A Call for Judgment: Sensible Finance for a Dynamic Economy

October 21, 2010

Introduction

JOANNE MYERS: I'm Joanne Myers, director of Public Affairs Programs, and on behalf of the Carnegie Council I’d like to thank you all for joining us.

In the wake of the ongoing financial crisis, we are very pleased to have Amar Bhidé as our speaker this afternoon. His contributions to our understanding of the financial markets are noteworthy on many levels, but primarily for his advice about what we need to do to revamp our institutions and regain the dynamism our economy once had.

In trying to understand what led to the recent economic crisis, we are usually offered two explanations. One theory argues that the current crisis is a consequence of basic flaws in the capitalist system, thus requiring comprehensive reform. The other view, which is much narrower in scope, focuses on finance and posits that finance hasn’t been under-regulated or over-regulated, just mis-regulated, and can be fixed by technical fine-tuning.

In A Call for Judgment, Professor Bhidé challenges both views. He urges vigilance against opportunistic assault on the vital elements of capitalism, a system that he says has served us so well. He also rejects modest modifications to the financial system. Instead, he proposes bold changes that go far beyond just readjusting financial tools.

The centerpiece of his proposal is straightforward: many of the key elements are drawn from Friedrich Hayek's seminal essay, "The Use of Knowledge in our Society." Accordingly, Professor Bhidé argues that lending decisions have become overly-mechanical and centralized. He sees this as causal factors in this financial crisis.

As an alternative, he writes that he would like to see limits on the activities of commercial banks as well as other entities, like money market funds. The rules he proposes would profoundly change the nature of the financial game.

Professor Bhidé has gained knowledge from working in two worlds. He has been an entrepreneur and a Wall Street trader. He left the world of high finance to teach at the Columbia Business School and at the Fletcher School. He has had the time to study this present crisis and reflect on what happened and why.

He knows that to forestall future disasters we need to look at more than just the immediate missteps that triggered this recent debacle and realign the interests of the real economy with those of the financial sector.

In our hour of financial need, having an innovative, practical, and thoughtful individual who knows what is needed to make the system work is just what the economy ordered.

Please join me in giving a very warm welcome to our guest today, Professor Bhidé. Thank you for joining us.

Remarks

AMAR BHIDE: Thank you. Good afternoon. It is a pleasure to be here.

As Joanne mentioned, there are two explanations of what has gone wrong.

    • There is one which says that the entire system of capitalism is broken and we need to reform it; we need to get rid of the root and branch. President Sarkozy of France would be one of those people.

 

  • On the other side, we have some people in academic finance and some practitioners who say, "We had a little bit of a hiccup in the financial system in 2008. Nothing really serious. Nothing fundamentally wrong. All we need to do is bring the regulatory structure up to date."


I argue that both views are wrong, and that there is nothing fundamentally wrong with real economy capitalism. It has produced prosperity beyond human imagination. We live better than our forefathers could have dreamt that we could possibly live.

On the other side, there is something deeply and fundamentally wrong with finance. It is not stuff that has simply occurred in 2002. It isn't as if investment bankers suddenly became greedy in 2001, or some truly horrible instrument was invented in 2003—although there were some truly horrible instruments invented.

What we have seen is the consequence of defects that have been evolving over decades and decades. These defects are the consequence of bad financial theory, which has emerged again over decades. It has been a consequence of mis-regulation, and over-regulation in some parts and under-regulation in other parts.

I am going to talk about three specific things today. The first thing is my thesis of how modern finance undermines the dynamism of the real economy. For this I need to describe what makes a modern economy dynamic, at least in broad strokes.

Then I will go on to say, "If this is what makes a modern economy dynamic, what would a good financial system look like that would support the dynamism of a modern economy?"

Then I will tell you why a dangerous and dysfunctional divergence has emerged between what a good financial system ought to be and what we have now. I will be very brief in describing what has made modern finance pathological, but I will spend a little more time in describing what I think of as a retro and radical solution.

What's the basis of modern prosperity? It is widely agreed that modern prosperity derives from innovation. Nobody argues with that proposition now, but there is a widespread belief that innovation is an elitist activity, that it is undertaken by a few venture-capital-backed firms; that innovation is what men and women in white coats or R&D centers do.

I was speaking at a conference organized by The Economist, and there was a Silicon Valley savant who said, "Oh, face it, innovation is an elitist activity." I thoroughly disagree.

Our prosperity depends on widespread productivity improvements.

Widespread productivity improvements, in turn, derive not just from the development of gizmos like this [shows iPad], but it also requires widespread use of them. For the process of development and the widespread use of these gizmos to take place, we need not only new technologies but we also need a vast array of different kinds of know-how.

We need the marketing genius of Steve Jobs, not just the engineering genius of people who designed the hard drives that go into this. It requires good management. It requires good design. Lawyers are involved in this process.

It is a process which is far from elitist. It's what I call a massively multiplayer game in which many people contribute and benefit.

Then the question arises: How is this game organized? It turns on decentralized, case-by-case, forward-looking judgment. All of these things are important: decentralization, case-by-case, forward-looking judgment.

The classic argument for decentralization was made in 1945 by Friedrich Hayek. The principal target of his critique was central planning. He said central planning cannot work because good decisions require on-the-spot knowledge.

What the farmer knows about his or her plot of land that enables him or her to figure out what to plant, when, how much fertilizer to use, when to harvest, and when to sell the stuff. The kind of fine-grained knowledge that the farmer has simply cannot be communicated in a timely and effective way to a central ministry of agriculture.

The interesting thing about Hayek's argument, which many people may not be aware of, is (1) he didn't say a word about the mis-incentives of the central planner; he didn't say anything about central planners being stupid. Implicitly, what he said was even if you had brilliant central planners, even if they had the interests of the public entirely at heart, they still would not be able to make good decisions because they would lack knowledge of these facts on the ground.

Hayek also did not talk about innovation. Innovation requires more than what Hayek talked about. Hayek talked merely about adaptations to changes.

Innovation involves imagination. It requires on-the-spot knowledge of the technology, of customers, and what competitors are going to do. It also involves a leap into the future and a hunch, which cannot be communicated to a central planner.

Hayek's argument for decentralization becomes even stronger when we think of a dynamic world rather than merely a static world where people are simply adapting to changes.

The next question is how is this decentralized innovative game organized? The classic answer, again provided by Hayek and which you will read in most economic textbooks, is that we coordinate what autonomous agents do through the price system.

There is no question that the pricing system in modern capitalism plays a central role in coordinating decentralized activity. But—and this is a really important but—there are other mechanisms as well which are equally important in a dynamic economy.

If all we did was produce and consume exactly the same things day in and day out, year in and year out, then we wouldn't have to talk to each other. We could put up a price-and-quantity board and conduct our business without any conversation.

Because we are producing new stuff every day, the person who is producing these new gizmos needs to have a conversation with potential customers to understand what they would want.

Once the new gizmo is developed, the innovator then has to have a conversation with the potential user to persuade them why the new gizmo will satisfy his or her needs.

Likewise, a lot of coordination takes place, not in an anonymous market, but through relationships. If our economy was comprised of exactly the same goods and services, as primitive economies was, then perhaps we could transact entirely through an anonymous market. Because the stuff we are doing is ever changing and new, most of our transactions take place not in an anonymous market but through relationships. These relationships help us communicate; they help us to make adjustments as the world goes on.

What does all this mean for good finance? A good financial system should nurture and mirror a good real economy. This may seem somewhat uncontroversial, but it was only three or four years ago when a blue-ribbon panel studying the competitiveness of the American financial system declared that the American financial system was terrific because it produced high-paying jobs for financiers.

I don't think most of us would think in those terms today. One does not think of the worth of a correctional system in terms of the pay and jobs it provides for prison guards. Likewise, one should not think of the worth of a financial system in terms of whether or not it makes a few financiers really rich.

What you have to ask is: Does it support the pervasive dynamism that is ultimately the source of our prosperity?

The next question we should ask is: What kind of financial system would do that? Exactly the features that you see in a real economy—decentralized judgment, conversations, relationships—ought to be the kinds of things that you see in the financial system as well. Why?

First of all, virtually all demands from finance originate in a forward-looking judgment; they do not originate as the consequence of the solution to a mathematical equation.

If I decide to apply for a mortgage, assuming that I've done it sensibly, it is because I walked around the neighborhood, I know the neighborhood, and I have made a judgment that the price of this house isn't going to collapse right after I have bought it. I also have made a judgment that my job is secure and that the kind of mortgage that I'm applying for is one whose interest rate I can bear.

Likewise, if I am a small business person and I'm applying for a working capital loan, I'm making a judgment. I'm making a judgment that my business is sound, that it's going to grow, that my competitors are not going to destroy my business, and that my customers will continue to buy. It is on this basis that I apply for a loan for more working capital.

The only prudent way to make this working capital loan or to extend this mortgage is the Hayekian way, which is that the banker as well has to make a judgment about my judgment; the banker has to figure out if I have been sensible in thinking about housing prices and about the continuity of my income. The banker looking at a working capital loan application has to figure out whether the small business person has made a good judgment by getting into the head of the small business person. This cannot be done by looking at a few variables.

We need the banker to have a dialogue. There is no way that the banker can get inside the head of a person applying for a mortgage or working capital loan without having a conversation.

To the degree that a banker extends financing—not just overnight, but usually for extended periods of time—in many cases the deal that is struck at the outset needs to be modified. My business may do better than I expected, and therefore I may run into my credit limit. It may do worse and I may violate a covenant. I may lose a job or I may simply forget to make my mortgage payments.

Then the banker has to decide: Does the banker call the loan; does the banker stick to the letter of the agreement; does the banker foreclose or not? Good judgments about these kinds of decisions can only be made if there has been an ongoing relationship. You cannot parachute in from somewhere and decide whether to foreclose or not, or decide whether or not to change the terms of the working capital loan.

In many parts of finance you still have this structure. Small business loans are still made by bankers going around and talking to potential borrowers. Venture capital, which extends finance to the most advanced technologies in the world, is still done in an incredibly old-fashioned way. The venture capitalist actually goes and visits the person looking for a loan, they have many conversations, and the venture capitalist sits on the board and has an ongoing relationship with what is going on.

Unfortunately, the great growth in finance over the last 20 or 30 years has not been in a way that mirrors the real economy. It has been centralized, mechanistic, non-judgment-based, and formulaic. It involves no conversations and no relationships.

There are two particular pathologies I would like to draw your attention to.

One is the judgment-free, mass-produced explosion of asset-backed securities. It isn't the case that all finance has been decentralized. Railroads, for instance, could not be financed by your friendly neighborhood bank because of the size. The railroad was too large and you therefore needed to have railroad bonds. To the degree that you had railroad bonds, you had to delegate some responsibility to the underwriter; you took the underwriter's word that to some degree the bond was sound.

Although there was some centralization, it was not judgment-free. The underwriter would examine your books, look at your traffic projections, look at what your competitors are doing, and then opine about whether this was a good bond for customers to buy.

The credit-rating agencies might get involved. They too would do a case-by-case analysis of the railroad bond issue, and perhaps they might have a negotiation. They'd say, "If you add in this covenant, we'll give you a higher credit rating."

What has happened over the last 20 or 30 years is loans which could and should be made by a friendly neighborhood banker have now been securitized.

Your neighborhood bank cannot finance a railroad, but a neighborhood banker certainly can give you a mortgage or a car loan.

There are no economies of scale in this. The economies of scale in the process of securitizing car loans and the process of securitizing mortgages lie entirely in the process of finance itself, not in the real economy.

We are told allegedly that we have discovered the secret to doing away with case-by-case judgment and we have this fantastic new technology which does not require any analysis, any wearing down of shoe leather.

Likewise, we have seen a massive explosion of complex derivatives. Until the early 1980s, there were no complex derivatives. There were bond futures and currency futures, but there were no complex derivatives.

That number grew from zero to about $100 trillion in 2000, and it grew from $100 trillion, to somewhere between $600-to-$800 trillion by 2006.

These are really complex instruments. The documentation tends to be pages and pages thick.

You may ask: How could this stuff grow without adding a lot of people? People believed that we could thoroughly mechanize this process, that there were wizards who, with the press of a button, could tell you the right price for this incredibly complex derivative. You really didn’t need to know what was going on inside.

In the establishment's view, this stuff is terrific. This is like the Model T. Just as Henry Ford made cars affordable for the public at large, we have now made car loans affordable to the public at large.

We are also told that this process has led to better risk management. I cannot but help reading a portion of a speech by Chairman Ben Bernanke in 2006. He says: "Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks. Concepts such as duration convexity and option-adjusted spreads provide better risk returns to stockholders and greater resilience to the banking system."

In 2006 we were told that these great innovations were providing greater resilience to the banking system. One can only imagine what an irresilient banking system might have looked like without all these great innovations in 2008.

There is in fact a very serious down-side to this robotized form of finance. A very simple Hayekian analysis would suggest that there will be misallocation of capital, because as far as the model that figures out whether to give you a mortgage or not is concerned, income is income. It doesn't matter whether it's the income of a car worker whose plant is scheduled for closure next week or whether it's the income of a federal judge who has a job for life. The model doesn’t see these differences. It's a number as far as the model is concerned.

The model doesn't see whether the applicant for the mortgage arrived sober or drunk to apply for a mortgage. It's five variables.

Just as Hayek argued that a central ministry of agriculture is bound to fail because it relies on five variables or six variables, a process for extending mortgages based on this small formula is bound to fail because it relies on a small number of variables.

It also leads to the neglect of real enterprise. Imagine you are the chairman or CEO of an organization like Citibank or JPMorgan. On the one side, you could expand your small business lending, but that's a bit of a pain. You have to hire hundreds of bankers and send them through a two-year training program. Then they have to go out and find customers, then these people apply for loans, and then you have to have credit committees. It's just too slow. You can't really build a big business doing that.

With these mechanized mortgages, the sky is the limit. You just need to have a bunch of people fan out with forms, or perhaps just a website where people click on the data. Lo and behold, you suddenly have a gigantic mortgage book.

Building a $10, $20, $30 trillion derivatives book is easy. Hire ten traders, buy a computer, and you suddenly have a $10 trillion or $80 trillion derivatives book. Nine years out of ten it produces fantastic returns on equity. One year out of ten, sadly, it may cause the financial system to collapse. But in those nine years you get a piece of the action, and the action is much larger if you are expanding your derivatives book than if you are expanding real business lending.

How much more does Jamie Dimon make compared to his predecessors in the early 1980s? Ten times? A hundred times?

Is he contributing ten to 100 times the value that the prior chairman of JP Morgan used to add? No, but he now presides over a gigantic empire.

This whole process also leads to greater vulnerability of the system. Human judgment certainly is fallible. In a financial system based on lending officers' whims, there will be lending officers who make mistakes. But these will be independent mistakes. They will not bring down the system.

When we rely on three models which are virtually identical—they all come from the same sort of statistical training—if there is a mistake in these models, you are pretty much sunk.

There is a pretty good case to be made that this process increases hurting behavior. The argument was that mortgages in Boston are uncorrelated with mortgages in California. Banks would be sounder if, instead of holding a portfolio of Boston mortgages, they held a securitized portfolio comprising securitized mortgages both from California and from Boston. In theory, yes.

In practice what happens? Once you go from holding these Boston mortgages to this nationwide securitized portfolio, you become careless, because you believe that you are safe in holding this diversified portfolio, and then you begin to treat this stuff as an asset class.

Lo and behold, the prices of housing which used to be uncorrelated start becoming correlated. We see this in market after market. When people used to look at the prices of individual stocks, prices of stocks were not as correlated as when people started looking at stocks as an asset class and started buying and selling the S&P 500.

When you had corn traders and pork belly traders, the prices of commodities used to be broadly uncorrelated. When we were told commodities are an asset class, all commodities began to start moving in tandem.

Finally, another problem with this process is that it jeopardizes the legitimacy of capitalism. We do not begrudge the billions of dollars that Larry Page and Sergey Brin have made—we either implicitly or explicitly realize that they may have made $20 billion between them—but if you add up all the value that hundreds of millions of users of Google have derived from Google Spreadsheet, that amount swamps the value that is earned by the two innovators. Research suggests that 95 percent of the value of most innovations is captured not by the innovator but by the users of innovations.

In a capitalist system, some of us celebrate the accumulation of wealth through innovations—or at least we don't mind it terribly much. Once you begin to think that it's a rigged game, that people are becoming wealthy off state-subsidized borrowing and state-subsidized leverage, that it's a game where heads they win and tails all the rest of us lose, then it puts a taint on the entire process of wealth accumulation and it creates an atmosphere in which people begin to want to soak the rich.

Why has this happened? I will not get into this in detail. I hope you will buy my book and read the six chapters which pertain to this.

It derives, as I describe in considerable detail, from bad finance and economic theory.

It also derives from mis-regulation. There are people who say that the financial system has been over-regulated and there are people who say that the financial system has been under-regulated. I argue that it has been mis-regulated.

In general, technology tends to create the need for more regulation. As long as people rode around on horses, you did not need rules of the road, you did not need safety inspections. As long as there was no TV and radio broadcasting, you did not need an FCC. Generally most innovations require some rule to prevent what economists call negative externalities—or in simple language, hurting innocent bystanders.

The degree to which this happens is different. In a gizmo like this [shows iPad], very little regulation is required. All that is required is to submit the gizmo to the FCC, and they look at whether it is emitting radiation that will interfere with transmissions. If it doesn't, then the FCC says, "Fine," and that's all the regulation you need. But you could not imagine an automobile system or an air transport system without extensive regulation.

So the question is: What kind of regulation do the different parts of finance need?

I argue in my book that securities require very little regulation.

Banking, on the other hand, requires very tough regulation. Banks were regulated fairly closely right from the 1780s and 1790s, when virtually no other form of commerce was regulated. It took a lot of tough regulation before we got to 1935, when we got a stable banking system.

Securities, on the other hand, were not really regulated until the Securities Act. In my view, the Securities Act was probably unnecessary.

What has happened over the last 20 or 30 years is that the stuff that really did not need regulation became tighter and tighter and the stuff that needed to be well regulated became looser and looser. That’s the rough argument. To get the full flavor of it, you need to read the book.

Where do we go from here?

The establishment's analysis is: "There’s nothing terribly wrong. We had these great innovations in finance and regulation fell behind. The solution is simple: Let's modernize."

We passed the Dodd-Frank Act. It has 2,300 pages. What does it say? It establishes a Financial Stability Oversight Council. It gives the SEC [Securities and Exchange Committee] and the CFTC [Commodity Future Trading Commission] authority to regulate over-the-counter derivatives. There's a code of conduct for all registered swap dealers—if only we had had a code of conduct! We have a federal standard for all home loans. There is an Office of Credit Rating. And on and on it goes.

The idea is that finance is good, let's just have regulation that keeps up.

From the point of view of a few skeptical outsiders—me being one of them—this kind of regulatory catch-up is both futile and pointless.

It is futile because you will have to hire every single Ph.D. produced by every economics program in the world to be able to get to close to implementing half the provisions of the Dodd-Frank Act. Then you will have to stop them from going over to Wall Street.

It is also futile because we have been there before. Just as banking used to be case-by-case, regulation used to be case-by-case. Until the early 1980s, there were no uniform capital requirements for banks.

The principal line of defense against bank imprudence was loan-by-loan examination. The examiner would walk in, he'd look at every single loan file made of every business loan and a considerable portion of the loan files of consumer loans.

Imagine an examiner walks into a bank today. There are no loan files. You have these vast banks of computers with terabytes of data inside them. How on earth can you examine them?

What you do is say, "We are not going to get our hands dirty with the specifics. We are going to have top-down edicts." We are going to say, "If you have these kinds of risk exposures, you will have that amount of capital."

Then, of course, people game this process. They say: "Aha! This is how you define these kinds of exposures. We will figure out clever ways of loading up with risk." Then you recategorize stuff. And on and on it goes. It just doesn't work.

Finally, it's pointless because there is no value to it.

We regulate automobiles because we think there is value commensurate with the cost of regulation. We spend money on traffic police, traffic lights, and safety inspections because we think the road system provides value commensurate with the costs of this regulation.

The question is: Is this stuff of any value, that we should have this vast expansion of the regulatory apparatus? The answer is no.

I propose the following retro-radical solution. It is radical because it breaks sharply with the Dodd-Frank Act, it breaks sharply with what is proposed in Basel, it breaks sharply with what the milders and wisers have proposed, the Squam Lake people, and so forth.

We need to bring back case-by-case enforcement of broad rules and rely principally on on-the-spot examination, not top-down edicts.

A good model is the model through which we administer justice in this country. Congress passes laws; there is a common-law body of knowledge through precedents; but the actual dispensation of the law takes place case-by-case, jury-by-jury, argument-by-argument. That is what we need to bring back.

This is a labor-intensive process. If you want to do case-by-case, you have to be fairly focused in what it is that you want to control.

We don't criminalize everything, simply because we would swamp the criminal courts if we criminalized all forms of bad behavior. Let's figure out what it is that we really need to focus our regulatory efforts on.

History suggests that we really should focus on constructing a sound depository-and-payment system. If we do that, we will also as a by-product get, history suggests, prudent credit expansion, and we would contain speculative manias.

In the 1950s and 1960s, banks may have been conservative, but they were not skimping on extending credit. Credit in the 1950s and 1960s grew at 9 percent a year, three times as fast as GDP. Yet there were no bank failures. If we have a tough system of regulation, it doesn't mean the toughness will kill credit. It will certainly redirect the nature of credit, but it won't kill it in any way.

My very specific quasi-libertarian proposal is to tightly circumscribe what depository institutions can do, anything that takes short-term deposits from the public. The only thing they should be allowed to do is simple loans and hedging operations.

The standard is pretty straightforward: only stuff that someone with a college degree can understand. [Laughter]

If it's stuff which is beyond the capacity of someone with a college degree, no matter what brilliant people who win Nobel Prizes tell you about how valuable this is, the answer is: "No, we don't understand it. We will not let it get into the banking system."

Perhaps we also need something like a Prudent Lender Rule. If stuff ever gets litigated, the standard should be: "Is this the kind of loan that you would have made if it was your own money?" If you can persuade a jury that that was the case, then you're fine. This kind of rule should apply to every single depository institution.

This would basically mean that we would kill all money market funds, which in my view is a parasitical free-riding institution.

What do we do with all the other things, such as the hedge funds?

No additional oversight is necessary, but—and this is a crucially important but—these other things should have no access to credit emanating from the regulated depository system, and the regulated depository system should have no counterparty risks to these things.

It's like how there are some automobiles that are so dangerous that we deem them not to be street-legal. We don't ban them. We say, "If you want to race these automobiles, go race them on a Formula One racetrack. If you occasionally have flaming burnouts, that's your problem."

Let's put all this other stuff on a Formula One racetrack and let the people who are managing this Formula One racetrack devise their own rules. Let them do this as long as they don't spill over into the public roads and create mayhem, as they have over the last couple of years.

To conclude, I would say focus on what is really broken. We have a deep-seated pathology in our financial system which is not going to be solved by pouring more regulations on it. There are deep-seated causes which need to be attacked at its root.

On the other side, let us protect and nurture this widely inclusive form of innovation that has given us such a fantastic standard of living.

Thank you.

Questions and Answers

QUESTION: Bill Rubinstein. Where would the hedge funds and all the non-depository institutions get their access to capital? Are you going to allow them to raise money from the public?

AMAR BHIDE: I would allow them to raise money from the public, but not short-term deposits. They can raise long-term bonds, they can raise long-term equity, but not short-term deposits. Anything that touches the depository system and the payment system is excluded from them. Yes, they can raise money from the public.

QUESTION: [Off-microphone, inaudible].

AMAR BHIDE: We had an Internet blow-up and a lot of people lost meaningful amounts of money because they were stupid and unsophisticated in your view. But we cannot construct a system which protects everyone from all their stupidity. Then you get away from a system in which most people should be allowed to be free to make their own mistakes.

Depository institutions are special and they are different. Interestingly enough, in the 1790s, when the idea of federal regulation simply was verboten, we still had very tough rules regarding banks. The Texan constitution prohibited banks, believe it or not. California prohibited banks. We recognized right from the outset that there is something special about a depository system that creates credit from thin air, that is both vital to our well-being, but it is also incredibly dangerous.

QUESTION: Sondra Stein. I don't know if this is relevant, but when you were talking I was thinking: What about AIG and Lehman, who were not banks, and blew up and we felt we had to save them? Would we still have in your scenario those situations, and how would we respond?

Would we still have "too big to fail"?

AMAR BHIDE: Let me decompose this question into two pieces.

One is, under my scheme AIG might have blown up, Lehman might have blown up, but it would not have led to a widespread crisis. The reason it became a crisis was because it touched the depository-and-payment system.

Lehman became an issue because a lot of Lehman paper was held by money market funds. When Lehman failed, there was a run on money market funds. People basically couldn't write checks. A substantial part of what Justice Brandeis once called "the ready cash of the nation" sits in these money market funds.

Likewise with AIG. If AIG had gone down, it might have or it might not have taken down Goldman with it. It would not have been a national calamity. At least the claim was that it was all the counterparty risks that AIG had with the banking system that made it supposedly a crisis.

Now, "too big to fail." I part a little bit from some of my other friends who want to have tough regulation of banks. We need to distinguish between "too complex to manage" and "too big." I am dead against complexity of financial institutions, particularly where the complexity includes the depository system, because these things become simply impossible to manage.

We have seen widespread illegality in the robo-repossession crisis right now. It is not proven yet, but there is a pretty good chance that laws have been broken. They have been broken by employees of fine institutions like JPMorgan. The CEO of JPMorgan can legitimately say, "I knew nothing about this."

It is true that the CEOs of these large institutions know as little about what their employees are doing as Tony Hayward knew of the safety precautions in the Gulf oil spill. That is because the stuff is too complex.

Too large is a different matter. We have an economy where 50 percent of the economy is big business. These big businesses do provide a considerable degree of economic value to us. The only way we can have the banks provide credit to these big businesses is if we have large enough banks.

I argue in my book that one of the flaws in American banking regulation for a long time was that we resisted the idea of large banks. Because we resisted the idea of large banks, they could not serve what was a large portion of the economy, which is big business. That sort of pushed them to do crazier and crazier things, which they were allowed to do.

I don't mind having five large banks with a large share of the deposit base. Think of restaurants. There are some restaurants which are neighborhood restaurants, and there are McDonald's and Burger King. These two things quite happily coexist.

We need a financial system which is reasonably diverse in terms of its size. We have some big banks that provide the credit needs of big businesses, and then we have some small banks that make consumer loans and that make mortgage loans.

Bigness per se is not of great concern to me. Bigness that arises from complexity by shoehorning a great many unrelated, unmanageable things under the same roof, is truly dangerous.

QUESTION: Allen Young. You talk about the banks, the deposit institutions, as a source of capital. You also talked, in response to a question that was asked, about hedge funds and private venture capital funds that raise money and then therefore invest on their own. A significant source of capital today in the capitalist economy are large aggregations of capital, such as pension funds, money market funds, and the others.

How do you propose to regulate or not regulate the access to those types of capital funds?

AMAR BHIDE: I am critical in my book of the ERISA [Employee Retirement Income Security Act] rules that were passed in 1974 which changed the standard for prudence for retirement funds. Before, the standard was that each investment that a pension fund made or a retirement fund made had to stand on its own feet in terms of the due diligence that you did before you did it.

That rule was changed in response to modern finance theory. We said, "We don't really need to look at it case-by-case. As long as the portfolio is adequately diversified, we are fine." That was an unfortunate development. If I had my druthers, I would reverse it.

Is it absolutely vital as a first order of business? Probably not. What is absolutely vital is to make sure that the short-term cash of these fiduciaries is not put in places outside the regulated depository system.

As much as one would like the pension funds and retirement funds to behave more prudently—and I think there is a pretty simple solution, which is to reinstate the old Prudent Man Rule. That is not absolutely necessary at this time. We would have our hands full just doing what I suggested we do. But I don't disagree that greater prudence on their part would not be such a bad thing.

QUESTION: Recently in the news there was a story of Goldman Sachs recommending stock and then selling it short itself. Is that a practice you would—

AMAR BHIDE: Like I said, there is an awful lot of bad stuff that takes place in this world which we neither criminalize nor regulate.

My principal area of research is entrepreneurship along with finance. Finance and entrepreneurship have gone hand-in-hand.

Sad to say, a great many businesses would not come into being without their founders telling a few lies—in fact, telling quite serious lies—that "this product is really ready, it's really robust, and there are five other people who bought it." It's not quite ready, it's not quite robust, nobody has placed an order for it. You can go through business after business and look back at its history and stories that have been told in the process. Do we criminalize this behavior? Probably not.

I am much more concerned from a public policy point of view with Goldman being able to leverage itself 30:1 using taxpayer funds, than its conning people who should know better into buying and selling stuff that they should not be buying and selling.

It is an outrage that Goldman has access to taxpayer-subsidized borrowing, which allows them to take the risk that they take, and allows the people who work at Goldman to make the incomes that they make.

I have an interesting story to tell about Goldman, by the way, when I was doing research for my book.

I used to once upon a time work for a guy who invented the caps-and-collars market in the early 1980s. At the time, Salomon Brothers and Citibank, where I used to work, pretty much owned the market.

It suddenly struck me in retrospect, and I emailed him. I said, "Paul, how is that these shocks at Goldman Sachs,as they have now come to be known, how did they let you own the market?"

He said, "At the time Citibank was a publicly traded company (still is) and Salomon Brothers was a publicly traded company. Goldman Sachs was a partnership. The partners tried to read these documents. They said, 'We don't understand it, and for stuff which we don't understand, we will not put our homes and garages at risk.'"

Goldman has come a very long way from there to here. Part of it has come from Goldman going public. Equally, a large part of it has come from its access to the depository system, to the funds that have been provided, which are basically guaranteed by you and me.

I ask you this question: Would you put a nickel in deposit in a bank that had a $20 trillion derivatives book if there was no deposit insurance? I bet no sensible person in this room would. The only reason we do it is because our deposits are guaranteed, which basically means that we have passed on the responsibility to exercise prudence onto bank examiners.

If we wouldn't countenance a bank which had a $20 trillion derivatives book, why is it that the government that guarantees the deposits of these banks should allow the same thing? Why is Goldman, which is now a bank holding company, why is Bank of America, why is Citibank—why are these companies allowed to hold these gigantic derivatives portfolios, all guaranteed by us?

QUESTION: Matthew Olson. It appeared to me that the Basel I Accords did a pretty good job of introducing sound and sensible reforms of the banking system. The Basel II Accords introduced a lot of the financial models that you alluded to during your talk, which, especially considering value at risk, strikes me as being responsible for a lot of the problems that we've had.

Now we’ve got Basel III Accords. I'm farther away from the industry, so I haven't been able to follow what is going on. It doesn't appear to me that the Basel III Accords, which we may approve by the end of the year, are improving our situations with regards to financial modeling and guiding the risk management of the banks. Can you comment on that?

AMAR BHIDE: I guess we have a fundamental disagreement. I think all the Basel Accords were philosophically a mistake.

To me the analogy that I use is instead of inspecting the brakes of vehicles, we are just mandating large airbags. Basel is basically mandating cushions and airbags, instead of looking into the risks by inspecting brakes.

Until the early 1980s, there were no uniform capital requirements for banks. The principal line of defense was loan-by-loan examination. At the end of the process, the examiner would say, "Well, given what I think of the exposures on your book, I think this amount of capital would be prudent."

The Basel Accords are a surrender. They are saying, "We can't examine the brakes anymore. Let's just throw out these top-down edicts about what kind of capital you would have for what categories of risks." That comes from a Hayekian ground-up kind of view.

I couldn't prove my case. It’s a deep-seated belief.

QUESTION: I'm Randy Smith at Capital Counsel. Professor, I am interested in your comments about the dangers of money market funds. It seems as if the instance that you cite of a fund breaking the buck was The Reserve Fund, and they broke the buck because they owned Lehman paper. The other funds did not.

Why should the whole system's regulation be revised because of a single instance? Shouldn't the shareholders who put money in The Reserve Fund have been the ones who bore the brunt, not the taxpayers? That seems rather odd to me.

The other thing that I wonder about is what your view is on the lack of transparency of any kind in the bond market. That is the largest financial market in the world. There are no published prices.

AMAR BHIDE:
This is going to be a little historical meandering. We have been through a variety of progressions in the development of money.

At the very outset, money was privately issued by banks. If you entered a bank for a loan, the bank would literally print its note and give it to you. It might have a certain amount of gold to back that note which it printed to give to you. That was it. This was a horrible system and it lasted only until about 1862 because there would be periodic bank runs, and when there was a bank run commerce would collapse because the medium of exchange would disappear.

We solved this problem with the National Bank Act of 1863 by pretty much nationalizing all notes. We said: "You don't have to worry about the soundness of the bank that issued this note. All notes are the liability of Uncle Sam." That was a really good thing.

At about the same time, the medium of exchange shifted from bank notes to deposit accounts, to checking accounts. Roughly, by 1900 the amount of money in circulation in the form of checking accounts was ten times the amount of money in notes. Whereas you stopped runs on banks because people didn't believe that there was enough gold behind the notes, we began to get runs on banks to turn their deposits into cash.

That problem was ultimately fantastically solved by the 1933 and 1935 Acts, which did a variety of things.

First of all, they created deposit insurance. We didn't really care about the soundness of the bank where we had our deposit. We knew the FDIC was behind us. It pretty much put an end to bank runs.

It also did a couple of other things. It toughened banking examination to a considerable degree, and—this is something which people forget—it banned the payment of interest on deposits and it regulated the payment of interest on time deposits. This is something that the banking industry on its own had been trying to do for a century, because the logic was if you compete to pay higher and higher interest rates on your deposits, then the only way to be able to pay those interest rates would be to take higher and higher risks.

Then we stopped it by saying: "There will be zero interest on on-demand deposits and there will be regulated interest on time deposits."

This system worked find until about 1970. It worked fine because as long as inflation was zero, you didn’t mind getting a zero percent return in your demand deposit.

When inflation went up in the early 1970s to 4 and 5 percent, then people said, "Keeping money in the bank is a losing proposition." That’s when money market funds got started. Initially, money market funds basically were investing just in Treasury bills. Then they moved on to extending commercial credit as well.

What’s wrong with that? There are two things wrong with that.

One is they have grown to a size where they have now become the medium of exchange. Whether it was because of perception or whether it was because of reality, just as a perfectly sound bank could have a run, you could now have a perfectly sound money market fund have a run, as we saw.

There were meaningful withdrawals, to the point where the Fed had to step in before it tried to experiment to see whether somebody else would break the buck or not by guaranteeing these deposits. This, by the way, was a prudent thing to do, because if half of your ready cash is in the form of these money market funds and that thing collapses, you are in big trouble.

You could take the perfectly free-market view and say that all money should be free market, and we could literally transact with gold coins.

We have over time developed a system where we believe that money should be monopolized in some broad way. Just as we don't have a mixed system of police and law and order is a public monopoly, I believe money, as well as ready cash transactions, is a public monopoly. When push comes to shove, governments do step in. Free-market purity might say, "Let these guys go to hell." We simply do not have the guts to try that experiment, as we saw.

They are a parasitical instrument because, unlike banks, they conduct no credit analysis. They free ride off ratings provided for free by rating agencies. If you have one business model which is examined, where a bank examiner would come and look at your loan book and say, "How did you make this loan?" and justify why it's a good loan, where banks are required to exercise due diligence; and another model which is doing more or less the same thing where none of this needs to take place, then guess what? One model fails.

In the 1970s the banks could have lobbied to say, "This is an unfair competitor and it is recreating the kinds of activities that used to bring down the banking system in the early 1930s." They could have said, "Let's ban these things." Instead what the banks said was, "Let us play in that game as well." That's my view anyway.

I see you are now shaking your head and you disagree. We are all free to read history in our own way.

JOANNE MYERS: I thank you very much. I think your presentation will stimulate a great deal of conversation.

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