one of the issues that it raises in the short run, we need to know more, and we need to know more from independent sources about what really happened here. And it looks like there are moves in that direction. And we have some really nice precedent for that. When you think back to the London Whale, Senator Levin did a great job with the subcommittee investigation that provided an incredibly detailed report, first and foremost, of all the decision-making failures within JP Morgan that allowed that to happen, and we should have something similar with SVB and Signature. But the report also looked incredibly closely at the ongoing iterative engagement between the currency, which is the primary regulator of the National Bank, and folks at JP Morgan.

Judge: And that was just incredibly useful for everybody involved. And when you have these types of mistakes, it's absolutely critical to shine that really bright spotlight, to be able to provide the accountability that the public needs to understand where culpability lies and the myriad of failures that allowed this to happen. And the second thing, I'll just say briefly, I really want to echo what Peter just said about supervision being a residual. It's really important that we learn from this as a regulatory matter, that we update our rules and other regulations in light of new findings and new discoveries, but a lot here was really old. But just as importantly, the regulatory scheme is always going to be incomplete. And that is why we have always had bank supervisors with broad discretion when it comes to concerns that potentially affect a bank's safety and soundness. Peter has really been a leading voice in this area when nobody else was paying much attention to supervision. He dug in deep on the history of supervision, and I do think going forward, both studying supervision, understanding why we need supervision, even though it involves discretion, which is inconsistent with what the courts want to see out of administrative agencies right now, and then also understanding what it should be doing, are going to be some of the key questions going forward.

Beckworth: Speaking of that, Peter, don't you have a book coming out on the history of bank supervision?

Conti-Brown: That's it, and co-authored with my brilliant colleague Sean Vanatta at the University of Glasgow. And in it, we explore how it was that bank supervision became this residual category, this collaboration, this contestation, through a long period of institutional change from the Civil War through about 1980. I want to pick up on something that Kate mentioned, because I think one of the biggest challenges that we face right now is, in making sense of this banking crisis, is what kind of a system failure occurred? Was this a system failure, again, on legislation or regulation or supervision or private bank risk management? Was it a failure on the things that we didn't get right the first time around, or was it a failure of a specific kind of governmental reaction, which is too amped up, too hyped, too ready with fingers on triggers? We do not know the answers to this.

Conti-Brown: I've got some priors. I'm sure you both do, as well. And the vibrant conversations in scholarly pages from the global financial crisis and after have really shaped our thinking about some of these things. But Kate's analysis here of how we can know in the specifics, I think, is a fundamental point. What we can't have is simply a re-litigation of all of the issues from CoCos to orderly liquidation to systemic risk designation to capital ratios. We can't have those debates as if 2023 did not happen. We did that. It was incredible. Kate was one of the leading legal scholars shaping our thinking about those very issues, and all of them are important, they're ongoing. But what we don't know in 2023 is the information that has been kept secret. The Fed and FDIC have announced that they're going to do their own internal reviews for reasons, I think, having more to do with controlling a narrative than with discovering the facts. They've already announced when their results will come, and it is quick, May 1st.

Conti-Brown: I think that these exercises, whatever their value for internal actors within the Fed and FDIC, serve almost no useful purpose for all the rest of us, and indeed will serve quite a harmful purpose. I think it will undermine the Fed and FDIC's credibility that they could come to conclusions on such complexity so quickly, while they are simultaneously fighting the very fires that consumed these institutions. I think a Senate permanent subcommittee approach could be great. I think a Pecora style commission, which is a Senate Banking Committee whereby the chair and ranking member would collaborate in naming a chief investigator who would really pursue this. If they wanted to do it by legislation, that could do something like the Congressional Oversight Panel or the Financial Crisis Inquiry Commission. There are a lot of different ideas out there, but I not only want to see more done, I would love to see the Fed and FDIC announce that they're going to stop this. I think that the likelihood that they will release information that is incomplete or incorrect is sky high, given the haste. And I think that that could distort our politics and our policy as we spend the rest of the time trying to figure out what they got right and what they got wrong through independent reviews.

Beckworth: So two questions, Peter, that flows from this is, can Congress handle it? And secondly, what do you think, along these lines, of Senator Elizabeth Warren's proposal along with Senator Scott as a bipartisan bill they've laid out for an independent IG to take over and do these types of investigations?

How to Handle Bank Supervision Moving Forward

Judge: So I think there is a place for an independent Fed IG, which it doesn't currently have. As a standing matter, I think that it makes sense to be able to house that type of independence given the nature of the decisions that are being made. And I don't think this is going to be the last instance in which the Fed is taking actions where there's a sense that there needs to be more accountability and more understanding with respect to what drove that decision making. All that being said, I also think there is a real place for Congress in oversight. I actually have a new working paper I've been working on for some time with Dan Awrey looking at the role of congressional commissions and commission-like structures like hearings, and the critical role they've played in the evolution of financial regulation and the critical role they should continue to play.

Judge: One of those roles is investigative. It is trying to find a way that we put the facts on the table when those facts are hard to get. And I think that process can also involve developing a narrative so people understand what happens. And that can also help to shift the framework through which we understand what happened. A core challenge that all financial regulators face, not just the Fed, is that when you're deep inside of things, you tend to see things in one way. There's an established paradigm of how we're looking at problems, and bringing in fresh perspectives that come in from the outside can help to bring in a different way of understanding and framing the series of events and the directions of causality that allow things to go wrong, and therefore enabling a more productive conversation over what do we actually need in terms of reform in order to build a more resilient system. So I could go on a lot longer, but I think generally speaking, we're seeing a significant pushback on agency authority and expertise. And I think that's all the more reason we need to find ways, and commissions can be a critical one, to really house greater expertise in Congress and allow it to feed in to congressional processes.

Beckworth: So it's more important than ever, for political and democratic legitimacy reasons, that Congress take a look at this.

Conti-Brown: Yeah, that makes sense to me. I just loved everything that Kate just said, and I agree with all of it. I'm a historian, and as a historian, especially the United States and our politics, it's always a little bit heartbreaking to me and deeply ahistorical to hear people say, "Well, we can't trust Congress to do this, because Congress is too, fill in the blank, divided, polarized, corrupt, self-interested." We have been besmirching our institutions in exactly this way since 1789, with almost no period of good feeling. Even the so-called era of good feeling of the Monroe administration had people snipping and sniping at each other just outside of formalized political parties. When people say Congress can't handle this, what they're saying is American institutions can't handle that. And I just say, you're wrong. I think in all of these kinds of crises, including in Dodd-Frank, which although a quite partisan bill, in the final vote was a deeply collaborative exercise across party lines.

Conti-Brown: The very bill co-sponsorships that you've identified between Senator Warren and Senator Scott, before him, between Senator Warren and former Senator Toomey. The hearings that we have today, I have my own political priors and partisan affiliations, but with the exception of some rhetoric that I thought got a little bit ahead of its own skis, I thought the substantive points being made by Republicans, Democrats, and independents were all valid, all important questions about who owns this responsibility and how we can know. So I really wince when I hear people say there's no way that Congress can handle this. I think Congress is not just the least bad option, I think it's a very good option. And I would hope to see more of these kinds of investigations and understandings, recognizing that the institutional design of this is going to matter, of course, making sure that it doesn't become overtly weaponized for partisan purposes, but Congress is good at that, too. So I look forward to seeing what Congress does. I feel confident they'll do something. What I hope is the case is that we get enough of an exclamation point in front of the sentence that Congress must investigate that we have something big, and not just a series of ad hoc hearings.

Beckworth: Well, let's move on to the policy response that we've seen over the past three weeks, and looking forward to what may come. And let's start with the systemic risk exception they made for the banks, and they allowed all the deposits to be insured by invoking this, so above 250,000. Was that a good call, Kate? What do you think?

Rating the Policy Response to the 2023 Banking Crisis

Judge: I don't think we're going to be able to answer that question from the outside until we have the investigation that we just discussed, which is one of the reasons we really need that investigation. They were privy to a whole variety of information about what the collateral consequences might be. I mean, ultimately it's an incredibly difficult call whenever you're saying, this is so critical that we have to go around the obligation that otherwise exists for the FDIC to resolve any failed institution in a way that minimizes the cost to the insurance fund. One of the things that's striking here is that they chose to do it not just with respect to SVB, where I think a lot of the attention has been going, but also with respect to Signature Bank. And one of the interesting features of the systemic risk exception, SRE, that hasn't been getting as much attention as it could is that it's got two different prongs.

Judge: One is about systemic risk, the other prong is on adverse effects, economic growth. And there are some interesting and, I think, open questions of whether or not you could have focused really on protecting SVB, focusing on the unique role it plays in economic growth. So it's always easier to say hindsight is 2020, we should have done things differently. But I do think it does create some interesting challenges going forward in that I think regional banks might face more problems. We're seeing problems still with commercial real estate. There's still the unrealized losses on other bank balance sheets. There's a possibility that depositors pay a lot of attention to this, and suddenly deposits that had been really sticky become less sticky. Or to remain sticky, they have to be compensated in a different way, and that could really eat into net interest margin. And it's really hard, at this point, not to protect depositors or really protect the institution of any regional bank that was doing things that were less foolhardy than what led to Signature's demise.

Judge: So I think there's always some good reasons that we have flexibility to go in. I think it's really important that we have the ability to act aggressively and broadly in the face of potential threats to stability. But in all honesty, I would've liked to see a little more consideration and articulation of the intelligible principle that led to both of those protections, led to the invocation of 13(3). And then I would rather actually have had broader and more aggressive statements after that saying, regardless of what we did this, everyone now is going to find ways, at least temporarily, to protect people while we figure out how big the hole is and why we try to figure out what we should do going forward. So I'm of mixed minds, and I think it's going to be really hard to know until we understand the full set of ramifications that drove those decisions.

Beckworth: It's easy to be cynical looking at the people who were the depositors in Silicon Valley Bank, the Silicon Valley crowd, and then the other bank was crypto. It's easy to be cynical, but at the same time, it's also easy to be sympathetic with the regulators who made this call, because this is a whole new world. I believe it was on Thursday, $42 billion left the bank, largely driven by fear-mongering on social media, Twitter. And that raises another question. I mean, almost anything could become systemic with the right people talking loud enough, beating their drums. Is this a new dynamic, or is it just the same thing we've had before? It strikes me that there's a new element here, the social media, technology angle that allows a voice to be amplified much more than before. Peter, what do you think?

Systemic Risks and Social Media

Conti-Brown: Well, so you're absolutely correct that we have never seen $42 billion in deposits flee an institution in four hours. Before the era of digital transfers, such a thing would've been impossible. And in the spectacular banking crises from 1930 to 1933, we have very famous instances of bankers creating snaked lines throughout large lobbies to avoid the impression that there's a long line leading outside of the bank, and bankers being told to slow their count in giving change so that they could close the bank right on time. And so there are all kinds of questions like, okay, if people had apps in 1933, then what would've been the result? It would've been way worse. But here's my question, let me take devil's advocate to that idea of fear-mongering on social media as having a dispositive explanation here. Given what we know now, which is incomplete, as Kate said, about Silicon Valley Bank especially, could it have abided without significant changes to the discount window, a 48-hour period of $42 billion of withdrawals?

Conti-Brown: Could it have done it in a week? I don't think it could have done it in three weeks. I think it could have done it in six months, but that means it would have to completely change the portfolio allocation of its assets. So long as the discount window haircuts were in place for hold to maturity securities, and there was no 13(3) counterparty available to them, I think that what we saw is uninsured depositors for sure, many of whom were reacting to things they saw on Twitter, but others of whom were saying, "Wait, is Silicon Valley Bank not a well-run institution? Are their decisions making my bad decisions even worse?" And in that event, what we don't have is a Diamond-Dybvig irrational run, bank panic because of fear-mongering, the kind of thing that in the thirties we said Franklin Roosevelt's fireside chat was a slap to the face of a person suffering from hysteria. This wasn't hysteria at all. It was cold, hard logic saying, "I don't think Silicon Valley Bank was the institution that I should have trusted with my large uninsured deposits." Now, if that turns out to be true, and again, I want to note that caveat of humility that Kate invited for all of us, I don't know if that's right, we need to know more, but if it is correct or if it's partially correct, then we don't have a Silicon Valley Bank that is caught as a victim of panic or hysteria. What we have is Silicon Valley Bank that failed because it was insolvent and it was insolvent because it mismanaged basic principles of risk on both sides of its balance sheet.

Beckworth: That's fair and it may be the case, we'll find out that, in fact, it was a legitimately badly run business, but there were other people on Twitter not just saying things about SVB, but the entire banking system is under pressure. There are people creating fear and maybe this will be shown to be not that important in the future, but I just wonder about the amplification of fear through social media making it harder to distinguish between non-systemic and systemic, but let me segue into the invocation of 13(3) here, instead of the discount window part of the Federal Reserve Act.

Beckworth: I want to quote our chair, Jay Powell, at the last FOMC press conference. Someone asked him about this and this was his answer. He said, "13(3) seemed right. We have a little more flexibility under 13(3). We've done quite a lot under the discount window as well. We needed to do a special facility that was designed in a special way. We did it under 13(3). Really no magic to that." That was his answer to the question, why did you invoke 13(3) when you did what you did? What do you think, Kate? Was this a reasonable response or is there reason to be confused still as to why 13(3) was invoked over 10B?

Was the Fed Right to Invoke 13(3)?

Judge: I think we still need further explanation, which again is not saying it was the wrong decision, just like the decisions with respect to protecting the depositors. There's at least enough out there to understand why these decisions seem like they may have made sense under the circumstances that they were being made. That being said, we really, going forward, need to have a better understanding… the effect of what is the principle that's going to animate the use of 13(3), what is the principle that is going to drive use of the systemic risk exception. As you alluded to, it might well be not the size of these institutions, but the particular environment in which we are more worried about contagion and trying to calm panic, is a classic role of bank regulators and aggressively using the legal tools available to help calm that panic is an appropriate move by bank regulators, so I have no concerns if that was what was motivating these decisions.

Judge: What I would like to see going forward is more of an effort, whether it's in the short run or the long run, to say here's the particular set of factors, the set of conditions, that help to justify the use of these authorities in these particular instances because that's what allows the debate about whether they were appropriately used, what constraints otherwise should exist and also an understanding going forward of what are the set of circumstances in which we can expect them to be used and when won't they be used. I think developing the eliminating principles and the animating principles is key to getting some continuity and some public understanding. It certainly seems like it might have been reasonable once you're already doing a systemic risk exception to also say, clearly these are unusual and exigent circumstances and we need to be pulling out as much fire power as possible, but I think the explanation that you read is just a starting point of the explanation that we eventually need.

Beckworth: Now Peter, haven't you written on this issue too? Don't you have a proposal for more transparency on how we use administrative law?

Conti-Brown: I do and we can provide a link to it if you'd like. It's an article that I wrote with Yair Listokin and Nicholas Parrillo, which we called somewhat inelegantly, *Towards an Administrative Law of Central Banking.* The idea is that the Fed, like any agency, goes through administrative legal requirements to explain itself, to give reason not to behave arbitrarily and capriciously and in the United States context to be bound by the Administrative Procedure Act, when it is doing rule making and the two areas where the Fed is most powerful, it is not doing rule making or regulations, it's doing monetary policy or it's doing bank supervision. Those are the two major buckets of activity that also define the problems in the banking crisis of 2023.

Conti-Brown: In that piece we argued that the Fed should do more accordion style to explain itself both before, during, and after crisis. Before, it has done pretty well after the 2008 crisis to explain how it thinks about 13(3) through regulation, but what we're looking for are guidance documents and so it could go a little bit further there. What it has not done well, and your quote of Chair Powell is the sum total, besides one website, explaining why 13(3) for bank counterparty liquidity and what is different about the discount window when there's a very obvious difference and that is to use the discount window the Fed does not need to formally declare, with the approval of the Secretary of the Treasury, that we have a banking crisis on.

Conti-Brown: Now I'm being a little bit flip with that equation, but the Fed literally has to declare that the circumstances are unusual and exigent. It has to get the Secretary of the Treasury to agree with that conclusion and I think equating that invocation with the signal to the markets that this is a banking crisis is not a very far leap. The discount window doesn't have that defect. You can use the discount window in all kinds of instances of intermediate stress. We skipped that, changed some discount window conditions and then opened that spigot too and we don't have an explanation from the Fed yet about that difference, about how it sees its advantages or disadvantages when the counterparties are banks, which again is what we have in this 13(3) invocation.

Beckworth: One of the more interesting developments in this policy response were the conditions for accessing the bank term funding programs. This is this new facility. The big exciting development was that collateral could be taken at par value, at face value, and you had a lot of people saying, whoa, this is huge. This rewrites central banking 101, it changes Badgett's call for taking collateral at a discount. Tracy Alloway said on Twitter, "A bank with subpar risk management and flaky depositors just changed the US financial system forever." Other people made similar comments. Is this a big deal? Does this set a precedent that will forever affect how we respond to making crisis moving forward?

New Bank Collateral Precedents and Their Significance

Judge: I hate to be a broken record on this, but again, I think we have yet to fully know and it's partly going to depend on how the Fed uses it going forward. It certainly is a meaningful shift, but we are also in a circumstance where, post Dodd-Frank, regulators have fewer tools than they used to try to promote a sense of calm in circumstances where panic might otherwise arise and there's not the ability of the FDIC, for example, to broadly offer deposit insurance without going to Congress. There is the possibility that when you have an overly limited tool set, you're going to use those tools in suboptimal ways to try to project intention of doing whatever you can within your power to stabilize the system.

Judge: My personal optimal setting would be the Fed not having to use 13(3) in this way and not accepting collateral on terms where it is being valued in ways that are clearly in excess of its current market value, but in a circumstance where we actually allowed, for example, the Treasury secretary, a more politically accountable actor, to have broader authority and have written before about the possibility of emergency guarantee authority that could be used for short term liabilities, whether they're bank or non-bank liabilities, but with a lot of accountability later on regarding, why did you have to use that? What are the reforms that are necessary? How do we have to think about changing the system?

Judge: I don't think it's easy to answer that question once you realize we are definitely operating in a world of second bests and this is one of the few tools that they had available. I think what they were trying to do in the short run, which I have a lot of sympathy for, was trying to calm the overall markets by signaling that they were going to stand behind banks. Separately, I admit, I have some concerns only because I would like to see the discount window be used a little more frequently and be slightly less stigmatized. Whenever you're creating a 13(3) to avoid the potential stigma, attach the discount window, you might also be ignoring an opportunity to help remove that stigma, to help de-stigmatize the discount window more generally so it can be used to provide liquidity to banks and the banking system more generally during periods of distress.

Beckworth: Kate, do you worry that the current use of the discount window, which is elevated right now, may not carry over into future moments? That the stigma will still be there after this because of the way it was invoked?

Judge: We've already seen a shift, right? Originally more of the borrowing was from the discount window and now a lot of it is shifted to the new facility and so I would rather have had all of that or much of that occurring through the discount window, even if it was on favorable terms, largely because it starts to signal, echoing Peter's point, there's a difference between banks and non-banks and for the most part we want banks to really seek liquidity through the discount window and we have the separate 13(3) authority that we're really going to invoke quite rarely and we're really going to invoke primarily because there were market disruptions that occurred outside of the banking system that could not be adequately addressed for providing fresh liquidity to banks, whether it's through the discount window or again, they also have the new repo facility.

Beckworth: Okay. Well, let's move forward in the time we have left to proposals for reform, what can we do differently? We've touched on some of them already, but let me start with a really radical one. Let's scrap the deposit insurance limit altogether. Let's get rid of that $250,000 limit. Our friends, Morgan Ricks and Lev Menand had an op-ed in the Washington Post titled, *Scrap the Bank Deposit Insurance Limit,* and they eloquently spell out why and how to do it. I believe the Washington Post editorial board responded later with their own vision, a little bit different, let's not throw the baby out with the bathwater. Let's take baby steps here, but Peter, what do you think? What recommendations would you give for this issue of the deposit insurance and how to make it more effective?

How to Reform Deposit Insurance

Conti-Brown: Well, not that. I don't think that that guaranteeing all of banks' deposit liabilities with public money is the right approach. I really recommend both Morgan and Lev's work separate from this crisis and what they're writing now too to anyone who's interested. They have a very specific theory and framework of how money is and ought to be. It's not a framework that I share and that is the first point of divergence and when you don't think of money as something that should be, must be a public franchise exclusively done through banks, then I think the logic of unlimited deposit insurance starts to fall away very, very quickly.

Conti-Brown: I think that having deposit limits is important, not because I have some sort of romanticized view of uninsured depositors as being amateur bank analysts who are reading 10Ks and 10Qs and doing their own bespoke arithmetic about maturities and duration risk and convexity and all that. I don't think that at all. I think that uninsured depositors, by making decisions that make sense to them in the moment and over time, create a fear for banks that they're going to have to diversify their funding source. The reason for diversifying their funding source, the very need for it, means they're going to have to create a business model that will appeal to the various component parts of their funding source.

Conti-Brown: That is where we see some of the magic of competition that the Biden administration and the Trump administration before them saw in the antitrust side, that we need banks competing with each other. Well, banks cannot compete against each other if all of their deposit liabilities are guaranteed by the same source. That might be overstating it in the views of those who espouse unlimited deposit insurance, but I don't think it is. I think a major vector of bank competition is competition for funding, for customers and customers who loan to banks are also called depositors. If you just treat them as franchisees, like McDonald's on one corner or another, then the ability for depositors to differentiate, to bestow on banks, reward them, with their service, I think, is lost.

Conti-Brown: The other point here is that I'm profoundly uncomfortable with the commitment of public guarantees, which expands that residual category for bank supervision, without a similar guarantee that we would expand the rigor of supervisory discretion to participate as co-owners of that risk. Now they are guarantors of the system. If I ever sign my name or my wife and I to guarantee a loan of a child or a friend, you better bet your boots that we're going to have a lot to say about the risk taking that they take when they're doing so in our name. The problem is that US banking history illustrates beautifully that public guarantees are forever and commitments to supervisory rigor are cyclical and so we will have a period where to ensure all the depositors of the United States, we are going to create one massive bucket of money, that as we face reckoning on social security or Medicare will be tempting to politicians. Banks will say, get your hands off that bucket because we want to claw it back and so we're going to see all kinds of questions in the political economy of how we price deposit insurance products in ways that will be more favorable to industry. What we end up then is with an unfunded or underfunded mandate. The mandate stays, the funding doesn't.

Conti-Brown: For that reason, I would say we should experiment. I am very sympathetic to the idea that not all depositors with over a quarter million dollars in a single bank account are wealthy. Corporations meeting payroll, for example, small firms, I don't think they're fairly categorized as such. Maybe the banking crisis of 2023 can be our moment to differentiate between wealthy people who have a quarter million dollars in liquid assets that they want guaranteed by the government and small corporations that might have the same amount, but need more protection. The proposal I would make is that we should actually do something we've never done in history before since 1933, and that is lower the deposit insurance limit for individuals. Take it down to 200,000 and then for simplicity, increase it by an order of magnitude for companies with fewer than 100 employees. So 200,000 if you're a person, two million if you're a company and then let those limits do what they'll do, which is promote competition among banks, some sense of ownership by individuals, and a recognition that we do not want to increase the size of un or underfunded mandates.

Beckworth: Well that proposal is very similar to the Washington Post's editorial. They said keep 250. They didn't lower it, but, make an emergency provision for transaction accounts or small business payrolls. So my only question to that is, is that feasible? Do we have a technology to differentiate a wealthy person from a business that's meeting payroll? Can we do that?

Conti-Brown: Sure. Have you ever heard of the Internal Revenue Code? The tax code is filled with exactly these kinds of differentiated treatments. The idea here is to permit this kind of change through the companies. I mean, when you register, you register as a legal entity versus an individual. And one way that would be really quick to do it is just say it's fewer than a hundred employees but greater than five, and that way if you don't have an employee, it's just a shell corporation, you wouldn't qualify. The transaction account proposal that the Washington Post adopted is very similar to something that Todd Phillips circulated as an op-ed earlier. And I like it, I don't see how the basic promise of FDIC simplicity is accomplished in that way. The reason we have never treated different depositors differently in our history is not because it's never occurred to anybody, people have thought about this very problem before, it's that they were worried that they overcomplicate the incredibly simple story, which is the FDIC eagle says that the full faith and credit of the US government backs you up to a certain limit. If you say, oh, these things called no fee transaction accounts, or no interest bearing transaction accounts, you've already lost two thirds of the banking public. And so I'm a little bit worried about that complexity, hence the idea of keeping it in lockstep. 200 for individuals, two million for companies, and if we have to increase it to adjust for inflation, we can and adjust it in kind.

Beckworth: Let me bring up one other interesting development that's come out of this and I think this would be an area for change and improvement, and our friends Aaron Klein and George Selgin have been calling for this for some time, but the hours of operation of the payment system the Fed runs is very shockingly narrow. I mean, I made a joke about banker hours, but they literally were keeping banker hours. Now maybe this was an east coast, west coast thing, I don't know. So maybe Kate, I need to have some humility and wait for all the facts to come out. But it was pretty surprising to read from the testimony, the FDIC Chair Gruenberg's testimony, that SVB almost was not able to tap into Fedwire because it was about to shut down. And I think we all heard that, but Steven Kelly goes on to note that they also had problems with the discount window, the hours at the discount window almost precipitated an even bigger problem. And it's just shocking to me that in 2023 the hours of operation could turn maybe a localized banking problem into something broader because people clock out at a certain time and go home. Am I being too uncharitable here or is this just simply amazing that this is even an issue?

Other Banking Changes and Reforms

Judge: It's amazing that it's even an issue. And we have FedNow coming, it's been very, very slow to come. It is finally here, and I concur with Peter that we shouldn’t read too much into the uniqueness of this moment in terms of the drama of the run. That being said, the digitization of finance has changed a lot and it has changed the behavior… It's going to continue to change the behavior of depositors, it's going to continue to change demands that are put on the system and that are put on regulators. Quite separately, I think a lot of what we're seeing on the supervisory front is supervisors were just not responsive enough, or timely enough, in their responses to what it was they were learning. So I do think that there is a very broad conversation that we need to have given how quickly things change and how quickly things are going to change. How do we allow our regulatory apparatus, our systems through which we allow payments and liquidity to be provided, to evolve far more rapidly? And there's going to be operational challenges, there's going to be costs, but I think we also really need a fundamental change in mindset over what we can expect and acceptance of the status quo ought to no longer be the right default for where we're at.

Beckworth: Yeah, it's shocking to me that these legacy payment systems don't operate longer hours, and Aaron Klein does a good job noting that this really affects poor people the most in terms of they can't get money out, they can't pay bills, it's an adverse shock for them. But it could also affect financial stability. I hadn't thought of that angle till this event. Peter, any thoughts on that?

Conti-Brown: I think that it's one of the great mysteries why such low-hanging fruit has not yet been plucked by the Federal Reserve system. You hear so many jokes in the private sector about Fed bankers needing to make sure they get their afternoon naps in or whatever. I think that's got to be wrong, these folks are working their brains out during crises. I simply don't have the explanation of why this has resisted change so very much.

Beckworth: Okay, one last potential change moving forward and that is undoing the 2018 legislation, the S.2155. Is that something we need to look at as well?

Judge: We clearly need to rethink how we regulate regional banks. I think we're not out of the woods yet when it comes to regionals. It looked like the market was happy for the last day or two in part because for awhile it looked like regionals weren't going to be able to engage in a lot of acquisitions and now suddenly there might be a bunch of rapid acquisitions that are allowed. That being said, both the invocation of the systemic risk exception, but more broadly, I think the challenges that these particular set of institutions are facing suggest that we do need a more rigorous set of regulations. Some of that can be done despite the 2018 changes. The Fed's regulatory changes that they promulgated in 2019 when even further than was necessarily required. That being said, I do think we really need more rigorous oversight of these large regional banks and particularly if we're allowing mergers among these regional banks to produce what I'm calling super regionals. I mean something that's shy of G-SIBs but that clearly pose a different type of threat, we need to think quite seriously about the set of tools that are going to be required and regulatory requirements that ought to be in place to promote their resilience and stability.

Beckworth: I guess this goes back to our earlier part of the conversation we discussed causes, things that led up to this moment. Did that legislation matter or was it the interpretation of it by the Federal Reserve? You noted that the Fed maybe went an extra mile in how it interpreted that change in law. Where do we see this unfolding?

Conti-Brown: I'll refer back to this model with Sean Vanatta of supervision as the residual risk category. It is such not because there's some sort of constitutional protection that Congress can't change, it's that Congress has designed it to be this. So Congress has never, since the 1860s, been ignorant of the role of bank supervisors. We see two trends. Number one, because there's residual risk that the public will bear, when the push comes to shove and the risk is realized, people get very, very angry. That's true whether we're talking about a banking crisis, whether we're talking about a financial scandal or something else. When people get angry, Congress isn't far behind.

Conti-Brown: But what this means is that even when Congress does identify something that went sideways, what they always do is expand the size of that residual risk bucket for bank supervisors. What happened in 2018 is that Congress stood up and said, "We have done too much." This is in the language of the bill itself. The title that we're talking about is Title IV of the 2018 act and refers to tailoring. Tailoring… I'm not the best dress individual in the world, I have been to a tailor and tailors measure you to take in clothing to make sure that it is fitting you better to your form. They wanted to right size regulation, now right size means pulling it back.

Conti-Brown: The way to right size bank supervision is to either remove discretion or to indicate that Congress has a preference on the exercise of discretion. And the Crapo bill, or S.2155, did both of those things. It removed discretion for some of the things that could be done for banks the size of 50 to 100 billion, which would've included Silicon Valley Bank. But even if those removals, things like changes to the liquidity coverage ratio, one of the specific kinds of stress tests, although there are several, even if those things ultimately would not have caught the problems at Silicon Valley, it's not enough, as some of the bill's defenders have said, to simply say, "You're barking up the wrong tree, Congress had nothing to do with this." The bill that we're talking about is five pages long, very short for 21st century legislation. And in those five pages, it makes abundantly clear that there needs to be a change of ethos. That change of ethos in bank supervision is precisely what happened.

Conti-Brown: And that change of ethos means that when we have things like bank supervisors who are line examiners or who are conducting a horizontal review, note that a bank is deficient or has poor risk management and they note with specificity the problems on both assets and liabilities, then that change in ethos is the difference between resolving a problem in weeks versus resolving a problem in months or years or not at all. And so I think bank supervisors take their charge from Congress. In 2018, it was a letter to bank supervisors. So it's not enough to simply say, "Point to the provision of S.2155 that prohibited the Fed from doing X, Y, or Z." That's a non-sequitur. The question is, what did it do to the ability of bank supervisors not only to say, "Hey, I don't like what I'm seeing," but to say, "Now we are going to stop what I am seeing." And I think there, 2155 played a major role, just as Dodd-Frank did before it.

Beckworth: Alright, we're near the end, but Kate, I wanted to ask you a question about something you mentioned earlier. You mentioned the Federal Home Loan Bank and that banks in distress often go to it as a source of funding. Is this something we can address or at least meaningfully talk about moving forward?

FHLBs as a Source of Funding

Judge: It's something we can address and really ought to address. So first of all, it was a common characteristic across SVB, Silvergate and Signature, all of them borrowed heavily from their local federal home loan bank. It was also a really common characteristic back in 2008, Wachovia, WAMU, IndyMac, Countrywide all leaned heavily on the Federal Home Loan Banks. You go back to the 1980s and one of the distinguishing features between the thrifts that ended up having to be resolved and healthier thrifts is that the thrifts that failed were far more likely to rely on Federal Home Loan Bank advances and they did so in much greater amounts. So it has been a chronic problem and there's a whole variety of factors that lead into it. One of the biggest is that the Federal Home Loan Banks have this super lien, which means if the Federal Home Loan Banks loan money to a member bank, the Federal Home Loan Bank gets paid back in full. They get every single cent of that loan repaid before the Federal Deposit Insurance Fund or depositors see a single cent. So they really do not have adequate incentives to avoid lending to deeply troubled institutions. And so it's been a chronic challenge.

Judge: There's a lot more going on with the Federal Home Loan Banks in terms of how we want to reform it going forward. But, I think, I mean you could start very simply by really capping the amount that they can lend to any particular institution that would help avoid these big loans to troubled institutions and it would also help to reorient the overall system so it continues to provide the important support that it has for community banks, community thrifts, and other small organizations while potentially providing somewhat less benefit to Citibank and MetLife and a lot of the other very large banking organizations and insurance companies that currently really benefit from the system. So I think reforming it is a much longer project, but is of utmost importance.

Beckworth: Well, Congress, the Federal Reserve, the FDIC, and other have their work cut out for them in coming to terms with what has happened over these past three weeks. Hopefully, our conversation today has helped shed some light on these issues and, at a minimum, raised the important questions these parties need to be examining. I’m sure we’ll be coming back to you, Kate and Peter, in the future as we learn more, but thank you so much for coming on today. Our guests have been Kate Judge and Peter Conti-Brown. Thanks again for being a part of the show today.

Conti-Brown: Thanks so much, David.

Judge: Thank you. This was great.

Photo by Patrick Fallon via Getty Images