ECON 252: Financial Markets (2008)

Lecture 13

 - Banking: Successes and Failures


Banks, which were first created in primitive form by goldsmiths hundreds of years ago, have evolved into central economic institutions that manage the allocation of resources, channel information about productive activities, and offer the public convenient investment vehicles. Although there are several types of banking institutions, including credit unions and Saving and Loan Associations, commercial banks are the largest and most important in the banking system. Banks are designed to address three significant problems in capital markets: adverse selection, moral hazard, and liquidity. Banks make money by borrowing long and lending short and use fractional reserves to lend more funds than are deposited. History has seen numerous problems in banks, including bank runs and insolvency. Government support and regulation, such as those implemented via the Basel Accord, as well as rating agencies help to ensure that investors trust the banks with which they have relations.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 13 - Banking: Successes and Failures

Chapter 1. On Andrew Redleaf: Reaping Rewards from Opportunities [00:00:00]

Professor Robert Shiller: Before I begin, I want to say something about our speaker on Wednesday, Andrew Redleaf. First of all, he accepted our invitation to go to lunch with some of you. So, I want to arrange an event, actually at one of the college’s cafeteria. I haven’t figured out — maybe one of you has a suggestion, especially if we can get a — see what college he was here — we did it in his college because he graduated from Yale. I’ve forgotten which one that was. It had a nice room upstairs, so maybe I’ll try to get that one again. Of course, he said he doesn’t particularly care — maybe I should take him to another one. Yeah, if you can suggest a college, which has a nice room and that will be both — I’ll come and Redleaf will come; so, that’s this Wednesday. What I’m going to do is email you the details. If you could email me if you’re interested in coming, so we can have a good size group and a discussion.

I just want to say a little bit about Redleaf. He founded Whitebox Advisors in 2000 — so that’s eight years ago — and it is now up to $1.8 billion assets under management. “Assets under management” is how much money he has drawn in from investors. So, he’s doing quite well and he has some celebrity status among hedge fund managers. Notably, I put on the website for March 5th, under our class syllabus, a New York Times article about him entitled, “Curiosity Has Its Merits.” I guess it struck the author of that article that Redleaf is just a guy who was very curious about a lot of things. He wants to know how things work and why things are happening. That might be a natural impulse and some people have that more than others. It’s probably a good impulse to have if you’re going into investment. Of course, he turns it into productive purpose, so there are a couple examples from that article.

One is that — there’s a literature in finance about options and stock price performance, which goes back ten years, that shows that something is not quite right with the way companies issue options. Let me remind you what happens. What’s happening, increasingly, is that employees or top executive employees, at least, in companies are rewarded as part of their compensation with options on the value of the stock of the company they work for. You work for XYZ Corporation; the share is trading at $10 a share; they would give you “at the money” or “out of the money” options — say options to buy the stock at $11 a share. That’s $1 more than it costs now in the market, so the options are worthless unless the price of the stock goes up. So, that’s supposed to incentivize you as a manager to get the stock price up. Then you make money if the price of the stock rises above, in that case, $11 a share. All that is fine, it sounds good that managers should be given options because it will incentivize them to work for the benefit of the corporation.

The problem that’s been revealed in finance literature is that there’s an uncanny tendency for the stock price to go up after the company awards large quantities of options to its executives. Does that sound suspicious? I mean, you could say, well that means the options are really working well because it really motivated the managers and they did something and made the company worth more. If it suddenly goes up right after they’re issued you kind of suspect that something is screwy here. So, there’s been a number of articles that documented that stock prices tend to jump shortly after options are issued to managers. The immediate suspicion that this raised, and I think it’s more than a suspicion, is that companies will time announcement of good news until after they issue the options. The managers of the companies are kind of a group helping each other — let’s award options to each other and then after we award them we’ll announce the good news and the stock price will go up and you guys will get money. There’s a tax incentive to do that. If they awarded options that were “in the money” — that means already exercisable at profit — then they would be subject to a tax liability immediately, so they don’t want to do that. They want to issue them “out of the money” and then announce the news that brings them “in the money.” It’s been proven that companies do that.

More recently — I was just reading about this in the Times. There was an article by Eric Lee that showed that it’s not just announcement of news that does it; it’s also that companies must be backdating options because Lee showed that some of the price jumps that occur after the options are issued couldn’t possibly have been manipulated by the companies’ news announcements. It must have been that they somehow knew on the issuance date that the stock price was going to go up, but he said they couldn’t possibly know that in these general circumstances. Lee concluded that companies were fraudulently backdating options. He concluded this on the basis of a statistical test. You see what I’m saying? If stock price option — if stock options tend to be issued as announced by the company later, just before stock prices go up, there’s no way that that can be right because nobody can know exactly when the stock price is going to go up. So, they must have been lying about the date that they issued the options.

You understand that issue about backdating? It was — this article by Eric Lee was something of a scandal and it led then to regulatory authorities to — regulatory authorities then realized that there’s some fraud going on — not most corporations. I think Lee identified a small, but definitely some of them, that were lying about the date. You know what I’m saying? They would announce in December that we issued back in August these options to our executives. Funny thing — the stock price soared right between August and December when they announced it. The regulatory authorities were starting to look into this — that’s fraud to backdate options. What does Andrew Redleaf do? He decided to do his own study parallel to Eric Lee’s and much more pervasive. So, he was going after himself, finding out all the companies that were backdating options, trying to beat the SEC and the regulatory authorities to the conclusion. What did he do? He shorted the stocks or whatever to benefit. Once they’re investigated, their stock prices and their bond prices are going to fall. He did the — he found out who they were, using similar methods to Lee’s and profited from it.

Is that a good thing? Well, that’s the way Wall Street works or at least a — some people say markets are efficient and stock prices incorporate all information. I don’t think they are efficient and this is an example — a Redleaf example. In a sense, efficient markets would require that everybody — every analyst rushes out and completes Eric Lee’s study. But they don’t — I don’t know, it’s just — there isn’t enough initiative in the world, not many people do it. Redleaf was able to figure out who was going to get hit for the backdating scandal before other people did and then that was an advantage.

I’ll give another example of Redleaf’s success. General Motors, as you know, is an auto producer in the United States and it hasn’t been doing well, as you may have heard — as is the general auto industry in this country; it’s suffering under competition from abroad. So, Andrew Redleaf bought General Motors bonds, which were selling at a discount because people worry that General Motors wouldn’t be able to pay on them, and then he asked to speak to the General Motors management. He went there and he made a plea that General Motors should cut its dividend that it pays to stockholders, which is a reasonable thing to do. If they’re failing they should cut their dividend, but companies are reluctant to do that because it looks bad, so they hold off for a long time, not cutting. Redleaf went in and said, you should really do it and he convinced them, apparently, and they cut their dividend. Well after that, the bond price went up because people saw that as a sign that the company was tightening its belt and doing things right to have money to pay off the bondholders; so it was self-interested, I suppose — maybe you can ask him about this. But it was also what we call shareholder activism or investor activism — that he was getting involved in changing the way corporations do business. Those are just a couple of examples of Redleaf and what he does. I admire him; I think he has — it’s his curiosity and diligence that — he finds investment opportunities. He’s another example that markets are really not efficient. They’re efficient enough that you have to work hard to find opportunities, but not perfectly.

Chapter 2. The Origin of Banks, from Goldsmiths to Commercial Banks [00:11:06]

Today I want to talk about banking and this ties in somewhat to my previous lecture, which was on real estate, because banks are major real estate lenders and investors in real estate securities. We’re going through a subprime crisis right now, which is a banking crisis as well. I will talk a little bit about what we discussed last time. Anyway, I want to start out with the most fundamental thing: what are banks? What is a bank? Historically, money lenders of one sort or another go back — who knows how far back — thousands of years. So, you might say, banks existed in ancient times. The history of banking often goes back only a matter of hundreds of years.

One of the stories that is often told is the goldsmith banker’s story that goes back I don’t know how many hundred years. Goldsmiths are people who work in gold; they make jewelry and gold — goldware and whatever — coffee urns. They would store gold and they would have a safe or some sort of safekeeping. A lot of people would ask them, since they had a safekeeping for gold, could you put my gold in your safe? The goldsmith would accept that as part of an extension of the business as a goldsmith, especially if the gold was in the form of coins and people didn’t care whether they got the same coins back. The goldsmith then discovered, all this gold sitting in my safe is just sitting there. Why I don’t lend some of it out and I can earn interest on the loan and make money. Meanwhile, when people come back to ask for their gold, as long as they’re willing to take other gold, that’s apparently what they — they don’t care whether they are the same coins. I’ll have enough, still, in my safe so that I can pay them off.

So, it kind of just happened. It would happen to anyone who was a goldsmith because it’s just the logical extension of the business. Some customers want to use your safe because safes are hard and expensive to get and some — and then you’ve got all this gold, so you might as well lend it out. It started out that was as, what we call, fractional reserve. That is, the goldsmith only had a fraction of the gold that was owed by the goldsmith. The goldsmith might also write notes promising so much gold and not promising the return of any particular item of gold. So, the goldsmith would sign his name on it saying, I promise to give so many ounces of gold. In some cases, they were bearer notes. That means that the goldsmith would pay it to the bearer. In other cases, they would have the name of the person on them.

Bearer notes became very important. The goldsmith in your town writes out a note saying, I will pay to the bearer of this note so much gold, and then the bearer could be anyone. You still have to hide the note from theft, but at least you don’t have to hide a whole bunch of gold from theft. That’s how paper money got started, as bearer notes, because if you had gold with the goldsmith you could spend the note, at least within the town that you live in where the goldsmith was known and had a reputation. So, that’s the whole idea of how banking got started, and how paper money got started, at least in the West. There’s a different history in China.

There are different kinds of banks today — I’m going to jump to modern times. The most important kind is called a commercial bank. A commercial bank, like a goldsmith banker, accepts deposits — that’s critical — and that means you can put money in the bank. And it makes loans — very simple. It pays interest on the deposit and it collects interest on the loans and it charges a higher interest on the loan than they pay on the deposit. The difference is their profit; that’s how they make money. In addition to commercial banks — well, I’m not going to talk about investment banks here; that’s another lecture. Investment banks are very different in that a pure investment bank does not accept deposits and it doesn’t make loans; it’s an underwriter for securities. I’m not talking about investment banks in this — I’m talking about commercial banks, which accept deposits from depositors.

Traditionally, commercial banks did not deal with the general public; they were for wealthy people and business people. The traditional commercial bank would accept deposits from businesses and make loans to businesses. The other kinds of depository institutions that have developed are called thrifts and they really started from a movement in the United Kingdom. That’s the way I do the history — it may have some other version if you look further. But in the United Kingdom, there was a movement in the early nineteenth century to set up savings banks which were for — this was an effort to democratize finance, as I would put it — for ordinary people to have the opportunity to make small deposits. It used to be that people would hide money in their house and it would frequently get stolen and it didn’t earn any interest. So, there was a savings bank movement, which spread from the U.K. to the U.S. in the nineteenth century and it was a philanthropic movement. In other words, wealthy people, in an effort to alleviate penury, would create a savings bank. For example, here in New Haven, we had one created called The New Haven Savings Bank, which lasted for over a hundred years and was taken over. It’s now called NewAlliance Bank; it’s no longer a saving bank. A lot of these savings banks tend to be very old institutions that go back to the nineteenth century.

Another example is the Saving and Loan Association. This is also — I keep thinking how British we are; this is New England and this is the United States, a former British colony. A lot of things that we do here have origins in Britain. This also came from a U.K. movement called The Building Society Movement, which spread to the U.S. Savings and Loans are the same as Building Societies, but the idea — the original idea and also the general idea today — is that these are banks set up for small savers in order that they can buy a house. So Savings and Loans, traditionally, have made most of their loans in the form of home mortgages. The idea was that a lot of people can’t afford a house — let’s all get together and pool our money — in a Building Society or Saving and Loan Association — and then we’ll loan out to some of us to buy the house. It will help, rather than all trying to do it individually.

There’s also something called credit unions. Credit unions are — I think they came out of kind of the cooperative movement. There are lots of social movements that have some idealism behind them. I think maybe the same movement that created the Yale Cooperative Society in the late nineteenth century also spurred credit unions. The credit union is a kind of club of people who belong to some organization or live in one town or somehow connected that is supposed to accept deposits and make loans to the members for things, including home mortgages, but going broader than that into automobile loans. Well, it wouldn’t have been automobile loans when these were created; I don’t know, something loans, etc. It’s like a Savings and Loan Association except that credit unions are created by some entity, some club or group, and they’re not open to the whole public.

Saving and Loan Associations, by the way, no longer exclusively limit themselves to mortgage lending — either they do home improvement lending and auto loans and the like as well. I wanted to give you some idea of the size of these so I have data on the total assets of these classes of banks in the United States as of 2007, third quarter — that’s my date. Commercial banks had $10,872 billion in assets — or that’s 10.8 trillion dollars of assets at the end of 2007; about 20% of that is actually foreign. We’ve had a lot of big foreign commercial banks come into the U.S. It’s not as big as in some other countries. If you go down to Mexico, their main commercial banks are almost entirely foreign today, but in the U.S. it stands at — the domestic figure of commercial banks — the assets of domestic commercial banks is $7,987 billion so that’s about 8 trillion dollars — that’s domestic banks. Those are the big ones.

If you look at–now, I have these two lumped together; I don’t have them separately. In 2007, third quarter, they were $1.868 trillion — that’s almost 2 trillion dollars, so they’re much smaller — savings banks and savings and loans — than the commercial banks. The credit unions are even smaller, $748 billion — so it’s less than $1 trillion in credit unions. When we speak of banks, it is overwhelmingly commercial banks that matter. There’s another way to rank these: by number of banks; that gives you a very different look. If you look at number of organizations that do this business, it comes completely reversed and it’s credit unions that are the most important. Where do I have that here? I don’t have the latest data — this is from 1998 — but there were 11,000 credit unions — that’s the number of credit unions in the United States in 1998 — and there were only 9,000 commercial banks; that’s the number of banks. Of the savings institutions, there were only 1,500; that’s probably going down further because a lot of these old savings banks are being converted into commercial banks. You may have a false impression of the importance of credit unions. You hear about credit unions a lot because they’re in your neighborhood and they’re advertising for small depositors, so they’re in your face, but commercial banks are actually much more important.

Chapter 3. Why Banks Exist: On Adverse Selection, Moral Hazard and Liquidity [00:25:29]

I want to clarify just what it is that banks do. They’re in a — the first thing to understand is that — I start out by telling you the story of the goldsmith banker. I like to tell that story because it sounds obvious that if you were a goldsmith hundreds of years of ago you would have probably become a banker — it would just be the natural thing to do. So, banks are natural and fractional reserve banking is the natural thing to do. Hence, it exists in every country of the world; it’s everywhere and so it’s not something we can live without. There must be fundamental reasons for it and I wanted to go over some of the fundamental reasons why we have banks.

I’ve got three main reasons, they’re: adverse selection, moral hazard, and liquidity. In other words, the banks offer solutions to all three problems — adverse selection — and I’ll define these in a minute — moral hazard in lending and liquidity. This goes beyond the simple goldsmith banker story that I was motivating initially. What do I mean by adverse selection? The adverse selection problem, when it comes to borrowers — people who are trying to borrow money — is that if you become a lender — let’s say, if you — not talking about becoming a lender. Suppose you are interested in investing in debt of companies, then you as an investor are subject to the problem that you might end up with the worst stuff if you don’t watch out. Suppose you are a naïve investor and you say, okay I’m going to invest in companies’ paper, which is their promise to pay — their IOU. But the problem is, I, being a naïve investor, could get stuck with the bad stuff. The people who are in the know — know who’s trustworthy as a borrower and who has a good prospect of paying it back — if I go in there ignorantly, I’m going to get stuck with the worst stuff. That’s adverse selection — that you worry that someone is not going to — you can’t judge it well yourself, so your inability to judge the ability of a company to pay makes it very difficult for you to invest.

This leads us to what is called relationship banking — or it’s really all banking is, relationship banking. The core of banking is relationship banking. Banks are institutions that exist within the community and they live among the business people in the community and have an ongoing relationship with them. In fact, that is essential to banking and it’s kind of part of the — you might almost call it the definition of a bank. Bankers play golf a lot because business people like to play golf and you have to keep your finger on the pulse of the community. Playing golf with the local businessmen is a very good thing to do if you’re a banker because you’ll hear the gossip and it’ll all be off-the-cuff — things that no one would want to tell you because they wouldn’t want to be on-record of having called you up and told you that such and such a company is in trouble or that they’re doing something that I think looks a little funny to me. You can’t call up the banker and say that, but if you’re playing golf it comes out perfectly naturally. Or you join the Yale Club in New York and you sit around and talk with people.

I remember reading a — I like to browse among old books — I was reading a nineteenth century book about how to be a banker. The book stressed, you’ve just got to be available. You’re sitting there behind your glass window and someone comes in and wants to chat, you should be available; that’s what banking is. You’re kind of in this — but you’re in a different thing. You’re not a regular businessman running a business; you’re a lender to the businesses. As a result, people invest in banks — the stock of banks — because they understand that these people have a long-term relationship with business and they are immune from the adverse selection. You can’t stick your bad paper to the banker who knows everybody in the town; he’ll figure it out and that’s the — and so that’s the problem that’s solved by bankers.

The other thing is moral hazard — this is that companies, once they borrow money from anybody, a bank or anyone else, they have an obligation, which is fixed in dollar terms. They have an incentive to take big risks because — think of it this way — suppose you’re a company that has just borrowed a million dollars and now it’s looking a little bit precarious here that our business might go under. You have an incentive to say, because you’re the equity holder, you have an incentive to say, hey why don’t I just take some big gamble here and not tell anybody. I’ll just take the remaining money and I’ll put it in some lottery bet and one in three chance I’ll have three million dollars. If it fails, those guys will lose out because I’m going to lose anyway. I might as well — if I don’t do anything, I’m going to lose anyway. I’m just going to be paying back my debts and go bankrupt, so I’ll take a big gamble and then at least I have a one in three chance of making money. You see that? Isn’t that a compelling argument? That’s what you want to do?

Businesses of course can’t actually invest in the lottery — that would be contrary to the terms of their loan — but they can do similar things. They can do big gamble type business ventures. Again, that is a problem that lenders have — that the company that’s borrowing the money has this unfortunate incentive, at least at certain times, to take excessive risks because the debtors will end up bearing the losses. Not the debtors, the creditors who lent the money will end up bearing the losses. This is another reason why we want relationship banking. It’s exactly what you find out about when you’re playing golf with the other bankers. You’re on the phone with this guy all the time and you sniff something out, you can maybe stop. So, you’re watching over the company.

The third thing is liquidity. That is — maybe this goes back to the — I didn’t mention it, but it would apply to the old goldsmith banker story as well. Liquidity is that banks lend long and borrow short — short-term, I mean. Most of the people who want to borrow money from the banks — let’s talk about businesses — we’re accepting business loans — they don’t want to have to pay the money tomorrow. If you’re borrowing money for a business, you might want to open a store and you’d want to stock your merchandise and your business won’t prosper for a couple years. Or, you might be building a factory and you can’t pay the money back right away. You need the loan for years, but investors don’t want to tie up their money for years. What banks offer is liquidity — the ability to borrow short even though the loans that are made are long-term.

How do banks do it? They do it with fractional reserves. They trust to the fact that the depositors won’t all come on the same day, just like a goldsmith banker — he leaves only enough gold in the safe to cover the kind of withdrawals that are normally accepted. In that case, the bank can pay interest to depositors. Even though the deposits are short-term and the depositor can get the money at any time, the depositor is earning interest of a level that can only be made on long-term loans. People can’t pay — they can’t pay a high interest if they don’t have it as a long-term loan. Now incidentally, often bank loans to corporations are short-term, technically, so the bank is both lending short and borrowing short. In fact, they are in practice long-term because you have a relationship with your banker and you play golf with your banker and your banker understands that you have a business — he’s your friend, let’s hope. Your banker understands that your business can’t pay the money back and that the bank has a reputation in the community of helping business people, so they won’t ask for the money even though it’s a short-term loan that they made to you. The bank won’t ask for it back right away unless you start misbehaving.

It becomes an arm-twisting thing — because of this risk of moral hazard, the bank has a threat to take the money back and they are going to find out quickly if you, as a company, are behaving wrong. It works out, under normal circumstances, very well. It goes beyond all of this. The companies get advice from the banker as well. The banker knows everybody in the community and when you’re playing golf with the banker, it may go beyond just collecting information; the banker might have positive suggestions. You should really do business with so and so, who has a natural match up with you. Bankers require a lot of prestige and status in their communities; so, this is happening all over the world.

Chapter 4. Rating Agencies: Do They Work? [00:37:15]

Now, banking has a — it’s important to know that banking is bigger in developing countries — I’ll say LDCs, less developed countries — than in developed countries. That is, it tends to be bigger and that is because less developed countries have less developed securities, regulation and laws, and traditions. It often has to be that the only way you can raise money for a business is through a bank. In the more advanced countries, there is more trust in the securities markets, so we don’t need this relationship banking as much. It still becomes very important to a lot of things.

I wanted to mention in this context, because I’m emphasizing how banks help solve the adverse selection and moral hazard problem — I wanted to mention briefly here also the rating agencies, which fulfill some of these functions. I don’t have a separate lecture on these. The first rating agency in the world was created by Mr. John Moody, in the U.S. in 1909. He was dealing also with the moral hazard and adverse selection problem. He had a neat idea and that was to give letter grades to securities that represented credit worthiness. The highest grade was AAA and that was the best grade you could get. There are no A+’s; it sounds a little bit like college, but not quite. Then, if you weren’t quite AAA, you were AA and if you weren’t quite AA, you were A and then you could become BA. Well, all the way down, I guess, to C or beyond that — then you’re failing. It’s just almost like college grades.

The idea was that the — so he set up Moody’s Rating Agency and the job of Moody’s was to give letter grades to securities; it was a little bit like a bank, but it was different because he didn’t actually make the loans. There was another — Henry Poor set up Poor’s in 1916 on a similar model and they later merged with Standard Statistics to become Standard & Poor’s, S&P. Those are the two biggest rating agencies in the U.S. today and they’re extremely powerful organizations because they — Standard & Poor’s also does letter grades, a slightly different system, but almost the same. Then there’s Fitch, who’s the third, which is smaller than these two.

This is an interesting question: do they solve the moral hazard and adverse selection problem as well as banks do? Well, they’re similar to banks and they have a relationship with the investment community and they try to stay on top of everything that’s happening. They’ve become forces of nature in the U.S. economy, in the sense that people accept these letter grades with great authority. Recently, however, there is a bit of a scandal regarding these rating agencies because they gave AAA ratings to some subprime securities. In other words, securities that were themselves backed by subprime loans. So, this is the subprime scandal showing up. The question is: how can these rating agencies manage the current distrust that has developed? Because they — one important thing — John Moody was a very crusty, strong-willed man, who wrote a couple books. In these books he talked about his moral commitment to honest rating of securities. People trusted him and they trusted his organization. Well, they still do massively, although a little bit less than they used to.

John Moody died in the 1950s, but after he died, Moody’s and Standard & Poor did something that Moody would not have approved of — they started accepting fees from the people they rate; some people think that you shouldn’t do that. If you’re — a professor shouldn’t be paid by the students, at least not directly. Maybe you’re paying me indirectly, but I shouldn’t be collecting money from you and then awarding grades; that wouldn’t be right, but that’s what has started to happen. Some people think that the rating agencies have allowed a kind of moral hazard to creep into their organization. They have been working on improving their methods and they’re trying to create divisions within their organizations that prevent the moral hazard from happening. I think that going forward, both the rating agencies and the banks will be very important in our society. The history of financial innovation is always that the organizations adapt to crisis. The subprime crisis is harming both the banking sector and the rating agencies at the present time because it’s a situation of stress that stresses their organizations, but I think that it will be a time of correction.

Chapter 5. The Ongoing Fragility of Banks and Structures of Bank Regulation [00:44:08]

I mentioned fractional reserves; the fact that banks hold only a part of their liabilities as reserves, like the goldsmith banker only holding part of the gold, is a problem. The question is: how much reserves should a bank hold? Bank failures occur when there’s not enough gold in the vault and then people start asking for the gold and the goldsmith banker doesn’t have it to give out. The Basel Accord was in 1988 and you can read about this in detail in Fabozzi, et al. It was an international convention that gave, what they called, risk-based capital requirements and recommended risk-based capital requirements to bank regulators around the world. What we have — we have a problem that there can be a systemic problem to fractional reserve banking if there is ever a run on the banking system. If banks get in trouble and they can’t pay out — if one bank gets in trouble and can’t pay out on its deposits, then that can bring the whole system down because it can cause a panic among investors — among depositors and banks — and create a run on a bank. This has happened so many times in history that governments around the world now regulate banks and tell them that they have to hold a minimum amount of reserves and have a minimum amount of capital. Capital is the money that they have to pay out should there be a — its assets that they can quickly liquefy and pay out should there be a run on the bank.

Basel 1988 was an effort to make sophisticated risk management requirements for banks that relied on more modern, as of 1988, financial theory. The U.S. adopted the Basel requirements in 1989 and they’re still enforced today. The agreement — But incidentally, this was an international convention. No country had to follow these risks, but generally, countries have followed them because they want to be part of the international community and you want to use the standards that were recommended. It’s a little bit like the NAIC — the National Association of Insurance Commissioners — recommends laws to the local insurance regulators in the fifty United States. This is a super national version of this. Basel is a city in Switzerland, where the Bank for International Settlements is. It’s an international effort to recommend regulations for countries all over the world. In the Basel I there were Tier I capital requirements and — they defined Tier I capital as capital in a certain form — it’s stockholders equity plus preferred stock. Then there’s Tier II capital and then they have a formula — now, this is defined in Fabozzi.

They have a formula that defines how much Tier I and Tier II capital a bank has to hold and the amount depends on the risk class of their investments. They define four credit risk categories and they define a formula involving the amount of assets in each of the categories. Then there’s a formula that dictates how much Tier I capital and how much Tier II capital they have to hold. This system has worked well for twenty years now but it is being superseded by another Basel Convention — Basel II — which has been going on for some years now. This is Basel I that I just was telling you about and now they’ve come up with a new version, Basel II, and Basel II is more sophisticated. It recognizes that the risks that a bank faces are very complex and that they are not summarized by just the classes of borrowers that were defined in Basel I.

It took them years — I won’t get into details on Basel II, but it won’t get into — it tries to deal more sophisticatedly with the complexity that we have in modern finance when there are lots of unusual derivative securities that have difficult to understand properties. I think they may have to have a Basel III before too long because everything gets more and more complex in the world. To some extent, the subprime crisis is a failure of Basel II, which is not even fully born yet. It won’t come fully in force in the U.S. until 2009; it’s already starting to have its impact. It’s in other countries — it’s already been adopted.

I wanted to talk a little bit about problems and then I’ll conclude. I have various — there have been lots of banking problems in the world and let me just mention some. I don’t know what order I should go in here. Let me just talk a little bit historically. The S&L Crisis in the United States, 1980s — what happened there? Saving and Loan Associations were making bad loans, especially in Texas, but in lots of other states as well — this is when Ronald Reagan was President. Reagan was a big believer in free markets; we had a law that actually passed, it’s called the Depository Institution’s Deregulation and Monetary Control Act of 1980 — that’s actually before Reagan.

That’s Depository Institution’s Deregulation and Monetary Control Act; what that did was, it eliminated ceilings on interest rates — on deposits, it allowed banks to pay high interest rates. It used to be that the government didn’t let banks pay more than a certain amount on their deposits and that helped protect banks because then they didn’t have to compete to pay high interest rates — then be incentivized to make risky loans to try to make money with those high interest rates. Once they freed up interest rates, interest rates on deposits started soaring and banks started taking greater risks, particularly Savings and Loans. Now, the government insures deposits, as you know, through the FDIC — the Federal Deposit Insurance Corporation. For Savings and Loans, they had an organization called the FSLIC, which is now defunct because of this crisis — Federal Savings and Loan Insurance Corporation — it was insuring deposits of Savings and Loans.

They should have been watching, under Reagan, because if you let them pay high interest rates you better watch out that they don’t make risky loans if you’re insuring them. But the FSLIC wasn’t; it was sleeping at the switch, so it allowed banks in the United States — it was primarily Savings and Loans who did this — to make bad loans and they were playing this moral hazard game. The moral hazard crept in because they said, hey we can borrow at a high rate. Let’s make some risky loans and if it succeeds we make money; if the thing blows up, well then they government will pay. So, they had an unfortunate incentive to make bad loans. This thing collapsed in the 1980s and it cost the U.S. Government, through the FSLIC, about 150 billion dollars. The collapse of this was part of the reason for a general economic collapse. We saw a collapse in real estate prices after 1990 and a recession in 1991, so it was the big story of the 1980s.

I’m just going to mention some other stories that are important, just to illustrate the fragility of the banking system. The Mexican Crisis under President Salinas. What happened was, Salinas was a Harvard-educated economist; he came in to modernize Mexico and he wanted to privatize things, so he privatized a lot of the banks. Then the banks went on a lending spree in Mexico and bank loans rose from 10% of GDP — of Mexican GDP — in 1988 to 40% by 1994; that’s a huge increase in bank loans in Mexico. What was happening? It was again — something was amiss — that you had the government deregulating and not watching. A lot of these people in the Mexican banks thought, well surely there will be a bailout if something bad happens; the government will pay for it, so let’s run with it. They ran with a lot of loans that turned out bad. As a result, there was a huge banking crisis and I mentioned before that Mexico doesn’t have much in the way of domestic banks anymore. They basically all failed and were taken over by foreign banks after the Mexican Crisis, so that’s a sign of how things can go amiss.

The Asian Crisis in 1997–1998. It actually is a complex phenomenon not involving only banks, but there was a — in the mid-1990s, Korea, Taiwan, Thailand, Philippines, other countries were receiving a lot of international capital from international banks. There was a sudden change of heart and people wanted to withdraw their — foreign investors wanted to withdraw their money. Once the rumor got started that Asia was in trouble, these people started withdrawing their money faster and faster and it caused failures of domestic banks in these countries.

There’s also the Argentine Crisis of 2000-2002. Once again, I won’t get into all the details of this, but it ended up with a run on the Argentine banks. Again, there was a loss of confidence in the time of an economic crisis and people wanted to withdraw their money from the banks. The government was panicked because the banks didn’t have enough money to give it to them, so the government shut down the bank accounts and it led to rioting in the streets. People were very upset that they had left their money in the bank and the government was just saying, you can’t have it. It caused a huge economic crisis as well; the unemployment rate rose to 18%. There were five changes of government in Argentina in a short time. Fortunately, Argentina has survived this crisis pretty well; it’s coming back rapidly. There was a severe crisis and so that again highlights the importance of having good bank regulation.

Chapter 6. The Subprime Crisis in the U.S. and in Europe [00:58:17]

Now finally, I want to talk about the current situation in what’s called the subprime crisis. Let me talk about the U.S. first. In the U.S.–now, I’m talking about just the last few years and something that’s continuing today — and it’s international as well. There developed, in the U.S. in recent years, something called the Shadow Banking System. These are organizations that act like banks but are not called banks because they are not technically banks, so they escape regulation. Typically they issue, instead of deposits, something called ABS — Asset-Backed Securities — particularly commercial paper, which are short-term obligations of the organization. They invest in something long-term — notably, subprime loans. They’re operating like banks, but they’re not regulated as banks, so Basel II doesn’t apply to them and they can do what they want.

Unfortunately, what we’ve seen recently is a kind of a bank run on the asset-backed commercial paper. Banks have been creating something called Structured Investment Vehicles in recent years. What these are, they’re like companies but they typically don’t have any employees. An SIV is a company of a sort that invests in assets and they issue something like asset-backed commercial paper, but it’s not a real company because it only exists as an organization sponsored by some bank. So, the bank has an SIV on its books, but the SIV is not part of the bank, so it’s not subject to the bank capital requirements. Then you know, you might say, who would buy the paper of an SIV? Well, the only people who would buy it are people who trust the bank that supports it, so in effect, the bank is promising to bail out the SIV if it should get in trouble. So, it really is — it really ought to be on the bank’s balance sheet and it ought to be regulated by the bank regulators, but there was a failure to do that and that is the problem that we are in currently.

I wanted to talk about some very recent problems to illustrate that it’s always a challenge to keep banks — banks are extremely useful entities, but there’s sort of a fundamental flaw that has to be constantly dealt with — namely, the tendency of them to fail when they’re lending long and borrowing short. There’s always a risk that investors will suddenly want their money back. I wanted to just talk about some recent examples. Northern Rock, which was a building society in the United Kingdom, had a sudden bank run in September 2007. The Northern — what was happening? Northern Rock was a British building society that was investing in subprime paper in the U.S. So, it was having trouble and word got out that it was having trouble and the rumors started spreading in the U.K. — Northern Rock is going to fail. So, people started rushing to pull all their money out of Northern Rock in September 2007.

This was the first bank run in the U.K. since 1866. This was a tremendous embarrassment to the Bank of England and Mervyn King, who was a very good governor of the Bank of England; but this apparently took him by surprise. They thought bank runs were a thing of the past. In fact, the United Kingdom has been an international model for preventing bank runs because the Bank of England would always lend to a bank that was in trouble in order to keep them out of the problem. The U.S. Federal Reserve System was really a copy of the Bank of England — thinking that, well, the Bank of England managed to prevent bank runs for all these years, let’s create the Fed, which we’ll talk about again later. They thought they had the system solved, but then they had a bank run last year.

You talk to these people who were standing in front of the bank; the first question you’d ask them, aren’t deposits insured in the U.K. like they are in the U.S.? Well, sure enough they were. The U.K. had copied the U.S. idea — I guess they copied — I don’t know where the original — I think it’s probably — is it U.K. copying the U.S. in this case? But they didn’t copy it well enough because they had a limit on the insurance of £3,000 for full insurance and then they had 90% of the deposits up to £75,000. You go out to these people who are lining up in front of the bank and ask them, isn’t there deposit insurance? They knew perfectly well. They said, yes but only up to £3,000 — I don’t want to lose 10% of my money, I’ve got £50,000 in the bank. It was kind of a bad design for deposit insurance, so they fixed it. But still, Northern Rock is in such trouble that in February of ‘08 — that’s last month — the British Government nationalized Northern Rock. It’s in a terrible mess. This puts the British Government in an embarrassing situation of owning a failing mortgage lender, so they’ve got to now be the government collecting on all these mortgages; it’s a mess. It shows that little details about how the deposit insurance is run are important.

I wanted to talk about Germany. In August, or actually it was a little bit earlier — July. There’s a bank in Germany called IKB Deutsche Industriebank AG that invested heavily in U.S. subprime paper. The value of the paper collapsed and the bank became insolvent. It was doing it through an SIV on it’s — called the Rhineland Investment Vehicle. So these — it’s not just the U.S. — this thing is a heavily international problem. So, this was a German bank doing exactly the same thing and it became insolvent and the German Government had to come to its rescue. It turns out that 38% of this bank was owned by the German Government, so it was kind of their problem, right? They weren’t watching what was going on adequately and so there was a bailout. The bailout — I don’t have the exact number here — it was a huge number of Euros. It kind of was a wake up call in Germany because they were watching with amusement the subprime crisis in the United States and here it was causing losses to the German Government. I think it was in tens of billions of Euros; it was huge.

This wasn’t the only one. There was another German bank called Sachsen LB, which failed at the same time. I guess the two together — I think it was twenty-six billion Euros. Sachsen LB and IKB was a bailout of twenty-six billion Euros and that’s a huge scandal in Europe, which is still unfolding, and it derives from the U.S. subprime crisis. What was happening was, these banks were not being watched carefully enough; their capital requirements were not enough for the kind of assets they were investing. Now, part of the problem is that the rating agencies were rating their securities that they were investing in as AAA, in many cases. There was a big goof up. The rating agencies weren’t cutting the ratings as they should and these European banks were just kind of naively trusting and it just didn’t get figured out. Now, it hit France too; BNP Paribas is a major French bank and it had a couple of, well, several funds. PowerVest, Dynamic, BNP Paribas-ABS Euribor and BNP Paribas-ABS Eonia and these things collapsed and I believe the three funds lost — I have down two trillion Euros — I have to check that, that sounds high.

But it wasn’t — the point was, it was the same scandal that we saw in the U.S., U.K., Germany and now France; it was the same source. It was the U.S. housing crisis that was causing a contagion around the world from one country to another because the banks in the countries had invested in risky securities — they hadn’t taken proper account of the risk and they didn’t have enough reserves. The same thing affected U.S. banks as well. It was Bear Sterns, whose headquarters is right next to Grand Central Station, if you go into New York. They had a couple of funds; one was called High-Grade — I like to write this down — High-Grade Structured Credit and another one that was called Enhanced Leverage Fund. These names sound safe — High Grade, Enhanced — but they both collapsed and became leveraged fund. They became almost worthless because they were investing in subprime debt and the value of the debt collapsed and so these collapsed as well. These are just some examples.

Chapter 7. Conclusion

I think we’re in a very interesting time for banking and for the economy as a whole. What we’ve seen is a testing of the system — that we have regulatory requirements, that banks have enough capital — but this regulation is challenging because it’s being stressed right now. A lot of people get complacent during normal times and they assume that normal times will go on forever. They can’t imagine — they don’t have the power of imagination to think what the next crisis will be like, so it catches them by surprise. We’ll figure this all out. Banks, as I say, are with us to stay; we just have to improve our regulation and disclosure requirements so that banks can be prevented from taking unnecessary risks. I hope you will all come to hear Redleaf on Wednesday and I look forward to having lunch with some of you. I don’t think I can get either Icahn — both Icahn and Schwarzman are coming to give a lecture in April, but I don’t think either of them will stay for lunch, so this is our only luncheon event.

[end of transcript]

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