 Welcome to Free Thoughts from Libertarianism.org and the Cato Institute. I'm Aaron Ross Powell, editor of Libertarianism.org and a research fellow here at the Cato Institute. And I'm Trevor Burrus, a research fellow at the Cato Institute Center for Constitutional Studies. Today we're talking about financial regulation. We're joined by our colleague Mark A. Calabria, director of financial regulation studies at the Cato Institute. Mark, the specter of Wall Street makes a lot of people – it makes it – they're a little bit iffy about it. They're saying it. Wall Street versus Main Street makes people a little bit upset. And Libertarians get a little bit upset. Very, very upset about this stuff. And they read a lot of flak for supporting Wall Street and being against regulation. So I guess the first question is, are you against regulation and why do you want the billionaires to win? Because clearly they're such nice people. So it's true that rarely do you hear the term Wall Street uses anything but a pejorative. And certainly it's also used as a term for lots of things that aren't associated with Wall Street. And so I think there is often this perception that Wall Street is the Wild West untamed, lack of regulation, just greed let loose when it's worst form. And of course, as an economist and a libertarian, we get that most people are greedy in a world of scarcity. There's nothing really particularly un-greedy here that's more greedy than somewhere else. But it really is looked at in the same way that's just different. Even though we may look at actors and athletes making obscene amounts of money, nobody feels the same sort of anger toward you too that they feel toward Goldman Sachs. And so part of that I think is a feeling that you too, or Death Calf Recruity, or anybody that actors and athletes musicians, there's a sense that they earned that money fairly. There's a sense of they attracted fans, they paid their dues. Whereas there's really a sense that Wall Street is rigged, that the reason that there's so much wealth on Wall Street and so much money made is that it's stolen. And I think that that drives a lot of the animosity. There's always the tension of, well, is more regulation going to do any better? Let's set aside, certainly one of my great frustrations is when I hear people tell me that financial markets are unregulated. There's nobody who actually knows what they're talking about who thinks that. It could be about the quality of regulation. It could be whether you think there should be more or less regulation. And certainly what we'll talk about a little bit is whether you think this should be private sector versus public sector regulation. But we should be certainly clear that Wall Street is regulated. And also Wall Street tends to be a catch-all for anything in the financial system we don't like. For instance, Dodd-Frank, which was the financial reform passed in 2010 in response to the crisis, has a lot of new rules for what I would call Main Street lenders, paid lenders, check cashers. And of course it was all done under the we need to get Wall Street. So therefore this guy on the corner who has nothing to do with Wall Street gets regulated as well. And of course we have 7,000 banks in the United States, maybe 100 of them are arguably Wall Street related. The vast majority of them are not. And again, there is this sense that the game is rigged. I think it's also a degree to which most of what goes on on Wall Street is somewhat mysterious to most of us. I mean, we understand, maybe we put a little savings aside. Maybe we watch our stocks and we care what we're going on a little bit. But Wall Street uses a lot of terms, whether it's derivatives or in some cases Wall Street, I think, does themselves a disservice. Everybody does this in terms of picking terms that aren't very clear. Or they also just sound a little mischievous like dark pools or high-frequency trading. You might not be sure what those are, but they just don't sound good. And so Wall Street does a lot of that. But again, I suspect it's not any worse than most other professions in terms of things that were picked. And there's always a degree of envy. There's a bit of a lifestyle on Wall Street that – again, this is different by firm. I mean, several firms have always had an attitude of you be a little less ostentatious and other firms are you make a lot of money and you show it off and you throw money left and round. So I think there's also a degree to which for most of the American public, Wall Street is that thing way over there in New York. So it's so distant and it's so part of a big establishment that is against you. So why do we – I mean, I certainly run into this on occasion. Of course, I always scratch my head that after I get up and talk to people about why we should stop bailing out banks and then they tell me I'm a front for Wall Street. But all that said, because many libertarians myself included are very, very skeptical of government regulation, very skeptical of things like Dodd-Frank. We often get painted as Wall Street. And of course, that's also forgotten that Goldman Sachs came out and endorsed Dodd-Frank when it was passed. So again, there is this sense that you're only going to be opposing government involvement because you want to protect the industries involved rather than you oppose government involvement because that government involvement actually protects the industries involved. This is where I begin to maybe expose my profound ignorance on these matters by asking questions of this sort. But you said there are thousands of banks in the United States, but only what, 100 or so are Wall Street. What makes something Wall Street as opposed to a bank besides maybe it's just geography, it happens to actually be on Wall Street? So that's a great question and I appreciate you pushing me out so I can define this a little better. So what we tend to think of as Wall Street is really that you're directly involved in the capital markets. And I mean that in the sense of you're a broker-dealer and that you sell stock or you help exchange, you might be involved in the derivatives markets. So we think about, again, there are a little over 7,000 banks in the United States. Most of them are quite small, have a few locations. They take deposits from the local areas. They make loans, small business loans, mortgages. They don't really do anything all too fancy. It's cookie cutter. I mean despite the fact that many of them still continue to fail, it's fairly straightforward business and it's very much connected to the community. It is literally in many parts of the U.S. we still have a system where you would go down to the corner and put your money in MAPA, Independent Community Bank. MAPA, Independent Community Bank would gather that money and let you lend you money to make a mortgage or to start a business. And it's often money raised in that community stays in that community very transparent. It's a wonderful life lesson. Absolutely. Well, your money's not here. It's in Tom's house. Yeah, exactly. And that still exists to a lesser degree but it still exists out there. And there's also this sort of bias against Wall Street that, you know, another term that I feel should be relatively neutral but is used as a pejorative is speculation. You know, to me, I mean crossing the street is a speculative activity. You make it hit by a car. But there is this sense that if I make a loan for you to get a mortgage and buy a house that that's not speculation. That, you know, let's set aside whether you think processes are going to go up or down or whatever. It's generally looked at as well, that's the real economy. Whereas, you know, if you were buying a stock or buying a derivative, you know, that's looked at as speculation. So there is this sense that somehow Wall Street is gambling in a way that others are not. Of course, in my opinion, that distinction is completely artificial. But to get back to a more simple way of answering the question, most Wall Street banks, quote-unquote, do have some sort of physical presence in New York. Most of them are no longer actually on Wall Street but that's a different issue. They've just moved a few blocks over. They're in New York. They're tied to the capital markets directly. They're often internationally active. You know, a good measure is, you know, do they have a derivatives book? You know, for instance, 99% of banks don't have a derivatives book. You know, it's the bigger banks that are trading in that regard. And so, the thing that really separates Wall Street is whether you're essentially, in my opinion, doing underwriting or selling of publicly traded securities to me is probably a defining characteristic. And that's the capital markets in general as I described them. Now, we're going to even go back a little further here because we're going to ask what is a derivative just so we can be on the same page? So, a derivative is simply an instrument where the payoff is tied to some other instrument. Like, you know, if you and I bet on the outcome of the Super Bowl, you know, you and I aren't actually playing in the Super Bowl, but we're betting on the outcome of it. So, that bet is derived from the outcome of the Super Bowl. And it's the same thing on whether, you know, if I buy a pork belly future, I might not necessarily take possession of those pork bellies or deliver pork bellies, but the payoff is driven by the direction of the pork belly. So, it's quite simply an instrument whose value is derived from the movement of something more concrete. And of course, you can have derivatives of derivatives. It's also important to keep in mind because there's a lot of mystique around derivatives. Just like the Super Bowl bet, the net outcome is zero. Someone loses, someone gains. I bet $100, I lose, I pay you $100. There is no net loss. It's simply a transfer. And so, you often hear numbers thrown about like, you know, world derivative outstanding being like $600 trillion. That's what's called notational value. So, it adds up both sides of the trade without netting anything out. It's like saying, if I have a $100 bet with you on the Super Bowl, it's like saying it's a $200 bet. Well, no, it's $100 bet. And of course, again, the net is zero. So, the actual risk in the system from derivatives is zero in terms of loss wealth. The real question I think the concern about derivatives is often, you know, are people using them to hide losses or people using them to move losses? Are they being sold to people who don't understand them? And so, there's lots of questions about less the derivative than what the derivative is trying to do. And what are they trying to do? Because I'm trying – like, I can understand investing in a product, investing in a company, you know, buying the pork bellies and see if they go up, but – Or buying Apple stock. Right. But what – what do you – why would a bank do this? Why would anyone want to trade these things and then trade derivatives of derivatives that – I mean, the bet between us for the Super Bowl, we do it because it's fun. But to turn that into a financial instrument – They're not necessarily doing it for that reason. So, there's predominantly two reasons. Now, the overwhelming majority – and I really do mean, you know, we're approaching, you know, like, 90% of derivatives or interest rate swaps. And so, keep in mind, let's go back – Can you describe exactly what that would be? Okay. We're about to get into that. But so, let's start with our MAPA Independent Community Bank again. MAPA Independent Community Bank takes your money and deposits, and it pays you. Now, of course, in today's environment, it doesn't pay you anything on your deposits. But in a more normal interest rate environment, you get to pay it on your deposits. That rate, you know, is reset pretty regularly. And so, the bank then lends out that money for long-term assets. So, a mortgage could be as much as 30 years. Don't generalize that long. Even a small business loan is going to be 5, 7, 10 years, maybe. So, what the bank has done is it's borrowed very short-term and deposits, and it's lent very long-term for a fixed rate almost always. Now, the bank could decide that it's just going to lend adjustable rate and borrow adjustable rate, and that risk goes away. But that's for a variety of reasons you generally don't see that. So, in most situations, the situation facing the bank is that I have lent you a long-term money on your mortgage, let's say 5% for the sake of argument. I face the risk that if rates start going out from inflation or otherwise, I can be in a situation where I'm paying more to borrow than I am getting when I lend. And of course, that's what got the SNL savings loan industry. I mean, try to fan this. The entire savings loan industry, every single savings loan in the United States was insolvent in the late 1970s with interest rates. Their liabilities were bigger than their assets. Yep, because they had these mortgages for long-dated that were 4%, 5%, 6%, and they had to pay, you know, I think the federal funds rate in the early 1980s got into something like the overnight rate, which is a proxy for short-term rates. So, you literally had a situation where you had to pay 12%, 13%, 14% for money in which you were getting a return of 6%. Yeah, you're kind of bankrupt. And so, we really saw growth and derivatives market after that. So, interestingly enough, you really saw very little use of derivatives before Nixon took us off gold in 1971. And so, because you saw a lot more stability in currency markets, you saw a lot more stability in interest rate markets. But again, the overwhelming majority of derivatives used by banks are to hedge interest rate risk. So, that's one. The second one that gets talked about a lot are things that are called credit default swaps. So, keep in mind there are at least two basic risks in a loan. One is the interest rate risk that, you know, you get paid back less money than you lend out. The other part is you don't get paid back. And we think that... It's a default. Yes. So, you know, let's go back to our Super Bowl analogy for a second. Trevor and I make a bet on the Super Bowl. I win that bet. Hooray for me. However, let's say Trevor's a deadbeat. He doesn't want to pay me. Or Trevor goes bankrupt. Let's be generous. Or Trevor gets hit by a car or something, you know, after the game or something. So, let's say for whatever reason, despite the fact that I've won the bet, I'm not going to get paid. And that's a credit risk or a counterparty risk. And so, one of the things that really took a special interest during the financial crisis were these things called credit default swaps. And what a credit default swap is, it is a derivative where it's hedging a particular credit risk. It was an unusual, for instance, for a bank to buy lots of GM bonds and then buy a credit default swap so that if GM defaulted, it would get paid by somebody else on those bonds. So, let me sort this back. You buy a bunch of GM bonds, which have a risk to actually go under at some point. You could lose nothing. So, then you buy a different instrument on the other side, which is trying to keep that risk that you'll lose everything on the GM bonds. That sounds like an insurance plan. It is a way. And of course, there's a whole separate conversation of why don't we regulate these things like insurance. But so, one way to think about derivatives and since I'm with two lawyers, maybe I can sort of think about this is it's like your sticks and your bundle of rights. And it's really, if you think about it, anyone instrument has a variety of different sticks of different types of risk. And so, what derivatives allow you to do is pull out those different sticks and parse them out to whichever party is willing to bear that risk for the lowest cost. And so, you might say, I'll take that credit risk for X. I'll take that interest rate risk for X. So, of course, there are regulatory reasons. I mean, there's a whole different regulatory reason why banks loaded up on credit default swaps when they might not have. But the underlying fact about derivatives is they are a facilitator for you to essentially split instruments into finer and finer pieces of risk and diversify those risks to various parties. And to me, I think that overall they are very positive development. So, let's go back to the big picture then because people might be saying, well, how do the financial markets then help the economy? They can understand the house. So, the first one would be unless you want to pay all cash up front for everything you buy right now, you could never own a house, right? And that's a good thing if you like to own a house. Possibly. You could build one yourself. Or you could build one for yourself. So, they help you buy houses and then but anyone is going to lend you that money and the house is going to have a risk of losing that money. So, they want to have some sort of hedging themselves against that risk. But there's a lot of other things that these financial markets help do. They try and predict the future, right? Isn't that kind of what they're doing? So, you get to what I think is an important part and the way I think about the role of financial institutions is primarily this sort of inter-temporal exchange and almost in some sense an inter-temporal exchange. It's like charging things to future people and that for starters, most people kind of have a U-shaped earnings profile. You know, you don't make as much when you're 25 than is when you're 55. And so, in some ways, when everything works well, what the financial markets let you kind of do is your 25-year-old self-borrow from your 55-year-old self in so that either you could make those investments today or you can buy that house today or you can get that student loan today. And so, of course, what we're really doing is instead of you actually borrowing from your 55-year-old self, your 25-year-old self is borrowing from this other 55-year-old over here who stands in for you in a way. So, the role of financial institutions is on a very basic level to match savers and borrowers. And, you know, of course, you can have economies where there's, you know, a lack of one or the other, but it does allow you to borrow in a way that allows you to invest or allows you to even consume today. And increase your capital so if you want to start a business, if you want to do something, it allows you to find the person out there who has that money and then allows them to hedge against the risk that you're not going to make the money in the future and then everyone starts trading those risks with each other. Exactly. So, it allows them to be diversified. So, you could certainly, you know, for instance, and I'm very encouraging and optimistic about, you know, who is going to be relatively small because, okay, let's go back to this example and say, you know, rather than, you know, you're not going to be able to find the 55-year-old you because you can't go into the future, so the 25-year-old finds some other 55-year-old. He's just sort of touched upon. There's not a lot of diversification there. And many of these, and that's actually one of the things that... The 55-year-old gives you everything. He's highly risky. Oh, yeah. So, you know, so one of the ways to have all the 55-year-olds pulled their money together so they can lend all the 25-year-olds and that there does fault risk or somewhat, you know, estimatable, there's somewhat bearable. And of course, it's interesting because a lot of the newer sort of peer-to-peer online lending services have tried to find ways to diversify so that you don't get caught in this bilateral issue. But then you also get the problem of if you simply pulled, you know, 155-year-olds and they lent it to 125-year-olds, well, who's going to monitor the 25-year-olds? Who's going to make sure that, you know, they don't go spend all that money on beer and pizza? You know, of course, if they want to spend money on beer and pizza, that's fine, too, as long as they're... You know, the market would charge them a higher rate. And so what financial institutions have largely ended up doing is trying to serve that sort of monitoring role. So they screen borrowers. That's a big thing that they're supposed to do is try to be the expert. You know, and this is really one of the biggest changes we've seen in the financial markets. Prior, let's go back to that Jimmy Stewart world you mentioned, prior to, like, the 1980s, lending really was done a lot on a face-to-face basis. And so you certainly saw, you know, you looked at credit ratios, you looked at people's ability to pay, but a really big part. And if you go back and look at textbooks on lending and real estate and such from the 60s, 70s or even earlier, there's always something mentioned called character. You know, and so what really you got to be good at as a lender that distinguished you is you had a really good get sense of, is this guy across the table going to pay me back or not? And that kind of sounds kind of glib, but it really is that sort of tacit knowledge of time and place that would made a good lender. And to me, I think we've lost a lot of that in our financial system. But the underlying point is that a very big part in addition to matching borrowers and savers is that financial institutions monitor and discipline both sides of that equation. So it really is a division of labor in the marketplace. And that seems like how we create competition in that which goes back to this question of market regulation versus government regulation. Well, before we get to what the government does about this or the ways the government can muck it up, I'm curious, I mean, the picture that you've given seems pretty okay in the sense that like so these financial institutions are helping people who need money to borrow by spreading out the risk and facilitating lending and all that sounds great, but we're constantly hearing about lots of bad behavior by these institutions. So how does bad behavior fit into this or what does bad behavior look like in this picture? And so let's try to separate out the bad micro behavior from the bad macro behavior. And we'll get to the bad macro behavior later. So the bad micro behavior would simply be fraud. So for starters, financial institutions deal primarily in cash. Or some sort of transaction. And so if you can contrast that to you're working in a factory, you're working in a tractor factory in Indiana somewhere, you'd like to steal from the factory. What are you going to do? Lockout with the tractor? I mean, maybe you could. But my point being is that one of the reasons that financial institutions have been more fraud-prone embezzlement-prone is because the assets in which they deal with are so much more fungible than any other industry. And I could just change something on a computer. You don't have to walk out with a tractor. Exactly. That's all you need to do now. And so it's just what they deal in is so much easier. And of course, I think actually the computer part will make it over the long run harder because you'll be able to trace things easier than when it was all cash. And so that's part of it. Now part of it, of course, is that you have lots of bad behavior in the part of borrowers. And so it certainly should be kept in mind that bad behavior cuts across the spectrum here. I think you've also had, and we'll get into this a little bit more later, I think you've had more bad behavior in the financial services industry because of the regulatory barriers to entry. It's very hard to start a new trading firm with a new idea for how to do things better. Absolutely. So entry is very difficult. And so historically the way you've gotten around these issues before the imposition of government is you had to build up a reputation. You had to have some sort of credit comes from the drive from the line word for trust basically. And so you have to develop that reputation. You often would have to put your own money in. So early bankers often put most of their own money in. While the typical commercial bank today is leveraged 10 to 1, which means that for every dollar of equity, the owner's own money, there's another 10 there, of debt, the traditional early banking system was far more equity driven. It was far more your money at risk. And of course part of this also grew out of, a lot of banking grew out of this sort of store housing of gold and other precious minerals and goods. But again, you had to develop that sort of trust. And again, that to me is a big part of it. But underlying reason, I don't think it's that what is inherently the problem for attracting fraud is just because the asset and liabilities are so fungible. So let's go back to the beginning. Now that we have some sort of at least okay grip on maybe what's going on here. Let's go back to, by the beginning, I don't necessarily mean the fatimony. The fat I'd rather avoid to not get into monetary policy. I mean, we'll come up a little bit. But at least for financial regulation itself, we're really, let's go back to SEC and maybe the FDIC and the way that you see the story for how markets, market regulation maybe worked and then the SEC and different entities came in. So the SEC was first, I think, at 34, maybe at the same time, 33 and 34. And we can actually, so it's certainly worth pointing out to that just as we don't have a free market in banking and finance today, we've never actually had a free market in banking and finance in the United States. And so very early on, after the founding of our republic, you had many banks were set up by states. You for a very long time had entry restrictions. So it's been a very highly regulated industry since day one, essentially, in the United States. Now because of that, going into the Great Depression, you had a very large number, thousands and thousands of bank failures. Actually, many of these were even before 1929 because you had the housing, the real estate market peak in 2526, you had a lot of these ag banks fail. And so we saw a wave after wave of bank failure in the late 20s and early 30s. Foremost because at that time, you had these very stringent regulations on entry. And even up until the 1990s in Texas, a bank could only have a single location. Now, of course, if you think about it, if you're stuck in, again, this is an extreme example, but not all that uncommon, if you're the one bank in town and the one big employer goes to town, goes out of business. You're done. Yeah, you're done as a bank. So we had a pretty big lack of geographic diversification of the banking system. You know, the really comparison that people and the banking scholars often use is looking at Canada at that time. And so Canada had a similar decline in GDP during the Great Depression in the United States. They had, you know, they're even more dependent on ag than we are. Yet they had six very large banks and had zero bank failures. Because they were diversified. They were diversified. They had private lending arrangements, clearing houses. So, and again, they had much less regulation at the time. They were much less leveraged. And it's also fairly important to keep in mind that, you know, the reaction that we saw after the Great Depression where there's a separation of what's known as Glass-Diggle, now the separation of investment commercial banking actually played very small role. The vast majority of bank failures in the Great Depression were small agricultural banks that had almost no involvement in Wall Street, most of which failed before 29. And you had things like the dust bowl and other crops. So if you were only corn farmers putting deposits in your bank and getting loans and then all the crop dies, then you're done. Yeah. So again, you really didn't have a spreading out of that risk. And of course, there are lots of, it's a far broader conversation, but there are lots of reasons monetary policy to deal with during that time, why you had some of these problems. But again, you know, it's not like the U.S. is alone in bad monetary policy. Canada had bad monetary policy during that time, too, and still came out of this better than the United States. And so it's also important to keep in mind, later on as we, there were moves to go off-gold, you saw a lot of banks fail because people basically said, I'd like to have my gold, so I'm going to go pull out of the bank. And of course, we saw a modern-day parallel with that, where when there was a worry about Greece leaving the Euro area, you know, people literally took their money out of, about a third of the deposits left the Greek banking system and went under people's pillows because they wanted to keep the euros. And we saw this— And that's an image of the depression, too. We saw the same thing in the 30s when the fear of the U.S. going off-gold, people basically pulled all their gold out of banks. And of course, that shrunk the banking system and it didn't help the economy such. But all that leads up to that rightly or wrongly in the 1930s a number of decisions were made. And it's interesting because this was actually fairly well-debated at the time. For instance, I mentioned Glass-Steagall. That's— Well, first of all, yeah, make sure to tell us what that is because people have probably heard that before. It's sort of often talked about. So Glass-Steagall is a prohibition that was put in in 1933 that separates out investment banking, that is, that Wall Street activity from commercial banking, so that's taken the posits. It was named after Senator Carter Glass of Virginia who was also Treasury Secretary under Woodrow Wilson and also Henry Steagall from Alabama. And the interesting thing at the time was there was a debate, pretty strong debate between the two of them over the causes of the crisis. Unlike, say, Dodd-Frank, where I think 90% of the stuff Dodd and Frank were on the same page, Carter Glass really was a big skeptic of this fragmented banking system. So, Carter Glass' initial proposal was to allow nationwide branch banking. He was a really big push for that. Henry Steagall, unsurprisingly, from the rural South in Alabama where the unit banks were very powerful, said, no way. Let's instead set up the deposit insurance system. And of course, this is another one of those odd examples of we had a seven or eight state-level deposit insurance systems before the FDIC was created. Every single one of them failed and failed badly. So, it's one of those sort of like, let's experiment at the state level. Okay, if we learn this is a really bad ideal, let's do it at the federal level now. So, but the point being so, for the House to go to sign on and a number of other things that were included in the Emergency Banking Act of 1933, that were wanted that they included the federal deposit insurance. And it's interesting that even FDR at the time said that if we enact this, we will subsidize bad bank behavior and have more bank failures. So, he was dead right on that one. Let's look at that point because... Well, that seems, I mean, that seems obvious because you talked about so earlier there's this character thing, that you sit down across the table from somebody who wants to borrow and you make this judgment about whether they can pay you back and your money's on the line so you want to make sure that they're going to be good for it. But if suddenly I know that I'm going to, if I make that... Can't pay it either way. Yeah, I can't pay it either way. And then what incentive do I ever have to make, to put that effort in to making good loans? And I think that's a good general theory because you look at FDIC that way and see how market actors could discipline their banks if they paid attention to whether or not they're going to fail. And then maybe we start to see how market regulation could occur in financial... And of course that's assuming that these market actors want to be disciplined, which of course these small unit banks do not want to be disciplined. And so, you know, let's step back and talk a little theoretical before we go back to the substance. And so, you know, and let me also push aside very quickly one of the criticisms you often hear, you know, of libertarians and people like myself who want to have free of markets and banking is that somehow we, you know, believe self-regulation is the answer. But we don't. You know, I come from a general premise that I don't care if you're the president of the United States, I don't care if you're the president of J.P. Morgan, you're not capable of being the judge of your own actions. And so just as many of us are aware of the checks and balances, I don't want to get myself too much sure with my constitutional scholars here, but just as you have those checks and balances in government to try to make sure the president keeps the, you know, keeps the general interest in mind, a market only works when there are those checks and balances on the behavior of management, on the behavior of the CEO, on the behavior of everybody in the bank in that way. And so what, you know, I would advocate is what we ultimately want to have is how do you maximize the quality and quantity of monitoring of behavior within the financial institutions. And so you would have that in some way by the person who lends money has something on the line. And this matters whether it's a bank in which somebody has, you know, some big financier has lent a billion dollars to and therefore cares what they do with it versus the bank, versus you as the depositor has lent money to the bank and you care what they do with it. There certainly is a lot of debate within the financial academia over whether depositors actually discipline banks. And so the literature largely says that large-dollar depositors do discipline banks. So there's really very little evidence to the contrary. And so the real question is whether, you know, is the person with a thousand dollars or $10,000 from the bank going to discipline the bank or not. But that said, if you have deposit insurance, you're essentially telling the depositors, don't worry. And so you've created what we call in any sort of insurance market public or private or moral hazard, which is of course that you're incentivized to take more risk than you would otherwise because you're not being monitored. You're essentially not being regulated. So you start out with a situation where the government comes in and provides a guarantee. The person receiving that guarantee, in this case the depositor or any other type of creditor, suddenly says, well, I'm guaranteed. I don't have to care. Now, of course, there's a whole other theory within academia saying, well, that's what you want because if you don't give guarantees, then people panic. And so there was a very big vein of literature arguing that financial crises solely come about because of panic and, you know, we all freak out and run for the doors. Let me all say there's a lot of evidence saying that that's not simply the case, that deposits flow from good from bad banks to good banks and that people in the marketplace while not perfect are pretty good at distinguishing the insolvent poorly run banks from the well run banks. But let's get back to the you give creditors a guarantee and the depositors are, of course, creditors. They no longer care about the behavior of the institution because they get paid either way. Now, of course, in that case, and this is where I actually do agree you have to have some sort of market regulation. Some sort of government regulation come in. If the government has come in and created a moral hazard, you have set up a situation where you were incentivized risk-taking. Now, in that case, you could have government regulations that come in and set capital standards and set activity standards. Now, unfortunately, you also have government regulations that might come in and say, well, let's limit entry because, you know, if we give this guy a monopoly, he's less likely to go out of business because he's got something worth holding on to. And, of course, there's a very long academic literature about charter value, capturing franchise value as creating stability in the banking industry. Yep. What do you mean, Charlie? So that because charters are limited in bank charters, bank charters, so that we only give out so many bank charters, you know, we're essentially handing out monopolies. Those monopolies are worth something. You have a very strong incentive not to mess up because I've given you something of value which you lose and which you mess up. And so that was really a driving theory within both academia and even in practice. Let's not forget, even today, you can't open a bank without having the regulators look at your impact on competitors. And if you have a negative impact on competitors in that locality, they won't let you open the bank. No, it's explicitly anti-competitive. Yes. And it's often because, you know, we could have another, we could have an hour-long competition about ruinous competition and such, but there really is a mentality that came out of the 30s and a precursor of that. It was a sense of, if you have too much competition, that's what drives the banks, you know, out of business. And, of course, this is a world in which you have very little market discipline. So my fundamental concern with our system of bank and regulation is you've had the regulators basically come in and provide these safety nets that say, don't worry, so we've essentially lessened the market discipline you would get from creditors, and we've attempted to substitute that with having regulators try to offset that with various types of regulation. Now, there's a couple of concerns I have with that because in theory, you could say that might work. Well, you know, we'll pay the Tim Geithners of the world a lot of money. Their specialist will only get these really smart PhDs from Harvard, and, of course, they're going to do a better job regulating, you know, than the man on the street. Well, it turns out for a variety of well-known reasons that doesn't actually tend to be the case. Maybe foremost among those is that creditors have very strong incentives. When your money is on the line, you care. It's normally been the case that after each financial crisis, approximately zero regulators actually get fired as a supplant. So, of course, you're embarrassed, you know. You might get caught up over Congress and yelled at and your friends might make fun of you or whatever. Or you might be actually able to go on a book tour and make a lot of money. So, there's just very weak incentives from the financial regulator than there are relative to the depositors and other creditors. And so, of course, it's also important to keep in mind for 96% of the banks, their funding is almost exclusively depositors. You know, for the bigger banks, the J.P. Morgan's Bank of America is the world, you know, somewhere between a fourth of their funding might be non-deposit creditors. And so, you have that incentive problem. Weak incentives on the part of regulators, strong incentives on the part of creditors. But you also have the political aspect to it as well. You know, it's highly unlikely that you find a situation where government comes and creates market power, creates monopoly rents, and lets you keep all those monopoly rents. They usually don't do that. It's funny that way. Usually they come in and they ask for something. And so, a lot of what we see in banking regulation, in my opinion, you know, that looks like it's kind of banks versus government, is really an argument over the distribution of rents. It's not really an argument over the basic structure. Let's explore that. So they have some sort of monopoly or market power that is given to them in some way by government. Which leads them to then make more money than they would have otherwise. Absolutely. And so then you're saying government doesn't want to just let them keep that. So where does it go? So as government, government wants to increase taxes on them? So there's a variety of ways that this would work. And so, I mean, the bottom line is government spreads it pretty widely, but let's talk about some of the ways in which government might spread it. So government might spread it and, of course, requiring you to buy a certain amount of government debt. So for instance, when the national banking system was created at the end of the Civil War, near the end of the Civil War, rather, how much you could lend as a bank was a direct multiple of how much government debt you bought. So if you bought no government debt— That was part of the charter. That was part of the charter. So if you bought no government debt, you did no lending. And so in every extra dollar you would lend, you had to have X percent more government debt. So, you know, and often there was an expectation that the government necessarily wasn't even going to get paid back. You were just going to keep rolling over government debt. So the foremost way in which governments have shared in those monopoly rents is essentially either direct transfers. You pay a chartering fee. I'm fascinated, you know, fascinated and astounded by the fact that between 1820 and 1840 about almost half of the revenue of the state of Massachusetts derived from its banking industry, for the government in the state of Massachusetts. That was an outlier. But states set up these mechanisms where the banks basically funded them as fiscal agents. We see that today. Still, I mean, one of the reasons, of course, that the banks in Greece and Italy were bailed out was because they were the largest holders of the bank. You know, nobody is going to – Italians and Greeks will not pay the taxes that are required to support the level of welfare that they would like. And the only way they've deficit-financed with the banks is so fiscal transfers one way. Another transfer is requiring you to do hidden subsidies to preferred consumers. So we think about in the United States things like Community Reinvestment Act. We think about the GSCs, beginning-phrased housing goals. We give you a privilege. That's worth something. You share part of the value of that privilege with select constituencies, which are then therefore for us. So there are other ways in which you're maximizing that public support. In one of the ways that I mentioned earlier that you had this fragmented banking system, the reason that it was stable for a very long time was because part of the rent – part of the rents, if you will, the monopoly rents were shared with the agricultural community that the system was set up. So it's important to keep in mind that the political equilibrium between the banks and the governments is rarely one where it's just banks and government. There's almost always some other collection of parties. You know, in a shorthand way thinking about this as American history is, we went from a system of very fragmented small banks who partnered with the ag community to essentially extort the rest of us to a system now where we have fairly large too big to fail banks who have partnered with community activists to extort the rest of us. So the people have changed and, of course, some of this is because of the SNL crisis revealed the fragility of the fragmented banking system. You know, you really had this situation where the reason that we allow nationwide banking now is because the regulators didn't want to recognize, Congress did not want to recognize the cost of literally an entire industry that was insolvent. And so they allowed other banks and other SNLs to buy each other and merge each other and the only way to do that to pay proper losses was to allow that to go across state lines. Just like in some ways that we saw, you know, that you saw, you know, Bank of America buy Merrill Lynch. It was really a way that we didn't have to admit that Merrill Lynch was insolvent in the same way with J.P. Morgan buy and bear, although we admitted some of that insolvency in a more transparent manner. So again, for banks to sort of function in this political environment, they've almost always got to have some sort of partner. Certainly, there have been times in history where the partner has been the government. So almost, you know, of course, as we know, the Bank of England started out being a monopoly chartered bank that was there to fund the crown, exclusively there to fund the crown. So, you know, certainly it's a historical matter and of course this is one of the toughest things for those of us who want to move to a free banking system is that with a small number of exceptions, banking historically has been very tightly wed to the state, primarily as a captive vehicle for financing for the state. So this sounds like you're in this Occupy Wall Street Tea Park in the sense of saying there is a lot of collusion between Wall Street regulators and banks and maybe the, you know, fundamental difference from the Occupy Wall Street versus your position is that they think that there's some way to clean up that regulation and make it better, put it a different super regulator on top of the regulators who messed up but definitely don't let the greedy Wall Street people do this on their own and I think you would probably disagree with that. So what I would say, the part I would disagree with is, you know, the sense that if we just, you know, held more scrutiny to the regulatory system that it would somehow come out different. To me, the regulatory system we have is largely the outcome of the political coalition and the political economy we work under and that's a harder thing to fix you know, certainly it seems to me that the more complicated the banking regulation is, the more likely the industry is going to have the expertise to capture it and work it to their benefit. So I would certainly say that I think that there's a very close relationship between the banking industry and the government. Very little of it is an argument about the overall framework. Again, it's mostly an argument about the distribution of monopoly rents who gets to keep how much, you know, how much gets redistributed. It's probably more so a case of an agreement between the politicians and the banks than it is between the regulators. I think most regulators, even though that they face pretty weak incentives, are generally focused on safety and soundness of the banks. It's really quite interesting. I mean, the reason that you had this new consumer agency, the Consumer Product, you know, this bureau created out of Dodd-Frank, the consumer advocates long complained that the bank regulators cared too much about safety and soundness. And what they meant by that is, and therefore they wouldn't, you know, nudge banks to encourage banks to make bad loans. You know, of course, of course, if my consumer advocates friends were here, they would say... Bad loans, you mean, loans to more risky, lower income people. So the idea being that the Consumer Finance Protection Bureau would be there to protect the little guy who is being discriminated against by the bank because they were too risky, but there's another social justice, and I'm putting that in scare quotes. View of this, that's a wrong... You should not be discriminated against if you have no income, no assets. And of course, I mean, part of the problem is, as I mentioned, because you've essentially given these monopoly-style rents to the banking system, it's looked at as an off-balance sheet way to address a variety of social wrongs. And so, like, take the issue of we know, for instance, that credit scores, credit history, vary dramatically by race and ethnicity. You could have all sorts of debates about why. So, you know, if you want to feel like that, you know, whether... So, I guess I'll put it this way. There has been a very strong desire to use the financial system as a remedy to all sorts of social wrongs. Now, I'm quite skeptical that. I mean, let's have a debate if we want reparations or we want welfare or we want ever. Let's put it on budget. Let's debate it. Let's have it above board. But again, you know, politicians are much more attracted to, you know, the tax which nobody really likes if I can spend off budget via the financial system and hand out subsidies that way. And so, that's been the attractiveness of the banking system. Now, you'll certainly hear among my consumer advocate friends, you know, that, well, the banks are just ripping people off and they're not making they're making bad loans to credit worthy people. By and large, I think that that's grossly exaggerated. There certainly is fraud. There's certainly people taking advantage of, but to me, people well mean determinant of whether someone's going to pay the loan is the credit quality of the borrower. And that matter is much more than whether they're an adjustable rate versus a fixed rate mortgage. And of course, job loss is also the predominant driver of financial distress, regardless of the financial instrument. So, you saw this Bureau created to try to take this out of the bank regulators. And of course, I'll set aside that I don't know anybody after 500 bank failures says that the regulators care too much about banks. My take is they didn't care enough, but that said, you know, there is this sense of there being a trade-off. And so, you created this new Bureau to actually, so the politicians could take quote-unquote consumer protection, or rather, you know, consumer redistribution out of the hands of the bank regulators who were too concerned about the stability of the banking system and put it somewhere else where they wouldn't be so concerned about the stability of the banking system. Couldn't someone say, though, that there's a meaningful difference between banks to give loans to lower-income or risky people versus giving those people subsidies or handouts or something in the same way that we might say there's a difference as far as someone's quality of life between giving someone welfare checks and helping them get a job? And I would agree. And so, you know, it's interesting because I think the Community Reinvestment Act had a reasonable purpose at the time. Explain exactly what that is. Well, there's nothing. So it's actually the Community Reinvestment Act is actually a very short statute that's very clear that's just about process. And it was set up in a world in which you still had these local monopolies. Now, let's go back to our Econ 101. If you have a monopoly, the incentive for monopolist is what? To restrict output. And so, what that means is that these local monopolies, they're not making as much money as you would see in a competitive market. People who are credit-worthy but are on the margin of credit. And so, CRA was a response to this by basically saying, okay, we're going to keep your local monopoly, but we're going to nudge that supply curve out a little bit. You know, we're going to nudge it out to people within the community. So, I do think the CRA at the time it was passed in 19th Simpsons identified a very real problem. The oddity of it was probably a decade later that problem had been gone because, you know, it's today in the United States that we did not have in the 70s. But you saw CRA morph into something that became much more quota-driven over in the 90s when the regulations were changed. And so, I do think that you have to worry about if you set up monopolies that they're going to restrict supply and it's not random who they restrict supply to. And so, you do see more marginal credits. It's certainly, you know, very worth remembering and reminding ourselves that we had a tremendous amount of racial discrimination in the housing mortgage markets. It's certainly worth pointing out that some of that did come from the government. The term redlining actually came from FHA who literally and here in Washington, they drew red lines around certain parts of the map and said the federal government will not lend in these areas because of the, you know, uncertainty and instability of the racial makeup of the neighborhood. That was something that FDRs, good folks, decided. So that said, you certainly had these very real things. And so, this is one of the tensions I mentioned earlier that nature of character. And so, we also not only passed the fair housing act, and so, you really saw a lot of pressure on banks to move away from subjective decision making. And, you know, to me, on one hand, I think that has resulted in a tremendous reduction of racial discrimination in the mortgage market and the lending markets in general. On the day to bear that out. On the other hand, I have to scratch my head because it's clearly not. And the data are very clear on that fact. And so, on one hand, the move away from subjective decision making based on character resulted in an expansion of credit and a reduction of discrimination. That's good. What's bad, of course, is we also lost some of the subjectivity in the process that really judged character. And so, we've gotten to a situation where you don't even – people don't even talk about character and credit decisions anymore. It's all based on the numbers. It's all based on the ratios. It is a very model-driven world that the banking industry has become. And I think because of that, we really have squeezed that tacit knowledge out of their system in a bad way. Is there evidence about how that works in practice? I guess I'm curious do the kind of gut instincts that go into a character judgment do those work better in the chart and picking someone? So, there's two elements to this. And let me talk to the element that's maybe most relevant for the crisis and then get back to the broader point. So, one of the reasons we had a contributor and I'm certainly somebody who thinks there are at least a dozen if not more contributors to the financial crisis was we developed these models in a world in which there was subjectivity. So, for the economists out there listening, there might be that the previous regime cannot be used in your new regime. They will be biased. New subjective. New people are enforcing rules in different ways so that it changes the bottom. Yeah, exactly. So, my point is we developed all these models of default behavior in a world in which subjectivity entered. But we didn't count that subjectivity obviously because it couldn't be fit to the regression. And then once you squeeze the subjectivity out of the process those models were still being used based on that previous data. So, that's one reason why a lot of the default models that were used in the bacon industry grossly underestimated the performance during the crisis. They were just based on a different world. They were based on a world in which we had unobserved variables. The subjectivity character was actually included in the model even if it wasn't specified. Then it wasn't. So, then again your models broke down. Now, the other part of, of course, is that we'd had this massive expansion of subprime lending which we really did not have and trying to predict changes without an inflection point and changing your data. What do you mean an inflection point? So, subprime mortgage data really only goes back to the early 90's and so the last housing market bottomed out 93-94. So, essentially you were predicting subprime performance on a straight line of the housing market and so unless you have a turning point which is your inflection point then you really don't know how they're going to perform. You just think it's all going up. So, you know, what they were basing that on was of course we had data for the prime market because we had the late 90's and early 90's where in some places like New England it performed horribly and so you had data there for the prime market and then they're essentially trying to forecast out a sample. You know, they were looking at well this is how prime borrowers perform in a bad market and so we're just kind of assume a little bit fudges a little a couple fudge factors in the equation and assume that we know how subprime borrowers and so it's also important to keep in mind prior to the 90's and certainly the 80's subprime borrowers basically didn't get loans and it's also important to keep in mind we are the only developed country in the world where if you have a history of not paying your bills you can still get a mortgage. You know, that's unheard of and you know socialist France if you don't pay your mortgage they garnish your wages and they won't even give you one if you've ever not been laid on anything so part and that's of course in my opinion part of the totally rinse in the banking system is you have this coalition of essentially subprime borrowers who would not get credit otherwise and now we don't have that much time and this might be opening up a big big bag of worms but so now we have Dodd Frank which is supposed to solve some of these problems and so how is it supposed to do that and will it do that in any meaningful way or should we be afraid that the government is coming in and once again messing the very very afraid be very very afraid not just afraid very very afraid so let's start out so the theory of Dodd Frank is essentially that you had a run in the non-bank parts of the financial system you know an old-style bank run and so the theory of Dodd Frank is we simply the non-bank meaning like yeah so the Lehman Brothers the investment banks insurance companies the shadow banking is a term that's used often without actually defining it very well and would also mean sort of Fannie and Freddie except they were explicitly ignored in Dodd Frank and so the sense was well you know if we just expanded an FDIC safety net to everybody else we would stop panics you know and that's really the theory of Dodd Frank is you know I usually my quip is that the theory of Dodd Frank is that if we only regulate everybody else as well as we regulated Citibank everything will be fine of course as we know Citibank been bail out four times and so that is the theory behind it so as you could imagine I'm very very scared and worried that it will not only not avoid future crisis but make them more likely and so while Dodd Frank deserves a lot of criticism it really is an extension of the previous system where we are expanding government safety nets with the promise that government regulators will come in this time let's forget whether they did or not last time that they will come in this time and control the moral hazard that those safety nets create and of course part of the problem is that you know I think the problem here of course is that as I equip democracy loves a bubble you know during a boom it's very hard for any politician any regulator to push back we all sit around talking about how much we sold our house for and you know this and that and so what nobody's ever got a win on re-election on I'm going to bring the value of your house down and so you know leaning against the wind is just something the political system does not do I saw it when I was in the staff of the banking committee in the senate you really saw the regulators bend to the will within their discretion and let's keep in mind most of Dodd-Frank has actually delegated decisions made by the bank regulators not by the congress themselves the bank regulators bend to the will of congress congress bends to the popular euphoria and so my problem with our current system of regulation and I think you know we're stuck with this is that it's extremely pro cyclical it ends up making the boom is bigger and the bus deeper than you would have in a purely market system and because it does end up just echoing you know the positive sort of boom mentality rather than actually bringing a pessimistic side to this and so you don't get you know like the downside of hey maybe this is a little crazy so final question you seem like you do you believe in no regulations or that's the question whether do you believe in no regulations prefer market but what is the simplest way you can explain your view I think how we should approach these problems I think ultimately we need to rely on market participants regulating each other and they will only do so with very strong incentives to do so such as that their own money is at risk I think if we have a system that is reliant upon government regulators then we will have a system that repeatedly fails I think if we have a system where we tell creditors not to care about if we tell creditors like depositors not to care about the quality of loans the quality of activities that banks engage in then we're going to get poor quality and I don't think the regulators will ever be able to offset that so not only do I think that government regulation does an inferior job of the private sector regulation I think there's considerable evidence to suggest that the public sector regulation crowds out private sector regulation in that the end of the day we actually have less regulation total public and private combined than we would in a purely private world Thank you for listening to Free Thoughts If you have any questions or comments about today's show you can find us on Twitter Free Thoughts pod that's Free Thoughts P-O-D Free Thoughts is a project of Libertarianism.org and the Cato Institute and is produced by Evan Banks To learn more about Libertarianism 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