Martin Wolf on why banks fail and what to do about it

This is an audio transcript of the Behind the Money podcast episode: ‘Martin Wolf on why banks fail and what to do about it’

Michela Tindera
Over the last few weeks, there’s been so much news coming out of the banking sector. We jumped from crisis to crisis, on one continent to another. It’s been hard to keep up with it all. But it’s also had me wondering, why is this happening? Is there something bigger that I need to understand here? So in a time like this, I figured, who better to turn to than my colleague, Martin Wolf? He’s the FT’s chief economics commentator. And I wanted to talk with him so I could get beyond the day-to-day headlines of what’s happening and move to a more existential place.

Martin Wolf
A bank is designed to fail.

Michela Tindera
See what I mean? We’re gonna cover a lot here today. But in short, Martin says banks fail because of risk is built into their DNA. Sure, they hold our money, but they also have to take bets. These bets? Well, they can backfire. Look at what happened with Silicon Valley Bank. Martin says SVB illustrates this kind of identity crisis around how we think about banks. Some people think banks are institutions that should live and die by their own success. And to others, the government’s desire to keep stepping in and backing them sort of makes them more like utilities.

Martin Wolf
We get pretty upset if all the electricity got cut off because our electric utility failed to manage perfectly obvious risks. And in the same way, we expect banks to continue to function. And the way we’ve ensured that is to give essentially an open-ended guarantee from the state that we will allow them to do so.

Michela Tindera
Martin says we need to change how we understand banks so we can avoid another SVB. Do they live or die on the whims of capitalism or are they basically an arm of the state?

Martin Wolf
We have to decide which it is.

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Michela Tindera
I’m Michela Tindera from the Financial Times.

The FT’s Martin Wolf has been covering all kinds of banking crises over his decades-long career. Today on Behind the Money, we’re gonna travel deeper into this wonky world of banking, how banks fail and why. And Martin is going to share what he thinks are the four paths that banking reform could take in the future.

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Hi, Martin. Welcome to the show.

Martin Wolf
Pleasure to be with you.

Michela Tindera
Martin, banking news has dominated headlines for the last few weeks now. That’s from Silicon Valley Bank in the US to Credit Suisse in Europe. But first, I wanna zoom out quite a bit here to ask a very broad question. What would you say is the purpose of a bank?

Martin Wolf
Now, that’s a really good question. As we have designed them or as they have evolved, they have two different functions which are not really very well matched. The first function is to provide people, both households and businesses, with the money that they need to manage their lives.

Michela Tindera
This part of a bank is super important. It’s the accounts where we keep our money, and we can put it in and take it out whenever we want. This is known as a bank’s liabilities. And then there’s the second function, which is the side of the bank that takes bets. That’s called the asset side.

Martin Wolf
They’re intermediaries, and the assets they hold are, by and large, risky assets. A lot of them are private sector risky assets. And these risky private sector assets might be mortgages, they might be long-term bonds. They might be working capital, so short-term funds that can be rolled over.

Michela Tindera
It’s how they lend credit to other people and businesses. Having these two sides — assets and liabilities — operating in one place can lead to trouble.

Martin Wolf
People have to get in their minds that this is a very strange combination of activities to have in one institution and we have to deal with that.

Michela Tindera
I wanted to kind of dig into this a little bit more because, I mean, just hearing this idea that an institution like a bank is designed to fail in the way that it operates and it’s structured now, I mean, doesn’t this strike you as a bit odd? I mean, what other business is designed to fail?

Martin Wolf
Well, we would say that we need these businesses because they perform a vital economic function. The argument is people really want to hold safe liquid assets, gives them comfort. But we want as a society for there to be a very large supply of relatively cheap and flexible credit to our economy.

Michela Tindera
Martin says this can be tricky because we want both of these at the same time. And he says this goes back a long, long way.

Martin Wolf
Of course, it’s fragile. We know that. There have been banking crises and bank runs throughout the history of banking, going back all the way to the Florentines in the 15th century and actually even in the ancient world. But the beauty of it is it provides the two things that people seem to want, namely liquid assets, money, and lots of credit activities. And then over time, we’ve been in a sort of race to try and keep these two things together. Over time, we have radically improved the characteristics of banks and radically increased the support they get from the state in such a way that these undesirable properties are minimised. And the most convenient way we found to do that with a lot of government intervention has been to create this institution called the bank, which marries the two in the way that I’ve described.

Michela Tindera
Martin believes that in fact banks have become so important that they should be considered more like an electric or a water company than a for-profit business.

Martin Wolf
I think that to me, the essential point is that banks are, really are utilities. They’re not and shouldn’t be the prime risk-takers in the economy. That’s what we have equity for. And if they are to be seen as utilities, they don’t need to be vastly profitable. They need to be run as utilities and be capitalised in ways that ensure that they will survive in tough times. Because surviving in tough times is the most important thing banks can do.

Michela Tindera
Right. So where do we take this from here? You have some ideas on that, I’m guessing.

Martin Wolf
As I see it, there are four options for dealing with the problems we’ve been seeing in the last few weeks. And that, of course, have existed in the banking industry for a very long time. The first is go back to the free market.

Michela Tindera
So that means let the banks fail. The government shouldn’t step in at all. Seems pretty bold, right? But this free market approach does have its supporters, and Ken Griffin, who founded the hedge fund Citadel, is one of them. After SVB collapsed, he told the FT that the government shouldn’t have bailed it out because letting the bank fail would have taught everyone a cold, hard lesson about something called moral hazard. That term essentially means that if you know you’ll get bailed out, you’ll probably make riskier choices.

Martin Wolf
So an obvious example is if your car is insured against damage in an accident, you might be inclined to drive more carelessly. And the same would apply in the banking case. If you’re insured against the consequences of a banking failure, you’re less likely to spend a significant part of each day trying to work out whether your bank is likely to fail.

Michela Tindera
Martin basically thinks that Griffin’s point is moot.

Martin Wolf
Allowing uninsured depositors, so the deposits of corporations and wealthy individuals, to be lost in a run is not something states are now willing to do. And this is partly because these entities are very, very powerful. But it’s also because they think if that happens, there will be a generalised run. And if that happens in a generalised way, it creates mayhem. So I believe there is an implicit, if not explicit, guarantee of all deposits. Now, would it be better if that were not the case in some theoretical sense? Is Ken Griffin right? Well, I think we have to go back far further than that. If Ken Griffin were right and it really would help if depositors understood the risks they were running, then we probably shouldn’t have deposit insurance at all. But the big problem with the argument is that in practice, I don’t think it’s possible for depositors, even big depositors, to monitor in real time the state of the balance sheet of their banks, because it’s not transparent. They’re very complicated. But in the end, the moral hazard argument doesn’t work because people can’t assess the risks.

Michela Tindera
As you might have guessed, Martin’s not 100 per cent sold on that free market, tough love idea.

Martin Wolf
Just leaving them to the free market without any rules on capital and liquidity and no bailouts afterwards, that we know just leads to enormous banking crashes and disruption of the economy, and I just don’t think that makes sense economically, and it certainly wouldn’t make sense politically and socially. So a better way to go is to make the system safer. It’s not and cannot be actually saying, well, we’ll go back to the wild, wild west of capitalism when you could lose your money in a bank at any time, which really guaranteed that when runs started, they just became generalised and terrible.

Michela Tindera
So that brings us to option two.

Martin Wolf
Tighten regulation and improve transparency of banks. So we would insist that all banks that could conceivably be significant and conceivably have to be rescued, would be subject to the same regulatory oversight in terms of capital requirements, liquidity requirements, stress tests as systemically significant banks. That would become a generalised rule for all banks. You’d only exempt really small and insignificant banks.

Michela Tindera
With option two, a bank like SVB would be in the same regulatory net as the banking giants, and that would have meant more scrutiny on the bank before it collapsed. But Martin says there’s a third option here.

Martin Wolf
The third possibility is to strengthen radically, and this would reduce the problems we’ve talked about, strengthen the soundness of banks, which continued to be, by and large, the same sorts of institutions as we’ve known in the past.

Michela Tindera
Here’s one way that Martin’s noticed how to do that.

Martin Wolf
One is to force banks to hold much higher capital or to have, be financed by much more equity, which comes from two academic economists: Anat Admati, who teaches in Stanford, and Martin Hellwig, a German economist.

Michela Tindera
Yeah, and on that higher capitalisation that you’re talking about, that’s something that was put in after the financial crisis, right? So you’re saying that should go up even more?

Martin Wolf
Yes. Basically, on the eve of the financial crisis, we discovered — I wasn’t aware of it — that banks had almost no equity capital at all. So we’ve discovered major banking institutions were operating with leverage of 40 or 50 to 1. And now that was obviously insane. So this capitalisation has certainly dramatically improved.

Michela Tindera
Those ratios Martin’s talking about, that’s referring to how leveraged a bank is. So for example, for every $40 in assets, the bank would have $1 in equity. Since the financial crisis, banks have improved that leverage. It’s more common now to see a 20-to-1 or 10-to-1 ratio. But Martin believes it’s still not enough.

Martin Wolf
You just need a bad economy or a big interest rate shock and you’re insolvent. And then you’re in terrible territory. And the suggestion is, well, it should go to 3 to 1. It’s much more capacity to lose money. And that makes it much easier to lend to a bank for a central bank because they’re much less likely to be actually bankrupt. I think the argument for higher equity is very, very strong. But of course, it would raise the cost of intermediation and lower the return on equity.

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Michela Tindera
So here’s our options so far. Number one: Keep the government out of it. Let the banks fail. Number two: Go the other way. Regulate more banks rather than fewer. And number three: Strengthen banks by significantly reducing their leverage. But there’s one more option, which Martin says is the most radical of them all.

Martin Wolf
Essentially, what it says is we’ve got to get away from this whole business of mismatching the asset and liability side of our financial core institutions, of our financial system.

Michela Tindera
And this is how that would work.

Martin Wolf
What would happen is that if a financial institution offers its depositors perfect liquid assets, ie money, which will always be worth a dollar in the dollar, it will never be discounted, then the assets this institution holds must match that. That, let’s just say, they must be equally illiquid and safe. So there’s no longer this intermediation within this institution. Money is money and the intermediary is fully matched.

Michela Tindera
So assets and liabilities would have to align. One way to make that happen? Martin says by creating a digital currency that’s issued by a central bank, not private ones.

Martin Wolf
Essentially, that would allow everybody to bank with the central bank and it would become the dominant money in the system. And you would then say to the financial institutions that are left, you can continue to operate, continue to hold risky assets and so forth, but your liabilities must be in one of two forms. Either they must be like a mutual fund. So the value of your liabilities moved with the value of your assets. And so there’s essentially, instead of being a depositor in this mutual fund, you are an equity owner. And depending on the riskiness of the bank, the value of your equity would go up or down. And the alternative way of financing this would be to have longer-term deposits, time deposits, plus a substantial bulge of equity as well, again, to reduce the risk of the run and reduce the risk of insolvency. And the intermediation process in both cases would no longer have liabilities, which have to be completely safe, completely liquid. And this proposal will clearly make the financial system structurally sound. But there’s no doubt about it. The debate, of course, is whether it would deprive the economy of credit supply on such a scale as to cripple it. I myself, I must say I’m sceptical. I like these proposals, but no one has had the nerve and nobody wants to dare to bring in such a radical transformation of our financial system as this would imply.

Michela Tindera
So which one should we go with?

Martin Wolf
I would go at this stage with the combination of two and three. That is to say tighten regulation. Don’t allow anyone outside their generalised net. Make accounts more realistic. Increase equity further — it’s not enough. All of these things would increase the incentives of the management of shareholders of the bank to run themselves soundly.

Michela Tindera
Mm-hmm. Yeah. How likely is it, do you think, at this moment that governments, regulators will be looking to make these sorts of changes? Or would they rather sweep this under the rug and move forward? (Chuckles)

Martin Wolf
I think at this stage it’s not big enough to generate really big changes. The last financial crisis led to a big tightening of regulation. I would be very surprised if this didn’t lead to a great unification of the regulatory structure in the US for banks. But basically they don’t want loopholes like SVB to survive. I hope this precedent for insuring deposits, if it’s going to be there, will become explicit, not implicit. So the . . . If the FDIC insures all deposits, then that will clearly imply a very substantial increase in insurance fees and a very much tighter oversight. So that’s, I think, the minimum that they can and should do if they want to manage the risks they have of further problems of this kind. You can’t have banks outside the regulatory safety net in this way. I would like to see higher equity requirements, but I don’t think it’s gonna happen. But at some stage I think it’s gonna have to because I believe we will have further crises.

Michela Tindera
Well, thanks for being here, Martin.

Martin Wolf
Pleasure.

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Michela Tindera
Behind the Money is hosted by me, Michela Tindera. Saffeya Ahmed is our producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Special thanks to Rob Armstrong and Josh Franklin. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

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