 We're really excited that we're getting to launch this book today. How did this come about? Well basically for a number of years now we've been providing critiques of the financial regulatory system and we get asked from time to time. So what are your ideas? What are the ways that you think that you can address some of these issues that we have? This program will have two segments. The first will be an interview discussion with a very special guest and my colleague is going to be doing the interview. My colleague J.W. Varrette who also happens to be a professor of law at the Antonin Scalia Law School at George Mason University. He is also a senior affiliated scholar at the Mercator Center at George Mason University and also not too long ago he was senior counsel and chief economist on the House Financial Services Committee. So he's very familiar with this area and he has expertise in securities law banking regulations and so many other areas of financial regulations. With that said I'd like to invite J.W. Varrette and the special guest to the stage. Thank you. Join me in welcoming them. Former Commissioner Gallagher, Dan Gallagher started out at his relationship with securities law. Started out when he was an intern at the SEC in law school, Catholic Law School. This is the late 90s. I say the 80s were probably the best period in history but 90s were not so bad. Gallagher starts off in the 90s as an intern at the Securities and Exchange Commission. He served as a staffer at the SEC. He's been a partner at Wilmer Hale, probably one of the leading securities law firms. He's been counseled to Commissioner Adkins, to Chairman Cox. He's been the acting head at the Division of Trading and Markets and a commissioner we all remember in recent history. It's last five years as commissioner at the SEC. A very active and vocal commissioner never shy to weigh in on issues. And now he's president at the Potomac Global Partners, a leading consultancy here in Washington on financial regulatory issues. And I would say probably has one of the leading minds from each of the major financial regulatory agencies and adorn fine Christmas party if I don't, I should add, which is why I'll try to be gentle and kind today because I don't want to lose that invite for this December. So Dan, let's start off. I guess it's sort of like an inside the actor studio thing. So I'm going to try to make you cry, make you laugh. Me or that? Damn. Start off. I'll cry you. You're interning at the SEC in the late 90s. What was that experience like? It was a really great experience. This was probably 1997, I think. The agency people haven't noticed because regulatory accretion, as you know, happens over time, but the agency was probably half the size that it was today, that it is today. I was in the enforcement division and it was the way the government should be small and lean. And as an intern you got to be able to get thrown right in to matters to really do the work of the staff attorneys. And it was incredibly rewarding. It was the esprit de corps was great. The focus back then under Bill McLucas, who was the enforcement director, was vindicating the rights of the small investors and going after these scoundrels that ripped them off. And that's a very good problem for the SEC. And it got me so excited about that field that, of course, I focused on that after law school and went to Wilmer. Funny enough, McLucas ended up there right around the same time I did when he left the SEC and so worked in the regulatory group there as a broker dealer regulatory lawyer, worked as an enforcement lawyer. But it was all because of that time as an intern. And I always wanted to get back. I wanted to do some public service. I wanted to do it there. When you were in that summer honors program, as what they called it, it used to be very hard to get into as this kid from Catholic night school there with all the Yale and Harvard people, sorry, DW. I'm an LSU guy. Yeah, right. Keep telling yourself that. But when you were in the one big treat was that you got an interview at the end. It was the only way to get into the agency directly from law school. And so I thought, well, I'm going to do this. This is great. And did the interview, got an offer and the starting staff attorney salary back then was GS9, has to know GS9, something like that was $39,000 a year. This is great, except my rent costs more than that. And all the student loans wouldn't allow me to do it. So I had to go in the private sector first. And then eventually when Commissioner Atkins was looking for a counsel, and Hester was there working with them at the time, and we knew each other from Wilmer. It was the right time to go back to the SEC. So you're from intern to division head in some 10 years or so to commissioner. What was that experience like running the division of trading in markets? It seems like dealing with some of the issues then in the wake of NMS that we're still talking about 10 years later. What what was that like? And what do you see? How do you see that bridging to some future for finally rethinking NMS? So I had kind of two lives in my first in at the Christian had two lives. It was 2006, 2007, wonderful time to be at the SEC. You want to be at the SEC in a bull market, I can tell you that much. People are happy. They're getting their 401k statements, and they're feeling good about the world. They're feeling good about you. The SEC is terrific in 2006 and 2007. Oh, wait, a little bit different. And you know, I went down to be deputy director of trading a market six weeks before Lehman went under and I took over that investment bank holding company program. So I owned it for six weeks before it went under and basically never looked back. So I didn't have a normal tenure there. And as far as you know, I was thrown right into the crisis, the the made off scandal actually landed on our laps too, because folks probably have seen or heard the word SIPIC, the securities investor protection company, which is the insurance program for broker dealers, we oversaw that in trading and markets. And so the issue of SIPIC coverage for your brokerage accounts came up in the Lehman failure, it came up clearly and made off. And so between the crisis, the crisis related made off issues, my whole tenure there until I left in early 2010 was marked by the crisis less by policy. And so your question is about reg NMS, which is the 2005 rulemaking that changed the landscape of US equity markets of the trading markets. That was implemented finally in 2007, months before the financial crisis. And because of the crisis. And for other, you know, reasons I think there was never a look back. You know, here, here we just effectively mandated high frequency trading, you know, we created a utility structure out of otherwise competing exchanges. We let it loose on everybody. And we never to this day haven't done a full and rigorous look back. You've heard a lot of clamor to do that. You've seen a lot of problems the flash crash and other things, you know, from 2010 and all these systems outages that have happened at the exchanges, that's given rise to this clamor, let's revisit NMS. They've nipped around the edges of it. At the commission last few years, I pushed hard and get very far with it. But my guess is they're going to take that back up pretty quickly. I'm optimistic that in particular rule 611, the order protection rule, the trade through rule will be revisited my hope is that it goes away. So that brings us to the future. So we got a new day, a new chairman nominee for the SEC. He's a deal lawyer, he's an M&A lawyer. And in near history, we haven't really seen that at the commission. So that's a whole new approach to securities regulation, a new theme from the president of some rethinking of regulation, streamlining of regulation. And also, I think the promise of, you know, we want to bring back IPOs to US shores, we want to make accessing capital easier, who better than a deal lawyer to get it done. So what an interesting future ahead. What do you see as possible for this new chairman and given given the constraints every chairman has notice and comment, political pressure, a staff who, you know, despite best intentions, there's regulatory momentum at an agency and they've been pretty invested in the last eight years of rulemaking. So reorienting focus might be difficult. So how do you see him navigating those challenges? And what do you see as his sort of range of motion? Look, I think Jake, Jake Clayton, the chairman nominee for the SEC is someone I got to know, actually, through the Lehman Brothers nightmare, when he and his firm represented Barclays, I got to know him well. And in a pretty intense situation, he's a he's a fantastic guy. And you know, the I know, I just saw John police, I've seen a bunch of SEC staffers who grabbed me when I'm in Union Station and say we hear this guy's really great. And he's as great as as advertised. He's smart, hardworking, down to earth, he listens more than he talks, he's going to be great for everyone, you're going to have a chance, no matter what your issue is, what side of the aisle you're on with Jake Clayton, because he's a thoughtful guy. You know, one thing you mentioned about the staff being invested in the last eight years, that's an issue I might take a little bit of the different view on which is, you know, if you watch the, the surveys of the employee surveys of federal agencies, the SEC I think is in the midsize agency range, and it used to always be the number one place to work forever, ever and ever, it was a great place to work. After the crisis, as you might imagine, it dipped. And for a whole bunch of reasons, but we went down to last for a while. And I think now we're a little bit above halfway. And you look at all the reasons that go into it, right? The being tarred on CNBC and in the Wall Street Journal, you know, the crisis related issues, the former Inspector General who put out some pretty salacious reports, you know, the misuse of, you know, the computers and all sorts of other salacious things. And, and the quality of life, the morale, the esprit de corps went down in a tremendous way. One of the things I called out when I was a commissioner, though, is that, in part, this was because of Dodd-Frank also, right? That if you think about the agency and how the agency typically works and should work, it should take whatever authority Congress has given it, faithfully implement it, not get crazy, trying to push the edges of it or not enforce it, right? If it's on the books, it should be enforced. And with Dodd-Frank, what you got in 2,319 pages were 400 regulatory mandates, 100 of the SEC, outsized number being sent to the SEC. And those who know the place, you know, from a rulemaking, policymaking perspective, no, that's 10 years worth of work. I remember when I came in at the end of 11 and said to the then chairman, this is 10 years worth of work. Why are we trying to meet to your, to your deadlines? Because they were chock full of one year, two year deadlines. Let's just be adult about this. Let's say it's impossible. And let's figure out what makes the most sense. What's most core to investors or, or efficient markets, or capital formation, what's most related to the crisis, right? Let's pick out these categories of things and rank, where we put these 100 mandates and then march off for the next 10 years, unless Donald Trump wins. I said that in 2011. I didn't. And, you know, let's, let's do it that way. And we didn't. It was the scattershot nonsense of conflict minerals here and one derivatives rule there. And it just is a total mess. And so here we sit with the third of the mandates left to do. So as predicted, right? Seven years later, a third left to do. So it was a 10 year track. And the staff and the morale of the staff who were mandated by Congress, right, to do these things that quite frankly, they might not do otherwise, they might not want to do. It's believe me, it's a mixed bag, some of the stuff like some of it. But, you know, when you're in the division of corporation finance, and you administer these programs on corporate disclosure, and you view that as sacrosanct, right? Let's make sure that these companies disclose what's material to investors. And then you get a mandate from a bunch of people who don't know the securities laws to disclose the use of conflict minerals from the Congo and have an audit program, you're not happy about that. Because you wouldn't do it yourself. It's been forced upon you. It's a heck of a lot of work. You have angry commissioners like Gallagher, you know, yelling dissents, you know, from the dais about it, you're getting mocked in the newspaper, you know, makes you look unserious. And I think that ties directly into the morale issues. And so I don't believe, we can say as a general matter, the staff bought into the last eight years. And so, bringing it again full circle, I think Jay is going to be able to tap in to a reservoir of goodwill, a reservoir of pent up ambitions of the staff who've been told for eight years by folks out in the market, this program doesn't work. This interpretation is silly. The markets have evolved around here. The staff gets that oftentimes. But guess what? They were doing conflict minerals. They can't update, you know, their own program. They can't be introspective about shareholder proposals when, you know, they're busy doing extractive resources the second time. Right. So I think it's going to be a positive thing by way of agenda. I would expect and and hope this is just me looking from the outside. Jay in the new commission, they're going to have to deal with how do you fix a lot of the bad stuff from the last eight years, call it deregulation, call it what you will, right? I think it's fixing bad things. That's how I say. So that's one bucket. How do you deal with the unimplemented mandates? The one third left you, you know, what's your congressional strategy? Do you actually do the rules because it's the law of the land but do them in a way that's least harmful? Do you let them sit? There's a whole strategy there. And then I think you have a positive agenda, right? And he'll have a positive agenda. And I wouldn't be surprised to your point if it because of his background and because of what you've been hearing out of the administration on the economy and jobs, if it dealt with capital formation, right? A lot of pent up ideas, even after the Jobs Act, even after all these bills floating around the house, ideas to help in particular small, medium sized businesses raise capital. I wouldn't be surprised if that was a big focus along with equity market structure. And hopefully I would hope some fixed income market structure review. All righty. And to your credit, and I think to the credit of former commissioner Paraitis and former commissioner Gallagher, former commissioner Casey, I don't think I've ever read a dissent that didn't start with I want to thank the staff. I respect the staff. And I always thought that was a classy thing to do. And after that, it's on the policy basis. This stuff's crazy. This is the problem. I identify the problem not shy about it in the problem, but always respectful of staff. And I always admired that. So you've got a chapter on broker dealer regulation. I recommend it to everybody. It gives you the basics of broker dealer regulation. What's going on there boils down some complicated concepts and then talks about some ideas for the future of broker dealer regulation. What's one of the basics and what are your ideas in this chapter? I mean broker dealer regulation is as old as the agency. It's literally from the 34 act that you know and it's this idea from the New Deal Congress, but one I think that makes sense that if you're acting in the capacity of either a broker or dealer or both, if you're buying and selling securities for your own account or for someone else's, that's a really important function in this country. You're probably dealing with somebody's retirement assets. You're dealing with somebody's nest egg and there's a national interest in putting some protections around that. So not everybody's doing it, that if you're doing it you're capitalized, that you're being inspected by regulators and there's a fine balance. There can be too much of that, but it was this sort of 80 now three-year-old notion that what they saw in 1929 with the crash, you know, the abuses they saw in particular with respect to retail investors, you know, getting preyed upon by miscreants, required this registration status as a broker dealer. So the key to the whole regime is registration. You file a form BD, you register, you disclose some stuff, it's publicly available, you have, you know, ownership, structure, disclosure to the regulators, you have disciplinary history, disclosure to investors and others. It's a very basic measure of transparency. Then you get into what comes with registration and now you get into a FINRA rulebook that's this thick, an SEC rulebook, you know, that's this thick because, you know, FINRA oversees broker dealers, the SEC also oversees broker dealers, so you have this SRO federal government structure, which you know, people say, well, wasn't that enlightened of the New Deal Congress to think about self-regulation that's kind of, in my eyes, the core of self-regulation is very free market and should be. It wasn't really enlightened, it was their codification of the existing structure of the time. So they basically federalized what was happening. The exchanges were member clubs and they codified that structure and they put in regulatory requirements on that membership structure, so therefore the exchanges became SROs, they de-policed their members and the SEC got to police them. In 1938 there was this realization, my goodness, we've now regulated the exchanges and all their members, but there's this body of broker dealers out there called OTC brokers that have no regulation by the federal government, so they created section 15 cap A of the exchange act, the Maloney Act, it was the ability of an association of brokers to register as the National Association of Securities Dealers, NASD, to oversee these OTC brokers. NASD over 70 years evolved, it eventually merged with the regulatory arm of the New York Stock Exchange which was the primary exchange. SRO it's now called FINRA and you see FINRA and its rule books were controlling the day-to-day oversight of broker dealer activity, so within the rule books you have all sorts of things, a suitability rule that's been called deficient by many people who want a so called fiduciary rule, books and records requirements, I mean some very prescriptive measures in there, some too prescriptive, some principles based, but the day-to-day activities of broker dealers are intensely regulated and both by the SEC and by FINRA and there's still some vestigial regulatory functions by the exchanges, so we've gotten to a point I think over eight years where broker dealers are intensely and I think very well and efficiently regulated by both the federal government and the SROs, this contrasts, because I alluded to the fiduciary duty issue, this contrast to the advisor oversight program in 1940 Congress gave us the Advisors Act of 1940, it was meant to deal with a market that's very different than what investment advisors are today, it was mostly just these institutional advisors, a small little pool, now you get advisors and brokers doing kind of the same thing, they're advising individual customers and institutional customers on on investments, advisors are held to what they call what the Supreme Court found to be a fiduciary duty, this is supposed to be the greatest thing sent down by God, you know Moses and the tablets, the whole thing, the fiduciary duty is wonderful, cures cancer in case you're curious, and it's you know I'm supposed to be provocative here, it's fraud, so the notion is you always have to put client's interest first unless you disclose to them that you're not going to do that, that's the caveat, right? When you register as an advisor, you have your ADV, you can disclose all sorts of conflicts that otherwise would not be consistent with the fiduciary duty, don't get me wrong, I love it, it's a different option, it's a different way of providing advice, you pay by fees on assets under management as opposed to commissions, there should be as many options for investors as possible, but the notion that it's much more pure than broker oversight I think is a fallacy, on the advisor side, it's not free and on the advisor side you have three times as many advisors as you have broker dealers in the United States and no SROs, because when they created the advisors act in 1940 they did not create an SRO for advisors probably because there were only a couple of hundred at the time, so the federal government the SEC is the only direct regulator of advisors unless they're state registered also, so it's a great system but it should not be a, you know, this is a better channel type analysis, the brokers oftentimes seem to be the CD business, right, because you constantly see these enforcement cases being rolled out and you see the enforcement cases because there are examinations of them and because there are enforcement cases brought by both FINRA and the exchanges and you also get the SEC, so it seems like there's this parade of miscreants all the time and if it does it's because it's actively pleased you have a 50 percent exam coverage ratio there at least probably even more and on the advisor side you get 12 percent per year, so that's what I'm going to say I'm fiduciary for now, besides DOL rules dead, which is great, but this is the core of Broker Dealer, it's registration, transparency, examination and oversight. Broker Dealer regulation changed tremendously with the crisis because the six biggest brokers basically went away, right, we lost Lehman in the sale and Bear Stearns became JP Morgan and then Merrill of course went to B of A, you had Goldman and Morgan Stanley convert to bank holding companies and so the biggest change that I'll tee up for you I will sum up this at some point, the biggest change is that you now have the Fed as a bank regulator at the holding company level, regulating effectively broker dealers without the statutory authority to regulate them the commission retains that but with the authority to regulate the holding companies around them and if you can regulate the ecosystem you can regulate the subsidiary, so this is a massive tension it's you know look it dropped on the Fed's lap, not that they didn't go chasing it, not that they're gonna give it away, not that they're gonna give it away so I understand why they want to control something that they now have authority for but I will pause it to you, I think as I did in the chapter that the Fed is the wrong regulator for brokers for a whole bunch of reasons. I want to tease that out a little bit so historically the Fed has done capital regulation, broker dealer regulation includes a net capital rule it's a form of capital regulation they're done in different ways and they're done for different purposes broker dealers are not as highly levered they don't engage in maturity transformation the way banks do banks borrow short and lend long which is requires a whole different approach to capital regulation, bank regulators use more historical accounting numbers the SEC takes a more mark-to-market approach or the two approaches inherently just different does that feed into the problem of the Fed regulating the BHC there's a broker dealer underneath and the Fed uses that lever to effectively kind of push the SEC aside even though the SEC is better equipped to regulate broker dealers. Look I mean it's a philosophical divide and it should be right the there should be a theory I gave a whole speech on this when I was a commissioner I watched everybody fall asleep in front of me called the theories of capital but there should be a theory to any capital requirement it should never be more money just to have more money because it makes us feel better right because every penny you take by way of regulation and put into a capital reserve you take out of the American economy right you take away from that private enterprise for them to use in the markets to grow right for the benefit of all Americans and so you have to be very careful as a policymaker why am I doing this what what am I after here in the broker dealer world it's incredibly simple we want enough capital sitting there that when you take too much risk and when you fail we can pay the electric bill and the employees for a couple months while we give customers their assets back that's that's all it's about or another broker can come in and buy the assets and you can transfer it out it's a wind down measure of capital which horrifies bank regulators right because for them capital something wholly different it's a substantial enough cushion to keep the creditors and others away from taxpayers because you have a taxpayer backstop there is no taxpayer backstop on the broker dealer side and I'll tell you my sense is after the crisis that's what Americans want they want a system where big small medium who cares you take too much risk you fail you're done no more of this implicit guarantee no more bailouts and so I think there's virtue in the broker model I think there's things we saw during the crisis where we could fine tune it and tweak it don't get me wrong there are lessons learned but the notion especially now in the bank holding company space where you have you know Goldman Morgan Stanley is still massive broker dealers but but technically bank holding companies that we should be going out of our way to ensure that they have capital so that if they fail they don't go to the taxpayer as opposed to reverting to the SEC model I think is antithetical to where the American public wants to be right now so the philosophies are and should be totally different they've been blurred tremendously because of the crisis and we have to break free from it again and what you're getting out of policymakers the SEC you've gotten silence on these issues which is tragic right because it shouldn't be a turf fight it should be a battle of ideas our ideas better here and I've said this time and again and what you've gotten from the Fed in particular these conflicting messages out of various you know the New York Fed or or you know various governors here of we need more capital because we'll never bail out that broker dealer in that holding company and it needs to stand on its own so let's get more capital but it's more than you could ever require to wind it down or you're getting a different message that says we need to oversee brokers expressly because we know we're going to bail them out the next time this is I mean if you look at Tarillo Dudley comments and I have this in my speech that I was talking about they're just directly conflicting what are you going to do you're going to bail it out not and this this uncertainty of broker bailouts in particular bailouts generally but broker bailouts in particular is what drives bad policy we don't know if we're going to bail it out so let's let's require more capital here there let's require more margin here there let's just have only side pockets of money so the next time it hits the fan we can go digging around right and try to you know pretend we have it all figured out so sorry no that's good about that that's good and perhaps my solution is uh my fed rant a while yeah well perhaps part of the solution is a fed vice chair who has some experience of the sgc maybe that would be uh i have some candidates all not me uh yeah i know i think i think after first would be fantastic there you go yes i'll support that support that somebody's gonna have to edit the chapters to do that but um before we leave i want to talk about fennel the future of fennel there's some more appetite on the hill in fennel oversight um discussions about changing the sgc's relationship with fennel and you touch on that in the chapter one of the ideas that floats around is a cost benefit analysis requirement for quasi-sro's like fennel amsrb even fazby perhaps pcob um is that part of the solution and what else do you think is part of the right cocktail to increase the needle on the self aspect of self-regulatory organization at fennel so in the chapter you know i teed up up the issue which i talked about a couple times in the commission that there have been efforts over the years mostly because of scandal right if you look at the nasd there was the scandal in the mid 90s the soh's bandits scandal and they had an enforcement action brought against them by the sgc as part of the settlement they agreed to move the composition of their board to i think a majority independent board at the time and and make other changes that really began this process of the federal government dictating how sro's work right in dod frank you saw the msrb have a mandate by the congress to go to a majority independent board um and you know during the crisis and after the crisis you saw every regulator sro federal government everyone acting you know in a crazy way and so i think the attention that finra has drawn is in part because of member complaints right members are feeling more disenfranchised as they're playing less of a role maybe because of the board i think that you know there's been a it's been a heightened regulatory atmosphere so you get member complaints and i think it's been you know this blurring not not really with finra as much as on the exchange side of what does it mean to be a self-regulatory organization these exchanges have now this uh you know they've ip owed right so they used to be member organizations and now they're no longer member organization they're owned by public companies uh they have in large part outsourced their regulation of uh members to finra so they're kind of at this vestigial remnants of regulation but then they're not really regulators the way they used to be and i got i got yelled at by the nasdaq ceo for saying exactly that a couple weeks ago at a conference so i'll repeat it again you know it's it's you know a vestigial role finra because this has taken on more and more because of this evolution in the sro space and so you see them doing a lot more than what they set out to do in 1938 now i believe that a couple you know the chapter is now a year and a half old since i started writing it some good things have happened uh at finra i did i do tee up their 2013 cost benefit commitment which i mean they hired folks they committed to it they're doing cost benefit and they're doing it in a way i think that's me uh real and meaningful uh and in some ways i thought at the time even better than what the commission committed itself to in 2012 by way of cost benefit you've seen a change of leadership i think rick ketchum was actually a great guy but robert cook who's now the ceo came in six seven months ago maybe eight minutes ago and is on a listening toward he's trying to understand these member complaints and i think he's committed to you know not only listening but taking action based on what he's heard he's committed to being a real sro so i think that's very positive change and the one thing i saw when i was on the commission and i still worry about today is and now you see sort of bipartisan criticism of finra you know the letters coming from both sides and you know and they're here again we have a philosophical divide that we need to figure out it from what i've seen on the democrat side of the aisle there's this real belief in the federal government's the only place where this type of regulation should be done so that's i don't like finra because i think we should have those four thousand employees you know be nt eu members and work at the sec and you know uh that's where they should be on the republican side i think there's just been a little confusion because of the evolution of of sro what is it it it inherently at base a very free market way to oversee the markets right it's members overseeing themselves it's people with skin in the game why would you need cost benefit analysis if if a bunch of members were sitting around writing rules for themselves they have inherent skin in the game that is cost benefit right and so you know the republican side i spent a lot of time meeting with people saying careful right you you go in your bash finra you go in your bash the sro model and what you argue for what you lend yourself to is an argument that it should all be sent to the sec because what is done at finra needs to be done somewhere and if you're going to replicate in the federal government i think as a small government person that's not what we're looking for so i think it's this it's a the sro structures a victim right now of evolution we got to figure things out i think cooks the right guy to do it i'm actually very optimistic on all this that you know they get it you know that some of these perceived missteps like the cards proposal and other things that have you know come out over time you know they strayed from the core mission they're going to get back to it's overseeing brokers it's doing it well um and that's my hope i mean i personally think self-regulation is and should be a key component of our oversight forever i would like to see it on the advisor side because right now the alternative is as the number of advisors grow that the federal government has to grow to oversee and i don't think that's the right place to do it we only have a couple of minutes left you care about corporate governance i care about corporate governance i want to talk about that a little bit by the way i have a chapter in the book on corporate governance you should check it out um so today the business roundtable sent a letter to president trump and what surprised me was on their list of top five or ten things they want to see addressed aca clean waterways epa regs making the top 10 list was shareholder proposals they want to see reform and shareholder proposals that surprised me i mean i it would be on my top 10 list but surprised me it's on the brt's top 10 list that went to the president today um you've written about this he worked on this issue uh what do you see as possible in the near term that the an initiative the new chairman could take up to reform the shareholder prop proposal process make it a little bit more uh rational uh just to give folks a flavor if you read through shareholder proposals all you need is about two thousand dollars of shares to issue one and think about the worst comment you've ever seen on a blog that guy gets involved in the shareholder proposal process um or girl or girl yes right sure so what well how can we fix that and what what range of options are available in 14-8 that you would support to fix that yeah it would make uh my top one of one list if i was sending a list to the president this is a the disaster of a program it's uh this is the rule 14-8 that the sec administers it's meant to replicate your experience as a shareholder if you were to go to the annual meeting of a public company you can't be there so you go through the proxy process right um and as part of the proxy process share shareholders who get a certain amount of support for a proposal that they submit to the company get their proposals included in the proxy uh for a vote and there's a a weird kabuki dance that goes on where a shareholder sends a proposal the company tries to keep it out of the proxy because for a bunch of enumerated reasons in the rule they think it shouldn't be in there the staff at the end of the day has to decide what do we do with this because they're asked to give a no-action letter meaning yes you can exclude this from your proxy and we won't recommend enforcement action against you that's all they need if they get that the company's doing fine over the years the the policy direction on the shareholder proposals has veered tremendously off to a point where they're really the staff is not giving out these no-action letters you one can assume this pressure is coming from the chairman's office and that you saw things like the whole food's proposal on proxy access a couple years ago where the staff actually gave them the no-action letter and then the chairman's office pulled it back and ordered a review caused chaos uh in in the corporate community for folks who are going to rely on that no-action letter so I think if reform isn't made through a rule making through a revamp of how the program is administered at the sec then congress can and should take action there should be legislation to fix this because it's gotten completely out of control the two thousand dollars you point to has been a standard for decades I gave one speech where I went down to Tulane and gave this speech you know again putting everyone to sleep in the room almost myself talking about how we should raise the threshold you know to this percent I mean it's the most technical speech ever the the absolute blowback that I got from the Gadfly and other communities uh you know and the pension funds and the unions and how dare you suggest that someone should have five thousand dollars worth of stock instead of two thousand how dare you suggest that you just want to disenfranchise investors right yeah that's I come in every day thinking how am I going to disenfranchise investors today no what I want to do is make sure that companies aren't spending time and resources which are owned by the entire corpus of shareholders just to address the idiosyncratic views of a couple and there are usually things like should Walmart be able to sell ammunition for automatic rifles right that's that's a famous one to come up to third circuit isn't that part of Walmart's ordinary business which is a standard by which you could exclude that yes right we all know that well guess what that got all muddled up the third circuit in that opinion which you know put us on the right course actually said the sec process here is impenetrable right we this is just we can't figure this out how it's administered it needs to be totally revamp those subsequently and procedurally now is the time you have to though have a thick skin because I'll tell you if you google that speech and solve the letter I was the only commissioner that was getting letters that were cc to all of my colleagues on the commission I could why am I never a cc on someone else's letter why are they all getting cc'd on all my speeches and but if you went and read that too late speech you'd be bored of tears and then go my god this caused such an uproar and you can see there's so much passion so much religion about this that you can't touch it and everyone who says they want to go to touch it they think it gets attacked completely and withdraws it's been going on for decades and it's it's it's too late it's it's crazy I think it's actually referred to as the shareholder town hall provision which given the tenor of recent town halls is kind of an apt description that's exactly right so our time's up for the interview we're moving on to the Q&A session we've got my colleague Chad Reese from the Mercatus Center which all of my friends here from the hill should know Chad well he's our congressional affairs director for the for the financial markets working group at the Mercatus Center Chad's got an app where he's going to tell you about where you can email questions Chad that's right so Ben mentioned the Slido information you can see the code is hashtag reframing on the screen in front of you and I'll continue to ask questions but please feel free to continue to contribute questions as we as we go along I will start with one person who has a specific question about your chapter and asks that because many people in blame investment banks for the crisis your chapter suggests that the broker dealer regulation model works well you kind of teed this up when you discuss some of the challenges of the investment banks during the crisis can you discuss the discrepancy perhaps between there the seeming discrepancy so there's this public narrative that the investment banks cause the financial crisis which is a convenient one you know when you want to overlook decades of failed federal housing policy so you know it's easy to point to regulators and Wall Street which is what Dodd Frank does of course you know it wasn't perfect like I said the one failure that you can imagine in this program is called the Consolidated Supervised Entity Program CSE program which was a 2005 rulemaking of the SEC that allowed these big investment banks to come into a new voluntary holding company oversight program in exchange the SEC got to impose on them additional capital requirements examination requirements and the like their capital model changed to use the Basel standards like the banks they used modeling for the first time instead of the rigid grid of of haircuts there is a lure a myth out there that this program unleashed pent up regulatory capital allowed the banks to go buy more and more of these illiquid mortgage backed securities put them on their balance sheet rip off everybody in the process and then blow up then it's actually just factually not true I mean just the facts are not true the SEC has never done a good job of defending itself in this regard you know I tried my best here and there but by the time I got back as a commissioner it was too late the narrative was set that the SEC was an incompetent regulator of investment banks the narrative was codified in Dodd-Frank there's a provision in Dodd-Frank I can't remember it's got to be Title VI that allows any broker-dealer who wants to because of pressures from foreign regulators to come in and be regulated by the Fed at the holding company level I mean that to me was about as emblematic of the distrust and false narrative of SEC oversight as you can be and so I mean we had one I think it was Merrill or one of the major investment banks actually because of that CSE rule making had to had to put in extra capital so on on you know day T minus one they were holding 4.8 billion in excess net capital to get into the program you needed five so they actually had to pony up more capital to get into this program now and the other thing is you know this notion that the investment banks were out you know ripping everybody off and look don't get me wrong there were stupid business practices there were stupid quotes like we're gonna keep dancing and till the punch bowls pulled away you know all this sort of stuff there was excess and whenever there's a bubble you're gonna see excess and also whenever there's a bubble there's usually a federal government standing behind it causing it right monetary policy failed housing policy and so but the notion that these investment banks would go load up their balance sheets full of things that were so awful right and they're eating their own cooking that's what took them down they had massively illiquid securities that became valueless when the rating agencies took them from AAA you know to triple D and it just doesn't make business sense if that's the intent let's go rip everybody off so I'm not saying it was perfect I'm telling you that the narrative is a lot more nuanced right the narrative is wrong because the story is a lot more nuanced if you looked at Andrew Lowe at MIT actually wrote a really good piece not too long after the crisis talking about fallacies of the crisis and this is one of them that the CSE program caused the the crisis this reminds me of the narrative behind Gramleys-Bliley and the Volcker Rule which is a similar narrative trading must have been riskier than making loans even though making loans took some banks took some huge banks down in 08 traditional bread and butter commercial banks yeah yeah the narratives are so much easier than the facts so you mentioned Basel then you mentioned capital requirements before and you just mentioned liquidity as well so this this question is more straightforward has market liquidity declined as a result of post-crisis capital regulation yeah dramatically and you only need to look at simple metrics the corporate debt market in particular right the issuances have been massively up ever since you know zero percent interest rates started so from 08 forward you had trillion dollar plus issuances on the corporate debt side where was it going right it was going into big asset managers right so there's a lot of buy there hasn't been a lot of sell pressure but when rates go up you're going to see it and if you look at the markets if you look at the balance sheets of the big dealers who used to provide liquidity in those markets who used to be willing to hold themselves out as a dealer I will buy and sell for my own account I'll buy from yours and they're not there anymore that their inventories are down 85 percent so what we haven't seen and I got massive trouble on this one with CNBC and you know you know by by saying this is going to be like you know a tsunami this is going to be a total you know disaster especially for the retail investor if rates go up and there's sell pressure you're actually going to see principal reduction whether it be on the corporate debt side or in the muni side and these markets are massive these are like 12 trillion dollar markets on the corporate side four trillion dollar market on the muni side 70 percent retail participation in the muni markets 40 percent on corporates you know and the Fed sits there and says I did this whole thing at the Library of Congress before I left the commission Congressman Neugebauer had a liquidity round table and they would not admit that the Volcker rule and the Basel standards and CKAR and all this other nonsense had reduced liquidity you know it's the first step of healing is admitting you know that you've caused the problem they wouldn't do it and then you just saw the recent Fed study by the staff that came out and said yeah it is impacting liquidity but it defies logic you know that to sit there and say with a straight face no no everything everything's fine you know this is just prudent internal risk management standards by the banks they're the ones that pulled out it's interesting when Chair Yellen was asked about this recent Fed liquidity study on Volcker Dino's here he remembers it when the Fed gets asked a question about about a staff study where it likes the conclusion it's it calls it a Fed study but when it doesn't it it says oh well that's it's only a staff study a rogue study a rogue must be a rogue staff so I raised this issue in 2012 in a in a speech should have seen that push back that was pretty fun saying this is pretty pretty bad we're seeing a trend now liquidity is down and these rules are up and you know the push back was pretty massive I think we have time for one more you had mentioned the jobs act briefly so this question is capital formation has been a bipartisan issue at least in part for congress in the last few years what still needs to be done and is the ball in congresses or the SEC's court right now lot I mean I don't have enough time for you know that's another speech I gave it heritage whatever happened to facilitating capital formation which is a pretty long litany of things that can be done so I'm not hard getting no fees by hawking my old speeches to you guys but I would take a look at that one you know everything that was done in the jobs act but for one or two small things could have been done organically by the commission you know should have been done right the the elimination of the prohibition on general solicitation title two of jobs act that had been kicking around the SEC for 27 years and we had talked about it before the jobs act let's just do it corp fin even in that highly regulatory state 2012 2013 we talked about doing this and then said oh no you know I can't do that congress comes in and makes you do it the the the organic current statutory authority of the commission to do these things because of the exemptive authority that was granted in 96 because of the ability to interpret the statutes it's massive and so there are so many things that can be done so many things that will be done and if the commission doesn't move quickly enough I'm pretty sure you're going to see these bills that have been floating around the house become law because you're whoever asked the question is right this amongst yeah all other things should be bipartisan and then this is you know one little points going to make me sound very conciliatory here at the end before I head off to CPAC the things that need to be done this goes to your Jake Clayton question the things that need to be done in the next four years need to be things that are made to last this is the challenge right DOL fiduciary rule is going to die God bless America that's fantastic right but there's still an impetus there what what caused this drive towards the standard you know what what in that impetus is real what's followed it needs to be an investigation and quite frankly there's where there's smoke there's right there are issues there were abuses in IRA rollovers there's a lack of transparency on fees that brokers charge and when people feel like they don't know what they're paying they feel like they're getting screwed pardon my French right and when you feel like you're getting screwed you're always going to have is some anxiety about that relationship and so the the industry the SEC Finner they everyone's got to get together and say what was this all about this is I'm using fiduciaries an example and let's try to take some steps to to address those issues it even in lieu of this DOL rule let's hope that we can get broad support for this so that in four years if Bernie Sanders is coming in as president that he doesn't go and do DOL squared right let's let's do some things at last this is going to be the real challenge you have to get bipartisan support for things I argue this all the time when I was losing partisan votes and I lost more than most almost anybody I guess people who might beat me but his his reign is over his reign of losing is over wasn't as long as mine but you know you sit there and you you make these arguments you dissent you say you guys you can't if you want to build this thing to last whether it's a conflict minerals rule or or a pay ratio rule you got to get buy in you got to get consensus it's why Sarbanes actually is still around and Dodd Frank is heading for the chopping block and so you know it sounds overly conciliatory believe me I'd be you know the first that would want to dance on the grave of a whole bunch of these rules but the everyone's got to take a step back take a deep breath we're far enough away from the crisis and all this to just say how can we work together on so many of these things especially capital formation to do these things like the job deck that are that are going to last and what's your perspective on it seems the small business advisory committee the SEC has been a tremendous well spring of ideas sort of how regulations should work what's your perspective when working with that advisory commission well so now you know Obama one of his last acts as president was to sign the legislation to formalize by statute the office of the small business advocate and the committee so just like the investor advocate that was created by Dodd Frank and the investor advisory committee you now have a small business advocate role full time position and a committee that's created by statute whose reports we're going to go over to Congress I mean that's this this committee was at the small kids or the little kids table for far too long and now it's it's at the adult table and it's going to have to be taken seriously I think this current commission the J in particular is going to take it seriously so if you look at those ideas go pull all of their old reports for last 10 years they're great ideas venture exchanges and all these things that actually ended up in the jobs act these are smart people right that just want to do good by the small business community had great ideas and you know you know we're given lip service for far too long yeah yeah thanks for your great ideas now we're going to go do conflict minerals we'll be right back crazy all right please join me in thanking Commissioner Galler for a great interview thank you transition right into our next panel we want to do our best to delve a little bit deeper in this next segment into some of the chapters that are in the book we have three experts and panelists we're going to be joining us Justin Sharton is going to lead this discussion Justin is the director of their financial regulatory reform initiative at the bi-partisan policy center prior to joining BPC in January January 2013 he served as a senior policy advisor to former Senator Kent Conrad with that I'd like to invite the panelists to come up appreciate you all coming to this event to discuss an important book and I'm honored to be asked to moderate this panel with three distinguished colleagues when I do these panels I found when you're at a bi-partisan think tag sometimes you're the furthest right person on the panel sometimes you're the furthest left and today I'm a flaming lefty so I maybe challenge some of the the issues in the book and some of the questions you have in the book and hopefully we have a good discussion I think we're in a situation now where I would think most of the people in this room are surprised at the results of the election and I think the current president is probably was surprised as well and we go from a situation where we had Dodd-Frank in 2010 and since then it's been almost exclusively regulatory action as to what's happening on the Finrag side Congress has passed very little in terms of updating Dodd-Frank even though there's been a lot of debate around it and now we go to a situation where there's a lot that could potentially happen and I think everything else is on the table and it's a very good time to have for this book to come out to really get into some of the high-level details and all or the high-level views as to how the finance the financial system should be regulated and gets into the sum of the details as well. So maybe I could start with you Hester since you and Ben edited the book could you maybe just tell us a little bit about how the you came up with the idea for the book and what you and it's intended purposes. Sure. Thanks Justin. So we approached this and said all right we have identified lots of problems with the existing financial regulatory system but what kinds of things would we like to see in a new financial regulatory system. And so we decided that the best way to go about this was to to go out and look for people that we respected to write on these issues and what we asked them to do is identify a problem that you see in the existing regulatory structure and tell us what market-based alternative to that problem would would solution to that problem would be. And so that's what we have in this book and so we cover lots of different areas obviously there's much more that we could have talked about but at I think 500 pages we thought the book was was going to be long enough as is but so in addition to the folks you're going to hear from on this panel and you heard from J.W. Verrett and Dan Gallagher on the last panel they're two authors we also have a couple other authors here Steph Miller has a chapter on bank capital and we have Garrett Jones I believe is here as well who has a chapter who suggests he suggests in that chapter some ways to to plan ahead for crises he says it's all well and good to be laissez-faire before a crisis happens but during a crisis you might not be so laissez-faire so he he suggests some practical ways to deal with that problem and so the book covers a wide range of topics and and our hope was just to get a conversation going as Justin alluded to our ideas are somewhat controversial and and we intend for them to be controversial drawing on people's experiences looking back at history and looking back for some good ideas in history and trying to put out there some ideas that we can debate and say did we really get it right when we picked a regulatory a system that's really focused on regulators making decisions could we instead have a system that's based on on market participants making decisions and that's what we're trying to get out in the book great so I and I didn't agree with everything in the book but that's the way it's supposed to be but I found it all well written and well reasoned and thought provoking so let's let's talk a little bit about what each of you wrote individually Hester your chapter is rethinking the swaps clearing mandate my initiative a couple of years ago we did a paper on systemic risk we got former comptroller John Dugan former undersecretary the treasury Peter Fisher and a long time FDIC an attorney Chuck Mockenfuss together to see what do they want to say about systemic risk and to do that they said well let's do a survey where we'll send key policymakers academics and just people who know this stuff an informal survey we'll ask them what what of the Dodd-Frank and post-crisis provisions have been best at addressing systemic risk and which one has been most problematic so this is non-scientific by any means but the top three that they thought at the time were decreased systemic risk we're we're stress testing higher capital requirements and the derivative is exchange and clearing so your chapter essentially argues that they're they're wrong about that last one could you explain a little bit why sure I think that they like a lot of people have gotten caught up in this narrative that the financial crisis was a result of massive failures related to derivatives and people point poster child AIG and they say look AIG was was brought down by derivatives which is sort of an aside but that wasn't all of what was going on at AIG there was another major problem related to securities lending but putting the narrative aside derivatives were not deregulated before the crisis that the bank regulators did have insight into what the big dealers were doing because the big dealers were banks and so there was a window into what was going on in the derivatives market could the regulators have had better information absolutely and that's one of the things that I argue in my chapter you know transparency is one thing and having the regulators have a view of what's going on in the market is one thing but to try to remake the whole market was very ambitious and I think very misguided so the the thing that bothers me the most about it is that we we took this idea of central clearing which is a great idea and markets already voluntarily centrally clear a lot of things so you have a transaction in the two sides to the transaction take that transaction to a clearing house and the clearing house then becomes counter-party to both sides so instead of worrying about your counterparty failing during the length of that contract you you know that the clearing house is a pretty safe place so that's a that's a nice concept but what Dodd-Frank did is is it mandated that these contracts be centrally cleared and a lot of contracts just don't lend themselves well to central clearing so that's one problem the other problem is that a lot of these are very complicated and the dealers in these markets know these products very well so now what you've said is you've said okay we're shifting this all to a clearing house which then has to manage the risk for the life of the contract and so what some people at the time of Dodd-Frank were saying is whoa you know clearing houses are not a way of eliminating risk you transfer risk to the clearing house and then the clearing house is this big institution with lots of risk and so that's my concern and that the worry is that something is going to happen to one of these clearing houses and because of the interconnections these clearing houses have if there's a problem at a clearing house it could easily spread to the rest of the financial system so you can imagine a large derivatives deal are failing and it has a lot of interaction with the clearing house so it defaults and it can't meet its obligations to the clearing house but clearing houses have to make they've got to make payments all the time to their counter parties and so if they're not getting money in from the deal the defaulting dealer they've got to deal with that problem clearing houses are well organized to do that when you let them run themselves when it's members running themselves they police one another but what we've basically done is we've turned this into an extremely regulator-centric thing where again the regulators are saying this stuff has to be cleared and then the regulators are trying to figure out how the risk management should work at clearing houses and so you end up with all kinds of very strange incentives that I think ultimately could make it light more likely that a clearing house would fail and I think given the idea that the government is standing there probably to back it up because after all it was the government that said these clearing houses had to clear all this stuff so if there's a problem the clearing houses are going to say to the government well you created the problem and so now you have to fix the problem and that sounds to me like a taxpayer bailout so there is you mentioned complexity and transparency and there was you know I think the criticism mostly focuses on things like CDS over the counter derivatives where there was a lot more opacity it's not interest rate derivatives and things like that that were the problem where most of the derivatives were traded so I guess one question would be do these derivatives need to be that complex you know if the market wants them in certain cases there may be some advantages to them but if there is that opacity that goes with them and you don't know what's in them and you can't always tell the prices is it worth the trade-off if that's a fair question yeah I mean I think that's probably not a decision that I can make or that a regulator a regulator can make the market has to decide whether they need these products to hedge their risk and so you know if you have the understanding that if there's a problem with the product it's not going to be the government who comes to your rescue but you've got to deal with the problem with the fallout of that you might end up with less complex products because maybe no one's going to want to write a derivative if they know that they're not going to have that government backstop so I would say one of the beauties of the over-the-counter market is that you can really tailor the products to a very specific risk a company is trying to manage and we've lost a little bit of that when we really encourage the standardization I mean the futures markets are wonderful and they've been there for these standardized products and that's what we like interest rate derivatives standardized interest rate derivatives wonderful they serve a purpose but what if a company has a very specific time frame that it needs to hedge your risk or a very specific risk there's nothing wrong with a dealer going to that working with that company to develop a product that's very specifically tailored for that company one of the things that the financial choice act does and we don't have the new version but I think most people expect it to be similar is that it would repeal CIFI designations including for clearing out this financial market utilities do you could you maybe talk a bit about what you're you did already but it's more extensively about what you're proposing as an alternative but if congress does not take up your alternative what you think would be a better system and all they do is get rid of FMU designations is that the right way to do it or does that leave us with a situation where we really don't have a backstop as imperfect as it might be yes so my proposal is to say let's focus on getting the record keeping and reporting right and let's have principles based regulation of these clearing houses which is how they were the CFTC typically or historically has used principles based regulation I would say let's get back to that and then we can and and eliminate any any sense that you're going to have a government backstop so title eight was a reaction to title seven of Dodd-Frank title seven is the one that puts in the derivatives clearing mandate and the exchange trading mandate or exchange like trading mandate so title eight was the Fed coming and saying if you're if you're creating these clearing houses the Fed had an understanding that there could be a problem so we need a heightened regulatory regime and that's where now you can get clearing houses designated under title eight and they have a a heightened regulatory regime and they have access to some Fed account services emergency lending and so that the idea of taking away the designation raises some fair concerns but I would say that as with any designation that creates more problems than it solves it it definitely creates an expectation of government seal approval which is not what we want to have and it also opens up the possibility that we're going to have some kind of emergency lending which is a conversation we can have but my argument would be that whenever you get rid of designations you're taking a step forward to telling the market there is no guarantee implicit explicit or anything so I would say we're going to be ahead of the game and also because there's so much emphasis now on clearing regulators have been putting more resources into stress testing clearing houses and looking at their rule books and that's not going to change because they they realize that there is a potential clearing houses that are a potential source of problems so I think you wouldn't lose that regulatory oversight even if you took title aid away I will mention in that survey that I set up the top the thing that they were least enamored of was taking away the regulatory discretion from the Fed and the FDIC which you're alluding to there so I know they would just you would disagree Thomas let's move on to you and I mentioned on the phone I like to if possible when I'm doing these things to try to find some sort of weird connection between where I'm from Fargo, North Dakota and the people that I'm talking about and in our case it's when I was a kid North Dakota State Bison which just won six national championships had another string of almost had four net straight national championships in the 80s and the one loss was to Troy on a last second field goal 18 to 17 and I don't know that you had anything to do with that but it's as tenuous a connection as I can come up with so he's got a good football program he too so I think we're going to touch on some themes we've already touched on here and then runs throughout the book which is that the crisis brought the ideas of systemic risk and moral hazard really to the front those are terms that existed before but they were they're much more popular since then and this the debate since then has been how best to address them and I think both sides think that they're addressing they're probably more than two sides but everybody thinks that they're addressing these same issues like too big to fail in the right way how do you see deposit insurance as playing into that debate so yeah I think you're right that there's clearly more discussion of systemic risk and moral hazard I think there's been a sort of shift in focus because of the financial crisis away from only looking at individual firms and thinking about what is affecting the market as a whole you know in terms of systemic risk and so the type of systemic risk that we talk about in our chapter is moral hazard created by government deposit insurance so the chapter in the book is co-authored by myself and Christine Johnson and I should say that at the time that this was written I was the chief economist at the senate banking committee and Christine Johnson is still a staff member at the senate banking committee so these are our own opinions and not those of the senators or the committee and so we have this this chapter that is somewhat provocatively titled alternatives to the federal deposit insurance corporation and really we make a couple of recommendations or possibilities discuss some possibilities about reforming government deposit insurance and one of those is well we it could just go away and we might have private systems that replace it so it's really only you know one that is a true alternative the other ones might be considered really just reforms or ways to improve government deposit insurance and so the way that we the way that we think about this in the book is that we go through a literature review on the current research on deposit insurance and the impact on financial systems and then we take that research the findings of the research and consider okay well then how can we learn how can we learn from this research and potentially improve deposit insurance and I was surprised to find that reading through all of that insurance that literature there is a very strong conclusion that government deposit insurance increases bank failures and financial crises and that's something that most people do not expect I mean even most economists are would be really surprised if you told them yeah all the research on this says deposit insurance is basically a failure and that it increases bank failures like that's very surprising and so that's why in the paper or the chapter we go through a lot of the research and talk about all the different papers and we basically classify it into three different categories one is we look at what happened during the lifetime of the FDIC and we look at studies of the FDIC and other countries that generally find when you increase the level of deposit insurance coverage you get more bank failures and that seems weird it seems totally contrary to what we would expect from deposit insurance so so let me explain just for a second about why that happens so we have when we have deposit insurance we would normally think okay that's something that's going to protect banks and prevent bank failures because it prevents bank runs right so if you think all right the government is going to provide insurance for anyone if their bank fails the government's going to pay them right they don't lose all their money that they deposited in the bank the government is going to ensure their deposits and so yeah that that can be true clearly if we're going to have people don't have to worry about their deposits and their banks then when the bank's in trouble they don't have to run to the bank and take all their money out so it's it's likely that we're going to have fewer bank failures from bank runs and so on one hand deposit insurance we expect to decrease bank failures on the other hand it creates moral hazard and so because the bankers themselves know that the depositors aren't going to come run to the bank they know that they're not being carefully monitored in the types of risks they're taking so they have a little bit more leeway to kind of push the envelope and take more risk than they otherwise would they're not going to totally just gamble in a way they do have equity holders and the you know bank managers want to keep their jobs but they're going to take more risk on average and so we have to look in the real world and say all right in theory we can't tell whether banks are going to have more failures from fewer bank runs because of deposit insurance yeah banks are going to have fewer failures or banks are going to have more failures because of moral hazard and so it turns out that when we look at studies of the FDIC and other countries when they increase the level of deposit insurance they get more bank failures the second type of literature is when we look around the world at different systems of deposit insurance deposit insurance is implemented in a lot of different ways around the globe the US is one of the few countries where it's entirely run by the government most developed nations have some kind of private or semi-private system that they use and the studies that look at the different types of deposit insurance around the world universally find that countries with more government involvement in the deposit insurance program and higher levels of deposit insurance both experience more bank failures and more financial crises right so that's that's another way and then the third type of literature is historical in the United States so if you look back prior to the FDIC and the Federal Reserve at that time every state had a different system most of this is actually from before the Civil War because after the Civil War we had the national banking system and that made it a little bit harder to do state level programs but if we look before the Civil War and a little bit towards like right before the FDIC there's a big variety in the types of programs that are implemented at different states but the conclusion is generally the same states that have very strong state government deposit insurance programs have lots of bank failures and financial crises in states that don't have government programs what they end up doing is they have some kind of private alternative usually the banks are ensuring each other through some kind of banking association or clearing house where the banks have to be careful if they know another bank is going to fail they're going to be on the hook for that and so they charge higher rates that are more appropriate for the bank's level of risk they audit each other so that the other banks aren't taking too much risk and the conclusion is the same right those private programs are better at preventing bank failures than the government programs that deposit insurance and so that to me was a very surprising result in the literature I think most economists and most people would not know about that at all and so it's kind of important you know to me to make sure that that's really well known that there's there's a lot of evidence that shows that these government run programs cause bank failures they don't reduce bank failures well let me let me challenge that on the US history and see you know because I'll play devil's advocate here and say how I how I look at it through limited history I've seen the US had you know regular and severe banking crises throughout the 1800s up to the Great Depression a lot of them that were maybe almost as bad as the depression several of them that we don't remember in the 1800s and since then we've had basically zero bank runs there were a couple in the last financial crisis but they didn't spread really to the rest of the economy where the runs that you saw were really in the non-bank sector where they were money like instruments money markets mutual funds and other things short-term funding that was outside of deposit insurance that's where the runs occurred and so you know we've had two crises since the depression one was the SNL crisis one was the last one and it seems to me that deposit insurance played a role in the SNL crisis but was not the primary factor by any means and then the last one again it was it was more the runs in the non-bank sector so maybe you could respond to that narrative yes so I can but I basically disagree with almost all of that or at least I would say the historical evidence disagrees with almost all of that so if we look if we look back prior to the FDIC and the Federal Reserve okay so yes it's true that we had more bank runs at that time I don't know that they that those things led to bigger financial crises and I might be wrong about that but think about it like this if the argument is well prior to the FDIC banks were uninsured and that's the reason that we had more bank runs and bank failures well that's not true because of the evidence that I just talked about if we look prior to the FDIC some states had government systems some states had private systems the ones that had government systems had more bank failures and more bank runs yes on average there was a higher number of bank failures and bank runs but it's clearly not the case that because we did not have deposit insurance we had runs it's exactly the opposite of that where we did have government systems we had more bank runs so then you can ask okay well then what caused all these bank runs and bank failures during that period it was an issue that the banking system was fundamentally different we basically had no branch banking you couldn't if you had a bank you couldn't open branches in other states sometimes not even other counties sometimes unit banks where you were allowed to have one single branch so no diversification at all at that time okay and so if a bank if there's some kind of local problem in the in the community the banks are likely to fail okay the other thing about the economy in general at that time is that it was highly agricultural and so you were very likely to have localized shocks from crop failures or some kind of weather event that would cause a problem with the whole community and cause that community bank to fail and so you did it's true you had lots of individual bank failures because it was farming and because those banks were isolated and not allowed to branch and for that reason I think I don't know that they so I'm not positive about this but I don't think that the bank failures magnified into major financial crises I'm not sure that that's right the let's see the next one was the Great Depression okay so the Great Depression could be it could be the case that the that if we had deposit insurance during the Great Depression that we wouldn't have had as many bank runs I think the evidence is against that too so if we think about what caused the Great Depression kind of the standard story from economists is based off the Friedman and Schwartz study from 1963 the Monetary History of the United States where they find that the thing that really caused the Great Depression was that the Federal Reserve mismanaged the money supply and going into the 1930s they thought there was a lot of money in the economy they were using the real bills doctrine and some wrong economic theory but there wasn't enough money to go around and so the banks at that time had to hold gold reserves at the bank and they just didn't have enough and so they couldn't support the amount of economic activity and so because of the economic downturn at that time we start to see a lot of bank failures the Federal Reserve should have tried to step in and be a lender or a last resort but it didn't and so the Fed magnified the crisis because of that okay so we end up having all these bank failures 30, 30, 31 big time in 33 and then after that they stop in a lot of high school textbooks they say bank failure stopped because we put in deposit insurance that I think is not believed by a lot of economists I think what we what what economists say is well that doesn't seem to be to fit the evidence because the bank runs stopped and then months later we started deposit insurance how did it go back in time and prevent you know cause all these bank runs or prevent more bank runs really what it was is the bank holiday bank runs stopped after the bank holiday when FDR said we're going to close all the banks in the country and the ones that are insolvent they just don't reopen and so we had about 4,000 banks that closed because of that and never reopened and so after that yeah well we had deposit insurance but all the all the bad banks had already failed and gone out of business and so that seems to be the reason that that it stopped during the Great Depression you could still argue you could still argue well if we had had it before if we had started it earlier in 1929 then we would have had fewer bank failures during that time but that also is not consistent with the evidence because when we think about the types of failures that deposit insurance prevents there are two different types one is you could have a fundamental failure where the bank has made bad investments and it's going to fail anyway if people run on that bank that's about to fail the losses are pretty minor and so it's not as big of a deal but it's not the thing that deposit insurance prevents right if deposit if people don't run on that bank and it's going to fail anyway it's going to fail anyway right the type of the type of failures that deposit insurance prevents are the contagion type of runs where that you know in theory what happens is a bank fails and everyone thinks oh my god if that bank failed my bank could fail too and then everyone runs their bank and takes their money out and so that other bank fails even though it was solvent that could happen in theory but the studies that look at the Great Depression find that that's really not what happened okay there's there's a couple of studies on this the the best one probably is Calamirs and Mason and the AER which is the top journal of all of economics and they look at bank failures during the Great Depression and and they decide okay was there contagion or did these banks fail because they had made bad investments in their fundamental failures they find that they're all fundamental failures that there's almost no contagion therefore if we had had deposit insurance none of those runs would have been prevented or at least none of those failures would have been prevented they might have even been worse because with deposit insurance the bank has the incentive to take on a bunch of risk right before it's about to fail without deposit insurance it has the incentive to become safer if it's worried about a run I will agree with you on the monetary policy and lender of last resort at least I mean I'm saying I mean all those opinions are based on evidence you can look some of those citations are in the paper and other ones if you want to ask me I'll be glad to provide them and email me but I mean all those things are well documented in the literature all right the holly let's you go back to the capital market side with your chapter on high frequency trading or proprietary algorithm of trading I just could say and I think most people who have studied this at all know get most of their information from flash boys right so you know the the idea there is well why don't I just say can you tell us a bit about what your proposal is that would be different and whether you think that the book kind of gets its prescriptions for what should be done about high frequency trading right or wrong well first of all I think it's important to talk about what high frequency trading ends really and what it is is it's proprietary trading the market makers and the statistical arbitrage traders that have been around as long as there have been markets so what changed them from being called proprietary traders to being called high frequency traders well it was simply the algorithmic trading aspect of it the suddenly being able to trade at the microsecond level and that sounds really scary and because of that it became highly politicized and if you look at flash boys they like to blame it for a lot of things so the reality is algorithmic trading and my chapter does talk a little bit about proprietary algorithmic trading but it does talk about algorithmic trading more broadly have really improved markets they've improved of course they've narrowed bid-ask spreads which is an improved liquidity they have in many ways decreased volatility and so there are a lot of advantages to algorithmic trading but if you read flash boys it really seems like it's a very scary thing that you know there's going to be some if you read science fiction there's going to be some singularity in financial markets that's caused by algorithmic trading and in reality that's not the case because if you if you look at the causes of every major market event and I'm talking about things like the flash crash algorithmic algorithms and algorithmic trading still rely on humans they rely on humans to program the algorithms they rely on humans to select the appropriate algorithm at the appropriate time they rely on humans to enter orders they rely on humans to comply with regulation they have they always rely on humans and if you look at every market disrupting event and I do talk about these in the book you will find that there is some element of human error involved in each and every one of those events the algorithms did not suddenly develop a conscience and go out and and start making trading decisions on their own there has been a human error in every event so here's something we don't know in the marketplace what types of human errors are happening how often are they happening and how often for example do they happen and they're caught so there's not a major market disrupting event because most human error does not result in a major market disrupting event and so how do we learn about what are these human errors that are occurring in the marketplace and so one of the things I'm proposing is we need to develop some type of system a self-reporting system not for punitive means but to be able to understand how many human errors are happening when we're talking about algorithmic trading what are they what are their frequencies and once we have that information what can we cooperatively do to prevent it one example that I don't think I use in the book but you know there is a recent example where a programmer who was working on an algorithm removed a section of code that they said this doesn't look like we really need it in here I don't understand why it's here so they removed it and that particular piece of code was actually a regulatory compliance piece right and so now the company is out of compliance because they're not complying with the regulation well how many times do things like that happen and it gets caught and it gets fixed if we had some type of self-reporting system to a neutral third party much like the airline industry has for pilot error these types of procedures are also being adopted by the medical community like you know every time a doctor leaves a sponge in somebody they report it right and they figure out how many times this is happening and if it's happening regularly we if we have a pattern of this we need to take some cooperative measure to try to figure out how to prevent this and we don't have enough of this data in markets right now and we do have for example Reg SCI does have a self-reporting requirement for exchanges when technology errors occur but one of the problems with that is because it's it's regulated reporting it also becomes punitive right if I report you're going to come after me you're going to find me and I think that's a mistake because the incentives are wrong right if you are self if you are being asked to self-report and if you self-report I'm going to give you a fine there's a lot of disincentive to self-report so I'm not sure how accurate that reporting is and so what I would like to see is to be able to aggregate and analyze this data now my example of that computer code that went away that was specifically for regulatory compliance if that is happening in other places and we know this perhaps the industry can get together and say all right when our programmers code a section of code in an algorithm that is a regulatory compliance piece in the comments section we're going to put this code so that any programmer who goes to any other company and programs will know this is a regulatory compliance code and it is those types of things that we can do that will help us to disrupt some of these human errors and so we cannot forget about the human side of this whole algorithmic trading right that's basically what I'm saying fair enough so you know what it's been a little bit since I've read the book not your book but that was very recent very flash boys when I read and one of the things that stood out the most to me was using it as an HFT is an example of where the market is driving lots of innovation that is useless to society and you do deal with this a little bit in your book but you hear stories about where the I think it starts off where somebody's building a new trunk line across the country to directly link one part of the country to the other so they can save a few milliseconds or half a second off of trading times or people saying I want my server to be a few feet closer in the server facility to New York so that I have a slight advantage here isn't this an example of a market failure where you know we're spending a lot on innovation that doesn't help anybody out well I would disagree that it doesn't help anyone out first of all I think that's you know there have been a lot of enhancements in the market so for example in the past if I were trading against a proprietary algorithmic trader it would have that trade might have cost me 70 cents today it'll cost me a penny so that is in effect a benefit to the broader market and to retail traders not just to proprietary algorithmic traders it's algorithmic traders more broadly but the other issue here is you know we start talking about social optimality what we're really talking about is someone's normative value judgment about what market outcomes should be and really it's the the absence of that all knowing neutral third party who has all information past present and future who can tell us what the moment by moment or the long run socially optimal market outcome should be at any given time and so it's that ignorance that requires us to rely on markets in order to price securities and develop technology and all of this stuff and you know the markets don't care markets don't care if you're being a completely rational social social optimizer in your trading as long as you are doing making the best decisions based on the decisions that other people in the marketplace are making and so in that regard you're kind of moving toward a social whatever is socially optimal because you're all working toward that same same point all right I know we only have a couple minutes here I just wanted to ask a couple of general questions before we get to the Q&A from the audience you know I mentioned before that one of the themes that runs throughout the book is moral hazard versus regulation and what you know what how we should do those kinds of trade-offs and I often come back to that when I'm thinking about financial regulatory policies that any policy just about any policy involves trade-offs it's just on what side do you want to be on so doesn't a lot of the debate around financial regulatory policy now come down to whether you're more worried about government failures or market failures and if that's the case you know why should we be more concerned about government failures whoever wants to take that so I think yes we would worry about both of those things so government or private institution we're all individuals people have limited knowledge people you know make mistakes but what makes this systemic is when it affects all firms and not just your firm if individual firms make mistakes and they fail that's okay if the government makes mistake in policy that affects everyone right and so if we have if we have something that's going to tell banks or financial institutions which assets they have to buy which risk management practices they have to use if the regulator makes a mistake in those that's bad for everyone but as it is when the market does and it leads to a crisis when the market makes mistakes it's individuals at individual firms unless it's stomach unless it transmits to the rest of the market okay so when we look for problems economists look for what we call clusters of errors so if you see a lot of people making mistakes it's usually that some people got it right and some people got it wrong some people had you know mortgage back security some banks had too many some banks had too few and those are mistakes that individuals at a bank or individual banks separately or whatever they might make but if you see everyone make the same wrong decision that's weird that's probably a policy that caused that I mean what are the odds that everyone happens to make the same bad choice at the same time it's pretty unusual I mean it can happen but it's probably if everyone does the same thing it's probably because there was a policy that affected everyone and encouraged them to do or a culture I mean the culture is very much a factor in that and just what other people are doing that happens all the time as well but I don't know do you want to different places have different cultures yeah go ahead and I think what you're really talking about are negative externalities is what it sounds like to me I'm going to put my economist hat on here and start talking about things like negative externalities but if you are in a market-based system and you have negative externalities you can deal with those negative externalities on a on a one-off basis on an issues basis the problem is sometimes we get into a predicament where we're no longer operating in a market-based system so for example if you are creating regulatory policy that says you have to give mortgages to these people you would normally not give mortgages to and then it's okay we're going to let you transfer that risk back to the federal government we're okay with that the market is never going to correct that problem because it is not a market-based system to begin with I would add to that something like healthcare right how do we control why doesn't the market control healthcare costs the market does not control healthcare costs because it is not a market-based system it is a third-party payer system and third-party payer systems usually see increases in demand and increases in cost and so it's not a market-based system so the market is not going to correct that so we have to we're going to talk about externalities we have to be talking about market-based systems and if we're in a truly market-based system we can deal with those on a one-off basis do you want to win? yeah no I would just say that there are both market failures and government failures but probably more government failures than market failures and so I think what you want to do is have simple rules in place that you can address the market failures with a set of simple rules which are harder than to game because it's the problem is that when you have these complicated rules then weird things start to happen and sort of like Thomas said then you need the economists to go in and say wait why are these weird things happening and often it will track back to a rule that the government has put in place so better to have simple rules that you know don't lead to those kind of consequences yes there are market failures but let's be honest about when it really is a market failure and when it's it stems from something else there's a question from the audience is what are the author's opinions on the administration's financial regulatory plan so we President Trump gave very little specific in his campaign about what he was going to do just dismantle Dodd-Frank in some capacity earlier this month there was an executive order that laid out seven core principles of how to regulate the financial system most of them are non-controversial it's everybody's trying to and too big to fail it's a question of specifics right and that's what it's going to come down to so do you think that the principles that he put forward were the right ones and what do you expect to see in the report that he's requested from Treasury in 120 days so I mean I was I think that the principles are a good start you can't come in and and set out a detailed plan until you figure out what's wrong so the idea of setting forth principles and the first principle I thought was very important making sure that people have choices about what they invest in and then going down the list things like you talked about ending too big to fail making sure that you're incorporating economic analysis these are all good basic principles to to bring in and so I think going from that we're going to see the agencies sitting down and thinking about what they can actually change to address those I think we'll see some things I'm hopeful that we'll see some things like trying to find those rules that are the the source of bigger problems throughout the financial system so as one example and something that the book touches on I'm hoping that there'll be a renewed focus on risk-based capital to see kind of the problems that that is causing in the system and I think that's that's the type of thing that we could see identified if this review is done in a really honest fashion Yeah I tend to agree with that I mean with both your statements on that actually I mean it is it is difficult to tell what what is really going to happen when Trump says something like let's repeal Dodd-Frank what does that really mean right because Dodd-Frank dedicated designated all these laws for the regulators to make and the rules you know eventually come out and so now it's covered all these different areas that would be very difficult to just say let's pull that back so in practice you know what will happen will we end up with a couple of the major pieces that stay and the bad things go I don't really know but I think something I think there are probably some positive indications of good things that could happen and I'm glad to see some of the topics that were that we've been discussing here and discussed in the book that are popular today I think one of them that is important to me is one that Hester just mentioned about the risk-based capital system of regulation and banking I think is is another area where where it's surprising to me that there's a lot of research that says that risk-based capital regulation has bad problems that it I mean everyone knows it's very complicated and so it's difficult for smaller banks and so that's where a lot of the emphasis politically has been put but the academic research tends to find that it encourages banks to take more risk than they otherwise would have because regulators have a difficult time identifying what assets are actually risky and whatnot I'm sorry are you in favor of the 10% leverage ratio in the financial choice act yeah so I was going to say yeah so the fact that people are talking about that and putting forward some good alternatives where we could potentially get a system that is less complex and less onerous and try to maintain some of the safety and soundness of the financial system I think is is good the choice act is is something that is out there right now the Tom Honig at the FDIC you know is also another guy that's been vocally supporting simple rules rather than complex rules and I think there there are actually a lot of academics that believe that and I'm glad to see it's finally getting some traction and I think you know this issue using marginal costs marginal benefit analysis looking at first, second, third, fourth fifth order consequences of any policy that's put out there is important as far as things that I'd kind of like to see happen you know I think the Volcker rule has to go away I think it's going to be imperative for the survival of bond markets and I think that you know we look at things like Reg NMS the you know the protected quotes it probably needs to go away those are two things that probably need to happen pretty quickly let's talk a little bit about cost benefit analysis that you alluded to there it's the third principle essentially of the seven is that we need to do more of that and it's something that I've always struggled with because I like the idea in theory but I find it impossible to quantify the benefits of financial regulation how do you say that this regulation has an x percent chance of decrease or of preventing a future crisis and valuing that I think it's relatively easy to get the cost down at least of compliance costs so how do you do how do you do cost benefit in a way that kind of is able to balance both sides of that so I'm going to plug a paper that just came out from Mercatus I think it came out last week or the week before and it's by Steph Miller and he and Jim Barth from the University of Auburn Auburn University or I don't know which one is which I'm sure they're both anyway they have done a cost benefit analysis related to bank capital regulation actually and so I think that part of the reason that we wanted to do an analysis like this is to say there are a lot of critics who say financial regulation is the one area where we can't do economic analysis because the benefits are so hard to quantify and so they were able to say well let's let's actually try this out and they were able to look at how capital relates to crises so they look at at different levels of capital so I commend that to skeptics to as an example of how it can be done another way you can do that too is to look at just the cascading effects if I do this then what happens what does the market structure look like and then where are the incentives right where are the incentives what are what are the incentives in this new structure I think you can do a lot of analysis of incentive structures in the in the newly formed market to try to make some predictions about what might happen and that can help you understand what those second third fourth order consequences would be I mean ultimately economic analysis is just asking what's the problem we're trying to solve what are the alternatives what are the alternative solutions and then doing the best that you can do to figure out the costs and benefits of each of those alternatives yeah I I would say a couple of things so one thing you're right that it's difficult to quantify the benefits but on the other hand it's difficult to quantify the costs I mean economists are always worried about unseen costs and and we never know what would have happened in another scenario so it's tough but I think the the process of doing cost benefit analysis just the process itself is very helpful and so when when I was at Senate banking we talked with a bunch of different agencies about how they were doing it and who is doing what and Senator Shelby that was the chairman of the banking committee at the time has long been an advocate of cost benefit analysis and a lot of the agencies that we talked to said you know it was helpful just to think about this when we went into it we just assumed that we knew what the cost and benefits were and then we went out there and we studied the research we did some of our own studies and found actually there was a pretty clear solution to this or if we had multiple things that we were considering we were able to decide okay that one doesn't make any sense and we should just try to figure out which one of these is better and so I think even though it's definitely true that you will never be able to figure out precisely what the costs and benefits are doing some kind of quantitative analysis or rigorous thought about what are going to be where would we expect the true costs and benefits to be and how big are they I think just that exercise is pretty valuable I don't disagree I just want to mention that it occurs to me that that's the parallel of the argument in favor of living wills to have companies do that just going through the exercise is a big help but I don't want to dwell on that I just wanted to mention I should also plug a chapter in the book which deals with this issue the last chapter in the book is about how it can be done okay fair enough did you want to and I think the other issue too when you're trying to quantify some of these costs a lot of times you can look at similar regulations that have happened in other countries you know I talk about financial transaction taxes a bit in the book and we can look at some of the things there's good quantifiable data out there because we know what those changes were in other countries we know what the impacts were and we can find that got time for more I'm sorry go ahead with time for one more question we have two questions from the audience about Basel three one is you know what you expect from the administration to do on Basel and the other asking isn't Basel really more the problem than Dodd-Frank yeah so in some ways the the issue that I said about the complexity of capital regulations I mean it's really the Basel system that I'm that I'm talking about there and so there's a little bit of difficulty in separating those things because when the regulators write a new regulation that's related to capital even though a lot of times they can do that under their own regulatory authority they also say well it's motivated by some part of Dodd-Frank or something like that so so drawing a clear distinction between those is not always possible but yes a lot of the things that come out of of Basel the complexity the poor incentives for regulators are what I see is potentially the biggest problem in banking regulation right now well okay what was the first question that you had just what do you expect the administration to do on Basel one of their principles was dealing with international so clearly I think Basel is not the only instance where we're seeing agreements made overseas and then being imported back here and and put into rules so I think we're going to see push back across the board on those on those international attempts to decide what regulation will be in the US yeah so I would agree with that and especially since we see already pushback from the Europeans on Basel 3 so they're already considering are sorry on on Basel 4 and so that too it's like where do you draw the line some people want to call it Basel 4 some people are saying it's just an extension of Basel 3 the Europeans don't like some of the new programs that are coming out and so it's potential that they might defect and just decide we're not going to do some of this stuff if that happens then it gives the US regulators more of an ability to say yeah there were things that we weren't really comfortable before with either or that have turned out we thought they were a good idea and it turns out they're not to pull back on some of those things one area where that may already be happening is the complexity of Basel 3 that's been applied to small banks at Agrippa last year that is the Economic Growth and Paperwork Reduction Act that the regulators have to go back and look at some of their old regulations and see if there are things that they can repeal that was one of the major complaints by small banks we just can't do this level of complex forms that we have to fill out and it's crazy it's killing us and the regulators were actually receptive to that promised to shorten it and are doing short forms and so I think there is some turnaround and I hope that that will continue and I can tell you Basel I'm going to put in a plug for Mercatus here Basel really is one of those examples of some of the why you need a place like Mercatus you can talk about academic work and then talk about practical application of that academic work because Basel is like a it's like a great academic theory that has no practical application to me and so I think that's why we're doing some of the stuff we're doing here so read Arnold Klings chapter in our book which talks about Basel all right please join me in thanking the great panelists here today and again as you're on your way out please grab some of the papers and the table to the right in the back because I don't want to have to carry them back to the office thank you for staying the whole time we hope you enjoyed it