this is a bloomberg wall street week a roundtable discussion of what happened to our banks im david westin and im delighted to say i am joined by a special wall street contributor and former treasury secretary larry summers also ive met a former fed governor dan tarullo and stephanie flanders our very own senior executive editor for economics and government so thank you all for joining us really appreciate it and theres a lot thats going on in the banks the last two weeks weve heard it from jay powell the show fed yesterday so lets talk about exactly what happened lets start you dan you were a colleague for several years of jay powell during the time you were on the fed you had responsibility for bank supervision weve been told the banks were so strong we dont have to worry about it were we misled what happened here we didnt think that we still had banking problems well i trust that the largest banks truly are in that much better capital and liquidity position that jay powell referred to yesterday during the press conference we dont david obviously know yet the whole story but i think there are some things that we do know we know first that there was a significant supervisory failure somewhere along the way was that failure in the san francisco feds inability to identify problems of growth and maturity mismatches and the like early on was it the failure of the second san francisco fed team to which did identify some problems to follow up in a sufficiently robust way was it a supervisory failure because of the light touch approach to supervision that the federal reserve board had put in place over the last four or five years or was it a supervisory failure because the supervisors generally had not adjusted their method of assessing liquidity to take account of very high uninsured deposit concentrations coexisting with the capacity of big depositors to run at warp speed rather than the way they used to run those are not mutually exclusive explanations and i also would not rule out a contributing factor being that 2018 legislation in 2019 fed regulation both of which deregulated banks of under 700 while the regulation banks have under 700 billion dollars in assets the legislation banks have under two hundred and fifty but i think in the in the most immediate sense this is clearly a supervisory failure other factors may be uncovered as the feds own investigation proceeds dan do we have a sense of how big the breadbox is if i can put it that way what is it likely that this could spread to other parts the financial system we heard a chair pile yesterday saying that silicon valley bank was an outlier dan how do we know its an outlier i know that thats a good question david and you know when your correspondent bloomberg correspondent catarina soraya asked a really good question in the press conference yesterday she looked back at the notes from the january 30 first february 1st fomc meeting and noted that there had been a discussion of the potential financial stability implications of the rapid rise in interest rates which the fed has engineered over the last year and she pointed to some specific areas of concern which the fomc had identified one being runs on nonbank institutions a little bit ironic in retrospect but also the position of banks with large portfolios of treasuries that had not been marked to market but had lost value obviously because of the interest rate increases and she she asked the chair for a little bit of an explanation of what that discussion had been and he was unable to give it to her for me it raises the question of whether they were monitoring just those kinds of issues throughout last year as they were increasing rates i mean you would think that interest rate risk would have jumped to the top of the supervisory heap and that the fomc would have been getting reports on the impact of the interest rate increases on deposits deposit flows holdings of securities especially those that are not marked to market so i think as a backward looking matter it will be interesting to find that out as a forward looking matter as the fed in since a week ago friday done the kind of assessment to be able to tell jay powell you can go out and say that its an outlier in the banking system is safe he didnt indicate that any such assessment had been done perhaps it has perhaps it hasnt maybe vice chair bar well talk about it next week for congress but right now our basis for evaluating his statement is kind of limited so larry lets put you back at the treasury or for that matter at the white house if you were looking at this situation what questions would you be asking to make sure you understood the possible ramifications of what weve seen so far in a broader financial context well before i answer before i answer that hypothetical let me put a question to my friend dan who ill just say i think did an enormous amount to strengthen our financial system during his time at the fed dan ive heard it said and i dont know that even in 2022 the feds stress tests that were applied to the largest banks did not include an analysis of the stress from a major interest rate hike if thats true that seems kind of bizarre from the point of view of the world of early 2022 when it certainly many people certainly me on davids show were emphasizing that there was likely did need to be very substantial increases in interest rates can you say some and if the stress tests werent considering increases in interest rates then perhaps the exempting of silicon valley bank from the stress tests was not central to understanding the problem can you say something about interest rate hikes and fed stress tests sure so first off i think larry i agree with that the statement you made toward the end of your question which is i asked if silicon valley had been in last years stress test for real rather than its dress rehearsal i dont think it would have made much difference for precisely the reason you say that they werent stressing the things that were this sbb vulnerabilities with respect to stress testing generally over again over the last five or six years the stress test has become eminently predictable the scenario thats used is now a single scenario which is essentially a variant on the very first one we put in some years ago that is a severe is quite severe recession but it follows the basic pattern of the scenario that was developed when we began doing the annual stress test the scenario of course includes a reduction in interest rates because of the hypothesis of a recession and the feds reaction when i was at the fed we were using also an alternative scenario its called the adverse rather than severely adverse scenario and we use that scenario to test things other than the prototype of the severe recession and indeed we used at least one year and i think a couple of years to test what would happen with unusual changes in interest rates which were not then anticipated so to some degree the answer to your question is like supervision generally the stress test has become less rigorous over time and i think more importantly its become too predictable and the whole purpose of the stress test is that youre trying to stress against the unanticipated not the anticipated but at the risk of perhaps being too tough on your former colleagues at at the fed you talk about predictable versus unpredictable i would argue that at a very minimum the stress tests ought to consider what is the major risk of their moment when you were at the fed dan in that period i think it was reasonable to think that the major risk was a tilt towards recession and deflation but i dont see how anybody last spring could have thought that the major risk was anything other than a spike in interest rates so a process that didnt consider as a risk seems to me to be a profoundly problematic process even if you were to accept that you were only going to look at one scenario and all of that it seems almost like the supervisors were mailing it in if they werent thinking about at a moment when monetary policy was turning in a dramatic way towards tightening and at a moment where the fed had just retired the word transitory were not looking at interest rate hikes is there a reasonable is there a defense well i would say first this is not by way of defense or certainly not an apology but just a bit of explanation its its quite likely that the scenario development was was taking place in the latter part of twenty twenty one if it was going to be that 2022 stress test and of course this is the period in which the fomc was still figuring out that the inflation problem was not transitory but i dont want to use that as a kind of ethical passion of the supervisors second thing to say is its not the supervisors meeting the staff who are making the policy decisions as to what kind of stress tests to have whether to have multiple scenarios thats a decision of the board of governors and so it rests with them and the fed and i i but i agree with the gravity of your remarks which is not to have tried to think about something other than the same scenario is a failure of supervision in and of itself stephanie youve worked at the treasury united states you also have covered financial markets and other business issues over in europe for a good long time one thing were hearing from both larry and dan is rates were going up and they werent just going up here theyre going up over in europe as well was what were seeing right now in the banking system maybe not the specifics of silicon valley bank but with something like that almost inevitable after we pumped so much money in the system and start taking it out theres going to be stress real stress and theres gonna be some failure yeah and i wish i was i was closer to you guys because i knew i was going to struggle to get a word in with you too but i think in this conversation i think it is important when were thinking about what the implications are you know you have to distinguish what is an outlier about not just silicon valley bank but others that have got into trouble in this episode what is fundamentally a regulatory stupidity you know a very traditional problem the interest rate risk that was just hiding in plain sight and what is a genuinely new issue which was not being fully taken into account by anyone looking at the risks and i think when you look at something like silicon valley bank you know clearly it was an outlier in the speed with which deposits had been built up in its massive exposure to onyx uninsured deposits and reliance on that for funding i hope it was an outlier in not having a chief risk officer for nine months which was an extraordinary state of affairs what was but what was very traditional about this and as the discussion with larry and danas suggesting was that you know right here was a massive interest rate risk that was whether or not it was in the stress test was something that central banks should have been thinking very hard about and i think it was sort of striking that we had a lot of the debate around this what are the hidden risks you all the conversations that you will have had david when you ask regulators whats keeping you up at night they would always talk about private equity that talk about nonbank shadow banking has been the thing that people were you know was was this worry for all these years and in fact it was the most obvious problem sitting on bank balance sheets as a direct result of monetary policy actions by central banks that has actually caused this issue i would just say though one of the reasons maybe they werent looking at that so closely although id be interested to know what dan and larry think about this you know there is an element of this which is new and we see in the speed with which deposits left these institutions and thats the non stickiness of those deposits and i think you know one of the things that regulators were thinking when they looked considered interest rate risk potentially was that there was a sort of self as a self hedging mechanism in a bank of the fact that deposits would be slow to move if they werent being paid the higher interest rates that is no longer the case and i think that probably does have longer term implications for for regulation and potentially longer term implications for how much we insure deposits i think thats a question for either larry or dan does our entire approach to deposits change given what were seeing the fact is there no stickers we thought they were thats what i was alluding to earlier id like to have a sense of exactly what the deposit profiles of this group of banks is as a whole because in theory at least the supervisors should already have been distinguishing among different kinds of uninsured deposits some of which have always been understood to be eminently reasonable others of which have sought to were thought to be at least somewhat stickier than insured retail deposits if it turns out that those and this is what stephanie i think was suggesting that those middle categories are have changed then you are going to need a change in regulation and not just in supervision larry let me sort of widen the frame a little bit without i agree with what dan said but i would put it this way we know that the fed staff has a problem with discontinuous change they basically entirely miss the discontinuous change in inflation because they stuck with their model and its traditions and i think the broad concern that someone has to put is that for the first time ever we are now in a world of highly digital banking with the ability to withdraw funds extremely quickly and with the ability to put them somewhere else extremely quickly and easily because of digital account opening so were in this super digital world and were in a super digital world with five percent interest rate and weve never been in a high interest rate super digital world before and large amounts of the economics of the banking industry rest on earning substantial interest premiums on deposits and whatever the traditional models are of whats sticky and whats not the fact that weve had the worlds fastest run and the worlds biggest run at one of the 16th largest bank in the country managed to have the biggest bank run in history has to teach us theres a lot of reason to be open to a much wider range of possibilities about the risks associated with deposits than we thought previously and so it seems to me that you asked me earlier what i would be thinking about if i was in the treasury department and i guess i would be feeling my responsibility as the chair of the financial stability oversight council very strongly at a moment like this and id be thinking about making sure that whatever i was saying and doing i was adding to confidence rather than subtracting from confidence in the very short run that if youre in an institution and that institution fails its going to be okay for you if that happens right now because if youre not sending that signal in a reasonably clear way youd ever know where the runs are going to start next id be thinking about this issue that i just raised of the new high interest rate digital world and id be thinking about making sure that there was some broader discussion of the whole official financial community about these questions of stress testing because i must say doing stress testing for 2022 even if it was started in 2021 without considering unlock unusual increases in interest rates as a stressor is really very problematic its own a pick at the speed of digital just for a moment its been talked about by others as well digital is not going away at least not that i can see its not going to work we cant regulate digital out of existence are there other possible regulatory responses that i mean we have circuit breakers when it comes to stock market right theres too much moved too quickly stefan i ask you the question is there a prospect of having something thats the equivalent a circuit breaker for deposits i think i mean i think theres a whole range of things we can get into i think one could also think about you know the degree of how we look at liquidity ratios and liquidity buffers might have to change if there is that lack of if theres lack of stickiness if we think that those deposits could go much faster you may even get a number of people have drawn the conclusion its quite a leap from here that this is one of the biggest arguments for having a central bank digital currency because then you can automatically have a claim on on the central bank for your deposits and you you dont face any of these issues its a big leap from where we are now and it means a fundamental change to to the model of banking that weve had but i think you know larry is right and that was one of the things i was alluding to that it is its a threat to the basic business model of model of banking and also to the way we have thought about safety nets in this area and how one provides confidence i would just add two things one i think we need to be careful about the time scale of things it may be that it will be appropriate to fundamentally rethink the structure of our financial system but the worst time to do that would be in a six week period while the fires were burning and so we need to separate the what are we going to do now tactically from the longer run strategic questions the other thing id say is that i agree with stephanie about strengthening liquidity dan will be very knowledgeable about exactly how you would do that but i would dissent massively from the idea of circuit breakers on deposits if you start saying that when certain things happen then youre no longer going to be able to get your money out of the bank what thats going to do is accelerate the run because people are going to want to make sure that they get their money out before the circuit breaker comes down so i dont think theres likely to be a circuit breaker mechanism that works and i think theres a lot of debate about the merits of the circuit breakers we have in equity markets so that would not be the direction i would bill so so then let me accept that larry is very strong dissent from circuit breakers and turn all the way around the other way and thats guaranteeing deposits across the board we had the secretary of treasury janet yellen go up to congress this week and say you know what were not really considering seriously just taking all the limits off the guarantees and then she came back the next day as they have to demand my remarks a little bit here because were going to do what we need to do to back deposits are we getting a clear message about exactly the security of deposits secured by the federal government well i mean i let people judge for themselves whether the message is clear heres one i drew from what both janet yellen and jay powell have said over the last 48 hours they do not have the authority without congressional action to ensure that deposits in open banks and when i think they have done is effectively to say the following we do have the authority along with the fdic to insure previously uninsured deposits in failed banks and so what we are basically telling you is if a bank fails we will insure the uninsured deposits and i take it that thats what jay powell was really saying yesterday when he said all deposits are safe and when he was asked to elaborate on that he just repeated the talking point and thats when i inferred that that this was their message that he was trying to give and if you think about it if that is indeed their position if you think about it its its essentially the same as insuring uninsured deposits because even if you said ex ante all these big deposits are insured no one would actually draw on that insurance until the bank failed so in that sense it it may be the equivalent of the the insuring of deposits in the system except for the fact of course that its presumably a policy that will not last forever and when are they going to kind of back off of it it is obviously a pretty important point the second thing one might say and i can already i can feel larry maybe having this reaction is if thats what you mean why didnt you say it more clearly so that you will maximize the calming effect of whatever tool it is that youre prepared to use and i dont know why they didnt say it more explicitly except perhaps that they didnt want to intimate that somehow they were using the authority they do have to achieve an end that supposedly they cant achieve without congressional approval and i think theres one i think theres one other point certainly you may have passed the statements more that i did but some of the statements particularly i think from the treasury side have talked about contagion as well so im not sure the authorities have been quite as clear as you suggest in saying that if youve got money in a bank and that bank fails and its not a source of contagion you will nonetheless have your deposit insured and as i understand it in order to pay off on insured deposits there need to be some set of claims made by the government about the systemic seriousness of the moment so i think that is also a place where there is some play but i think i would share what i think is your instinct to be urging on the side of projecting confidence as ones choosing the way in which one talks about this i mean the contagion to reference contagion sends the message that is exactly what a lot of depositors quite reasonably doing it is why okay i need to get into a bigger bank i just have just to spell out why that matters if you if you make it all part of a contagion argument youre not giving that confidence to people who are in the relatively smaller banks although still pretty big banks by european standards well i think i think if i were at the fed now and we were trying to formulate a rationale for when i suggested a moment ago was the likely policy even though its not stated explicitly i think i would probably say something like the following like six weeks ago if there had been a failure of a two billion dollar bank somewhere insuring uninsured depositors would be a very hard case to make on systemic risk grounds but at this juncture even if a two billion dollar bank fails and an uninsured depositor is not made whole in the current circumstances the anxiety the nervousness the uncertainty that itself will add fuel to the potential systemic fire and thus in these circumstances one could take the action there as well you do as a statutory matter need to make the systemic risk argument though that is the authority that they have and i think janet yellen did make reference to small banks yesterday as well dan i want to pick up on your comment if you were still at the fed we had a decision from the fed this week to raise another 25 basis points some people had been urging that actually they just hold given the difficulty of banking at the same time he jay powell admitted that theres more uncertainty about the extent to which whats already happened with financial conditions may have essentially imposed a further rate hike already did they get it right dan from your point of view did jay paul get it right well i mean its a its a very obviously arguably the most difficult decision since hes been there although i actually think market expectations helped him they had they had sort of converged around 25 basis points and so then it became a communication issue i mean when i was struck by david in on the monetary policy side of what he said yesterday was that he he said quite explicitly its too soon to tell how monetary policy should respond to the anticipated credit tightening but i actually think their actions yesterday were a fairly significant response i mean everybody is three or four weeks ago people are anticipating a 50 basis point increase we got 25 three or four weeks ago we thought we might see the sep suggest a ceiling of 5 7 5 or 6 percent interest and now were back to exactly where they were in december last december when they did the last step and of course they changed the language on the what but the forward guidance type language instead of ongoing increases were back to may have some firming and of course some people are reading that as the end or close to the end of the tightening cycle so i actually thought that they were conveying more that an assessment of the impact than chair policy suggested in his remarks yesterday so larry what about you in the past youve suggested perhaps they might have to have a tall rate as high as 6 percent do you agree with dan that what we saw from jay powell and the fed reserve this week was a monetary policy reaction to what weve seen already and if so was it appropriate i think what they did was broadly appropriate it was a time for temporizing because theres a lot of uncertainty and a lot of cards are going to be turned over in the next several months and the question then was just temporizing mean stopping all rate increases and i think if they had done that it would have sent actually a signal that they were very highly alarmed and would have been a mistake whether to continue precisely on the path that they were on before these banking concerns arose i think that would have seemed almost oblivious to what was a potentially gathering storm and so i think as dan suggests that a middle ground path was right and it was particularly right if the policy is going to be signaling in a clear way that even if your bank fails youre going to be a depositor as well and so nobody in america needs to have the kind of sweaty palms weekend that a large number of people had worrying about whether they were going to meet their payroll because of silicon valley bank and i think in the context of providing those kinds of assurances that the monetary policy path they set was appropriate and appropriate it doesnt mean that it will turn out to be right appropriate means that the errors are kind of two sided that theres a chance that theyll need to tighten more than theyre currently projecting and theres also a chance that not all the tightening theyre currently projecting will be necessary i think if authorities are sufficiently aggressive about adding confidence to the system my guess best guess is that the feds judgment in the sgp will turn out to be considerably more accurate than the markets assessment that the fed is going to be pushed into rate cuts very soon but thats a judgment that one cant have any great amount of confidence in but yes i think what they did was broadly appropriate particularly if we can be sending reasonably strong signals of confidence in the system so let me ask you about what we saw from the fed reserve this week and in a larger context what it indicates if anything about central banks in general and how theyre reacting to this situation look i think it showed you know weve had a lot of debate about whether theres a conflict between trying to bring down inflation as effectively as possible and how to react and responding to this situation in the banking system and larry is larrys said it well but i think also weve had sort of central banks explicitly say the ecb saying we have a different set of tools available we had a bit of that from the fed this week but i think you know propping up confidence in the stock market is in conflict with bringing down inflation in an orderly and as effective way as possible but trying to resolve these questions of confidence especially if we do see the kind of policies that larry and dan have been discussing down the road i think is perfectly consistent what i would worry about is that uncertainty is going to continue the uncertainty about how these higher interest rates feed through into bank balance sheets and the broader economy is going to still be there in six months time and you are going to have those potentially those discontinuities that larry was talking about earlier which the fed is not necessarily going to be able to gauge so yes it was the right decision and it makes the point that it doesnt have to be a conflict between these two things but it probably still narrows the path yes again to an effective approach so that is going to conclude our bloomberg wall street week roundtable the first weve ever had actually thank our panelists stephanie flanders shes a senior executive editor for economics and government for bloomberg daniel a former fed governor and also of course our special endure on wall street week hes larry summers of harvard