Transcripts For CSPAN2 Connectedness And Contagion 20160917

Its my pleasure to remind you that you are welcome to buy a copy and how will be available to autograph them after words. Here we are in the stylish new Conference Center to discuss a very old problem, namely how best to survive financial panic of which there have been many throughout the century, how to survive the fear and mistrust when financial actors try to withdrawal from risk to protect themselves, a rational strategy for each but as we all no, not when they do it at the same time. It is highly interesting historically but much more pressing than we can consider as how scotts book does in detail. What should we do in the next panic that will arrive sooner or later. Two centuries ago they accurately observed, on extraordinary occasions, a panic may seize the country one becomes desirous of possessing him self of precious metals. Again such panic concludes that banks have no security on any system that is to say that private banks on their own. In 1873 they drew the conclusion we all know whats true then and is still true now to which, if all the creditors demand their money at once, they cant have it. Moreover they go on, when apprehension passes a certain bound, no private banker is safe. They also say every banker knows that if he has to prove he is worthy of credit, however good his argument may be, in fact his credit is gone. Thats what happens in a panic. Everybodys credit is gone because nobody can prove he is worthy of credit and were not even sure about their own solvency. What do you do then . Then you have to finance the bust. The central bank and the government treasury provide new debt and new equity, expanding their own Balance Sheets so everybody elses Balance Sheet can shrink, expanding their own so everyone elses can go down. That is what you have to do if you want to avoid driving asset prices into a wild downside overshoot. His book discusses how this survival process has been made much harder by the post crisis legislation in the u. S. And the dodd frank act. He interestingly points out how this is different from other countries. For example he said the United States is unique in bailouts in the future. There will be bailouts in the future but they could be harder to do. We could greatly reject the changes that have been made if theyre not corrected before the next crisis and those changes will make things, the next time, a lot worse. How scott will present his book for about 25 minutes and then we will have comments from our outstanding panel. Our author, hal scott is a professor and director of a program on International Systems at the Harvard Law School where he has taught since 1975. He is also director of the markets regulation, a member of the britton Woods Committee and the past president of the international. [inaudible] his books include the Global Financial crisis and tonight he is presenting connectedness and contagion. He will discuss how to be better prepared for the next crisis. Welcome to the pope podium. [applause] thank you for the introduction and thank you for hosting this event. The thesis of my book is that the heart of the 2008 crisis, and most other crazies was Systemic Risk in the form of contagion. This crisis was successfully stems with weapons. Post crisis all of these weapons were eliminated primarily by dodd frank as undesirable bailouts. Dodd frank purports to solve the contagion problem with what i call to wings and a prayer. The wings are heightened capital and new liquidity requirements. You dont ever abolish the Fire Department even if you have. [inaudible] thats what the attitude has been. Have an anti bailout consensus that is very low so we are dangerously exposed to future crisis. Let me talk about the elements of sis democrat. The point of the Financial System is to prevent Systemic Risk of which there are three varieties that i call the three cs. Correlation, connectedness and contagion. Connectedness comes into flavors it can set off a Chain Reaction of failure. One failure can uncover the finding of more failures. If repose were to fail, that would create a problem. Contagion is where the actual ale your or of failure of the Financial Institution causes shortterm credit or investors to and withhold funding for Financial Institutions either out of a lack of information or a rational for some combination. The first part of the book looks at whether the problem in 2008 was contagion or connectedness. Contagion, in my view, was the primary driver of the 2008 financial crisis, basically asset, was not the primary driver, excuse me, of the financial crisis. Major banks saw some deposit runs but. [inaudible] they put contagion in overdrive is shortterm creditors headed for the exit internet thats feared for the institutions to which they extended credit might be the same fate. The failure triggered a major run on u. S. Money market funds starting with the reserve primary fund on september 16, 2008 going mainly to investor. [inaudible] the runs spread quickly across the industry, including institutions with no significant [inaudible] it also spread to commercial paper markets and money market shifted for government securities. Many banks discontinued lending completely. Thats what happened. Many people believed asset connectedness was a major problem during the crisis. The book examines the claim in detail. It was less than a penny on the dollar and no Financial Institution connected failed as a result of the failure of lehman. Moreover, no Financial Institution exposed if aig would have failed. This does not take account of the cds that they had on aig which further protected them from loss. Nonetheless, the scenario coming out of the crisis was that it was connectedness problem. Dodd frank reforms largely focused on this. Its largely built around connectedness. We will look at the terms of designation. A lot of connectedness. As a Central Clearing for all the derivatives, they argue we have to meet julys losses and we will have a Chain Reaction Chain Reaction of failure. It certainly bilateral exposure in dodd frank. While one can argue that these reforms are desirable as prevented measures, generally apart from the experience in 2008 connectedness was not a problem in 2008. Dodd frank also gives Something Else which was to legislate with wrist act ii contagion. As i said at the outset, 33 measures were deployed during the crisis to stop this on banks , limited ability of guarantees. [inaudible] the fed was created in 1913 to to stop financial panics. The latest of which was 1907. Interestingly, that panic in 1907 started in the nonbank sector at the Knickerbocker Trust company. During the 2008 crisis the fed discharges a last resort responsibility to a variety of names, lower penalty rate, discount window and wider access for primary dealers for the window and a term auction facility for major changes. A number of new facilities were created for nonbanks. I cant go into all of them here but they included the commercial Paper Funding Facility to purchase unsecured and a bcp paper from issuers and the money market investor funding facility to purchase assets for Money Market Funds to provide them with liquidity. The supply of this liquidity to the Financial Sector doubled to 2 trillion by 2009. In 2007, before these actions, 91 of the Balance Sheet was of the Balance Sheet was invested in u. S. Treasuries, by 2009 it was only 25 due to lending expansion. Supply and liquidity to the nonbank system was fairly important. More portly, the availability of these facilities help stop the run. The fed and taxpayer actually benefited. They make money on the assets and supports general revenue. In 2008. [inaudible] as i said a key part of the lending was to nonbanks but the contagion run was centered after the 2084 failure. I estimate there was about 7 trillion. The percent of this in nonbanks, Money Market Funds and broker deals. The ability to lend to nonbanks in a crisis is essential. I would expect this to increase as lending and Capital Market activities are driven out of the overregulated Banking System. The Legal Authority for this funding to nonbanks was the quite broad Section Three of the Federal Reserve act. It provided that in unusual circumstances the board could authorized loans to any individual or business. This authority is quite separate from the discount window authority under sections 10b and 132 of the Federal Reserve document to lend to depository institutions. This was crucial in stopping the contagious run, after the fact it was and continues to be widely attacked. Legitimate concerns are there but the beneficiary were largely victims that cant panics. Solid institutions would be set by these runs. This anti bailout concern triggered radical calls for changes for nonbanks but it did not transfer over to the feds count window. The result was that the dodd frank act laced constraints on the feds are teen three lending authorities. What are they. The fed can only lend to nonbanks with the approval of the secretary of treasury under procedures adopted in consultation with treasury. Interestingly this requirement for approval was first put forward by the treasury itself then added by the secretary. Perhaps this was just another chapter in the fed chapter 24 or maybe they thought it was a way to protect the fed from greater restrictions which were being considered in the congress. One can argue with the importance. It is really taking independent authority away from the fab. The law secretaries and treasury and the new anti bailout environment be willing cheerleaders . Treasury approval was now carrying a significant risk. If we think it is important for the fed to have independence to lend to banks, why not the nonbanks and everincreasing in factor. Second the amendment that they provide can no longer make one off loans to single beneficiaries that it did in 2008 to aig. It must now do so under abroad program. Institutions must be eligible for any fed program. This means eligible at the time the fed provides the first loan it may make it harder because youll have to wait till five institutions have the problem. If it means ever eligible for a loan then it is not much of a restriction but under that interpretation first loan could trigger calls of problems or illegality. A lentil value was assigned. This rained in the Feds Authority to buy unsecured commercial paper which it did for major. [inaudible] during the crisis. Fourth the fed can only loan to solvent institutions, a requirement not applied to banks, just nonbanks. The solvency requirement is a cardinal principle in the 19th century formulation of the window of laughable resort one reason for not requiring the central bank is the judging solvency is extremely difficult. An underlying argument for solvency requirement is that it should be a fiscal issue and that the congress would play a major role through preparation as it did indeed. I sort of agree with this point. If you have that point of view then lender of last resort needs to be coupled with Standing Authority so there is the possibility that the treasury can act when the fed cant. A fifth provision of dodd frank provides for disclosure. All loans to nonbanks must be reported within seven days to the chairman of the house and Senate Financial committee must be disclosed to the public within a year. On the banking side, one change on the window, all discount window loans must be publicly reported within two years. The concern of those Disclosure Requirements are much more stringent than those facing any other major bank. Within two years they discourage buyers concerned with stigma from seeking needed support. Thats the worst than the problem. You want them to get the support indeed in the crisis, they avoid the discount window out of the fear that their borrowing could be leaked or covered by illness. They can no longer pass on discount window loans to their affiliates without being subject to normal section 23 a limits on inter affiliate lending which would be precluding the pass off. This means substantial borrowing would have to occur under the new restrictions of 133. Indeed the multiplicity that are now imposed on section 133 but did not apply to discount window borrowing which is reserved for depository institutions, the new york fed president suggests last may that the congress amend its discount window authority to. [inaudible] this is dead on arrival because it would, in effect, represent a repeal a repeal of the dodd frank restrictions. They said they could live with these restrictions on november 15 last year they passed an act largely along party lines. The bill has not been enacted into law. Federal reserve can only lend two nonbanks if all regulators of the potential borrower which would include the sec or the cf pb would have to certify that the borrower was not insolvent. Chair yell and said the time that these provisions would end Federal Reserve lending to nonbanks. This has now been incorporated into the house financial reform. These attacks on the feds role of lender of last resort are not recent. My book were counts how opposition to court federal bank whether lending to commercial or Bank Borrowers goes back to the early controversies over the first and Second National bank. Andrew jackson vetoed the renewal of the Second National bank in 1832. It is this debate over federal Bank Institutions that took us so long to create the fed in 1913. The debate still goes on. All right, so the second part of the fight against contagion were guarantees. They used the authority to remove authority for transaction accounts. Increased insurance limits. Wow dodd frank increase the limits to two 250,000, they 50000, they couldnt raise limits in the future without joint resolution from congress. [inaudible] this power was also taken away by dodd frank. They did make money on these programs. In addition, in 2008, the treasury used this authority to guarantee the Money Market Funds this had a major effect on the funds. This was taken away by dodd frank, no by the earlier tarp legislation. Runs on Money Market Funds remain a problem in my view which has not been cured by the secs required floating Net Asset Value on prime institutional funds. They expect values to go lower. Sec rules give the authority to charge for redemptions in average conditions. The final tool we will use to combat contagion is tart. As of june 2016, there had been 200 alien of capital injection in the bank. The treasury made, not lost 16point to billion. The taxpayer did not pay portraits tarp expires by its own terms. Much unlike the eu which has Standing Authority for capital injections, the u. S. Needs such injections in the future, authority would have to be obtained and might have to be contained in limits for the crisis itself as it was in 2000. Now, on contagion fighting powers had been curtailed, the centers of dodd frank point to what i call to wings and a prayer. The wings being capital and liquidity and the prayer being the resolution procedures. The premise is that contagion is much less likely if you nine not worry about it before. We have greatly increased Capital Requirements, nope doubt about it. I put aside the difficult issue about methodology and Capital Requirements. [inaudible] lets not fool ourselves. There are major methodological problems in Capital Requirements when theyre not done by the market. Capital requirements can reduce Systemic Risk by decreasing the probability of bank failure from any form and they generally reduce. [inaudible] no realistic level of capital can prevent a run on banks. Fire sales and capital is quickly eroded. Even higher capital proposals like suggestions of 20 or 30 of leverage ratio, and Capital Requirements only apply to banks, not to the ever increasingly important nonbanks. The second way was liquidity. After the 2008 crisis, we adopted certain liquidity requirements, most notably the coverage ratio which has a 30 day horizon and requires banks to hold high quality liquid assets to cover funding runoffs. These requirements in effect scourge lending. Again, they do not a plate apply to nonbanks. As for Capital Requirements, there are significant issues around runoff exemptions and liquid assets. In my view, the new adoption of private liquidity requirements represent a retreat by the fed from providing public liquidity as a lender of last resort. The fed can now say it will only be a backup source of liquidity. The frontline is the banks liquidity itself. Ironically the private requirements may actually reduce collective private liquidity because it requires each bank to hold their own liquidity rather than making it available to others in a crisis. Whether it really comes to prevent that lending is open to question. Two minutes, i think ill make it. So the prayer is resolution. Dodd franks order Liquidation Authority gives the fdic new powers to resolve nonbank Financial Firms including Bank Holding Companies whose failure upon a two thirds vote of the directors and treasury are determined to pose serious adverse effects to the financials stability of the United States. Such a determination was not made then they would continue to be resolved in bankruptcy. Such procedures in my view are not likely to deter contagion. At the outset, without the requisite approvals this may pursuit engine new procedure may never been used. If it is used, the fdic is designed as a single point of entry will require change at the. [inaudible] shortterm funding at the operating subsidiary level for almost all shortterm funding exists mainly through banks and their corporate subsidiaries would be on content unaffected. Some hope this will stop contagion since the fdic resolution will not invade existing shortterm funders. Whether such restructuring will actually work, particularly for a major Multinational Bank is problematic. The procedure has never been tested. Thus this is a prayer. The reality is, the creditors at Financial Institutions will run if the large Financial Institution is put into any kind of resolution. Better safe than sorry and we need to be prepared for that. Resolution procedures are good but dont think you can get rid of contagion fighting just because you have that. It actually works the other way. Its easier to resolve in the institution. [inaudible] i wont comment because alex will be pushing me off his platform on other solutions to the problem like limiting shortterm funding but if we have time to discuss it in the q a ill discuss that. What are the conclusions . Contagion in the nonbank as well as the bank sector, not connectedness is the major systemic concern that dodd frank was focused on. Do you know how to stop contagion. These powers have been greatly weakened by legislation and do to the fear of bailouts and it wont easily be restored. Capital liquidity and resolution will not save proof the system of contagion. Even if homes are fireproof, you still need a Fire Department. Lets just hope we do not have another crisis before we can move beyond the fears of bailing out wall street and are able to rectify the situation. Thank you so much. [applause] we have coming up where we can speak for about eight minutes. I will introduce them all and in the order they will speak. After they do, we will give hal a chance to respond to him and then the panel to Exchange Ideas after which we will spend some time on your questions. We are going to adjourn promptly at 615 to a reception. Our first discussion will be al who is president of the Federal Reserve bank of richmond from 1993 until 2004. He served as an economist. As a Federal Reserve president , he served as a member of the open Market Committee and he is a member of the board of the Virginia Council on economic education, the Advisory Council in the school of business and the university of richmond and the executive committee of renaissance and numerous other boards. The next will be kyle who is the professor of finance at the school of business. His Research Includes market microstructure, highfrequency trading, and form speculative trading, market manipulation, price volatility, market volatility and contagion. He has been a staff member of the president ial tax force, a consultant to the Exchange Commission and the department of justice and a member of their Technology Advisory committee. Our third discussion will be paul is a resident scholar and focuses on the management and regulation of Financial Institutions. Financial markets, Systemic Risk and the impact of financial regulations on the economy. Previously paul was director of the center for Financial Research at the Insurance Corporation and chairman of the Research Task force and the Basel Committee on supervision and held positions at the freddie. , j. P. Morgan and the board of governors of the Federal Reserve. He has also organize this event. Thank you paul for getting us all here and al, we will start with you. Thank you very much. I hope i didnt scare anybody, he you probably want to make my sign over. I was trying to get there and when i did i couldnt open it. Its probably a sign of age. Its a liquidity problem. There you go. Only a couple minutes from now. Its good to be here, we are instructed pretty firmly in advance to try to hold our remarks to eight minutes which made me think, it reminded me of mark twain that if he had more time he wouldve written a shorter letter. In any case i will try to meet the requirement knowing that we are maybe going a little bit late here. I believe professor scotts book is a very good book and a very important book. As you all know well, a number of books have been written from various perspectives about the financial crisis in several i would argue i really essential to appreciating the scope, nature and significance of the event. I think of Ben Bernankes recent memoir, secretary paulsons book, they all help us understand what it was like for policymakers actually confronted the crisis on the frontline and i would answer that list with alan blinders book which i think is the one that is a bit like Musical Chairs. It seems when i read instruct me as a review of the causes of the crisis and how effectively it was dealt with as it played out. House book is a very valuable and useful addition to this literature. It provides an intense and penetrating analysis of the anatomy of the crisis. I almost want to say the section of the crisis which then is a Solid Foundation for evaluating the steps that have been taken, especially in the dodd frank law to prevent more realistically mitigate any recurrence. His clear delineation which has already reviewed and which is online by the books title, the connectedness from the contagion as the systemic driver of the crisis and his conclusion as he noticed, contagion was the primary driver and hence the appropriate focus to remediate. It argues that asset and liability connectedness does not play major roles in the core collapses of the Lehman Brothers and aig but rather the contagion which is simply todays augmented version of an oldfashioned wonderful life bank run. It turns these events into a broad and extremely dangerous crisis. Even this, they address crisis appropriately, if not always smoothly and prevented a much worse outcome. From this premise, prof. Professor scott seems to take the Central Point that many of the sometimes politically charged provisions of the dodd frank law are largely based on the mistaken belief that connectedness was a problem and that the provisions restrict the lender of last resort powers and the feds complementary powers risks severely weakening the government ability to contain a crisis if one arises. As weve already heard scott analyze each of these limitations, he does this in chapter nine which is the heart of the book. I cant review them all. How has done a pretty good job already. Let me give you an example of one hes already mentioned which i think gives you the flavor. During the crisis, the fed, as you mentioned was able to make it launch independently. Dodd frank, as he pointed out needs to be approved by the treasury secretary. This is understandable given the Political Climate in which the dodd frank law was written. Ben bernanke seems to conclude in a recent blog piece that the requirement isnt necessary. Maybe thats right, what if the treasury secretary, at the time of a future crisis is not wellinformed about managing financial crises. I suggest its not difficult to imagine such a scenario in todays world. A strong perception, requires absolute confidence among participants that the fed can and will act forcefully and to stop it would be essentially to doing so. In more common banking language, it would need to be complete and robust. If there were doubts and mortgage that the treasury secretary would go along or that he would delay unduly, markets would be at highrisk of running if you think thats gonna be a, but someone else take that hit. I would say that his insistence on the privacy of this reality with respect to the treasury secretary approval provision is the principal contribution. All of this said, the the concern about moral hazard and reducing the risk of tasks pair losses are obviously not frivolous. I think he does not deny that the enhanced capital standards, authority and other actions that have been taken to reduce the likelihood of another crisis in the nearterm and its severity, if its occurs may prove beneficial although i think youve already argued with some of the details for the book argues persuasively and this is the key point that none of these reforms, individually or collectively are sufficient to prevent a run or stop one once it starts. There is one other point i need to make almost on a personal note for me which is led by my colleagues. They have warned of the dangers of policies or actions that involve credit allocation. Its referred to as credit policy. I share this concern and i have to confess that ive generally thought about it in a macro Monetary Policy context rather than the context of lender of last resort role. His book challenges me by demonstrating convincingly that the crisis was largely an oldfashioned run. It was a new costume. It forces me to ask whether it would be feasible in dealing with a similar crisis to avoid some credit policy risk. I need to think about this because it certainly has me thinking and asking the fundamental questions here. I feel compelled to offer at least one, i found the reasoning in a few sections a little on the tense side. One section in chapter 21 discusses the possibility that the repo program might be used to or result in some way a crowding out of a significant portion of the economy shortterm credit liabilities and it goes on to consider, this is where i got a ticket trouble, how such Development Might conflict with the Monetary Policy objective. I got really confused and i will tell you i was on an amtrak train south of washington behind a Freight Train when i read that section so maybe that had something to do with it. I do think that section in one or two others could be simplified a little bit and clarified. I probably set enough by now to signal. With regard to this book. In closing, let me salute the very strength of the book to me actually highlights if the fed and fdic lead strong in discretionary powers to prevent these runs, how do we reconcile such powers with the legitimacy requirements of a democratic society. This is obviously a critical question in todays political environment with this highly populous elements, the dodd frank requirement and treasury secretary approval and a company requirement that they consult with the elected president in making such decisions is presumably a recognition of this issue although i would say a problematic one. Resolving this tension in our political economy, if thats possible at all is beyond the scope of this particular book although theres no question that he is well aware of the issue. I do believe some of the contributions of paul tucker regarding the legitimacy of centralbank independence, not only in the emergency lending arena but also the Monetary Policy arena, looking at them as a sort of regime, taking together some of his work and from what ive seen i think that is a good place to start thinking more about these issues. Thank you very much. Thank you. This is a really interesting book. He has three seeds, one of them is called connectedness. Sometimes they use the term fragility or networks and theres been a huge amount of research on Network Theory and the application of networks to finance. He comes along and tells us, a lot of this research is useful or not really relevant to explaining what happened in the financial crisis. Weve got the second one that is not in the title of the book, the title of the book is connectedness and contagion. The other is what he calls correlation. I like to think of correlation as capital and deleveraging. A big shock, in this case it was the declining real estate prices it turns out that the real estate assets that are affected, a lot of them are in the Banking System. It turns out that lending standards had been relaxed so the result was that when housing prices fell, many banks simultaneously or in a correlated manner suffered hits to their capital. Theres a lot of Macroeconomic Research that says when that happens the Financial Institutions are going to deleverage. The reason they have to deleverage is they were holding these mortgages with leverage. Their capital is leveraged 10 1 or 20 1, or whatever the racial ratio is that they were allowed to hold it. Then there is the third in the title which is contagion and contagion is what i call panic. What david calls panic and what a lot of others would call panic his book gives us a different view on the financial crisis and its relationship to the dodd frank act than the view i had before i read the book. Let me tell you the view before i read the book and then the way in which it changed my view. The way i used to summarize the dodd frank act is to think if there had been a big capital goal in a Financial System as a result of declining real estate prices in the problem that needed to be fixed was that banks needed more capital. This is where they got it and the more capital they got the more rapidly the Financial System would recover. I summary of the dodd frank act was that while the dodd frank acted encourage policies to make banks have more capital, mainly what it did was impose regulations on the Financial System. Authors of the dodd frank act had faced a tradeoff between mandating more capital and mandating more regulation and made chose to mandate regulation rather than capital. His book has changed my view on that. As he points out, if you have a capital problem or even if you dont have a capital problem, you can have a panic. People are going to tell you if you do have a capital problem and it keeps getting worse, before the Financial Institution collapse or declare bankruptcy from late lack of capital, people will try to pull their money out. When that happens you will have a panic in the panic is not only going to hit the bank that maybe was truly undercapitalized and on the verge of insolvency but that panic is going to hit other banks in the system regardless of if they are wellcapitalized or not. It will be indiscriminate and it will create a crisis. The crisis requires Immediate Response. The Immediate Response that is necessary to fight this contagion for this panic is lender of last resort or other facilities and they have to be provided by the fed. Hell scotts book comes in and says if you look at the dodd frank act, what youre going to find is not just imposing regulations on regulations for regulation sake but theres a misguided three theory behind it and that is that the feds lender of last resort Facility Needs to be curtailed and harder for the fed to provide the support to Financial Institutions that may well need to be recapitalized but in the meantime you have a panic going on and you need to address that panic with some strong, immediate action. He spells out the scenario in great detail and it changed the way i think about the financial crisis and it does make me worry whether our fed has the tools it will need to fight the next financial crisis, especially if what happens if it originates outside the Banking System that the fed itself is most capable of making lender of last resort loans two. Thats the big picture. Theres some very interesting chapters in the book that describe more details about what i just said. Let me mention a few of them. First of all, talking about connectedness, he paints a beautiful picture of Lehman Brothers. Lehman brothers itself is an incredible fragile institution. They are our huge important connections between the Holding Company and cross guarantees and so forth and the result of that is that the problems start within Lehman Brothers and there is a connectedness problem. These problems are going to spread throughout Lehman Brothers. Lehman brothers itself, as he paints a very detailed picture, Lehman Brothers collapsed in a very connected way. But he sang the connectedness was not so important for the financial crisis, if you look to see how the financial crisis spread from Lehman Brothers to the rest of the economy, it didnt spread through connections, it didnt spread because lehman was defaulting to another act, the economy blew up that way. Instead Lehman Brothers just kind of collapsed rather neatly through its own internal fragility but it didnt spread to the rest of the system. It spread to the rest of the system through panic. The assets declined in values and the investors and that Money Market Fund lost the money so what happened. The investors who invested in the other market fund panicked, pulled their money out of this fund even though those funds didnt invest in lehman assets at all. It paints a very interesting system of how fragile it was within itself and how that fragility was not what made things spread to the rest of the system. Indeed if you look at the collapse of bear stearns, they collapsed in a way that was similar to lehman and you didnt have the panic. At that time the panic waited until it could could occur later. Interesting thoughts about connectedness. Let me also talk about correlation or capital. I think the financial crisis of 2008 was largely a problem of capital. The book has some interesting chapters on how to deal with this and it also has chapters on resolution and orderly resolution and other ways of bailouts and tarp and how that happened. I will end my comments about contingent capitalist. The one area i slightly disagree , contingent capital doesnt need to be a longterm liability of the bank. It can be shortterm. The key feature of contingent capital is that it has to be replaced. If the bank has contingent capital and amateurs but the the bank cant replace it with new contingent capital, right then and there that capital is not being replaced and will get converted into equity. It doesnt have to be longterm. The second thing that i slightly disagree with is that he says that one trigger mechanism for contingent capital which is security that will convert to equity when the bank gets into trouble is one conversion proposal is to look at an index of bank stocks and and as they declined it gets converted. His book says that if that happens that could kind of amplify panic. I think thats not quite right because one interesting thing about contingency capital is that panic makes them not rollover their capital so that it converts. All of the sudden theres this massive flow of new equity that they have just gotten from the capital and i think that will stop panic, not make them worse. It is something we should think about and we should certainly think about the ability of the feds to exercise the powers that it needs to act as a lender of last resort. Thank you. [applause] in his new book kick connectedness and contagion he remind us that historically the most important function of a central tank is the provision of lender resort or llr for short was the reason that most Central Banks were originally created. Yet dodd frank comes along and sort of cuts off the Federal Reserves ability to effectively do last resort lending for much of the economy. I want to focus my room remarks on lender of last resort. In his book he does a superb job of distinguishing between connectedness and contagion. All large Financial Institutions are connected. Theres no surprise there. Contagion is a property whereby the well being of one firm can impact the wellbeing of many separate firms that are not necessarily connected to the firm in question. For example the reserve primary fund breaks the backend then only institutional money funds without exposure to either the primary fund or Lehman Brothers need the quiddity systems to meet redemptions. The classic example of contagion, a oneonone bank creates a general panic and depositors run unhealthy banks. The Federal Reserve use of these powers has been unfavorably portrayed as a taxpayer a bailout. As a consequence they face new limits on these powers. This is a complex issue. The emergency provision of liquidity probably will always have the appearance of a special privilege for a few select firms. In a sense it is. They protect them from suffering firesale losses and outright default. The justification for llr is that the run forces firms to undertake sales that affect other and while they may be shortterm creditors is not always other fundamentals. Spaced on the idea that everybody can be made better off if the government can prevent panic redemptions. The policies were discretionary so they could be used in the midst of a run you cant tell the difference between a firm that deserves liquidity support and one that doesnt. The judgment can always be open to criticism. Why let them fail and save aig the next week. This discretionary policy created a lot of problems. If you think about it, the need for llr is somewhat ironic given regulatory rhetoric. Financial regulators are quick to highlight the disciplining effects of Market Forces well a bank run is perhaps the most fundamental of all market discipline forces. Many scholarly papers are written to explain how banks fragile Business Model is a market innovation, not a mistake its before government safety nets that investors required banks to fund themselves using shortterm liabilities and mandible deposits precisely because of the fragility impose discipline on the banks investment decision. A banker with in in adequate liquidity would be a successful banker, at least not for very long. So while regulators a spout, they simultaneously argued they need lots of tools to prevent bank runs and fire sales. Hal stott rightly suggest that post chrysler crisis politics are stacked against lender of last resort powers. However, i think the political Sticking Point may be, not lender of last resort so much as the free and discretionary nature of the prior fed arrangements. The congress and the Federal Reserve should Work Together to develop a new approach that relies on a market where institutions pay the taxpayers to purchase liquidity insurance before its needed. He discusses such a proposal in his book but i want to go bit further. The Federal Reserve should be required to sell liquidity options. Liquidity options are options that once a firm owns can be presented and exercised as long as they have appropriate collateral and they would receive a loan from the fed. I believe the fed should sell two kinds of options, one that allows for the Term Exchange of collateral and one that allows collateral to be exchanged for reserved for a fixed term. Their securities lending option and a repo lending option. The instrument i believe should be sold at regular options and traded thereafter. They should have specified Exchange Terms that are less generous than those prevailing in the private security and repo markets. These options would reflect the shadow price of emergency liquidity. If Bank Liquidity coverage ratios and that Stable Funding ratios in these new rules, if they were amended to allow the quiddity options to satisfy this requirement, we could create a Natural Market for these options. Banks would buy them. This arrangement would improve the risk sharing in the economy over the current selfinsurance approach for liquidity insurance which hal mentions. If we did Something Like this with the market, the access would no longer be a special privilege but the exercise of liquidity insurance on previously agreedupon terms in terms that allow the right to exercise that option. This should be open to all Financial Institutions, not just depository. Nonbanks as well should have access. If a liquidity crisis were subsequently to develop, the terms terms of the liquidity insurance contract could be adjusted to allow the fed to provide all the emergency liquidity that they needed. They could lower the rate over the market rate, change the collateral terms, adapt the options of still sell them and meet the liquidity demands of the economy. This approach would remove the need for them to determine whether or not an institution is solvent. If they have the option in the collateral the fed would honor the contract. The taxpayer losses could be prevented a setting appropriate priority on any borrowing institution that subsequently entered bankruptcy. I think a marketbased solution to some of these problems would stem a lot of the issues and he brings this up and talks about a proposal in his book and i would like to see folks take that up in a little more detail because i think it solves many of the problems that we discussed in the book. I think the book discusses a very important issue and gives us a lot of food for thought about the right way forward. Llr, in particular, i find to be the most distressing problems created by dodd frank. Thank you very much. Thank you paul and thank you to all the commenters. We are going to give hal some time to respond in any way that he would like to those comments and well hes thinking, al mentioned Musical Chairs. When challenged, after the crisis to come up with metaphor, Musical Chairs is a natural one. Imagine a game of Musical Chairs that has 500, for a Financial System, there is a lot of actors that they have 500 people playing Musical Chairs but there are 700 chairs. The music that is playing is the charming mozart serenade. When it stops everybody easily finds a chair. We call the high liquidity. Suddenly the music shifts to a ruckus of obnoxious popular music and 400 chairs armor removed leaving 500 players and 300 chairs. I think thats a great picture of what happens in a panic. Hal scott, comments on the comments . You ended with a reference to paul tucker and the legitimacy of centralbank independence. To me, i remember discussing coauthoring a piece on contagion along the lines of development. Peter said to me i dont have any problem with that but its the rest of the powers, if youre critical of that, ill join you on the contagion. I guess what i would say is that i think the feds centralbank independence of the fed has been more undermined in my view by these other powers that theyre exercising, regulation and supervision may be then the last resort. Its a bigger question. On contingent capital i guess my Central Point is that i wouldnt think that having a good system of capital says to abolish the Fire Department. I dont think he would say that so my Central Point of resolution is, even if it works, we still need to worry about contagion. Now imagine Jamie Donovan calling up the secretary and sang heads up, were going to bankruptcy tomorrow, is the response of the secretary, no problem, we have resolution procedures . I dont think so. The first thing hes going to think about is the proverbial proverbial hitting the fan and panic on the Financial System. You need to be prepared for that. In terms of paul, as paul pointed out, i did hold hold out this idea going back to y2k was actually fisher who created this procedure in advance of y2k so it would be very clear to the market that people have liquidity. Its interesting because that idea blends in the face of 25 years ago when they talk about Systemic Risk. Ambiguity about whether the fed was going to learn land injury court and the chips and Payment System which was an earlier manifestation. I think your point fundamentally says just the opposite. We need to know in advance. The beauty of wonder of last resort, however its on engineered, if you know it exists, youre not going to have the problem. Thats when he says i do what it takes and nobody uses his facility. As long as the power is there, people arent going to run. Its when you have ambiguity and people are uncertain as to whats going to happen. I guess the other thing i would say about this proposal is, if you dont require people to have these options, the happens as you go into a situation where they dont have the option and lehman sales. What you can say is that everybody else has that option. I think you have to have a Critical Mass of acceptance of the options in the obtaining of these options in order to solve the problem. So the idea that you change the liquidity ratio rules to allow the use of options in replacing actual instruments means that the banks will have some and you have a secondary market so that if lehman didnt buy any they could buy them from the banks that dont need them and if you observe that price they have the right to step in, open the auction, sell more and you have the monitoring in the secondary market. You would expect them to purchase and stockpile these liquidity options and sell them to people who needed them and they charge for them. You know the price and you would see the demand for liquidity. I dont think the fed would be caught flatfooted like they were in the summer when the commercial paper market blew up. You would see what was going on. It wouldnt be able to deny that there was a liquidity problem. Then they could make adjustments. With that provocative thought, and we could have a lot of fun talking to each other, i do want to fit in one or two questions. I would say, of course they could lend money so they could buy options. Im kidding. We would have time for one or more questions. Please wait for the microphone to come to you. Im a lawyer in new york. I hate to say this about a Harvard Law School professor, but i think this is terrific. I went to Harvard Law School. Its excellent, ive had the same issues in the same concerns during this whole dodd frank development. Part of dodd frank is capital enhancement, trying to eliminate incentives, bad incentives and moral hazard, not very successfully there, but the key thing i think you focused on is tying the hands of the fed and the treasury. I think they really are very wrapped up, and this is made worse by the aig case where the fed has said they didnt have 133 authority in the case of lending to aig and taking back stock. That was considered not to be a security interest collateralized by the judge as totally wrong. Please come to a question if you have one. My friends at the fed also think that section 133 as amended does not tie their hands for a. I think its wishful thinking, i dont understand this and i think also the resolution of authority is totally useless when city goes down, they dont have time to resolve it. I also agree with you. I think thats the question to you hal scott. Why would they think that . I dont think they do think that. If i was at the fed, i would be saying what the fed is saying, we dont have a problem here. Do we want to undermine the confidence in our own institution . No. I can tell you from my private conversations, i think the fed is extremely concerned about this and the first fed official who raises his hand publicly and says we need to do something, oh, you want to bail out washington again. This is toxic. Its going to take time. Its going to take a lot of time. I think we have come to our adjournment time. Id like to give every member of the panel one more minute if you have a parting thoughts. Im very intrigued by pauls proposal. I think its worthy of some additional thought and investigation. One thing, in dealing with a crisis an issue that bernanke thinks is one of the most difficult is stigma, getting banks to borrow. This is based on. [inaudible] that would be one benefit of it and you get around that problem. Thats why they had the procedure to begin with. That way it would be builtin right up front. Just one thing about pauls, i think if the fed proposed that you want to give them advance protection . You want to give them a prize to bail them out. Within the political system today, i think that would be a problem. I agree, i think you sell people on the fact that they are paying for the right to have protection. They are paying the taxpayers for this and its not free any longer. I agree there are political