WEBVTT 00:00.080 --> 00:00.550 PROFESSOR ROBERT SHILLER: OK. 00:00.550 --> 00:06.390 So, today we're going to talk about banks, banking. 00:06.390 --> 00:11.530 Before I start, I want just to remind you that we have Hank 00:11.530 --> 00:15.600 Greenberg coming on Wednesday [addition: next lecture]. 00:15.600 --> 00:19.300 And we talked about him in a previous lecture, but he is 00:19.299 --> 00:22.759 one of the most important capitalists, I 00:22.760 --> 00:24.430 think, in the world. 00:27.450 --> 00:32.430 The firm, AIG, which was started by C.V. Starr, was 00:32.430 --> 00:35.250 converted into the biggest insurance company in the world 00:35.250 --> 00:38.050 by Hank Greenberg. 00:38.050 --> 00:42.330 Over many years, the two of them ran AIG exclusively, 00:42.330 --> 00:45.270 first Starr and then Greenberg. 00:45.270 --> 00:55.510 And Greenberg produced a very innovative insurance giant. 00:55.510 --> 00:58.590 It didn't end well, but I think he -- 00:58.590 --> 00:59.910 I talked to him the other day. 00:59.910 --> 01:03.940 He said he's going to talk about the end, what he learned 01:03.940 --> 01:07.190 from the experience. 01:07.190 --> 01:12.510 Once again, no one can control everything that happens. 01:12.510 --> 01:18.530 And random shocks affect all of our lives. 01:18.530 --> 01:22.170 He remains a very important -- 01:22.170 --> 01:24.220 he's no longer at AIG -- 01:24.220 --> 01:26.540 remains a very important force in our society. 01:26.535 --> 01:32.725 Now, he's very much involved with philanthropy and doing 01:32.730 --> 01:37.780 things like lecturing young people, what he freely does 01:37.780 --> 01:40.470 out of a sense of commitment. 01:40.470 --> 01:43.180 So, I think he's a committed person that has a moral 01:43.180 --> 01:48.160 purpose, that's why I asked him to 01:48.160 --> 01:49.410 be one of our lecturers. 01:53.630 --> 01:56.300 But today we're talking about banks. 01:56.300 --> 01:58.370 And I wanted to -- 01:58.370 --> 02:01.520 The outline my lecture: I'm going to start with the 02:01.520 --> 02:05.700 origins of banks, thousands of years ago. 02:05.695 --> 02:11.035 Then, I'll talk about the theory of banks, fractional 02:11.040 --> 02:13.970 reserves and deposit insurance. 02:13.970 --> 02:17.630 Then, bank regulation, particularly in light of the 02:17.630 --> 02:21.660 world financial crisis, which has changed the nature of 02:21.660 --> 02:22.360 regulation. 02:22.360 --> 02:26.250 Changes that will be with us for decades to come. 02:26.250 --> 02:30.030 I'll talk about shadow banking, which is the new 02:30.030 --> 02:35.150 banking sector that emerged and escaped regulation until 02:35.150 --> 02:36.490 the crisis. 02:36.490 --> 02:39.540 And then, I'll talk at the end a little bit about a 02:39.540 --> 02:45.710 comparison of financial crises in the past in various places 02:45.710 --> 02:52.220 around the world, to see how banks managed in those crises. 02:52.220 --> 02:55.800 So, the first thing I want to say is, this is a lecture 02:55.800 --> 03:02.500 about banks, OK, and that means traditional banks who 03:02.500 --> 03:05.530 take deposits and lend money. 03:05.530 --> 03:07.520 It's not about investment banks. 03:07.520 --> 03:08.970 That's another lecture. 03:08.970 --> 03:13.480 An investment bank, a pure investment bank, does not 03:13.480 --> 03:15.330 accept deposits. 03:15.330 --> 03:18.610 And its most characteristic thing is underwriting of 03:18.610 --> 03:19.950 securities. 03:19.950 --> 03:21.960 So, that's a different lecture. 03:21.960 --> 03:25.690 And I'm not talking about central banks in this lecture. 03:25.690 --> 03:26.890 That's also -- 03:26.890 --> 03:28.870 well, the lecture on monetary policy. 03:28.870 --> 03:33.420 Central banks are the government organizations that 03:33.420 --> 03:37.510 manage the money supply of a country. 03:42.770 --> 03:48.720 So, we're talking here about banks, and I thought I should 03:48.720 --> 03:51.190 start out by defining a bank. 03:56.660 --> 03:59.630 The word bank, by the way, means counter or tabletop 03:59.630 --> 04:02.560 where bankers used to do their business. 04:02.560 --> 04:08.770 That's the English word that emerged in the 15th century. 04:08.769 --> 04:13.559 But banks, of course, precede that with other names. 04:13.560 --> 04:14.840 What is it that is the 04:14.840 --> 04:17.670 characteristic activity of banks? 04:20.320 --> 04:25.120 I would say, maybe the most characteristic thing is that 04:25.120 --> 04:27.140 banks earn spread income. 04:29.990 --> 04:34.050 That is, they borrow at a lower interest rate, and lend 04:34.050 --> 04:36.370 it out at a higher interest rate, and they make the 04:36.370 --> 04:37.250 difference. 04:37.250 --> 04:41.910 Your deposit rate is lower than the rate at which they 04:41.910 --> 04:43.560 charge for the loans they make. 04:43.555 --> 04:48.435 So that's the spread income or margin. 04:48.440 --> 04:54.640 So, that might be considered the core idea of a bank, that 04:54.640 --> 04:57.760 you borrow at a lower rate than you lend. 04:57.760 --> 05:00.090 But I'm not sure that that summarizes it, either. 05:00.090 --> 05:05.060 There's other aspects of banks that we'll talk about. 05:05.060 --> 05:11.370 Another aspect of banks, traditionally, 05:11.370 --> 05:14.340 has been note issue. 05:17.030 --> 05:21.810 That is, they print paper money, and then it circulates 05:21.810 --> 05:24.050 and goes -- 05:24.050 --> 05:26.910 you have some of these in your pocket. 05:26.910 --> 05:29.640 They're currency. 05:29.640 --> 05:32.920 If you stopped a person on the street a couple hundred years 05:32.920 --> 05:36.620 ago, and said, what is the essence of a bank? 05:36.620 --> 05:39.800 I suspect, the first thing they would say is, oh, they 05:39.800 --> 05:41.430 print money. 05:41.430 --> 05:43.510 And that's the paper money that we use. 05:43.510 --> 05:46.350 But you don't think of it this way. 05:46.350 --> 05:51.000 Probably not, because most of that function all over the 05:51.000 --> 05:54.670 world has been shifted to the government banks, the central 05:54.670 --> 05:59.300 banks, in the various countries. 05:59.300 --> 06:03.210 And so, you don't think of private banks as 06:03.210 --> 06:05.810 issuing bank notes. 06:05.810 --> 06:09.310 But they used to and it used to be prominent. 06:09.310 --> 06:14.780 The private bank issuing of notes today in the world, I 06:14.780 --> 06:20.020 believe, is concentrated primarily in two countries. 06:20.020 --> 06:23.120 One of them is the United Kingdom, and the 06:23.120 --> 06:26.090 other one is Hong Kong. 06:26.090 --> 06:27.420 Tell me if there's another country. 06:27.420 --> 06:29.420 I don't know who else does it. 06:29.420 --> 06:32.810 In the United Kingdom there are eight banks that still 06:32.810 --> 06:35.090 print pound sterling notes. 06:37.920 --> 06:39.960 And they're not very prominent. 06:39.960 --> 06:46.650 In Scotland, there are some. 06:46.650 --> 06:49.440 I actually once went through the Chunnel from England to 06:49.440 --> 06:51.620 Scotland, oh, from Scotland to France [correction: from 06:51.620 --> 06:54.260 England to France], and I tried to spend my Scottish 06:54.260 --> 06:57.900 sterling notes on the train, and the guy, who was 06:57.900 --> 07:01.230 French-speaking, stared at it and said, what's this? 07:01.230 --> 07:02.460 And he wouldn't take it. 07:02.460 --> 07:04.890 So I said, this is pound sterling. 07:04.890 --> 07:07.930 This is official. 07:07.930 --> 07:13.250 It trades at par with the Bank of England notes. 07:13.250 --> 07:18.380 Hong Kong has three banks that issue their bank notes. 07:21.260 --> 07:23.030 Let's see, Hong Kong Shanghai Bank [correction: Banking] 07:23.030 --> 07:25.960 Corporation, the Standard Chartered Bank, and the Bank 07:25.960 --> 07:29.290 of China, Hong Kong. 07:29.290 --> 07:31.720 Everywhere else, banks don't issue notes. 07:31.720 --> 07:35.560 And the reason they don't is, laws have been made to prevent 07:35.560 --> 07:39.820 them, because these notes lost value so many times in 07:39.820 --> 07:42.790 financial crises that governments said, it's not 07:42.790 --> 07:46.130 something that we'll allow private banks to do. 07:46.130 --> 07:49.260 So, it's generally gone. 07:49.260 --> 07:53.350 If you look at your $1 bills in your pocket, it will give 07:53.350 --> 07:55.880 the name of a Federal Reserve bank. 07:55.880 --> 07:57.580 And there's 12 of them. 07:57.580 --> 08:00.010 Our Federal Reserve bank here is the Federal 08:00.010 --> 08:01.390 Reserve Bank of Boston. 08:01.390 --> 08:04.340 So, you can look at your dollar bills and see which 08:04.340 --> 08:06.220 bank issued it. 08:06.220 --> 08:10.130 So, you're probably carrying a lot of Boston money, but since 08:10.130 --> 08:12.540 it's all the government, you know, you don't even notice 08:12.540 --> 08:12.990 that, right? 08:12.990 --> 08:14.680 You don't notice. 08:14.680 --> 08:18.210 If this were 1750, and you had Boston money in your pocket, 08:18.210 --> 08:19.850 you might -- because we're in Connecticut -- 08:19.850 --> 08:20.930 you might have a problem. 08:20.929 --> 08:23.389 You'd have to go to a money dealer and have it exchanged, 08:23.390 --> 08:26.840 because they didn't know or trust the Boston bank. 08:26.840 --> 08:32.450 That's all past. So, note issue is a matter of history. 08:32.450 --> 08:38.560 So, there's other aspects of a bank I want to emphasize. 08:38.560 --> 08:41.060 One is liquidity. 08:46.270 --> 08:48.770 And this is an essential element of banking as well, 08:48.770 --> 08:50.740 and I'll come back to that when we talk 08:50.740 --> 08:52.590 about theory in a minute. 08:52.590 --> 08:58.410 But banks offer liquidity by borrowing 08:58.410 --> 09:01.330 short and lending long. 09:01.330 --> 09:03.690 This is different from spread income. 09:03.690 --> 09:06.660 I'm saying, the interest rate is lower on the borrowing of 09:06.660 --> 09:09.640 the bank than the lending of the bank. 09:09.640 --> 09:11.020 There's another discrepancy. 09:11.020 --> 09:15.500 The maturity is longer on the lending of the bank than the 09:15.500 --> 09:17.120 borrowing of the bank. 09:17.120 --> 09:19.020 So, banks are providers of liquidity. 09:19.020 --> 09:22.530 That means, a business wants to borrow money, or let's say 09:22.530 --> 09:25.850 a homeowner wants to borrow money to buy a home. 09:25.850 --> 09:27.030 Let's take that example. 09:27.030 --> 09:28.430 That's more familiar. 09:28.430 --> 09:30.920 You're going to lock up the money for maybe 30 years. 09:30.920 --> 09:33.710 You don't want to pay the loan back tomorrow. 09:33.710 --> 09:36.810 What if the lender says, I need the money, give it back. 09:36.810 --> 09:39.470 You can't give it back, or you don't want to give it back. 09:39.470 --> 09:44.420 So, what a bank does is, it takes deposits and allows 09:44.420 --> 09:49.620 people to cash them in whenever they want. 09:49.620 --> 09:54.720 It lends the money out long on 30-year, or so, loans. 09:54.720 --> 09:56.240 So, it generates liquidity. 09:56.240 --> 09:58.750 The borrower has what he or she wants, which 09:58.750 --> 10:01.300 is a 30-year loan. 10:01.300 --> 10:03.710 The lender has what they want. 10:03.710 --> 10:12.620 They have an account they can get at any time. 10:12.620 --> 10:15.940 And so this is an important function of banks. 10:15.940 --> 10:19.510 But the problem with it is, that there's 10:19.510 --> 10:20.760 a problem of crises. 10:23.140 --> 10:26.700 Because if everybody asks to pull their money out at once, 10:26.700 --> 10:28.890 they can't do it. 10:28.890 --> 10:32.390 The banks, in normal circumstances, generate 10:32.390 --> 10:36.280 liquidity, but they create a system that's vulnerable. 10:36.280 --> 10:42.910 And so, the banking industry has been plagued by frequent 10:42.910 --> 10:45.920 crises throughout history. 10:45.920 --> 10:49.210 So, I wanted to say something about the very 10:49.210 --> 10:50.690 beginnings of banking. 10:50.690 --> 10:51.940 Who did it first? -- 10:54.850 --> 10:55.820 By the way, I should have written the 10:55.820 --> 10:57.590 words interest rate. 10:57.586 --> 11:00.606 When I'm talking about spread income or margin, I'm talking 11:00.610 --> 11:03.450 about the difference between two interest rates. 11:03.450 --> 11:09.740 But more primitive is the idea of interest rate. 11:09.740 --> 11:12.790 So, where did that idea come from? 11:12.790 --> 11:18.130 Well, I was reading some economic historians. 11:18.130 --> 11:21.920 Apparently, the word interest first appeared in 11:21.920 --> 11:23.350 the Sumerian language. 11:27.300 --> 11:31.490 I guess, the oldest records are about 2000 BC. 11:31.490 --> 11:36.140 And they had a word which they write as mas. 11:36.140 --> 11:39.440 I guess, that's pronounced mosh, which was their word for 11:39.440 --> 11:41.960 interest, but it also means lamb. 11:41.960 --> 11:45.070 And so, one historian was wondering, why do the 11:45.070 --> 11:50.370 Sumerians use the same word for interest as they do for an 11:50.370 --> 11:51.600 animal, a lamb. 11:51.600 --> 11:56.860 And he thought that maybe it was because the idea of 11:56.860 --> 12:01.390 lending money at interest grew out of an earlier idea of 12:01.390 --> 12:02.910 renting land. 12:02.910 --> 12:06.360 So, you would have land that you weren't using in ancient 12:06.360 --> 12:10.650 Sumeria, and you would rent it out to somebody who 12:10.650 --> 12:12.140 would then use it. 12:12.140 --> 12:14.230 And one of the things that the person would do with it, is 12:14.230 --> 12:17.980 raise livestock, raise sheep, on the land. 12:17.980 --> 12:20.760 So, you would say, well, I need some produce from the 12:20.760 --> 12:24.480 land to compensate me for letting you use it. 12:24.480 --> 12:26.270 So the guy would say, fine, I'll give you all the 12:26.270 --> 12:29.080 offspring of our sheep, the lambs. 12:29.080 --> 12:31.490 That was an old tradition in Sumeria. 12:31.490 --> 12:33.960 So, they thought it's basically the same thing. 12:33.960 --> 12:35.710 It's like giving over the lambs. 12:35.710 --> 12:37.900 If I lend you money, I'm giving you productive 12:37.900 --> 12:40.020 resources, and it's going to produce something. 12:40.020 --> 12:41.550 We'll call it lambs. 12:41.550 --> 12:42.500 And I want that. 12:42.495 --> 12:44.625 And you're compensating me for it. 12:44.630 --> 12:46.680 So, that's where the idea began. 12:49.680 --> 12:55.990 And so, you'll find it in the ancient world, in the near, 12:55.990 --> 12:58.630 non-oriental ancient world. 12:58.630 --> 13:01.960 In ancient Greece and Rome, interest was well-established. 13:01.960 --> 13:03.710 And some kind of banking. 13:03.710 --> 13:07.230 Now, I don't know whether there were bankers in Sumeria, 13:07.230 --> 13:10.410 but there probably were, because all it takes is that 13:10.410 --> 13:11.660 you do both sides. 13:13.760 --> 13:15.560 They actually didn't necessarily lend money in 13:15.560 --> 13:16.380 those days. 13:16.380 --> 13:20.260 They would lend barley or wheat, and they would charge 13:20.260 --> 13:23.100 interest in terms of wheat. 13:23.100 --> 13:24.950 You don't need money to do banking. 13:28.240 --> 13:32.570 But I suspect that somebody in ancient Sumeria 13:32.570 --> 13:33.700 was doing both sides. 13:33.700 --> 13:36.970 He was borrowing wheat, and lending it, and earning a 13:36.970 --> 13:37.740 spread income. 13:37.735 --> 13:44.405 And so, there must have been banking in the ancient world. 13:44.410 --> 13:47.680 But anyway, what about these kinds of institutions that we 13:47.680 --> 13:48.350 call banks? 13:48.350 --> 13:51.900 Oh also, the first -- apparently, if I've got my 13:51.900 --> 13:57.140 history right, the first record of interest rates in 13:57.140 --> 13:58.740 China was Song Dynasty. 14:02.540 --> 14:07.930 And that was from the year 960 to 1279. 14:07.930 --> 14:10.810 They were, at that point, inventing paper money and 14:10.810 --> 14:14.240 other financial institutions. 14:14.240 --> 14:16.410 I don't know if they had institutions called banks. 14:16.410 --> 14:19.630 But, you know, it often would be a family 14:19.630 --> 14:22.910 business lending money. 14:22.910 --> 14:26.510 If you were a prominent family, you would often take 14:26.510 --> 14:31.210 other people's money for safekeeping. 14:31.210 --> 14:37.370 And it was also connected with religious temples in the past. 14:37.370 --> 14:43.860 But the modern banks seem to appear in Italy in Renaissance 14:43.860 --> 14:49.780 times, where they actually had a banking institution. 14:49.780 --> 14:51.850 And that's where the oldest bank in 14:51.850 --> 14:55.360 the world today exists. 14:55.360 --> 15:11.720 It's Banca Monte dei Paschi, in Siena. 15:11.720 --> 15:16.030 And that means the bank of the mountain of sheep. 15:16.030 --> 15:19.070 It's the same analogy, I guess. 15:19.070 --> 15:21.720 I don't know if they called their interest lambs. 15:21.720 --> 15:28.520 And so, that bank was set up in 1472. 15:28.520 --> 15:31.120 That's the oldest surviving bank in the world. 15:31.120 --> 15:31.660 I went there. 15:31.660 --> 15:33.840 You can go there if you visit Siena, and they have a little 15:33.840 --> 15:37.570 museum on the first floor near the lobby. 15:37.570 --> 15:41.290 And it's actually the third largest bank in Italy. 15:41.290 --> 15:44.450 A very old institution. 15:44.450 --> 15:48.160 It's interesting that this bank, which was founded in 15:48.160 --> 15:53.580 1472, was founded as a philanthropic institution to 15:53.580 --> 15:55.760 lend money to the poor. 15:55.760 --> 15:59.030 And wealthy donors in Italy gave money 15:59.030 --> 16:00.360 to set up this bank. 16:00.360 --> 16:01.560 It goes beyond that now. 16:01.560 --> 16:04.270 It's not just lending to the poor. 16:04.272 --> 16:09.872 The other thing is in the 1600's, they 16:09.870 --> 16:11.560 gave it deposit insurance. 16:11.560 --> 16:13.840 Believe it or not. 16:13.840 --> 16:19.680 The Duke of Siena said he would guarantee all deposits. 16:19.680 --> 16:22.420 So, deposit insurance appears to have been 16:22.420 --> 16:23.980 invented in Italy as well. 16:26.640 --> 16:29.240 But a lot of people emphasize, when they talk about the 16:29.240 --> 16:32.570 history of banking -- 16:32.570 --> 16:39.020 I was reading, in preparing for this, economic histories 16:39.015 --> 16:41.605 to see what they would say about banking. 16:41.610 --> 16:46.950 And professor Clive Day, a professor here at Yale, wrote 16:46.950 --> 16:54.740 a book called, History of Commerce, in 1907. 16:54.740 --> 16:57.380 You can pick up his book, if you want to, on Google Books. 16:57.380 --> 16:59.560 It's past its copyright. 16:59.560 --> 17:02.040 I had great fun reading it. 17:02.040 --> 17:05.860 He's long gone, a professor at Yale. 17:05.859 --> 17:08.989 But his history begins in England, with the so-called 17:08.990 --> 17:10.240 goldsmith bankers. 17:14.780 --> 17:21.390 What happened was, in England in the maybe 1500's or 1600's, 17:21.390 --> 17:24.060 somewhere around that, goldsmiths who made gold 17:24.060 --> 17:28.460 jewelry had safes or good places to store gold. 17:28.460 --> 17:31.930 And so, people would go to the goldsmith, and maybe they're 17:31.930 --> 17:34.730 having jewelry made, but then they'd say, could you keep 17:34.730 --> 17:37.360 some of my gold in your vault? 17:37.360 --> 17:39.130 And so, the goldsmith banker would say, all 17:39.125 --> 17:40.595 right, I'll do that. 17:40.600 --> 17:44.390 And I'll give you a note saying, I'll promise to pay 17:44.390 --> 17:47.580 you this amount of gold that's in my vault. 17:47.580 --> 17:49.980 So, sometime when you were out shopping, the goldsmith 17:49.980 --> 17:53.710 banker's note would be in your pocket still, and you'd want 17:53.705 --> 17:55.125 to buy something. 17:55.130 --> 17:56.650 So you'd say, well, I've got this -- 17:56.650 --> 17:58.920 you talk to the merchant and you say, I've got this gold. 17:58.920 --> 18:00.160 It's in the goldsmith. 18:00.160 --> 18:01.840 I've got his note here. 18:01.840 --> 18:05.690 So the merchant would say, all right, I'll take that, but 18:05.690 --> 18:07.130 you've got to endorse it over to me. 18:07.130 --> 18:11.840 Write a note on the note saying that this thing is 18:11.840 --> 18:13.850 being transferred to me. 18:13.850 --> 18:16.180 And so, I can go to the goldsmith and get it out. 18:16.180 --> 18:19.680 That's how paper money got started in England. 18:19.680 --> 18:22.710 It started to circulate with many endorsements on it. 18:22.710 --> 18:25.140 And then finally, the goldsmith said, let's forget 18:25.140 --> 18:27.240 about endorsing it to one person. 18:27.240 --> 18:29.460 Let's just say, to the bearer. 18:29.460 --> 18:31.720 And so, paper money started developing kind of 18:31.720 --> 18:33.130 spontaneously. 18:33.130 --> 18:35.710 And then, the goldsmiths noticed, you know, they've got 18:35.710 --> 18:38.640 all this gold in their vault, they can lend it out. 18:38.640 --> 18:39.220 Why not? 18:39.220 --> 18:41.450 Because nobody ever comes and asks for it, now that these 18:41.450 --> 18:44.570 paper notes are circulating. 18:44.570 --> 18:47.950 Nobody asks for it, so I'll start lending it out. 18:47.950 --> 18:50.230 And they didn't have to pay any interest on the notes, 18:50.230 --> 18:53.330 because people would hold them anyway just because they 18:53.330 --> 18:54.530 valued the safekeeping. 18:54.530 --> 18:56.360 I guess they were paying interest in the sense that 18:56.360 --> 18:58.760 they were providing the safekeeping. 18:58.760 --> 19:02.520 So, that's how banking got started in England, but it was 19:02.520 --> 19:04.400 really preceded in Italy. 19:16.540 --> 19:23.960 What has happened is, because of repeated problems in the 19:23.960 --> 19:26.490 banking industry, which gradually grew through time 19:26.490 --> 19:29.520 into something that's more and more important, governments 19:29.520 --> 19:32.110 all over the world regulate them. 19:32.110 --> 19:35.540 And that means they define certain specific types of 19:35.540 --> 19:42.890 banks that differ a little bit from one country to another. 19:42.890 --> 19:43.950 And you have to -- 19:43.950 --> 19:46.780 when you decide to create a bank -- 19:46.780 --> 19:51.240 you have to decide which type you are. 19:51.240 --> 19:52.490 So, I wanted to start -- 19:52.490 --> 19:55.750 And in your textbook, Fabozzi et al., talks a lot about 19:55.750 --> 19:58.240 types of banks. 19:58.240 --> 20:04.150 But let me just talk about the major types. 20:04.150 --> 20:09.080 I'll talk in the U.S. The most important type of bank is 20:09.080 --> 20:11.530 called a commercial bank. 20:14.490 --> 20:17.550 And these are banks that take deposits. 20:17.550 --> 20:19.990 You can put your money in the bank, and then it will pay you 20:19.986 --> 20:25.786 interest, and it will also make loans of various kinds. 20:25.790 --> 20:30.970 But, most characteristically, business loans. 20:30.970 --> 20:35.550 Commercial banks were even more prominent 100 or 200 20:35.550 --> 20:37.530 years ago, because they didn't do mortgages 20:37.530 --> 20:38.780 and consumer loans. 20:38.780 --> 20:41.500 It was all business loans, initially. 20:41.500 --> 20:42.950 So, this is kind of the historic 20:42.950 --> 20:45.860 important kind of bank. 20:45.860 --> 20:57.280 And in 2010, the total assets of U.S.-located, commercial 20:57.280 --> 21:00.690 banks were $14.6 trillion. 21:00.690 --> 21:05.170 But actually, a lot of that was foreign commercial banks 21:05.170 --> 21:07.190 operating in the United States. 21:07.190 --> 21:17.030 Of that $14.6 trillion, only 10.1 was U.S.-chartered banks. 21:17.030 --> 21:19.520 So, bankers operate all over the world. 21:19.520 --> 21:22.120 So, we have banks like, I mentioned Hong Kong and 21:22.120 --> 21:22.970 Shanghai Bank [correction: Banking] 21:22.970 --> 21:26.250 Corporation, or the various Swiss banks that have big 21:26.250 --> 21:28.700 operations, or Deutsche Bank, big operations 21:28.695 --> 21:29.805 in the United States. 21:29.810 --> 21:36.620 So, they account for almost a third of our commercial banks. 21:36.620 --> 21:38.410 But then, there are other kinds of banks, and they're 21:38.410 --> 21:43.830 smaller in terms of -- this is assets of the banks. 21:43.830 --> 21:45.420 It's not their market cap. 21:45.415 --> 21:48.335 The market cap would be much lower, because remember 21:48.340 --> 21:51.590 offsetting these assets are liabilities they owe to the 21:51.590 --> 21:52.840 depositors. 21:56.050 --> 21:57.960 But there's other kinds of banks. 21:57.960 --> 22:00.140 There are savings banks. 22:05.530 --> 22:13.740 In the U.S., savings banks had only $1.2 trillion. 22:19.530 --> 22:27.260 These savings banks tend to be old institutions that have 22:27.260 --> 22:29.290 grown very large over time. 22:29.290 --> 22:31.720 They're the result of a savings bank movement in the 22:31.720 --> 22:34.970 19th century, which was a philanthropic movement to set 22:34.970 --> 22:39.050 up banks for lower-income people. 22:39.050 --> 22:41.350 Because commercial banks traditionally wouldn't take 22:41.350 --> 22:43.220 deposits from small -- 22:43.220 --> 22:44.830 you'd have to have a minimum size. 22:44.830 --> 22:48.950 They didn't deal with ordinary people. 22:48.950 --> 22:50.670 So, they created savings banks to 22:50.670 --> 22:54.870 encourage thrift and saving. 22:54.870 --> 22:57.610 Actually, it follows on a U.K. movement, a savings bank 22:57.610 --> 22:59.830 movement in the U.K. And they're still with us, but 22:59.830 --> 23:02.150 they're not so big. 23:02.145 --> 23:05.935 And there's also credit unions. 23:05.940 --> 23:08.470 That's another social movement. 23:08.470 --> 23:15.250 And they're only $0.9 trillion, or about $900 23:15.250 --> 23:17.190 billion in assets. 23:17.190 --> 23:21.300 Credit unions are basically clubs of people that belong 23:21.300 --> 23:24.210 together in some group. 23:24.210 --> 23:26.680 If you have a company, you can set up a credit union for the 23:26.680 --> 23:27.930 employees of your company. 23:32.810 --> 23:34.800 Both savings banks and credit unions make a 23:34.800 --> 23:36.150 lot of mortgage loans. 23:36.150 --> 23:42.100 That's kind of their characteristic business. 23:42.100 --> 23:46.250 In the U.K., you have the same kinds of banks. 23:46.250 --> 23:51.450 Savings banks would be called building societies, but it's 23:51.450 --> 23:52.630 the same idea. 23:52.630 --> 23:54.460 They make loans for building. 24:00.490 --> 24:07.300 So, I said I would talk about the theory of banks. 24:07.300 --> 24:10.410 I've already given you some indication by describing what 24:10.410 --> 24:12.690 is it that banks do. 24:12.690 --> 24:17.590 But I see I have a lot more to talk about. 24:17.590 --> 24:21.310 I have to consider my time here. 24:21.310 --> 24:22.730 There's so much to say about banks. 24:22.730 --> 24:25.500 It's a whole fascinating subject. 24:25.500 --> 24:32.760 But I wanted to mention, the theory of banks was laid out 24:32.763 --> 24:41.973 in the Diamond-Dybvig model in the Journal of Political 24:41.967 --> 24:44.807 Economy, 1988. 24:44.810 --> 24:46.920 They were both colleagues of ours at Yale. 24:46.920 --> 24:48.630 They've moved on. 24:48.630 --> 24:49.970 So, I know them both. 24:49.970 --> 24:52.390 Doug Diamond and Phil Dybvig. 24:52.390 --> 24:54.840 But what they described is a model -- 24:54.840 --> 24:56.490 I'm not going to give you the model, just to tell you about 24:56.490 --> 24:59.280 it -- the theoretical model of banks as 24:59.280 --> 25:03.050 providers of liquidity. 25:03.050 --> 25:06.690 That liquidity is an economic good that you can somehow get 25:06.690 --> 25:08.590 for nothing. 25:08.590 --> 25:11.850 It's just like portfolio diversification. 25:11.850 --> 25:14.800 We don't need to expend any resources to get 25:14.800 --> 25:16.990 diversification, we just have to manage 25:16.985 --> 25:18.705 our portfolios right. 25:18.710 --> 25:20.570 Similarly, you set up a bank, and lo and 25:20.570 --> 25:22.900 behold, liquidity appears. 25:22.900 --> 25:24.550 And it makes it possible for people to 25:24.550 --> 25:26.140 live their lives better. 25:26.140 --> 25:29.080 I mentioned that you can live in a house for 30 years, or 25:29.080 --> 25:30.520 you can move whenever you want. 25:33.020 --> 25:35.890 But the problem with this is that there are multiple 25:35.890 --> 25:37.850 equilibria. 25:37.850 --> 25:42.390 Their model has a good equilibrium and a bad 25:42.390 --> 25:45.290 equilibrium, and it depends on expectations. 25:45.290 --> 25:49.390 If people think that the banking system is sound and 25:49.390 --> 25:52.220 it's going to work well, it works splendidly. 25:52.220 --> 25:55.590 But the problem is, all it takes is for people to 25:55.590 --> 25:58.670 suddenly change their expectations, and then it all 25:58.670 --> 26:00.890 falls apart because you have a run. 26:00.890 --> 26:02.140 You have a bank run. 26:04.900 --> 26:09.210 So, what Diamond and Dybvig did is to provide an economic 26:09.210 --> 26:13.460 rationale for deposit insurance. 26:13.460 --> 26:20.330 Insuring deposits against default of the bank helps 26:20.330 --> 26:25.240 prevent bad outcomes, keeps us in the right equilibrium. 26:25.240 --> 26:31.060 So, this is an important paper. 26:31.062 --> 26:37.852 The problem is that banks runs can be triggered by random 26:37.850 --> 26:40.140 shocks to the model. 26:40.140 --> 26:44.510 And so, what happened in the latest crisis is, there was a 26:44.510 --> 26:46.310 real estate bubble. 26:46.310 --> 26:47.700 It's not something that's represented 26:47.700 --> 26:51.110 in Diamond and Dybvig. 26:51.110 --> 26:55.180 And the bubble, when it burst, when home prices started 26:55.180 --> 26:58.880 falling, and commercial real estate prices started falling, 26:58.880 --> 27:04.180 the banking system started to fall apart. 27:04.180 --> 27:11.530 So, it's not entirely easy to keep banks under good control. 27:16.980 --> 27:21.110 You see, Diamond and Dybvig emphasized that banks are an 27:21.110 --> 27:24.340 invention that creates liquidity. 27:24.340 --> 27:28.330 And liquidity is a positive economic good that makes us 27:28.330 --> 27:29.430 run our lives better. 27:29.430 --> 27:31.720 So, it's an important invention in 27:31.720 --> 27:34.550 the history of economics. 27:34.550 --> 27:38.290 But there's other issues that banks do, problems they solve. 27:38.290 --> 27:46.920 One of them is an adverse selection problem that plagues 27:46.920 --> 27:48.170 securities. 27:51.250 --> 27:54.690 I didn't mention that the alternative to banks for 27:54.690 --> 27:58.710 raising money, if you're a business, is, that you could 27:58.710 --> 28:01.370 issue bonds or commercial paper. 28:01.370 --> 28:05.310 You can borrow money directly from the public without an 28:05.310 --> 28:08.020 intermediary. 28:08.020 --> 28:09.560 They do this. 28:09.560 --> 28:10.730 I'm a company. 28:10.730 --> 28:13.600 I need money to, say, build a new factory. 28:13.600 --> 28:15.480 I go not to a commercial bank. 28:15.480 --> 28:18.650 I go to an investment bank, and they help me issue some 28:18.650 --> 28:21.520 paper to the public. 28:21.520 --> 28:24.180 And we sell it off in some market. 28:24.180 --> 28:30.370 The problem with issuing debt directly to the public is, 28:30.370 --> 28:35.880 that the public can't judge the quality 28:35.880 --> 28:38.410 of the company easily. 28:38.410 --> 28:42.780 Most people who are investors are not good at estimating the 28:42.780 --> 28:45.720 value or the security of a company. 28:45.720 --> 28:48.510 So, they need some kind of experts. 28:48.510 --> 28:51.870 If the adverse selection would happen, see, the experts, the 28:51.870 --> 28:55.400 people who know, would buy all the good stuff, and it would 28:55.400 --> 28:57.500 leave beyond -- 28:57.500 --> 28:59.600 people would start to think, I'm not going to buy these 28:59.600 --> 29:03.190 securities, because why are they being offered to me? 29:03.190 --> 29:04.100 I don't know anything. 29:04.100 --> 29:05.530 I'm a sucker. 29:05.530 --> 29:06.700 That's the idea. 29:06.700 --> 29:08.980 I'm not a sucker, I just don't know. 29:08.980 --> 29:11.550 I may be smart, but I just don't know what the quality of 29:11.550 --> 29:13.480 this company is. 29:13.480 --> 29:16.590 If I just go in there blindly and pick up whatever seems to 29:16.590 --> 29:19.680 be out there, I'm going to suffer an adverse selection. 29:19.680 --> 29:21.240 I'm going to get the worst stuff, because 29:21.240 --> 29:22.060 I'm not looking -- 29:22.060 --> 29:25.750 I can't look, they're going to dump the bad paper on me. 29:25.750 --> 29:31.930 So, banks solve that by being in the community, knowing who 29:31.930 --> 29:38.080 is borrowing, and having a reputation, so that instead of 29:38.080 --> 29:41.160 you suffering this adverse selection problem, the bank 29:41.160 --> 29:43.890 has people who know what's going on. 29:43.890 --> 29:47.030 So, the thing about banks is, that they have local loan 29:47.030 --> 29:50.870 officers who serve in a particular community. 29:50.870 --> 29:54.270 And they know all about that community. 29:54.270 --> 29:56.270 And they solve the adverse selection problem. 30:00.520 --> 30:04.290 So, for example, if you are a loan officer in a bank, by 30:04.290 --> 30:08.600 tradition, you are someone who gets 30:08.600 --> 30:10.000 involved in the community. 30:10.000 --> 30:13.440 You'll find them on the program at the symphony. 30:13.440 --> 30:15.100 They're one of the donors. 30:15.100 --> 30:16.760 They show up for all kinds of things. 30:16.760 --> 30:18.010 They know what's going on. 30:18.010 --> 30:20.720 They play golf with local business people. 30:20.720 --> 30:22.160 They hear the gossip. 30:22.160 --> 30:24.470 So, someone says, you know, this guy, the CEO of this 30:24.470 --> 30:27.140 company, I think he's an alcoholic. 30:27.140 --> 30:29.740 You better watch this guy, I don't know what he's doing. 30:29.740 --> 30:30.590 You hear these things. 30:30.590 --> 30:31.530 And you know what happens? 30:31.530 --> 30:34.030 The guy doesn't get a loan the next day. 30:34.030 --> 30:38.820 I hate to say it, but they kind of vouch for the 30:38.820 --> 30:40.630 character of people. 30:40.630 --> 30:43.130 I mentioned this in a previous lecture, that there's all 30:43.130 --> 30:44.720 kinds of people out there. 30:44.720 --> 30:47.490 And you can't prove or judge who's good. 30:47.490 --> 30:50.340 You can't write it down in some objective way, who's 30:50.340 --> 30:53.280 going to be a responsible business person. 30:53.280 --> 30:55.920 But banks know that, so they solve the 30:55.920 --> 30:59.060 adverse selection problem. 30:59.060 --> 31:04.370 There's also a moral hazard problem that banks solve. 31:08.090 --> 31:13.550 The moral hazard is that a company may borrow money, and 31:13.550 --> 31:17.520 then take a big flyer and do some wild investment. 31:17.520 --> 31:20.390 Let's take this, for example: Suppose we owned a small 31:20.390 --> 31:22.810 company and it's not doing well. 31:22.810 --> 31:24.620 We have this great idea. 31:24.620 --> 31:30.000 Let's borrow $10 million, and let's go to the racetrack and 31:30.000 --> 31:35.390 let's put it all on the least likely 31:35.390 --> 31:36.620 horse to win, all right. 31:36.620 --> 31:41.600 And, you know, our chance of winning is only one of 10, but 31:41.600 --> 31:45.700 if we win, I got $100 million. 31:45.700 --> 31:47.940 If we lose then, hey, we just go bankrupt. 31:47.940 --> 31:49.940 We say, sorry. 31:49.940 --> 31:51.810 Of course, you really couldn't do it at the racetrack. 31:51.810 --> 31:53.980 I mean, you'd be sued if you did that. 31:53.980 --> 31:55.780 But you see what I'm saying. 31:55.780 --> 31:57.090 I could see -- 31:57.090 --> 31:58.470 I wouldn't do that -- but I could see 31:58.470 --> 31:59.640 wanting to do that, right? 31:59.635 --> 32:02.065 Your company's going out of business anyway, you know, you 32:02.070 --> 32:03.720 don't have any prospects. 32:03.720 --> 32:07.580 But if we can borrow $10 million, go and bet it on the 32:07.580 --> 32:10.060 racetrack, and one in ten we'll be super rich. 32:10.060 --> 32:11.750 We'll have $90 million, right? 32:11.750 --> 32:12.560 Pay off the debtors. 32:12.560 --> 32:13.740 Everything's fine. 32:13.740 --> 32:15.800 They won't complain if you win. 32:15.800 --> 32:18.810 They'll complain if you lose, but then you say, sorry, you 32:18.810 --> 32:20.140 know, we're out of business. 32:20.140 --> 32:22.160 It's limited liability. 32:22.160 --> 32:25.540 So, what banks do is, they help solve this problem by 32:25.540 --> 32:29.820 constant monitoring, and they make commercial loans that are 32:29.820 --> 32:34.230 at effectively long-term, but in practice, officially 32:34.230 --> 32:34.750 short-term. 32:34.750 --> 32:38.040 They keep renewing them, and they can cut you off, when 32:38.040 --> 32:40.270 they think you're doing something that 32:40.270 --> 32:42.220 reflects moral hazard. 32:42.220 --> 32:47.570 So, the constant monitoring that banks provide solves the 32:47.570 --> 32:51.640 moral hazard problem, just as their information collection 32:51.640 --> 32:53.480 solves the adverse selection problem. 33:03.330 --> 33:05.840 I'm just trying to see, where I want to go next. 33:09.950 --> 33:13.900 So, I mentioned deposit insurance. 33:13.900 --> 33:19.980 I mentioned that it started in Italy in the 1600's, but it 33:19.980 --> 33:25.610 has a long history of governments backing up 33:25.610 --> 33:28.790 deposits of banks in order to prevent banks runs. 33:28.790 --> 33:30.790 Because bank runs happened too often. 33:30.790 --> 33:32.870 People would get a little scared, and they would go to 33:32.870 --> 33:34.590 the back and try to pull all their money out. 33:34.590 --> 33:37.390 They'd hear a rumor, and then the whole banking 33:37.390 --> 33:38.480 system could collapse. 33:38.480 --> 33:42.480 And so, people in various governments at various times 33:42.480 --> 33:44.170 offered guarantees. 33:44.170 --> 33:46.410 But the problem is, those guarantees 33:46.410 --> 33:48.240 can get really expensive. 33:48.240 --> 33:51.100 So sometimes, they had a limited guarantee, and so 33:51.100 --> 33:55.810 sometimes, the deposit insurance scheme would fail. 33:55.810 --> 34:02.060 And so, the history of deposit insurance is a checkered one. 34:02.060 --> 34:04.480 So, in United States there were various state 34:04.480 --> 34:06.380 governments, local governments, that created 34:06.380 --> 34:10.580 deposit insurance schemes before the FDIC, but a lot of 34:10.580 --> 34:14.150 them failed, and so, people said this is a crazy idea. 34:14.150 --> 34:19.240 But the United States government in 19 -- 34:19.239 --> 34:23.159 I think it was '33, do I have this right? -- 34:23.159 --> 34:24.809 created -- 34:24.810 --> 34:26.710 I think that's right -- 34:26.710 --> 34:30.390 the Federal Deposit Insurance Corporation as part of the New 34:30.389 --> 34:34.549 Deal under Franklin Delano Roosevelt. 34:34.550 --> 34:39.030 And it has never failed to this date. 34:39.030 --> 34:40.990 Why didn't it fail? 34:40.989 --> 34:42.019 It's hard to know, exactly. 34:42.020 --> 34:46.000 We never had a big back run since 1933. 34:46.000 --> 34:49.590 It seemed to create the psychology that people stopped 34:49.590 --> 34:53.070 worrying about bank failures, because they believed they 34:53.070 --> 34:53.770 were insured. 34:53.770 --> 34:58.490 I guess they believed Franklin Delano Roosevelt. 34:58.490 --> 35:04.610 And so, if you believe it, then it's one of those funny 35:04.610 --> 35:06.520 things, it's the multiple equilibria that 35:06.520 --> 35:08.240 Diamond-Dybvig mentioned. 35:08.240 --> 35:10.340 As long as people believe the bank system is 35:10.340 --> 35:11.590 sound, it is sound. 35:15.660 --> 35:18.970 We also created later, another deposit insurance, called the 35:18.970 --> 35:21.550 Federal Savings and Loan Insurance Corporation 35:21.552 --> 35:22.742 [addition: abbreviated FSLIC], 35:22.740 --> 35:26.940 that was doing the savings and loan associations, which were 35:26.940 --> 35:29.590 a type of savings bank. 35:29.590 --> 35:34.140 And that did fail. 35:34.140 --> 35:37.960 And so, we had a huge crisis in the United States, called 35:37.960 --> 35:43.900 the savings and loan crisis, in the 1980's. 35:43.900 --> 35:58.080 So, the S&L crisis in the 1980's was due to a widespread 35:58.080 --> 36:01.130 failure of savings and loan associations, and then, kind 36:01.130 --> 36:04.880 of a run on the savings and loans, but it wasn't really a 36:04.880 --> 36:08.310 run, because the FSLIC was trusted. 36:08.310 --> 36:14.060 And what ended up happening is, the FSLIC had reserves 36:14.060 --> 36:17.360 against a certain amount of losses from the banks, but 36:17.360 --> 36:19.030 they went through them completely. 36:19.030 --> 36:20.650 And then they were bankrupt. 36:20.650 --> 36:22.510 So, the insurer went bankrupt. 36:22.510 --> 36:25.330 What then happened is, the United States government 36:25.330 --> 36:27.330 picked up the tab. 36:27.330 --> 36:33.840 And the total tab was $150 billion. 36:33.840 --> 36:35.590 And that restored confidence. 36:35.590 --> 36:39.610 I guess, the government had to do that. 36:39.610 --> 36:42.360 And the FSLIC no longer exists. 36:42.360 --> 36:45.520 Savings and loans are now insured by the Federal Deposit 36:45.520 --> 36:47.430 Insurance Corporation. 36:47.430 --> 36:50.290 So, you know, these institutions really don't 36:50.290 --> 36:53.680 necessarily represent the real insurance. 36:53.680 --> 36:55.520 You have to always see beyond institutions. 36:55.520 --> 37:00.350 The FSLIC was encouraging people to believe in the 37:00.350 --> 37:03.320 security of the banking system, but it really wasn't 37:03.320 --> 37:04.310 the ultimate security. 37:04.310 --> 37:07.430 The ultimate security wasn't even written down. 37:07.430 --> 37:12.610 It was the recognition by the U.S. government, that if we 37:12.610 --> 37:17.050 let FSLIC fail, and we let all these depositors in the 37:17.050 --> 37:20.150 savings and loans lose their money, it's going to destroy 37:20.150 --> 37:23.260 the confidence that has kept us away from bank runs. 37:23.260 --> 37:26.020 And the next thing are commercial banks, or who 37:26.020 --> 37:28.140 knows, what else will happen. 37:28.140 --> 37:32.510 So what always happens is, the government stands behind these 37:32.510 --> 37:35.380 promises, even if they weren't made so clearly. 37:38.040 --> 37:41.970 There's another example, I'll give you, which is more 37:41.970 --> 37:45.590 recent, of a bank run. 37:45.590 --> 37:51.160 And that occurred in the United Kingdom in 2007. 37:51.160 --> 37:52.810 The bank was called Northern Rock. 37:58.440 --> 38:02.910 And a rumor started -- this was at the beginning of the 38:02.910 --> 38:05.970 financial crisis -- a rumor started that Northern Rock 38:05.970 --> 38:08.520 held a lot of subprime securities, and was going to 38:08.520 --> 38:09.620 go bankrupt. 38:09.620 --> 38:12.900 So, people rushed to Northern Rock, and big lines formed 38:12.900 --> 38:15.020 outside of Northern Rock. 38:15.020 --> 38:17.080 People, they wanted to get there first, because you 38:17.080 --> 38:19.080 thought, they're still handing out the money. 38:19.080 --> 38:22.510 I want to be there first. And then, newspaper photographers 38:22.510 --> 38:25.490 photographed the crowd outside the bank, and people thought, 38:25.490 --> 38:28.810 well, this is just like 1933 and the huge banking crisis. 38:32.460 --> 38:40.830 Now, actually, the U.K. government did have deposit 38:40.830 --> 38:46.740 insurance, but the deposit insurance in the U.K. would 38:46.740 --> 38:53.190 insure fully all deposits up to GBP 3,000. 38:53.190 --> 39:04.560 And then, it gave 90% insurance up to GBP 75,000. 39:04.560 --> 39:07.120 After that, you were out of luck. 39:07.120 --> 39:10.250 So, why was there a bank run on Northern Rock when there 39:10.250 --> 39:11.850 was deposit insurance? 39:11.850 --> 39:12.530 Well, I tell you. 39:12.530 --> 39:16.170 It was people who had more than GBP 3,000 in the bank, 39:16.170 --> 39:18.520 very simple. 39:18.520 --> 39:22.080 And so, you know, they didn't really have enough deposit 39:22.080 --> 39:23.390 insurance to stop a run. 39:23.390 --> 39:28.120 So Mervyn King, who's head of the Bank of England, just 39:28.120 --> 39:31.850 decided, you know what, we'll bail everybody out. 39:31.850 --> 39:32.910 No questions. 39:32.910 --> 39:35.800 Forget our deposit insurance scheme. 39:35.800 --> 39:37.620 And that stopped the run. 39:37.620 --> 39:40.940 So again, it happened the same way in the United Kingdom. 39:40.940 --> 39:47.990 The deposit insurance stopped it, before it was any problem. 39:47.990 --> 39:52.020 So, the United Kingdom has never had a bank run failure 39:52.020 --> 39:56.940 since 1866. 39:56.940 --> 40:00.620 It's not really because of any deposit insurance scheme. 40:00.620 --> 40:03.070 It's about the Bank of England, which is their 40:03.065 --> 40:07.665 central bank, and what it does to maintain confidence. 40:07.670 --> 40:09.340 Other countries handle it differently. 40:09.340 --> 40:19.480 I was going to mention, in Germany, IKB Deutsche 40:19.480 --> 40:30.200 Industriebank, in 2007. 40:30.200 --> 40:32.890 This is a German bank that German depositors 40:32.890 --> 40:34.000 put their money in. 40:34.000 --> 40:39.060 And it had invested a lot in subprime securities. 40:39.060 --> 40:41.610 And it was in trouble, and there were starting to be 40:41.610 --> 40:43.800 worries of a run on them. 40:43.800 --> 40:47.370 The German government didn't even wait for a bank run. 40:47.370 --> 40:58.330 They just bailed them out, and it cost them EUR 1.5 billion. 40:58.330 --> 41:00.920 But again, the governments know that they want to 41:00.920 --> 41:03.540 maintain confidence, and so they do it. 41:03.540 --> 41:06.730 They do what they have to do. 41:06.730 --> 41:11.130 Now, I want to go to bank regulation, more generally. 41:11.130 --> 41:15.720 If you are insuring banks, then you'd better regulate 41:15.716 --> 41:18.206 them, because there's a moral hazard problem. 41:18.210 --> 41:21.670 I just described a moral hazard problem for a company 41:21.670 --> 41:24.480 that borrows money from a bank, but there's moral hazard 41:24.480 --> 41:27.240 problems for banks as well. 41:27.240 --> 41:29.880 Namely, banks can do the same trick. 41:29.880 --> 41:31.970 I said, go to the racetrack. 41:31.970 --> 41:33.720 Borrow money and go to the racetrack. 41:33.720 --> 41:35.820 Banks can do that, same thing. 41:35.820 --> 41:37.560 Except, they wouldn't actually go to the racetrack. 41:37.560 --> 41:41.270 They would pick some really risky business venture. 41:41.270 --> 41:46.630 And if it fails, then it all falls to the deposit insurer. 41:46.630 --> 41:49.240 This is a fundamental lesson of insurance, whenever you 41:49.240 --> 41:51.310 insure something, you've got to 41:51.310 --> 41:53.660 regulate the person insured. 41:53.660 --> 41:56.430 Because once you've taken a risk from their shoulders, you 41:56.430 --> 41:59.730 create moral hazard for them. 41:59.730 --> 42:04.400 And so, bank regulation is very important. 42:04.400 --> 42:08.600 So, I was going to talk mostly here about the kind of bank 42:08.600 --> 42:12.630 regulation that has an international dimension. 42:12.630 --> 42:17.370 And so, what I wanted to talk about is the Basel bank 42:17.370 --> 42:24.500 regulations that were generated by an international 42:24.500 --> 42:27.170 organization in Basel, Switzerland. 42:33.370 --> 42:40.490 After the savings and loan crisis was Basel I. It was an 42:40.490 --> 42:45.030 international meeting that published a set of 42:45.030 --> 42:49.670 recommendations for all the countries of the world to 42:49.670 --> 42:51.320 regulate their bank. 42:51.320 --> 42:53.360 The idea was that there should be some 42:53.360 --> 42:55.220 coherence across countries. 42:55.220 --> 42:58.850 If one country regulates its bank very stiffly, that's 42:58.850 --> 43:01.110 going to drive business out of that country 43:01.110 --> 43:02.860 and into other countries. 43:02.860 --> 43:05.010 Also, there should be some standardization. 43:05.010 --> 43:08.220 It helps the world economy, if everybody knows that all the 43:08.220 --> 43:11.250 banks of the world have similar regulations. 43:11.250 --> 43:14.000 But Basel, the Basel Committee, as it's called, 43:14.000 --> 43:15.890 that created the recommendations, 43:15.890 --> 43:17.810 had no legal authority. 43:17.810 --> 43:20.780 All it could do is recommend. 43:20.780 --> 43:25.160 But it did recommend bank regulations, and these were 43:25.160 --> 43:27.760 widely adopted around the world. 43:30.790 --> 43:32.610 Each country could make modifications, 43:32.610 --> 43:34.060 whatever they want. 43:34.060 --> 43:37.220 You can't order countries around, but they often 43:37.220 --> 43:40.350 followed the Basel recommendations. 43:40.350 --> 43:46.850 In Basel II, they met again in the 2000's, and they issued 43:46.850 --> 43:51.950 recommendations in 2004. 43:51.950 --> 43:54.530 What they said in Basel II was, the banking system was 43:54.530 --> 43:57.330 getting so much more complicated that they had to 43:57.330 --> 43:58.970 think more about how to do it. 43:58.970 --> 44:01.770 Now, there's all these complicated derivatives and 44:01.770 --> 44:07.540 special purpose vehicles, and so they had to update their 44:07.540 --> 44:08.830 regulations. 44:08.830 --> 44:12.760 Unfortunately, Basel II has suffered a reputation blow, 44:12.760 --> 44:16.210 because right after Basel II we had the 44:16.210 --> 44:17.510 world financial crisis. 44:17.510 --> 44:19.640 So, they didn't do something right. 44:19.640 --> 44:22.930 They didn't really fix the system in Basel II. 44:22.930 --> 44:26.670 So, that brought us to Basel III, which 44:26.670 --> 44:30.520 is the latest version. 44:30.520 --> 44:35.190 And they issued their report in 2010. 44:35.190 --> 44:40.360 And also in 2010, the G-20 nations meeting in Seoul, 44:40.360 --> 44:47.070 Korea, expressed their support for Basel III. 44:47.070 --> 44:51.300 So, Basel III is the current world regulation standard. 44:55.550 --> 44:59.960 But it's phased in gradually, and it won't be fully phased 44:59.960 --> 45:02.930 in until 2019. 45:02.930 --> 45:05.650 They didn't want to put it in all at once, because the world 45:05.650 --> 45:08.450 is in a financial crisis, and it would be too stressful. 45:08.450 --> 45:12.590 So, it has a slow phase-in. 45:12.590 --> 45:17.500 And some of the details haven't even 45:17.500 --> 45:20.420 been worked out yet. 45:20.420 --> 45:23.580 The G-20 countries have agreed, in principle, that 45:23.580 --> 45:27.990 these regulations are where we'll go, but details have yet 45:27.990 --> 45:29.240 to be worked out. 45:32.300 --> 45:34.240 You know, bank regulation is a big business. 45:34.240 --> 45:37.230 We could have a whole semester on studying 45:37.230 --> 45:39.380 what these guys do. 45:39.380 --> 45:42.310 So, I just wanted to give you kind of a caricature 45:42.310 --> 45:43.680 of what's in Basel. 45:43.680 --> 45:45.980 It's also in Fabozzi et al., the Fabozzi et al. 45:45.980 --> 45:49.040 textbook, which is copyright 2010. 45:49.040 --> 45:51.430 You'd think this would be in it, but it's not. 45:51.430 --> 45:54.350 Basel I and Basel II are in Fabozzi et al. 45:54.350 --> 45:57.730 Basel III isn't, because it didn't come in until the end 45:57.730 --> 46:03.050 of 2010, and so it didn't make it in time to 46:03.050 --> 46:06.220 appear in your book. 46:06.220 --> 46:13.710 But I wanted to just give you a simple account of all the 46:13.710 --> 46:18.130 Basel agreements, and some sense of where we 46:18.130 --> 46:21.780 are with Basel III. 46:21.780 --> 46:25.280 They're all about banks having enough money. 46:25.280 --> 46:27.400 You know, not taking on too much. 46:27.400 --> 46:29.620 Enough money for the risks they take. 46:29.620 --> 46:38.140 Let me start with Basel I, because part of Basel I is 46:38.140 --> 46:39.990 enforced in all three of them. 46:39.990 --> 46:47.010 And there's a concept called ''risk-weighted assets,'' 46:47.010 --> 46:53.630 which is in Basel I, and Basel II and Basel III, 46:53.630 --> 46:56.280 essentially the same. 46:56.280 --> 46:57.690 OK, so, here's the idea. 47:00.490 --> 47:03.790 We're going to put capital requirements based on 47:03.790 --> 47:05.550 risk-weighted assets. 47:05.552 --> 47:07.052 Now what does that mean? 47:07.050 --> 47:11.330 That means, that banks cannot take too many risks. 47:14.420 --> 47:17.280 They have to have enough money to back them up for 47:17.280 --> 47:18.740 the risks they take. 47:18.740 --> 47:20.970 And we'll call that money capital. 47:20.970 --> 47:21.930 It's not money. 47:21.930 --> 47:26.220 It's not cash, but it's assets that they can use to get them 47:26.220 --> 47:29.680 out of trouble, if the risky assets do badly. 47:29.680 --> 47:33.120 So, if we're going to have a requirement on how much 47:33.120 --> 47:39.700 capital a bank holds, we have also to define their risks. 47:39.700 --> 47:45.750 And so, Basel I had a very simple formula to compute 47:45.750 --> 47:47.600 risk-weighted assets. 47:47.600 --> 47:51.070 Well, it's very simple, until you get into all the details. 47:51.070 --> 47:53.820 And so, you'll see the definition of 47:53.820 --> 47:55.470 risk-weighted assets. 47:55.470 --> 48:00.110 It's in table 3.3 in Fabozzi et al. 48:00.110 --> 48:02.390 But basically, here it is. 48:02.390 --> 48:05.480 There's four categories of assets. 48:05.480 --> 48:10.290 The 0% weight, the 20% weight, the 50% weight, 48:10.290 --> 48:12.080 and the 100% weight. 48:12.080 --> 48:16.220 The higher the weight, it means more risky. 48:16.220 --> 48:19.900 So, where will I write these? 48:19.900 --> 48:21.220 I'll do it up here. 48:21.220 --> 48:26.740 Now, we're talking about all three, Basel I, II, and III. 48:26.740 --> 48:37.530 0% are national -- well, I'll say OECD government bonds, 48:37.530 --> 48:40.350 national government bonds. 48:40.350 --> 48:45.850 The OECD is the organization for European Cooperation and 48:45.850 --> 48:47.060 Development. 48:47.060 --> 48:51.130 And they represent advanced, stable European countries. 48:51.130 --> 48:57.320 And U.S. government bonds are included among them. 48:57.320 --> 48:58.570 What else? 49:05.660 --> 49:06.730 Yes, basically that's it. 49:06.730 --> 49:08.470 Now, there might be something else in there, and I'm sure 49:08.470 --> 49:11.990 there is, but this is the simplest. 0% weight, because 49:11.990 --> 49:13.860 these have 0% risk. 49:13.860 --> 49:15.640 There's no risk. 49:15.640 --> 49:18.730 So, banks can hold all they want of these and they don't 49:18.730 --> 49:21.070 have to hold any capital. 49:21.070 --> 49:29.550 Then, next up is 20% weight, and that's municipal bonds, or 49:29.550 --> 49:35.170 local bonds, that's not issued by the national governments 49:35.170 --> 49:37.480 but issued by a city or state. 49:37.480 --> 49:39.940 We're having a municipal bond crisis now. 49:39.940 --> 49:42.850 They're suddenly showing their risk, and we're worried about 49:42.850 --> 49:45.620 defaults on them, so Basel I was right to 49:45.620 --> 49:47.730 give them some weight. 49:47.730 --> 49:50.660 They gave them a 20% weight, because they thought, 49:50.660 --> 49:54.520 municipal bonds are pretty safe. 49:54.520 --> 49:57.310 They're not as safe as national government bonds, 49:57.310 --> 50:00.550 because there's examples of default. 50:00.550 --> 50:02.460 But they're also included -- 50:02.455 --> 50:04.655 there's a long list of what they include -- 50:04.660 --> 50:09.110 but notably Fannie and Freddie -- 50:09.110 --> 50:12.080 these are the two mortgage lenders in the United States-- 50:12.080 --> 50:14.960 were included with 20% weights. 50:14.960 --> 50:17.040 Because people thought, these guys are really safe, and 50:17.040 --> 50:19.130 anyway, the U.S. government backs them up. 50:19.130 --> 50:20.690 Although the U.S. government said, it 50:20.690 --> 50:21.810 wouldn't back them up. 50:21.810 --> 50:24.840 But you know, we all know, they're going to back them up, 50:24.840 --> 50:27.850 and indeed, they did back them up when they failed. 50:27.850 --> 50:33.060 But Fannie and Freddie, prior to the crisis, started 50:33.060 --> 50:36.920 increasingly investing in subprime mortgages. 50:40.650 --> 50:44.270 And they were issuing subprime mortgage securities that were 50:44.270 --> 50:48.130 really very risky and eventually went kaput. 50:48.130 --> 50:52.600 Basel I didn't know that, or Basel II and Basel III still, 50:52.600 --> 50:54.290 they just gave them a 20% weight. 50:54.290 --> 50:57.210 That was a big mistake, and that's where part of the 50:57.210 --> 50:59.250 banking crisis comes. 50:59.250 --> 51:02.520 Then, there's 50% weight, and that's for 51:02.520 --> 51:06.500 mortgages, home mortgages. 51:06.500 --> 51:10.030 The Basel people thought, there could be some big real 51:10.030 --> 51:11.760 estate crisis. 51:11.760 --> 51:15.320 You know, it's something to worry about, so there's more 51:15.320 --> 51:16.220 weight than that. 51:16.220 --> 51:21.100 And then, we have 100% on everything else, but notably 51:21.100 --> 51:24.380 loans, like commercial loans to businesses. 51:30.560 --> 51:32.740 So, those are the weights. 51:32.740 --> 51:34.740 And so, I just wanted to go through a simple example. 51:34.740 --> 51:43.200 Suppose you are a bank, and you have $400 million in 51:43.200 --> 51:47.250 assets on your balance sheet. 51:47.250 --> 51:49.140 These are things that you as a bank own. 51:49.140 --> 51:53.850 And let's say you have 100 in government bonds, federal 51:53.850 --> 51:55.770 government bonds. 51:55.770 --> 52:00.260 100 in Fannie Mae, $100 million. 52:00.260 --> 52:06.170 And you have 100 in mortgages that you own directly. 52:06.170 --> 52:09.010 And you have 100 in commercial loans. 52:12.380 --> 52:16.340 So, your total assets are $400 million. 52:16.340 --> 52:19.850 But you've got to know what your risk-weighted assets are. 52:19.850 --> 52:21.260 What are your risk-weighted assets? 52:21.260 --> 52:23.910 Well I take the 100 -- and Fabozzi et al. goes through an 52:23.910 --> 52:26.750 example too, but this is very easy -- 52:26.750 --> 52:30.300 I multiply the 100 by 0, I get 0. 52:30.300 --> 52:36.880 I multiply this 100 by 20%, so that gives me 52:36.880 --> 52:38.210 $20 million, right? 52:38.210 --> 52:42.020 I multiply the mortgages by 50%, it gives me $50 million, 52:42.020 --> 52:45.730 and I've got to throw all these in. 52:45.730 --> 52:47.840 So, what does that add up to? 52:47.840 --> 52:54.280 It's $170 million RWA, risk-weighted assets. 52:54.280 --> 53:00.060 It's 0 plus 20, plus 50, plus 100. 53:00.060 --> 53:04.570 So, those are my risk-weighted assets, and then, the amount 53:04.570 --> 53:09.070 of capital that I have to hold is a percentage of the 53:09.070 --> 53:10.320 risk-weighted assets. 53:12.600 --> 53:15.250 I could go through Basel I, Basel II, Basel III, they kept 53:15.250 --> 53:18.760 changing these percentages, as they went along. 53:18.760 --> 53:21.620 So, I'm just going to talk about Basel III, because 53:21.620 --> 53:22.900 that's going forward, all right? 53:25.660 --> 53:27.650 And Basel III is complicated, too. 53:27.650 --> 53:31.590 I'm going to just talk to you about common equity 53:31.590 --> 53:33.870 requirements. 53:33.870 --> 53:39.900 So, Basel III says -- 53:39.900 --> 53:44.260 it's an interesting and creative construct -- 53:44.264 --> 54:01.904 common equity must be 4.5% of RWA at all times. 54:01.900 --> 54:04.540 But I'll add to that. 54:04.540 --> 54:17.010 They have plus 2.5%, what they call a capital 54:17.010 --> 54:24.730 conservation buffer. 54:24.725 --> 54:29.855 And so, that adds up to you 7%, and I'll explain. 54:29.860 --> 54:36.830 You absolutely have to have 4.5% as common equity, but if 54:36.830 --> 54:39.380 you don't also have another 2.5%, you 54:39.380 --> 54:41.660 can't pay out any dividends. 54:41.660 --> 54:43.020 That's not so good. 54:43.020 --> 54:46.930 So, in reality, you better keep 7%. 54:46.930 --> 54:50.400 So effectively, Basel III -- 54:50.400 --> 54:58.970 this is Basel III, it's not in your textbook, but it's coming 54:58.970 --> 55:02.690 all over the world, 7%. 55:02.690 --> 55:04.670 Now incidentally, the interesting thing about Basel 55:04.670 --> 55:08.620 III, they're thinking creatively, they added another 55:08.620 --> 55:12.850 buffer, called a countercyclical buffer. 55:16.540 --> 55:17.790 Well, that's not added automatically. 55:20.394 --> 55:28.864 And that's another 2.5%, but only if the regulators in the 55:28.860 --> 55:30.870 country choose to impose it. 55:30.870 --> 55:35.040 And here's the idea: We have to stop bubbles before they 55:35.040 --> 55:36.640 burst, right? 55:36.640 --> 55:39.580 So, suppose you think that a bubble is building up in your 55:39.580 --> 55:43.000 country, then the regulators are asked by Basel, if they 55:43.000 --> 55:47.790 make that judgment, to add another 2.5% to the capital 55:47.790 --> 55:51.220 requirement, while it's booming. 55:51.220 --> 55:53.940 You don't wait until the crisis to do this, because 55:53.940 --> 55:56.240 then they'll all be in trouble, and if you tighten up 55:56.240 --> 55:59.110 on banks then, they'll stop making loans, and that will 55:59.110 --> 56:00.320 crash the whole economy. 56:00.320 --> 56:02.630 You have got to tighten up when times are good. 56:02.630 --> 56:07.850 So, that adds up to 9.5%. 56:07.850 --> 56:11.730 So, you'd have to hold capital equal to 9.5% of your 56:11.730 --> 56:13.500 risk-weighted assets. 56:13.500 --> 56:17.270 But presumably, the normal number is 7%. 56:17.265 --> 56:21.255 So, let me just go through for this bank here, which has $400 56:21.260 --> 56:24.640 million in assets. 56:24.640 --> 56:26.970 What is their requirement? 56:26.970 --> 56:30.910 Well, we figured out that they have $170 million in 56:30.910 --> 56:33.350 risk-weighted assets. 56:33.350 --> 56:40.910 Multiply that by 7%, and that gives you, I think it's $11.9 56:40.910 --> 56:49.530 million that they have. So, your common equity must be 56:49.526 --> 56:55.746 $11.9 million. 56:55.750 --> 56:57.230 So, you go to your balance sheet. 56:57.230 --> 56:59.010 We showed balance sheets in an earlier -- 56:59.010 --> 57:00.260 STUDENT: It's common equity plus the first buffer, right? 57:02.940 --> 57:05.010 PROFESSOR ROBERT SHILLER: I'm sorry? 57:05.012 --> 57:06.222 STUDENT: The $ 11.9 million is -- 57:06.220 --> 57:07.360 PROFESSOR ROBERT SHILLER: Oh, did I do with -- 57:07.360 --> 57:16.220 yes, I'm sorry, that's 7% of $170 million. 57:16.220 --> 57:21.460 You don't actually have to hold this buffer, but it 57:21.460 --> 57:23.020 limits you if you don't. 57:23.020 --> 57:26.380 And so practically, most banks will. 57:26.380 --> 57:28.570 So then, you go to look on your balance sheet, and you 57:28.570 --> 57:32.700 see, hey, we're lucky, we have got $12.9 million. 57:32.700 --> 57:35.110 Let's say, I just made that up. 57:35.110 --> 57:36.360 How do you get common equity? 57:36.360 --> 57:39.360 You take the total assets in your balance sheet, you 57:39.360 --> 57:42.460 subtract off all of the liabilities, all 57:42.460 --> 57:44.230 the money you owed. 57:44.230 --> 57:46.150 And that gives you shareholders' equity, but that 57:46.150 --> 57:49.360 has two components, common equity and preferred equity, 57:49.360 --> 57:51.690 so you've got to subtract off the preferred equity. 57:51.690 --> 57:55.860 But it's a sense of how much extra resources you have. 57:55.860 --> 57:58.120 After you've paid off all your debts, you 57:58.120 --> 58:04.850 still have $12.9 million. 58:04.850 --> 58:06.710 You say, hey, we're good. 58:06.710 --> 58:09.880 We've got an extra million dollars. 58:09.880 --> 58:12.410 So then, you bring that up at the board meeting and say, 58:12.410 --> 58:15.250 we're satisfying Basel III, isn't that great? 58:15.250 --> 58:18.530 But someone at the board might say, but wait a minute, that 58:18.530 --> 58:20.910 means we have $1 million too much. 58:20.910 --> 58:24.110 It's just sitting there, we're not even using it. 58:24.110 --> 58:27.070 Let's lend it out. 58:27.070 --> 58:29.510 I'm sorry, let's use it up, not lend it out. 58:29.510 --> 58:32.210 How do you use it up? 58:32.210 --> 58:35.280 You've now got more than the amount of capital required. 58:35.280 --> 58:37.270 You've got another million dollars. 58:37.270 --> 58:39.940 You could lend out $1 million, but think about it. 58:39.940 --> 58:45.990 You can borrow more and lend more. 58:45.990 --> 58:50.020 Or you can borrow more and take other assets. 58:50.020 --> 58:51.340 And you can go beyond $1 million. 58:53.920 --> 58:54.900 Let's consider this. 58:54.895 --> 58:56.445 So, do you understand the situation? 58:56.450 --> 58:57.940 That we've done our accounting. 58:57.940 --> 59:01.800 We have $170 million in risk-weighted assets. 59:01.800 --> 59:06.520 We have a requirement, therefore, of $11.9 million in 59:06.515 --> 59:07.435 common equity. 59:07.440 --> 59:09.540 We have an extra million dollars. 59:09.540 --> 59:12.330 Let's consider buying different kinds of assets. 59:12.330 --> 59:14.480 How about buying Fannie Mae bonds? 59:20.280 --> 59:22.580 How much more can you buy? 59:22.580 --> 59:24.560 Well, you've got $1 million. 59:24.560 --> 59:26.830 If you're going to buy more, you're going to add both 59:26.830 --> 59:27.890 assets and liability. 59:27.890 --> 59:30.240 You're going to borrow money, and you're going to buy more. 59:30.240 --> 59:32.480 So, you're going to add both assets and liabilities to your 59:32.480 --> 59:34.020 balance sheet. 59:34.020 --> 59:40.060 How far can you go without violating the capital 59:40.060 --> 59:40.910 requirement? 59:40.910 --> 59:46.080 Well, the amount you can buy of Fannie and Freddie bonds is 59:46.080 --> 59:53.540 $1 million all over 0.2 times 0.07. 59:53.540 --> 59:56.860 And that's about $70 million worth of 59:56.855 --> 59:58.355 Fannie and Freddie bonds. 59:58.360 --> 1:00:02.010 Because you add that to this mix, then it will raise your 1:00:02.012 --> 1:00:06.432 risk-weighted assets by exactly $1 million. 1:00:06.430 --> 1:00:11.960 So, you can buy $70 million of Fannie and Freddie bonds 1:00:11.960 --> 1:00:17.140 according to this weighted asset calculation. 1:00:17.135 --> 1:00:18.115 You see that? 1:00:18.120 --> 1:00:20.360 Well, how about making loans to small 1:00:20.360 --> 1:00:22.740 businesses in our community? 1:00:22.740 --> 1:00:26.100 Well, that's 100% risk-weighting. 1:00:26.100 --> 1:00:31.270 So that means, I can make loans of $1 million all over 1:00:31.270 --> 1:00:36.890 0.07, and that's about $14 million. 1:00:36.890 --> 1:00:37.880 So, this is what you would tell. 1:00:37.880 --> 1:00:39.830 You're at a board meeting and you're saying, 1:00:39.830 --> 1:00:41.280 let's consider that. 1:00:41.280 --> 1:00:45.460 We're going to stay within the requirements, we can buy $70 1:00:45.460 --> 1:00:49.590 million of Fannie bonds, or we can make $14 1:00:49.590 --> 1:00:50.860 million more in loans. 1:00:50.860 --> 1:00:53.130 But at the board meeting, someone might say, you know, 1:00:53.130 --> 1:00:56.120 $70 million sounds better than $14 million, I think we should 1:00:56.120 --> 1:01:00.220 do Fannie bonds, and tell all the guys with small businesses 1:01:00.220 --> 1:01:03.200 coming by, tough luck. 1:01:03.200 --> 1:01:06.590 You know, we don't have any money for you. 1:01:06.590 --> 1:01:07.880 So, we see what it's doing. 1:01:07.880 --> 1:01:09.360 Its pushing people -- 1:01:09.360 --> 1:01:12.740 the Basel requirements, and these are Basel II, or Basel I 1:01:12.740 --> 1:01:16.530 requirements, we're pushing banks toward investing in 1:01:16.530 --> 1:01:21.770 subprime loans issued by Fannie Mae as against lending 1:01:21.770 --> 1:01:23.190 to businesses. 1:01:23.190 --> 1:01:26.500 And people are starting to wonder about that now. 1:01:26.500 --> 1:01:30.170 But you have to say, isn't the prosperity of the country 1:01:30.170 --> 1:01:34.000 determined by the businesses? 1:01:34.000 --> 1:01:37.230 When you're making a subprime loan, what is a subprime loan? 1:01:37.230 --> 1:01:40.900 It's a loan to someone with bad credit, with bad 1:01:40.900 --> 1:01:43.490 employment history, to buy a house. 1:01:43.490 --> 1:01:48.960 So, we have created an incentive for banks to lend to 1:01:48.960 --> 1:01:52.640 those people rather than to businesses. 1:01:52.640 --> 1:01:55.690 And so there are critics of Basel, all the Basel 1:01:55.690 --> 1:01:59.140 agreements, saying, it's counterproductive. 1:01:59.140 --> 1:02:01.710 We shouldn't have done this. 1:02:01.710 --> 1:02:03.740 These weights were wrong. 1:02:03.740 --> 1:02:06.150 There shouldn't have been so little risk-weighting on 1:02:06.150 --> 1:02:08.090 Fannie Mae. 1:02:08.090 --> 1:02:10.860 But then, the Basel people would say, look, we can't get 1:02:10.860 --> 1:02:11.700 it exactly right. 1:02:11.700 --> 1:02:13.710 We thought Fannie and Freddie -- and we're right, they 1:02:13.710 --> 1:02:14.770 haven't failed. 1:02:14.770 --> 1:02:19.070 Our job at Basel is to prevent a run on the banks, so we want 1:02:19.070 --> 1:02:20.530 banks to be sound. 1:02:20.530 --> 1:02:23.290 And maybe you're right, maybe businesses should be 1:02:23.290 --> 1:02:25.480 encouraged, but it's not our department. 1:02:25.480 --> 1:02:27.760 We're trying to prevent bank failure. 1:02:27.760 --> 1:02:30.750 So, these rules stick, and they're still with us today 1:02:30.750 --> 1:02:32.480 under Basel III. 1:02:32.480 --> 1:02:36.090 If you want to subsidize small businesses, like in the United 1:02:36.090 --> 1:02:39.410 States we have the Small Business Administration, that 1:02:39.410 --> 1:02:41.100 gives loans to small businesses. 1:02:41.100 --> 1:02:46.270 But Basel III is not going to do that. 1:02:46.270 --> 1:02:56.330 So, I said I would talk about other financial crises, and 1:02:56.330 --> 1:02:58.760 let me talk briefly about a few, and then I'm going to 1:02:58.760 --> 1:03:01.100 have to wrap up. 1:03:01.100 --> 1:03:08.450 The crisis that we have been through was a worldwide 1:03:08.450 --> 1:03:16.740 crisis, starting in 2007, peaking in 2008 and 2009. 1:03:16.740 --> 1:03:19.140 And it caused a worldwide recession. 1:03:19.140 --> 1:03:21.720 So, it's especially vivid in our memory. 1:03:21.720 --> 1:03:25.830 But I want to just reflect that these crises -- 1:03:25.830 --> 1:03:31.030 we've had banking crises so many times in history that 1:03:31.030 --> 1:03:33.970 it's not a unique event. 1:03:33.970 --> 1:03:36.110 And I just wanted to remind ourselves 1:03:36.110 --> 1:03:40.270 of a few other crises. 1:03:40.270 --> 1:03:46.500 I'm going to start with the Mexican crisis, our neighbor 1:03:46.500 --> 1:03:56.530 to the south, of 1994 to 1995. 1:03:56.530 --> 1:04:00.960 Under President Salinas, the government 1:04:00.960 --> 1:04:04.630 privatized Mexican banks. 1:04:04.630 --> 1:04:09.810 Salinas was a Harvard-educated economist who wanted to 1:04:09.810 --> 1:04:12.580 modernize the Mexican economy. 1:04:12.580 --> 1:04:17.900 And they privatized government banks, and turned it over to 1:04:17.900 --> 1:04:20.750 the free market, and they forgot to regulate it. 1:04:20.750 --> 1:04:26.210 And so, it led to a bank lending boom. 1:04:26.210 --> 1:04:35.420 In 1988, lending was 10% of GDP. 1:04:35.420 --> 1:04:42.820 In 1994, up to 40% of GDP. 1:04:42.820 --> 1:04:47.540 Salinas did not stop this. 1:04:47.540 --> 1:04:51.630 And it led to a boom in Mexico, because lending was 1:04:51.630 --> 1:04:55.300 going wild, everything was happening really fast, and it 1:04:55.300 --> 1:04:58.080 led to a bubble and a boom in Mexico. 1:04:58.080 --> 1:05:00.570 And there should have been a regulator who 1:05:00.570 --> 1:05:02.550 said, stop it, anyway. 1:05:02.550 --> 1:05:07.450 But there wasn't effective regulation, because Mexico had 1:05:07.450 --> 1:05:11.930 deregulated but it hadn't set up the banking institutions, 1:05:11.930 --> 1:05:14.210 the regulatory institutions. 1:05:14.210 --> 1:05:20.410 So, it developed an atmosphere in Mexico that, you know, I 1:05:20.410 --> 1:05:23.500 don't worry about the possible crisis, because the Mexican 1:05:23.500 --> 1:05:25.420 government will bail everybody out. 1:05:25.420 --> 1:05:29.610 And, you know, they couldn't bail everyone out, it turns 1:05:29.610 --> 1:05:31.840 out, there was a collapse. 1:05:31.840 --> 1:05:37.780 So, Salinas was replaced by Yale-educated Ernesto Zedillo. 1:05:37.780 --> 1:05:40.420 I shouldn't put it that way. 1:05:40.420 --> 1:05:45.660 And the Mexican banking system was destroyed by this crisis. 1:05:45.660 --> 1:05:49.180 And what ended up happening is that most Mexican banks were 1:05:49.180 --> 1:05:51.700 taken over by foreign banks. 1:05:51.700 --> 1:05:57.080 And it was followed by an economy that was heavily 1:05:57.080 --> 1:05:58.330 damaged by a crisis. 1:06:04.230 --> 1:06:06.370 But Mexico recovered. 1:06:06.370 --> 1:06:13.330 And 1994 and 1995 was unique to that country. 1:06:13.330 --> 1:06:18.290 It was a terrible recession that hit Mexico briefly. 1:06:18.290 --> 1:06:19.540 That's one example. 1:06:21.460 --> 1:06:24.350 But again, it was a regulatory failure that did it. 1:06:24.350 --> 1:06:27.580 If you allow the moral hazard to develop, if you allow 1:06:27.580 --> 1:06:31.350 people to think that, hey, let's make all these loans. 1:06:31.350 --> 1:06:33.840 I think it'll work out, but maybe it won't, and if it 1:06:33.840 --> 1:06:37.860 doesn't, hey, we have friends in Mexico City, so we'll all 1:06:37.855 --> 1:06:39.545 be all right. 1:06:39.550 --> 1:06:52.970 The next example is the Asian crisis of 1997. 1:06:52.970 --> 1:06:55.950 It's a very complicated crisis involving a number of Asian 1:06:55.950 --> 1:07:00.840 countries, but it was heavily related to bank lending. 1:07:00.840 --> 1:07:04.240 And international banks had lent a lot of 1:07:04.240 --> 1:07:07.600 money to Asian countries. 1:07:07.600 --> 1:07:12.880 And the countries then had loans that were -- 1:07:12.880 --> 1:07:14.580 they were dependent on loans -- 1:07:14.580 --> 1:07:18.730 that were withdrawn when a sort of a bank run occurred. 1:07:18.730 --> 1:07:23.340 It was something like a bank run, because the international 1:07:23.340 --> 1:07:26.210 investors suddenly wanted to withdraw their money from the 1:07:26.210 --> 1:07:28.170 Asian countries. 1:07:28.170 --> 1:07:40.100 And the Asian crisis started in Thailand, and Korea, and 1:07:40.100 --> 1:07:44.020 Indonesia, and then it spread all over the world. 1:07:44.015 --> 1:07:48.605 It reached Russia as a consequence, and it's called 1:07:48.610 --> 1:07:50.880 the Russian Debt Crisis. 1:07:50.880 --> 1:07:54.420 It was a contagion effect. 1:07:54.420 --> 1:07:57.940 And it got all the way down to Brazil. 1:07:57.940 --> 1:08:01.890 You wonder, why was Brazil affected by an Asian crisis? 1:08:01.890 --> 1:08:07.510 Well, the world, it was and is interlinked. 1:08:07.510 --> 1:08:12.510 So, it's experiences like this, that encourages the G-20 1:08:12.510 --> 1:08:17.550 countries now to agree on bank regulation, that will prevent 1:08:17.550 --> 1:08:20.150 this kind of collapse. 1:08:20.149 --> 1:08:24.899 And the last example I have is, again, it's not -- this 1:08:24.899 --> 1:08:26.669 one is not so international. 1:08:26.673 --> 1:08:32.923 The Argentine crisis of 2002. 1:08:32.920 --> 1:08:38.630 This was, again, a complicated crisis. 1:08:38.630 --> 1:08:41.620 But it involved the Argentine government shutting down the 1:08:41.620 --> 1:08:45.370 banking system in Argentina. 1:08:45.370 --> 1:08:50.620 And I don't have much time to talk about all this. 1:08:58.399 --> 1:09:02.339 The examples that I gave of crises around the world, I 1:09:02.340 --> 1:09:06.370 went through them very quickly, but let me just 1:09:06.370 --> 1:09:09.540 reiterate the themes that I started out with. 1:09:09.540 --> 1:09:14.820 And that is that banks fill a 1:09:14.819 --> 1:09:17.879 fundamental role in our economy. 1:09:17.880 --> 1:09:19.630 They make things work. 1:09:19.630 --> 1:09:22.370 They solve moral hazard problems. They solve adverse 1:09:22.370 --> 1:09:28.760 selection problems. They create liquidity, so that 1:09:28.760 --> 1:09:33.320 businesses can function and individuals can function. 1:09:33.319 --> 1:09:40.689 When the crisis develops, we suddenly realize the 1:09:40.689 --> 1:09:45.719 importance of our banking system in its absence or in 1:09:45.720 --> 1:09:50.190 its poor behavior. 1:09:50.190 --> 1:09:54.540 And so, I think there's an attitude among a lot of people 1:09:54.540 --> 1:09:56.680 that they don't like regulators, or they don't 1:09:56.680 --> 1:09:58.420 appreciate regulators. 1:09:58.420 --> 1:10:03.530 But in fact regulators are people who are managing a very 1:10:03.530 --> 1:10:07.690 complicated system, which is really important to our 1:10:07.690 --> 1:10:09.400 prosperity. 1:10:09.400 --> 1:10:13.550 If you look at causes of economic disruptions, it's 1:10:13.550 --> 1:10:17.220 failures in our banking system that seem often to be 1:10:17.220 --> 1:10:18.490 responsible. 1:10:18.490 --> 1:10:21.490 There's other things, like, for example, an oil crisis can 1:10:21.490 --> 1:10:23.010 bring on a -- 1:10:23.010 --> 1:10:25.410 it seems to be completely independent of a banking 1:10:25.410 --> 1:10:29.240 crisis, but you take those two together and you explain most 1:10:29.240 --> 1:10:30.900 economic crises. 1:10:30.900 --> 1:10:34.850 It's a very important thing to get banks regulated right. 1:10:34.850 --> 1:10:38.710 Now what I didn't talk about in this lecture is -- and I'm 1:10:38.710 --> 1:10:40.410 going to come back to this -- 1:10:40.410 --> 1:10:42.260 is the shadow banking system. 1:10:42.260 --> 1:10:43.840 Let me just mention this in anticipation. 1:10:52.394 --> 1:10:57.954 And that refers to other kinds of companies, not officially 1:10:57.950 --> 1:11:02.770 banks, that are doing business that resembles banking and is 1:11:02.770 --> 1:11:05.230 not regulated. 1:11:05.230 --> 1:11:11.880 So for example, Lehman Brothers or Bear Stearns, 1:11:11.880 --> 1:11:15.330 which were major failures that led to this crisis, 1:11:15.330 --> 1:11:17.370 they were not banks. 1:11:17.370 --> 1:11:18.760 Well, they're not commercial banks. 1:11:18.760 --> 1:11:21.070 They're not under Basel III. 1:11:21.070 --> 1:11:24.310 They are investment banks, which is a different animal 1:11:24.310 --> 1:11:26.510 and it's not regulated by Basel III. 1:11:33.515 --> 1:11:38.625 Let me add innovation in finance. 1:11:38.630 --> 1:11:41.830 It's making the financial world harder and harder to 1:11:41.830 --> 1:11:42.670 understand. 1:11:42.670 --> 1:11:45.790 That's why we keep having Basel I, Basel II, Basel III. 1:11:45.790 --> 1:11:50.090 There's going to be a Basel IV. Financial systems are so 1:11:50.090 --> 1:11:52.000 much more complicated than they were, 1:11:52.000 --> 1:11:54.030 say, in the 19th century. 1:11:54.030 --> 1:11:55.120 There used to be a bank. 1:11:55.120 --> 1:11:57.430 You can see, there's one in downtown New Haven that looks 1:11:57.430 --> 1:11:59.170 like a Greek temple. 1:11:59.170 --> 1:12:00.470 You probably didn't even notice it. 1:12:00.470 --> 1:12:02.130 I looked at the corner stone. 1:12:02.130 --> 1:12:03.900 It was 19th century. 1:12:03.900 --> 1:12:05.790 It's a beautiful old building. 1:12:05.790 --> 1:12:06.830 Banks were like that. 1:12:06.830 --> 1:12:08.750 They had a nice granite edifice. 1:12:08.750 --> 1:12:11.540 You'd go in and there'd be a banker sitting there. 1:12:11.540 --> 1:12:13.500 And you could talk to a person, and 1:12:13.500 --> 1:12:15.650 they'd make a loan. 1:12:15.650 --> 1:12:18.560 But now, we have all these complicated derivative 1:12:18.560 --> 1:12:21.940 contracts, and they trade all over the world and it's so 1:12:21.940 --> 1:12:23.190 interconnected. 1:12:25.880 --> 1:12:28.720 And shadow banking, which I'll come back to later, shadow 1:12:28.720 --> 1:12:31.390 banking is a consequence of -- 1:12:31.390 --> 1:12:34.260 it's the kind of thing that happens. 1:12:34.260 --> 1:12:37.580 Regulators can't keep up with all these innovations. 1:12:37.580 --> 1:12:40.120 But I don't think the answer is to shut down innovations. 1:12:40.120 --> 1:12:44.390 We just have to allocate resources, and that's a trend 1:12:44.390 --> 1:12:45.940 that we are doing. 1:12:45.940 --> 1:12:51.360 And I think that we will benefit, if we have effective 1:12:51.360 --> 1:12:53.970 and sound regulation that takes into account the 1:12:53.970 --> 1:12:57.970 subtleties of moral hazard, adverse selection, importance 1:12:57.970 --> 1:12:58.500 of liquidity. 1:12:58.500 --> 1:13:02.490 These are basic, important concepts that make for better 1:13:02.490 --> 1:13:04.270 lives for people. 1:13:04.270 --> 1:13:06.690 And we have to expect that regulation is 1:13:06.690 --> 1:13:08.880 going to get complex. 1:13:08.880 --> 1:13:10.660 Basel III may look complex. 1:13:10.655 --> 1:13:12.615 It's going to get even more complex, but we'll have 1:13:12.620 --> 1:13:17.130 computers managing the regulations somewhat, so it'll 1:13:17.130 --> 1:13:18.410 all be doable. 1:13:18.410 --> 1:13:18.800 OK. 1:13:18.800 --> 1:13:19.800 I'll see you again. 1:13:19.800 --> 1:13:22.080 I hope you have a nice spring vacation.