PROFESSOR ROBERT SHILLER: OK.
So, today we're going to talk
about banks, banking.
Before I start, I want just to
remind you that we have Hank
Greenberg coming on Wednesday
[addition: next lecture].
And we talked about him in a
previous lecture, but he is
one of the most important
capitalists, I
think, in the world.
The firm, AIG, which was started
by C.V. Starr, was
converted into the biggest
insurance company in the world
by Hank Greenberg.
Over many years, the two of
them ran AIG exclusively,
first Starr and then
Greenberg.
And Greenberg produced a very
innovative insurance giant.
It didn't end well,
but I think he --
I talked to him the other day.
He said he's going to talk about
the end, what he learned
from the experience.
Once again, no one can control
everything that happens.
And random shocks affect
all of our lives.
He remains a very important --
he's no longer at AIG --
remains a very important
force in our society.
Now, he's very much involved
with philanthropy and doing
things like lecturing young
people, what he freely does
out of a sense of commitment.
So, I think he's a committed
person that has a moral
purpose, that's why
I asked him to
be one of our lecturers.
But today we're talking
about banks.
And I wanted to --
The outline my lecture: I'm
going to start with the
origins of banks, thousands
of years ago.
Then, I'll talk about the theory
of banks, fractional
reserves and deposit
insurance.
Then, bank regulation,
particularly in light of the
world financial crisis, which
has changed the nature of
regulation.
Changes that will be with
us for decades to come.
I'll talk about shadow banking,
which is the new
banking sector that emerged and
escaped regulation until
the crisis.
And then, I'll talk at the
end a little bit about a
comparison of financial crises
in the past in various places
around the world, to see how
banks managed in those crises.
So, the first thing I want to
say is, this is a lecture
about banks, OK, and that means
traditional banks who
take deposits and lend money.
It's not about investment
banks.
That's another lecture.
An investment bank, a pure
investment bank, does not
accept deposits.
And its most characteristic
thing is underwriting of
securities.
So, that's a different
lecture.
And I'm not talking about
central banks in this lecture.
That's also --
well, the lecture on
monetary policy.
Central banks are the government
organizations that
manage the money supply
of a country.
So, we're talking here about
banks, and I thought I should
start out by defining a bank.
The word bank, by the way,
means counter or tabletop
where bankers used to
do their business.
That's the English word that
emerged in the 15th century.
But banks, of course, precede
that with other names.
What is it that is the
characteristic activity of banks?
I would say, maybe the most
characteristic thing is that
banks earn spread income.
That is, they borrow at a lower
interest rate, and lend
it out at a higher interest
rate, and they make the
difference.
Your deposit rate is lower than
the rate at which they
charge for the loans
they make.
So that's the spread
income or margin.
So, that might be considered the
core idea of a bank, that
you borrow at a lower
rate than you lend.
But I'm not sure that that
summarizes it, either.
There's other aspects of banks
that we'll talk about.
Another aspect of banks,
traditionally,
has been note issue.
That is, they print paper money,
and then it circulates
and goes --
you have some of these
in your pocket.
They're currency.
If you stopped a person on the
street a couple hundred years
ago, and said, what is the
essence of a bank?
I suspect, the first thing they
would say is, oh, they
print money.
And that's the paper
money that we use.
But you don't think
of it this way.
Probably not, because most of
that function all over the
world has been shifted to the
government banks, the central
banks, in the various
countries.
And so, you don't think
of private banks as
issuing bank notes.
But they used to and it
used to be prominent.
The private bank issuing of
notes today in the world, I
believe, is concentrated
primarily in two countries.
One of them is the United
Kingdom, and the
other one is Hong Kong.
Tell me if there's
another country.
I don't know who else does it.
In the United Kingdom there
are eight banks that still
print pound sterling notes.
And they're not very
prominent.
In Scotland, there are some.
I actually once went through
the Chunnel from England to
Scotland, oh, from Scotland to
France [correction: from
England to France], and I tried
to spend my Scottish
sterling notes on the train,
and the guy, who was
French-speaking, stared at
it and said, what's this?
And he wouldn't take it.
So I said, this is
pound sterling.
This is official.
It trades at par with the
Bank of England notes.
Hong Kong has three banks that
issue their bank notes.
Let's see, Hong Kong Shanghai
Bank [correction: Banking]
Corporation, the Standard
Chartered Bank, and the Bank
of China, Hong Kong.
Everywhere else, banks
don't issue notes.
And the reason they don't is,
laws have been made to prevent
them, because these notes lost
value so many times in
financial crises that
governments said, it's not
something that we'll allow
private banks to do.
So, it's generally gone.
If you look at your $1 bills in
your pocket, it will give
the name of a Federal
Reserve bank.
And there's 12 of them.
Our Federal Reserve bank
here is the Federal
Reserve Bank of Boston.
So, you can look at your dollar
bills and see which
bank issued it.
So, you're probably carrying a
lot of Boston money, but since
it's all the government, you
know, you don't even notice
that, right?
You don't notice.
If this were 1750, and you had
Boston money in your pocket,
you might -- because we're
in Connecticut --
you might have a problem.
You'd have to go to a money
dealer and have it exchanged,
because they didn't know or
trust the Boston bank.
That's all past. So, note issue
is a matter of history.
So, there's other aspects of
a bank I want to emphasize.
One is liquidity.
And this is an essential element
of banking as well,
and I'll come back to
that when we talk
about theory in a minute.
But banks offer liquidity
by borrowing
short and lending long.
This is different from
spread income.
I'm saying, the interest rate
is lower on the borrowing of
the bank than the lending
of the bank.
There's another discrepancy.
The maturity is longer on the
lending of the bank than the
borrowing of the bank.
So, banks are providers
of liquidity.
That means, a business wants to
borrow money, or let's say
a homeowner wants to borrow
money to buy a home.
Let's take that example.
That's more familiar.
You're going to lock up the
money for maybe 30 years.
You don't want to pay the
loan back tomorrow.
What if the lender says, I need
the money, give it back.
You can't give it back, or you
don't want to give it back.
So, what a bank does is, it
takes deposits and allows
people to cash them in
whenever they want.
It lends the money out long
on 30-year, or so, loans.
So, it generates liquidity.
The borrower has what he
or she wants, which
is a 30-year loan.
The lender has what they want.
They have an account they
can get at any time.
And so this is an important
function of banks.
But the problem with
it is, that there's
a problem of crises.
Because if everybody asks to
pull their money out at once,
they can't do it.
The banks, in normal
circumstances, generate
liquidity, but they create a
system that's vulnerable.
And so, the banking industry has
been plagued by frequent
crises throughout history.
So, I wanted to say something
about the very
beginnings of banking.
Who did it first? --
By the way, I should
have written the
words interest rate.
When I'm talking about spread
income or margin, I'm talking
about the difference between
two interest rates.
But more primitive is the
idea of interest rate.
So, where did that
idea come from?
Well, I was reading some
economic historians.
Apparently, the word interest
first appeared in
the Sumerian language.
I guess, the oldest records
are about 2000 BC.
And they had a word which
they write as mas.
I guess, that's pronounced mosh,
which was their word for
interest, but it also
means lamb.
And so, one historian was
wondering, why do the
Sumerians use the same word for
interest as they do for an
animal, a lamb.
And he thought that maybe it
was because the idea of
lending money at interest grew
out of an earlier idea of
renting land.
So, you would have land that you
weren't using in ancient
Sumeria, and you would rent
it out to somebody who
would then use it.
And one of the things that the
person would do with it, is
raise livestock, raise
sheep, on the land.
So, you would say, well, I need
some produce from the
land to compensate me for
letting you use it.
So the guy would say, fine,
I'll give you all the
offspring of our sheep,
the lambs.
That was an old tradition
in Sumeria.
So, they thought it's basically
the same thing.
It's like giving
over the lambs.
If I lend you money, I'm
giving you productive
resources, and it's going
to produce something.
We'll call it lambs.
And I want that.
And you're compensating
me for it.
So, that's where
the idea began.
And so, you'll find it in the
ancient world, in the near,
non-oriental ancient world.
In ancient Greece and Rome,
interest was well-established.
And some kind of banking.
Now, I don't know whether there
were bankers in Sumeria,
but there probably were, because
all it takes is that
you do both sides.
They actually didn't necessarily
lend money in
those days.
They would lend barley or wheat,
and they would charge
interest in terms of wheat.
You don't need money
to do banking.
But I suspect that somebody
in ancient Sumeria
was doing both sides.
He was borrowing wheat, and
lending it, and earning a
spread income.
And so, there must have been
banking in the ancient world.
But anyway, what about these
kinds of institutions that we
call banks?
Oh also, the first --
apparently, if I've got my
history right, the first record
of interest rates in
China was Song Dynasty.
And that was from the
year 960 to 1279.
They were, at that point,
inventing paper money and
other financial institutions.
I don't know if they had
institutions called banks.
But, you know, it often
would be a family
business lending money.
If you were a prominent family,
you would often take
other people's money
for safekeeping.
And it was also connected with
religious temples in the past.
But the modern banks seem to
appear in Italy in Renaissance
times, where they actually had
a banking institution.
And that's where the
oldest bank in
the world today exists.
It's Banca Monte dei
Paschi, in Siena.
And that means the bank of
the mountain of sheep.
It's the same analogy,
I guess.
I don't know if they called
their interest lambs.
And so, that bank was
set up in 1472.
That's the oldest surviving
bank in the world.
I went there.
You can go there if you visit
Siena, and they have a little
museum on the first floor
near the lobby.
And it's actually the third
largest bank in Italy.
A very old institution.
It's interesting that this bank,
which was founded in
1472, was founded as a
philanthropic institution to
lend money to the poor.
And wealthy donors in
Italy gave money
to set up this bank.
It goes beyond that now.
It's not just lending
to the poor.
The other thing is in
the 1600's, they
gave it deposit insurance.
Believe it or not.
The Duke of Siena said he would
guarantee all deposits.
So, deposit insurance
appears to have been
invented in Italy as well.
But a lot of people emphasize,
when they talk about the
history of banking --
I was reading, in preparing for
this, economic histories
to see what they would
say about banking.
And professor Clive Day, a
professor here at Yale, wrote
a book called, History
of Commerce, in 1907.
You can pick up his book, if you
want to, on Google Books.
It's past its copyright.
I had great fun reading it.
He's long gone, a professor
at Yale.
But his history begins in
England, with the so-called
goldsmith bankers.
What happened was, in England in
the maybe 1500's or 1600's,
somewhere around that,
goldsmiths who made gold
jewelry had safes or good
places to store gold.
And so, people would go to the
goldsmith, and maybe they're
having jewelry made, but then
they'd say, could you keep
some of my gold in your vault?
And so, the goldsmith banker
would say, all
right, I'll do that.
And I'll give you a note saying,
I'll promise to pay
you this amount of gold
that's in my vault.
So, sometime when you were out
shopping, the goldsmith
banker's note would be in your
pocket still, and you'd want
to buy something.
So you'd say, well,
I've got this --
you talk to the merchant and you
say, I've got this gold.
It's in the goldsmith.
I've got his note here.
So the merchant would say, all
right, I'll take that, but
you've got to endorse
it over to me.
Write a note on the note saying
that this thing is
being transferred to me.
And so, I can go to the
goldsmith and get it out.
That's how paper money got
started in England.
It started to circulate with
many endorsements on it.
And then finally, the goldsmith
said, let's forget
about endorsing it
to one person.
Let's just say, to the bearer.
And so, paper money started
developing kind of
spontaneously.
And then, the goldsmiths
noticed, you know, they've got
all this gold in their vault,
they can lend it out.
Why not?
Because nobody ever comes and
asks for it, now that these
paper notes are circulating.
Nobody asks for it, so I'll
start lending it out.
And they didn't have to pay
any interest on the notes,
because people would hold them
anyway just because they
valued the safekeeping.
I guess they were paying
interest in the sense that
they were providing
the safekeeping.
So, that's how banking got
started in England, but it was
really preceded in Italy.
What has happened is, because
of repeated problems in the
banking industry, which
gradually grew through time
into something that's more and
more important, governments
all over the world
regulate them.
And that means they define
certain specific types of
banks that differ a little bit
from one country to another.
And you have to --
when you decide to
create a bank --
you have to decide which
type you are.
So, I wanted to start --
And in your textbook, Fabozzi
et al., talks a lot about
types of banks.
But let me just talk about
the major types.
I'll talk in the U.S. The most
important type of bank is
called a commercial bank.
And these are banks that
take deposits.
You can put your money in the
bank, and then it will pay you
interest, and it will also make
loans of various kinds.
But, most characteristically,
business loans.
Commercial banks were even
more prominent 100 or 200
years ago, because they
didn't do mortgages
and consumer loans.
It was all business
loans, initially.
So, this is kind
of the historic
important kind of bank.
And in 2010, the total assets
of U.S.-located, commercial
banks were $14.6 trillion.
But actually, a lot of that was
foreign commercial banks
operating in the
United States.
Of that $14.6 trillion, only
10.1 was U.S.-chartered banks.
So, bankers operate all
over the world.
So, we have banks like, I
mentioned Hong Kong and
Shanghai Bank
[correction: Banking]
Corporation, or the various
Swiss banks that have big
operations, or Deutsche
Bank, big operations
in the United States.
So, they account for almost a
third of our commercial banks.
But then, there are other kinds
of banks, and they're
smaller in terms of -- this
is assets of the banks.
It's not their market cap.
The market cap would be much
lower, because remember
offsetting these assets are
liabilities they owe to the
depositors.
But there's other
kinds of banks.
There are savings banks.
In the U.S., savings banks
had only $1.2 trillion.
These savings banks tend to be
old institutions that have
grown very large over time.
They're the result of a savings
bank movement in the
19th century, which was a
philanthropic movement to set
up banks for lower-income
people.
Because commercial banks
traditionally wouldn't take
deposits from small --
you'd have to have
a minimum size.
They didn't deal with
ordinary people.
So, they created savings
banks to
encourage thrift and saving.
Actually, it follows on a U.K.
movement, a savings bank
movement in the U.K. And they're
still with us, but
they're not so big.
And there's also
credit unions.
That's another social
movement.
And they're only $0.9 trillion,
or about $900
billion in assets.
Credit unions are basically
clubs of people that belong
together in some group.
If you have a company, you can
set up a credit union for the
employees of your company.
Both savings banks and
credit unions make a
lot of mortgage loans.
That's kind of their
characteristic business.
In the U.K., you have the
same kinds of banks.
Savings banks would be called
building societies, but it's
the same idea.
They make loans for building.
So, I said I would talk about
the theory of banks.
I've already given you some
indication by describing what
is it that banks do.
But I see I have a lot
more to talk about.
I have to consider
my time here.
There's so much to
say about banks.
It's a whole fascinating
subject.
But I wanted to mention, the
theory of banks was laid out
in the Diamond-Dybvig model in
the Journal of Political
Economy, 1988.
They were both colleagues
of ours at Yale.
They've moved on.
So, I know them both.
Doug Diamond and Phil Dybvig.
But what they described
is a model --
I'm not going to give you the
model, just to tell you about
it -- the theoretical
model of banks as
providers of liquidity.
That liquidity is an economic
good that you can somehow get
for nothing.
It's just like portfolio
diversification.
We don't need to expend
any resources to get
diversification, we just
have to manage
our portfolios right.
Similarly, you set up
a bank, and lo and
behold, liquidity appears.
And it makes it possible
for people to
live their lives better.
I mentioned that you can live
in a house for 30 years, or
you can move whenever
you want.
But the problem with this is
that there are multiple
equilibria.
Their model has a good
equilibrium and a bad
equilibrium, and it depends
on expectations.
If people think that the banking
system is sound and
it's going to work well,
it works splendidly.
But the problem is, all it
takes is for people to
suddenly change their
expectations, and then it all
falls apart because
you have a run.
You have a bank run.
So, what Diamond and Dybvig did
is to provide an economic
rationale for deposit
insurance.
Insuring deposits against
default of the bank helps
prevent bad outcomes, keeps us
in the right equilibrium.
So, this is an important
paper.
The problem is that banks runs
can be triggered by random
shocks to the model.
And so, what happened in the
latest crisis is, there was a
real estate bubble.
It's not something that's
represented
in Diamond and Dybvig.
And the bubble, when it burst,
when home prices started
falling, and commercial real
estate prices started falling,
the banking system started
to fall apart.
So, it's not entirely easy to
keep banks under good control.
You see, Diamond and Dybvig
emphasized that banks are an
invention that creates
liquidity.
And liquidity is a positive
economic good that makes us
run our lives better.
So, it's an important
invention in
the history of economics.
But there's other issues that
banks do, problems they solve.
One of them is an adverse
selection problem that plagues
securities.
I didn't mention that the
alternative to banks for
raising money, if you're a
business, is, that you could
issue bonds or commercial
paper.
You can borrow money directly
from the public without an
intermediary.
They do this.
I'm a company.
I need money to, say,
build a new factory.
I go not to a commercial bank.
I go to an investment bank, and
they help me issue some
paper to the public.
And we sell it off
in some market.
The problem with issuing debt
directly to the public is,
that the public can't
judge the quality
of the company easily.
Most people who are investors
are not good at estimating the
value or the security
of a company.
So, they need some
kind of experts.
If the adverse selection would
happen, see, the experts, the
people who know, would buy all
the good stuff, and it would
leave beyond --
people would start to think,
I'm not going to buy these
securities, because why are
they being offered to me?
I don't know anything.
I'm a sucker.
That's the idea.
I'm not a sucker, I
just don't know.
I may be smart, but I just don't
know what the quality of
this company is.
If I just go in there blindly
and pick up whatever seems to
be out there, I'm going to
suffer an adverse selection.
I'm going to get the worst
stuff, because
I'm not looking --
I can't look, they're going to
dump the bad paper on me.
So, banks solve that by being in
the community, knowing who
is borrowing, and having a
reputation, so that instead of
you suffering this adverse
selection problem, the bank
has people who know
what's going on.
So, the thing about banks is,
that they have local loan
officers who serve in a
particular community.
And they know all about
that community.
And they solve the adverse
selection problem.
So, for example, if you are a
loan officer in a bank, by
tradition, you are
someone who gets
involved in the community.
You'll find them on the program
at the symphony.
They're one of the donors.
They show up for all
kinds of things.
They know what's going on.
They play golf with local
business people.
They hear the gossip.
So, someone says, you know,
this guy, the CEO of this
company, I think he's
an alcoholic.
You better watch this guy, I
don't know what he's doing.
You hear these things.
And you know what happens?
The guy doesn't get a
loan the next day.
I hate to say it, but they
kind of vouch for the
character of people.
I mentioned this in a previous
lecture, that there's all
kinds of people out there.
And you can't prove or
judge who's good.
You can't write it down in
some objective way, who's
going to be a responsible
business person.
But banks know that,
so they solve the
adverse selection problem.
There's also a moral hazard
problem that banks solve.
The moral hazard is that a
company may borrow money, and
then take a big flyer and
do some wild investment.
Let's take this, for example:
Suppose we owned a small
company and it's
not doing well.
We have this great idea.
Let's borrow $10 million, and
let's go to the racetrack and
let's put it all on
the least likely
horse to win, all right.
And, you know, our chance of
winning is only one of 10, but
if we win, I got $100 million.
If we lose then, hey,
we just go bankrupt.
We say, sorry.
Of course, you really couldn't
do it at the racetrack.
I mean, you'd be sued
if you did that.
But you see what I'm saying.
I could see --
I wouldn't do that --
but I could see
wanting to do that, right?
Your company's going out of
business anyway, you know, you
don't have any prospects.
But if we can borrow $10
million, go and bet it on the
racetrack, and one in ten
we'll be super rich.
We'll have $90 million, right?
Pay off the debtors.
Everything's fine.
They won't complain
if you win.
They'll complain if you lose,
but then you say, sorry, you
know, we're out of business.
It's limited liability.
So, what banks do is, they help
solve this problem by
constant monitoring, and they
make commercial loans that are
at effectively long-term, but
in practice, officially
short-term.
They keep renewing them, and
they can cut you off, when
they think you're doing
something that
reflects moral hazard.
So, the constant monitoring that
banks provide solves the
moral hazard problem, just as
their information collection
solves the adverse selection
problem.
I'm just trying to see, where
I want to go next.
So, I mentioned deposit
insurance.
I mentioned that it started in
Italy in the 1600's, but it
has a long history of
governments backing up
deposits of banks in order
to prevent banks runs.
Because bank runs happened
too often.
People would get a little
scared, and they would go to
the back and try to pull
all their money out.
They'd hear a rumor, and
then the whole banking
system could collapse.
And so, people in various
governments at various times
offered guarantees.
But the problem is,
those guarantees
can get really expensive.
So sometimes, they had a limited
guarantee, and so
sometimes, the deposit insurance
scheme would fail.
And so, the history of deposit
insurance is a checkered one.
So, in United States there
were various state
governments, local governments,
that created
deposit insurance schemes before
the FDIC, but a lot of
them failed, and so, people
said this is a crazy idea.
But the United States
government in 19 --
I think it was '33, do
I have this right? --
created --
I think that's right --
the Federal Deposit Insurance
Corporation as part of the New
Deal under Franklin
Delano Roosevelt.
And it has never failed
to this date.
Why didn't it fail?
It's hard to know, exactly.
We never had a big back
run since 1933.
It seemed to create the
psychology that people stopped
worrying about bank failures,
because they believed they
were insured.
I guess they believed Franklin
Delano Roosevelt.
And so, if you believe it, then
it's one of those funny
things, it's the multiple
equilibria that
Diamond-Dybvig mentioned.
As long as people believe
the bank system is
sound, it is sound.
We also created later, another
deposit insurance, called the
Federal Savings and Loan
Insurance Corporation
[addition: abbreviated FSLIC],
that was doing the savings and
loan associations, which were
a type of savings bank.
And that did fail.
And so, we had a huge crisis in
the United States, called
the savings and loan crisis,
in the 1980's.
So, the S&L crisis in the 1980's
was due to a widespread
failure of savings and loan
associations, and then, kind
of a run on the savings and
loans, but it wasn't really a
run, because the FSLIC
was trusted.
And what ended up happening
is, the FSLIC had reserves
against a certain amount of
losses from the banks, but
they went through
them completely.
And then they were bankrupt.
So, the insurer went bankrupt.
What then happened is, the
United States government
picked up the tab.
And the total tab was
$150 billion.
And that restored confidence.
I guess, the government
had to do that.
And the FSLIC no
longer exists.
Savings and loans are now
insured by the Federal Deposit
Insurance Corporation.
So, you know, these institutions
really don't
necessarily represent
the real insurance.
You have to always see
beyond institutions.
The FSLIC was encouraging
people to believe in the
security of the banking system,
but it really wasn't
the ultimate security.
The ultimate security wasn't
even written down.
It was the recognition by the
U.S. government, that if we
let FSLIC fail, and we let all
these depositors in the
savings and loans lose their
money, it's going to destroy
the confidence that has kept
us away from bank runs.
And the next thing are
commercial banks, or who
knows, what else will happen.
So what always happens is, the
government stands behind these
promises, even if they weren't
made so clearly.
There's another example, I'll
give you, which is more
recent, of a bank run.
And that occurred in the
United Kingdom in 2007.
The bank was called
Northern Rock.
And a rumor started -- this was
at the beginning of the
financial crisis -- a rumor
started that Northern Rock
held a lot of subprime
securities, and was going to
go bankrupt.
So, people rushed to Northern
Rock, and big lines formed
outside of Northern Rock.
People, they wanted to get
there first, because you
thought, they're still handing
out the money.
I want to be there first. And
then, newspaper photographers
photographed the crowd outside
the bank, and people thought,
well, this is just like 1933 and
the huge banking crisis.
Now, actually, the U.K.
government did have deposit
insurance, but the deposit
insurance in the U.K. would
insure fully all deposits
up to GBP 3,000.
And then, it gave 90% insurance
up to GBP 75,000.
After that, you were
out of luck.
So, why was there a bank run
on Northern Rock when there
was deposit insurance?
Well, I tell you.
It was people who had more than
GBP 3,000 in the bank,
very simple.
And so, you know, they didn't
really have enough deposit
insurance to stop a run.
So Mervyn King, who's head of
the Bank of England, just
decided, you know what, we'll
bail everybody out.
No questions.
Forget our deposit
insurance scheme.
And that stopped the run.
So again, it happened the same
way in the United Kingdom.
The deposit insurance stopped
it, before it was any problem.
So, the United Kingdom has never
had a bank run failure
since 1866.
It's not really because of any
deposit insurance scheme.
It's about the Bank of England,
which is their
central bank, and what it does
to maintain confidence.
Other countries handle
it differently.
I was going to mention, in
Germany, IKB Deutsche
Industriebank, in 2007.
This is a German bank that
German depositors
put their money in.
And it had invested a lot
in subprime securities.
And it was in trouble, and
there were starting to be
worries of a run on them.
The German government didn't
even wait for a bank run.
They just bailed them out, and
it cost them EUR 1.5 billion.
But again, the governments
know that they want to
maintain confidence,
and so they do it.
They do what they have to do.
Now, I want to go to bank
regulation, more generally.
If you are insuring banks, then
you'd better regulate
them, because there's a
moral hazard problem.
I just described a moral hazard
problem for a company
that borrows money from a bank,
but there's moral hazard
problems for banks as well.
Namely, banks can do
the same trick.
I said, go to the racetrack.
Borrow money and go
to the racetrack.
Banks can do that, same thing.
Except, they wouldn't actually
go to the racetrack.
They would pick some really
risky business venture.
And if it fails, then it all
falls to the deposit insurer.
This is a fundamental lesson
of insurance, whenever you
insure something, you've got to
regulate the person insured.
Because once you've taken a risk
from their shoulders, you
create moral hazard for them.
And so, bank regulation
is very important.
So, I was going to talk mostly
here about the kind of bank
regulation that has an
international dimension.
And so, what I wanted to talk
about is the Basel bank
regulations that were generated
by an international
organization in Basel,
Switzerland.
After the savings and loan
crisis was Basel I. It was an
international meeting that
published a set of
recommendations for all the
countries of the world to
regulate their bank.
The idea was that there
should be some
coherence across countries.
If one country regulates its
bank very stiffly, that's
going to drive business
out of that country
and into other countries.
Also, there should be some
standardization.
It helps the world economy, if
everybody knows that all the
banks of the world have
similar regulations.
But Basel, the Basel Committee,
as it's called,
that created the
recommendations,
had no legal authority.
All it could do is recommend.
But it did recommend bank
regulations, and these were
widely adopted around
the world.
Each country could make
modifications,
whatever they want.
You can't order countries
around, but they often
followed the Basel
recommendations.
In Basel II, they met again in
the 2000's, and they issued
recommendations in 2004.
What they said in Basel II was,
the banking system was
getting so much more complicated
that they had to
think more about how to do it.
Now, there's all these
complicated derivatives and
special purpose vehicles, and
so they had to update their
regulations.
Unfortunately, Basel II has
suffered a reputation blow,
because right after Basel
II we had the
world financial crisis.
So, they didn't do
something right.
They didn't really fix the
system in Basel II.
So, that brought us to
Basel III, which
is the latest version.
And they issued their
report in 2010.
And also in 2010, the G-20
nations meeting in Seoul,
Korea, expressed their support
for Basel III.
So, Basel III is the current
world regulation standard.
But it's phased in gradually,
and it won't be fully phased
in until 2019.
They didn't want to put it in
all at once, because the world
is in a financial crisis, and
it would be too stressful.
So, it has a slow phase-in.
And some of the details
haven't even
been worked out yet.
The G-20 countries have agreed,
in principle, that
these regulations are where
we'll go, but details have yet
to be worked out.
You know, bank regulation
is a big business.
We could have a whole
semester on studying
what these guys do.
So, I just wanted to give
you kind of a caricature
of what's in Basel.
It's also in Fabozzi et al.,
the Fabozzi et al.
textbook, which is
copyright 2010.
You'd think this would be
in it, but it's not.
Basel I and Basel II are
in Fabozzi et al.
Basel III isn't, because it
didn't come in until the end
of 2010, and so it didn't
make it in time to
appear in your book.
But I wanted to just give you
a simple account of all the
Basel agreements, and some
sense of where we
are with Basel III.
They're all about banks
having enough money.
You know, not taking
on too much.
Enough money for the
risks they take.
Let me start with Basel I,
because part of Basel I is
enforced in all three of them.
And there's a concept called
''risk-weighted assets,''
which is in Basel I, and
Basel II and Basel III,
essentially the same.
OK, so, here's the idea.
We're going to put capital
requirements based on
risk-weighted assets.
Now what does that mean?
That means, that banks cannot
take too many risks.
They have to have enough money
to back them up for
the risks they take.
And we'll call that
money capital.
It's not money.
It's not cash, but it's assets
that they can use to get them
out of trouble, if the risky
assets do badly.
So, if we're going to have
a requirement on how much
capital a bank holds, we have
also to define their risks.
And so, Basel I had a very
simple formula to compute
risk-weighted assets.
Well, it's very simple, until
you get into all the details.
And so, you'll see
the definition of
risk-weighted assets.
It's in table 3.3 in
Fabozzi et al.
But basically, here it is.
There's four categories
of assets.
The 0% weight, the 20% weight,
the 50% weight,
and the 100% weight.
The higher the weight,
it means more risky.
So, where will I write these?
I'll do it up here.
Now, we're talking about all
three, Basel I, II, and III.
0% are national -- well, I'll
say OECD government bonds,
national government bonds.
The OECD is the organization for
European Cooperation and
Development.
And they represent advanced,
stable European countries.
And U.S. government bonds
are included among them.
What else?
Yes, basically that's it.
Now, there might be something
else in there, and I'm sure
there is, but this is the
simplest. 0% weight, because
these have 0% risk.
There's no risk.
So, banks can hold all they want
of these and they don't
have to hold any capital.
Then, next up is 20% weight, and
that's municipal bonds, or
local bonds, that's not issued
by the national governments
but issued by a city or state.
We're having a municipal
bond crisis now.
They're suddenly showing their
risk, and we're worried about
defaults on them, so Basel
I was right to
give them some weight.
They gave them a 20% weight,
because they thought,
municipal bonds are
pretty safe.
They're not as safe as national
government bonds,
because there's examples
of default.
But they're also included --
there's a long list of
what they include --
but notably Fannie
and Freddie --
these are the two mortgage
lenders in the United States--
were included with
20% weights.
Because people thought, these
guys are really safe, and
anyway, the U.S. government
backs them up.
Although the U.S. government
said, it
wouldn't back them up.
But you know, we all know,
they're going to back them up,
and indeed, they did back them
up when they failed.
But Fannie and Freddie, prior
to the crisis, started
increasingly investing in
subprime mortgages.
And they were issuing subprime
mortgage securities that were
really very risky and eventually
went kaput.
Basel I didn't know that, or
Basel II and Basel III still,
they just gave them
a 20% weight.
That was a big mistake, and
that's where part of the
banking crisis comes.
Then, there's 50% weight,
and that's for
mortgages, home mortgages.
The Basel people thought, there
could be some big real
estate crisis.
You know, it's something to
worry about, so there's more
weight than that.
And then, we have 100% on
everything else, but notably
loans, like commercial
loans to businesses.
So, those are the weights.
And so, I just wanted to go
through a simple example.
Suppose you are a bank, and
you have $400 million in
assets on your balance sheet.
These are things that
you as a bank own.
And let's say you have 100 in
government bonds, federal
government bonds.
100 in Fannie Mae,
$100 million.
And you have 100 in mortgages
that you own directly.
And you have 100 in
commercial loans.
So, your total assets
are $400 million.
But you've got to know what your
risk-weighted assets are.
What are your risk-weighted
assets?
Well I take the 100 -- and
Fabozzi et al. goes through an
example too, but this
is very easy --
I multiply the 100
by 0, I get 0.
I multiply this 100 by
20%, so that gives me
$20 million, right?
I multiply the mortgages by 50%,
it gives me $50 million,
and I've got to throw
all these in.
So, what does that add up to?
It's $170 million RWA,
risk-weighted assets.
It's 0 plus 20, plus
50, plus 100.
So, those are my risk-weighted
assets, and then, the amount
of capital that I have to hold
is a percentage of the
risk-weighted assets.
I could go through Basel I,
Basel II, Basel III, they kept
changing these percentages,
as they went along.
So, I'm just going to talk
about Basel III, because
that's going forward,
all right?
And Basel III is complicated,
too.
I'm going to just talk to
you about common equity
requirements.
So, Basel III says --
it's an interesting and
creative construct --
common equity must be 4.5%
of RWA at all times.
But I'll add to that.
They have plus 2.5%, what
they call a capital
conservation buffer.
And so, that adds up to you
7%, and I'll explain.
You absolutely have to have 4.5%
as common equity, but if
you don't also have
another 2.5%, you
can't pay out any dividends.
That's not so good.
So, in reality, you
better keep 7%.
So effectively, Basel III --
this is Basel III, it's not in
your textbook, but it's coming
all over the world, 7%.
Now incidentally, the
interesting thing about Basel
III, they're thinking
creatively, they added another
buffer, called a countercyclical
buffer.
Well, that's not added
automatically.
And that's another 2.5%, but
only if the regulators in the
country choose to impose it.
And here's the idea: We have
to stop bubbles before they
burst, right?
So, suppose you think that a
bubble is building up in your
country, then the regulators
are asked by Basel, if they
make that judgment, to add
another 2.5% to the capital
requirement, while
it's booming.
You don't wait until the crisis
to do this, because
then they'll all be in trouble,
and if you tighten up
on banks then, they'll stop
making loans, and that will
crash the whole economy.
You have got to tighten up
when times are good.
So, that adds up to 9.5%.
So, you'd have to hold capital
equal to 9.5% of your
risk-weighted assets.
But presumably, the normal
number is 7%.
So, let me just go through for
this bank here, which has $400
million in assets.
What is their requirement?
Well, we figured out that they
have $170 million in
risk-weighted assets.
Multiply that by 7%, and that
gives you, I think it's $11.9
million that they have. So,
your common equity must be
$11.9 million.
So, you go to your
balance sheet.
We showed balance sheets
in an earlier --
STUDENT: It's common equity plus
the first buffer, right?
PROFESSOR ROBERT SHILLER:
I'm sorry?
STUDENT: The $ 11.9
million is --
PROFESSOR ROBERT SHILLER:
Oh, did I do with --
yes, I'm sorry, that's
7% of $170 million.
You don't actually have to
hold this buffer, but it
limits you if you don't.
And so practically,
most banks will.
So then, you go to look on your
balance sheet, and you
see, hey, we're lucky, we
have got $12.9 million.
Let's say, I just
made that up.
How do you get common equity?
You take the total assets in
your balance sheet, you
subtract off all of the
liabilities, all
the money you owed.
And that gives you shareholders'
equity, but that
has two components, common
equity and preferred equity,
so you've got to subtract off
the preferred equity.
But it's a sense of how much
extra resources you have.
After you've paid off
all your debts, you
still have $12.9 million.
You say, hey, we're good.
We've got an extra
million dollars.
So then, you bring that up at
the board meeting and say,
we're satisfying Basel III,
isn't that great?
But someone at the board might
say, but wait a minute, that
means we have $1 million
too much.
It's just sitting there, we're
not even using it.
Let's lend it out.
I'm sorry, let's use it
up, not lend it out.
How do you use it up?
You've now got more than the
amount of capital required.
You've got another
million dollars.
You could lend out $1 million,
but think about it.
You can borrow more
and lend more.
Or you can borrow more and
take other assets.
And you can go beyond
$1 million.
Let's consider this.
So, do you understand
the situation?
That we've done our
accounting.
We have $170 million in
risk-weighted assets.
We have a requirement,
therefore, of $11.9 million in
common equity.
We have an extra million
dollars.
Let's consider buying different
kinds of assets.
How about buying Fannie
Mae bonds?
How much more can you buy?
Well, you've got $1 million.
If you're going to buy more,
you're going to add both
assets and liability.
You're going to borrow money,
and you're going to buy more.
So, you're going to add both
assets and liabilities to your
balance sheet.
How far can you go without
violating the capital
requirement?
Well, the amount you can buy of
Fannie and Freddie bonds is
$1 million all over
0.2 times 0.07.
And that's about $70
million worth of
Fannie and Freddie bonds.
Because you add that to this
mix, then it will raise your
risk-weighted assets by
exactly $1 million.
So, you can buy $70 million of
Fannie and Freddie bonds
according to this weighted
asset calculation.
You see that?
Well, how about making
loans to small
businesses in our community?
Well, that's 100%
risk-weighting.
So that means, I can make loans
of $1 million all over
0.07, and that's about
$14 million.
So, this is what
you would tell.
You're at a board meeting
and you're saying,
let's consider that.
We're going to stay within the
requirements, we can buy $70
million of Fannie bonds,
or we can make $14
million more in loans.
But at the board meeting,
someone might say, you know,
$70 million sounds better than
$14 million, I think we should
do Fannie bonds, and tell all
the guys with small businesses
coming by, tough luck.
You know, we don't have
any money for you.
So, we see what it's doing.
Its pushing people --
the Basel requirements, and
these are Basel II, or Basel I
requirements, we're pushing
banks toward investing in
subprime loans issued by Fannie
Mae as against lending
to businesses.
And people are starting to
wonder about that now.
But you have to say, isn't the
prosperity of the country
determined by the businesses?
When you're making a subprime
loan, what is a subprime loan?
It's a loan to someone with
bad credit, with bad
employment history,
to buy a house.
So, we have created an incentive
for banks to lend to
those people rather than
to businesses.
And so there are critics
of Basel, all the Basel
agreements, saying, it's
counterproductive.
We shouldn't have done this.
These weights were wrong.
There shouldn't have been so
little risk-weighting on
Fannie Mae.
But then, the Basel people would
say, look, we can't get
it exactly right.
We thought Fannie and Freddie
-- and we're right, they
haven't failed.
Our job at Basel is to prevent a
run on the banks, so we want
banks to be sound.
And maybe you're right, maybe
businesses should be
encouraged, but it's
not our department.
We're trying to prevent
bank failure.
So, these rules stick, and
they're still with us today
under Basel III.
If you want to subsidize small
businesses, like in the United
States we have the Small
Business Administration, that
gives loans to small
businesses.
But Basel III is not
going to do that.
So, I said I would talk about
other financial crises, and
let me talk briefly about a
few, and then I'm going to
have to wrap up.
The crisis that we have been
through was a worldwide
crisis, starting in 2007,
peaking in 2008 and 2009.
And it caused a worldwide
recession.
So, it's especially vivid
in our memory.
But I want to just reflect
that these crises --
we've had banking crises so
many times in history that
it's not a unique event.
And I just wanted to
remind ourselves
of a few other crises.
I'm going to start with the
Mexican crisis, our neighbor
to the south, of 1994 to 1995.
Under President Salinas,
the government
privatized Mexican banks.
Salinas was a Harvard-educated
economist who wanted to
modernize the Mexican economy.
And they privatized government
banks, and turned it over to
the free market, and they
forgot to regulate it.
And so, it led to a
bank lending boom.
In 1988, lending
was 10% of GDP.
In 1994, up to 40% of GDP.
Salinas did not stop this.
And it led to a boom in Mexico,
because lending was
going wild, everything was
happening really fast, and it
led to a bubble and
a boom in Mexico.
And there should have
been a regulator who
said, stop it, anyway.
But there wasn't effective
regulation, because Mexico had
deregulated but it hadn't set
up the banking institutions,
the regulatory institutions.
So, it developed an atmosphere
in Mexico that, you know, I
don't worry about the possible
crisis, because the Mexican
government will bail
everybody out.
And, you know, they couldn't
bail everyone out, it turns
out, there was a collapse.
So, Salinas was replaced by
Yale-educated Ernesto Zedillo.
I shouldn't put it that way.
And the Mexican banking system
was destroyed by this crisis.
And what ended up happening is
that most Mexican banks were
taken over by foreign banks.
And it was followed by an
economy that was heavily
damaged by a crisis.
But Mexico recovered.
And 1994 and 1995 was unique
to that country.
It was a terrible recession
that hit Mexico briefly.
That's one example.
But again, it was a regulatory
failure that did it.
If you allow the moral hazard
to develop, if you allow
people to think that, hey, let's
make all these loans.
I think it'll work out, but
maybe it won't, and if it
doesn't, hey, we have friends
in Mexico City, so we'll all
be all right.
The next example is the
Asian crisis of 1997.
It's a very complicated crisis
involving a number of Asian
countries, but it was heavily
related to bank lending.
And international banks
had lent a lot of
money to Asian countries.
And the countries then had
loans that were --
they were dependent
on loans --
that were withdrawn when a sort
of a bank run occurred.
It was something like a bank
run, because the international
investors suddenly wanted to
withdraw their money from the
Asian countries.
And the Asian crisis started
in Thailand, and Korea, and
Indonesia, and then it spread
all over the world.
It reached Russia as a
consequence, and it's called
the Russian Debt Crisis.
It was a contagion effect.
And it got all the way
down to Brazil.
You wonder, why was Brazil
affected by an Asian crisis?
Well, the world, it was
and is interlinked.
So, it's experiences like this,
that encourages the G-20
countries now to agree on bank
regulation, that will prevent
this kind of collapse.
And the last example I have is,
again, it's not -- this
one is not so international.
The Argentine crisis of 2002.
This was, again, a complicated
crisis.
But it involved the Argentine
government shutting down the
banking system in Argentina.
And I don't have much time
to talk about all this.
The examples that I gave of
crises around the world, I
went through them very quickly,
but let me just
reiterate the themes that
I started out with.
And that is that banks fill a
fundamental role in our economy.
They make things work.
They solve moral hazard
problems. They solve adverse
selection problems. They create
liquidity, so that
businesses can function and
individuals can function.
When the crisis develops,
we suddenly realize the
importance of our banking system
in its absence or in
its poor behavior.
And so, I think there's an
attitude among a lot of people
that they don't like regulators,
or they don't
appreciate regulators.
But in fact regulators are
people who are managing a very
complicated system, which is
really important to our
prosperity.
If you look at causes of
economic disruptions, it's
failures in our banking system
that seem often to be
responsible.
There's other things, like, for
example, an oil crisis can
bring on a --
it seems to be completely
independent of a banking
crisis, but you take those two
together and you explain most
economic crises.
It's a very important thing to
get banks regulated right.
Now what I didn't talk about in
this lecture is -- and I'm
going to come back to this --
is the shadow banking system.
Let me just mention this
in anticipation.
And that refers to other kinds
of companies, not officially
banks, that are doing business
that resembles banking and is
not regulated.
So for example, Lehman Brothers
or Bear Stearns,
which were major failures
that led to this crisis,
they were not banks.
Well, they're not commercial
banks.
They're not under Basel III.
They are investment banks, which
is a different animal
and it's not regulated
by Basel III.
Let me add innovation
in finance.
It's making the financial world
harder and harder to
understand.
That's why we keep having Basel
I, Basel II, Basel III.
There's going to be a Basel IV.
Financial systems are so
much more complicated
than they were,
say, in the 19th century.
There used to be a bank.
You can see, there's one in
downtown New Haven that looks
like a Greek temple.
You probably didn't
even notice it.
I looked at the corner stone.
It was 19th century.
It's a beautiful old building.
Banks were like that.
They had a nice granite
edifice.
You'd go in and there'd be
a banker sitting there.
And you could talk
to a person, and
they'd make a loan.
But now, we have all these
complicated derivative
contracts, and they trade all
over the world and it's so
interconnected.
And shadow banking, which I'll
come back to later, shadow
banking is a consequence of --
it's the kind of thing
that happens.
Regulators can't keep up with
all these innovations.
But I don't think the answer is
to shut down innovations.
We just have to allocate
resources, and that's a trend
that we are doing.
And I think that we will
benefit, if we have effective
and sound regulation that
takes into account the
subtleties of moral hazard,
adverse selection, importance
of liquidity.
These are basic, important
concepts that make for better
lives for people.
And we have to expect
that regulation is
going to get complex.
Basel III may look complex.
It's going to get even more
complex, but we'll have
computers managing the
regulations somewhat, so it'll
all be doable.
OK.
I'll see you again.
I hope you have a nice
spring vacation.
