experts who we'll introduce you to in a minute. but before that, let me just set the stage here. as you all know, the financial crisis changed the banking system. the resolutions that happened in the crisis integrated commercial and investment banking like never before. these resolutions created today's too big to fail institutions. the crisis led to greatly expanded fed emergency liquidity support. the fed became the lender of first resort instead of the lender of last resort. t.a.r.p. temporarily nationalized the banking system, and the congress passed the dodd/frank act to extend post t.a.r.p. control over the system. it gave regulators extensive new powers and responsibilities over the financial system. deposit insurance limits increase by a factor of two-and-a-half, and the slow recovery triggered fed qe stimulus, which created massive bank reserves, which required new fed operating procedures. so this morning, we're going to discuss all these changes with a panel of experts. and instead of me introducing a panel of experts, i'm going introduce our moderator of the panel. alex j. pollack, distinguished fellow. he was previously a resident fellow at aei, and president and ceo of the federal home loan bank of commission from 1991 to 2004. alex is a recognized authority on financial policy issues, including financial cycles, government-sponsored enterprises, housing finance, banking, central banking, be uncertainty in risk, retirement finance, corporate governance and political responses to financial crisis. he's the author of "boom and bust," financial cycles in human prosperity, numerous articles, congressional testimonies and what is perhaps his most consulted work by those of us who know him well, known as pollack's laws of finance. so with no further ado, or with further ado, here is our moderator, alex pollack. >> thank you, paul, and ladies and gentlemen. let me join paul in welcoming you to our conference this morning on how is a decade of extreme monetary policy changed the banking system. you'll all remember the most famous line about the federal reserve from its long-serving and former chairman martin, which is that the fed is supposed to remove the punch bowl just as the party is really warming up. but what about a federal reserving which spikes the punk punch, or changing the beverage, consider the dominant personality in the federal reserve of his day, benjamin strong. who memoribly said in 1927 he was giving the stock market a little koou de whiskey. a pint of whiskey. seven decades later, ben bernanke, who gave the stock, bond and house markets a barrel of whiskey. the feds' long-term bond and mortgage-buying spree, plus zero or so nominal interest rates, plus negative real interest rates. as we all know, has set off asset price inflations of notab notable magnitudes in stocks, bonds and houses. and how about what it's done to the banking system. this amal gam of 5,787, as of june 30th, fdic-insured depository institutions, with total assets of $17 trillion, which are equal to about 90% of gdp. or we might argue that the banking system actually and properly understood, includes the fed itself, which is part of and indeed an integral part of the banking system. then we would add the feds' $4.5 trillion in assets to the size of the banking system, and we would get a greater banking system, we might call it, of $21.5 trillion or 112% of gdp. however we think about the banking system and the fed, how have years of extreme monetary and bond market manipulations by the fed changed the banking system, our outstanding panel of experts is about to tell us. and let me introduce them in the order in which they'll speak. first, will be chris whalen, an investment banker, author, chairman of global advisers, focusing on financial services, mortgage finance and technology. previously, chris was director of reserve at the crowley bond rating agency, and was with the federal reserve, bear stearns. among his books is "inflated: how money and debt built the american dream." and as we think about this topic today, we have plenty of money and debt to consider. second will be norbert michigano, meritage foundations, financial markets, and monetary policy, including reform of the dodd/frank act and of fannie mae and freddie mac. norbert, i wanted to say that since both dodd and frank were big proponents and supporters of fannie and freddie, these two issue areas go very well together. norbert also focuses on the best ways to address credit difficulties of large or too big to fail financial companies, as paul said. and on the issues concerning the role of the federal reserve, as we'll be discussing today. next will be nellie liang, senior fellow at the hutchins center on fiscal and monetary policy at the brookings institution. nellie is also a consultant of the international monetary fund. and is a member of the congressional budget office's panel of economic advisers. her research specialties include financial stability, credit markets and the intersection of monetary and financial policy. just on the topic of today, she was previously director of the office of financial stability policy and research at the federal reserve board. and finally, we'll have paul kupiac, resident scholar at aei, who brings insights into the study of banks and financial markets, issues of systemic risk and the impact of financial regulations on the u.s. economy. previously, he was director of the center for financial research at the federal deposit insurance corporation, chairman of the research task force of the basel committee, and held positions at the international monetary fund, jpmorgan, and the federal reserve and as you know, he's the organizer of this conference for which we all thank you, paul. each panelist is going to speak with opening remarks of 10 or 11 minutes, after which we'll give the panel a chance to exchange views or clarify points, and then we will open the floor to your questions and we will adjourn promptly at noon. chris, you have the floor. >> well, thank you, alex. and thanks very much to paul and aei for organizing today's session. we have had a lot of fun over the years considering various bubbles. and today i'm going to talk about the banking industry and how it's been affected by monetary policy, not just over the last decade or so, but really over many decades. and i think that's actually some of the most interesting things to talk about. first and foremost, just top level, the fed is part of a much larger effort by global central banks to essentially take both public and private securities out of the market. they buy them using reserves from banks or money made up out of thin air. but essentially, they're taking duration out of the market. if you think of it in technical terms, it's kind of like jurassic park. you have these big dinosaurs all looking for earning assets to put on their balance sheets, and there's less and less available. and this is a deliberate act of social engineering that says that if we can't get you to borrow and engage in economic activity merely by lowering the suggested price for benchmark interest rates, then we will forcibly change the pricing of risk. and thereby get investors and intermediaries to boost employment and consumption. it's it's a keynesian perspective, and one discredited by the published research which is so interesting. i think the obvious observation has said debtors are the beneficiaries of quantitative easing, particularly public sector debtors. so very quickly, this chart shows us issuance. and you'll notice a big green bar. that was mortgage securitizations during the 2000s. we were doing trillions of dollars some quarters. countrywide was the leading issuer. and we were literally turning over bank balance sheets several times a year with mortgage securitization activities. and it has declined almost by half now. it has been replaced by the u.s. treasury, whose issuance has gone up dramatically and also by corporations, who use the issuance and the low rate environment, provided by the central banks, to buy back their shares. this is not very productive activity. this is practiced by our friends in japan many decades ago. exactly the same. so when people say we're not japan, yes we are. and i think it's very evident from the record bond issuance we have seen in the u.s. bond market over the past five years. spreads, this is the chart from our friends at the st. louis fed. you can see the big, big surge in high yield spreads during the crisis. the real object of monetary policy, and i think chairman bernanke understands this, was to get spreads down. because spreads, particularly high-yield spreads, are what tells you if the economy is working or not. today, they're quite low. very tight. in fact, so tight that i would argue that many banks, larger banks, have a hard time making money. when you think that citibank has a 1.6% gross spread on their commercial and industrial loan book, and that the average cost of funds for that bank is 72 basis points, that's not a great business. you know, you would assume that those are reasonably decent credits in that portfolio. but still, they're not getting paid enough. the average for most fdic-insured banks is close to 4%. and the big banks are twice citi. and even then, still not making a lot of money. so, you know, we -- i think know in general terms what's been going on for the last few years. but the key thing i think we have to accept is that over the past 30 to 40 years, going back to chairman volcker, the use of lower and lower interest rates to goose economic growth has had a cost. and the cost, you can see, in the return on earning assets for banks. which used to be well over 1%. and has since declined down to around 72 basis points. even though the system is getting bigger, they're making less money on every dollar of assets. and that's why, especially for the larger banks that tend to have relatively low spreads dependence on nonbanking activities, security derivatives, et cetera, they're almost pressured to get into exotic activities, because they don't make money on core businesses, especially the retail side of the bank. and this is, again -- this is partly democrgraphics, partly monetary policy, but it does have an impact on bank behavior. this is derivatives. you can see jpmorgan, the top red line. but now the blue line, citigroup, is once again the largest derivatives house on wall street. and when you look at their business mix, when you look at the fact they have sold their mortgage business, they have sold asset management, there isn't a lot left to the bank. so in this environment, again, where it's difficult to generate returns and get large assets to feed these very large balance sheets, they tend to go back into synthetics. and citi just announced they're going back into collateralized debt obligations. notice the yellow line at the bottom. that's the average for all large banks in the united states. most of them don't play in derivatives. it's a highly concentrated market. the top six banks or so. in fact, you could argue that citi and jp probably face each other on more than half of their trades. so it's a snake eating its tail in many respects. now, just quickly, think about the schizophrenia of the fed on the one hand trying to boost activity through a variety of means, and the prudential regulators on the other hand through dodd/frank telling banks to take less risk. and in particular, the guidance that's come from regulators over the past seven, you know, ten years, really, has been avoid default, and i want to see lower loan to value ratios on commercial loans, construction loans, this sort of thing. what that means is that there's less leverage in the economy. if i as a home builder have to put up 50% equity on all of my projects instead of 30%, or less, which i could have done before the crisis, i'm going to build fewer homes. and that change in the structure of leverage throughout the u.s. economy gives you less growth. it's basic fisher 101. but, you know, they don't really think about this. there's nobody who gets everyone into a room and says what do we want. because i think, you know, there were so many aspects of policy that were not connected and were not thought out. unfortunately, one of them is, we have less leverage on the book today. and i think that's why it's so difficult to get growth to where people think we ought to be. now, this, again, is another part of the story. how did the fed keep the banking system alive? well, two ways. they drove the cost of fund down to almost nothing. at one point, it went down to single digits. you know, if you look at the top of that red line -- >> basis points. >> well, in basis points. but -- no, no. it was in actual billions of dollars, too. the cost of funds for u.s. banks around the time of the crisis was around $100 billion a quarter. and it went down to less than 10. and that is money that's transferred directly from depositors to the banks. and the same thing in the marketplace. the cost of funds dropped so debtors had the advantage of that, and earning assets for a while were a lot higher, which boosted the returns for the banks. but to see, you know, how it's just barely $20 billion, this past quarter. so that gives you some measure, just how much transfer there is. it's around $400 billion a year. it's a lot of money. now, the thing that really keeps me up at night is i see signs of skewing that we saw during the 2000s. but it's even more pronounced this time. and this has to do with both residential mortgages, commercial real estate and also some other asset classes. first and foremost, this is all bank loans. you can see loss given default, which is chargeoffs, less recoveries, you is actually pretty low. 75% for the entire 6, $7, trillion in loans on the u.s. bank industries books. you can see there's been periods when it was also very low. but those -- if you look at it, that was the roaring 2000s, and back in the early '90s, none of which were particularly good periods. but, again, when you watch this, it gives a sense of what's going on in the underlying loan markets. now, this is one of the four family mortgages. one of four family mortgages are at the lowest net loss rate we have ever observed. and i think this is two things. this is home prices have been going up double digits in many markets for years. far higher than the reported inflation rate. but the board of governors refuses to beilook at it in parf their deliberations. the other thing, again, less leverage on the book. current production mortgages are lower than they were before the crisis. so i think that may be a factor, as well. i haven't been able to isolate it. but i suspect there's more than just, you know, top home prices involved here. this is i think an even more striking -- this is construction and development. construction and development loans are almost not on the menu for banks today. the regulators have told them not to do it. after the crisis, the portfolio got cut in half from $600 billion to literally $300 billion. a lot of those loans were charged off or paid off or whatever. but the banks were discouraged from going back there, and they have been told to have much higher amounts of capital from the client than they would have required previously. however, look at the numbers. they have been skewing for quarters, which means that when a loan defaults, they're making the entire loan balance back, plus. they're actually making money on default. and, again, that tells you that there's a buyer standing there to purchase that property when the developer runs out of money. there's no cost to credit. and, again, this is a red flag. we haven't seen this since the 2000s. but look how much more pronounced it is than at any other period going back to 1990. now, what's interesting is the commercial industrial loans, which is a big chunk of the bank balance sheet. it's $2.6 trillion. are actually edging up. i can't tell you why. but i think, given the run on really exuberant credit that we have seen over the past five years, with, you know, double b and single b credits out issuing debt as though they were single as, you know, maybe we have literally run out of customers in this case, and we're starting to see some of the default risk that is buried under the comfortable blanket of low interest rates. you know, if you're not charging people anything for loan, it's very easy for them to carry it. but if they have to start actually paying the loan, and they have, you know, inferior resources, then they're going to show up as a default. and then finally, the trend -- you know, people keep talking about rates going up, and they do flutter up. but i think the dominant trend, even with the feds stopping their purchases and changing some of their behaviors is going to remain down, because the other central banks are not going to stop. in fact, the purchases by the ecb and the total net of assets owned by global central banks, even if the fed were to start selling. just as an aside, i spent a lot of time in the mortgage business, we're down 30% year over year because of the movement of the treasury after the election. most of the refund market just went away, and it was long in the tooth anyway, but the pricing change killed it. the fed could be selling $50 billion a month easily in mortgage-backed securities without affecting the market at all. in fact, i think they could do double that, but unfortunately the folks at the board, for whatever reason, have taken this extremely cautious approach. my view, personally, is they should have been kind of coming out the way they went in. you adjust the portfolio first, and if the market tells you the prices go up, fine, but i think current policy today is distorting the markets, even as they try to normalize things, because they don't understand the impact that they've had on mortgage-backed securities, on options, and on other aspects of the market that are very important. thank you, alex. >> thank you, chris. norbert? >> thank you. here we go. thank you, paul, for inviting me today. so, i had this interesting conversation with a colleague the other day, and it's the third or fourth time that i've had one in the last few years or last four years, and it essentially went something like this, well, i don't understand what the big deal is with the fed and interest on excess reserves. they are paying a quarter point. what's the problem, that can't do anything. banks can earn a lot more than that. they are not going to divert resources. this is just silly, i don't get any of this. and i said, well, i don't agree with that, david, and there's plenty of reasons why. and, his name's david. and, rather than get into the difference between the marginal costs, excuse me, the marginal costs of the loan and the average, i said they are not paying a quarter point. they haven't been paying a quarter point in almost two years. actually paying one and a quarter point. that's an overnight rate, okay, so that's an overnight rate for banks to part cash at the fed. and if you look, it's not only above what many other rates, overnight rates are, it's above what many other we'd call safe assets are, what those rates are, and you can look at one-month treasuries, three-month treasuries, you can go out to a year to get close. you can look at one-month cd rate. you can play around with this, too. i'm not just trying to hide the early portion of the crisis. if you look at other cd rates, and i can't get a continuous series off of fred, but basically what you see is for the entire period that the fed's been charging or i'm sorry paying interest on excess reserves, it's been doing so at an above market rate. with the very narrow exception when a policy was first implemented, it's been paying in above market rate on an overnight rate relative to term, longer term safe assets. so, the idea that it wouldn't make any difference is a little fishy if you just think about it in terms of what they are paying relative to what else you could get in the market. and i'll kind of hit on that as i go through here. of course, the fed's been doing a lot of things. they've been doing two of the bigger things, i think, are the repo program and then the interest on excess reserves. all of that is in the face of, of course, the qe programs that chris eluded to. just to give some idea of the scale, and alex talked a little bit about this, if you look pre-crisis, fairly well back historically, you're talking about the fed's balance sheet being in the neighborhood of about 10% of the commercial banking sector ballpark. that spiked up, and it spiked up again later on in 2014 with the other qes, and it has come down a little, but it has not come down very much. it is still over 25%. was up around 30%. in other words, the fed has held assets roughly equal to one-third of the entire commercial banking sector. that's not having a minimal footprint in the market. that's having a major footprint in the market, and, of course, most of that is with the treasuries, longer term treasuries, and mortgage-backed securities. and if we check to see, you know, sort of where this shows up in the banking sector, you can look at the monetary base and the monetary base was on a slightly upward trend, of course, going back to the '80s, but you have a very large spike during the initiation of these programs, and you have both the quantitative easing programs and the emergency lending programs. most of those are temporary, most of those are gone, but some of the spike in between the crisis and now is due to the emergency lending programs, as well. if you look closely at the balance sheet, you'll see that most of this is, of course, or maybe you don't know -- maybe of course isn't the right term, but most of this is in excess reserves now, and with this sort of monetary base, typically, you would see much larger creation of broader money by private banks. and we don't see that. so that's a big difference now. and this is not the case -- it's not the case that the banking sector has been shrinking. if we look at the deposits that are flowing into the banking sector, we know that that's up, and it might be a little hard to tell from back there, but if you look at the decade prior to the crisis, the trend was about double. in other words, deposits in the banking system just about doubled, and then from the crisis to then, it just about doubled. so something in the transmission mechanism, the monetary transmission mechanism, is definitely not the same. and this is -- you can break this down by small banks, large banks, foreign banks, domestic banks. pretty much get the same trend. but when you look at the money multiplier, and i'm not saying that this is a policy lever. i look at this as just what it is, it's a quotient. if you look at this as sort of how much broader money has been created relative to what that base is, again, you see a long-term downward trend, but you see a cliff. and you see a cliff here in 2008 that probably in history has only been matched by something you saw around the great depression. it took about 30 or 40 years to get back on trend then, and it seems it's starting to come up a little bit now, but it's, obviously, nowhere near where it was. so, what that means in layman's terms is that banks are doing something else with their funds. there's a lot of funds in the banking system that banks aren't doing what they normally do as banks. that has changed. and you can see that if you look at other measures, as well. prior to the crisis, the fed funds market, you can split it out, or you can combine it with repos or you can split repos out. i just went with one slide, put them all in there. that's off the cliff. they are not doing fed funds lending anymore. that's a completely different market now. they are not doing repos with other banks. that's completely off the table now. what are they doing? well -- oh, and you could do this with large and small banks, domestic and foreign, it's pretty much the same trend line. so, what are they doing? cash on the right axis and loans -- loan share on your left axis. so if you look at the bank balance sheets and you look at sort of the shares of where their assets are, cash is now huge relative to what it used to be. it was on a downward trend, down below around 3% of the balance sheet through percentage total assets, and it spiked up to almost 20%. it has come down a little, but it's still, obviously, well elevated compared to where it was pre-crisis. and you can see in towards the right side of this graph, as the loan share drops, that's when the cash share is rising. again, that is what's going on. they are investing more, if you will, in cash. you can do the same thing with treasury and agency. if you wanted to do a safe asset measure, where you lumped cash and treasuries all in there, you kind of get the same effect. it doesn't really show up on the graph as well, but it's kind of there. then if you just go ahead and look at cash and line it up with excess reserves, it's almost perfect. it's almost one for one. the fed funds market, probably should have stuck this one back a little further, but as i said, lending into the fed funds market is dead compared to what it used to be. over $200 billion, it's now around $50 or $60 billion per quarter, and it has not come back at all. if we look at this and try to summarize this really quickly, think about the pre-crisis system. everybody would talk about the fed funds market. what was that? that was banks lending and borrowing to cover their reserve needs. they don't need to do that. that's totally gone, completely gone. the only thing happening now is gses are lending into the fed funds market, banks are taking and borrowing that and putting it at the fed and earning the ioer, interest on excess reserves. that's all that's happening in the fed funds market, so the transmission mechanism, which depended on those reserve balances and keeping those reserves relatively scarce has fundamentally changed. banks are not doing that at all anymore. and they are investing a large portion in the cash, a larger share of their balance sheets in cash than they used to. that's a very different sort of monetary control aspect for the fed. the fed, as regulator of liquidity and the economy has been doing that by simply putting piles of cash there. >> thank you, norbert. i only want to say that the reason the transition mechanism doesn't work like a mechanism is because it isn't a mechanism. it's an interaction of financial entities driven by financial minds and strategies, and we keep fooling ourselves by thinking the fed operates a mechanism or machines, and none of these things are machines, they are markets, which are a different form of reality. so much for my footnote on a very interesting presentation. nelly, and welcome to aei. >> and i don't disagree, alex. >> well, thank you very much for having me here today. i think i will offer a slightly different perspective. so, hopefully it will make the conversation interesting. so, i'm going to talk today about monetary policy, banks, and financial stability. and i'm going to take this broader financial stability perspective, since the reason we care, the primary reasons we care about banks, is because we expect them to provide credit to support the economy, and we want to prevent systemic fallout if any bank were to fail. banks, per se, just thinking through, we don't -- they are behaving differently now. the pre-crisis period is not the right benchmark, which we expect them to behave, so just to put that into perspective. so i want to make two points. extraordinary monetary policies, in my view, have improved financial stability, not undermined it, by supporting growth. and, two, i think today banks are strong, and they are viable. and more broadly, financial stability risks are not high. there are risks that are increasing, given the high asset evaluations, and the imminent start of the exit from unconventional policies. so, to make my points today, i'm going to just start with one slide here on a framework for financial stability. so, i'm going to start by defining what we mean. so, a common operational definition is a financial system is stable if it doesn't amplify adverse shocks and create negative spillovers, which then can significantly increase downside risks to economic growth. that is we think of a stable financial system as one that's resilient, that can continue to perform its functions, even when it's been hit by reasonably large negative shocks. what this definition does is it highlights the financial stability risks reflect the interaction of two different factors. one is shocks and the other is vulnerabilities. and, you know, trivially, bigger shocks and bigger vulnerabilities mean bigger financial stability risks. so, in terms of what shocks are, they are sort of the things that are always possible that you can't really predict or control. so think of oil price shocks, eruptions in geopolitical tensions, great debt crisis and the like. as they are hit, as they hit the economy, they are transmitted through financial conditions and then to economic growth, but the affects of these shocks can be much sharper, they can be larger, they can be prolonged if there are serious vulnerabilities in the financial system, so these vulnerabilities can be high bank leverage, low liquidity, for example, when they couldn't even repo treasurys to fund itself because of leverage, that revealed the fragilities of the vulnerabilities. so what you can see from this framework is the financial stability is the opposite thing as low market volatility and this research is consistent with that which finds a volatility paradox. periods of low volatility can, through risk taking lead to higher volatility in the future and that's the kind of framework you work and try to avoid. so let me turn then to the current assessment and that's what sets the stage. i currently view financial stability risk not to be high, despite the extraordinary monetary policy measures including quantitative easing. financial vulnerabilities in the core of the financial system are low to moderate and this is consistent with what the fed has said in its monetary policy reports and previous fomc meeting minutes. we know financial leverage is low. we know capital is high, and non-performing loans as chris has shown have declined substantially as banks dealt fairly quickly with legacy assets and the economy that's been growing and second, banks have ample liquid assets. so we don't have a lot of risks from run risk or short-term risks in the market. so this particular chart shows for u.s. banks, all banks, commercial banks that even with the higher capital liquidity requirement, banks return on assets and this is all assets and not eligible assets have been steady about 1% per year in the recent years. this is lower than the pre-crisis period, but if you go back, it's not unusually low and to the right and the interest margins have been falling and they are quite low, but they are three percentage points. note that the decline has been falling for quite a while, and not just during the period of extraordinary monetary policy. so this reflects partly that yield curves have gotten much less steeper as inflation has fallen and inflation risk premiums have come down. so this gives a sense of the sustainability of the u.s. banking sector. on the credit side which i don't show a chart, banks have also been extending loans and loans have been growing about 7% a year. this is despite mortgages that have been extremely weak. so if we look more broadly at credit. so this is all credit to households and businesses. so it would come from banks, markets, et cetera, you can see the credit and then i scale by gdp which is just a scaling metric. think of it as income. the credit to gdp ratio for households and that's this blue line that peaked in 2008 and 9 during the recession. that line had been falling for quite a while and it's now flattened out and then the orange line is for the business sector and that's credit to gdp that's been rising for the past few years. the right chart transforms this into growth rate and this is the three-year rolling average growth rate and the orange line again. business credit has been growing pretty quickly, and we know that some parts of the business sector have increased their debt ratio significantly and these kinds of higher debt burdens suggest there are vulnerabilities that could rise in the system. so it's attracted a lot f attention in the recent months is the fed's assessment and market participants' assessments that asset valuation measures have increased and many are elevated by historical standards. and many observers including notable academics and policymakers and i would note manu rajan in particular could lead to financial excesses that may not translate to spending growth. in particular, could generate reach for yield behavior by investors who have nominal, minimal nominal return targets that could lead to buying assets just to meet the targets and pushing assets to unsustainable levels. so there are two measures that i have here. first on the left are corporate bond spreads, and i think chris showed these earlier. corporate bond spreads are narrow. the red line is the one for junk bonds, speculative grade bonds and they're below four percentage points now and this is the ten-year which are near historic lows. generally, when they get this low, investors' compensation for risk is viewed as inadequate. to the right, treasury yields are low. so the top red line is a ten-year treasury yield and the green line is an estimated premium. so that is currently below zero. these kinds of measures and long-term premiums and low-risk spreads suggests that there is potential to fixed income investors to be -- that losses will be larger than expected because the response to any price shock will definitely be larger. putting all of this together, i see the u.s. financial system is much stronger, credit is growing, but there are asset valuations that are high. so in response to the initial question of whether extraordinary monetary policy actions of the past decade have harmed banks in financial stability, i would say no. my view, monetary policy has reduced risk to financial stability by strengthening banks and borrowers. it has lowered interest payments and increased collateral values which has effectively reduced debt burdens and improved bank balance sheets. of course, this was done in combination with new regulations and financial regulations and with changes that firms willingly took on their own to change the risk management practices, but combined, monetary policy and financial stability in my view have achieved what is a positive feedback loop which is strong banks and a strong economy. that said, i do think there are some risks that could increase financial stability and risk in the future quarters. certainly qe was done with the intent of reducing premiums and raising the price of risky assets, but access to the policies definitely carries some risks and the risk that any overshoot is larger than expected is higher. while the fed is doing what it can by being transparent announcing on a regular schedule, shocks by definition are expected. high asset prices can lead to increased leverage and may have already. leverage or maturity or liquidity mismatch is not easy to see or observe. so it could be that vulnerabilities are higher than we actually think they are. and finally, increased pressures to significantly scale back financial regulations, i think, could jeopardize recently into the financial sector, but to summarize, i believe that extraordinary monetary policies have improved, banks and financial stability not undermined it. thank you. >> thank you. >> paul? >> thanks, alex. >> so how has a decade of extreme monetary policy changed the banking system? quite a lot, i think, actually. 2008 financial crisis created too big to fail financial institutions. they've been known at systematic important financial institutions or cifis. congress passed the dodd-frank act which gave regulators new powers and responsibilities and they had regulators have exercised these powers in the form of new capital, liquidity and compensation, macro prudential regulations with the goal of reducing systemic risk. now under the dodd-frank act and the regulations that have been imposed under it, the largest cifis, the largest financial institutions have shrunk. some have shrunk in nominal terms and some in real. this particularly colorful 3d picture, and i went back to the holding company data and the last date online which is the first front row of blue columns and there's 2012 quarter four. in 2012 quarter four, i took the four largest bank holding companies and those are the names below. i tracked where they were size wise until the last data point which was 2017 quarter 2. since 2017 quarter two is the green columns in the very back. the column right in front of that, the dark blue would be 2016 quarter two. so those are annual snapshots. the largest institutions haven't grown very much at all. if we go in terms of growth -- by the way, aig is missing from this batch because aig didn't actually file any holding company reports until 2013. you can also see that ge capital disappeared before the end as did aig. one thing to keep in mind is, the cifis that didn't have major deposits are the ones that either restructured to get out of cifi designation and the regulations or litigated in the case of metlife. if you didn't have a lot of deposits you tended really to be unhappy as a cifi. these are the compound annual growth rates. now, in the top box here, i have the growth rates and the macro economy. the first one is sort of the compound and annual growth rate over the period of nonfinancial, noncorporate liability and the second line is household credit. these are nominal numbers. if you look at the cifi which are either negative goldman sachs, melon, hsbc. they actually shrunk in nominal terms. so the regulations imposed since dodd frank have kept the largest of the institutions from growing whereas the regionals, capital 1, pnc they grew on pace with the economy and u.s. bancorp, the large regionals seemed to grow about the same rate as credit in the economy, but dodd frank kept the biggest shops from growing. now is this a good thing or bad thing? i think it depends on who you ask. i think if you asked senator warren or senator sanders, i think it was a pretty good outcome, and he was willing to talk to you, he would say not so much. not a very good outcome. did the largest cifis constrain economic growth or was it the reverse? did the constrained economic growth constrain the cifis growth? to the best of my knowledge, no matter how hard you try to beat the data, i don't think econometrics can identify which of the views is correct. i don't think the data analysis can clearly identify which side is right. if we go to the banking system, equity is up and those are the headlines they tout and the biggest is the use of deposit funding. what i have here is my creation, my living, breathing, banking system and if you click it again so it continues to run what i do every quarter is i take a histogram of the deposit to asset ratios over a billion dollars. wish we could get that to move again. i spent a lot of time trying to get that to move and my technical guys are supposed to have that move. somebody click on that and get it to move. i smooth it with the currency estimate and you watch the banking system change through time, and you probably missed it earlier and if they clicked on it again, that whole thing that looks like an inch worm will crawl to the right. it will crawl to the right. click it. it crawls to the right in a very noticeable way and there's a couple of factors that make it crawl to the right and i think it's pretty cool. if it were closer to halloween that would be my frankenstein. so what happened? why did banks increase their funding? well, in 2008 the feds started paying interest on bank reserves while at the same time hit a drove customer deposit rates pretty close to zero. in 2012 there was a new deposit insurance assessment scheme introduced and the change was mandated by the dodd-frank act and banks now are charged premiums based on total assets less their equity instead of on their domestic bank balances and deposit balances and this allowed banks to expant their use of deposits without paying deposit insurance premiums. so if you look at small banks and these are smaller banks. they already used a lot of deposits in their capital structure. the bottom chart, the left column are banks less than -- i can't even read it from here. they're 500 million to $1 billion and you can see they increased their deposit funding and that's the upper row, a little bit, but not a lot. and the bottom is what happened to their equity position and it went up a smidgen and the scales are not the same and the equity went up just a tiny, tiny bit. if you go to the bigger banks, the changes are quite dramatic the blue line is december 2007 and the red is 2016, and you can see what you saw before. the largest banks are the panel column all of the way over in the far right and they're banks by different sizes and you can see the larger banks really started using a whole lot of deposit funding and the deposit funding was replacing wholesale liabilities and things that run when banks get into trouble. so they replaced their wholesale uninsured deposits, and what you can find in a bank fixed regression with hundreds of thousands of observations and is just what we said. the smallest bank increased their use of deposits about 3.9 percentage points, deposit to asset ratio went up, 10 to 50 billion went up by about 12.25 and the largest ones went up 7.6 percentage points or thereabouts. so the banks took on a lot more. now, okay, let me go to the next slide. why does this matter? uninsured wholesale bank funding is the canary in the coal mine. wholesale money runs when banks get into trouble, when they smell a sign of trouble wholesale money runs and deposits not so much and they run nowhere near like wholesale money. it was the wholesale funding run in the last crisis that started the fed and regulators that alerted them that they had a problem. they didn't realize subprime mortgagees or any of the other stuff were a big deal until the wholesale money started to run. monitoring by wholesale investors brings banking problems to the fore much sooner than those who monitor. if you identify something more quickly and address it more quickly, chances are you'll have less losses. the longer you let losses fester before they're identified and something is done about them the bigger they tend to become. so when they're hidden the problems get hit bigger before they get addressed. so was the regulatory solution to take the canary out of the coal mines? was this intended? when i talked to folks in the mutual fund industry they said yeah, it was. the feds wanted the banks to keep cpa and they wanted the mutual funds to buy from cp and they really wanted to get out of wholesale funding because it caused them so much difficulty last time. in their testimony's chair, yellin calls the systems safer because banks have increased their use of core deposits. core deposits are another name for government-insured deposits and i.e. taxpayer-backed funds. so what we have here is with this new balance sheet mix and the taxpayer is really on the hook for banks, more than it's ever been, right? the deposit to asset ratio is closer to 10%, and they're up 1.8 percentage points for two, and on balance, deposits are a way bigger percentage. if the banks get into trouble and the taxpayers have to stand behind the banks we're not better protected than we were. we were in a worse position. wholesale lyle abilities are not there to take losses if a bank should be fail. so when we talk about this, it's not just the taxpayers on the hook. the taxpayer is actually paying the bill. here's the ironic math. if you think the fed ior payments, they cover all of this and even more. so at 1.25% given the reserves in the banking system right now, the fed is paying banks roughly $30 billion annually. it's 29-point-something billion. now the interest rate that banks pay on their deposits, according to the fdic national survey which comes out once every week, it's 4% on checking accounts and 6% on savings and that's about $7 billion annually. okay? so there's 7 billion. deposit insurance premiums and that's about 17 billion. so banks have 13 billion left over to cover regulatory costs. regulatory costs to dodd frank. what does dodd frank actually cost to implement? nobody really knows those numbers. bloomberg did a piece on it earlier in the year and they estimates of the total cost of implementation over the next few years and they ranked between 2.9 billion and 36 billion was the upper one. that was the total cost of implementing all of dodd frank over many, many years. once the implementation is put in place the cost of complying with dodd-frank is a fraction of that. i don't know. call it 5 billion. call it what you want. i don't know being maybe chris has an idea. here we have ior payments compensating for what you have on our deposits? the deposit insurance premiums that banks have to pay the fdic every year and probably all of the regulatory calls to dodd-frank. so through fed ior payments, taxpayers literally are paying for all these things. we really are, and this is back to who left the cifis? it was the institutions that had no deposits. aig. they just got out last week. ge capital restructured so they could get out. they didn't have much of a deposit base. metlife has very little deposit base. small snl. so the institutions that have no deposits and got no payments by the fed are the ones that found this system that we put in place since the crisis so onerous that they had to get out of the financial business altogether to get out of the cifi designation. so i think the banking system is a lot different than it was. the deposits are now a source of revenue. they're not a cost to the bank. the deposits make the money. so when they look at return on assets, somehow deposits look like an asset now, i guess, but i'll stop there. >> thank you, paul. >> i think it's a tremendously important point to remember that, quote, stable deposits mean government guaranteed deposits mean taxpayer risk and it's a great link. i want to give the panel a chance before we get to your questions to either react to something somebody else said or provide alternate views are or just expand on the points that you want to emphasize. two or three minutes each and we'll go down the panel in the same order. chris? >> thank you, alex. what i can get from listening to the presentations this morning is the solution that comes from washington every time there is a market problem is to reduce the market and going back to 1998 when the sec changed the rules for non-banks to sell to pass-through security to money market fund. the objective there was to prevent systemic risk and the only problem is that that created a monopoly on short-term funding in the united states for banks, and this was done deliberately. the sec staff who didn't like to be inconvenienced decided to hand the tar baby to the federal reserve board thinking that the world would be better. and, in fact, no, nonbanks need to have a way of raising money separate from the commercial banking system, otherwise you get 2008 which is when citi basically took their monopoly and ran the bank into the ground. and with michelle, too. the interest on excess reserve, yes, they shouldn't have raised the price. they don't understand what they're doing in this regard. they should have unwound the physical intervention in the market first, but this just shows you how regulation and how ruled by experts as alex has taught me over the years inevitably goes wrong because they don't know what they're doing, and so when replace the market mechanism with the -- i'm sorry i shouldn't use the word mechanism -- when you replace the market in capital letters with the discretion of a bureau crat who doesn't have at all perfect knowledge, you end up with a situation like we have with reserves which should ynl speaking be well below the market rate unless you see one of the big banks exercising market power and forcing rates down and that was the one thing i've talked to both michelle and george about, which is that there are times when the fed should be able to pay above market rates as when they first started and rates were just about 0 because you know what happened the next day? there was a bid above jpmorgan and wells. if you were a small bank selling funds through the market that was kind of nice. so anyway -- >> thank you. >> norbert? >> i suppose i would think about conceding that they should pay above market rate, but otherwise, if you'll implement a system, other central banks that you see, this below. >> if you have government-sponsored monopolies, how do you fix it? >> no, we're on the same page there. i mean, i don't think the system should still be in place. i think they should shrink. i think they should get all of this stuff out and they have to balance contractionary and expansionary forces to not create a disaster, but i don't think they should keep the system going. the only other thing that comes to mind is i don't disagree with nelly in the stability sense that the banking sector could be more stable right now, but that brings to mind jerry dwyer, a friend of paul's which i think it was the 14th century irish graveyard and it's very stable. there's just not much going on there. and that's how i think of this. you have an enormous pile of cash sitting there earning government interest and nothing is really going on there compared to what could be going on there. >> thanks. nellie? >> a couple of comments. i think, again, i think about what banks try to do and what they fundamentally do is take funds from savers who want access to their money when they want it and try to lend it and that will be longer. so you have this inherent mismatch of maturities, so you do need deposits that are with an insurance scheme. either that or you're open to the idea that you have no insurance, but if you have deposit insurance you're working in a system like that, more deposits versus less is not necessarily bad, but that's what banks do and try to find the other thing is that they offer transaction services and a lot of the deposits have gone to the banks partly because they've left the money funds. i don't see that as being an absolute negative. on the ior or the ioer and the payments to banks, what you will hope for is that the fed can reduce that range so i agree that the payments on reserves are higher than the bank's funding costs. they're probably higher than the rates you earn on check, but a market rate could be, say, 1%, but then you add the capital requirements, the fdic insurance premiums they're paying for more and there probably is a gap and over time, i think the fed should, once they get the system in place and it's a very new system for them, and they might be able to narrow that gap, and instead of a quarter range, it could be 1.25 and 1 1/4 and there would be much less funds being given. >> what's that? >> but the marginal cost, and there are reserves and they have to fund them somehow, and it is an asset that has to be funded on the liability side. so they're -- you know, i agree that to narrow it, but it's not, you know, just like entirely the whole 1.25. >> paul? >> if we go forward, the fed has had this argument that bank deposit rates and they're always slow to adjust and eventually they'll come around and we've been paying interest on reserves now for almost three years and they haven't adjusted and they're pretty slow and i'm not willing to wait another ten. so as the fed normalizes its balance sheet and you believe in the new york fed's president's words they're going to keep excess reserves around a trillion dollars and the long run, dot plot path for the and it's still $30 billion and that's a lot of money. the way i see it the fed has a political problem going forward. i don't think any of this was intended. i think they got into this position trying to do all of the right thing, but i think they're now in a bad way. most people don't understand that ior payments are taxpayer payments. they're payments that would lower the federal government deficit if they weren't paying it to bank's. and it's a transfer of payment, plain and simple to banks, and i think it more than covers their cost of deposit funding and deposit insurance and the cost of now regulatory compliance. and we're quite happy with dodd frank and they're going to be happier as the fed raises interest rates. so i don't see this as politically sustainable long term. it could go on for a long time, but eventually there is a day of reckoning where people kind of figure this all out and it's going to take a while because the whole thing's complicated. >> we'll first have chris and then nelly here. chris? >> the question i have is this. a lot of these reserves came about because the fed was buying securities. so i think i ought to pay the banks and what's the net though, paul, between the cost of ioer and the forgiveness that the fed is giving to the taxpayer by holding treasury debt because basically, that's a plus, right? >> the fed does make more money on the treasury portfolio than it pays banks, that's true, but you know, for the -- since 1914, up until 2008 the reserves were viewed as a tax and that's why reserve requirements were tiny. it's a sea change in that reserves actually became an asset, an earning asset and not a tax. it's a whole change in the way you have to think about banking and what assets you hold. i think all of your charts show that banks realize this and are holding a lot more reserves for cash as it was in your charts. >> if they want to the move out of that, they can certainly do so. there's nothing preventing them -- >> they're getting paid an overnight rate that's an annual rate on treasurys. >> there's no interest rate risk. >> hang on. >> 14% gross yield on my credit card book. that's a pretty easy choice. >> nellie wants to get in here. i would agree with paul that there is no magic size for the side of a central bank balance sheet. the fed got into this extraordinary policies. they have to have a certain size for required reserves and the system has gotten bigger, so the balance sheet in the future will be expected to be a little bigger just because the system is bigger. there are required reserves of 10% which has not changed for decades, but it does -- the concern which is what i fully agree with is it does put the central bank into the political sphere and that is an issue and over time, you know, they have, you know, the extra they pay to the treasury, up until now, i think between 2009 and now, the fed has paid the treasury $550 billion. in the next few years some of that may go negative and so on net, i don't know -- to think about chris' question how you come out positive or negative on that, but the time seary, it will matter. >> and we're talking about the fed and treasury. we're talking about the federal government and how involved we want them to be or not to be in the banking sector. i don't agree that the fed has to have a certain size balance sheet and it has to have a certain required reserves. and the fed is the only one who can increase the reserves in the system or decrease the reserve in the system and we don't each have to have required reserves much less a bigger balance sheet. they can still control the quality of reserves because they'll have to have balances to clear. so i don't agree at all, and we don't have to have anything close. to what we have. >> other comments from the panel? chris. >> the biggest beneficiary of quantitative easing is the federal government. so if we throw a few pennies back in the cup for the private banking industry, what a shame. i can't believe i'm sitting on a panel with a bunch of free market advocates and we're sitting in a building that was created to fight fascism and economic tyranny in this country after world war ii. come on, you know? >> all right. the chair allocates 2 minutes to put out an alternate hypothesis here. bert ealy who is sitting right over here always tells me you have to understand the fed and the treasury and they're two aspects of the consolidated government financial operation and i think there's a lot of truth in that and that explains why the fed wants to decrease the -- or has wanted to decrease the federal deficit by buying a couple of few trillion dollars of treasuries and another piece of this consolidated government operation is the fannie freddie mechanism and that explains why the fed is financing to the tune of 8.9 trillion of fannie and freddie mortgages. i think it's helpful to think of it all as one big, government financial operation, and when you do that, you see what a hugely important event it was, as the panel -- all, i think, the panel agree when ben bernanke and the fed in a brilliant strategical political move got authority from the congress which they didn't have before to pay interest on reserves. and it does benefit the banks. i think paul is right about that. in my view, more importantly, it allows the fed to be a much bigger element of the total government role in the financial system and to allocate resources and you can think about what these excess reserves are doing is actually the banking system channeling its investments through the federal reserve to two favored -- to favored sectors by political credit allocation, and the two sectors are housing through the fed's gigantic mortgage portfolio and of course, the government deficit through the purchase of long-term treasurys, and my last point is to remind us, the fed now owns zero, zero treasury bills. all its treasury securities are long, and they've taken as chris said, that duration out of the market to cut the cost of the government. basically, the consolidated treasury fed, fannie, freddie government financial operation is all funding itself short through the deposits at the fed and taking all of the long funding out of the market and the net is all short funding and that's the end of the chair's comment, and now i want to come to your questions, ladies and gentlemen. i remind you the aei style and please, first of all, wait for the microphone to reach you. when it does, tell us your name and your affiliation and ask your question. if you feel an overwhelming desire which sometimes happens at these events to make a statement before your question and that statement has a tendency to turn into a lecture, after one minute the chair will remind you that it's time to ask your question and with that, the floor is open. there is a fellow way in the back here who i am just cited. bert ealy. i was just quoting your excellent point about the consolidated government and wait for the microphone to come, please. >> banking consultant. alex took away a lot of my fire by referencing the work that i've done and shared with him and in looking at the fed and treasury balance sheet on a combined basis, and then i think what you see, and this leads up to my question is that essentially since the crisis, the government has reduced the average duration of the outstanding federal debt, and that is federal debt held outside of the federal reserve. my question for you now is this. the government, the fed, plus the treasury is in that position and has only just started to unwind that position. two-part question, number one, what will be the consequences for the financial markets and it is the yield curve as the fed goes through that unwinding and more of the treasury that gets held by the public and second of all, has the federal government made a long-term fiscal error by not using the recent years of very low interest rates to issue long-term, low-cost treasury debt. how much more -- how much future interest expense is the government going to take on because of the fact that it has not used this opportunity during its low-rate period to really extend out the average maturity of its debt? >> thank you. who wants to take either or both of those questions. chris? >> think the answer to your second question is you have the other central banks buying and you've created an enormous dearth of investment-grade assets and the fed could be selling all of them over the next few years and keep the treasurys for the portfolio and i don't think it would have an impact and short of big headline risk. the curve will get flatter and even if it goes forward, starts selling overtly and i don't think it will have much of an impact, and i do think the treasury made a big mistake. peter fisher's decision will be long, because why wouldn't you take advantage of the 30-year debt, you know? >> other views? >> if i could just add to this a little bit, and i guess i don't fully agree that treasury and fed work in synchronous -- work in combination here. treasury, when it auctions debt has a very different objective. they want to make sure they can auction their debt when they need to, and they have a specific maturity schedule and types of securities they want to sell. the fed tried to reduce duration. that's not sort of the treasury's mandate. so you don't have -- i'm not sure we can answer your question because i don't actually think they work in coordination on this. they have different objectives. >> anybody else? paul, go ahead. >> they do have operational independence, that's true, but the framework they created endangers the hell out of that. >> the chief objective of the board of governors is keeping the treasury market open before any other. the soundness of banks, and that's their chief objective is the institution. i think chris is right about that and it goes back to the founding of the bank of england in 1694 which was a deal between the government of england and the newly created bank, is that if the bank would lend the government money which is equivalent to treasurys and they would give them privileges and monopolies and that's a pretty durable deal and it was helped out by the fact that the royal family became shareholders in the bank of england. historical note. paul, do you have a view on what's going to happen if the fed seriously starts reducing purchases or starts selling securities? >> i think i'll pass on that. >> okay. no one wants to be on tv with a firm forecast. but i think -- my own view is the market reaction to that and the terms are rising of long-term rates could be more severe than what people are anticipating or believing, and i say that in spite of your point, chris, which is right that the central banking fraternity around all of the major countries which is a very tight fraternity is all in this together. >> as nelly pointed out, that high-yield spread and the fed has taken high-yield spreads down almost two points and that's the shift in credits and until you see the spreads widen, i don't think you have much chance for longer term rates to go out. >> stay over here, please. >> hi. thomas lord. as a plug to a.i. tomorrow you have the housing conference tomorrow and the next day, i think that's one thing to bring into this. secondly -- >> and ed pinto will answer all of the housing finance questions that you have. >> no problem, and secondly, we have the debt hole and the bank meetings going on right now because you have 40 trillion in debt and you have 40 trillion in pensions that are in trouble and going back to the series that you had going for a long time of the shadow fed reserve, much talk was about how the policies actually forecast what the next problem's going to be and the fixes were actually the baseline for the next problem, do you agree? >> do we agree that the fixes for the last problems tend to create the next problem? >> norbert? >> i don't know if it creates to deal with it. what they've done is they've divorced monetary policy from the balance sheet. that's basically it. they've got a system where they can keep buying stuff and keep using the interest to offset where that stuff goes. so if there is a pension crisis, great. we can buy that. i mean, if there is a california bankruptcy, i don't know. i'm not saying that will happen, but great, we can buy the bonds. >> he said it. all of the agendas are driven by debt. the europeans are broke and now you have christine le guard going out there talking about sdrs and my friend jim ricards will start overtly issuing them to indebted governments to use as money because they've run out of layers of leverage, if you will, going back to inflated, right? it's all about layers of leverage. the question is what's the new layer and they haven't figured that out yet, but otherwise we have default. if mario draghi stopped doing what they're doing, you would see a lot of defaults and they just will not tolerate that. whatever gets them away from that is what they'll do. >> i'm going to wait for the microphone, please. i have the gentleman here and i'll come over to you, ed. >> maybe just a couple of quick questions. if the ioer is so attractive why is it only the foreign banks that seem to be the only ones parking the reserves and that seems it isn't so attractive for the domestic banks? two, what would the alternative have been for the fed to the two inflating during qe and inflating reserves and three, to bert's point, was there a lot of controversy, actually, that the treasury was actively trying to lengthen the maturity of its debt while the fed was actually taking duration out. so they weren't working together by any means. >> all right. we have a three-part question. who wants to start? >> the best data i saw was that the half of the reserves in the top largest 25 domestic banks and about a third are in the foreign banks. >> it's not just foreign. it's not just foreign. there are plenty of large banks that own a lot of reserves. the second question? >> what was the alternative to paying ioer or qe? i think -- i don't think there's a solid agreement anywhere that the qe stimulated the economy and i think there are lots of people that think at least the last version of it might have been a pretty big mistake and even the fed itself its internal research struggles to look for really clear benefits of the qe program. so the answer might have been, you let markets equilibrate and get out of the crisis quicker. rather than find the equilibrium where the bottom is so people start buying stuff. part of the problem when you intervene and there's all this government this and that is that people don't know where the real equilibrium price is, you kind of can't get back to a normal growth trajectory because nobody knows what it was worth because somebody is supporting the price and this happens in all kinds of markets and you have to clear the decks and get to an equilibrium. >> if you think of qe-1 of liquefying, if they had stopped at that point, then what we would be talking about in term of excess reserves it would be much smaller and they wouldn't have this around their neck, but they are tied to this world view that comes out of 40, 50 years of just using price to manipulate credit demand in this country and price doesn't work anymore. so then they moved on to overtly intervening in the market and it's the same mentality and it's market intervention and as paul said, it didn't work, but they didn't know what else to do. there's nothing in the playbook beyond that and that's why the board has done this, even though it's very clear that fed funds rate and other benchmark rates no longer cascade through the market. they don't really push things anywhere near the external factors. it's not even close. so i think it's a structural problem with the fed. they just don't have anywhere to go intellectually and this is why they did it. any comments? >> if you go back to the first qe, too. you can read what they said. they sterilized everything. maybe if they hadn't sterilized anything, they wouldn't have had two and three. >> but swelling reserves like that in that time frame, '10 was not a good year. that helped. and then they should've stopped. >> to summarize, you can do something temporary, but it's ten years almost since the end of the crisis. did we answer the third question, thanks for the stimulating question. >> [ inaudible ] the treasury was linked. >> oh, yes. >> and there's been a lot of controversy about that including larry summers, among other people, have raised this issue. >> there's always debates within families, you know? i have ed pinto next and we'll come back to you, sir. right here. >> thank you and thank you for the hat tip for the conference tomorrow and thursday on housing risk. so two things were mentioned and one was the integrated balance sheet between the fed and treasury and the other, i think, you said something about deficit reduction through all of the money coming from the fed. isn't there a better way of looking at it that what the fed did was to allow congress to borrow much more in the way of deficits because it was so cheap to fund them, thanks to the 500 billion that the fed was given over a period of five to six years. comments on that? >> the net came from the housing market. if you look at the swings and you've seen each year you see issuance go up. there's been record issuance for five years in the bond market if you look at the numbers, but it's corporates and treasurys today. versus housing >> right. yes. >> it's used for share repurchases and we're buying back $2 worth of equity for every dollar and new ipos in the equity market. in all of these asset classes are now correlated thanks to the fed. this is great. we've never had this before and every major asset class in the united states and globally. is now correlated. >> other comments? >> if you look at the flow of funds and the federal reserve flow of funds. i mean, the government debt is what has taken off since 2008. household debt not so much. corporate debt, not so much. in a lot of ways they've moderated quite a bit. the government has taken on the job of borrowing and replacing private sector debt growth. if you just look at the flow of funds numbers, it's right there. i think that just agreed with your point. go ahead, nelly. >> i would add so the household and business credit to gdp numbers are exactly what i was showing and you can see the households have come down for quite a bit from 80% to 60% and the businesses are up and the government has risen and it's pretty typical of recessions in slow periods and there is counter cyclicality in government spending, you know, but it has reached a new high and i don't want to dismiss that it's a something to be concerned about, but it's fairly frequent for government spending to go up when private spending falls the way our expenditures are. >> okay. >> i have this gentleman here, please. >> erin klein brookings and one comment and then a question. i think your government numbers will be accurate, but know that student loans and it's just a bookkeeping things and private debt and bank debt with the 98% government guarantee and now it's represented as government debt so that $1.2 trillion you should back out of your calculations in making that point which even in washington, the numbers over $1 trillion matter. the question i have, paul, and it's counter factual, and i was in congress when the fed asked for authority on ioer which was given without terribly much public debate. at the time the balance sheet was so miniscule that the impacts you were describing weren't contemplated, but it was asserted by the fed that they needed this to switch from the point target to the bound target. if you go all of the way back and run the counter factual, say congress didn't give them that authority and they had to run the point target through the crisis. how would that -- how would we look different? >> so the original argument for interest on reserves was really interest on required reserves because required reserves had always been discussed as a tax on banks and required reserves were actually tiny, $900 million and the fed originally sought power to pay interest on required reserves and they did that for the first few weeks and they wanted to pay a different rate and all of a sudden they wanted to pay in december 2008 so i don't think they ever -- it was ever supposed to offset the push there is in the financial system for deposits to go into money funds because they don't have to pay deposit insurance premiums and so for years money funds had drained transaction-pipe balances out of the money systems and they sought to pay some small amount of interest reserves and it was never intended back then to be the policy target and all through the '90s the fed had done things without changes in the law reduced the banks that had the inteep accounts and they had required reserves overnight so the fed had for many, many years tried to reduce, actually the burden of required reserves on banks. in terms of the counter factual going forward other i can tell you if the fed wasn't paying interests on reserves the banks would vpt have $2.5 trillion banked at the fed right now. i pretty much guarantee that. >> but the reserves won't disappear until they sell their securities. they're never destroyed. so what would happen? >> they would turn into other assets and the classic theory of the reserved multiplier which paying -- and you would have massive inflation which paying interest on reserves cuts out the classic theory of the reserve multiplier and that's a hugely fundamentally important change which was made without a whole lot of discussion or knowledge of what was really going on. other comments? >> i think it would force them to be temporary. that's the one i think would be different about it. the operations that i undertook would be the normal and they want to flood the market and get it as quickly as we can, and there wouldn't have been the economic incentives to keep it in place. without the higher interest on excess reserves. >> but they would've sold the reserves and bought securities so it would drive yields down. >> maybe. >> so one of the reasons for wanting to pay interests on the reserves and they asked for it early in 2008 before the crisis and before the balance sheet, banks were taking all these actions every single night to move all kinds of funds around so it's costly to hold things if you're not getting interest. so there are all these unnecessary actions every night to make sure you have met your required reserves and still weren't paying a penalty. so i think, you know, that was the reason for the request at the time, but that was a day before the balance sheet got very big, and so it's worth considering. >> i passed in the law earlier. it accelerated in the tarp bill and it was never intended a tool to set interest rates monetary policy interest rates. it was never intended to be that. >> they've been arguing about that, actually, for decades. i contemplated when they did the federal reserve act and the treasury fought paying interests on reserves historically. >> for that very reason paul mentioned. >> i have a question right here, please? >> can't you make the case that federal reserve policy has been spot-on since the crisis in terms of qe and saving us from a very catastrophic situation and that the move toward normalization is appropriate, and i sense that at least you, chris, think that the last couple of qes were inappropriate. i wonder what you think the proper course of fed action is going forward? >> qe-1 declared success. the spreads come in and i'm in the school that spreads are all that matter and i think chairman bernanke believed. he was horrified as qe. he wanted to describe it as asset purchases and they came up with another name because that was unacceptable. and i really believed that if the point is to get the markets functioning again, there is a whole raft of monetary policy and prudential policy actions that should never have been taken, but we never get policymakers in a room with the chairs and the minority leaders of the different parties who are responsible and we talk and say what do we want? so everything is piecemeal and it's the net-net-net that really matters for the economy, so today i would tell you there's less leverage in the economy and less growth as a result and yes, we have safer banks, but we turned them into islands and they don't trade with each other because we're afraid of the market. we're afraid of what the market might tell us, right? that's our solution. we don't have a market anymore. so it's another way to do it, but they didn't have the courage to start reversing some of the decisions which have been made for 20 years, to be fair, right? so what do you do? >> other comments? >> the strategy that janet yellen and the board have put forward is very slow, very deliberate strategy. they hope that it is so boring that no market reacts. that's their best hope. if there is some kind of financial meltdown, i think that will test whether they'll keep going forward with the strategy or they revert to qe. it's meant to be boring. it's going to take a long time to get the balance sheet down to the long run and equilibrium size and i don't even think they decided what that is yet. currencies are twice what they were in 2008 so the balance sheets have got to be bigger. they're thinking they like the ior or ioer. i don't know why they'd ease anymore because they pay interest on all reserves and they think they like that strategy. it's really easy for us to do. we don't have to do all of of this bond buying day in and day out. it's just really simple and to do that, he's mentioned a trillion dollar balance sheet. i don't think any of this has settled yet. i think there would be political backlash eventually and they'd have to rethink this and how they want to manage reserves and set interest rates and there is no federal funds markets anymore and if they want one they'll have to get them way down and people are willing to bid for them and trade them again and we're not -- we're years away from that under the current plan. >> and they're still buying. >> still buying. >> they're still buying. >> they're just letting it roll off slowly. >> eight years after the end of the crisis. go ahead, nellie. >> so in terms of whether the financial sector is financial stability, you don't want stability of the graveyard, but i guess i have a slightly different perspective. i look at the banks and their stock prices have risen quite a bit. in the u.s. the price book ratios are like 1.5 for some of the biggest ones and bank of america and citi are closing on one but they've been sort of laggar laggards, growth, debt growth is 7%, 8% a year. how much dealt growth is sustainable for the private sectors? you want -- it is -- i'm not seeing the -- you know, on the one hand we see massive corporate bond issuance, we're seeing loan growth, we're seeing banks that are viable, so i'm not -- i'm not seeing the same sort of graveyard view that chris sometimes mentions. >> it's very simple. they have negative risk adjusted returns. the little guys make money. that's the difference between banks. >> i have another question over here, please. >> hi. karl poser. i hope this isn't too much of a mad cap question, but given the increased intertwining between the treasury and the fed and the increased possibility that congress will use the fed in a political way, the question of social security, it's facing a financial short fall of like 20 years from now when the boomers move through, it's only raising 75% from the workforce of what it needs to pay out. is there a possibility that the fed could come into play in some financial restructuring with long-term, low interest credit? i mean, could that be? i'm just -- >> i think it's a very good question. how about an extreme monetary policy and its effects on social security and how might that play out? free association. >> if the treasury needs cash the fed will buy the paper. the answer's yes. they've already tasted the forbidden fruit. >> we agree completely on that. there's no doubt, in my mind. >> others? the next question is pensions in general after social security. >> other questions? if there aren't any more question -- oh, yes. right here. >> al from global associates. mine is a crystal ball question. given the current state of political affairs in the u.s. and the fact that there's a perspective change in the fed chairmanship, do you expect or i'd appreciate your opinion as to whether or not you think what is already a close association between treasury and the fed could potentially become even more intwined depending on who the next fed chairman might be? >> good question. >> i don't think it matters. the fed is the alter ego of the treasury both -- cumberland advisers. he's laid it out. the congress doesn't make money from the fed. it's an expense. they get back to treasuries money less the fed's operating cost. that's it. so, yeah. >> that's changed by mortgages, chris, 1.8 trillion of mortgages. that's -- other points about new chairman of the fed, relation between fed and treasury or any other part of the government. >> the current administration seems to be somewhat unorthodox to put it nicely so it's hard to say, but historically this notion of fed independence doesn't hold up. it just doesn't. yes, volcker comes along and does something different, okay, and yes, there's this aura of operational independence, but over the long haul they're not independent. >> you remember what former fed chairman arthur burns said which was we can't exercise our independence or else we might lose it. >> that's right. >> before i give bert a second chance, other questions? okay. wait for the microphone. >> thank you. this comes back to the fed and new appointments to the board. randy coral has just been confirmed to be vice president of supervision. this is as a result of dodd-frank. what are your thoughts as to what -- is there going to be an increased emphasis on supervision and how is that going to interact with monetary policy now that supervision to some extent been elevated by virtue of having this new vice chairman for supervision? >> you want to take that? >> i suspect supervision will be de-emphasized compared to the tra littlo years. one of the big problems with the dodd-frank act in my opinion, is that so many of the powers in regulations are not very tightly conscribed. you can do huge -- you can be peddle to the metal under one administration and full on the brakes the next administration, depending on whose in charge. they're just not -- it doesn't constrain the regulators enough. you don't really know what the law requires them to do and i suspect the pendulum will swing from the trillo years. will we have, you know, the financial crisis that some of my colleagues predict is eminent for the last four years every week? yeah, eventually we will. we'll, you know -- the banks are probably less exposed now than they were but two, three years from now after this change in regime, who knows? it could end up badly, any financial crisis would end up badly. i think we're in for a change. the pendulum is swinging. i think part of the reason and i think the democrats will probably come around to understanding this when there's a new cfpb, chairman whose a republican who doesn't undo all the things the last guy did because there's so much wiggle room in all these lies, they'll grow to dislike the dodd-frank act when the trump people, if he ever does nominate anybody for half of these positions, if they ever get put in power, i think, it will come full circle that they'll decry it and how are you doing this and the same thing you heard from the republicans when people thought the last administration was way too strict. so it'll come full circle i think. >> other comments? >> it's already under way. the enormously way that paul referred to in terms of guidance and implementation of statutes is very powerful. treasuries just does it with omb via fiat. it's going to manifest itself for reduced cost especially in the mortgage world, when richard cordray leaves office there's going to be a big party on the mall. he increased the cost for lending and servicing by 300% and there are many, many firms on the verge of failure in the fha market today and the hurricane, i got to tell you, has not helped. there's been a whole series of interest rate shocks and external shocks from weather that are going to decimate that market and people are going to have to pay attention to this. we have to actually sit down with the regulators and figure out a way to make money because for the last eight years it was all punishment. they weren't concerned with whether the industry could make money. i think that's a big change and it will make revenues grow, but earnings will be better. >> other comments? okay. other questions? hearing none we thank you all for coming very much for the great questions you're asked and let's thank the panel. [ applause ] >> announcer: attorney general jeff sessions spent the morning answering questions about various issues. he was asked about president trump firing fbi director james comey last may. here's the top democrat on the judiciary committee senator dianne feinstein.

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