Amit Seru is a prominent finance professor and academic researcher recognized as a leading expert on banking, financial regulation, fintech, and corporate finance. He is the Steven and Roberta Denning Professor of Finance at the Stanford Graduate School of Business (GSB) and a Senior Fellow at the Hoover Institution.
As Hoover’s annual monetary policy conference gets into gear, Professor Seru joins me to discuss a major issue embedded in its title: Independence, Structure, and Risks Ahead for Central Banks.
Specifically, has the Fed’s use - or what some would say it’s overuse - of its lender-of-last-resort role, meant that the central bank has rescued more than banks that are temporarily illiquid and propped up banks that are chronically insolvent? Has the Fed crossed the line and conducted fiscal policy inadvertantly?
Amit emphasizes that central bank independence is not just about setting interest rates, but also about overseeing financial regulation and bank supervision. Simply put “the Fed… should be doing… lender of last resort, in times of crisis, <so it> should have information about where <there> is solvency and liquidity, and be able to manage this so that the shocks to the economy are somewhat moderated.”
And he warns of “mission creep,” where the Fed’s interventions go beyond its original mandate. “Independence is great in the sense that you are trying to bring in <the Fed> an institution <which is insulated from politics>. But when the same institution actually has direct control over allocation of credit through the financial system, through this lender of last resort function... How do you draw the line? This expansion has led to bailout expectations among banks, as seen in recent crises like Silicon Valley Bank.
Amit is critical of the tendency to bail out insolvent institutions. “When you go out and bail out institutions, which we have repeatedly done, most recently with the Silicon…Valley Bank episode, all the banks basically have that inbuilt expectation that, okay, we can take a risk if it pans out, great. If it doesn’t, we will be bailed out.” He argues this undermines market discipline and encourages excessive risk-taking.
So dive in and hear how Amit maps a balance between central bank independence, effective regulation and market discipline and the reforms he is urging to increase accountability while at the same time preserving the innovative spirit of the U.S. financial system.
Spoiler alert: He sees serious consequences ahead if this is not resolved. “At some point or the other, the public is going to realize that you are running a fiscal shop, and whenever it is fiscal, we have elections. We are a democracy. And that’s where you then need to decide this.”
The Fed’s angle into regulation 00:01:12:10
Historically… the Fed has a mandate, and… it’s about interest rates and huge debate around setting interest rates. Where does supervision come into all this? Where does financial regulation come into all this? And it has to do with the fact that shocks propagate into the economy through the banking sector. So, the Fed should be having some overseeing powers over the financial system. And that’s how it all started. The big function that we told the Fed that they should be doing is the lender of last resort, that in times of crisis, you should have information about where is solvency, where is liquidity, and be able to manage this so that the shocks to the economy are somewhat moderated.
The eternal question…00:02:05:18
Problem is, how do you figure out what the right level of intervention should be when a lender of last resort kicks in? So, this whole debate of independence, while it has focused on interest rate cuts and rises, as we’ve been debating, is also a lot about what the Fed has been doing over the last two decades, which is intervening pretty actively on the financial sector side.
Unconventional monetary policy 00:02:33:15
Now, the whole unconventional monetary policy was all about affecting assets, and asset prices through allocation of credit. But the Fed, when it intervenes on that side with the perspective that it is trying to do something like a lender of last resort, when does it actually cross that<line>? And the mandate is what it is, but you end up doing, a sort of mission creep.
The Fed’s independence and power can play out in many ways 00:03:03:10.
So, independence is great in the sense that you are trying to bring in an institution which is insulated from politics. But when the same institution actually has direct control over allocation of credit through the financial system, through this lender of last resort function, which is why the whole operation of supervision and regulation has been put in place.
LOL-resort bleeds into market interference and bailout policy 00:03:26:21.
How do you draw the line? So, independence is also on that side. And it’s getting debated right now because should the supervision and financial regulation be done the same way where we have now the bailout expectations from the Fed inbuilt into the banking sector? All because we wanted the lender of resort function to operate in a certain way.
LOL-Resort links to Fed independence issues 00:04:19:21.
So that’s going back to this whole debate on independence. The issue is lender of last resort (LOL-Resort). If you go back to where the doctrine comes in, the idea is that, hey, if you have information, supervisors and regulators go looking and only save institutions which are illiquid in the short run, but they are going to be solvent in the long run.
Moral hazard is to be avoided 00:04:44:02.
You don’t want to be going in and saving institutions which are insolvent. When you go out and bail out institutions, which we have repeatedly done, most recently with the Silicon Valley Bank, episode, all the banks basically have that inbuilt expectation that, okay, we can take a risk if it pans out, great. If it doesn’t, we will be bailed out.
How did we get to such a state? 00:05:09:06
And now suddenly, why is that bailout happening? Well, it’s happening because the Fed is exercising it. The lender of last resort function that it’s supposed to be doing. And but you know, the lender of last resort function is very clear that you do it only when the institution is illiquid but solvent. We have given up on that principle.
Helping the mistake-makers undermines systemic discipline 00:05:36:12.
Sometimes in turmoil, funding disappears. But if you inherently have invested in prudent projects or loans given to entrepreneurs or whoever. Yes, they’ll pan out in a few years, but they will pan out. Yes. Versus a scenario where you’ve made loans, they are never going to pan out, or they are unlikely to pan out. And we are still using the lender of last resort to prop you up as an institution. That is what sets the whole financial system on the back foot, where everybody thinks you can take any risk, and if it pans out, great. If it doesn’t, it’s not my problem.
Bank Regulation tried to prevent these situations; but that failed 00:06:39:01.
So, we are at an interesting time where, over the last decade and a half, we have this lender of last resort bailout expectations squarely being put with financial institutions. At the same time, after the financial crisis of 07- 08, we also regulated the banks in terms of what they can and cannot do, capital requirements and so on. And one push from many folks out there is that well, what has happened is that a lot of credit activity has migrated outside the banking perimeter, and we go to somehow bring the activity back. And one way we can bring the activity back, we can talk about whether it makes sense or not, but the premises that we will bring the activity back by deregulating.
Now we ask if regulation went ‘too-far’ 00:07:28:18.
And one way in which we are going to deregulate is to make sure that the supervision burden on banks, that’s being put in place, we are going to cut it. So, Michelle Bowman comes with this mindset that maybe the supervision and compliance and regulation have become too tight on banks, and we got to dial back on it.
Regulation failed in some very basic ways; more may not be better 00:07:47:18.
And we can argue how or, you know, what the approach might be. But the central premise is that, like if the credit is getting allocated outside the banking system, then there is no, we have no way of there’s no sunlight. My flip side to that argument is that we had Silicon Valley Bank, we had other banks recently where all the regulators and supervisors are looking at the banking system, and yet we couldn’t detect pretty basic level of risk mismanagement, as we can call it.
Less might be better with a bank’s own capital ‘at risk’ clearly 00:08:24:14.
So why are we worried about, us not knowing things outside when we don’t even know what’s happening inside and in fact, if you look at where the credit is migrating with private credit and so on, turns out that those entities are actually funded, by their own skin in the game, so called equity, so they can absorb losses.
No ‘truth’ without consequences 00:08:48:06.
And that’s exactly what we want a market to do so that you should be allocating credit and taking risks but also bearing the consequences of the risks. So, I think while I have some sympathy that maybe supervision has become too complicated and so complicated that we miss the basic risk management inside the perimeter. I also think this worry about private entities and markets responding. And allocating credit is a bad idea. It doesn’t ring, the bell in my head, at least.
Supervision system is ‘interesting’ 00:09:36:02.
I think the system of supervision is interesting, I will say, because there are a lot of good elements in it. So, as you probably know, and your viewers know the way we regulate banks is supervisors go in, they look at documents, they look at the balance sheet information, other information, and rate you on a camel score.
Camels 00:09:59:12
Camels being the acronym for Capital adequacy, Assets, Management capability, Earnings, Liquidity, Sensitivity to risk…
CAMELS scoring sets the stage 00:10:11:05.
Know that one. Yes. So, camel. We give you a score from 1 to 5. Five is you’re not doing great work. One is you’re doing great. And the way we sort of have done this is supervisors collect both information from balance sheet and income statement and so on. But also interview talk to people and construct this score.
More than one regulator; more AI less regulator? 00:10:31:00
You could argue that with technology and advances that have happened that maybe we can bring some of those elements to reduce some of the burden, both on banks and on the supervisors. But an interesting thing, which my research and some other research has also shown is the information inside these scores come, differently from Federal regulators. So, to your question and the state regulators themselves, so, you know, a Silicon Valley bank, for example, is regulated by both the California State regulators and the Federal regulators. In tandem, both sets of regulators bring some good information to the table. So that’s why I said it’s a little bit nuanced. It’s not like either or. But at the same time, Michelle Bowman and others are right that there is also much of this complexity and compliance, which could probably be streamlined with technology, with AI.
Still no easy answer 00:11:28:18
But the answer is not either or. I wouldn’t just say, okay, let’s replace their old regulators and neither would I say, let’s only take it to the state regulators or only to the Federal regulators. But there is a better design that one can produce.
Mission creep 00:12:11:20
So, if you clearly have a mandate towards the monetary policy and making sure, those, those, goals are met, but, if you start using lender of last resort function, to go well beyond the mandate… This is the kind of thing where, mission creep kicks in.
Unconventional monetary policy 00:12:36:05
Okay, maybe the Fed should be doing unconventional monetary policy, which is now because we are at zero lower bound, we are going to start buying and selling assets. Well, when you buy and sell assets, for trillions of dollars, which we have done with the Fed balance sheet, you move asset prices, you move the signals in the economy.
Unconventionla policy disrupts normal pathways 00:12:56:06.
Resources don’t flow where the market participants think they should flow. They flow where the Fed or the government thinks they should flow. So that’s, again, going back to our very first question about independence, that while each of these steps at that moment of time might have seemed sensible, when you look at the long horizon, you see that the Fed actually has veered away from the mandate because it’s really doubled down on this lender of last resort, oriented intervention in the markets.
A loss of focus; a change in mission; a violation? 00:13:28:00
And once that has happened, how do you claim that you are really independent because you now are intervening, like you said, buying and selling assets, as you know, mortgage-backed securities here or climate change there. And now you are actually doing what independence should allow you not to do, which is politically getting, in charge of where the allocation of credit should be.
Does too much independence beget authoritarianism? 00:13:56:09
There was some discussion about reducing inequality. Right. So, Europe, as you know, with the ECB, has taken the lead where they were dictating the banks to then go and tell their corporate clients where they should be lending, which sectors they should be lending. And there has to be a better way of doing it, because it actually leads to problems when it comes to independence.
“Independence” means freedom from political influence 00:14:21:04.
We want independence for the Fed because we don’t want political intervention. But if you do this where you are now effectively, actually, if you think about it, doing fiscal policy, which is what Scott, Bess and Boyles saying, that is not your mandate and you’re doing it in a stealth way while claiming don’t ask us questions because we are independent.
A drift in central bank focus is dangerous 00:14:42:12.
So, you’ve got to basically be a little bit careful, because if we go down that route and that independence is questioned, then it leads to spillovers. On questioning independence with respect to monetary policy, too, which is not a place we want to be.
Regional Fed system works well 00:15:28:09.
My understanding is again, pretty much like supervision, where you have the Fed and the states rotating this system of district banks who rotate in and rotate out with respect to FOMC votes has, by and large, been working reasonably well. So, I wouldn’t try and change the system.
Policy needs context for its organizations 00:16:38:05.
So I think if you look at the way, UK has approached this with the Bank of England, what they have done, and the tricky situation going back to the context, is just that you have a monetary policy function that you got to do, and then you have this lender of last resort stuff, which is useful in crises, by the way, because at that time when you go to coordinate and do it pretty quickly, it makes sense for the <central bank> to have some, understanding of where the institutions are in the economy, because you might have to bail out some banks because they are illiquid but solvent, and then let some others go because they are insolvent. So having that information and doing it quick is good. The question is how do you have that information while maintaining independence and not being caught into, the cycle that we have been caught in? So just to give you one example, with Silicon Valley Bank and other banks for example, when there was risk mismanagement and supervisors and others were kind of caught, if you remember, we were also seeing raging inflation.
Policy needs meets asset/liability mismatch 00:17:42:22.
So, the monetary policy should tell you… you’ve got to raise the interest rates. The problem was if you raise the interest rates more, you would have broken more banks because many of the banks had this risk mismanagement problem where they had invested in long term bonds and their value was going down. And the uninsured depositors who had funded were feeling more and more spooked.
When monetary policy needs and regulation clash…00:18:04:14
So, there was a constraint on your monetary policy because your banking system was really in bad trouble. That is not what you want when you have financial and monetary policy running together inside the Fed. So how do you deal with that? Bank of England has two separate committees. One is for interest rate setting and monetary policy, and one is looking at financial stability issues so that when crisis comes, the information can be shared.
US policy suppresses stability issues 00:18:31:14.
But at other times they are both accountable for what they are saying and doing. Right now, in the US, what we have is the monetary policy function has some accountability because you’ve got to go out, talk about it, discuss it. Financial stability angle is completely hidden. Yes. And so, the question is can we restructure it?
BOE has two committees 00:18:52:06.
So, Bank of England is one model where there is some sunlight on the financial stability bit as well. And if there are errors, they are held accountable too because right now everything is put together and if there are errors and someone points them out, it immediately becomes a debate about independence of monetary policy. That’s because both are together.
Regulation in the US working better than in EMU 00:19:40:05
We have a series of regulators <in the US>. There has been a ton of debate about whether we should have so many should be consolidated. I think the US with the system of, national versus state regulators, and the dual regulatory system has done reasonably well. I would say, relative to, for example, in the ECB; it has tried to follow a similar supranational regulator and national regulator model, but because there are different countries, it’s much harder to manage that.
Key issue: reducing complexity 00:20:12:14.
The question is what’s the best way to reduce complexity, but still retain discretion, which gives you information about doing the job in a reasonable manner?
Is private credit up due to bank over-regulation? 00:21:11:06
So, I’ve been studying non-Banks for some time, mainly in the consumer space before, but now over the last few years, private credit is important. It’s funding, small, and medium enterprises, even larger firms. And in many cases, its displacing banks, from what their core function was. So that’s the debate: Is it happening because banks are over regulated or is there something else to it?
Private credit’s success is more than just excess regulation on banks 00:21:38:00.
And I think, the answer is, it’s more than just overregulation. Like I said, we can streamline what the banks face in terms of compliance costs. But at the same time, private credit and non-bank financial intermediaries are serving a great function because it’s in the market where these private entities are taking risks. They are not under the purview of a bailout guarantee, implicit or explicit.
Private credit takes risks…risk its capital 00:22:04:18.
And they are taking risks, but they are also telling their investors that they are taking a risk, and the investors are giving them capital, knowing that that risk is there. So, the study that we did was essentially looking at private credit firms who have grown over the last few years. They are now funding about $1 trillion worth of credit in the US.
Banks Vs private credit: Very different on the liability side 00:22:29:08
But if you looked at their, liability side, like who funds them, that’s a very important piece to understand the puzzle, because when we think about banks, yes, they invest in mortgage backed securities and, government, bonds, but also make a bunch of loans to entrepreneurs, to households and so on. And usually the worry is that, well, they’re funded by depositors who are subsidized, by the government and run, that, you know, we got to manage the banking system. Look at private credit. Private credit on the asset side is also investing in entrepreneurial projects to households or whatever-have-you. And it’s funded by folks who are putting a lot of equity capital so that if there is any loss, they will absorb it. At the same time, who is funding debt to private credit? It’s long-term lenders, so everybody understands I’m giving you money as private credit fund. It’s with you for seven years and you’re going to take bets, which are going to take seven years to realize. And there is no mismatch like we have in a bank where you and I have deposits. We can take out the money any time. So that’s short term. But banks then go out and invest in long term projects.
Less of a private credit funding mismatch 00:23:51:01
So that mismatch is gone in in private credit firms. So, to that extent it’s a good thing, the problem and worry that a lot of people have is that, oh, we don’t know where the risk is. Maybe some of this risk is going to come back to the banks themselves. Maybe banks are also lending to private credit firms, which I think is reasonable.
Capital-based lending works 00:24:13:00.
And we should try to get that information. But per se, just because there are these private credit entities, knowing that they are funded by long term investors or with investors who are taking skin in the game is not a bad thing. That’s what we should do. I mean, if you look at Silicon Valley, we did a lot of entrepreneurial, risky ventures send people to Mars and wherever through funding from venture capital. What is venture capital? It’s patient capital. People are putting in money knowing that many of these risks are not going to be panned out, but it’s our skin in the game.
Directed lending is stifling 00:24:58:12.
So, I think again, as if you were to take the view that we need to regulate everything and we are going to be dictating where funds should go, which sectors should try, which sectors should not thrive, like climate, tomorrow it could be AI. And let’s regulate not just banks but also private credit firms. Any firm which is lending out there, we need to regulate them, and we need to regulate them, and we need to dictate where funds need to be allocated. That becomes very quickly, like a government control, socialist economy. And we have to be very careful because innovation in the US is what has made us an amazing, prosperous economy. And if you cut that chord, there are going to be very serious consequences when the government is then deciding where the funds should be allocated.
Markets need risk to prosper 00:26:17:05.
Something that the Fed, Kevin Warsh, and the rest of the governors have to grapple with is that we have now built-in this bailout expectation for all the actions that have happened, so much so that every institution expects the Fed to intervene as soon as there is some turmoil. And if you don’t cut it out, it’s going to create problems.
Need the lender of last resort function but with discipline 00:26:40:03.
So, it goes back to your exact question about lender of last resort. Because it’s a great function to have a lender of last resort, because when things are bad in crisis, you need to arrest the fall. Lots of research showed us that if you don’t do it, it’s a bad idea. But you have got to be very responsible and careful.
Once the Fed steps outside its core function everything changes 00:27:00:23.
And if you don’t have accountability, for what you are doing, it’s going to eventually lead to there being no independence, because once central banking becomes fully political, which is where we are moving towards or were moving towards, you can’t ask for independence because you are running fiscal policy in the camouflage of monetary policy and asking for independence.
Fiscal policy simply is not monetary policy 00:27:28:01.
At some point or the other, the public is going to realize that you are running a fiscal shop, and whenever it is fiscal, we have elections. We are a democracy. And that’s where you then need to decide this.
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Robert A Brusca, PhDThe Fed’s angle into regulation 00:01:12:10
Historically, as you know, Fed has a mandate, and you might wonder, okay, it’s about interest rates and huge debate around setting interest rates. Where does supervision come into all this? Where does financial regulation come into all this? And it has to do with the fact that shocks propagate into the economy through the banking sector. So, the Fed should be having, some overseeing powers over the financial system. And that’s how it all started. The big function that we told the Fed that they should be doing is the lender of last resort, that in times of crisis, you should have information about where is solvency, where is liquidity, and be able to, manage this so that the shocks to the economy are somewhat moderated.
The eternal question…00:02:05:18
Problem is, how do you figure out what the right level of intervention should be when a lender of last resort kicks in? So, this whole debate of independence, while it has focused on interest rate cuts and rises, as we’ve been debating, is also a lot about what the Fed has been doing over the last two decades, which is intervening pretty actively on the financial sector side.
Unconventional monetary policy 00:02:33:15
Now, the whole unconventional monetary policy was all about affecting assets, and asset prices through allocation of credit. But the Fed, when it intervenes on that side with the perspective that it is trying to do something like a lender of last resort, when does it actually cross that<line>? And the mandate is what it is, but you end up doing, a sort of mission creep.
The Fed’s independence and power can play out in many ways 00:03:03:10.
So, independence is great in the sense that you are trying to bring in an institution which is insulated from politics. But when the same institution actually has direct control over allocation of credit through the financial system, through this lender of last resort function, which is why the whole operation of supervision and regulation has been put in place.
LOL-resort bleeds into market interference and bailout policy 00:03:26:21.
How do you draw the line? So, independence is also on that side. And it’s getting debated right now because should the supervision and financial regulation be done the same way where we have now the bailout expectations from the Fed inbuilt into the banking sector? All because we wanted the lender of resort function to operate in a certain way.
LOL-Resort links to Fed independence issues 00:04:19:21.
So that’s going back to this whole debate on independence. The issue is lender of last resort (LOL-Resort). If you go back to where the doctrine comes in, the idea is that, hey, if you have information, supervisors and regulators go looking and only save institutions which are illiquid in the short run, but they are going to be solvent in the long run.
Moral hazard is to be avoided 00:04:44:02.
You don’t want to be going in and saving institutions which are insolvent. When you go out and bail out institutions, which we have repeatedly done, most recently with the Silicon Valley Bank, episode, all the banks basically have that inbuilt expectation that, okay, we can take a risk if it pans out, great. If it doesn’t, we will be bailed out.
How did we get to such a state? 00:05:09:06
And now suddenly, why is that bailout happening? Well, it’s happening because the Fed is exercising it. The lender of last resort function that it’s supposed to be doing. And but you know, the lender of last resort function is very clear that you do it only when the institution is illiquid but solvent. We have given up on that principle.
Helping the mistake-makers undermines systemic discipline 00:05:36:12.
Sometimes in turmoil, funding disappears. But if you inherently have invested in prudent projects or loans given to entrepreneurs or whoever. Yes, they’ll pan out in a few years, but they will pan out. Yes. Versus a scenario where you’ve made loans, they are never going to pan out, or they are unlikely to pan out. And we are still using the lender of last resort to prop you up as an institution. That is what sets the whole financial system on the back foot, where everybody thinks you can take any risk, and if it pans out, great. If it doesn’t, it’s not my problem.
Bank Regulation tried to prevent these situations; but that failed 00:06:39:01.
So, we are at an interesting time where, over the last decade and a half, we have this lender of last resort bailout expectations squarely being put with financial institutions. At the same time, after the financial crisis of 07- 08, we also regulated the banks in terms of what they can and cannot do, capital requirements and so on. And one push from many folks out there is that well, what has happened is that a lot of credit activity has migrated outside the banking perimeter, and we go to somehow bring the activity back. And one way we can bring the activity back, we can talk about whether it makes sense or not, but the premises that we will bring the activity back by deregulating.
Now we ask if regulation went ‘too-far’ 00:07:28:18.
And one way in which we are going to deregulate is to make sure that the supervision burden on banks, that’s being put in place, we are going to cut it. So, Michelle Bowman comes with this mindset that maybe the supervision and compliance and regulation have become too tight on banks, and we got to dial back on it.
Regulation failed in some very basic ways; more may not be better 00:07:47:18.
And we can argue how or, you know, what the approach might be. But the central premise is that, like if the credit is getting allocated outside the banking system, then there is no, we have no way of there’s no sunlight. My flip side to that argument is that we had Silicon Valley Bank, we had other banks recently where all the regulators and supervisors are looking at the banking system, and yet we couldn’t detect pretty basic level of risk mismanagement, as we can call it.
Less might be better with a bank’s own capital ‘at risk’ clearly 00:08:24:14.
So why are we worried about, us not knowing things outside when we don’t even know what’s happening inside and in fact, if you look at where the credit is migrating with private credit and so on, turns out that those entities are actually funded, by their own skin in the game, so called equity, so they can absorb losses.
No ‘truth’ without consequences 00:08:48:06.
And that’s exactly what we want a market to do so that you should be allocating credit and taking risks but also bearing the consequences of the risks. So, I think while I have some sympathy that maybe supervision has become too complicated and so complicated that we miss the basic risk management inside the perimeter. I also think this worry about private entities and markets responding. And allocating credit is a bad idea. It doesn’t ring, the bell in my head, at least.
Supervision system is ‘interesting’ 00:09:36:02.
I think the system of supervision is interesting, I will say, because there are a lot of good elements in it. So, as you probably know, and your viewers know the way we regulate banks is supervisors go in, they look at documents, they look at the balance sheet information, other information, and rate you on a camel score.
00:09:59:12 - 00:10:10:18
Amit Seru
Camels being the acronym for Capital adequacy, Assets, Management capability, Earnings, Liquidity, Sensitivity to risk…
CAMELS scoring sets the stage 00:10:11:05.
Know that one. Yes. So, camel. We give you a score from 1 to 5. Five is you’re not doing great work. One is you’re doing great. And the way we sort of have done this is supervisors collect both information from balance sheet and income statement and so on. But also interview talk to people and construct this score.
More than one regulator; more AI less regulator? 00:10:31:00
You could argue that with technology and advances that have happened that maybe we can bring some of those elements to reduce some of the burden, both on banks and on the supervisors. But an interesting thing, which my research and some other research has also shown is the information inside these scores come, differently from Federal regulators. So, to your question and the state regulators themselves, so, you know, a Silicon Valley bank, for example, is regulated by both the California State regulators and the Federal regulators. In tandem, both sets of regulators bring some good information to the table. So that’s why I said it’s a little bit nuanced. It’s not like either or. But at the same time, Michelle Bowman and others are right that there is also much of this complexity and compliance, which could probably be streamlined with technology, with AI.
Still no easy answer 00:11:28:18
But the answer is not either or. I wouldn’t just say, okay, let’s replace their old regulators and neither would I say, let’s only take it to the state regulators or only to the Federal regulators. But there is a better design that one can produce.
Mission creep 00:12:11:20
So, if you clearly have a mandate towards the monetary policy and making sure, those, those, goals are met, but, if you start using lender of last resort function, to go well beyond the mandate… This is the kind of thing where, mission creep kicks in.
Unconventional monetary policy 00:12:36:05
Okay, maybe the Fed should be doing unconventional monetary policy, which is now because we are at zero lower bound, we are going to start buying and selling assets. Well, when you buy and sell assets, for trillions of dollars, which we have done with the Fed balance sheet, you move asset prices, you move the signals in the economy.
Unconventionla policy disrupts normal pathways 00:12:56:06.
Resources don’t flow where the market participants think they should flow. They flow where the Fed or the government thinks they should flow. So that’s, again, going back to our very first question about independence, that while each of these steps at that moment of time might have seemed sensible, when you look at the long horizon, you see that the Fed actually has veered away from the mandate because it’s really doubled down on this lender of last resort, oriented intervention in the markets.
A loss of focus; a change in mission; a violation? 00:13:28:00
And once that has happened, how do you claim that you are really independent because you now are intervening, like you said, buying and selling assets, as you know, mortgage-backed securities here or climate change there. And now you are actually doing what independence should allow you not to do, which is politically getting, in charge of where the allocation of credit should be.
Does too much independence beget authoritarianism? 00:13:56:09
There was some discussion about reducing inequality. Right. So, Europe, as you know, with the ECB, has taken the lead where they were dictating the banks to then go and tell their corporate clients where they should be lending, which sectors they should be lending. And there has to be a better way of doing it, because it actually leads to problems when it comes to independence.
“Independence” means freedom from political influence 00:14:21:04.
We want independence for the Fed because we don’t want political intervention. But if you do this where you are now effectively, actually, if you think about it, doing fiscal policy, which is what Scott, Bess and Boyles saying, that is not your mandate and you’re doing it in a stealth way while claiming don’t ask us questions because we are independent.
A drift in central bank focus is dangerous 00:14:42:12.
So, you’ve got to basically be a little bit careful, because if we go down that route and that independence is questioned, then it leads to spillovers. On questioning independence with respect to monetary policy, too, which is not a place we want to be.
Regional Fed system works well 00:15:28:09.
My understanding is again, pretty much like supervision, where you have the Fed and the states rotating this system of district banks who rotate in and rotate out with respect to FOMC votes has, by and large, been working reasonably well. So, I wouldn’t try and change the system.
Policy needs context for its organizations 00:16:38:05.
So I think if you look at the way, UK has approached this with the Bank of England, what they have done, and the tricky situation going back to the context, is just that you have a monetary policy function that you got to do, and then you have this lender of last resort stuff, which is useful in crises, by the way, because at that time when you go to coordinate and do it pretty quickly, it makes sense for the <central bank> to have some, understanding of where the institutions are in the economy, because you might have to bail out some banks because they are illiquid but solvent, and then let some others go because they are insolvent. So having that information and doing it quick is good. The question is how do you have that information while maintaining independence and not being caught into, the cycle that we have been caught in? So just to give you one example, with Silicon Valley Bank and other banks for example, when there was risk mismanagement and supervisors and others were kind of caught, if you remember, we were also seeing raging inflation.
Policy needs meets asset/liability mismatch 00:17:42:22.
So, the monetary policy should tell you… you’ve got to raise the interest rates. The problem was if you raise the interest rates more, you would have broken more banks because many of the banks had this risk mismanagement problem where they had invested in long term bonds and their value was going down. And the uninsured depositors who had funded were feeling more and more spooked.
When monetary policy needs and regulation clash…00:18:04:14
So, there was a constraint on your monetary policy because your banking system was really in bad trouble. That is not what you want when you have financial and monetary policy running together inside the Fed. So how do you deal with that? Bank of England has two separate committees. One is for interest rate setting and monetary policy, and one is looking at financial stability issues so that when crisis comes, the information can be shared.
US policy suppresses stability issues 00:18:31:14.
But at other times they are both accountable for what they are saying and doing. Right now, in the US, what we have is the monetary policy function has some accountability because you’ve got to go out, talk about it, discuss it. Financial stability angle is completely hidden. Yes. And so, the question is can we restructure it?
BOE has two committees 00:18:52:06.
So, Bank of England is one model where there is some sunlight on the financial stability bit as well. And if there are errors, they are held accountable too because right now everything is put together and if there are errors and someone points them out, it immediately becomes a debate about independence of monetary policy. That’s because both are together.
Regulation in the US working better than in EMU 00:19:40:05
We have a series of regulators <in the US>. There has been a ton of debate about whether we should have so many should be consolidated. I think the US with the system of, national versus state regulators, and the dual regulatory system has done reasonably well. I would say, relative to, for example, in the ECB; it has tried to follow a similar supranational regulator and national regulator model, but because there are different countries, it’s much harder to manage that.
Key issue: reducing complexity 00:20:12:14.
The question is what’s the best way to reduce complexity, but still retain discretion, which gives you information about doing the job in a reasonable manner?
Is private credit up due to bank over-regulation? 00:21:11:06
So, I’ve been studying non-Banks for some time, mainly in the consumer space before, but now over the last few years, private credit is important. It’s funding, small, and medium enterprises, even larger firms. And in many cases, its displacing banks, from what their core function was. So that’s the debate: Is it happening because banks are over regulated or is there something else to it?
Private credit’s success is more than just excess regulation on banks 00:21:38:00.
And I think, the answer is, it’s more than just overregulation. Like I said, we can streamline what the banks face in terms of compliance costs. But at the same time, private credit and non-bank financial intermediaries are serving a great function because it’s in the market where these private entities are taking risks. They are not under the purview of a bailout guarantee, implicit or explicit.
Private credit takes risks…risk its capital 00:22:04:18.
And they are taking risks, but they are also telling their investors that they are taking a risk, and the investors are giving them capital, knowing that that risk is there. So, the study that we did was essentially looking at private credit firms who have grown over the last few years. They are now funding about $1 trillion worth of credit in the US.
Banks Vs private credit: Very different on the liability side 00:22:29:08
But if you looked at their, liability side, like who funds them, that’s a very important piece to understand the puzzle, because when we think about banks, yes, they invest in mortgage backed securities and, government, bonds, but also make a bunch of loans to entrepreneurs, to households and so on. And usually the worry is that, well, they’re funded by depositors who are subsidized, by the government and run, that, you know, we got to manage the banking system. Look at private credit. Private credit on the asset side is also investing in entrepreneurial projects to households or whatever-have-you. And it’s funded by folks who are putting a lot of equity capital so that if there is any loss, they will absorb it. At the same time, who is funding debt to private credit? It’s long-term lenders, so everybody understands I’m giving you money as private credit fund. It’s with you for seven years and you’re going to take bets, which are going to take seven years to realize. And there is no mismatch like we have in a bank where you and I have deposits. We can take out the money any time. So that’s short term. But banks then go out and invest in long term projects.
Less of a private credit funding mismatch 00:23:51:01
So that mismatch is gone in in private credit firms. So, to that extent it’s a good thing, the problem and worry that a lot of people have is that, oh, we don’t know where the risk is. Maybe some of this risk is going to come back to the banks themselves. Maybe banks are also lending to private credit firms, which I think is reasonable.
Capital-based lending works 00:24:13:00.
And we should try to get that information. But per se, just because there are these private credit entities, knowing that they are funded by long term investors or with investors who are taking skin in the game is not a bad thing. That’s what we should do. I mean, if you look at Silicon Valley, we did a lot of entrepreneurial, risky ventures send people to Mars and wherever through funding from venture capital. What is venture capital? It’s patient capital. People are putting in money knowing that many of these risks are not going to be panned out, but it’s our skin in the game.
Directed lending is stifling 00:24:58:12.
So, I think again, as if you were to take the view that we need to regulate everything and we are going to be dictating where funds should go, which sectors should try, which sectors should not thrive, like climate, tomorrow it could be AI. And let’s regulate not just banks but also private credit firms. Any firm which is lending out there, we need to regulate them, and we need to regulate them, and we need to dictate where funds need to be allocated. That becomes very quickly, like a government control, socialist economy. And we have to be very careful because innovation in the US is what has made us an amazing, prosperous economy. And if you cut that chord, there are going to be very serious consequences when the government is then deciding where the funds should be allocated.
Markets need risk to prosper 00:26:17:05.
Something that the Fed, Kevin Warsh, and the rest of the governors have to grapple with is that we have now built-in this bailout expectation for all the actions that have happened, so much so that every institution expects the Fed to intervene as soon as there is some turmoil. And if you don’t cut it out, it’s going to create problems.
Need the lender of last resort function but with discipline 00:26:40:03.
So, it goes back to your exact question about lender of last resort. Because it’s a great function to have a lender of last resort, because when things are bad in crisis, you need to arrest the fall. Lots of research showed us that if you don’t do it, it’s a bad idea. But you have got to be very responsible and careful.
Once the Fed steps outside its core function everything changes 00:27:00:23.
And if you don’t have accountability, for what you are doing, it’s going to eventually lead to there being no independence, because once central banking becomes fully political, which is where we are moving towards or were moving towards, you can’t ask for independence because you are running fiscal policy in the camouflage of monetary policy and asking for independence.
Fiscal policy simply is not monetary policy 00:27:28:01.
At some point or the other, the public is going to realize that you are running a fiscal shop, and whenever it is fiscal, we have elections. We are a democracy. And that’s where you then need to decide this.
Amit Seru
Amit Seru is a Senior Fellow at the Hoover Institution, the Steven and Roberta Denning Professor of Finance at the Stanford Graduate School of Business (Stanford GSB), a senior fellow at Stanford Institute for Economic Policy Research (SIEPR), and a Research Associate at the National Bureau of Economic Research (NBER). He was formerly a faculty member at the University of Chicago’s Booth School of Business. He is currently co-directing Hoover initiatives on corporate governance, long-run prosperity, and regulation and the rule of law.
Professor Seru’s research focuses on corporate finance with an emphasis on financial intermediation and regulation, technological innovation and incentive provision and financing in firms. His research in these areas has been published in American Economic Review, Journal of Political Economy, Quarterly Journal of Economics, Review of Economic Studies, Journal of Finance, Journal of Financial Economics, Review of Financial Studies, and other peer-reviewed journals. He is a co-editor of the Journal of Finance and was previously an editor of Review of Corporate Finance Studies, department editor (Finance) of Management Science and an associate editor of the Journal of Political Economy.
He has presented his research to U.S. and international regulatory agencies, including the Bank for International Settlement (BIS), Consumer Finance Protection Bureau (CFPB), European Central Bank (ECB), Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Financial Industry Regulatory Authority (FINRA), the International Monetary Fund (IMF), the Monetary Authority of Singapore (MAS), the Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC). Most recently, he gave the Biennial Andrew Crockett lecture on regulation of banks in the era of fintechs to central bank governors around the world at the BIS. He has received various National Science Foundation grants, the Alexandre Lamfalussy research fellowship from BIS and was named as one of the top 25 Economists under 45 by the International Monetary Fund in 2014. His research has been featured in major media, including the Wall Street Journal, The New York Times, the Financial Times and the Economist. His opinion essays have appeared in several outlets including the Wall Street Journal and The New York Times.
Seru earned a B.E. in electronics and communication and an MBA from the University of Delhi. Subsequently, he received a PhD in finance from the University of Michigan. He was a senior consultant at Accenture before pursuing his Ph.D. Seru was the recipient of a Rackham Pre-Doctoral Fellowship at University of Michigan and received a Lt. Governor’s gold medal for overall academic excellence at the University of Delhi.
