In the JP Morgan annual letter to shareholders, Jamie Dimon – The CEO - blamed regulators
for the recent banking panics that we’ve seen and warned that “the current crisis
is not yet over.” And that “there will be repercussions from it for years to come”.
He argued that the recent events where three US Banks failed and the Swiss government-engineered
an emergency takeover of Credit Suisse risked undermining confidence in the banking industry
and prompted investors to price in a greater risk of a recession in the United States.
In his letter he put forth that the regulations (ushered in after The Credit Crunch) encouraged
banks to build large portfolios of Treasury bonds that then fell in value when the Federal
Reserve raised interest rates, leaving certain banks nursing losses that spooked investors.
“Ironically, banks were incented to own very safe government securities because
they were considered highly liquid by regulators and carried very low
capital requirements,” he wrote in the letter, published earlier this week.
Dimon took aim at banking stress tests in his letter too. Stress testing is the annual process
run by the Fed to gauge the biggest banks’ ability to withstand major economic shocks. He
said in his letter that the exercise has become “an enormous, mind-numbingly complex task about
crossing t’s and dotting i’s” that might give risk committees a false sense of security.
He says that “even worse, the stress testing based on the scenario devised by the Fed never
incorporated interest rates at higher levels”. He says that he is not aiming to “absolve bank
management” – he just wanted to make clear that this wasn’t the finest hour for many
players. All of the colliding factors became critically important when the marketplace,
rating agencies and depositors began focusing on them. “A less academic,
more collaborative reflection on possible risks that a bank faces would better inform institutions
and their regulators about the full landscape of potential risks.” According to Dimon.
Dimon pointed out that many of the risks - including a sharp rise in
interest rates - had been "hiding in plain sight". He criticized regulators for not
considering such an obvious risk in tests that were supposed to test bank stability.
This is all true and seems to be a type of mistake that both investors and regulators
make over and over again. They often miss bigger – more structural problems - because they focus on
the last crisis – as if it will repeat itself exactly. Patrick Honohan (the former governor
of the central bank of Ireland) told the press recently that interest rate risks “flew under
the supervisory system’s radar”; so much so that “the Fed’s recent bank stress tests used scenarios
with little variation - and none examined higher interest rates” — even in a cycle of rising rates
because the credit crunch had left investors obsessively worried about credit risk alone.
Interest rate risk became downplayed, probably because it hadn’t caused problems since 1994.
Some of what Jamie Dimon says in his letter reflects a growing fear among banking executives
that the collapse of these banks will lead to a toughening up of regulations beyond what
might make sense. Dimon cautions that "Erratic stress test capital requirements and constant
uncertainty around future regulations damages the banking system without making it safer."
Silicon Valley Bank and Signature Bank were (of course) exempt from most of the toughest
regulatory measures that banks in the developed world have to deal with, including stress tests,
because they had less than $250 billion dollars in assets. This exemption – it has been argued
came as a result of significant lobbying by community banks in the United States.
So, could this panic have been prevented? Well, before I get into that let me tell
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link in the description to sign up today. OK, So, could this panic have been prevented?
Well, the Federal Reserve tightened its oversight of big Wall Street banks in response to the 2008
financial crisis – and I think this made sense. If the government is providing a
free put option to banks that are considered too big to fail – it makes sense for them to
dampen down the volatility of those banks – to reduce the risks that they are taking.
Barney Frank, whose name was on the Dodd Frank act that overhauled financial regulation in
the aftermath of the credit crunch went on to take a board seat at Signature bank (one of the
banks that failed) after he left congress. While Frank never officially registered as a lobbyist,
he made numerous public speeches that the Dodd-Frank act’s $50bn threshold for triggering
greater regulatory oversight was too low. In response to lobbying US regulators in 2018
raised the threshold for a financial institution to be considered systemically important
to $250bn. This exempted much larger banks from the Fed’s toughest supervisory measures,
including stress tests as well as capital and liquidity requirements.
It is worth noting that bank failures are not actually that uncommon. According to the FDIC,
there were 563 bank failures between 2001 and 2023, and when the FDIC closes down small banks
that are not systemically important, it tends to happen with minimal impact. Often depositors
have access to all of their money the next day. Jamie Dimon – in his letter - urged policymakers
to avoid “knee-jerk, whack-a-mole or politically motivated responses”. He said that the recent
turmoil should push regulators to scrutinize risks to banks that arise from having a high proportion
of uninsured deposits, or an undiversified customer base, which were issues at all
three of the US banks that failed last month. “We shouldn’t aim for a regulatory regime that
eliminates all failure but one that reduces the chance of failure and the odds of contagion,”
wrote Dimon, who - in the past has complained that regulatory requirements disincentivize banks from
providing some traditional – and important - banking activities like mortgage lending.
He added that “We should carefully study why this particular situation happened and not overreact.”
Dimon went on to say that higher interest rates can be expected to result in pain
for any borrowers who have to refinance their loans, which Dimon said could expose
additional weaknesses in the US economy, including in the real estate market.
He said that he did not expect the turmoil to lead to a global financial crisis like in 2008,
noting that it "involved fewer players and fewer issues".
In terms of the longer-term repercussions, Dimon argued that the recent events had
provoked "jitters in the market" which were likely to prompt lenders to pull
back from making loans in the months ahead, increasing the odds of an economic recession.
Dimon discussed in his letter how the huge levels of intervention by central banks around the world
over the last decade led to extraordinary liquidity that drove increased prices
across many investment classes – from financial markets to crypto, meme stocks and real estate,
among others. He pointed out that this liquidity also increased bank deposits significantly (and
the now-famous uninsured deposits went from $6 trillion dollars to $8 trillion dollars).
What Dimon says in his letter makes a lot of sense. The failure of Silicon Valley Bank was
driven by failures of both regulation and banking supervision – along with gross mismanagement.
There was an overreliance on the rules as they are written – by regulators, and a failure
to complete the discretionary oversight that banking supervisors are supposed to be doing.
Under the risk weighted capital rules, treasury securities are risk weighted to zero,
meaning that a bank has to hold zero equity against their treasury positions. Because of
this Silicon Valley Bank was able to build up a lot of interest rate risk without it being
reflected in their capital requirement under the regulatory framework. Silicon Valley Bank
essentially figured out how to take additional risk without holding additional capital.
There is (of course) a supervisory framework in place designed to be able to deal with the
holes in the capital requirement regulations. Up until the 1980’s there were essentially no
meaningful capital rules in place, just this discretionary safety and soundness oversight by
bank supervisors. Any seasoned supervisor looking at the balance sheet of Silicon Valley Bank would
have picked up on the problems immediately – they weren’t exactly hidden. Lev Menand
of Columbia University argued on The Odd Lots Podcast that contemporary supervision is broken
because outside of the stress testing framework supervisors just focus on process and procedures
today and are reluctant to make judgements about the actual decisions being made by banks as to
the appropriate level of risk. Bank Supervisors are allowed to exercise independent judgement
under current laws, but they don’t tend to. Sheila Bair – the former chair of the FDIC
wrote a piece for the FT after the depositor bailout. She said that at combined assets of
$300 billion dollars, the two banks represent a minuscule part of the US banking system.
She did not agree with the VC’s who claimed that letting Silicon Valley Bank go would
cause nationwide bank runs, and she cast doubt on the idea that the financial system is so
delicate that it couldn’t absorb some small haircut on these banks’ uninsured deposits.
She argued that the uninsured depositors of Silicon Valley Bank were not a needy
group – requiring special protection, and that while some start-ups argued that they needed
their uninsured deposits to make payroll, under the FDIC’s normal procedures, they would have
received a sizeable payout to help with their cash flow needs the next day when banks opened.
She said that Signature Bank’s uninsured depositors similarly would have probably achieved
significant recoveries as both banks have good assets for the FDIC to sell. The banks could have
been wound down as they were supposed to be. Janet Yellen who spent years voicing her
concern about income inequality in the United States, rushed to the rescue of careless tech
investors – whose wealth had ballooned due to low interest rates in recent years. She
could not allow them to take a haircut on their deposits, possibly for fear that she
would be called out on the “All In” Podcast. Bank runs can be difficult events to predict
or even understand. There is an anecdote from the early 1980’s of a local bank in Hong Kong
which had an awning over its front window to block the sun on hot days and keep the bank
branch cool. The office was near a bus stop and on a very rainy day, the people waiting for the
bus moved to take shelter under the awning. Passers-by thought that the crowd outside the
door was the start of a bank run and so joined them, as a result, a bank run quickly developed.
The panic at Silicon Valley Bank highlighted how the Federal Reserve is not set up to deal
with the speed of online consumer behavior. People no longer have to stand in line to
move their money in the era of banking apps. A striking feature about the American banking
system, even before the March panic, was that bank customers were moving money out of
low-paying deposit accounts into better-yielding money market funds – or even Treasuries - at a
dramatically faster pace than at similar points in financial history. Money just
moves faster today than it did in the past. The chart on screen shows that as interest
rates began rising - bank customers across the country quickly began taking advantage of these
new higher rates by moving their money out of bank accounts and into money market accounts. The pace
obviously then picked up after the panic. When the run was in full effect,
the Silicon Valley Bank managers asked the Federal Reserve for help in meeting depositors’ claims,
but unlike mobile banking apps that the customers were using, the Fed facilities
are only open for a few hours each day. Silicon Valley Bank contacted the Fed for help too late
in the day – the window was already closed... There is a good argument for moving central
banking processes into the 21st century and keeping them running around the clock in times
of crisis, or even just having them match the opening hours of retail banks all the time.
An amusing side story to the panic in March was that when Signature Bank of New York was taken
into receivership, depositors at other banks across the country panicked too. The reason for
this is that there are four banks named Signature Bank in the United States, and customers weren’t
initially sure which of them was in trouble. The fact that there are so many Signature Banks
shows you how many small banks there are in the United States. At the end of last year,
there were almost 5000 commercial banks in America, which is far more than anywhere else.
Canada has fewer banks in total than the state of North Dakota has. Japan has just 4% the
number of banks that America has. Because of the differing regulation,
The United States has ended up with a two-tier system where the big banks are subject to full
supervisory scrutiny, and a long list of smaller banks are exempt from the type of regulation that
is standard in the rest of the developed world. One point that may be a good thing is that the
recent panic ignited some fear in the financial system and has forced both the
public and regulators to pay more attention to what’s going on. The anxiety created by
small shocks can be a good thing if it makes big crises somewhat less likely.
If you enjoyed today’s video, you should watch my video on Blackstone’s struggling real estate
investment fund next. Don’t forget to check out today’s video sponsor Surfshark using
the link in the description below. See you in the next video. Bye!