PROFESSOR ROBERT SHILLER:
Today's lecture is on central banks. We already had a lecture, a few
lectures ago, about banks, so what are central banks? Well, today they're very special
government banks that are responsible for the
currency, the money. And so, every country in the
world has a paper money that has the name of their
central bank on it. But I wanted to take the -- as you know, I like
to understand origins of things -- I wanted to take it back to
the beginnings of central banking, so we'll understand
better what the institution is. I wanted to bring up first the
theme of this course, which is that financial innovation or
invention is an important process that is not unlike
engineering invention. When somebody gets an idea, and
it's proven to work, it gets copied all over
the world. That's the way the
human species is. We all have the same kind of
cars, we all have the same kind of airplanes. Why? Not because we're copycats,
but because someone has figured out something that
works, and of course, everyone copies it. And I think the same thing is
true with central banks. So, I wanted to get to the
history of central banks and to go back first to the
first central bank. Then, I'll bring it all the way
up to the modern times, where the recent financial
crisis -- the actions during the crisis,
the actions of the world's central banks was extremely
important in preventing what might have been another
Great Depression. So, these institutions have
become of fundamental importance. Remember the story I told you in
our banking lecture, about how banks got started in the
U.K. They'd already been seen earlier in other places, but
the really modern banking institution is traced to
the goldsmith bankers. So, people used to -- there were goldsmiths who made
gold jewelry, and people found that, since they had a safe or
they had a way of protecting things, they would leave their
gold on deposit at the goldsmith banker. And the goldsmith banker would
give you a little piece of paper, indicating that you
could, at any time, come back to the goldsmith and claim
this amount of gold. And then, the pieces of paper
started circulating as paper money, and that's how it all
started -- unregulated, nothing to do with
the government. It was just private
businesses. And that system, paper
money backed by gold, lasted until the 1970s. Amazing. Well, it wasn't always gold. It was bimetallic. There would be gold and silver,
and things -- or all silver -- it's a long story, but
we were effectively on the gold standard until just
a few decades ago. But there were problems right
from the beginning. And the problem was, that
sometimes the goldsmith bankers wouldn't make
good on their pledge to redeem in gold. You'd come with your piece of
paper, and they'd say, I've gotten too many requests. I don't have any gold anymore. So, that was the problem. So, I wanted to start with the
Bank of England, which was founded in 1694. And it was just a bank, but it
had a special charter from the parliament, from the British
government, that gave it a monopoly on joint stock banking,
to start with. It would be the only bank in
the United Kingdom that was allowed to issue shares
and sell shares to a large number of people. There were other banks, but they
were partnerships and had only a limited number
of partners, so they didn't get as big. So, the Bank of England became
the dominant bank in the United Kingdom. It started a practice -- and this is very important,
historically -- it realized it had a lot of
power, because it was the gorilla bank and there were
a lot of little banks. And they realized soon that they
could put any bank they wanted out of business, whenever
they felt like it. How? Well, because the Bank of
England was so big, they got a lot of notes issued by these
other banks, so anytime they wanted to, they could just
present them all for payment, and no bank could
withstand that. They didn't have enough
gold on hand. So, they could drive any
bank to bankruptcy. But the Bank of England began
to assume its role as essentially a government bank,
without being officially government, by using a ''let's
live and let live'' policy under one condition: If you are
another bank in the U.K., you have to keep a
deposit with us. And the Bank of England would
tell you how much. If you didn't do that, you
could be destroyed. But that created a stability
to the system, because the Bank of England had money to
bail them out whenever -- you know, they had a deposit
with the Bank of England. The Bank of England
required that. And so, whenever a bank got in
trouble, they could always take their money out of
the Bank of England. So, the Bank of England than
would help these banks in return for their keeping a
deposit, sometimes even lend more money to them. So, that created a
stable banking system over the centuries. So, that was the model for
all of the central banks of the world. They're all copies of
the Bank of England. The Bank of England, by the way,
was not an independent -- it became a government bank. I don't know the whole history,
but it wasn't really independent of the government
until 1997, when the United Kingdom made it formally
independent. But nonetheless, it was a model
for central banking, and it was observed over
much of the world. Notably, in the United States
there was a bank called the Suffolk Bank. This is much later. It was founded in 1819
in Boston, and it was a private bank. And on its own, it just decided
to do the same thing that the Bank of England did. It required that all of the
New England banks kept a deposit with it. And it did the same thing,
and it stabilized New England from bank runs. The Suffolk System lasted
until 1860. So, you can see how
central banks are inventions of people. They weren't government
inventions at all. This Suffolk Bank
just did this. It became a big and
influential bank. The United States in the first
half of the 19th century had repeated banking crises, and
there were repeated problems with the currency. It used to be that, if you went
to a store and you wanted to buy something, they'd say,
let's see your money. You'd take out all of your
money, you'd lay it down, and they'd look at it, and they'd
say, well, this is Boston money, this is New Haven money,
this is Hartford money. And they would pull out a book
called the Bank Note Reporter, and they'd say, well, our money
dealers are now doing a 20% discount on Hartford money,
so I'll give you $0.80 on the dollar for the
Hartford money. Boston money, we're
down 30% on that. What a messy system. I shouldn't mention Boston,
because Boston had a good record because of the
Suffolk Bank. It was worse in other
states, the further you got from Boston. So, the Suffolk Bank became
held up as a model of a banking system. But the U.S. also had two banks,
one called The Bank of the United States, which
was founded in -- I'm forgetting the year,
it's not in my notes. Anyone tell me? When was the Bank of the
United States founded? 1789, I think. And we had a Second Bank of the
United States, but they weren't really functioning
like the Bank of England. They were maybe somewhat like
them, but the Banks of the United States were not really
central banks, and they were not renewed. They disappeared in 1836. It's a big movement in
the United States. Because the United States didn't
want the government involved in private business,
they were reluctant to set up a central bank for
a long time. In 1863, the U.S. passed the
National Banking Act. Actually, there was a revision
of it in 1864, and they tried to get some of the advantages of
these central banks without actually founding one. So, what they did then is, they
said, there's a new kind of bank called a national bank,
and the national bank would have a name
like the First National Bank of New Haven. Every city created a bank in
1863, which was called the ''first national bank
of something.'' And the government required that
they keep on deposit with the Treasury capital to
back their currency. So, they were called National
Bank Notes that were issued by the banks -- printed by the
government -- but they all looked the same, except they
had a different name of the different bank on them. And they had capital
requirements, so the banks had to put deposits with
the Treasury backing their currency. That was a success. The United States never
again had a problem with its paper money. There was never a problem
of discounts anymore. All the national banks would
honor each other's notes at par, and so that's when the
United States had a paper money for the first time. But it didn't create a system
of stable currency. There were still banking
crises, but they had a different form. It wasn't a failure
of the bank notes. We fixed the bank note problem
in 1863, but the problem was, there were still runs on banks,
and there were still credit expansions and
contractions, that led eventually to people in the
United States thinking, we've got to eventually copy the Bank
of England and do the same thing here. There was a terrible banking
crisis in 1893, for example, when everybody thought the
banks were going to fail. Somehow they didn't worry
about the currency. The National Bank Notes were
thought to be perfectly safe, but they thought the banks
weren't safe, and so there was a crisis, and it led to the
depression of the 1890s. Then, there was another one in
1907 that was really bad. And so, people wanted to fix
somehow the system, and so, that led to our current system,
which has been around almost 100 years. And I call it a copy of the Bank
of England, but it might not be described that
way by everyone. It's called the Federal
Reserve System. And that was created by an act
of Congress in 1913, and it opened its doors in 1914. But the U.S. -- again, we always feel that
we're different. We have to make it
look different. We can't just copy the
Bank of England. We've got to do something
different. So they said, why don't we
create 12 banks -- that sounds more American -- and have them all over
the country. And so, we didn't create a
central bank, we have a banking system with 12 Federal
Reserve Banks. But of course, they decided
to have a headquarters in Washington, DC, called the
Federal Reserve Board, or the Board of Governors of the
Federal Reserve System. It's an agency in Washington
that oversees the 12 regional banks. Do you know what region -- the country is divided up. What region are we in? It's Boston. This is the Boston region. So, most of the money in your
pocket is Boston money. It only says so now on the $1
bills, I think, but you can look and see where your money
came from, which of the 12 banks your currency -- But the Federal Reserve System,
as founded in 1913, required, just like the Bank
of England, that banks have deposits -- either currency in their vaults
or deposits with their Federal Reserve Bank to back
up their currency. And once again, if they got into
trouble, they could draw on their deposits with
the Federal Reserve. Or even beyond that, the Federal
Reserve could come to their rescue. They've been good banks, they've
kept their deposits -- just like under the
Suffolk System -- they've kept their deposits
with the Federal Reserve. The Federal Reserve will then
help them a little bit more. And so, it became known as the
lender of last resort. And the system also operated
something called the ''discount window.'' Why do
they call it a window? You people never go into
a bank anymore, right? Or do you go into banks? Remember, they used to have a
teller, and the teller would be sitting at a table, and there
was a little something. He's talking to you
through a window. I guess, they wanted to keep you
separate from the money. So, there was a window, where
a teller would talk to you. The discount window was a
special window at the Federal Reserve Bank for
banks to come. This is the metaphor, anyway. I don't know if they ever
had such a window. And so, the bank that was in
trouble could go to the discount window, and has to
bring something, though. They have to bring some
securities as collateral. And so, the teller behind the
discount window would discount the collateral brought by the
bank, and lend money. It's called a discount window,
because you couldn't just borrow money, you had to
bring some asset as collateral for the loan. So, in 1913, when the Federal
Reserve was founded, President Wilson -- who was the president who
signed the bill -- was almost ecstatic. I have a quote from that. I don't remember exactly, but
something like, we have put banking crises behind us
forever, and this will lead to a system of prosperity and -- I can't think of all the
nice words he used. People thought that now that
we have adopted the British system, it ought to be smooth
just like in Britain. There shouldn't be a
problem anymore. And so, we still live with
that system today. I think Wilson was right. It was a big step forward. Again, it was a copying of
other people's successes. Nobody knows exactly, how the
banking system works. There's a theory of money
in banking, but it has worked in practice. So, central bankers start to
become very important in modern society, because they are
really the keepers of the gate of sensible lending. There is a tendency for banking
systems to over-lend. They create booms, and create
a false prosperity for a while, and then it crashes, and
we have a banking panic and a recession or
a depression. That means, then, that the
banking system has to be the source of stability
and good sense. We tend to recruit as central
bankers people, who are moral and stable in their lives. One of our Federal Reserve
chairs, William McChesney Martin, summed it up very
nicely: ''The job of the central banker is to take away
the punch bowl as soon as the party gets going.'' It's
like a parent, right? You can have one drink, but
we're going to stop. So, that's what the
central bank -- The central bank controls the
system through reserve requirements. That is, by telling the banks,
who are members of the system, how much they have to hold in
reserves, which are deposits at the central bank
or currency. If they hold currency in their
vaults, if it's right there, then they're OK. This term, reserve requirement,
actually goes back to before the
Federal Reserve. Because we had state -- in the
United States, we had state banking regulators that were
already imposing reserve requirements. I haven't tracked down exactly,
when it began, but I think, probably around 1900 in
the United States, during the Progressive Era. There are also capital
requirements. And I'll come back to making a
distinction between the two. Capital requirements and reserve
requirements, both of those terms began to flourish
around 1900, even before the Federal Reserve, with state
banking regulators, who were requiring both capital and
reserves in the United States. I don't know the history
of every other country. But after the Federal Reserve
was set up in 1913, it began to take over both of these
functions of setting reserve requirements and setting
capital requirements. Let me go a little forward
in history. The system appeared great. Now, every country of the
world -- not just the U.S. and U.K. -- virtually every country of the
world had a central bank. Even communist countries, I
think, had central banks. But the system broke
down in 1933. Well actually, before '33. After 1929, banks
started to fail. And the Federal Reserve could
have bailed out the banks -- in the United States they
started to fail, not the United Kingdom. There was a banking crisis after
1929, and it reached its peak in 1933. So just before President
Roosevelt took office, the banks were in total disarray. And the first thing Roosevelt
did as president was to shut down the entire banking system
of the United States. It was called a banking
holiday. Because everyone was running
to the bank, it was a catastrophic bank run. Everyone was failing at once. And it was quite a scary
situation, because nobody could get their money. The banks were all closed,
all of them. And people started to
run out of money. I remember that -- was it the Harvard Crimson? -- it did a poll of its students
asking them, how much money do you have
in your pocket? And it got down to, like,
$0.10 and $0.05. They just spent all
their money. What do you do? I mean, how can you get lunch? Well, I assume they
had a cafeteria. Somehow, you could
still do it. You couldn't go anywhere and
spend any money, if you didn't have it, because it
was all tied up. So, people started exchanging
IOUs, and it was just a mess. So, the Federal Reserve didn't
stop that crisis, but the Roosevelt administration did
other things to prevent crises like this, notably set up the
Federal Deposit Insurance Corporation. Now this was a -- deposit insurance had preceded
the FDIC in 1933, but it had never been a success. It had been tried in
a number of places. The U.S., I think, set the
example for deposit insurance. And that began to augment
central banking. The U.S. had not had another
banking crisis since 1933 until 2007, just recently. Well, I should say, there was
the Savings and Loan Crisis, but not a big banking crisis. And that is testimony to, I
think, the importance of deposit insurance. But the Federal Reserve began
to see it's role as not so much preventing banking crisis
-- that was always in the background -- but as stabilizing
the economy. And so, the Fed began to think
of itself as preventing the recurrence of recessions. So, when the economy was
over-heating, the inflation was building up, the Fed would
raise interest rates, and the higher interest rates would
cool down the economy. And when the economy got too
soft, when the unemployment rate went up, the Fed would cut
interest rates, and that would encourage borrowing,
encourage spending, and boost the economy. Actually, that function
of the Fed goes back to even before 1933. There's an economist, Charles
Amos Dice, who wrote in the 1920s, that the Federal Reserve
is like the regulator on a steam engine. Do you know anything about
steam engines? They have this thing that whirls
around with two little weights, and if the steam engine
gets too fast, the weights spin out by centrifugal
force, and it cuts off the steam, so that it
doesn't overheat, the engine doesn't get going too fast. And
so Dice said, the Federal Reserve is an invention,
it's the regulator for the whole economy. And I think he was right,
although it's not as accurate as a regulator on a steam
engine, but it works out somewhat well. I wanted to mention that every
country now has a central bank, but I just wanted to
mention the European Central Bank, because it's quite new. It's quite new, and it's maybe
the biggest central bank now in the sense that it -- well, I shouldn't say that. It might be the biggest central
bank by some standard. There was a treaty signed at
Maastricht in 1992, which led to the creation of the European
Union from the European Communities, and it
also created a plan for a new currency called the euro, which
is a European currency. And the euro did not actually
start until 1999, and the currency, actual currency, was
not issued until 2002. So, that is a relatively
recent invention. The European Central Bank, or
ECB, was founded in 1998 -- that's before the euro
currency started. They created a list of countries
that wanted to participate in the euro zone. Not all European Union
countries decided to participate in the euro, notably
the United Kingdom had a referendum and voted
against it. And to this day, they are
not members of the euro. Also
[addition: as of April 2011] Sweden, Lithuania, Latvia,
Estonia, Poland, Czech Republic, Hungary, Romania,
Bulgaria, and Malta are not in the euro zone. [addition: All these countries
are members of the European Union (EU).] [correction: Malta officially
adopted the euro in 2008, and Estonia in 2011] Some of these countries, that
are not officially in the euro zone, use the euro
unofficially. It's not their currency, but
there's no law against you coming in and spending euros,
so the euro seems more distributed than that. So anyway, that's the most
recent central bank, but it's the same general
structure as -- every European country has it's
own central bank, like the Banca d'Italia or the
Deutsche Bundesbank. But their original purpose is
kind of gone, because they no longer maintain a currency. There are no more Deutsche
Marks or Italian Lire. They're all using the euro. So, the real central bank is the
European Central Bank in Frankfurt, led by Jean-Claude
Trichet right now [addition: as of April 2011]. Bank of Japan, by the way,
became independent in 1997. Bank of Japan, another very
important central bank. There's been a movement in the
last few decades to make central banks independent. This was something that our own
Federal Reserve had from the beginning. It was designed to be separate
from the government. The reason was, they thought
that a government might want to inflate the currency. Political pressures might at
certain times cause them to try to influence the
central bank. And so, the Federal Reserve
was set up, so that the members of the Board of
Governors had 14-year terms. They couldn't be kicked out,
except for impeachment offenses, and so the government
couldn't control the central bank. The independent central bank
has been very important. What tends to happen is, you
bring people in, who've had long careers in banking,
who have a reputation for integrity. And you tell them,
that you are the custodian of a currency. You can bring in people, who
believe in the importance of a stable currency, and then you
give them a 14-year term. And they're there. It's like the Supreme
Court, almost. You can't kick them out. Some people think, that's why
the U.S. has had such a stable price level, because of our
independent central bank. So many countries have fallen
into inflation that has undermined the currency,
but the U.S. hasn't. I think, that's why there has
been a move to copy the independent central bank. I wanted to talk now about
specifics of what the central bank does. Notably, the Federal Reserve
System has a committee called the Federal Open Markets
Committee, FOMC, Federal Open Markets Committee, that meets
around once a month. And they issue a statement every
time they meet, and as it is now -- actually, FOMC doesn't
go back to 1913 -- but I'm talking about the
Federal Reserve as it is now. This committee decides on a
range for an interest rate called the ''federal funds
rate.'' And the federal funds rate is an overnight interest
rate, that is charged on loans between banks and some other
financial institutions. You generally would not
have access to the federal funds rate. Now, you probably don't need it,
because you don't need an overnight loan, anyway. Most of us would borrow money
for more than one night, but banks, for various reasons, do
this lending and borrowing every day, at least under
normal circumstances. So, we have an overnight
interest rate. There's also a longer federal
funds rate, but we're emphasizing the overnight
rate. And it's unsecured. This is just an unsecured --
there's no collateral -- it's an unsecured loan
between banks. So, the interest rate
reflects some risk. Negligible risk, usually,
because banks trust each other, at least overnight. They know pretty much, they're
going to get paid bank. And the current federal funds
rate in the United States is 0.13%, as of last Friday
[addition: April 1, 2011]. That's 13 basis points, so
it's virtually zero. This is a policy decision
of the Federal Open Markets Committee. They have decided that the range
for the federal funds rate will be between zero and 25
basis points, so as of last Friday
[addition: April 1, 2011], it was exactly in the middle
of their range. The FOMC uses its decisions to
set the federal funds rate as a way of stabilizing
the economy. This is the regulator that
Dice talked about. Right now, they've set it
virtually at zero, because the economy is so weak. The unemployment rate last week
was 8.8% [addition: as of April 1, 2011], extremely
high. And so, the Federal Reserve is
not worried about inflation now, it's worried about
high unemployment. And it's pushed it about
as close to zero as it can get it. It can't below zero, because
you can't have negative interest rates -- no one would lend at a negative
interest rate. So, that's where we are. Now, I wanted to just tell
you about an interesting development that came in just,
well, just in 2008. I mentioned that banks hold
reserve accounts at the Federal Reserve. Traditionally, those accounts
were not interest-paying. Banks had to either hold money
or an account at the Federal Reserve for their reserves,
and neither of them pay interest. If you hold money, you
don't get any interest. If you actually have currency in
your vault, you don't get interest. And until recently,
banks didn't get interest on their deposits at the Federal
Reserve, but that all changed in 2008 with the Emergency
Economic Stabilization Act, that President George
Bush signed. EESA, as it's called. And EESA allowed the Federal
Reserve to pay interest on the reserves, held in the accounts
at the Federal Reserve. So, the Fed has a policy
now of paying interest on reserve balances. Do you see what I'm saying? I don't know what the Suffolk
Bank did, or the Bank of England did, but I know what
the Fed is doing now. If a member bank puts money in
deposit with the Federal Reserve, they will get
an interest rate. And you can find out what the
interest rate is by going to the Federal Reserve website, and
right now [addition: as of April 1, 2011] it is 0.25%. So, that's an important policy
change, because now it encourages the holding
of reserves. Some people look at this, and
ask this question: Here's the federal funds rate -- why isn't it the same as the
interest on reserves? Interesting question. Why would any bank invest in the
federal funds market, if they can get a higher interest
rate by just holding a reserve at the Federal Reserve? There's been a lot of discussion
of why that is now. It's a new phenomenon, because
the interest on reserves goes back only less than
three years. I think the simplest answer to
the question is, that member banks of the Federal Reserve
System have stopped lending on the federal funds market,
basically. They just leave it in reserves,
because that's a higher interest rate. So, who is lending at this? It turns out that there are
some people, notably the government-sponsored enterprises
like Fannie and Freddie, that are not eligible
for interest on reserves. So, they have taken over the
federal funds market. The reason the Fed added
interest on reserves is to create another tool of
monetary policy. There's a lot of concern that,
after this crisis is over, there'll be a sudden
surge of inflation. Let me come back to that. Basically, what the Fed has
as a new tool is, if that happens, to raise the interest
on reserves, and that will help contract the economy
instantly, very rapidly. The way the Fed controls the
federal funds rate, and has been doing for years, is by
buying and selling Treasury bills on the open market, by
affecting the supply and demand for short-term credit. And that indirectly -- they don't actually deal in the
federal funds market, they deal in the Treasury bill
market, but since those markets are interlinked, they
indirectly target the federal funds rate. So, that's the old way
of trading in the federal funds -- not in the federal funds market
-- trading in the short-term Treasury market
through the New York Fed. But now, they have a new tool. So, we're entering a whole new
regime of monetary policy. So, I wanted to talk to about
reserve requirements a little bit more and what those are. So, the Federal Reserve has
the authority to set the amount of reserves that
a bank holds. I wanted to make clear the
distinction between reserve requirements and capital
requirements. The Federal Reserve has what's
called Regulation D, which specifies how much banks have to
hold as a function of their liabilities. And as of right now
[addition: April 2011], the reserve requirements are 10%
of transaction accounts. That means, that a bank has
to total up all of the transaction accounts, and that
consists of checking accounts, NOW accounts, and
ATS accounts. Their transactions accounts are
accounts like checks that -- people have a deposit in the
bank, that they'll use for spending, and those are
instantly withdrawable. In contrast, there's something
called ''time deposits.'' Those are savings accounts, and
the bank does not have to give you the money
immediately. In other words, if you go
to your checking account [addition: checking account
institution], and say, I want my money -- it's a transaction account -- they have to give it
to you instantly. That's the rule. But if you go to your savings
account, they can stall. You might not have noticed
it, but it's in the fine print somewhere. This is a time deposit. So, the Fed is not worried
about time deposits. Here, we're talking about
reserve requirements. Reserve requirements are still
based on the old theory that we're trying to prevent
bank runs. We don't want there to be a
run on banks, where people panic and try to withdraw
their money all at once. So, we want to make sure the
banks have enough reserves, and the Fed currently thinks
10% ought to be enough. For time deposits, it's zero. You don't have to
put any money on reserve for time deposits. Why does the Fed think that? Because you've got 60, 90 days,
or a year to pay the person back, so they
can't run on you. So, we don't require any reserve
requirements against time deposits. But it's 10% for transactions
accounts, which is substantial, because they're
still worried about this. So, this is the situation. We used to emphasize in lectures
about central banking the so-called ''money
multiplier.'' The money multiplier, well, it's
complicated, but the simplest thing is, it might be one over
the reserve requirement. It's not exactly that, but if
the reserve requirement is 10%, then the total amount of
deposits, that banks can issue, is going to be 10 times
the amount of currency and deposits they have at
the Federal Reserve. So, that means that the reserve
requirements would fix the money supply under the
old theory, because the high-powered money is the
currency plus deposits at the Federal Reserve -- that's reserves -- and if the reserve requirement
is 10%, and banks want to just meet that requirement and
nothing more, they're going to have 10 times as much deposits
as there are reserves. I'm over-simplifying the money
multiplier, but I'm telling you that, at the moment in
history, it's irrelevant because banks are holding
excess reserves. The world has changed. Just a few years ago, before
this financial crisis, banks didn't want to hold excess
reserves, and so there were hardly any excess reserves. Why? Because they don't get
any interest on them. And so, banks didn't hold
excess reserves. So, the money multiplier theory
would work, because the amount of reserve was just about
exactly equal to 10% of transactions. I'm over-simplifying, but
something like that was true. But now they're paying 25 basis
points on reserves, so that's a lot more than you can
get investing in the federal funds market, so banks are just
perfectly happy to hold excess reserves. So, the excess reserves
now are over -- I think it's $1.2 trillion. It's huge, because of interest
on reserves. I don't have the exact number. But something has fundamentally
changed in just the last few years. So, reserve requirements, they
must hold for some banks, but for most banks, they don't
even look at reserve requirements anymore. What do I care? I'm so happy the hold reserves,
I'll hold way more than they require. So, reserve requirements are
non-binding for most banks now, so it's a different
world. This brings us, then, to
capital requirements. So, in the world -- history has always changed --
the world, as of a few years ago, everyone emphasized reserve
requirements, and those were the requirements
that had as its motive preventing bank runs. But we're not going to have a
bank run now, when these banks have over a trillion dollars
just sitting there. They're holding so much, that
it's not an issue right now. So, something else has taking
the center stage, and that is capital requirements, which
we talked about last time [correction: in the lecture
about banks]. So, capital requirements are
different from reserve requirements. I just defined -- reserve requirements
were a fraction of the transaction accounts. They were defined by a liability
of the bank. A transaction account is like
a checking account. It's money that the bank owes
to other people, and we have this requirement, that 10%
of that is the reserve requirement. But capital requirements are
different, and they're more likely to be binding
these days. And these were emphasized in
Basel III, which we talked about before. Basel III is not yet in force. It's going to take
a long time. Basel III has a phase-in period
that is going to take until, I think it's 2019. But there's a lot of talk
now about trying to get Basel III phased in. Remember, we talked about
risk-weighted assets? Now, it is, banks have to hold
capital as a fraction of their risk-weighted assets. So, right now, the countries of
the world, they've agreed, the G-20 countries have
agreed on Basel III. But each country has
to decide on the implementation of Basel III. The United States, in
particular, is having problems with Basel III, because Basel
III refers to credit ratings in many places. But Dodd-Frank, the Dodd-Frank
Act of 2010 abolishes credit ratings. The government will no longer
make any use, in any regulation, of credit ratings. Remember what credit
ratings are. Moody's and Standard & Poor's
are the two best-known credit rating agencies. The government, the SEC,
starting in 1975 defined what they called NRSROs. That's Nationally Recognized
Statistical Rating Organization. And that included Moody's, which
was founded about 1900, and Standard & Poor's, which was
the result of the merger of Standards Statistical
Association and Poor's a little bit after 1900. They're venerable old
institutions that give a risk rating for securities. For example, Moody's
will give its best securities a AAA rating. That means, Moody's thinks
they'll never default. Yale University is rated AAA
by Moody's, for example. But if they don't like you
quite as much, they'll down-rate you to AA. Or if they don't like you even
more, you're only A. And then God forbid, you go
down into the Bs. In fact, Moody, John Moody, in
this book, acknowledges that he took the same grading system
that he got in college. It's a little different. You don't get a AAA grade
here, do you? I've never given a AAA. But that's, how Moody saw
it, so it survived. It's like letter grades
to securities. But Moody did that in 1900. If you read his autobiography,
people said, you're crazy. How can you give a grade
to a security? It seemed like a wild idea, but
he stuck with it, and over the years, people began to
believe in them more and more. So, it led to the idea that we
fully understand the risk of securities, and so, a
complacency set in, and the government started to recognize
these NRSROs as if they were proclaimers
of God's truth. And they started all kinds of
regulations, said what your capital had to be depending on
the rating of various assets that you hold. But the whole thing collapsed
in the recent financial crisis, because some AAA
securities lost almost everything. So, the rating agencies made a
big problem, or issue, and so Congress has now said, nobody
can make any regulation based on ratings of the NRSROs. But Basel III people didn't
get the message. But they're not America, they're
international, and they still believe in them. I think it's a little bit
difficult to know how to handle risk. This is the fundamental
problem. And it would be nice, if Moody's
and S&P could tell us, but the problem is that they
missed this whole crisis. They didn't see it coming. And why didn't they? Well, that's a deep issue, but
that's what people are wrestling with right now. So, the U.S. has to figure out
what to do to reinterpret the Basel III recommendations for
the United States without using any reference to Moody's
and S&P. What will probably happen, I think, is, that the
banks will have to have their own risk committees, and they
will have to come up with their own assessments of
risk, and they'll be responsible for those. But what will really happen is,
they'll just look at the Moody's and S&P ratings. It'll be rubber-stamping them. So, I don't think that -- there's a whole question whether
Dodd-Frank will be effective in reducing
our requirement. But I wanted to go over the
capital requirements once again, because now they're
increasingly important. And I wanted to go through
just a simple example of capital requirements, so that
you'll understand them. And I don't think, the general
public understands them very well at all. This is old accounting,
or old finance. These requirements go
back 100 years. I'm going to talk in very
simple terms about them, over-simplifying. Basel III is a complicated
new agreement. It has a lot of ins and outs,
but I'm just going to over-simplify it and talk about
the Basel III common equity requirements. I'm going to tell a
little story about founding a bank, OK? Now that's just to understand
how capital requirements work. So, imagine that you decided
to found a bank. In developed countries of the
world today, you can do this. You can set up your own bank. The only problem you have, you
have to get a charter, you have to apply for a charter. You have to decide, whether
you're a national bank in the United States or some other kind
of bank, but you get a charter and you open
your doors. Now you've got to start
complying with capital requirements. But let's say you do
that, all right? You find that there's an empty
bank building downtown. You rent the building, you go
through the paperwork, and you set up your bank, and
you open the doors. And now, we have one of those
windows with a teller, and are inviting deposits. So, I'm going to tell a story,
which is over-simplified maybe a little bit. Let's say, that you open your
doors, and someone walks in with $100 and deposits it. So, this is your bank,
or I'll say my bank. Now, I think regulators would
require you to come up with some capital first, but it seems
to be a nicer story -- you start out with a deposit. Assume your regulators
allowed you to start. So, somebody walks in and
deposits, and here's your assets, and here's
your liabilities. Left side is assets, right
side is liabilities. So, someone deposits $100
in cash to your bank. So, you've got an
asset of $100. And you have a liability
now of $100. If that's a savings account,
you don't have any reserve requirements. If it's a transactions account,
you have to hold $10. I've got it, right? I've got $100 sitting in my
vault, because the guy just gave me $100, so I'm satisfying
both my reserve requirements and -- Now, am I satisfying my
capital requirements? Well, I have to calculate
risk-weighted assets. Remember, every kind of
asset has its risk. What about cash? Well, cash has a zero risk, so
it has a zero risk-weighting. So right now, my risk-weighted
assets equal zero. OK, I've got to satisfy all the regulations that are on me. I'm satisfying my reserve
requirements, right? I've got my reserve,
I've got $100. This is cash in my safe, and
this is a liability. I owe $100 in the form of
a, let's say it's a transactions account. Whenever this person comes back,
I've got to pay $100. So, my reserve requirements are
satisfied, because I've got more than $10 of my
transactions account. My risk-weighted assets
are zero. Now, Basel III says, that you
have to hold 4.5% of your risk-weighted assets
as capital. But now, wait a minute. I have a problem. What is my capital here? I don't have any capital. I've just opened my doors, and
I've got $100 in assets, $100 in liabilities. Everything looks okay from the
perspective of the reserve requirement, but there's
no capital. So, what is capital? I have to issue shares to come
up with capital, and I'm going to need -- Basel III says, 4.5% common
equity requirement. And they also have something
called a capital conservation buffer, which is another 2.5%. Plus 2.5%, which you don't
absolutely have to hold, but if you don't hold it, you're
subject to restrictions, so I'm going to add these. This is the capital conservation
buffer. I've got to hold 7%
under Basel III. And I don't have any
capital here. So, what do I do? I'm not in compliance. So, I've got to raise capital. So, what I can do is I
can issues shares. I have to sell shares
in the business. So, all I need to do
is sell seven -- OK, what would it be? Let's say, I issue
$20 in shares. And then, that means someone
gives me more cash, because someone paid for the shares. So, I've now got $120. Well, I add another plus $20,
so it's a total of assets of $120, all held in cash. Now, this is a different
kind of liability. This is common equity. And the regulators make a big
distinction between this kind of liability, the transactions
account, and this kind of liability, the $20. Why do they make a
big distinction? Because this guy can come
to the window any time. You've got to give him $100,
whenever this person asks. The shareholders have no
demand on you at all. They own a share
of the company. They can't come to the window
and demand anything. You can just send them away. The only deal you have with
shareholders is, that all shareholders will receive an
equal dividend, if the board of directors decides to vote
for dividends -- they're shareholders in the company. But they can't run the bank. The shareholders can't show up
at the window, so there's no risk of bank runs for them. And there's no risk of problems,
because if anything goes bad, you just tell the
common equity guys, you're out, you lost. So now, what are my
risk-weighted assets? They're still zero. I've got $120 in cash. Zero -- I don't have any -- 7% times zero is zero. So now, I'm in great shape. I've satisfied both my reserve
requirements and I've satisfied my Basel III
capital requirements. So, what do we do next? We've created a bank, and
there's no interest paid on these checking accounts, and
we're not earning any interest. We've got a bank
and we're satisfying the requirements, but nobody's
making any money, so we've got to do something to make money. So what I'm going to do is, I'm
going to -- let's say we get our board of directors
meeting -- a board of directors elected
by the common equity shareholders -- and we decide, let's make
some corporate loans. So, why don't we lend out all
of this $100, that was cash, and lend it to some business as
a corporate loan, and we'll charge them interest? Now, we're going to start
making money. So, this is no longer cash in
safe, this is corporate loans. Loans to corporations
to do business. So, there we are. Our balance sheet balances,
everything looks fine. But what are our risk-weighted
assets now? Well, you remember, corporate
loans get 100% risk-weight, because under Basel -- going back to Basel I, they
always thought corporate loans are risky assets. So, my risk-weighted assets
are now $100. And 7% of $100 is $7. So, hey, I'm doing fine. Now, we're capitalized enough,
we're in business. We're satisfying both our
reserve requirements -- reserve requirements
being 10% -- and that's only $12
[correction: $10], we've got it in cash-- and we're satisfying our Basel
III capital requirements. So, everything is fine. Everything is fine and
we're in business. And we're not done
yet, because our risk-weighted assets -- our $7 is the capital
requirement, and we've got $20 in common equity. So, everything is great. This is fine. But now, let's go on. Now, there's a crisis. Business gets bad. So, the next thing that happens
is 20% of my corporate loans default. And so, we then -- it becomes clear, we have
another board meeting, and someone says, I have bad news:
We made $100 in corporate loans, but these guys
-- $20 is never going to get paid back. The borrower is out
of business. So, I suggest, we do a write-off
of our corporate loans, and lets reduce
them to $80. So, what happens? Now, assets have to
equal liabilities. $100 is our assets now, not
$120, right, because we just lost $20. Our liabilities can't be
$120, because they have to equal our assets. What gives? Well, it's the shareholders
that give, so we mark down common equity to zero. And now, assets and
liabilities match. So now, let's look at
our requirements. What about our reserve
requirements? Reserve requirements are fine. We're holding excess reserves. We've only have to hold $10,
and we've got $20 in cash. But we're no longer satisfying
our capital requirements. So, our bank regulator is going
to shut us down, unless we do something to
raise capital. So, how do we raise capital? That's the next step. Well, one thing we could do is,
we could sell some of our corporate loans. We could find a buyer for our
corporate bonds, and we could sell, say, $20 worth of them,
bring this down to $60, and this would go up to $40. Our risk-weighted assets
would now -- let me see. No, that wouldn't do it. Sorry, that wouldn't
do it, would it? We'd still have -- I'm sorry, I misspoke. We still don't have
any common equity. In this case, if we don't have
any common equity, we can't get out of this by selling
our loans. We could have, if it didn't
reduce it to zero. If the common equity went down
to $10, then I could sell some of my corporate loans to
get out of this mess. But I made it zero, so the only
way out that I can do, is to issue more shares. So, I've got to go to my friends
again and say, well, we started this bank,
but we goofed up. We made bad loans, and so we've exhausted our common actually. I've got to raise more
capital now. And so, what you could do is,
get more friends to come in. Now, they might not want to do
it, because the previous friends got wiped out. They lost everything, right? But you're coming in as new
shareholders on top of the old, and you could then go back
to where you were before by just issuing march shares. So, this is the system. I think I've pretty much
summarized it. It's simple. Now, the issue is, however,
that, what motivated Basel III was that -- this system of requiring banks
to hold capital is supposed to stabilize the system. If they've got enough common
equity, the bank won't go bankrupt, even if they lose some
of their corporate loans. It would be a big disaster to
drive them to insolvency. But the problem is that the
system they set up has banks responding to a crisis by
selling corporate loans or issuing new shares. The problem is, both of those
are hard to do in a crisis. In a crisis, when everything is
falling apart, you go out saying, I want to issue new
shares in my bank that just lost everything, the investors
are going to say, you have got to be kidding. I'm not going to invest
in you right now. So, you can't raise
new equity. OK, what about selling loans? Well, the problem is, in a big
national or international crisis, every bank on the planet
is trying to sell its loans at the same time. So, it creates a collapse
in the system. And this is, what happened
in the financial crisis. This story repeated a million
times: Banks were trying to raise capital and they were
trying to sell assets either by issuing -- they were trying to raise
capital either by issuing shares or by selling assets. And everyone doing it at the
same time created a crunch, and the whole system would have
collapsed, if it weren't for the central banks. The central banks of the world
responded quickly by making loans to companies, to banks
and other companies. So, the lender of last resort
saved the whole system from collapsing. That's the story of the
financial crisis. The remaining story is, the
Basel III people in Switzerland said, let's
analyze how we got into this situation. How did it get so bad? And they thought, you know, it's
kind of a funny system, because we're requiring banks to
raise capital at the worst time, and that can't be
the right system. They looked around and tried to
decide what to do better. Most countries of the
world were following this kind of system. There were some -- some people were impressed by
the government of Spain having a better system, but the
Spanish banking system collapsed anyway, so it didn't
solve the problem. So, Basel III came up with a
solution, which was to allow the central regulators to add
another buffer of 2.5%, if they think, there's
a bubble going on. They would do this before the
crisis, and that raises the common equity requirement
to 9.5%. So, the idea is, this is going
to be a problem -- raising capital at a time of
difficulty is always going to be a problem. And we can always rely again
on our central banks, but maybe we can't, maybe
we shouldn't. And so the idea is, let's take
bank regulators and make it their obligation to raise
capital requirements in advance, when they see
a bubble coming. Now, another thing that happened
in the United States is the Dodd-Frank Act of 2010. Because of intense public
reaction to all the bailouts, it said that the Federal Reserve
can no longer use discretion in deciding
who to bail out. They can operate a discount
window, but it has to be completely fair and
even for everyone. They can't decide, we're going
to bail out Bear Sterns, and we're going to let Lehman
Brothers fail. All they can do is operate a
consistent discount window. So, they've constrained -- the Dodd-Frank Act constrained
the central bank in the United States from exercising the kind
of judgment that saved us from the crisis. And we're going to have to rely
on some different things, like better capital standards,
like Basel III, to fix the situation. Whether we're there or not, is
going to be a big question. This is a complicated system,
and we put a lot of the best minds into trying to figure out,
how to prevent the kind of instability that we're seeing
in this example, where everyone is short on capital at
the same time, everyone is selling loans at the
same time, and the whole system collapses. We've come up with different
solutions, but they have to be implemented yet, and there are
problems of implementation. The roles of central banks and
of regulatory authorities are evolving and changing, and
it'll be a period of many years, before we know where the
system is actually going. All right. I will stop here. Next lecture is on investment
banking, and we have a former ECON 252 student, Jon Fougner,
who is back after nine years, and he will tell us about his
experiences as an investment banker, and also as a
Facebook executive.
