This post by Paul McCulley,a Managing Director of PIMCO, is from a speech McCulley gave at Levy Institute and it comes via John Mauldin. Edward Harrison has inserted the images. They are not in the original. Enjoy.
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Thank you very much. It is an absolute pleasure and honor to be here. I gave the keynote a couple years ago and it was my first time to be at the Minsky Conference. I feel that I’m part of a church, and it’s a good church in that we’re on the right side of history. And it’s absolutely wonderful to be attending services with you again.
I want to open up with a little story that should make everybody in the room feel particularly good, and then we’ll get into discussing economics. Harry Markowitz has been a friend of mine for about a decade. I became friends with Harry through two channels. Number one, Rob Arnott of Research Affiliates has an Advisory Panel of famous academics, such as Harry and Jack Treynor, that he gets together every year. I’m frequently invited to speak. We spend two or three days over a weekend together. I’ve also gotten to know Harry because he and the late great Peter Bernstein were very close friends. Peter and I were also very close friends.
I’ve been preaching the Minsky Framework at Rob’s event for a number of years. And Harry’s always been very, very polite. I spoke again just this past Sunday morning. After I finished, we had a nice Q&A. And Harry said, "Paul, if I had to read one book by Minsky, which one would it be?" And I said, "Harry, please, tell me that you’ve read at least one book by Minsky." And he says, "No, I haven’t, but I think I would like to, and I think I’m probably old enough now."
I promised Harry that I would send him one personally. And I’m quite sure that if I don’t follow up on that, somebody at the Levy Institute would gladly follow up. So, the bottom line is that one of the fathers of the Efficient Market Hypothesis has finally decided to attend services at the Church of Minsky. I think that is a glorious, glorious moment. Don’t you? Harry is an absolutely delightful man.
From the standpoint of what I want to talk about tonight, a great deal of it has already been discussed today. I feel a little bit like St. Louis Federal Reserve President Jim Bullard did at lunch when he said that Paul Krugman, who spoke just before Jim, had already given 90% of his speech. That’s basically true for me as well. Paul’s speech was superb, laying out six possible culprits in the financial crisis.1
I want to focus on Paul’s Number 3, the Shadow Banking System. Paul was drawing a lot of his comments today from the work of Professor Gary Gorton of Yale, which is absolutely fantastic material. Have a lot of you read Gary’s essay, "Slapped in the Face by the Invisible Hand"?2 I see a lot of nods here. That’s where the phrase that Paul used, "Quiet Period," came from. Gary coined it. He’d be a great person to have here next year at the Minsky Conference.
And one of the fascinating things that he details is the nature of banking. That’s where I want to start tonight. Let’s start with first principles. If we do, then I think we can understand why we shouldn’t look at the conventional banking system and the Shadow Banking System as separate beasts, but intertwined beasts.
The essence, or the genius of banking, not just now, the last century or the century before that, but since time immemorial, is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post. In turn, the essence or the genius of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.
A second principle: A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver. Everyone following me here?
Professor Gorton, in his paper, goes through how that promise was dealt with during the 19th century, before the New Deal Era. There were panics all the time, otherwise known as runs, because we didn’t have a lender of last resort and we didn’t have deposit insurance. During the 19th century, the system dealt with its reoccurring panics in lots of novel ways, including clearing houses which would de facto be a central bank, and suspension of convertibility of deposits into cash. So the problems we’ve been dealing with in the last couple of years are not new. They go back to the origin of banking.
The Quiet Period, from the New Deal Era until the Panic of 2007, was actually unique in history. And the Quiet Period came about, I think, for a lot of the reasons that were articulated earlier today in that banks, conventional banks, after the Great Depression, were considered to be special. And, in fact, banks are special. If you think that the banking system can be guided to stability as if by an invisible hand, then you are deluding yourself. But, that is, in fact, what happened with the explosive growth of the Shadow Banking System.
Banking is a really profitable business. In its most simple form, think in terms of a bank issuing demand deposits, which are guaranteed to trade at par because they’ve got FDIC insurance around them and also because the issuing bank can rediscount its assets at the Fed in order to redeem deposits in old-fashioned money, also known as currency.
In fact, let’s take a look at the $1 bill I am holding in my hand. It says right at the very top, "Federal Reserve Note." It also says right down here, "This note is legal tender for all debts, public and private." This is what the public ex-ante wants: the knowledge that they can turn their deposits into these Federal Reserve Notes. And if the public knows they can turn them into these notes, they don’t. With me here? If I know I can, I don’t.
Now, this is a unique note. This is a Federal Reserve liability. And, actually, it’s really cool. It’s missing two things. It doesn’t have a maturity date on it. So, it’s perpetual. And it doesn’t have an interest rate on it. I would love to be able to issue these things. It would make me very, very happy to issue these things. But it would be against the law! But, in fact, that’s what banks did in the 19th century. They issued currency. After the creation of the Federal Reserve, it was given monopoly power to create currency, which I think was a pretty bright idea. But demand deposits issued by banks are just one step away from a Federal Reserve Note.
Conceptually, demand deposits have a one-day maturity. I can write a check on it, and it goes out at par tomorrow, if not today. Demand deposits, conceptually, have a one-day maturity. But in aggregate, they have a perpetual maturity. So, therefore, banking can engage in maturity, liquidity and quality transformation: a very profitable business. Banks can issue, essentially, perpetual liabilities – call them demand deposits – and invest them in longer dated, illiquid loans and securities, earning a net interest margin. It’s a really, really sweet business.
In the early years of the Quiet Period, we regulated that really sweet business. I think that was a really bright idea. In order for that business not to be prone to panics and, therefore, financial crises, you needed to have deposit insurance. Deposit insurance, by definition, cannot come about as if by the invisible hand. Deposit insurance cannot be, cannot be a private sector activity. It is a public good. The deposit insurer must be a subsidiary of the fiscal authority. And in extremis, the monetary authority can monetize the liabilities of the fiscal authority. I’m not saying that pejoratively. I’m not being pejorative at all. Just descriptive. Bottom line: Deposit insurance is inherently a public good.
Access to the Fed’s balance sheet is also inherently a public good, because the Federal Reserve is the only entity that can print currency. So essentially, banking has two public goods associated with it. Therefore, naturally, it should be regulated.
That was the Quiet Period Model. And regulation took the form of what you could do, how you could do it and how much leverage you could use in doing it. And, as was mentioned by Paul Volcker a number of times earlier this afternoon, the regulatory burden that has historically come with being a conventional bank has been actually quite high. During the early years of the Quiet Period, however, banking was nonetheless a very profitable endeavor.
There was a quid pro quo, which actually led to the old joke – which was actually said about the savings and loan industry – that banking was a great job: Take in deposits at 3, lend them out at 6, and be on the golf course at 3. 3-6-3 banking was a pretty nice franchise. So, therefore, bankers had a pretty strong incentive not to mess it up. Essentially, there were oligopoly profits in the business. I think Gary Gorton is actually right on that proposition.
The invisible hand, however, naturally wanted to get the oligopoly profits associated with banking while reducing the impact of some regulation. Thus, the Shadow Banking System came into existence, where the net interest margin associated with maturity, liquidity and quality transformation could be earned on a much smaller capital base.
And, in fact, that’s what happened starting essentially in the mid-1970s, accelerating through the 1980s and 1990s, and then exploding in the first decade of this century.
That asset – which, again, is the bank’s liability – needed, in Gary Gorton’s terms, to be characterized by "informational insensitivity," meaning that the holder didn’t need to do any due diligence, just taking it on faith that this asset could be converted at par on demand. And, in fact, money market mutual fund shares achieved that status. With one small exception prior to the Reserve Primary Fund breaking the buck, they always traded at par. And if there was any danger they wouldn’t trade at par, the sponsor would step in and buy out any dodgy asset at par. So, essentially, the money market mutual fund industry was at the very core of the growth of the Shadow Banking System.
It created a liability perceived as just as good as a demand deposit wrapped with deposit insurance, issued by a bank with access to the Fed. It was a great game. But in and of itself, that didn’t lead to the explosive growth in the Shadow Banking System. There needed to be another link in the chain. Yes, money market mutual funds needed an asset that the public perceived as just as good as a bank deposit. But they also had to put something on the other side of the balance sheet.
What went on the other side of the balance sheet? Money market instruments such as repo and commercial paper (CP). And under Rule 2a-7, they were allowed to use accrual accounting for their assets. The assets didn’t have to be marked to market. So, therefore, 2a-7 funds could actually maintain the $1 share price, unless they did something really dumb.
At their peak, money market mutual funds were about $4 trillion. They are about $3 trillion now. They interacted with the larger Shadow Banking System. And the largest shadow banks were the vehicles of investment banks, funded heavily with repo and CP. So, explosive growth of the Shadow Banking System was logically the result of the invisible hand of the marketplace wanting to get the profitability of the regulated banking system, but without the regulation. Shadow banks created information-insensitive assets for the public that were perceived as just as good as a demand deposit, and then levered the daylights out of them into longer, less liquid, lower-quality assets. And it all worked swimmingly well, for a while. But then they embarked on the Forward Minsky Journey.3
Shadow banks were the predominant place where securitizations of subprime mortgages were placed, as well as securitizations of other types of assets. So the Shadow Banking System was, essentially, mirroring the banking model, which had deposits and loans.
Turn the deposit into asset-backed commercial paper. Turn the loan into a security. What you end up with is the same vehicle as a bank from a functional standpoint, but you have it outside the conventional bank regulatory structure. Actually, let me correct myself. There was a de facto regulator in the Shadow Banking System. They are called the rating agencies.
In order to do the trick of creating a shadow bank, you had to have the rating agencies declare that your senior short-dated liabilities were just as good as bank deposits. In fact, most money market mutual funds get themselves rated, and S&P, Moody’s, and Fitch do have particular rules for giving a AAA rating to a 2a-7 money market fund, mirroring SEC Rules. But, for the rest of the Shadow Banking System, the rating agency rules evolved on the fly, often under the guidance of shadow bankers themselves. It didn’t work out very well, as the Shadow Banking System became the lead owner of what was created in the originate-to-distribute model of mortgage creation.
It was only my second year there. And I was in awe, and mainly listened for most of the three days. At the end, Marty Feldstein always does the wrap-up. Everybody wanted to talk. And since I was a newbie, I didn’t say anything until almost the very end. I stood up and (paraphrasing) said, "What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system."
Now, I certainly didn’t anticipate that it was going to lead to the debacle that eventually unfolded. In fact, while the run commenced on August 9th of 2007, it was pretty much an orderly run up until September 15, 2008. And it was orderly primarily because the Fed – and here I give the Fed credit, not criticism – evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility.
I’m sure that was an incredibly difficult decision for the Federal Reserve Board to make – to open its balance sheet to borrowers it didn’t regulate. But it was necessary, because runs are self-feeding; you can’t stop them without the aid of somebody with the ability to print legal tender. That’s the only way you can stop it, because only the Fed can create an asset that will definitionally trade at par in real time. During a run, that’s what the public wants. A run turns upside down the genius of banking. A run is when the public’s ex-post demand for liquidity at par equals its ex-ante demand.
Post-Bear Stearns, financial life regained some sense of normalcy. But then came the run on Lehman Brothers, and the Fed didn’t have the legal power to implement a Bear-like rescue. And then the Reserve Fund broke the buck. That week will be one that we remember for the rest of our lives. It will also be one that we will remember where the Fed was at its finest hour. The Fed created a whole host of facilities to stop the run. In fact, they expanded the Primary Dealer Credit Facility to what are known as Schedule 2 assets, which meant that dealers could rediscount anything at the Fed that they could borrow against in the tri-party repo market.
Concurrently, the FDIC stepped up to the plate, doing two incredibly important things. Number one, they totally uncapped deposit insurance on transaction accounts, which meant that the notion of uninsured depositors in transaction accounts became an oxymoron. If you were in a transaction account, there was no reason to run. And then the FDIC effectively became a monoline insurer to nonbank financials with its Temporary Liquidity Guarantee Program (TGLP) allowing both banks and shadow banks to issue unsecured debt with the full faith and credit of Uncle Sam for a 75 basis points fee. No surprise some $300 billion was issued.
So, bottom line, you had the Fed step up and provide its public good to the Shadow Banking System. You had the FDIC step up and do the same thing with its public good. And as Paul Volcker was noting this afternoon, you had the Treasury step up and provide a similar public good for the money market mutual funds, using the Foreign Exchange Stabilization Fund. It was a triple-thick milk shake of socialism. And it was good. Again, I’m not being pejorative. I’m being descriptive.
Banking is inherently a joint venture between the private sector and the public sector. Banking inherently cannot be a solely capitalistic affair. I put that on the table as an article of fact. And, in fact, speaking at a Minsky Conference, I know I’m preaching to the converted. Big bank and big government are part of our catechism. And, in fact, that’s exactly what came to the fore to save us from Depression 2.0.
Let me draw to a few conclusions. How should we re-regulate the financial landscape – as President Bullard was calling it today – to make sure this doesn’t happen again? We must, because the collateral damage to the global economy has been truly a tragedy.
And I think the first principle is that if what you’re doing is banking, de jure or de facto, then you are in a joint venture with the public sector. Period. If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be considered functionally a bank, regardless of the name on your door. That’s the first principle.
There truly is a devil in the details, because it’s quite natural that non-bank levered-up financial intermediaries don’t want to be treated like banks. I wouldn’t either. But the truth of the matter is if you’re going to have access to the public goods associated with banking, then you’re going to be treated like a bank.
In fact, here is an example of this concept in my own life, which I’m sure most of you have experienced who have older children. When my son turned 18, he said, "Dad, I’m now the age of majority and I can do whatever I want." I said, "Son, that’s absolutely true. However, I still control the Bank of Dad. And if you want to have access to the Bank of Dad, there are going to be rules. If you don’t want access to the Bank of Dad, that’s fine. But if you want access to the Bank of Dad, there are going to be rules."
The Federal Reserve and the FDIC and the Treasury, together, are the Bank of Dad. And Mom. I expect regulation to be similar to that which I have imposed on my son. It doesn’t mean I want to stifle his innovation. That doesn’t mean I want to stifle his creativity. I want him to be all he can be. But as long as he’s banking at Bank of Dad, there are going to be rules.
So there’s my regulatory framework for you. Yes, think in terms of the Federal Reserve and the FDIC and the Treasury as all providing public goods to banking. But the Federal Reserve has got to be at the top of the totem pole, because the Fed truly is the Bank of Dad. The entity that can print money has got to be the lead supervisor. To me, it’s unambiguously clear. And the fact that it’s being debated actually befuddles me. I operate on the notion that self-evident truths should be self-evident. But apparently Washington doesn’t operate on that thesis.
I’ve talked too long. I promised you I wouldn’t do this. I was going to talk short and then have a long Q&A, but I’m a Baptist minister’s son, and we can’t help ourselves. Regardless of how simple the sermon may be, it always goes on too long because the minister always enjoys giving it more than the audience enjoys receiving it.
Thank you very much.
Paul McCulley
Managing Director