“When Banking Fails” with Amit Seru | All Else Equal #bigIdeas

In the episode ‘When Banking Fails’, finance professors Jonathan Berk and Jules van Binsbergen, along with guest Amit Seru, delve into the recent banking crisis, exploring the causes of bank runs, the value of government subsidies to banks, and the relevance of banks in financing risky investments.

They question the stability of the current banking system and propose potential solutions for its inherent issues.

An alternative solution to banking instability is to revise the withdrawal rights of depositors.

If a bank invests in risky securities, depositors should only be able to withdraw their money at the current value of the bank, similar to a mutual fund.

This would remove the incentive for investors to run on the bank.

The continued existence of the current banking system, despite its instability and the availability of more stable alternatives, may be due to a lack of understanding or resistance to change among those in the banking industry.

Bank runs can be triggered by rising interest rates, which decrease the value of long-term securities that banks invest in.

When interest rates rise, banks may have to liquidate these securities at a loss, causing a decrease in confidence in the bank’s solvency.

‘Sleepy’ depositors, who accept low interest rates and don’t move their deposits out of banks due to transaction costs and other issues, can become very active and quick to withdraw their money when there’s a risk of significant losses.

This can trigger a cascade effect, causing a significant portion of a bank’s deposits to leave within a short span of time.

Stress tests, designed to evaluate how a bank would fare under severe economic conditions, may not adequately consider the possibility of correlated deposits in combination with rising interest rates.

This suggests that stress tests may need to be updated to consider different types of risks and scenarios.

While government subsidies may be necessary to prevent bank runs and maintain financial stability, they also create moral hazard by encouraging banks to take on excessive risks.

This raises questions about whether banks are the best way to finance risky investments, or if they are merely historical artifacts.

This archaic way of financing banking it is somewhat puzzling why does it continue, I mean, why do we still have banks? – Jules van Binsbergen

Banks should internalize the costs of the risks they take.

While regulators have a role to play, they should not be the sole drivers of the direction in which banking, credit, and risk are allocated.

Instead, market participants should be allowed to internalize the risk in their own way.

There is a tendency to manage risks based on past crises, potentially overlooking the risks that could lead to future crises.

This raises questions about the effectiveness of this approach to risk management.

Stress tests may accurately assess the credit situation of a loan portfolio, but they may not effectively evaluate the potential impact on other parts of the portfolio that could be sensitive to macroeconomic changes.

This highlights the importance of understanding the whole picture at all times, as all factors do not remain equal.