ECON 252: Financial Markets (2011)

Lecture 12

 - Misbehavior, Crises, Regulation and Self Regulation


After talking about human failures and foibles in the last lecture, in this lecture Professor Shiller discusses regulation to minimize the impact of human errors. He outlines five different levels of regulation: regulation on the firm level, on the level of trade groups, on the regional, the national, and the international level. Concerning the first level, he emphasizes the role of the board of directors as the regulators of a company, its duties of care and loyalty, and its responsibilities in the face of tunneling. On the level of trade groups, Professor Shiller presents the history of the New York Stock Exchange from the signing of the Buttonwood Agreement until today. The subsequent description of regional regulation centers on Blue Sky laws during the progressive era of the U.S. in the late 19th and early 20th century. On the national level of regulation, he covers the founding days of the Securities and Exchange Commission, its regulation of hedge funds, as well as its efforts against the trading of insider information and stock price manipulation. He complements his coverage of national regulation with the regulatory efforts in the aftermath of the financial crisis from 2007-2008, i.e. the creation of the Financial Stability Oversight Council and of the Consumer Financial Protection Bureau by the Dodd-Frank Act from 2010, paired with the European efforts in the course of the European Supervisory Framework, also from 2010. With respect to the fifth and final level of regulation – international regulation – Professor Shiller talks about the Basel Committee on Banking Supervisionand the G-20.

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Financial Markets (2011)

ECON 252 (2011) - Lecture 12 - Misbehavior, Crises, Regulation and Self Regulation

Chapter 1. The Importance of Regulation and Its Challenges [00:00:00]

Professor Robert Shiller: All right, good morning. I wanted to talk today about regulation. Well, actually, regulation and human misbehavior. So, this is a continuation of my previous lecture, in a sense, which was about Behavioral Finance and about human foibles. But now, I want to go on to talk about what we do about some of these things, and that means talk about regulation. So, I think that regulation of finance, financial markets, and institutions is substantially directed at dealing with psychological problems, and the tendency for some people to exploit human weaknesses, and manipulate and take money from other people rather than help them.

But I think regulation goes beyond this, because it also has another, more technical side, and that’s about making sure that the financial system works well. For example, regulation deals with monopolies and externalities. It’s been talked about a great deal that regulation has to take account of the–why don’t I write this down–the ”too big to fail” problem, that is, regulation that deals with systemic problems. ”Too big to fail” refers to a phenomenon that’s been observed many times in many countries, that, whenever a big firm fails, the government bails it out. And that’s because they realize that, if this firm, especially if it’s a financial firm, collapses, it will bring down the whole system with it. So, that means big firms have an implicit government guarantee. Small firms don’t. This is not the way anyone wanted it to be, but it happens naturally, because big firms are the only ones that can bring the whole system down. So, this tendency then creates an opportunity for big firms to take more risks than small firms, because they know that they have this free insurance policy from the taxpayers. And so, they take bigger risks and they bring on systemic crises.

So, dealing with this is another aspect of regulation. And it’s central to regulation right now in the wake of the world financial crisis. Another term I wanted to emphasize, well, a pair of terms: There’s two kinds of regulation, called microprudential–I think this is a relatively new word; at least it has become popular since the financial crisis of the 2000’s–and macroprudential. So, microprudential–prudential sort of means regulation, dealing with prudent standards for business–microprudential regulation protects the small firms, the small people, the individuals. Macroprudential protects the system. Macroprudential regulation deals with the ”too big to fail” problem, and it deals with other problems that affect the whole system. I think the history of regulation involved both of these, but I think the mix was more microprudential then macroprudential until recently. So, we’ll talk about both of these here.

So, I thought I should say just something first about regulation and regulators. I’ll start with an analogy. I think regulators are analogous to the referees at a sports event. They enforce rules. They decide when someone has broken the rules, and they can punish people who fail to adhere to the rules. But I think that’s a good analogy, because, I think, we generally all appreciate the importance of referees at sports events. The players often argue with the referees, but the players want them, because it wouldn’t be a very good game if we didn’t have a referee, right? Because the, for example, dangerous player, or player that risks others being hurt, or deliberate hurting of other players would become almost necessary in order to succeed in the game. So, this reflects a problem. In a competitive system, there’s kind of a race to the bottom, right? If everyone else is doing something that you think it’s shady, well, you kind of have to do it too or you can’t compete.

And so that means people in the sports world or the business world will themselves ask for regulation, or they’ll try to do it themselves as much as they can. Just as children, when they play on an empty lot when there’s no adults around, will agree on some rules. And maybe they have a referee, I don’t know. Usually not. They’re all referees. They’re all enforcing the rules. That’s what we’re talking about when we talk about regulation.

We tend do admire the players more than the regulators. This is true both in sports and in finance. You know, one thing I’d like to also say is that we should show respect for regulators and referees. It’s a profession, and they’re not losers, as some people say. It’s true; the referees in the sports game probably couldn’t play the game very well. They’re probably too old to play it very well. But even so, they have a different profession, right? And some of them are very good at what they do. They don’t attract as much attention, except when they make mistakes. It’s the same thing with regulators–the regulators that I’ve met seem to me often to be well-meaning, intelligent people. I think it’s a career that you should consider. So, when I say I’m hoping that this class prepares you for a job in finance, I’m including in that a job as a regulator. Some people like it better, because it adheres more to their personal sense of moral, morality, and integrity. They would rather be enforcing good rules of financial behavior, than being compromised. I think, maybe it’s a different personality. When you’re in there in the game, I mentioned this last time, you get compromised one way or another. There’s no avoiding that, because you’ve got to kind of play to the rules, right? And if the rules allow something that is questionable, you may have to do that too. I think you should try not to, but reality is something that interposes. So, some people will spend years on Wall Street making money, and they’ll switch to a regulator job. And it isn’t because they failed on Wall Street. I think it’s because life offers many different kinds of rewards.

Chapter 2. Firm Level Regulation: The Board and Its Duties [00:08:10]

Anyway, in this lecture, I have five levels of regulation that I want to talk about. So, the first one is the lowest level. It’s within the firm. And maybe people don’t always talk about that as regulation, but I’m going to count that. Firms set up their own rules. There’s no government involved. This is just internal. Then, there’s trade groups, all right, where a group of firms will get together and form a trade organization, or a self-regulatory organization, and they will decide on rules among them. Then, there’s a local government. That would be at a city-, or province- or state-level. And then, there’s national. And you can see where I’m heading, to international. So, those are the five kinds of regulation. And I think that the oldest are the ones at the top of the group, and as time moves on, we’re becoming more and more broad in geographical scope. So, I’m preserving international regulation for the end of this lecture.

So, let me start with number one, which is the within-firm regulation. We’ve talked about this before, about the modern corporation as having a board of directors. And they could be called a board of regulators. Nobody calls them that, but I think that they look a lot like regulators. But they’re not imposed by the government. Remember, I said that a team playing a sport wants a referee. So, companies want somebody imposing some kind of standards on them as a group, so companies have boards of directors. Now, in most companies, they have both inside directors, who work for the firm, and they have outside directors, who have nothing to do with the firm, except that they’re on the board of directors. I think that it’s really the outside directors that make the board of directors into a sort of regulator.

In the last lecture I was talking about how people are different. And some people show more character than others. That’s a problem, a fundamental problem, in human society. A lot of the people who rank very low on character end up in jail, unfortunately. But most of the time, we don’t want them in jail, but we can’t put them in positions of responsibility. So, society finds some way of kind of quarantining them so that they don’t–these are all uncomfortable problems, and, I don’t know–I can’t get into all of the issues here. But we don’t want them running a company. We want people of character running a company. And so, in a sense, a board of directors imposes that. You put people on the board who have reputations as high-minded people. That’s the way it should work. Anyway, it usually does work. High-minded people who, you know, you’d probably not want to propose some shady deal to.

So, you want to have regular meetings of these, where you talk about what the company’s doing. And these people impose a kind of community standard on what the company is doing. And it also has an effect on the standing of the company in the community, because they see the names on the board of directors, and they think, well, this company can’t be shady, right? With these people on the board. When you join a board of directors, you’re merging your reputation with the reputation of the company. So, you wouldn’t do it if the company looked shady.

So, I’ll give you an example of a board of directors. I’ll use our own most familiar example, the board of directors of Yale University. And it’s called “The President and Fellows of Yale College.” And they meet regularly. They come to campus and have their meetings. But it’s a small group of–I don’t know what the whole number is, like 20 people. I’ll give you some examples of the members of the Yale–they also call it the Yale Corporation. Richard Levin, the President of the University, of course is Chairman of the Board. The Governor of Connecticut, Dannel Malloy, has always been, going back hundreds of years, on the Yale Corporation. So, we have the governor of the state.

I’ll just give you several more examples. Fareed Zakaria, who was born in Mumbai, India. He’s now editor of Time Magazine, and he’s the author of many intellectual books. And he has a kind of an intellectual television show, public TV, and is a Yale alumnus. So, he’s on the board. We also have Indra–maybe I should write these names since they’re hard to spell. Fareed Zakaria, I mentioned. And then, Indra Nooyi. That one you might have trouble spelling. I don’t think she went to Yale. She was educated in India. But she’s president of PepsiCo, the big international corporation. She’s a director at the Lincoln Center for the Performing Arts in New York. And this is an example of interlocking directorships. So, you judge a director partly by what other boards they sit on. And she’s chairperson of the U.S.-India Business Council. And I have one more example who’s on the Yale Corporation. Mimi Gardner Gates. You know who she is? She’s Bill Gates’ stepmother, but maybe that’s not the way to introduce her. I just found out that Bill Gates’ mother died in 1994, and his father remarried to a woman who ran the Seattle Art Gallery, so she’s an art conservator. All these people are people who have reputations as high-minded intellectuals and members of our community. I don’t know that Yale is in strong need of a board of directors like that. I think we would function like an orchestra without a conductor. We could do all right. But it imposes, on any corporation, a sort of regulatory standard that is important.

So, a board of directors has a really important function, because–let’s move away from the nonprofit. Yale is a nonprofit organization. Let’s consider someone doing business in a for-profit corporation. There are way too many opportunities for sleazy behavior. And you only are willing to invest in a company, if the sleazy behavior is somehow under control. So, I’m going to talk about maybe the most important kind of sleazy behavior in a company. It’s called tunneling. Tunneling is sneaking away with value, putting it in your own pocket, if you work for a company, rather than in the stockholders’. The stockholders own the company. They’re supposed to get the money. But the employees have never met the stockholders. And they sometimes think, you know, there’s a lot of things we can do and let’s do them. And the money is going to come from the stockholders, and will somehow end up in our pockets.

So I’ll give you just examples of tunneling. The company has some asset and it’s going to sell it, right? So, asset sales. In part of doing business, how does the company make sure that it gets a good price? Well, if you work for a company and you’re in charge of the asset sale, you can tunnel. You say, I’ll sell it to my brother-in-law at a really low price. All right. OK? He’ll wait a while and then he’ll pay me off later, OK? That’s hard to detect. Because how do you know, if you are a stockholder, how are you going to find out? That’s stealing from the company, right? If you sell it at a non-market price. How does somebody know that? I mean, the stockholders can’t be looking at every deal.

So, I’ll give you another example, contracts. The company is signing a contract to provide something to them regularly. They can pay too much. Now, it could be your brother-in-law who’s running. But hey, let’s not be so obvious about it. It’ll just be some guy that I met, and we’re both antisocial personalities. We’ve just discovered each other. And, you know, it doesn’t even have to be written down. I’ll give this contract to you over somebody else. And I’ll pay you too much. And, you know, sometime later you take care of me. You know, I did it for you, you return the favor, OK? This is tunneling.

Another one, executive compensation. The CEO decides to pay his friends in the company, his cronies, very high salaries. And he would defend it, if anyone asked, by these people are worth every penny. Who knows what somebody is worth, and who’s going to judge that?

Expropriation of corporate opportunities. See, one of the most valuable things about a company is that you’re in the business and you know what’s happening, right? And your company is producing a certain kind of product. Then, someone comes along and says, you know, I don’t really want your product, but you seem like the kind of people who could produce something that I really need. Something else. And so, you as a director, as a president of a company, you should say, OK, we can do it. But you don’t do that. Instead you say, I’m setting up a new company with my name. Or my brother-in-law is setting up a new company. And you tell him all the corporate secrets and how he can do it. That’s tunneling, again.

And of course, there’s insider trading. That’s when people in the company will buy or sell their own shares based on knowledge that they have, that they haven’t told the public yet. So, if you know that the company’s going to collapse, you sell your shares right away. If you know the company has some great news, you buy them before you announce it. That’s tunneling again, because you’re taking money out of the company because of the opportunities you have as part of the management of the company.

You see how many different ways, and I haven’t listed them all, there’s many, many ways. Companies do so many things. So, why would you ever invest in a company? You might think there’s a million ways to get money out of the company. And the people, who are running it, don’t know me. They don’t care about me. That’s why a corporation is kind of a delicate thing to work at all. It has to have some way of controlling all these things. And there’s so many of them and they’re so complex.

I would say, that’s why we have boards of directors, and why we put people of known reputations on boards of directors. So, this is maybe the most essential kind of regulation, and it’s within firm. And you may someday be serving on a board. The thing you have to remember is that a board member has–if you ever agree to serve on a board, I think you should interpret it as a moral obligation that you have taken on to prevent all of these things, OK, and to make sure that the business is run in a high-minded way. And remember that your reputation is at stake, because you’re part of the company. But it’s more than that, it is a moral duty.

So, you have what’s called the duty of care as a board member. Duty of care is a duty to act as a reasonable, prudent, rational person would. That means you have to make sure that you’re getting the information, you’re watching, you’re being careful about your obligation as a board member. You are not managing the company. You are watching the management of the company. And you don’t follow every detail, but you have to follow enough that you act as a sort of regulator. And you have to know what you’re doing.

You also have a duty of loyalty. And that’s usually interpreted as loyalty to the shareholders. I would say, it’s expanding. Now, there’s more and more talk of corporate social responsibility, and the loyalties that you have to other people, members of the community at large. But I’d say that, let’s just start from the beginning, because there’s so much temptation to steal money, to tunnel money out of corporations, it probably remains true that your main duty of loyalty is to the actual shareholders. Because they’re the ones who put up the money, and they’re expecting to get a profit back. So, if you ever serve on a board of directors, I think you may become–many board members don’t view it as a very significant thing. They think, well, this is just an honor to be on the board, and I just show up at four meetings a year. And we listen to a presentation from the CEO, and we say fine. That’s not what you should be doing.

I think one has to kind of notice the ambience. You have to use your intuitive judgment as a board member. Is this an up-and-up firm? Is there a good atmosphere here? So, that was my first thing, at the firm level. Of course, firms have compliance departments. They issue rules. They issue statements of purpose. And that’s all within firm.

Chapter 3. Trade Group Level Regulation and Its Controversies [00:25:37]

But I wanted to move up now another step in my regulatory thing, and move to trade groups. And these are groups of firms that get together to form an organization. Well, what did I say? Indra Nooyi was on the U.S.-India–what was that? I don’t remember the exact name. It sounds like a trade group. A private group that deals with businesses in both–U.S.-India Business Council. So apparently, business people in both countries got together and formed an organization where they discuss issues. And there may be a regulatory function associated with them.

But I wanted to start with an example of a trade group, and that is the New York Stock Exchange, because it’s important in history. And it was founded in 1792. In 1792, stockbrokers functioned; we had a stock market in the United States. Of course, it was a small one. The big stock markets then were in Europe. But there was no organization for the U.S. stock market. We had our first stock market crash in 1792. The first American stock market crash. And within two months, the stockbrokers set up a trade organization, called the New York Stock Exchange. And they met outdoors under a buttonwood tree, so they signed a document called the Buttonwood Agreement. Stockbrokers used to work outdoors. Even into the 20th century, the so-called American Stock Exchange used to be called the Curb Exchange. That’s because they were guys who would stand on the curb outside of the New York Stock Exchange, which had a building, and they would just dicker among themselves and trade. Then, they decided they better get a building, and that became the American Stock Exchange, which doesn’t exist anymore, it was absorbed by the New York Stock Exchange eventually.

But anyway, the stockbrokers in New York got together under the buttonwood tree and signed a historic agreement, setting up the stock exchange. And it’s been described as an idealistic document about our duties and our ethics. But I found, actually, the text of the Buttonwood Agreement, and it’s really short. So, I will read it to you. I’ll read you the whole Buttonwood Agreement. “We, the subscribers, brokers for the purchase and sale of the public stock, do hereby solemnly promise and pledge ourselves, to each other, that we will not buy or sell from this day, for any person whatsoever, any kind of public stock at less than 1/4 of 1% commission on the specie value of gold, that we will give preference to each other in our negotiations.” Period. “In testimony, we have set our hands this day, 17th day of May, 1792, in New York.” That’s the whole Buttonwood Agreement. It sounds like a price-fixing agreement, doesn’t it? And excluding other traders, so it sounds like a cartel.

I was wondering how I got the impression that the Buttonwood Agreement was so idealistic. Where is the idealism there? So, I went and I looked on the New York Stock Exchange website. And this is their interpretation–it’s on the website right now–of the Buttonwood Agreement. It says there, “At the heart of the Buttonwood Agreement was the need for fairness, responsibility, and trust.” OK. I think, actually that might not be as outrageous a self-serving claim as you might think. Because what had happened in the 1792 stock market crash. There was one person who figured very heavily in it. His name was William Duer. Am I spelling that right? It’s E–no, it’s U-E. Maybe that was a u-Umlaut. William Duer, who was a stock promoter. And he got a lot of people to manage their money for him, and he got buying stocks on margin, encouraged a lot of people to buy stocks on margin. And it created a bubble in the stock market, pushing prices up. Other people thought that Mr. Duer was not a good character, but he managed to create a bubble in the market, and it eventually collapsed.

So, it was within two months of that. Obviously, the stock exchange was created in response to Mr. Duer. And so, what they’re basically saying is, we won’t do business with this guy. We’ll close him out. If we all agree that we won’t trade with him or people like that, then they’ll be out of the business. The other thing is putting a minimum commission on sale. This is the profit they get from the sale. It makes it into kind of a gentlemen’s organization, because they chose a commission, which was sufficiently high, that they could make substantial money trading stock. I think the philosophy was, we are ethical members of the community. We don’t want this business to be turned over to discount brokers who don’t care. And we will exercise a duty of care. I wish, it said that in the agreement. I’m reading between the lines here. I think that probably was part of the motivation. And so, we have to keep our incomes up, so that good people can stay in the business. That was the philosophy.

And then later, the New York Stock Exchange adopted many rules about ethical trading. And so, they were imposing standards. It was just not explicit in the original Buttonwood Agreement. So, things changed recently. You know, our attitude toward cartels has changed over the years. And there’s a couple of important dates I wanted to emphasize. One of them is 1975, and it’s May Day. It was May 1st, 1975. In the United States, the government, under the Securities and Exchange Commission, made fixed commissions illegal. Until 1975, the New York Stock Exchange was still following something like that 1792 rule. Anyone who was a member of the New York Stock Exchange had to impose a minimum commission. And then secondly, they could only trade with each other, closing everybody else out. Now, they could justify that because they’re closing out the scoundrels. And so, that prevents a race to the bottom. But it had another effect. It was creating monopoly profits. And eventually the Securities and Exchange Commission said, no more. We’re going to have competitive commissions. Any effort to fix commissions in a trade group is now illegal, in ‘75.

I think it’s interesting, by the way, that the chairman–this is a local interest–the chairman of the SEC, the Securities and Exchange Commission, in ‘75 was Ray Garrett, a Yale College graduate, and the President of the United States was Gerald Ford, a Yale Law School graduate. So, this had a local beginning. But I wasn’t lecturing about finance in those days. Incidentally, 1975 is the beginning of the National Market System, which Congress created.

So, this idea that you only trade with other New York Stock Exchange brokers was ended. Now brokers have an obligation to find the best price for their customers on any exchange, OK? So, what the government really did is, it broke the monopoly. And that’s why the New York Stock Exchange has faltered since. It has so many competitors now. You’ve got all these discount brokers. So, it hasn’t done as well. If they haven’t made these changes in ‘75, it wouldn’t have done as well [correction: it wouldn’t have faltered as much].

Right now, it’s about to be taken over by the Deutsche Börse, the German stock exchange. That’s still on, I think, right? That deal? So, substantially, it was a cartel. In the United Kingdom, it took a little longer. But in 1986, when Margaret Thatcher was prime minister, they had what’s called the Big Bang. That’s the British counterpart to May Day. They deregulated commissions. And again, it had the same effect. It broke the monopoly. So, I could go on a lot about trade groups, but I think we see some idea that–incidentally, the New York Stock Exchange, even today, has its own market surveillance unit that looks, it goes through trading records and it looks for examples of, say, manipulation. And they will track down and find you, if they think that something immoral was done. So, even though they had a deregulation of their commission, they still are doing that.

You know, this idea about allowing groups to regulate prices is controversial. Airlines used to have their fares regulated by the–what’s the U.S. government agency? [The Civil Aeronautics Board, which regulated fares since 1937, was phased out by the Airline Deregulation Act of 1978 and finally shut its doors in 1985.] The airline fares were regulated at high levels. And in those days, airplanes would give you great service, because they were competing on service rather than on fares. So, it used to be that when you got an airplane, there were a lot of empty seats, because they were scheduling many more flights than needed. And you got great meals. But it was expensive. And so, if they deregulate, fares come way down. Services, now you’re jammed in shoulder to shoulder, and if you don’t like that, you can pay more. But very few people will pay more. So, I think, on balance, it’s a good thing to deregulate commissions.

And now we have all these websites now that sell on very low commissions. It’s a product of deregulation. I mean, a product of regulation, I’m sorry, regulation that prevents the cartels from forming and closing out competitors who might charge a lower rate.

Chapter 4. Local Regulation: The Progressive Era [00:38:17]

So, the third thing I said about local regulation. This is my third category. It used to be that it was a more local phenomenon. I’m particularly thinking of the United States, but I think it was true elsewhere as well. Local banks would be regulated locally by the people who saw them rather than a distant national government. In the United States, until the 1930’s, financial regulation was almost exclusively local. The federal government didn’t do anything. So, we had a bunch of laws called Blue Sky laws that were put in place by state governments during the progressive era. The progressive era was from the 1890’s to the 1920’s. That was an era in U.S. history when a lot of state governments started adding regulations. They did other things like regulate food safety and other business laws. But regarding finance, it was the Blue Sky laws.

Now, I don’t know if anyone remembers why they’re called Blue Sky laws, but one interpretation is, that there were a lot of sales people for investments. And some of them would give you an exaggerated sales job. They would say, there’s no limit to how high the price can go of this stock, nothing but the blue sky above. So, that’s my story about how they got to be called Blue Sky laws, but I don’t know if there’s any agreement on where that name came from. And I think the first Blue Sky law was in the state of Kansas in 1911. It was given some impetus by a book written by Louis Brandeis, called Other People’s Money in 1914, I think it was. That was a book that detailed the scandals of fake securities, or dishonest promoters of securities. So, it started in Kansas in 1911, but by the 1930’s practically every state had Blue Sky laws, and they had state regulators that enforced them.

But the problem was, that they were state laws, and it made it difficult for state governments. There’s all these different state governments are trying to regulate an industry, which is really national or international in scope. So people could evade the Blue Sky laws, now especially since the telephone became prominent in the 1920’s. You could set up a boiler room, so-called, in one state. A boiler room, I think I said this, is a–you rent the cheapest space for your telephone bank, and you pick the boiler room of the basement of some building, and you put a bunch of people manning the telephones. And they call across state lines, so this confuses the Blue Sky regulators, because it involves two different states. And you called long distance to the other state and you give–this used to happen a lot, doesn’t happen so much anymore–they would try to sell you on something. I’ve got a great stock. It’s going to triple in five days. If you don’t buy it today, it’s too late. And they would get people into stocks that were utterly worthless. And it was fraud.

The whole progressive movement to regulate securities was of limited success. But it left in place a huge state and local regulatory system, that was considered inadequate to the task, but which remains today for the regulation of smaller companies.

Chapter 5. National Regulation: The Securities and Exchange Commission [00:42:59]

The next step is the national regulation, which occurred in the United States in the 1930’s under the New Deal of President Roosevelt. So for national. Notably, in 1934, I mentioned this before, the U.S. government set up the–it’s actually, we spell it out–Securities and Exchange Commission, or SEC, which regulates the larger firms. Practically any firm that’s listed on a stock exchange would be regulated by them.

One of the first directors of the SEC was William O. Douglas, a Yale Law Professor, who wrote a book, called Democracy and Finance, about his experience as SEC director. And he talked about the conflicts he had with Wall Street at the time. They really didn’t like this regulation. It was an antagonistic atmosphere. The Securities and Exchange Commission was widely regarded in the business community as practically a socialist organization–and that’s a dirty word in the United States–because it seemed like the government was involving itself in things that they had no business involving themselves in. So, Douglas fought kind of a battle against Wall Street, as detailed in his book. But to get everything on an up-and-up format, he was following one of the rules that Brandeis–he wanted disclosure. Louis Brandeis, there’s a famous quote in his book Other People’s Money, and it is, quote, “Sunshine is the best disinfectant.” That’s a parable to hanging out your clothes on the clothesline and letting the sunlight fall on them, and that disinfects them.

But the same idea applies in finance. That if everybody knows what the firm is doing, they’ll figure it out and there’ll be talk. We just don’t want firms to keep secrets. So, the SEC is built around disclosure. And so, I mentioned, EDGAR is their online information system, but it’s on They put everything up about a company, of any public company, up on that website. And it’s free, absolutely free to the world. That’s disclosure, and that was the motivating thing.

Another SEC chairman is Arthur Levitt. And he wrote a book, called Take on the Street, after he left the SEC chairmanship. This was recently. I mean, like in the last 10 years. And he told a lot of stories about nasty people on Wall Street. [Levitt was chairman of the SEC 1993-2001, his book was 2003.] He said he had vivid memories of the reactions he got from proposed new regulations. And he was particularly upset by the, kind of, ability that Wall Street had to fool people by using complex language that they couldn’t understand. They would write prospectuses that no one could understand without a law degree. He wanted plain English.

So again, taking a job as SEC chairman, or commissioner on the SEC, is taking on a high-tension job, I think. But it’s like the same thing as in sports. You know how referees in sports get punched every now and then by the athletes. But we all see that they’re necessary.

So, one thing that the SEC does is, protect small investors by managing the distinction–I mentioned this before–between public and private securities. So, if you want to go public and list your security, or the shares of your company, on a stock exchange, you have to go through a procedure defined by the SEC, called an IPO. That stands for initial public offering. And to do that procedure, you have to follow a system of rules, dictated by the SEC, that makes it difficult for you to do any shenanigans, any tricks. It creates a level playing field. And the rules are very strict and enforced by the SEC.

The SEC allows other companies to remain private, but it has rules about what you have to do to stay private. When you become a public company, you are involved in the public trust. And you have to, among other things, include all of your documents on But they do allow private companies. And a particularly important category of private company is the so-called hedge fund.

Chapter 6. Minimal Regulation: Hedge Funds [00:49:41]

A hedge fund is an investment company for wealthy individuals only. And the idea is, that small investors need to be protected, because they don’t know. They don’t have expensive advisors and lawyers to tell them what to do. And so, lots of controversial things can’t be done in funds that are offered to the public. A hedge fund is a fund for these wealthy investors, and the SEC has minimal regulation of them. The Dodd-Frank bill, we thought, would put more regulation on them, but they’re still surviving as largely unregulated organizations.

The law, the SEC code of rules, is huge and is complicated. I guess, you can read about it on But there’s a 3C1S hedge fund, it’s one type of hedge fund, it can take on no more than 99 investors. Can’t be more than 100. And they must be accredited investors. And the SEC defines accredited investors. They were proposing to change the definition, but I think it still stuck. To be an accredited investor–I don’t have it here–I think it’s still that you had to have an income of at least 200,000 a year if you’re single, or 300,000 if you’re married, or $1 million in investable assets not including your house. I think that’s the definition. I’ve got it fairly close. [Definition is correct as stated.] So, it excludes most investors. But then, there’s others kinds of hedge funds. There’s also a 3C7S hedge fund, that’s allowed to take on 500 investors. But these have to have a net worth of $5 million, or if they’re an institution it can’t be a little institution. So, it would be 5 million. So, it’s more than an accredited investor, it’s called super-accredited. 5 million for individuals, 25 million for institutions. That excludes most family foundations, I suspect.

So, hedge funds you don’t hear about as much, because they don’t advertise. And they are not allowed to advertise. If you click on their website, they’ll have a website, it will give you the contact information, typically, and say very little more about them. They don’t put anything on their website, because they worry that they’d run afoul of the SEC, that the SEC would call it advertising. And you’re not supposed to be for the public.

This creates some conflict. Some people think, why is it that the United States has this kind of two-tier system? It’s not just the United States; other countries have this as well. But let’s talk about this system. Why is it that we have special rules for poor people, which in effect, in their estimation, excludes them from some of the biggest profit opportunities?

Hedge funds are allowed to impose high management fees. And the typical management fee has been called ”two and 20.” 2% of the assets under management goes to the managers every year. And 20% of any profit, trading profits they make, go to the managers. Nothing of their trading losses. If they lose money, it doesn’t come from the managers. Now, that sounds like a really good deal, right? Think about it. If you can raise just $1 billion in your management fund, you’re getting 2%. What is 2% of $1 billion? That’s 20 million? Did I get that right? And 20% of the profits. I mean you’re going to make a huge amount of money, right? I suspect some of you will do this, because it’s so tempting.

But of course, you can’t do this. It’s not so easy to start a hedge fund, because the whole idea of a hedge fund in most people’s minds is, there are genius traders, and you have got to pay them, right? You can’t hire them cheap. So, the hedge funds raid all of the geniuses out of the mutual funds, which are public investment companies for these retail investors. They get the smartest guys and pay them this huge amount, and the idea is, they’ll make a lot of money. Whether they really do make a lot of money is a difficult question. It’s hard to tell, because hedge funds haven’t been around. They’re changing through time. I’m sure some of them do make a lot of money. Some of them are good investments. But it’s like a Wild West. It’s a jungle out there. And the SEC doesn’t think that you, the small investor, should get involved in that. And so you won’t. That’s another example.

Chapter 7. Market Surveillance: Preventing Manipulation [00:55:39]

So, market surveillance is something that the SEC does, and it does it in connection with the self-regulatory organizations like the stock exchanges. It’s, again, trying to prevent manipulative behavior. See, the markets don’t function that well by themselves without some kind of referee. The 1792 stock market crash was only one example, but market surveillance is now a well-established principle to prevent manipulators from taking over a market.

I’ll give you an example of what happens, and this is a news story from 1995. In May 1995, a secretary at IBM Corporation was asked to copy documents related to secret plans to take over the Lotus Corporation. Lotus was this spreadsheet–it doesn’t exist anymore–spreadsheet company that was a pioneer in computer spreadsheets. So anyway, she just commented to her husband, because she was copying these documents, she said, oh, IBM is going to take over Lotus. Her husband saw that as valuable information. The stock price of Lotus is likely to go up. And she said that they were going to do it in three days. So, that’s a perfect thing. So, what did he do? He merely telephoned all of his friends and told them. By the takeover date, 25 people had bought a half million dollars. These people included a pizza chef, an electrical engineer, a bank executive, a dairy wholesaler, a schoolteacher, and four stockbrokers, OK? Well, they caught them, because they saw this unusual activity in the stock, and they subpoenaed their phone records and they figured out who called who, and they called them in and made them declare what they’d done, and they were all punished for this. It’s illegal. You can’t trade on inside information. Again, the SEC is trying to create a level playing field for everyone.

I’ll give you another example. It was Emulex Corporation. A former employee of this company shorted stock in his own former company. And he then decided he would try to help make the price go down. So he sent–because he knew the company, he knew how to do this–he sent a fake press release to the Internet. And nobody suspected it, because it looked real. He just sent it out from his own computer. Actually, it wasn’t his own computer. He thought he was being smart. He went to the El Camino Community College library.

Student: Yes.

Professor Robert Shiller: You know the story.

Student: I know the college.

Professor Robert Shiller: Oh, you know the college. Well, he went to the library, and he sent the press release from the library’s computer. And he thought, that’s going to be sure. And then it worked. It was picked up by all the news services, the bad news about Emulex. And then, he immediately covered his short position, and he made a big profit. And he thought, he was smart, but he wasn’t smart enough for the surveillance. Because they suspected. Well, immediately, Emulex immediately protested, we didn’t send out this press release. So, the market surveillance team went into action. And they found out. It’s all in the stock exchange record, who covered a short position right after the announcement. They got his name as one of the people. They actually traced down where the email was sent from, and they went to El Camino Community College, and they talked to the librarians, and they showed them photographs. And they remembered him, and so they nailed this guy. So that’s an example of what happens in our markets. And so that makes things work well.

I also wanted to mention, what the SEC does with creating private organizations, or self-regulatory organizations, that do some of its jobs. So, we have something called FASB, which is called the Financial Accounting Standards Board. It’s right here in Connecticut. The SEC decided that companies fake their books in too many ways. There’s too much funny business going on, and we need to manage this better. But they didn’t want to take over completely this as a government function. So, the government recognized an industry group called FASB as the arbiter of accounting standards. And FASB is the authority that defines GAAP accounting standards. And GAAP is an acronym for Generally Accepted Accounting Practices. I’m sorry, Principles. Generally Accepted Accounting Principles are defined by a private group. And these principles are used on EDGAR, which is the website that the SEC uses to present accounting. So, they’re in Norwalk, Connecticut, and they have their own website, and you can see how they define accounting standards. I’m running out of time here.

I wanted to tell you about another government agency called SIPC. I’m just having too much fun telling you about all of these. The SIPC is the Securities Investor Protection Corporation, created by the United States Congress in 1970. And it’s part of an effort to protect small investors. SIPC insures your brokerage accounts against losses due to failure of your stockbroker. It corresponds to the FDIC. Did I mention this before? Maybe, I mentioned it briefly. The FDIC is the company that insures your bank account. SIPC is the company that insures your brokerage account, and it’s a government corporation. It has limits on the amount that it insures. It was actually created in 1970, in response–a lot of things happen in response to a crisis–There was a brokerage firm called Goodbody that failed in 1970, just before SIPC was created. A lot of people had their stocks in Goodbody, and they had accounts there, and it looked like they were going to lose it. They held their stocks in street name, and I remember telling you about that. So, they thought they owned shares, but really Goodbody owned the shares, or they thought Goodbody owned the shares. But Goodbody went under, so they ran the risk of losing the shares they thought they owned. So, SIPC was created in order to prevent that.

Chapter 8. Regulatory Pushes at Home and Abroad [01:04:25]

Continuing along on the national level. Regulation is getting stronger at the national level. I’ll talk about two examples in the U.S. And I’m going to talk about the European Union as if it were a nation. It sort of is a nation. It’s an assembly of nations, but it’s kind of halfway between national and international. But I’ll start with the U.S. I mentioned that in the 1930’s there was a big step up in regulation with the New Deal, creating the Securities and Exchange Commission. The next big regulatory push in the United States occurred last year, in 2010. We had the Dodd-Frank Act. Christopher Dodd is our own–was our own senator from Connecticut. And Barney Frank is chair of the House Financial Services Committee. I’ll just give you a couple of things from the act. The act is really trying to push regulation more to the macroprudential from the microprudential. All this thing about fraudulent activities that milk innocent individuals, that was taken care of by previous legislation. Well, not all of it, some of it was.

But Dodd-Frank creates the Financial Stability Oversight Council, or FSOC. The Financial Stability Oversight Council is designed to worry about ”too big to fail.” They are the regulator that deals with systemic risk. That is, risk that affects the whole system. They’re regulating not just to protect the individual from bad activities, or from being fooled, but also to protect the whole system. So that’s part of Dodd-Frank. The other part I was going to mention is the consumer–I see it two ways. Bureau of Consumer Financial Protection, or Consumer Financial Protection Bureau, so I’m not sure how to write the acronym. It hasn’t actually taken form yet. I’ll say Bureau of Consumer Financial Protection. This one is a microprudential regulation. I mentioned her before, I think, Elizabeth Warren proposed it. She’s a Harvard Law professor. And what it’s going to do is have a government agency that is focused on protecting small investors, or borrowers in the mortgage market or the like.

Student: Shouldn’t the last B be a P?

Professor Robert Shiller: Yes, that’s right. I can’t write always on the blackboard. Thank you. Bureau of Consumer Financial Protection. Elizabeth Warren pointed out, and I said this before, that there’s a lot of abusive tactics. Now, other regulators weren’t so focused on protecting, say, mortgage borrowers or credit card borrowers. They were more focused on disclosure and other issues. So, the idea in Dodd-Frank is, let’s create an agency whose express purpose is protecting the consumer. The idea is, that you have to have an agency focused on each problem, and this is a problem that hasn’t been dealt with well.

I wanted to move to in Europe, because Europe has had similar legislation, also in 2010. So, we have the European–OK, I’ll write it out–European Supervisory Framework. And that’s also in 2010. And it consists of a number of things. One, the European Systemic Risk Board, which will be in Frankfurt, well, which is. I think they’re just getting started. European Systemic Risk Board is the European counterpart to FSOC. All these things are brand new, and so we don’t know too much about how they’re going to function yet. But it’s supposed to worry about ”too big to fail,” and about systems. It’s about systems. How the whole European economy could collapse if something goes wrong in the future. Then there’s the European Banking Authority. These are big steps for Europe, because regulation was more done by the individual countries. And the European Banking Authority is in London, and it will impose Europe-wide banking regulations.

And then, we have ESMA, the European Securities Market Authority. And that’s in Paris. And then there is the European Insurance and Occupational Pension Authority, and that’s in Frankfurt. They spread things out across Europe. They don’t want to centralize things. I don’t know why Frankfurt got two of them, but somehow that worked.

Finally, I want to do international. If I could just have five more minutes of your time. International regulation is a problem, because people can leave the country that they’re in and, you know, it’s called offshore. If you don’t like the regulations in the United States, there’s always the Bahamas, or there’s the Cayman Islands, and you can set up your financial organization with the regulator that you please. That’s why it’s important for international cooperation and regulation, so that all the financial activity doesn’t migrate to the cheapest place, cheapest in terms of regulatory cost.

But I just wanted to give you a few more institutions that are important. One is the Bank for International Settlements. That’s in Basel. This is the oldest of my regulators. 1930. Actually, when we get on the international front, they don’t really have authority anymore. They can’t impose on anyone, but they can suggest things. So, the BIS is a bank that has as members heads of–I think it’s 57 central banks. [correct] And they meet regularly in Basel to discuss monetary policy. So, what comes out of these meetings is suggestions about how to run a central bank. And it has real impact, even though it doesn’t have the force of law. Then, I wanted to mention the Basel Committee, also in the same city. You notice these are in Switzerland. That’s because by longstanding it’s been a neutral country, and has such a long tradition of neutrality, so it seems to be the place to set up a lot of international organizations. This was created in 1974, and it issues suggested bank regulation. Basel I was in 1988. That was their first set of recommendations. Basel II was in, sorry, in 2004. And obviously Basel II wasn’t successful, because we had a huge banking crisis. So we’ve had Basel III. I’ll come back to these. Well, it’s been going on for years. It was finally approved, Basel III, in 2010.

Then, I wanted to talk about the G-6. And going back to the 1970’s, the finance ministers in six major countries met together. The countries were France, Germany, Italy, Japan, United States, U.K. In 1976, they added Canada, and it became the G-7 countries. So, that’s Canada, France, Germany, Italy, U.S., U.K. Who am I missing? Japan. So, these seemed to be the most financially prominent countries at the time, and their finance ministers got together and thought about, what the countries should do, and it coordinated financial regulations somewhat. This expanded notably–I’m just about done now–in 2008. The world is changing, and there was resentment that these countries represent overwhelmingly Europe and the U.S., or the North America. We created the G-20 countries in 2008. And I don’t have the whole list, but it notably adds China and India, and adds other developing countries. It now represents most of the world. Again, it’s the finance ministers. Typically, what happens now is the finance ministers will meet, and after that the heads of state will meet. And it’s involved in financial regulation.

The current president of the G-20 is Nicolas Sarkozy from France [addition: in the year 2011], and he intends to make it a stronger organization. He has proposed that they have a permanent secretariat. The G-20 has created something called the FSB, the Financial Stability Board. And guess where it is. It’s in Basel again. Any of these things that are really–if it’s European Union, they’ll scatter it around the EU, but if it’s really international, it seems to go to Switzerland. Basel is a sleepy little town if you visit it, but somehow it’s the center for the world finance. So, the Financial Stability Board is making recommendations for regulatory procedures for the whole world. And they report to the G-20, and then the G-20, they’ve already agreed, to take FSB seriously.

So, what I’m seeing here as developing is, the financial regulation is becoming more and more large scale. And it’s something that covers the whole world. And it’s very important, because we’ve just seen a worldwide financial crisis, and it has to be dealt with by worldwide–I think, this is an inspiring moment for financial regulation. The G-20 seems to be an effective body that is promoting good financial regulation. At this point, this is a good time in history, where there’s a lot of cooperation. And if it continues, and we see this develop further, it will make for more successful world economy.

[end of transcript]

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