Raghuram Rajan: Why The Banking Crisis Isn’t Over

Episode Summary

Several questions continue to swirl around the collapse of Silicon Valley Bank and its larger implications. In this special episode, Chicago Booth’s Raghuram Rajan – former Governor of the Reserve Bank of India and IMF Chief Economist – joins Bethany and Luigi to explore the risks in the financial system and possible solutions. Rajan discusses a paper he presented (with NYU Professor Viral Acharya) at the Federal Reserve’s Jackson Hole conference in 2022, arguing that the Fed’s liquidity provision left the financial sector more sensitive to shocks, and suggesting that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability. Together with the hosts, Rajan discusses the path forward on inflation, given economic and political pressures, and his recommendations on how to manage risks and tradeoffs.

Episode Notes

Several questions continue to swirl around the collapse of Silicon Valley Bank and its larger implications. In this special episode, Chicago Booth’s Raghuram Rajan – former Governor of the Reserve Bank of India and IMF Chief Economist – joins Bethany and Luigi to explore the risks in the financial system and possible solutions.

Rajan discusses a paper he presented (with NYU Professor Viral Acharya) at the Federal Reserve’s Jackson Hole conference in 2022, arguing that the Fed’s liquidity provision left the financial sector more sensitive to shocks, and suggesting that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability. Together with the hosts, Rajan discusses the path forward on inflation, given economic and political pressures, and his recommendations on how to manage risks and tradeoffs.

Episode Transcription

Raghuram G. Rajan: The earlier view was we’ve flooded the system with liquidity. If we take it out, no big deal. The problem is the financial system, the banks, had gotten used to it, and you’re trying to remove something from an addict. It is painful.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Bethany: Perhaps not surprisingly, we are somewhat obsessed with the collapse of Silicon Valley Bank, because everything about it is antithetical to, at least, how we’re supposed to practice capitalism, from the fact that the bank collapsed, to the fact that we had to step in and rescue uninsured depositors. So, we’re still trying to get answers to what went wrong with SVB.

Luigi: We decided to take advantage of some of the world experts who are at the University of Chicago: in particular, my friend and colleague, Raghu Rajan, who has written a very interesting paper that was presented last summer at the meeting of the central bankers in Jackson Hole and a summary of which appeared last week on ProMarket.

Bethany: And the crux of the paper argues that the genesis of what happened with SVB isn’t as simple as pandemic-era fiscal and monetary policy, and in fact, has its roots in Federal Reserve policy stretching back to the wake of the financial crisis. And I think, to me, it’s really interesting, there’s also this paper that just came out from the National Bureau of Economic Research arguing that long periods of very easy monetary policy do lead to financial crises. And so, I think that this paper fits into that framework in an interesting way.

Luigi: Last year we interviewed Matt Stoller, and Matt Stoller has this idea of the Cantillon effect, that when you pump money in the system, it stays where you pump it. At some level, this paper is in the same spirit, because it’s saying when you pump liquidity, the liquidity stays where you pump it, and when you subtract liquidity, you take it away from where it was. And so, in the moment of quantitative tightening, what’s happening is that the Fed is taking away liquidity from the banks, and that’s the reason why the banks are so unstable.

Raghu, you wrote an article with Viral Acharya on ProMarket describing what are the fundamental problems that are leading to a weakness in the banking sector. Can you please elaborate on that?

Raghuram G. Rajan: Yeah. Well, this is one of those situations where you work on both the theory and the evidence, and everybody says, “You’re crying wolf, this is not a big deal.” And then this stuff happens, and we say, “Hey, this is what we were talking about.”

And I want to say there were precursors of what we are seeing in the financial system today, which suggests it has a long genesis. So, what happens in QE? QE, quantitative easing, is when the central bank essentially buys long-term securities from the market, typically pension funds, insurance companies, and so on. How does the central bank pay? It pays with reserves.

And those reserves are the most liquid asset on the planet because they’re essentially money. The central bank is creating money as it buys these long-term assets. So, when the Federal Reserve buys the bond from the insurance company, the insurance company goes and deposits the proceeds in a bank, because ordinary insurance companies are not allowed to hold reserves directly. And so, the net outcome is the bank has issued deposits to the insurance company, and it holds the reserves against the Federal Reserve. As the Federal Reserve expands its balance sheet, banks also expand their balance sheet.

The problem with the bank expanding its balance sheet is it’s got reserves on the asset side, but very, very, highly volatile demand deposits held by the insurance company or anybody else who sold assets to the Fed on the liability side. So, essentially, you don’t have a whole lot of spare liquidity in the system because what the Fed put in is taken out, in a sense, by the demand deposits that the commercial banks have issued.

But it doesn’t stop there. What then happens is the commercial banks are sitting on all this liquid reserve. So, what they do is they issue lines of credit. They say to corporations, “If you want the money, we are here to provide it for you, but give us a fee upfront for being willing to provide this to you.”

So, that’s a claim on liquidity which the commercial banks have written, and they do a lot of this because they’ve got these really liquid assets sitting on their balance sheet. What we discovered with Silicon Valley Bank and the other banks is they do even more. They convert some of those reserves into long-term illiquid or less liquid assets. And, actually, those assets in good times were very liquid. They’re Treasury securities, et cetera. They’re fine. The only problem is it subjects them to a new sort of risk, which is interest-rate risk. We’ll come to that in a second.

But even before the Fed started raising interest rates, this was creating a problem when the Fed took out the liquidity from the system, when it switched from quantitative easing, which was putting liquidity into the system, to quantitative tightening, which was taking liquidity. Because what happened was commercial banks lost some of their reserves, so they had, in a sense, less cash, but they didn’t lose the liabilities they had written. The demand deposits still stayed at really high levels. The lines of credit they had written stayed at high levels.

In a sense, we had a system which was becoming less and less liquid as the Fed withdrew the liquidity from the system. What were the consequences? September 2019, all hell breaks loose in financial markets. You have repo rates going through the roof. Why? Because there’s not enough liquidity in the system. That was the first warning. And what the Fed did was, “Oh, we’ve taken out too much liquidity. Let’s pump it back in.” So, it put more liquidity back in the system. That was a short-term fix. Now, remember March 2020, again, all hell breaks loose. This time, the Fed says a little bit of liquidity will not do. They’re pumping trillions of dollars of liquidity into the system.

So, now it would seem we’re really very liquid, but banks do exactly what they did the last time around. They finance it by issuing large demand deposits. And look at Silicon Valley Bank. When do its demand deposits, uninsured demand deposits, go through the roof? When the Fed does the pandemic QE. The Fed is pumping tons of money into the system. The banks are holding this money, financing it with very short-term, uninsured deposits. Remember, Silicon Valley Bank had uninsured deposits up to 97 percent. Now, some of it was tech money coming into Silicon Valley Bank, but some of it also was just the recycling of the enormous amount of cash the Fed was putting out. That’s why it was not just Silicon Valley Bank. It was First Republic, it was Signature. All these banks were doing exactly the same thing. The common feature was the Fed.

Luigi: Let’s break down a bit of what you said, because you said a lot. Let’s start with the QE. My understanding of your description is that some of these negative side effects are really what the Fed was looking for. Are you saying that all QE was wrong, or are you saying that something else should have been done to minimize the negative effect of QE?

Raghuram G. Rajan: Well, what we are saying is, put aside for the moment any positive effect of QE. And as you know, some of our colleagues have written papers saying it’s hard to find those positive effects, and it depends on who is looking. If the central banks are looking, there’s a lot of positive effect. If the academics are looking, not so much.

Luigi: That’s a polite way to say they don’t exist.

Raghuram G. Rajan: Well, let me say, we don’t need to take a stand on that. What we are saying is whatever the monetary-policy reason for doing QE is, you’re actually increasing financial-stability risks in the system. Why? Because the money you’re pumping into the system is being offset by claims on the system. But this is all running not through the central bank but through the commercial banks. And as you know, if the commercial banks issue a lot of short-term claims, they’d better have the liquidity to meet those claims.

And what we’re saying really is, while the Fed is doing QE, they have that, but once the Fed stops and even once it starts withdrawing, the system becomes much less liquid very quickly, even if you’ve got trillions of reserves above the level you were at previously. That’s because the commercial banks are taking what you give and saying, “We are going to use it all.” There’s no spare liquidity. They’re using what you’re giving in full measure.

Luigi: What I hear you saying is, basically, the Fed made the banking sector addicted to high liquidity. And so, taking away that addiction is super painful, and you cannot do it very aggressively, and that limits tremendously the ability of monetary policy to fight inflation. When there was this debate about inflation, some people said, “Oh, we’re not worried about a temporary spike in the level of prices, because we know how to fight inflation and we can do it.” And, basically, you’re saying they were completely wrong.

Raghuram G. Rajan: I wouldn’t go so far, but what I would say is you’ve got much of what we are trying to say exactly right, which is this thing that they’re doing on the side will interfere with their ability to fight inflation. Because to fight inflation, they’re saying, “OK, if QE had positive effects, we should withdraw that by doing QT, quantitative tightening.” The problem is you can’t do it very fast—that’s what we are discovering—because of the financial fragility that has built up. A lot of people, I think, are looking at just one end of what the banks did. Why did these guys take on so much interest-rate risk?

What they’re not looking at is the other end. How come these guys got so much in demandable deposits at such a fast pace that they had to invest it in anything that moved? In order to get a few basis points in spread, they took those deposits which are flowing, and it was like the Fed was holding a fire hose to their mouth, and they were taking that and putting it in longer-term securities because they couldn’t make loans out of all these things, and they were getting a certain spread from that.

It was a search for yield, it was to some extent what we call greed, but it was also because of the enormous amount of money that was flowing into the banks at that time. And for that, the Fed has some responsibility.

Bethany: Did the Fed understand that conundrum, and should they have understood that conundrum?

Raghuram G. Rajan: I don’t think they saw that side that clearly. I mean, we presented this paper at Jackson Hole in August of last year, and I got the sense that they didn’t fully see that the flip side of all this liquidity that poured into the system was highly demandable claims written by the system. They hadn’t recognized, to my mind, the extent to which those claims were there and the extent to which they had eaten up the liquidity, so to speak.

Remember the previous time we went to quantitative tightening in 2017-18. Senior Fed officials—Pat Harker was the first, Janet Yellen echoed him—said, “This will be like watching paint dry.” And it wasn’t because the earlier view was, we’ve flooded the system with liquidity. If we take it out, no big deal. The problem is the financial system, the banks, had gotten used to it, and you’re trying to remove something from an addict. It is painful.

Bethany: Is there a deeper issue here that we can’t seem to get bank supervision right, and we don’t even know we’re not getting it right until something bad happens? And I ask that because Dodd-Frank, of course, was supposed to have fixed everything, and we weren’t supposed to be presented with any more financial crises originating in the banking sector. And yet here we are, just over a decade later, and it’s been, of course, a crazy time, but maybe the world these days is always a crazy time. What does that say about our ability to supervise the financial sector going forward?

Raghuram G. Rajan: Actually, what this suggests is you can’t press the accelerator with monetary policy fully down, because that’s when people have much greater incentives to take risk. Silicon Valley Bank is basically saying, “If I put my deposits in short-term Treasuries, I earn nothing. So, let me take a little bit of interest-rate risk. And, after all, interest rates haven’t moved for a long time, so I’ll put it in long-term Treasuries,” and that’s when all hell breaks loose when interest rates go up. I think periods of easy money tend to prompt a search for yield, which causes entities to take more risk.

In that time, obviously, you have really high-class, intrusive supervision, which is very hard, especially at a time when things are going reasonably well. And on the political side, they say, “Look, no problem. You’re scared of your own shadow. Stop worrying.” And so, supervision becomes easier in easy times, which is precisely when it should be a lot more attentive. So, I think this notion that monetary economists have, we can press on the accelerator on the monetary policy side, and there’s some magic supervisor who will take care of all the risks on the financial-stability side, that simply doesn’t work.

And I think the sooner we realize this . . . I mean, how many episodes of this kind should we have before we realize you can’t be so aggressive on monetary policy and imagine that there will be no financial-stability risk? And so, to some extent, I think, if that is the realization which dawns on us after this, it will be very healthy for the system.

Luigi: So, you have been the governor of the Reserve Bank of India, which is the Indian central bank, and a very successful one, I may say. Had you been the governor at a time where the inflation went three or four times the level that your target was and you basically caused a financial crisis and you didn’t pay attention to this, would you feel the need to resign to save the name of the institution?

Raghuram G. Rajan: Look, this is a leading question if there is one, but look, it’s a really difficult job, especially in the most-developed financial system in the world. It’s hard to keep tabs on everything. And, of course, as the central banker to the world, everybody’s watching you. It’s not always easy to look into the future and see how developments will take place.

The Fed has made some mistakes. I don’t think any of them were marks of gross neglect or incompetence. I do think that hindsight would say there’s a lot that they could have done differently and better, and we should take lessons there, but it’s not as if they didn’t do the best job they thought they were doing. We have very strong differences in opinion, but that comes from a different sense of what the theory is and not so much that they were not really paying attention to the data.

Forget the specific names. Let’s just take, supposing I’m a central banker and I’ve flubbed the inflation issue, and there’s some financial instability. There is a mystique, an aura about the central bank. And the question is, by resigning, am I breaking that mystique, breaking that aura? Or am I sort of saying, “Well, stuff happened which we can’t possibly have fully anticipated, but we’re on the job, we’re trying to do the right thing, and we will bring it back onto course.” One example of the faith the markets have still in the Fed is, look at the five-year, five-year forward on inflation. It’s been stuck at two and a quarter for the last six, eight months.

And that’s saying, well, no matter what the short-term ups and downs are, the market—and I don’t know how much faith you want to put in those market prices—but the market certainly seems to think that inflation will be brought under control. You look at other measures, they’re coming back into line. So, it’ll take longer, it’ll be harder, maybe we have a recession, but I would not impugn the motives of the Fed or the fact that they did what they thought was the best job under the circumstances and given the information.

What I would disagree with is the frameworks that they use, but that’s a different issue. They believe their frameworks, I believe my framework, and therefore, there’s a difference in opinion.

Bethany: What is the path forward from the Fed here on fighting inflation? There’s clearly a lot of pressure from, at least, some segments in the business community to stop raising rates and even to start cutting rates. There’s political pressure on the Fed to do that, too. And I guess I’m thinking maybe there are two issues for the Fed. One is this matter of perception and the need to placate various constituents, from the political ones to the big business ones. And the other is the reality of the thing, in the sense that now, with a crisis in the banking system that is going to result in some tightening of credit, the Fed’s ability to manage the economy through interest-rate increases has gotten a little more difficult, because there are multiple factors going on. And so, is there a clear path forward on what the Fed should do, and can they follow that clear path if there is one?

Raghuram G. Rajan: Well, I think before data that came out towards the end of February, early March, there was a sense that, yes, inflation was coming down, the Fed was on the right path, the slower pace of rate increases, 25 basis points a meeting, would have the desired effect. And then some data came out which suggested a stronger economy than earlier thought, a prospect of no landing rather than a hard landing or a soft landing.

And the Fed then started making very strong noises, but immediately after Jay Powell talked about maybe even a 50-basis-points raise, we had the financial instability show up. So, yes, the Fed is now torn. I think it has a month and a week to look at the data, to see what’s happening, and to reassure itself that we are on the path of slowly building slack and bringing down inflation.

What the Fed really worries about is the labor market, that it has been too tight, and it would like to see some evidence of slack. The problem the Fed has is, every time it seems like as if it’s going to slow or even pause, the financial markets take off. And if the financial markets take off, then people feel much, much happier, wealthier, and then the spending doesn’t slow, and corporations say, “Oh, well, maybe the economy is picking up again. Let me not lay off people.” And we don’t get the slowing that is necessary. Even if inflation is coming down, we are still, depending on the measure, at 4 percent to 5 percent inflation, and the goal is more like 2.5 percent. And so, the Fed still has a way to go.

The last mile is probably most difficult, and I think if the Fed sees the financial sector stabilize, it will certainly be careful that it doesn’t want to signal a pause too quickly. So, it’s going to watch until the last moment before it has to take the next decision. But the next decision, if there is financial stability, and we haven’t seen more slack build up in the labor market, may well be to continue the policy of rate increases. Certainly, it will be very, very careful about pausing or declaring a pause, because that will mean it can’t do much against inflation if inflation takes off again.

Bethany: That’s a really interesting point about the feedback loop between the Fed announcing pauses in hikes and the markets taking off, and then that suddenly reinvigorating consumer spending. Is that a tighter link than it’s ever been in the past? A tighter and more dramatic link, and something also new for the Fed to contend with, in the sense that the markets have become much more leveraged to what the Fed says and does over the past couple of decades than it seems to me they ever were in the past? But I wasn’t really paying attention to this four decades ago, so I don’t know if that’s accurate or that’s just my perception.

Raghuram G. Rajan: No, you’re exactly right. I think it’s two ways. The Fed will say, “I’m not paying attention to the market,” but unfortunately, its actions in the past have suggested it is paying a lot of attention to the market. But this sort of works in both ways, right? Actions that should essentially make the markets more cautious and tighten financial conditions have a perverse effect that when it gets a little too tight, the market starts saying, “Oh, well, the Fed is going to be really worried about these conditions tightening so much and they’re going to start cutting,” and as a result, that doesn’t take it to the point of tightness, which the Fed needs to slow down the economy.

So, it’s really a very perverse dynamic. Some people term this financial dominance. There is a term called fiscal dominance, the Fed or monetary policy being dominated by the fiscal, too much spending, but financial dominance is monetary policy being dominated by the markets.

Bethany: Fascinating.

Luigi: So, at the last meeting, would you have raised the interest rate by a quarter of a point?

Raghuram G. Rajan: Let me just say it depends on what I knew about the banking sector. If I thought that the deposit outflows were still not overly worrisome, I would have, because I think the pause at that point might have signaled a lot more worry about the state of the economy, maybe the state of the banking sector. So, that would be the downside risk.

The upside is what we just talked about, that the markets start celebrating and we still haven’t done the job, in the sense that I think a measure of whether you’ve done the job is whether there’s a reasonable amount of slack in the labor market, and there isn’t.

Luigi: But, sorry, we know the information about the deposits. I think that the regional banks lost $120 billion in deposits and the large banks gained $66 billion. So, we lost what, $54 billion to the rest? I think that there is a shrinkage of the deposits, but there is a major movement away from regional banks.

Raghuram G. Rajan: Yeah. If it was widely spread out and it wasn’t focused on a few banks, I’d be less worried. If it was focused on a few banks and it was more than First Republic, and I started worrying about specific banks failing, I’d be a lot more concerned. But, again, I would say given how much noise you’ve made that inflation is job one, and then suddenly you pause because of this, it might actually convey the signal that you are a lot more worried and to the extent it may precipitate more adverse action on the banks. So, I was saying even before the meeting that if I were there, it would be 25.

Bethany: Does all of this say anything to you about the structure of the banking system? And what I mean by that is that officially we have a policy, I guess, of some big banks, community banks, regional banks, yet everything that seems to be happening seems to be pushing toward bigger and bigger banks being the direction of the future, in the sense that the financial crisis, the whole cry was too big to fail, yet we came out of it with too bigger to ever fail again or something like that. We certainly came out of it with even bigger institutions.

And right now, for all the noise everybody is making about the importance of preserving regional banks and community banks, everything that’s happening seems to once again be moving in the direction of very big institutions. So, is there a right answer here? Is there a what-we’re-saying versus what-we’re-doing issue?

Raghuram G. Rajan: Well, there is one. It’s this notion that we really aren’t willing to tolerate any banking-system risk now. There’s a hint of banking-system risk, and we bail out all the depositors because nobody wants to see banks implode on their watch, and then some contagion takes place. And so, I think coming out of this, it’s going to be the case that it’s not just too big to fail. Even if you’re a midsize bank, so long as you have correlated positions with others, you have to be truly out on a limb in what you’re doing to be allowed to fail under these circumstances, which then means the only way that you can have a banking system which doesn’t take intolerable risks is to up the level of supervision and regulation.

And, of course, the banks are going to scream bloody murder at that. But what do you do? If you’ve effectively guaranteed all deposits, you can’t let the riskiest bank basically go out and go on a limb while raising money with government backing on all its deposits. So, I really think we are moving to a system which is going to be much more heavily regulated.

Luigi: Since you’re in the business of predictions, a year from now, what is the inflation rate going to be? What is the growth rate going to be?

Raghuram G. Rajan: Aye yai yai.

Bethany: Heavens, Luigi.

Raghuram G. Rajan: I am not in the business of prediction. I keep telling people, economists predicting the future don’t have any better track record than astrologers. No. What you can only say is, looking at what’s happening and trying to divine the trend from what is happening, that’s the best you can do.

I think inflation is coming down. Hopefully, if all goes well, maybe we bring it down to three, somewhere there. That would be, in my view, a good outcome over this period. Of course, if we have a recession, these financial-sector issues take hold, then perhaps it might come down more.

I’ve given you the classic economist left-hand, right-hand answer, but really, I think at this point, almost surely, we are going to see a slowing of the economy. The soft landing where you ease into much lower inflation, I think that’s going to be really hard. It’s either going to be a harder landing because of Fed policy, or a harder landing because of financial tightening. But the soft landing seems very low probability at this point.

Luigi: Thanks a lot, Raghu.

Raghuram G. Rajan: You’re most welcome.

Bethany: So, what did you think was most interesting about what Raghu had to say?

Luigi: How careful he is in not criticizing anybody.

Bethany: Well, you did try to back him into a corner on that one, I must admit. I didn’t blame him for trying to squirm away.

Luigi: Yeah. I think that actually, to be honest, the criticisms were very stark, and I think that he was very soft with the language, but he carries a very big stick.

Bethany: Yeah. And he was very stark in the paper that they coauthored. He may not have been quite as stark here. He didn’t want to pin it on Powell, for example, but the last line of his paper says this: “The bottom line is clear. As it reexamines bank behavior and supervision, the Fed cannot afford to ignore the role that its own monetary policies, especially QE, played in creating today’s difficult conditions.”

That’s pretty blunt, isn’t it?

Luigi: Oh, absolutely. Because this does not only involve Jay Powell. It actually involves Janet Yellen and Ben Bernanke as well, because those are the big guys of the QE. And in that respect, Jay Powell just inherited the mess.

Bethany: I also thought there was something very interesting in his answer, and I debate with myself how much this always matters, but I don’t fault the Fed’s intentions. I think the Fed has always had the best of intentions. I don’t think there have been intentions to create financial instability or to somehow make the rich richer with asset-price inflation or widen wealth inequality through its policies.

I think the Fed has been trying to do the best it can with the very blunt tool of monetary policy. And I think if anybody’s to blame, it’s probably Congress for not taking a more active role. In other words, maybe the clearest way to say this is, I don’t fault the Fed’s intentions even if you fault the outcome.

Luigi: I think you are a bit too generous. I don’t doubt—

Bethany: Me? Oh, my goodness gracious.

Luigi: I don’t doubt the good intentions, but I think that, number one, if you are blind to certain aspects, it’s probably not coincidental that you’re blind. If you push an instrument too aggressively, not knowing, you have a responsibility. And maybe you do it with the best intentions, but you should be aware of your own limitations. I think hubris is very dangerous.

Bethany: You’re right, I am being too generous, because something else that I’ve been told has happened at the Fed in the last decade is that they have increasingly not wanted to listen to market participants about what is happening in the markets. And the gap between what the Fed and what even academic economists have thought versus what market participants will tell you is dramatic. And that the Fed, through the start of the pandemic, said: “There are no bubbles, everything is great, everything is solid. None of our policies lead to asset-price inflation. That’s not the way this works.”

And if you talk to anybody in the market, they will tell you exactly the opposite. There were all sorts of signs of a crazily overheated market and that the Fed’s monetary policies absolutely were contributing to asset-price inflation. And so, it was just a fascinating gap. And there is something to the notion that the more true that became, the less the Fed wanted to hear it and the less interested they became in hearing from market participants who had something to say that they didn’t want to hear.

Luigi: Yes, absolutely.

Bethany: I don’t think the banking system is about to collapse, but I think if it doesn’t, it’ll be because we got lucky because there’s still too much of a sense that the Fed won’t let it collapse and so, therefore, it won’t be put to the test. But I think if people wanted to put that to the test, the result could be a little bit frightening. I mean, all of this . . . In the end, financial-system stability is confidence; banking-system stability is confidence. And so, as long as people stay confident, the loop works in a very reinforcing way. And thus far, despite the cracks in the confidence, it hasn’t cracked in a big way.

Luigi, does that sound right to you?

Luigi: Yeah, I don’t think that there will be a major collapse, but I think that we’re going to have problems along the way, and one might be a recession soon. And the other is, as Raghu said, it will take a while to bring back inflation at the targeted level of 2 percent. The Fed will pay with bad performance over the long term, for the hubris of controlling everything, fine-tuning everything.

Bethany: I remember thinking decades ago, when I was first thinking about the stock market, how interesting it was that there was this thing that human beings had created called the stock market, which we couldn’t understand or predict. It was created by people, yet it was like Frankenstein. It had somehow escaped our control. And I think that what has happened with SVB is yet another example of that, in that you have this thing called the economy and the Federal Reserve and all these experts studying it and trying to make things work in a particular way, and yet something is somehow always escaping our control. There are always unintended consequences. And there are policies that sound pretty straightforward, like QE, quantitative easing, that it turns out nobody really understood, and nobody really understood how it worked, what the effects were, and what the unanticipated consequences could be.

Luigi: Yes, I think you are absolutely right that there is a bit of that effect, but I think that some effects are more predictable, and even if they’re more predictable, they’re being ignored. So, after our conversation in the previous podcast on SVB, you challenged me because you didn’t believe that deposits would move unless they are threatened by the bank.

Bethany: No, no, no, wait, I’m going to correct that because you put something on Twitter about that, too. I granted your point, and I thought you were right at the time, and I think you are all the more right now. I just didn’t think that what precipitated SVB’s collapse was people moving their money in search of a higher yield. And I think we don’t know the answer to that, but I still think I’m right.

Luigi: You may well be right.

Bethany: But in the big picture, you’re right. Just to be clear.

Luigi: Anyway, that was a hunch, but I teamed up with two researchers from Columbia, Tano Santos and Naz Koont, and actually got data on the banks that have a good mobile app or do not have a good mobile app, measured by how many reviews you have on the mobile app, and whether you have a brokerage account inside the bank or not.

What we show is that you get much more sensitivity to interest rates, not surprisingly, if you have a mobile bank app or if you have a brokerage account, but particularly if you have a mobile app and a brokerage account. So, just to give you a sense, 400 basis points of interest in the fund rate will lead to a 12 percent decline in deposits for a traditional bank but will lead to a 24 percent drop in deposits for a bank that has both a mobile app and a brokerage account.

So, I think the sensitivity has increased quite substantially, and it does contribute to the bank instability. But one thing I read on Twitter that I thought was interesting is things might even get worse when they introduce FedNow at the end of June. As you know, FedNow is the payment system that will make 24/7 availability to transfer money, which means that the central bank will not have the weekend to solve problems, because they will happen 24/7. So, the bank run that took place with $100 billion in one day could be even faster with FedNow.

Bethany: That’s an absolutely fascinating finding. Does that mean that we should ban mobile apps, get rid of technology and banking, and reinstate Glass-Steagall so that you don’t have a bank and a brokerage in one company?

Luigi: No. I think we should give up the idea that the safe deposits should be at the bank. We should introduce the central-bank digital currency where there are some safe deposits, but they’re at the central bank. This is worth another episode, but I think it’s an inevitable consequence of what we’re observing today.

Bethany: It is really fascinating, because I think everything that we have been talking about is arguing for a really fundamental restructuring of the banking system. I think it has to be, and I hope that that’s the outcome of this, because it’s very clear in the wake of the financial crisis that half measures are really, really dangerous. And I thought Raghu’s point about how regulation gets easier as market conditions get easier is a really interesting one.

I think the structure of our banking system, of our financial system, doesn’t work for the modern economy, and the idea that supervision is going to be able to fix that is obviously untrue. So, yes, I think we should do an episode on this and on how we should restructure the financial industry from scratch, really.