13. Banking: Successes and Failures


Professor Robert
Shiller: Before I begin, I want to say something about
our speaker on Wednesday, Andrew Redleaf.
First of all, he accepted our invitation to
go to lunch with some of you. So, I want to arrange an event,
actually at one of the college’s cafeteria.
I haven’t figured out–maybe one of you has a suggestion,
especially if we can get a–see what college he was here–we did
it in his college because he graduated from Yale.
I’ve forgotten which one that was.
It had a nice room upstairs, so maybe I’ll try to get that
one again. Of course, he said he doesn’t
particularly care–maybe I should take him to another one.
Yeah, if you can suggest a college, which has a nice room
and that will be both–I’ll come and Redleaf will come;
so, that’s this Wednesday. What I’m going to do is email
you the details. If you could email me if you’re
interested in coming, so we can have a good size
group and a discussion. I just want to say a little bit
about Redleaf. He founded Whitebox Advisors in
2000–so that’s eight years ago–and it is now up to $1.8
billion assets under management. “Assets under management” is
how much money he has drawn in from investors.
So, he’s doing quite well and he has some celebrity status
among hedge fund managers. Notably, I put on the website
for March 5^(th), under our class syllabus,
a New York Times article about him entitled,
“Curiosity Has Its Merits.” I guess it struck the author of
that article that Redleaf is just a guy who was very curious
about a lot of things. He wants to know how things
work and why things are happening.
That might be a natural impulse and some people have that more
than others. It’s probably a good impulse to
have if you’re going into investment.
Of course, he turns it into productive purpose,
so there are a couple examples from that article.
One is that–there’s a literature in finance about
options and stock price performance,
which goes back ten years, that shows that something is
not quite right with the way companies issue options.
Let me remind you what happens. What’s happening,
increasingly, is that employees or top
executive employees, at least, in companies are
rewarded as part of their compensation with options on the
value of the stock of the company they work for.
You work for XYZ Corporation; the share is trading at $10 a
share; they would give you “at the
money” or “out of the money” options–say options to buy the
stock at $11 a share. That’s $1 more than it costs
now in the market, so the options are worthless
unless the price of the stock goes up.
So, that’s supposed to incentivize you as a manager to
get the stock price up. Then you make money if the
price of the stock rises above, in that case,
$11 a share. All that is fine,
it sounds good that managers should be given options because
it will incentivize them to work for the benefit of the
corporation. The problem that’s been
revealed in finance literature is that there’s an uncanny
tendency for the stock price to go up after the company awards
large quantities of options to its executives.
Does that sound suspicious? I mean, you could say,
well that means the options are really working well because it
really motivated the managers and they did something and made
the company worth more. If it suddenly goes up right
after they’re issued you kind of suspect that something is screwy
here. So, there’s been a number of
articles that documented that stock prices tend to jump
shortly after options are issued to managers.
The immediate suspicion that this raised, and I think it’s
more than a suspicion, is that companies will time
announcement of good news until after they issue the options.
The managers of the companies are kind of a group helping each
other–let’s award options to each other and then after we
award them we’ll announce the good news and the stock price
will go up and you guys will get money.
There’s a tax incentive to do that.
If they awarded options that were “in the money”–that means
already exercisable at profit–then they would be
subject to a tax liability immediately,
so they don’t want to do that. They want to issue them “out of
the money” and then announce the news that brings them “in the
money.” It’s been proven that companies
do that. More recently–I was just
reading about this in the Times.
There was an article by Eric Lee that showed that it’s not
just announcement of news that does it;
it’s also that companies must be backdating options because
Lee showed that some of the price jumps that occur after the
options are issued couldn’t possibly have been manipulated
by the companies’ news announcements.
It must have been that they somehow knew on the issuance
date that the stock price was going to go up,
but he said they couldn’t possibly know that in these
general circumstances. Lee concluded that companies
were fraudulently backdating options.
He concluded this on the basis of a statistical test.
You see what I’m saying? If stock price option–if stock
options tend to be issued as announced by the company later,
just before stock prices go up, there’s no way that that can be
right because nobody can know exactly when the stock price is
going to go up. So, they must have been lying
about the date that they issued the options.
You understand that issue about backdating?
It was–this article by Eric Lee was something of a scandal
and it led then to regulatory authorities to–regulatory
authorities then realized that there’s some fraud going on–not
most corporations. I think Lee identified a small,
but definitely some of them, that were lying about the date.
You know what I’m saying? They would announce in December
that we issued back in August these options to our executives.
Funny thing–the stock price soared right between August and
December when they announced it. The regulatory authorities were
starting to look into this–that’s fraud to backdate
options. What does Andrew Redleaf do?
He decided to do his own study parallel to Eric Lee’s and much
more pervasive. So, he was going after himself,
finding out all the companies that were backdating options,
trying to beat the SEC and the regulatory authorities to the
conclusion. What did he do?
He shorted the stocks or whatever to benefit.
Once they’re investigated, their stock prices and their
bond prices are going to fall. He did the–he found out who
they were, using similar methods to Lee’s and profited from it.
Is that a good thing? Well, that’s the way Wall
Street works or at least a–some people say markets are efficient
and stock prices incorporate all information.
I don’t think they are efficient and this is an
example–a Redleaf example. In a sense, efficient markets
would require that everybody–every analyst rushes
out and completes Eric Lee’s study.
But they don’t–I don’t know, it’s just–there isn’t enough
initiative in the world, not many people do it.
Redleaf was able to figure out who was going to get hit for the
backdating scandal before other people did and then that was an
advantage. I’ll give another example of
Redleaf’s success. General Motors,
as you know, is an auto producer in the
United States and it hasn’t been doing well,
as you may have heard–as is the general auto industry in
this country; it’s suffering under
competition from abroad. So, Andrew Redleaf bought
General Motors bonds, which were selling at a
discount because people worry that General Motors wouldn’t be
able to pay on them, and then he asked to speak to
the General Motors management. He went there and he made a
plea that General Motors should cut its dividend that it pays to
stockholders, which is a reasonable thing to
do. If they’re failing they should
cut their dividend, but companies are reluctant to
do that because it looks bad, so they hold off for a long
time, not cutting. Redleaf went in and said,
you should really do it and he convinced them,
apparently, and they cut their dividend.
Well after that, the bond price went up because
people saw that as a sign that the company was tightening its
belt and doing things right to have money to pay off the
bondholders; so it was self-interested,
I suppose–maybe you can ask him about this.
But it was also what we call shareholder activism or investor
activism–that he was getting involved in changing the way
corporations do business. Those are just a couple of
examples of Redleaf and what he does.
I admire him; I think he has–it’s his
curiosity and diligence that–he finds investment opportunities.
He’s another example that markets are really not
efficient. They’re efficient enough that
you have to work hard to find opportunities,
but not perfectly. Today I want to talk about
banking and this ties in somewhat to my previous lecture,
which was on real estate, because banks are major real
estate lenders and investors in real estate securities.
We’re going through a subprime crisis right now,
which is a banking crisis as well.
I will talk a little bit about what we discussed last time.
Anyway, I want to start out with the most fundamental thing:
what are banks? What is a bank? Historically,
money lenders of one sort or another go back–who knows how
far back–thousands of years. So, you might say,
banks existed in ancient times. The history of banking often
goes back only a matter of hundreds of years.
One of the stories that is often told is the goldsmith
banker’s story that goes back I don’t know how many hundred
years. Goldsmiths are people who work
in gold; they make jewelry and
gold–goldware and whatever–coffee urns.
They would store gold and they would have a safe or some sort
of safekeeping. A lot of people would ask them,
since they had a safekeeping for gold, could you put my gold
in your safe? The goldsmith would accept that
as part of an extension of the business as a goldsmith, especially if the gold was in
the form of coins and people didn’t care whether they got the
same coins back. The goldsmith then discovered,
all this gold sitting in my safe is just sitting there.
Why I don’t lend some of it out and I can earn interest on the
loan and make money. Meanwhile, when people come
back to ask for their gold, as long as they’re willing to
take other gold, that’s apparently what
they–they don’t care whether they are the same coins.
I’ll have enough, still, in my safe so that I can
pay them off. So, it kind of just happened.
It would happen to anyone who was a goldsmith because it’s
just the logical extension of the business.
Some customers want to use your safe because safes are hard and
expensive to get and some–and then you’ve got all this gold,
so you might as well lend it out.
It started out that was as, what we call,
fractional reserve. That is, the goldsmith only had
a fraction of the gold that was owed by the goldsmith.
The goldsmith might also write notes promising so much gold and
not promising the return of any particular item of gold.
So, the goldsmith would sign his name on it saying,
I promise to give so many ounces of gold.
In some cases, they were bearer notes.
That means that the goldsmith would pay it to the bearer.
In other cases, they would have the name of the
person on them. Bearer notes became very
important. The goldsmith in your town
writes out a note saying, I will pay to the bearer of
this note so much gold, and then the bearer could be
anyone. You still have to hide the note
from theft, but at least you don’t have to hide a whole bunch
of gold from theft. That’s how paper money got
started, as bearer notes, because if you had gold with
the goldsmith you could spend the note,
at least within the town that you live in where the goldsmith
was known and had a reputation. So, that’s the whole idea of
how banking got started, and how paper money got
started, at least in the West. There’s a different history in
China. There are different kinds of
banks today–I’m going to jump to modern times.
The most important kind is called a commercial bank. A commercial bank,
like a goldsmith banker, accepts deposits–that’s
critical–and that means you can put money in the bank.
And it makes loans–very simple. It pays interest on the deposit
and it collects interest on the loans and it charges a higher
interest on the loan than they pay on the deposit.
The difference is their profit; that’s how they make money.
In addition to commercial banks–well, I’m not going to
talk about investment banks here;
that’s another lecture. Investment banks are very
different in that a pure investment bank does not accept
deposits and it doesn’t make loans;
it’s an underwriter for securities.
I’m not talking about investment banks in this–I’m
talking about commercial banks, which accept deposits from
depositors. Traditionally,
commercial banks did not deal with the general public;
they were for wealthy people and business people.
The traditional commercial bank would accept deposits from
businesses and make loans to businesses.
The other kinds of depository institutions that have developed
are called thrifts and they really started from a movement
in the United Kingdom. That’s the way I do the
history–it may have some other version if you look further.
But in the United Kingdom, there was a movement in the
early nineteenth century to set up savings banks which were
for–this was an effort to democratize finance,
as I would put it–for ordinary people to have the opportunity
to make small deposits. It used to be that people would
hide money in their house and it would frequently get stolen and
it didn’t earn any interest. So, there was a savings bank
movement, which spread from the U.K.
to the U.S. in the nineteenth century and
it was a philanthropic movement. In other words,
wealthy people, in an effort to alleviate
penury, would create a savings bank.
For example, here in New Haven,
we had one created called The New Haven Savings Bank,
which lasted for over a hundred years and was taken over.
It’s now called NewAlliance Bank;
it’s no longer a saving bank. A lot of these savings banks
tend to be very old institutions that go back to the nineteenth
century. Another example is the Saving
and Loan Association. This is also–I keep thinking
how British we are; this is New England and this is
the United States, a former British colony.
A lot of things that we do here have origins in Britain.
This also came from a U.K. movement called The Building
Society Movement, which spread to the U.S.
Savings and Loans are the same as Building Societies,
but the idea–the original idea and also the general idea
today–is that these are banks set up for small savers in order
that they can buy a house. So Savings and Loans,
traditionally, have made most of their loans
in the form of home mortgages. The idea was that a lot of
people can’t afford a house–let’s all get together
and pool our money–in a Building Society or Saving and
Loan Association–and then we’ll loan out to some of us to buy
the house. It will help,
rather than all trying to do it individually.
There’s also something called credit unions. Credit unions are–I think they
came out of kind of the cooperative movement.
There are lots of social movements that have some
idealism behind them. I think maybe the same movement
that created the Yale Cooperative Society in the late
nineteenth century also spurred credit unions.
The credit union is a kind of club of people who belong to
some organization or live in one town or somehow connected that
is supposed to accept deposits and make loans to the members
for things, including home mortgages,
but going broader than that into automobile loans.
Well, it wouldn’t have been automobile loans when these were
created; I don’t know,
something loans, etc.
It’s like a Savings and Loan Association except that credit
unions are created by some entity,
some club or group, and they’re not open to the
whole public. Saving and Loan Associations,
by the way, no longer exclusively limit themselves to
mortgage lending–either they do home improvement lending and
auto loans and the like as well. I wanted to give you some idea
of the size of these so I have data on the total assets of
these classes of banks in the United States as of 2007,
third quarter–that’s my date. Commercial banks had $10,872
billion in assets–or that’s 10.8 trillion dollars of assets
at the end of 2007; about 20% of that is actually
foreign. We’ve had a lot of big foreign
commercial banks come into the U.S.
It’s not as big as in some other countries.
If you go down to Mexico, their main commercial banks are
almost entirely foreign today, but in the U.S.
it stands at–the domestic figure of commercial banks–the
assets of domestic commercial banks is $7,987 billion so
that’s about 8 trillion dollars–that’s domestic banks.
Those are the big ones. If you look at–now,
I have these two lumped together;
I don’t have them separately. In 2007, third quarter,
they were $1.868 trillion–that’s almost 2
trillion dollars, so they’re much
smaller–savings banks and savings and loans–than the
commercial banks. The credit unions are even
smaller, $748 billion–so it’s less than $1 trillion in credit
unions. When we speak of banks,
it is overwhelmingly commercial banks that matter.
There’s another way to rank these: by number of banks;
that gives you a very different look.
If you look at number of organizations that do this
business, it comes completely reversed and it’s credit unions
that are the most important. Where do I have that here?
I don’t have the latest data–this is from 1998–but
there were 11,000 credit unions–that’s the number of
credit unions in the United States in 1998–and there were
only 9,000 commercial banks; that’s the number of banks.
Of the savings institutions, there were only 1,500;
that’s probably going down further because a lot of these
old savings banks are being converted into commercial banks.
You may have a false impression of the importance of credit
unions. You hear about credit unions a
lot because they’re in your neighborhood and they’re
advertising for small depositors,
so they’re in your face, but commercial banks are
actually much more important. I want to clarify just what it
is that banks do. They’re in a–the first thing
to understand is that–I start out by telling you the story of
the goldsmith banker. I like to tell that story
because it sounds obvious that if you were a goldsmith hundreds
of years of ago you would have probably become a banker–it
would just be the natural thing to do.
So, banks are natural and fractional reserve banking is
the natural thing to do. Hence, it exists in every
country of the world; it’s everywhere and so it’s not
something we can live without. There must be fundamental
reasons for it and I wanted to go over some of the fundamental
reasons why we have banks. I’ve got three main reasons,
they’re: adverse selection, moral hazard,
and liquidity. In other words,
the banks offer solutions to all three problems–adverse
selection–and I’ll define these in a minute–moral hazard in
lending and liquidity. This goes beyond the simple
goldsmith banker story that I was motivating initially.
What do I mean by adverse selection?
The adverse selection problem, when it comes to
borrowers–people who are trying to borrow money–is that if you
become a lender–let’s say, if you–not talking about
becoming a lender. Suppose you are interested in
investing in debt of companies, then you as an investor are
subject to the problem that you might end up with the worst
stuff if you don’t watch out. Suppose you are a naïve
investor and you say, okay I’m going to invest in
companies’ paper, which is their promise to
pay–their IOU. But the problem is,
I, being a naïve investor, could get stuck with the bad
stuff. The people who are in the
know–know who’s trustworthy as a borrower and who has a good
prospect of paying it back–if I go in there ignorantly,
I’m going to get stuck with the worst stuff.
That’s adverse selection–that you worry that someone is not
going to–you can’t judge it well yourself,
so your inability to judge the ability of a company to pay
makes it very difficult for you to invest. This leads us to what is called
relationship banking–or it’s really all banking is,
relationship banking. The core of banking is
relationship banking. Banks are institutions that
exist within the community and they live among the business
people in the community and have an ongoing relationship with
them. In fact, that is essential to
banking and it’s kind of part of the–you might almost call it
the definition of a bank. Bankers play golf a lot because
business people like to play golf and you have to keep your
finger on the pulse of the community.
Playing golf with the local businessmen is a very good thing
to do if you’re a banker because you’ll hear the gossip and it’ll
all be off-the-cuff–things that no one would want to tell you
because they wouldn’t want to be on-record of having called you
up and told you that such and such a company is in trouble or
that they’re doing something that I think looks a little
funny to me. You can’t call up the banker
and say that, but if you’re playing golf it
comes out perfectly naturally. Or you join the Yale Club in
New York and you sit around and talk with people.
I remember reading a–I like to browse among old books–I was
reading a nineteenth century book about how to be a banker.
The book stressed, you’ve just got to be
available. You’re sitting there behind
your glass window and someone comes in and wants to chat,
you should be available; that’s what banking is.
You’re kind of in this–but you’re in a different thing.
You’re not a regular businessman running a business;
you’re a lender to the businesses.
As a result, people invest in banks–the
stock of banks–because they understand that these people
have a long-term relationship with business and they are
immune from the adverse selection.
You can’t stick your bad paper to the banker who knows
everybody in the town; he’ll figure it out and that’s
the–and so that’s the problem that’s solved by bankers.
The other thing is moral hazard–this is that companies,
once they borrow money from anybody,
a bank or anyone else, they have an obligation,
which is fixed in dollar terms. They have an incentive to take
big risks because–think of it this way–suppose you’re a
company that has just borrowed a million dollars and now it’s
looking a little bit precarious here that our business might go
under. You have an incentive to say,
because you’re the equity holder, you have an incentive to
say, hey why don’t I just take some
big gamble here and not tell anybody.
I’ll just take the remaining money and I’ll put it in some
lottery bet and one in three chance I’ll have three million
dollars. If it fails,
those guys will lose out because I’m going to lose
anyway. I might as well–if I don’t do
anything, I’m going to lose anyway.
I’m just going to be paying back my debts and go bankrupt,
so I’ll take a big gamble and then at least I have a one in
three chance of making money. You see that?
Isn’t that a compelling argument?
That’s what you want to do? Businesses of course can’t
actually invest in the lottery–that would be contrary
to the terms of their loan–but they can do similar things.
They can do big gamble type business ventures.
Again, that is a problem that lenders have–that the company
that’s borrowing the money has this unfortunate incentive,
at least at certain times, to take excessive risks because
the debtors will end up bearing the losses.
Not the debtors, the creditors who lent the
money will end up bearing the losses.
This is another reason why we want relationship banking.
It’s exactly what you find out about when you’re playing golf
with the other bankers. You’re on the phone with this
guy all the time and you sniff something out,
you can maybe stop. So, you’re watching over the
company. The third thing is liquidity.
That is–maybe this goes back to the–I didn’t mention it,
but it would apply to the old goldsmith banker story as well.
Liquidity is that banks lend long and borrow
short–short-term, I mean.
Most of the people who want to borrow money from the
banks–let’s talk about businesses–we’re accepting
business loans–they don’t want to have to pay the money
tomorrow. If you’re borrowing money for a
business, you might want to open a store and you’d want to stock
your merchandise and your business won’t prosper for a
couple years. Or, you might be building a
factory and you can’t pay the money back right away.
You need the loan for years, but investors don’t want to tie
up their money for years. What banks offer is
liquidity–the ability to borrow short even though the loans that
are made are long-term. How do banks do it?
They do it with fractional reserves.
They trust to the fact that the depositors won’t all come on the
same day, just like a goldsmith banker–he leaves only enough
gold in the safe to cover the kind of withdrawals that are
normally accepted. In that case,
the bank can pay interest to depositors.
Even though the deposits are short-term and the depositor can
get the money at any time, the depositor is earning
interest of a level that can only be made on long-term loans.
People can’t pay–they can’t pay a high interest if they
don’t have it as a long-term loan.
Now incidentally, often bank loans to
corporations are short-term, technically,
so the bank is both lending short and borrowing short.
In fact, they are in practice long-term because you have a
relationship with your banker and you play golf with your
banker and your banker understands that you have a
business–he’s your friend, let’s hope.
Your banker understands that your business can’t pay the
money back and that the bank has a reputation in the community of
helping business people, so they won’t ask for the money
even though it’s a short-term loan that they made to you.
The bank won’t ask for it back right away unless you start
misbehaving. It becomes an arm-twisting
thing–because of this risk of moral hazard,
the bank has a threat to take the money back and they are
going to find out quickly if you,
as a company, are behaving wrong.
It works out, under normal circumstances,
very well. It goes beyond all of this.
The companies get advice from the banker as well.
The banker knows everybody in the community and when you’re
playing golf with the banker, it may go beyond just
collecting information; the banker might have positive
suggestions. You should really do business
with so and so, who has a natural match up with
you. Bankers require a lot of
prestige and status in their communities;
so, this is happening all over the world.
Now, banking has a–it’s important to know that banking
is bigger in developing countries–I’ll say LDCs,
less developed countries–than in developed countries.
That is, it tends to be bigger and that is because less
developed countries have less developed securities,
regulation and laws, and traditions.
It often has to be that the only way you can raise money for
a business is through a bank. In the more advanced countries,
there is more trust in the securities markets,
so we don’t need this relationship banking as much.
It still becomes very important to a lot of things.
I wanted to mention in this context, because I’m emphasizing
how banks help solve the adverse selection and moral hazard
problem–I wanted to mention briefly here also the rating
agencies, which fulfill some of these
functions. I don’t have a separate lecture
on these. The first rating agency in the
world was created by Mr. John Moody, in the U.S.
in 1909. He was dealing also with the
moral hazard and adverse selection problem.
He had a neat idea and that was to give letter grades to
securities that represented credit worthiness.
The highest grade was AAA and that was the best grade you
could get. There are no A+’s;
it sounds a little bit like college, but not quite.
Then, if you weren’t quite AAA, you were AA and if you weren’t
quite AA, you were A and then you could become BA.
Well, all the way down, I guess, to C or beyond
that–then you’re failing. It’s just almost like college
grades. The idea was that the–so he
set up Moody’s Rating Agency and the job of Moody’s was to give
letter grades to securities; it was a little bit like a
bank, but it was different because he didn’t actually make
the loans. There was another–Henry Poor
set up Poor’s in 1916 on a similar model and they later
merged with Standard Statistics to become Standard &
Poor’s, S&P.
Those are the two biggest rating agencies in the U.S.
today and they’re extremely powerful organizations because
they–Standard & Poor’s also does letter grades,
a slightly different system, but almost the same.
Then there’s Fitch, who’s the third,
which is smaller than these two.
This is an interesting question: do they solve the
moral hazard and adverse selection problem as well as
banks do? Well, they’re similar to banks
and they have a relationship with the investment community
and they try to stay on top of everything that’s happening.
They’ve become forces of nature in the U.S.
economy, in the sense that people accept these letter
grades with great authority. Recently, however,
there is a bit of a scandal regarding these rating agencies
because they gave AAA ratings to some subprime securities.
In other words, securities that were themselves
backed by subprime loans. So, this is the subprime
scandal showing up. The question is:
how can these rating agencies manage the current distrust that
has developed? Because they–one important
thing–John Moody was a very crusty, strong-willed man,
who wrote a couple books. In these books he talked about
his moral commitment to honest rating of securities.
People trusted him and they trusted his organization.
Well, they still do massively, although a little bit less than
they used to. John Moody died in the 1950s,
but after he died, Moody’s and Standard &
Poor did something that Moody would not have approved of–they
started accepting fees from the people they rate;
some people think that you shouldn’t do that.
If you’re–a professor shouldn’t be paid by the
students, at least not directly. Maybe you’re paying me
indirectly, but I shouldn’t be collecting money from you and
then awarding grades; that wouldn’t be right,
but that’s what has started to happen.
Some people think that the rating agencies have allowed a
kind of moral hazard to creep into their organization.
They have been working on improving their methods and
they’re trying to create divisions within their
organizations that prevent the moral hazard from happening.
I think that going forward, both the rating agencies and
the banks will be very important in our society.
The history of financial innovation is always that the
organizations adapt to crisis. The subprime crisis is harming
both the banking sector and the rating agencies at the present
time because it’s a situation of stress that stresses their
organizations, but I think that it will be a
time of correction. I mentioned fractional reserves; the fact that banks hold only a
part of their liabilities as reserves, like the goldsmith
banker only holding part of the gold, is a problem.
The question is: how much reserves should a bank
hold? Bank failures occur when
there’s not enough gold in the vault and then people start
asking for the gold and the goldsmith banker doesn’t have it
to give out. The Basel Accord was in 1988
and you can read about this in detail in Fabozzi,
et al. It was an international
convention that gave, what they called,
risk-based capital requirements and recommended risk-based
capital requirements to bank regulators around the world. What we have–we have a problem
that there can be a systemic problem to fractional reserve
banking if there is ever a run on the banking system.
If banks get in trouble and they can’t pay out–if one bank
gets in trouble and can’t pay out on its deposits,
then that can bring the whole system down because it can cause
a panic among investors–among depositors and banks–and create
a run on a bank. This has happened so many times
in history that governments around the world now regulate
banks and tell them that they have to hold a minimum amount of
reserves and have a minimum amount of capital.
Capital is the money that they have to pay out should there be
a–its assets that they can quickly liquefy and pay out
should there be a run on the bank.
Basel 1988 was an effort to make sophisticated risk
management requirements for banks that relied on more
modern, as of 1988, financial theory.
The U.S. adopted the Basel requirements
in 1989 and they’re still enforced today.
The agreement–But incidentally,
this was an international convention.
No country had to follow these risks, but generally,
countries have followed them because they want to be part of
the international community and you want to use the standards
that were recommended. It’s a little bit like the
NAIC–the National Association of Insurance
Commissioners–recommends laws to the local insurance
regulators in the fifty United States.
This is a super national version of this.
Basel is a city in Switzerland, where the Bank for
International Settlements is. It’s an international effort to
recommend regulations for countries all over the world.
In the Basel I there were Tier I capital requirements and–they
defined Tier I capital as capital in a certain form–it’s
stockholders equity plus preferred stock.
Then there’s Tier II capital and then they have a
formula–now, this is defined in Fabozzi.
They have a formula that defines how much Tier I and Tier
II capital a bank has to hold and the amount depends on the
risk class of their investments. They define four credit risk
categories and they define a formula involving the amount of
assets in each of the categories.
Then there’s a formula that dictates how much Tier I capital
and how much Tier II capital they have to hold.
This system has worked well for twenty years now but it is being
superseded by another Basel Convention–Basel II–which has
been going on for some years now.
This is Basel I that I just was telling you about and now
they’ve come up with a new version, Basel II,
and Basel II is more sophisticated.
It recognizes that the risks that a bank faces are very
complex and that they are not summarized by just the classes
of borrowers that were defined in Basel I.
It took them years–I won’t get into details on Basel II,
but it won’t get into–it tries to deal more sophisticatedly
with the complexity that we have in modern finance when there are
lots of unusual derivative securities that have difficult
to understand properties. I think they may have to have a
Basel III before too long because everything gets more and
more complex in the world. To some extent,
the subprime crisis is a failure of Basel II,
which is not even fully born yet.
It won’t come fully in force in the U.S.
until 2009; it’s already starting to have
its impact. It’s in other countries–it’s
already been adopted. I wanted to talk a little bit
about problems and then I’ll conclude.
I have various–there have been lots of banking problems in the
world and let me just mention some.
I don’t know what order I should go in here.
Let me just talk a little bit historically.
The S&L Crisis in the United States,
1980s–what happened there? Saving and Loan Associations
were making bad loans, especially in Texas,
but in lots of other states as well–this is when Ronald Reagan
was President. Reagan was a big believer in
free markets; we had a law that actually
passed, it’s called the Depository Institution’s
Deregulation and Monetary Control Act of 1980–that’s
actually before Reagan. That’s Depository Institution’s
Deregulation and Monetary Control Act;
what that did was, it eliminated ceilings on
interest rates–on deposits, it allowed banks to pay high
interest rates. It used to be that the
government didn’t let banks pay more than a certain amount on
their deposits and that helped protect banks because then they
didn’t have to compete to pay high interest rates–then be
incentivized to make risky loans to try to make money with those
high interest rates. Once they freed up interest
rates, interest rates on deposits started soaring and
banks started taking greater risks, particularly Savings and
Loans. Now, the government insures
deposits, as you know, through the FDIC–the Federal
Deposit Insurance Corporation. For Savings and Loans,
they had an organization called the FSLIC, which is now defunct
because of this crisis–Federal Savings and Loan Insurance
Corporation–it was insuring deposits of Savings and Loans.
They should have been watching, under Reagan,
because if you let them pay high interest rates you better
watch out that they don’t make risky loans if you’re insuring
them. But the FSLIC wasn’t;
it was sleeping at the switch, so it allowed banks in the
United States–it was primarily Savings and Loans who did
this–to make bad loans and they were playing this moral hazard
game. The moral hazard crept in
because they said, hey we can borrow at a high
rate. Let’s make some risky loans and
if it succeeds we make money; if the thing blows up,
well then they government will pay.
So, they had an unfortunate incentive to make bad loans.
This thing collapsed in the 1980s and it cost the U.S.
Government, through the FSLIC, about 150 billion dollars.
The collapse of this was part of the reason for a general
economic collapse. We saw a collapse in real
estate prices after 1990 and a recession in 1991,
so it was the big story of the 1980s.
I’m just going to mention some other stories that are
important, just to illustrate the fragility of the banking
system. The Mexican Crisis under
President Salinas. What happened was,
Salinas was a Harvard-educated economist;
he came in to modernize Mexico and he wanted to privatize
things, so he privatized a lot of the banks.
Then the banks went on a lending spree in Mexico and bank
loans rose from 10% of GDP–of Mexican GDP–in 1988 to 40% by
1994; that’s a huge increase in bank
loans in Mexico. What was happening?
It was again–something was amiss–that you had the
government deregulating and not watching.
A lot of these people in the Mexican banks thought,
well surely there will be a bailout if something bad
happens; the government will pay for it,
so let’s run with it. They ran with a lot of loans
that turned out bad. As a result,
there was a huge banking crisis and I mentioned before that
Mexico doesn’t have much in the way of domestic banks anymore.
They basically all failed and were taken over by foreign banks
after the Mexican Crisis, so that’s a sign of how things
can go amiss. The Asian Crisis in
1997–1998. It actually is a complex
phenomenon not involving only banks, but there was a–in the
mid-1990s, Korea, Taiwan,
Thailand, Philippines, other countries were receiving
a lot of international capital from international banks.
There was a sudden change of heart and people wanted to
withdraw their–foreign investors wanted to withdraw
their money. Once the rumor got started that
Asia was in trouble, these people started
withdrawing their money faster and faster and it caused
failures of domestic banks in these countries.
There’s also the Argentine Crisis of 2000-2002.
Once again, I won’t get into all the details of this,
but it ended up with a run on the Argentine banks.
Again, there was a loss of confidence in the time of an
economic crisis and people wanted to withdraw their money
from the banks. The government was panicked
because the banks didn’t have enough money to give it to them,
so the government shut down the bank accounts and it led to
rioting in the streets. People were very upset that
they had left their money in the bank and the government was just
saying, you can’t have it. It caused a huge economic
crisis as well; the unemployment rate rose to
18%. There were five changes of
government in Argentina in a short time.
Fortunately, Argentina has survived this
crisis pretty well; it’s coming back rapidly.
There was a severe crisis and so that again highlights the
importance of having good bank regulation.
Now finally, I want to talk about the
current situation in what’s called the subprime crisis.
Let me talk about the U.S. first.
In the U.S.–now, I’m talking about just the last
few years and something that’s continuing today–and it’s
international as well. There developed, in the U.S.
in recent years, something called the Shadow
Banking System. These are organizations that
act like banks but are not called banks because they are
not technically banks, so they escape regulation.
Typically they issue, instead of deposits,
something called ABS–Asset-Backed
Securities–particularly commercial paper,
which are short-term obligations of the organization.
They invest in something long-term–notably,
subprime loans. They’re operating like banks,
but they’re not regulated as banks, so Basel II doesn’t apply
to them and they can do what they want.
Unfortunately, what we’ve seen recently is a
kind of a bank run on the asset-backed commercial paper.
Banks have been creating something called Structured
Investment Vehicles in recent years.
What these are, they’re like companies but they
typically don’t have any employees.
An SIV is a company of a sort that invests in assets and they
issue something like asset-backed commercial paper,
but it’s not a real company because it only exists as an
organization sponsored by some bank.
So, the bank has an SIV on its books, but the SIV is not part
of the bank, so it’s not subject to the bank capital
requirements. Then you know,
you might say, who would buy the paper of an
SIV? Well, the only people who would
buy it are people who trust the bank that supports it,
so in effect, the bank is promising to bail
out the SIV if it should get in trouble.
So, it really is–it really ought to be on the bank’s
balance sheet and it ought to be regulated by the bank
regulators, but there was a failure to do
that and that is the problem that we are in currently.
I wanted to talk about some very recent problems to
illustrate that it’s always a challenge to keep banks–banks
are extremely useful entities, but there’s sort of a
fundamental flaw that has to be constantly dealt with–namely,
the tendency of them to fail when they’re lending long and
borrowing short. There’s always a risk that
investors will suddenly want their money back.
I wanted to just talk about some recent examples.
Northern Rock, which was a building society in
the United Kingdom, had a sudden bank run in
September 2007. The Northern–what was
happening? Northern Rock was a British
building society that was investing in subprime paper in
the U.S. So, it was having trouble and
word got out that it was having trouble and the rumors started
spreading in the U.K.–Northern Rock is going to fail.
So, people started rushing to pull all their money out of
Northern Rock in September 2007. This was the first bank run in
the U.K. since 1866.
This was a tremendous embarrassment to the Bank of
England and Mervyn King, who was a very good governor of
the Bank of England; but this apparently took him by
surprise. They thought bank runs were a
thing of the past. In fact, the United Kingdom has
been an international model for preventing bank runs because the
Bank of England would always lend to a bank that was in
trouble in order to keep them out of the problem.
The U.S. Federal Reserve System was
really a copy of the Bank of England–thinking that,
well, the Bank of England managed to prevent bank runs for
all these years, let’s create the Fed,
which we’ll talk about again later.
They thought they had the system solved,
but then they had a bank run last year.
You talk to these people who were standing in front of the
bank; the first question you’d ask
them, aren’t deposits insured in the U.K.
like they are in the U.S.? Well, sure enough they were.
The U.K. had copied the U.S.
idea–I guess they copied–I don’t know where the original–I
think it’s probably–is it U.K. copying the U.S.
in this case? But they didn’t copy it well
enough because they had a limit on the insurance of £3,000
for full insurance and then they had 90% of the deposits up to
£75,000. You go out to these people who
are lining up in front of the bank and ask them,
isn’t there deposit insurance? They knew perfectly well.
They said, yes but only up to £3,000–I don’t want to
lose 10% of my money, I’ve got £50,000 in the
bank. It was kind of a bad design for
deposit insurance, so they fixed it.
But still, Northern Rock is in such trouble that in February of
’08–that’s last month–the British Government nationalized
Northern Rock. It’s in a terrible mess.
This puts the British Government in an embarrassing
situation of owning a failing mortgage lender,
so they’ve got to now be the government collecting on all
these mortgages; it’s a mess.
It shows that little details about how the deposit insurance
is run are important. I wanted to talk about Germany.
In August, or actually it was a little bit earlier–July.
There’s a bank in Germany called IKB Deutsche
Industriebank AG that invested heavily in U.S.
subprime paper. The value of the paper
collapsed and the bank became insolvent.
It was doing it through an SIV on it’s–called the Rhineland
Investment Vehicle. So these–it’s not just the
U.S.–this thing is a heavily international problem.
So, this was a German bank doing exactly the same thing and
it became insolvent and the German Government had to come to
its rescue. It turns out that 38% of this
bank was owned by the German Government, so it was kind of
their problem, right?
They weren’t watching what was going on adequately and so there
was a bailout. The bailout–I don’t have the
exact number here–it was a huge number of Euros.
It kind of was a wake up call in Germany because they were
watching with amusement the subprime crisis in the United
States and here it was causing losses to the German Government.
I think it was in tens of billions of Euros;
it was huge. This wasn’t the only one.
There was another German bank called Sachsen LB,
which failed at the same time. I guess the two together–I
think it was twenty-six billion Euros.
Sachsen LB and IKB was a bailout of twenty-six billion
Euros and that’s a huge scandal in Europe,
which is still unfolding, and it derives from the U.S.
subprime crisis. What was happening was,
these banks were not being watched carefully enough;
their capital requirements were not enough for the kind of
assets they were investing. Now, part of the problem is
that the rating agencies were rating their securities that
they were investing in as AAA, in many cases.
There was a big goof up. The rating agencies weren’t
cutting the ratings as they should and these European banks
were just kind of naively trusting and it just didn’t get
figured out. Now, it hit France too;
BNP Paribas is a major French bank and it had a couple of,
well, several funds. PowerVest, Dynamic,
BNP Paribas-ABS Euribor and BNP Paribas-ABS Eonia and these
things collapsed and I believe the three funds lost–I have
down two trillion Euros–I have to check that,
that sounds high. But it wasn’t–the point was,
it was the same scandal that we saw in the U.S.,
U.K., Germany and now France; it was the same source.
It was the U.S. housing crisis that was causing
a contagion around the world from one country to another
because the banks in the countries had invested in risky
securities–they hadn’t taken proper account of the risk and
they didn’t have enough reserves.
The same thing affected U.S. banks as well.
It was Bear Sterns, whose headquarters is right
next to Grand Central Station, if you go into New York.
They had a couple of funds; one was called High-Grade–I
like to write this down–High-Grade Structured
Credit and another one that was called Enhanced Leverage Fund.
These names sound safe–High Grade, Enhanced–but they both
collapsed and became leveraged fund.
They became almost worthless because they were investing in
subprime debt and the value of the debt collapsed and so these
collapsed as well. These are just some examples.
I think we’re in a very interesting time for banking and
for the economy as a whole. What we’ve seen is a testing of
the system–that we have regulatory requirements,
that banks have enough capital–but this regulation is
challenging because it’s being stressed right now.
A lot of people get complacent during normal times and they
assume that normal times will go on forever.
They can’t imagine–they don’t have the power of imagination to
think what the next crisis will be like, so it catches them by
surprise. We’ll figure this all out.
Banks, as I say, are with us to stay;
we just have to improve our regulation and disclosure
requirements so that banks can be prevented from taking
unnecessary risks. I hope you will all come to
hear Redleaf on Wednesday and I look forward to having lunch
with some of you. I don’t think I can get either
Icahn–both Icahn and Schwarzman are coming to give a lecture in
April, but I don’t think either of
them will stay for lunch, so this is our only luncheon
event.

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