Eugene White on Bank Regulation
Apr 2 2012

Eugene White of Rutgers University talks with EconTalk host Russ Roberts about the regulation of banks and financial crises. White argues that most regulation tries to limit the choices of banks to restrain them from making choices that create instability or fragility. A better approach, White argues, is to change the incentives facing bankers so that they would be encouraged to make prudent choices without the need for top-down monitoring. He shows how in the 19th century various regulations and market results encouraged stability and prudence while some regulations made the system more fragile. White discusses the lessons for the current crisis and what might be done to improve the current state of regulation.

Anat Admati on Bank Regulation and the Bankers' New Clothes
Anat Admati of Stanford University talks with EconTalk host Russ Roberts about her new book (co-authored with Martin Hellwig), The Bankers' New Clothes. Admati argues that the best way to reduce the fragility of the banking system is to increase...
Charles Calomiris on Capital Requirements, Leverage, and Financial Regulation
Charles Calomiris of Columbia University talks with EconTalk host Russ Roberts about corporate debt, capital requirements, and financial regulation. This is an in-depth conversation about how debt works on a firm's balance sheet and the risks that debt vs. equity...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Apr 2 2012 at 8:49pm

Wonderful podcast.

I’d like to offer a different angle on the criticism your guest provided to your suggestion that the solution is profound deregulation. I personally just don’t know what the cost of deregulation would be. I don’t know(and it’s not really knowable) what the cost of the transition from a highly regulated, government secured banking system, to a more free market version would be.

It is perhaps less relevant whether a fully deregulated system is better than what we have now. How much improvement would we see? Would this reduced tendency towards crisis justify the costs of the transition? What would the costs of the transition be?

My interpretation of the financial bailouts was that the political class, at least, blinked and chose the devil they knew. Or at least they thought they knew. It is not at all clear how long an adjustment in the population to a new banking regime would take.

I can offer an example from a country with a highly disfunctional banking system(Romania) where for a long time into the 2000s people preferred to hold a big chunk(sometimes all) of their savings in cash. Money under the mattress. I’m not saying this is either a bad or good thing(it was certainly prudent in the context), it’s just a fact.

We have no idea what a meaningfully deregulated banking system would look like. We also have no idea what the TRANSITION to that system would look like. This is a gigantic chunk of uncertainty, dwarfing even something like potential Greece’s exit from the Eurozone, and that’s pretty much educated guess territory bordering on coin tossing.

The issue of path dependency really comes into play here. Do the benefits of changing course justify the costs? I honestly have no idea how to even begin to think about that issue.

Brad Hutchings
Apr 3 2012 at 4:02pm

“Children understand regulatory arbitrage.”

I have always that that children’s books would be a great way to teach economic concepts. Think South Park minus profanity plus deep economic insight in children’s contexts.

Son: Mom, can I spend the night at Timmy’s house?
Mom: No. We are all going out to breakfast in the morning.

(a few minutes later…)

Son: Dad, can I spend the night at Timmy’s house?
Dad: No, you can’t. Your Mom told me you already asked. Why did you think my answer would be any different?
Son: Regulatory arbitrage.

Apr 3 2012 at 11:51pm

Great discussion. Has anyone found a working link to Prof. White’s paper?

Scott Campbell
Apr 5 2012 at 9:32am

Thought provoking as usual. thanks
If the borrowing benefits the future I consider that justification to share the burden (we owe it to ourselves) with the future. i.e. a road, sewer, bridge, building,border fence, and self defense only.
If the borrowing does not benefit the future (why should I pay for your party) I do not consider that justification to share the burden with the future. i.e. monuments, welfare payments, goods and services consumed by the current generation.
In certain situations such as foreign aid and police actions by the military in foreign countries, environmental protection, deflecting asteroids the benefit is questionable because the outcome is uncertain and the decision to burden the future must be limited to a preconceived limit that is reviewed every four years by the electorate.
I vote for incentives over regulations every time. People like you need to keep up trying to educate the public and putting the pressure on the crooks and cronies in Washington to clean up their act.

Comments are closed.


About this week's guest:

  • Eugene White's Home page
  • "Rethinking the Regulation of Banking: Choices or Incentives", by Eugene White. Conference paper prepared for the Witherspoon Institute, Dec. 5-6, 2011.

About ideas and people mentioned in this podcast:Articles:

Podcasts and Blogs:



Podcast Episode Highlights
0:36Intro. [Recording date: March 22, 2012.] Russ: Banking regulation; we are going to draw on your recent paper, "Rethinking the Regulation of Banking: Choices or Incentives." What do you mean by the title of the paper, choices or incentives? Guest: I meant it to distinguish between two approaches to how you regulate banks. Banks are institutions which we really create--we give them certain privileges; and we retain the right to regulate them. However, the dominant means of regulating them for most of the past century has been to tell them what they can and cannot do--to regulate their choices, say you can invest in this or you can't invest in that, or you must make this type of loan. What I'm suggesting here is that there is another approach to doing that: instead of telling people what the choices are they should be making, what the bankers should be making, they should be giving the proper incentives for them to do so. That is, giving them incentives to make the right choices rather than telling them what the choices are. Russ: That seems like a very good idea. One of the stranger parts of the current mess we're in is the role that leverage played. And there's a debate--I think mainly a confusion, not so much a debate--about how much leverage was allowed to be used by certain types of banks. Some people have pointed to a 2004 change in regulation which turns out as far as I can tell only affected the brokerage side of banks, not the bank holding side, and so it wasn't nearly as important as people point to. But the intellectual part of that discussion, which I find strange, is the implication that if leverage was allowed to be 40:1, say, then it would be 40:1. That there was no natural restraint on the incentives that banks had to be leveraged, or more importantly on their creditors to continue to lend them money as their portfolios got more risky. Guest: No, I think that's right. If you say there's no natural restraint: well, the restraint would be, if because of that leverage, the individuals choosing that level of leverage, would then bear some penalty for it. Russ: Normally, it raises your risk of becoming bankrupt or insolvent, which means that usually people wouldn't lend to you. The fact that they continued to lend to these institutions, to me suggests the role that moral hazard played in the crisis. Guest: Right--that's the other side of it, that in fact, we've basically had a strong tendency to insure risks. So, there are two parts to the problem. One is that we haven't given managers, stockholders, the right incentives; but also haven't given depositors or lenders the right kind of incentives. And in fact sometimes they are very confused. People don't know what their liability is in all this. Russ: What do you think the role of moral hazard was in the crisis? Guest: Well, I think moral hazard played a big role, but I think I would take it back one step further--is that we've, there are different, for any type of financial institution there are all people who have an interest in the institution. We call them usually stake-holders. They are depositors, other lenders; there are managers, there are shareholders, and the directors which represent the shareholders. And the problem is, is that many of these parties, don't actively, aren't working as actively as they should be to ensure that the institutions don't take too much risk. Part of that is because--we'll say the managers or directors--don't bear a lot of risk if the institution fails, for themselves. They take on certain risky decisions. And the other is that we've provided all kinds of insurance to all the other lenders, so that they don't pay enough attention. If you had to ask any depositor who held $50,000, $100,000, $200,000, we had a limit of deposit insurance of $100,000. But many people who had $200,000 or $300,000 in the bank would never even think of running on the bank because there's an implicit insurance. They believe the government won't allow the institution to fail, so why should they seek out a safer institution? That allows the firm to take more leverage. Russ: And isn't it true that in the Savings and Loan crisis, in the aftermath of the S&L crisis, that large depositors who were above the FDIC limit were reimbursed anyway? Guest: Yes, that's true. Russ: Almost any one of them. Guest: And in fact, we raised the limit from $100,000 to $250,000 during the crisis, and we extended it to Money Market Mutual Funds. [Clarification: the FDIC limits were raised to those levels after the Financial Crisis of 2008, not during the Savings and Loan Crisis of the 1980s.--Econlib Ed.] So, it's much broader than is oftentimes made explicit.
5:56Russ: What incentives then--since your suggestion is we ought to regulate choices less and incentives more--why? Let's talk in a little more depth about the incentives facing--right now we've just talked about the incentives facing creditors, depositors. Obviously a depositor who has under $100,000 or under $250,000 doesn't think for a second about whether the bank they are depositing their bank in is a good, solvent, likely solvent bank. They just look at the rate of interest being paid and go to the highest one. Guest: Right. Russ: What about the executives in the banks, the decision-makers on the ground? Guest: Well, it seems to have really changed quite a bit. One of the things I like to do in my own research is I look back in time and look back to the 19th century, and there you can see a very different sort of regime which existed, which is that managers, and I will say the president of a bank or the chief financial officer or even the directors had a lot more of their interests tied to the institution. Many of them had significant exposure in terms of stock, but also sometimes in terms of performance bonds. Russ: Explain that. Because I was shocked to read that. That was amazing. Guest: So that, consider the Chief Financial Officer, which in those days would have had a simpler title of Cashier. We've tended to inflate titles quite a bit. Russ: Yeah, less impressive. Guest: But the Cashier of the bank was the second-most important individual. And frequently they would be asked to post a bond equal to one, two, or three times their salary. And the idea there was that if the bank got into trouble or if failed as a result of some mismanagement, that bond would be forfeit. Strong incentive to make sure they don't take too much risk. Russ: Now, that was law, correct? Guest: No, that was not law. Russ: Was that market? Guest: That was the market driving that, primarily. Russ: Because that would encourage confidence that the cashier would keep an eye on things. Who else was doing that kind of bond-posting? Guest: Well, that's a fairly--even the regulatory agencies sometimes do that as well. I can't give you precise data about when they stopped doing it, but it's only true in the 19th century that the Federal regulators had to post a performance bond as well. Russ: The regulators? Guest: Uhh, yes. Sometimes. Russ: And where would the bond be held? Where would that money go? Who was holding it, who was keeping an eye on that? Guest: Well, we don't know much about how the system operated, but it might have been held at the Treasury. A lot of these were not very carefully specified so it's not certain whether it was held by the government or by some private agency. These are some of the dark corners we don't know too much about in this period. The reason this information comes out is in terms of bank examination, when the regulators would go in and see how, what the performance of an institution was like. And examine and report back all these issues. So, you might say: Suppose banks failed in this period? This is the period I am talking about from after the Civil War up to WWI. If a bank failed, what would happen? What would happen--to understand the dynamics of this--is that what I call the liability regime differed. And the most important difference was that they had double liability. What this means is that anyone who held a share of stock, if that bank failed, the receivers for that bank-- Russ: the creditors-- Guest: Well, the Receiver, the person who is managing the closure of the bank-- Russ: Okay-- Guest: would have the right to go back to every shareholder and ask for a contribution to pay out all the creditors, equal to the par value of the stock. Russ: So, if I have a million dollars worth of stock in a bank, I was liable for up to a million dollars worth of the losses. Guest: Let's say that you bought the stock when it came out. And I bought a million dollars' worth of stock. The price might go up or down but you would be liable for that original million. Russ: Oh, so the par value means what it came out at. What you paid for it. Guest: What it came out at. So, what would happen is that every shareholder would be a little more nervous. Because you might buy your stock, but you better pay attention because the money you originally put out may come back and you may have to fork over more money.
10:52Russ: Now, that was a regulation, correct? Guest: That was a regulation. That was stipulated in the law, and they did go after the shareholders to do this. What this meant was that shareholders paid a lot more time paying attention to the management. Russ: Y'a think? Guest: Well, yes. Not very happy. And we know that they must have done so. We know that bank failures occurred. But what were much more common was that the shareholders and directors to close down a bank that wasn't doing well. That is, you didn't a bank to go on and on, over the edge, but you closed it down before it went over the edge. And that means the bank was not doing very well. You didn't push it to be more risky. In fact, you stopped. Russ: Right. And it's a fascinating example, given in the recent crisis when people talk about turning points, when a bank could have made a different decision--such as Lehman Brothers after the situation with Bear Stearns. They could have been a little more prudent. Instead they continued doing business as usual. That would sober you up, that idea that you were at risk. Guest: Sure. I mean, it's very different than the S&L crisis in the 1980s, which one really could think of as a complete disaster episode, where when the S&L, Savings and Loans, basically had been traditionally very conservative institutions which took savings deposits and made mortgage loans, when they became insolvent institutions, basically in the very late 1970s, the reaction in Congress, really in response to a lot of special interest groups, was to not close them all down, and absorb the large losses, but to raise the level of deposit insurance, keep people in, and then give them new lending powers. To take more risk. Russ: Hoping to, at least in principle, that they could recover from the-- Guest: That's right. It's just like a gambler, saying, Okay. It's like the house at a casino saying, All right. You owe us now, I don't know, say, $25 million. That's okay. We're going to let you gamble again. And we're going to let you take greater odds. Russ: Because at the roulette wheel, you put $25 million on black, if it comes up black, you are back in the clear. Guest: That's right. And instead you end up owing $100 million. Russ: Which doesn't naturally follow, as we've talked about in here and with William Black and the work of Ackerlof and Romer. The problem isn't so much that that's an inherently bad idea--though it probably is. But that once you do that the incentives to take more risk rather than less is really not so healthy. Guest: Sure. And also, too, if as part of that risk--suppose you win that bet. You say the institution, but because managers' pay is tied to their performance, they will get a big kick in salary. But if they fail, if the institution failed when it was already a little bit insolvent, they wouldn't have any lass. In other words, there's no loss they incur by taking more risk. Russ: They just push out the right-hand side tail; the left-hand side tail is truncated at 0.
14:33Russ: I guess the question some people would ask is, and I've been asked this myself a number of times. I have an answer; I'd like to hear yours. You could argue that the CEOs of the recent crisis--particularly Richard Fuld of Lehman Brothers and Jimmy Cayne of Bear Stearns--well, they had a lot of skin in the game. They were stockholders. They lost about a billion dollars, on paper, from their depreciation of the value of their companies. Surely they had the right incentives to act already. You are talking about ways to use incentives rather than regulating choice. Didn't they have lots of incentives to perform prudently? Guest: Well, they did have lots of incentives. I think part of the question is, you can have losses. Were they wiped out? Russ: No. They cleared about $500 million each--a mere $500 million is what they were left with. Guest: Well, see, one doesn't want to sort of judge--lapse in judgment--but that doesn't sound like a huge penalty. Russ: No, it doesn't. Guest: As one of my friends would say: That's already rich beyond your wildest dreams. Russ: Sure. Guest: I guess you could say perhaps. They are not any more in the billionaires' ring. Russ: That's right. Guest: But that doesn't deprive you of being in the top 1/10th of one percent of the wealthiest, in some sense. And certainly, I think if you would have posed this question to a 19th century banker, even J. P. Morgan, he would have been shocked. To see things like this happening. Russ: My claim is that their risk-taking before the collapse--which might have turned out well; they didn't deliberately plan to destroy the bank-- Guest: No. Russ: Jamie Dimon did similar things. He turned out fine; he got to keep his $1.5 billion or whatever he's left with. But in the meanwhile, while the stock was going up and down, they were buying it; and selling it. And pocketing the profits. And they weren't stupid. They weren't putting all their eggs in one basket. They put their money elsewhere, so that they were left with $500 million. Now, Steven Kaplan, who I interviewed on this issue--his claim is that that's wrong; they sold their stock along the way, not to pocket the gains from their aggressive risk-taking but just to pay off taxes and other things. I think that's an open question. I think Lucian Bebchuk has claimed otherwise. I don't know what the answer is; I'm still open-minded. Guest: Well, a financial collapse is always very messy, and it's very difficult from looking at single examples to see what happens. Especially when it happens industry- and economy-wide. It's hard to assess right out what we call a broad or systemic shock from the individual actions of who was a virtuous manager and who was a risky--we'll say an unvirtuous manager--taking more than appropriate risks. I think in some sense we often would like to isolate things, and I think the case of MF Global is very interesting to look at. Because that's a specific firm, but clearly one that took enormous risks. Russ: Well, using your customers' money, which has been alleged, is a special kind of risk. It's called fraud. Guest: Right, but the interesting question is--well actually, it's not a law that you segregate these, as far as I understand. Russ: Really? Guest: As practice. This is the problem, I think--I am not sufficiently knowledgeable about this. But there was supposed to be a bright line dividing this. Russ: I think it's a law. But we'll find out. Guest: We'll find out about that one. But the interesting thing is it doesn't appear that the man in charge bears any liability for this. He's the one--this is Mr. Corzine--who took over the firm and said: All right; we are going to make lots of money. We're going to make lots of money by proprietary trading. And yet he looks now and says: I don't know what happened. I don't know how we got this. And I think that's the kind of disturbing thing. Is that, if you are the CEO of a firm and you are pushing the firm to earn for all your shareholders, and for you--you must know that some wheels are turning underneath you. Russ: You'd think so. Guest: And I would find it disturbing to find that they are all the customer losses and that the senior executives don't bear any responsibility for that. And I think that's part of the misalignment. That's not to pass any judgment on a case where we don't know all the facts yet. But it is one that should make us ask certain types of questions. Russ: Yeah, I agree.
20:14Russ: Let's contrast the past regulations of the late 19th century, which you talk about and we've touched on. To me there's some kind of continuum, and we go from one extreme to the other. In the late 19th century, shareholders not only had the risk that their firms would go out of business, which would wipe out the value of their shares, but if that happened they were potentially at risk for additional monies, is what you are saying. Guest: Right. Russ: We go to the current situation where shareholders don't bear any additional risk. They do risk being wiped out. Some shareholders can buy and sell along the way, of course, and make a great deal of money. And I guess the other point that you make, which I think has been under-discussed, is the change on Wall Street--and now we are talking about investment banks, not commercial banks--but investment banks from partnerships to publicly traded companies. So, starting about 15 years ago, 18 years ago, virtually every investment bank on Wall Street which was a partnership became publicly traded. The last one I think was Goldman Sachs. But they are all publicly traded now. And in the old days--meaning 18-20 years ago, there was no way that that partnership would use the leverage that the publicly traded companies used, putting the partners' nest egg at risk. Guest: That's right. Russ: So, explain that, and then, why did that change? Why do you think it changed? Guest: This is one of these contributing factors to the boom and bust, which is a little bit hard to tease out, because it's one of those slow changes which happens over time and gains speed. But you are right. About 15 years ago almost all big Wall Street investment banks were partnerships. And in that respect each of these partners had a most of their capital tied up within the firm. So, if the firm went under, basically they lost most of their wealth. But along the way, and I forget which firm went first in switching, but when one of these firms went public, the partners got stock; and the initial incentive is, well if you have stock, you should diversify. So, that they were able to move some of their capital out of the firm. They are sold to the public; there was a considerable benefit to that. But then what happens? The public firm can become more leveraged; it can borrow more and take more risks. Russ: Get dramatically larger. Guest: Yes, become a bigger firm. And that's a [?] to other firms. Because it's bigger, it can take more risk; it can pay higher salaries to anyone from the stars down to their staff. And that can attract the best people to that firm. That's going to drive the other investment banks to do the same thing, to go public. So, there's a dynamic pushing the whole industry that way. Russ: Well, it raises the question, though; and this has come into the news because of the recent piece by Greg Smith, who resigned his Vice Presidency at Goldman Sachs, and says: I was disgusted; they treat their clients like dirt; their customers, they call them names. I don't know how much of that's true. It's an interesting, provocative piece. Guest: It follows from a long literature about the misbehavior of young men at investment banks. Russ: Right. But part of the mystery--a lot of people on the left and the right both loved this piece and hated it, for a whole bunch of interesting reasons. But one of the things that no one paid much attention to is: If you treat your customers like dirt, in most industries you have trouble keeping your customers. So, what's going on in this business that makes it possible--so you started talking about the competitive pressure to leverage up and get bigger and take more risks. But hey, wouldn't people say: I don't want to be part of this; I'd rather be in this nice, safe partnership with people I trust and like than these gunslingers. So, what was going on? Guest: One would hope that there would be a clear distinction between the two types of firms, but some of the firms which are--Goldman was earning its some of its customers, doing well by them. Russ: Evidently. Because they stuck with them. Guest: Well, here's the thing. In a boom--a boom lifts all ships. So, maybe you are doing this, but the customers don't perceive that they might be doing better. That's I suppose the rub. But traditionally, investment banks did worry more about reputation, about their customers and their links to them. This is certainly true in the great tradition of J. P. Morgan, who worried a great deal about making sure that they were presenting good deals to his customers in terms of buying stocks or bonds. And I remember reading this one great history of Lazard Frere, which at one time was a top investment bank. Talking about the 1950s, 1960s, some time ago; but it's kind of astonishing to read that the head of the company didn't want to have a new building. Didn't want any frills--because he thought customers would believe that he was being paid too much and misspending their money. Russ: Interesting. The good old days. Guest: We turn aghast at reading that because somehow that's been transformed to: if you have a bright new shiny building, you must be earning a lot of money; and we can do well for you. But I always think that when you see a firm erecting a new giant skyscraper, a luxurious one, you should ask the question of: What's going on? Russ: Where's my money going? Guest: To make a case in point, Northern Rock, just moved to England, built a great new headquarters--just before its collapse. So, that's what I would say is one of the potential signs of a problem. Russ: So, my story, which I'm kind of stuck with; I really like it; I'm always aware that I may be cherry-picking things that confirm it and ignoring things that don't; and correlation is not causation. But it seems striking that this move away from partnerships to publicly traded companies, which results in a massive growth in size in these firms, would seem to correlate with the middle of the too-big-to-fail era, where it suddenly became easier to attract borrowed funds from people because the government had got into the habit of compensating creditors 100 cents on the dollar. I don't know if anyone's done any work on that. It's just a thought. Guest: Well, no, but these two trends I think merge. If you say, why don't we have double liability any more, it turns out the answer is really the Great Depression. Where, again, you have this systemic, broad, wide shock, and it's very difficult to collect from anybody money to pay out depositors. There's a new idea for deposit insurance. So at the same time as they introduce FDIC insurance, they cancel out double liability. Russ: Interesting. Guest: FDIC insurance starts out as a very limited program. The idea is being a mutual fund, where the banks will pay in; and they'll pay out for bank failures, but not directly impinging upon the government. Russ: What does that mean? Guest: Basically it's like an insurance pool. Russ: Oh, you mean not requiring government funds. Guest: Not requiring government funds. But there is a slow creep. And if you look between 1934 and even up to 1980, the levels of deposit insurance creep up. People get better at splitting their accounts and moving them bank to bank. And once you've insured commercial banks, there's pressure to insure savings banks, and all kinds of other types of intermediaries. So, it's been a broad movement, not just by the public but by the institutions, because you don't want to compete with a rival institution which is insured. So there's a general, I would say, spread of this idea of liability insurance. And that's very hard to shift back.
29:48Russ: Well, let's talk about a wider range of political economy, and let's go back to the 19th century, which I know you've written about. The 19th century, I think the casual history of the era in the eye or mind of the lay person is: Well, the 19th century, that was a terrible time. We had a lot of bank runs, we had a lot of panics, so obviously all these incentives you are talking about didn't work very well. And it was a huge mistake; and finally we got out of that era, fortunately, with the Great Depression. It was a tough price to pay, but mercifully we got a different regulatory world, and look how good it worked. Now, I'm channeling a certain style of critique: Until Glass-Steagall was repealed, this was great; we had a good 60-year run, which isn't bad. What's your take on that--19th century bad, 20th century good? Guest: If we look at the big picture, what was growth of the economy like back in the 19th century? It was actually pretty good. It's a period of rapid growth. So the whole economy is growing fairly rapidly. They do have recessions. Russ: An occasional depression--1894 was a really one. Guest: Yeah, but probably more in line with what we call a long recession. In the sense that--business cycles are a natural phenomenon. They occur. Now it is true that there were runs on banks and panics; it appears that the panics tended to amplify the depth and duration of a recession. Russ: Yeah. Guest: This seems fairly well established. Russ: And for those who have forgotten, there was no Federal Reserve until 1914. Guest: So this is a system where you don't have a central bank operating. Russ: No lender of last resort. Guest: If the panic was bad enough, the banks simply closed their doors and restricted payments until everyone calmed down. Which is very extreme. But we know that panics tended to make these recessions worse. The question is what's driving the panics? And there really are two factors, which are underlying these panics. Panics and bank runs are much more frequent in the United States than they are in Canada or Britain or France, whatever economy was at roughly the same level of development. Russ: That's because we're a more nervous people. Guest: No, no, not at all. It's because we impose a particular set of regulations--we prohibited branching. So, we had tons of small, undiversified institutions. So, you might have a bank out in Kansas in a small community. There's no branches, but it lends mostly to wheat farmers. It has wheat farmers' deposits. If there is a drop in the price of wheat, you can have people withdrawing funds and failing to pay on loans, and the bank can fail. Given that all the banks are tied together through having to clear checks and everything else, one bank oftentimes can move to other banks engaged in the wheat business or farming business, and you can have a panic. So, with this fragmented banking system, it makes panics more likely. That's factor one. Factor two is you don't have a central bank to provide liquidity. So, with the two of these we would sometimes have these very large panics, which would spread. Now, Canada at the time had no central bank but it had a nationwide branching system, and it did not have the same problem. It didn't have these very frequent panics. So, that's always the root cause; and it's very important to make sure you don't misidentify the cause when you are searching for a remedy. Russ: That's a good point. So, my question would be--and George Selgin talked about this in his podcast as well--it raises the question: Okay, I think that's clearly part of the reason we had more runs in the United States than in Canada. Why do we have that silly law, and why did Canada have such a good law? Guest: Well, this is probably the result of what we might call the Law of Unintended Consequences. Early on, in the very early 19th century, early banks might have had no branches, or one or two. Not that many. Because, given the state of technology, you didn't necessarily do that. In the United States, they were very concerned--it's hard to explain why sometimes you get a particular regulation. In the United States, the National Banking Act of 1864 specified that the major activities of the banks be conducted in its office. And it seems to be the purpose behind that was to make sure that when an examiner came, he would have all the documents there. They wouldn't be moved around from branch to branch. Because there's no telephone, no real good telegraph, to follow around all of that. And once you get that law in place and you have single-office banks, the person saying: We can manage a branching bank. Then that bank is larger and might have some economies of scale and may be able to drive the small, unit-bank offices out of business. And they resent that and resist. So, that's what we really had, a system where we created, not really realizing what was going to happen, a very strong lobby of single-office banks which resisted branch banking. And we know this because the United States is really one of the last countries ever to have nationwide branching. We only actually get that in 1997. It takes a long time to reach that point. It takes basically a century. Russ: The wheels of progress turn slowly. I remember--I went to school at Chicago--and Illinois, maybe it was Chicago, but I think it was Illinois--there were no branches. Guest: The whole state of Illinois. Russ: Right. So, your bank--I think they could have a branch within something like 500 yards. So, my bank had a branch, just a nearby storefront, for some people it was a little more convenient. Guest: It was exactly like that. And every state effort to do this, they might begrudgingly allow them to have that. Or, New Jersey, for example: When they allowed it they said: We'll allow you to branch, we're going to cut the state into three zones, and you can only branch in your zone. Things which today sound really pretty silly, because we want--if I'm traveling from New Jersey to California, I might want to access my bank there from an automatic teller or whatever. So, this is one of those regulations which weakened the U.S. system profoundly for a very long period of time, and really in many ways contributed to the collapse in the Great Depression as well, because it was still many small banks, which were not robust.
37:22Russ: How does that political economy of the power of these small banks play out in the creation of the Fed? Guest: Well, it has a big influence on the creation of the Fed. Russ: Because most people think the Fed was created to prevent banking panics. Guest: The Fed's job certainly was aimed at preventing panics. It satisfied: It allowed it an ability to provide liquidity; but it didn't change the branching requirements. But the unit banks had a profound influence on the shaping of the Fed. Because all those--in 1914 there are well over 15,000 small banks--many of them are very nervous about the idea of having one central bank. And they are kind of sold the idea that they are going to have 12--12 regional central banks, which are going to look like clearing houses, which are going to help them process their checks, which they like, and which will have an opportunity to provide them with credit. So they said: Okay, that's a good idea. So a decentralized system that is really a reflection of this unit banking system much more than anything else. All the regional Feds really owe their existence to that. Russ: And, of course, if we imagined a different world today, which is sort of what economists do--say, wouldn't it be great if these were the incentives? Given the entrenched winners of the current system, whether it's by design, whether it is merely an emergent phenomenon, or whether it's an accident--it's kind of just a side-note of some other attention--do you think there's much prospect for doing anything other than what we are currently doing? Let me ask it a different way. Question number 1: If you had your 'druthers, what would you do? And then secondly: Why isn't it going to happen? Because whatever you say, I don't think it's going to happen. Guest: So, as economists will say, if I were able to be a social dictator, the person who can redesign things, how would you do that? I'm looking actually here for one second to give you a quote, which is actually pretty-- Russ: While you look for it, I'll tell you my version of this. I was once asked by a reporter: If you were President for the day, what would you do about x, using your skills as an economists? And I said: Well, if I were President, I wouldn't be an economist any more; I'd be a politician and I'd do what politicians do. Why would you think I'd act like an economist? It's the way of the world. People respond to the incentives usually of the job. Guest: Of course, I couldn't find it. But if you enter into the Federal Reserve, there are two bronze panels. One with a relief, a profile of Woodrow Wilson; the other of Senator Glass. And the quote underneath Wilson's says basically we can't start with a blank piece of paper if we are going to improve our financial system; but we can take it step by step to make it better. I think that's a very interesting quote because it's a very hopeful one. Russ: It is. It says you can't get it all done today or tomorrow, but we'll get in the car and we'll head in the right direction. Guest: The problem is that most of the time what we've done is we've tended to layer, add one layer of regulation on top of another. We've not done what he said we could or should do. And that's part of the problem. And that's why when you look at current legislation, it may deal with a few of the problems, but far from all of them. And it may add additional problems. The hard part for economists is there are so many different constraints and regulations, it's hard to say what the outcome is. Because it's not a simple model where you have one imperfection or regulation. You have thousands. Russ: It's like you make something more expensive; it's easy to predict people do less of it--we're good at that; but you are right: When there are all these interacting, interlocking effects it's almost impossible. Guest: And we can take, in the discussion about how to implement Frank-Dodd, this all comes to the fore, and as a result, a huge controversy about regulations and what their effect will be. Now, say, if I could advise some country which is just starting out, what would I do? I would set up a system which had relatively minimal regulation, but set up the right kinds of incentives so that depositors, directors, shareholders, and managers all had their interests properly aligned. That wouldn't mean they would take zero losses, but the incentives would be aligned with the risks they take. That's very general; I have to apologize because that's not a specific policy recommendation, but a general approach to design. Russ: I understand. But it's not so helpful. Guest: No. Russ: I need a little bit of help. You can't just say: Well, I'd create a world where people would be encouraged to do the right thing on their own, so they wouldn't need much regulation. The question is: Is there a way to do that? To me, the obvious way to do it is to tell them: You are on your own. Depositors, you are on your own. There's no federal insurance; there's no central bank; there's no lender of last resort; there's no backstop; there's no do-overs; there's no subsidies to irresponsibility. Now, the claim is that we can't do that; that's out of the question. Because when push comes to shove, we'll always bail out the losers, because it's just too expensive. Well, that's the claim; I don't know if it's true. Guest: Well, I think the problem with just saying everyone's on their own is the problem with asymmetric information. If everyone had perfect information then you really wouldn't even need banks, even, because I would know immediately who to lend to. I wouldn't need anyone to intermediate that. But I can't. You need people who specialize. Russ: Correct, it's unrealistic to have perfect information. I don't assume that. Guest: But what I'm saying is that once you allow someone to create a bank and they take my funds, it's hard for me to monitor the bank. Russ: Right. Guest: Because there's some information they might be induced to disclose, but there's a lot of proprietary information. So, then you get to fall back on disclosure and reputation. And I think there is always some role for government in setting up the rules under which these institutions will operate. And setting common standards. Because you don't want each bank having their own accounting rules. Because it's impossible to distinguish between the two. Russ: Well, it would make it expensive. Guest: That would make it very expensive. In some sense the evolution of regulation is part of the natural process, but trying to get each part to play its appropriate role. And I think that's the trick. And we've gone way too far. We expect too much from the regulatory authorities in solving the system. Russ: Which is surprising, don't you think, given their track record? I think it's fascinating. I'm not being silly. I think it's an extraordinary thing. I think it's reflected in the Rogoff and Reinhart title, This Time is Different. The implication is, now we've learned. We didn't know before, but now we've figured it out. It's remarkable that we have this, what would you call it, naivete? Idealism? Foolishness? Guest: Well, there is a little bit of disconnect because if a bank fails and I'm bailed out, I'm ultimately a taxpayer. I have to pay the bill. And people don't connect those two halves necessarily. Russ: Well, they've started to lately. I think they've kind of caught on. I mean, one of the virtues of the current mess we are in is it has raised people's consciousness rather dramatically about the nature of the rules of the game. Guest: It's a good thing; I think it's a very good thing. But the problem is in the political system, which is the general taxpayer has to contend with the special interests who tend to retain those special privileges. Russ: And has a little more of an incentive to be paying attention day to day. Guest: Absolutely.
46:47Russ: What about the Fed? Would you do anything the Fed? Or do you like the way it's constituted? Another way to ask it: What incentives does the Fed face? Guest: I think what I'd do is focus--there are two tasks the Fed has. They have monetary stability and financial stability; and I'll focus on the financial stability part, because that's in a sense I think the Fed's done reasonably well in terms of maintaining price stability in the country. We've had a period of not much inflation, no deflation, for quite a period of time. The real problem appears to be in the financial stability side. There's a big problem which we face because the authority for financial stability is broken into many agencies, each of which is funded differently, each of which has different incentives. And each of which fights for its position. And as a result, you get often to have what we call regulatory arbitrage, which is where financial institutions seek the weakest regulator. And so you have competition among the regulators. And this is very destructive and very weakening. Russ: Children understand this when they are negotiating. Guest: What we really need to do, and again this is unlikely to happen without a profound change, is to move more towards a system where we move all these agencies into one. We don't need to have many different types--we don't need a regulator for every type of financial institution. This is one of the ways we got into trouble on multiple occasions. And the Fed is just one of those regulators. Russ: I was just going to say that children understand regulatory arbitrage. If the Dad says no, they ask the Mom. And they don't tell the Mom often that they've already asked the Dad. And when the Dad says: I told you not to, they respond: Well, Mom said it was okay. Guest: Exactly the same idea. This is a major problem. When I talk about this I am thinking of what I call the spaghetti diagram. In many different locations there's a picture of all the agencies and the different institutions and the lines of authority between the two of them, and it just looks like a plate of spaghetti. Russ: There is a temptation to say: The more the better, because at least someone will be looking out. Guest: I would say that's a very nicely hopeful view. Russ: Well, the incentives to look out are not very big when there are lots of you, because you could say someone else is supposed to do it. Guest: And if we take the case of the Securities and Exchange Commission (SEC), which I'm going to say that I think that the agencies are staffed with honest and hardworking people; but it depends on the tasks you give them and the funding you give them. And we know that before the crisis, some of the agencies were starved for funds. We'd have to take a close look at the numbers, but it's not surprising that sometimes--for instance, the SEC--we know that's been subject to budgetary cuts at various times, usually before a crisis. And then people say: Well, gee, you didn't go out and catch the crooks. So, they are subject to a lot of these political constraints.
50:38Russ: Let me ask you about--we could talk about these desirable worlds versus the world we live in, and that's nice. But a lot of the time when you push seriously these kinds of changes that probably you and I would rather see, these reductions in guarantees, reductions in backstops, more incentives for executives and risk-takers to be prudent through their own incentives rather than outside monitoring--a lot of people respond by saying: Yeah, one of the problems with that is that our whole capital system, our whole financial system, would shrink. And one of the great things about America--allegedly--is we've got this vibrant financial system with this huge credit market, and that's the benefit of these kind of loose encouragements to risk, that you've got all this capital available. What do you think of that? Guest: I think that's kind of misplaced. Russ: And they say, for example: If we regulate too stiffly, if we make it too hard to make a lot of money, well some of these banks will just go elsewhere. And I'm thinking: So what? That would be good. Guest: When I've gone to Europe--actually, I was in Spain recently, at a conference on Spanish savings banks, which are deeply troubled institutions. And you can walk around Madrid and you can see all these closures. And so one of the things I asked my host, I said: Is there any new entry? Are there any new banks taking their place? And the answer is: No, it's too difficult. And I suspect, and it's pretty clear, that there are too many barriers to new banks or new financial institutions opening up. It's very hard to clear the regulatory procedure. One thing about the United States is that there is easy entry into banking. Any year you look at, there are new banks opening up. New small and medium-sized institutions. These provide credit to lots of small and medium-sized enterprises across the country. That tells me that our system would remain vibrant, even if you had the reforms we are talking about, because there's an opportunity. We have certain problems because of the way we regulate banks, and other countries have a different set of problems. The different set I find in a lot of European countries is that it's hard to enter with a new firm. That's not the problem here. So I think that there would be plenty of opportunity. There will be venture capital, there will be new banks--a whole range there. That, I don't think, is a big problem. Russ: One of the things you hear, though, is that some of these so-called innovative techniques wouldn't be available. So, in the aftermath of the crisis, people were fixated on re-establishing asset-backed securities markets. My view was: They didn't work so well. They misallocated capital. Why would I want to resurrect them back to their old level? But that was the push. And I think that push was mainly self-interested, not wise. What do you think? Guest: Well, that's because I think people wanted a quick fix, not a permanent fix. And that's important. The markets have to find their way around. One of the problems about insuring large financial institutions, insuring institutions, and so forth, is they may grow to be ungainly. They may have too many things they are trying to do simultaneously. And--let me try to give you an example. We know that in all the foreclosures the processing of documents was abysmally handled. Russ: Yeah, not so good. Guest: One feels terrible for people who were in a housing foreclosure and can't negotiate because the banks messed up all their documents. One of the things--it's very hard to understand exactly what all the incentives about insuring these institutions is--but if they can't fail, they are going to start absorbing all kinds of subsidiary enterprises, which become insured as well. So, they may begin to do everything poorly. So, one of the things you might see if you took away this permanent guarantee is that you might see banks becoming simpler types of institutions. Which would be the right way to proceed, as opposed to saying: You can't do this and you can't do that. But letting them decide which set of things they ought to specialize in and which they ought to contract out to. Russ: And as you said, creating the incentives for them to pick the right mix rather than the mix that affects taxpayers. Guest: Absolutely.
55:26Russ: Let's close with a look to the future. You are not a big fan of Dodd-Frank in terms of what appears to be its attempts to solve some of these problems. It really didn't do too much about Too Big to Fail. As far as I can tell, it doesn't have any teeth in it. Are you optimistic or pessimistic that there will be some serious useful reform, or do you think we are just going to keep going with business as usual? Guest: I tend to be a bit of a pessimist on this one. I don't like being a pessimist. One of the things is, at this point, Dodd-Frank really isn't in place. Russ: Right. Guest: Because the whatever, 1500 pages of Dodd-Frank, sits in outline and then delegates to the agencies to implement the laws. Russ: Bizarre example of modern legislation. It's common; I don't get it. Guest: So, in many ways, we don't know what the ultimate outcome will be. There may be some improvements. But on the whole, it kind of props up--and as you pointed out with the asset-backed market--the existing system without engaging in some underlying changes. Russ: So, we don't know how it's going to be implemented. And of course, the problem with that is that the people who have the incentive to pay attention during the implementation aren't you and me. And we care a lot. We are probably the top 5% or maybe 1% of informed people. But we are not going to be watching when that legislation gets put into place. Guest: I'm quite willing to believe that the people on the committees at the Federal Reserve and all the other places are people of good will who want to make the system better. The problem is, they are delegated by Congress to do certain things, they are given a certain degree of discretion, and then they are subject to very large pressures. Each one of those groups--and it's going to be hard to get consistency across them. It's a very hard task. And I'm afraid that when you get increased complexity, where once you set it in place, which allows creative entrepreneurs and their lawyers to find ways around some of the legislation which is designed to prevent problems. Which has happened before. Russ: So, help me out. I'm listening at home. You are talking to a listener who is jogging or doing some dishes or commuting. And basically you've just said: You know, it's going to just kind of keep going the way it is. Is that it? Is that the best you can do? Given the amount of political anger on the left and the right at the current system, it's kind of striking that it's business as usual, don't you think? Guest: Yes, it is kind of striking. But by the same token, we might argue that the political system is somewhat dysfunctional. And yet, it's very difficult to reform that. If we don't like, for instance, what redistricting every ten years has done, that's very difficult to reform as well. The only thing I can say, in a somewhat positive note, is that the crisis has swept out a lot of rotten trees from the forest, so it's going to clear things out; and for a while we'll have a fairly stable system. The only thing of course is that firms may be hesitant to offer credit because they've been told to be tight. But things should be stable for at least the medium term future. Russ: Is that 18 months? How long? Guest: At least 18 months. Because all the weaker institutions have been swept out. It gives them no sense that you have some stability. But for the longer term, you really need long-term solutions.