Welcome, ladies and gentlemen, to our discussion of health scotts new book, connectedness and contagion. Here it is. If you didnt notice, we have copies for sale. Its my pleasure to remind that youre welcome to buy a copy and how will be available to autograph them. Here we are in aei stylish new Conference Center to discuss a very old problem, namely how best to survive panics of which there have been many across the centuries and survive fear and distrust when financial actors try to withdraw to protect themselves, a rational strategy for each but as we all know not when they all do it at the same time. Highly interested historically but much more pressing when we consider as his book does in detail and what should we do in the next panic which would surely arrive sooner or later. Two centuries ago David Ricardo observed a general panic may seize the country when everyone becomes desirous of treasury metals, banks have no security on any system, that is to say the private banks on their own in 1873 draws the conclusion that was true then and is still now if all the creditors demand their money at once, they can be the have it. Moreover, when apprehension passes a certain bound, no private banker is safe. Every banker knows that if he has to prove he is worthy of credit, however good may be his arguments, in fact, his credit is gone. And thats what happens in the panic. Everybodys credit is gone because nobody can prove hes worthy of credit and not even sure about their own solvency. Also new equity, expanding their own Balance Sheets so everybody elses can shrink and everybody elses risk can go down and thats what you have to do if you want to avoid driving asset prices in a downside overshoot. This book discusses how the survival process has been made much harder by the postcrisis legislation in the u. S. And notably the doddfrank and, fraj, he says the United States is rather unique in apparent resolve however unrealistic it may be to bailouts in the future. But that theyll be a lot more cumbersome, slower and harder to do and he predicts that in time we will greatly regret the changes that have been made if not corrected before the inevitable crisis and the next changes hes going to present his books and we will have comments from our panel. Our author is hal scott on International Financial services at the Harvard Law School where he has taught since 1975. Also director on the committee of Capital Markets regulation and member of the brit aib Woods Committee and a past president of the International Academy of consumer and commercial law. His books include International Finance transactions, policy and regulation which has gone through 20 editions, sigh. 21. [laughter] the Global Financial crisis, that means the last crisis. Tonight in presenting connectiveness and he will address how to be better prepared for the next crisis, welcome to the ae ipod yum. [applause] thank you, alex, for a clear presentation of my book and thank you aei for hosting this each. So the thesis of my book at the heart of the 2008 crisis and most other financial crisis systemically for three weapons, last resort, liability guaranties and capital injection, post crisis, all the weapons were limited or eliminated primarily by doddfrank as undesirable bailouts. Doddfrank purports to solve the problem with what i call two wings and a prayer, heightened capital and the prayer is new resolution procedures, but you dont abolish the Fire Department even if you have basically. Thus we need to restore and strengthen the three powers we weaken or took away but bad news the likelihood of doing so in the antibailout consensus that exists today is very well so we are dangerously expose today future crisis. Thats the thesis of the book. Let me talk about elements of systematic reason. The main point of regulation is to prevent Systematic Risk of which there are three varieties, three cs, correlation, connectiveness and contagion, like the housing collapse, thats not the focus in my book. Connectedness, causes losses of other Financial Institutions which sets off a Chain Reaction of failure, liability connectedness where the failure endangers the funding of other institutions. For example, a Tri Party Repo of a party and the last one is contagion where Financial Institution causes shortterm inveddors to withdraw and withhold funding for Financial Institutions either out of lack of information or a rational panic or some combination of the two. The first part of the book looks at whether it was contagion or connectedness. Contagion was the primary driver of the excuse me, was not the primary driver, neither form of connectedness. Leaning to leihmans fall, washington mutual, a shortterm creditor headed for the exits fearful that the institutions to which they extended credit might meet the same fate as leihman. Starting with the reserve primary fund which broke out on september 16th, 2008 due to losses from the funds significant direct exposure leihman. The run spread quickly in the industry, however, including institutions with no significant exposure to leihman. The london wrote sharply and many banks discontinued lending entirely. Markets also froze up. Thats what happened. Many people believe that asset connectedness was major problem during the price sis. The book examines the claim in detail. While investors in the reserve primary fund which had overly invested in lehman last money, less than a penny on the dollar and no Financial Institution connected the lehman failed as a result of the failure of lehman. Moreover, no Financial Institution would have failed if aig had failed. Goldman sachs would have exposed, less than the conventional 25 loan, lending limits and this does not even take account of the cds goldman had on aig which further protected gold goldman from the loss. Nonetheless, there was connectedness problem and doddfrank reforms largely focuses on that, largely build around connectedness, look at the terms of designation, a lot of connectedness. As the Central Clearing for all the counterderivatives, we will have a Chain Reaction of failure and bilateral exposure limits. While one can argue that are desirable as preventive measures generally apart from the experience in 2008, connectedness was not the problem in 2008. So doddfrank also did Something Else which was to legislate with respect to contagion, three measures were deployed to stop contagion and capital instruction in the bank. Lender of last resort. The fed was created in 1913 to stop financial panics, the latest of which 1907. Interestingly the panic of 1907 started in a nonbank center that the nickerbooker Company Trust company. During 2008 lower penalty rate at the discount window, wider access and term auction facility were major changes and a number of new facilities were created for none banks, i cant go into all of them here but they included the commercial Paper Funding Facility to purchase unsecuredded abc paper from corporate issuers and money investor murkt facility to provide them with liquidity. The supply of this liquidity to the Financial Sector doubled the feds Balance Sheet to 2 trillion by 2009. In 2007 before the actions, 91 of Balance Sheet was invested in u. S. Treasuries, by 2009 it was only 25 due to this lending expansion. Supplying liquidity to the nonbank system was very important. Provided nonbanks with almost a trillion dollars in loans and general market liquidity. More importantly, the very availability of these facilities helped stop the run. The fed and in terms the taxpayer actually benefited. Balance sheet expansion generally leaves more profits. The fed pays not much on liabilities, bank reserves, didnt exist until the crisis and currency and makes money on the assets, the fed are submitted to support general revenue. In 2008 they had risen to 40. As i said, a key part of the fed lending was to none banks where the contagious run was largely centered after the 2008 failure of lehman. Primarily moneymarket funds and the ability to lend to nonbanks is essential. I would expect this percentage to increase because lending and Capital Markets activities are driven out overregulated Banking System. The Legal Authority to nonlending was then quite broad section 3 of Federal Reserve act. It provided that, quote, an unusual circumstances, the board could authorize reserve bank to make loans to quote any individual partnership or corporation, end of quote, where such loans were, quote, secured to the satisfaction of the Federal Reserve bank, end quote. This authority to loan known banks, by the way is quite separate from the discount window under under sections 10b and 132 of the Federal Reserve act to lend to depository institutions like bank. While use of this Broad Authority to lend to nonbanks was crucial in stopping the can teenagous run, after the fact, it was and continues to be widely attacked as bailing out wall street. But the beneficiaries of lending were largely victims of the panic. Without panic withdrawals from the institutions, alex alluded to this they would have been solvent, but in general totally solvent institutions. Now, this antibailout concern triggered radical calls for changes through Lending Authority for nonbanks and i have concerns that did not translate over to discount window. Kind of focused on the nonbanks. The result was that the doddfrank act played significant constraints on the fed lending authorities. What are they. The fed can only now lend to nonbanks with the approval of the secretary of treasury under procedures adopted in consultation with the treasury. Interestingly this requirement for approval was first put forward by the treasury itself then added by secretary gidner or maybe thought it was a way to protect the fed from greater restrictions which were, indeed, actively being considered by the congress. One can argue about the importance of this reconstruction though it is clearly taking independent authority away from the fed. Some point correctly that was bernanke and the new antibailout environment be such willing cheerleaders . Treasury approval would now carry political risks and the markets will now know fed support may not be assure which itself can accelerate. If we think it is important for the fed to have independence to lend the banks, why not nonbanks and ever increasing important factor in our Financial System. Second, the amendments to 13. 3 that the bank can no make off loans to aig. It must all right. Im okay. It must now do so according to doddfrank under a broad program. A fed regulation implementing this provision provides that at least institutions must be eligible for any fed program. Now, if this means eligible at the time the fed provides the first loan, it may make it harder for contagious run. You have to wait till fife institutions have a problem if it means that, on the other hand, ever eligible for loan, then it is not much of a restriction but under that interpretation the first loan could trigger of inappropriate behavior or i ilegalty. The ranged in the Feds Authority which it did for major and setting collateral requirements. The fed can only loan to solvent institutions not required to nonbanks, just banks. The solvency requirement is a principle of the appropriate role of the lender of last resort, many have pointed out that that this is in the breach here and abroad. Now, one reason for not requiring that the central bank determine that its solvent is the judging solvency is extremely difficult. Should assets be valued at price which may also reflect prices or should they be valued if they would be if the fed . Should be a fiscal issue in which the congress would play a major role through appropriations and i sort of agree with this point of view. But if youre going to have that point of view, then lender of last resort needs to be coupled with what i would call Standing Authority so that there is the possibility that the treasury can act when the fed cant. A fifth provision of doddfrank provides for disclosure all loans to none banks must be reported within seven days to the two chairman of the house and Senate Financial committees and must then be disclosed to the public within a year. On the banking side, one change on the woipped, i now the concern with such Disclosure Requirements much more stringent by the way than those facing any other Major Central Bank is that the prospect of disclosure certainly within seven days and even within two years made discourage concerns with stigma from seekingneeded support. You want them to get the support. Discount out of fear that borrowing could be leaked or covered by evidence. Six, doddfrank provides that banks can no longer pass out window loan to nonbank affiliates such as broke broker dealers, which would be precluding a full pass on. This means the substantial borrowing by bank affiliated broker dealers would have to occur under the new restrictions, it couldnt be by the window and then passed on. Indeed, the multiply does not apply to dye it was dead on arrival. Including governor powell and bernanke can live with doddfrank restrictions but they have taken the position to other restrictions. Republicans for and the democrats against. The bill has passed the house. The Federal Reserve can only loan to nonbanks if at least nine of the two voted in the affirmative. All regulators of the potential borrower which would include the sec or the cfpb would have to certify that the borrower was not insolvent. Chair yellen said at the time that the provisions were lending to banks, this has been incorporated. Now, these attacks on the feds loan are not recent. My book recounts for any opposition to a court federal bank whether lending to commercial or bang borrowers over the first and Second National banks. Andrew jackson vetoed the National Bank in 1831. Its this debate or federal Bank Institution that took us so long to create the fed in 1913. The debate still goes on. All right. So the second part of the fight against contagion were guaranties, in october 2008, fbi used authorities for transaction accounts, key to Payment System and increased insurance limits on other accounts from a hundred thousand to 250,000. While doddfrank increased insurance limits to 250,000, it removed the authority of the fdic to raise limits without joint resolution from congress. In addition, the fdic established so called temporary Liquidity Guaranty Program in october 2008 which gave depository institutions and Holding Companies authorities to issue new senior unsecuredded debt guarantied by the fdic. The fdic made money on these programs, no taxpayer losses. Treasury used authority under the fund to guaranty the must be market funds. This had a mayor impact on stopping the run on the funds. This power was taken away by doddfrank and not by doddfrank actually, the earlier tarp legislation and treasury made fees on the program and never paid a cent. It remains a problem in my view and not cured but the secs required floating on asset value, investors will still redeem and expect values to go lower. Sec rules give authority to limit or change redemption in adverse conditions accelerate as commissioners observe in her decent of reform. The final tool used to combat contagion was tarp, there had been 204. 8 billion. Taxpayer did not pay for this. Tarp expires by its own terms. Much like the eu or japan have Standing Authority if the u. S. Needs such injections from the future, authority would have to be obtained, might have been to be obtained in the midst of the crisis itself as it was in 2000. Defenders of doddfrank point to what i call two wings and a prayer, being capital and liquidity and resolution procedures. Its much less likely we need not to worry about it anymore. Capital requirements are wing. We have great increase Capital Requirements, no doubt about it. I put aside the difficult issues of methodology and callal requirements, lets not fool ourselves. There are mayor mythological problems when not done by the market. But no realistic level of capital can prevent a run on banks, due to fire sales capital quickly eroded even higher capital proposals, suggestion 20 to 30 leverage ratio would not prevent bank failure around the face of contagion and underline this, Capital Requirements only apply to banks not to the ever increasingly important nonbanks. The second wing was liquidity. After the 2008 crisis we adopted again through bazzle, has a 30day horizon, requires bank to hold assets to cover runoffs. The requirements scourge lending. Again, they do not apply to nonbanks. There are significant mythological issues like runoff exemptions and liquidity. The fed can now say it will only be a back up source of liquidity. The front line is the banks liquidity itself but ironically the private liquidity requirement may actually reduce collective private liquidity because it requires each bank to hold their own liquidity rather than making it available to others in a crisis. So whether it really comes, you know, to prevent that lending is open to question. So the two minutes. I think i will make it. [laughter] so the prayer is resolution procedures. Doddfranks overly Liquidation Authority gives fdic new powers to resolve Holding Firms whose failure upon twothirds vote of the directors and treasury are determined to pose serious adverse affects to the Financial Stability of the United States. Such of a determination was not made, the nonbank Financial Institutions including bank Holding Companies will continue to be resolved in bank are you bankruptcy. At the outset without requisite approvals this may never be used. If it is used, fdic is designed a single point of procedure requiring restructuring at the Holding Company level and major consequence of which is that shortterm funding, mainly through banks and the broker dealer sub subsidaries, whether such restrucking restructuring is problematic. The procedure has never been tested, thus this is a player, the reality is creditors of Financial Institutions would have won. Better, safe than sorry and we need to be prepared for that so resolution, procedures are good but dont think that you can get rid of contagion fighting, actually works the other way. Easy to resolve an institution if you know you can prevent the contagio, in the follows the institution. I wont comment because alex will be jerking me off on other solutions to the problem like limiting shortterm funding but if we have time to discuss it, in q ai will talk about that. Powers have been weakened by legislation and wont easily be restored. Third, capital liquidity and resolution will not safe proof the system from contagion, even if homes are fireproof, you still need a Fire Department. I do not think the answer, so lets just hope we do not have another crisis before we can move beyond the fears of bailing out wall street and are able to rectify the situation. Thank you very much. [applause] thank, hal. We have coming up three outstanding who will speak and i will introduce them in the order that they will speak. After they do, we will give hal a chance to respond to them and the panel to Exchange Ideas after which we should have some time for your questions, but we are going to adjourn promptly at 6 15 to our reception. Our first discussion, al who is president of the Federal Reserve bank of richmond, having joined and become director of research in 1985. As a Federal Reserve president , of course, he served as a member of the open market committee. Al is a member of the board of Virginia Council on economic education, Advisory Council of the school of business of the university of richmond, executive committee of richmond renaissance and numerous other boards. The next will be kyle, smith school of business, petes Research Includes highfrequency trading and contagion task member on mechanisms, consultants to securities and Exchange Commission and a member of the jts advisory committee. Our third discussion would be paul, resident scholar at aei and focuses on the management and regulation of Financial Institutions, financial markets, Systematic Risk and the impact of financial regulations on the economy. Previous paul was director of the center for Financial Research at the federal deposit insurance corporation, chairman of the Research Task force of the committee and held at freddie mac, jpmorgan and paul has organized this event, so thank you for getting us all here and al, we will start with you. Thank you. Thank you very much, alex. I hope i didnt scare anyone badly. I got punished. I was trying to get to my party and when i finally did i couldnt open it. I guess another sign of age. Liquidity problem. There you go. Only a couple of minutes from now i will be able to solve. Its good to be here. We are instructed to hold remarks to eight minutes which made me think or reminded me of mark twain that if he had more time she would have written a shorter letter. In any case i would try to meet the requirement and i know that we are running late here. I believe that professor scotts book is a very good book and important book. As you all know well a number of books have been written from various perspectives about the financial crisis and several i would argue are really essential to appreciating the scope, nature and significance of the event. I think it was Ben Bernankes memoir, secretary paulsons book, they all, i think, help us understand what it was like for policy makers who actually confronted the crisis on the front lines and i would add to that list, alan blinders, a book which is the one that has i think a phrase like Musical Chairs somewhere in the title. I struck me as elusive review of the broader causes of the crisis and dealt with as it played itself out. For me house book is a very valuable and highly useful addition to this literature and provides intense and penetrating analysis of the anatomy of the crisis and steps taken subsequently specially in the dad frank law to prevent realistically mitigate recurrence. I have professors scott delineation which he has reviewed and underlined by the books title. Connectedness from contagion and the conclusion was that contagion was the primary driver and focus efforts to remediate. The book argues that asset and liability connectedness did not play a major rules in the core collapses of Lehman Brothers and aig rather contagion augmented version of an oldfashioned wonderful life bank run turned events into broad and dangerous crisis. Scott believes that the fed, fdic and treasury addressed the crisis appropriately, if not oversmoothly and prevented outcome and i acknowledge my bias, i happen to agree with him. From this premise, professor scott seems to be the central points that many of the sometimes politically charged provision of the and provision that is restrict the feds lender of last resort powers and the complementary powers risk severely weakening the governments ability to successfully contain a future crisis if one arises and history teaches us that thats a very likely occurrence. As we already heard scott analyzes each of the limitations which he does in chapter nine which is the heart of the book. I cant review them all here. Let me give you an example of one that he has mentioned which, i think, really gives you the flavor, during the crisis was able to make independently the nonbank Financial Institutions. Dodd frank requires to be approved by the secretary, the doddfrank law was written, ben bernanke himself seems to conclude that the requirement is a necessary and workable compromise in a democratic society. Maybe thats right. What if the treasury secretary who is after all a political appointee at the time of crisis not a political figure, image such a scenario difficult to imagine in todays world. A strong perception, requires absolute confidence that the fed and the fdci can and will act forcibly to stop to actually doing so. In typical central banking language in this regard would need to be complete and robust. If there were doubts in mortgage that the treasury secretary would go along, markets would be at high risk of running. If you think thats going to be a hit, let someone else take that hit. I would say that professor scotts insistence of this reality with respect to the treasury, secretary approval provision and really the principal contribution. All of this said, the concern of moral hazard and reducing the risk of taxpayer losses that help drive the doddfrank restrictions are obviously not frivolous, professor scott, i think, does not deny that the enhanced liquidity requirements, orderly liquidation, action that has been taken to reduce likelihood of crisis if it occurs may prove financial although im arguing and i think you argue with some of the details. The book argues per saysively. This is the key point. None of the reforms, individually nor collectively are sufficient to prevent a run or to stop one once it started. Warned of dangerous of fed policies or actions that involve credit allegation, marvin, a good friend refers to credit policy from Monetary Policy. I share this concern and i have to confess, but i have to confess that ive generally thought about it in a macro monetary context rather than the feds last resort role. Scotts book challenges me by demonstrating that the financial crisis was an oldfashion run. Forcing me to ask myself whether it would be feasible in dealing with a similar future crisis to avoid risks. I need to think about this and asking the fundamental questions here. I feel compelled to offer at least one nip pick, if i may. I found the reasoning a little on the tense side. Significant portion of the economy shortterm private and credit liabilities and he goes onto consider, this is where i got into trouble. How such a Development One might conflict with the feds Monetary Policy objectives. I got really confusedded. I will tell you that i was on an amtrak train behind a freight train. Maybe it had something to do with it. Could be simplified a little bit and clarified. I probably said enough by now, the signal i can do it. I can do it. But in closing, let me salute that the strength of the book highlight ifs the fed and fdic need strong and essentially discretionary Emergency Powers to prevent or confront runs, how do we reconcile such powers with light legitimacy requirements. This is obviously a critical question with populist elements, the doddfrank requirement, treasury secretary approval and we discussed launch today nonbanks and importantly the requirement, the accompanying requirement that can be consulted with the elected president and is recognition of this issue although we have seen, i would argue a problematic one. Resolving this fundamental tension in our political economy if thats possible at all is beyond the scope of this particular book, theres no question that hal is well aware of the issue. I believe that some of the contributions with paul tucker, former deputy with bank of london, regarding legitimacy of Central Banks not only in lending arena but also policy, looking at the regime and taking together some of the his work, havent finished it all yet but from what i have seen its a good place to start thinking more about these issues. Thank you very much. [applause] thank you. This is a really interesting book. He has he has three cs, one of them is called connectedness. Networks, huge amount of research by young finance professors on Network Theory and the application of networks to finance and hal scott comes along and says research is pretty useless or not really relevant to explaining what happened to the financial crisis for some good reasons i will talk about in a minute. You have the second c thats not in the title of the book, connected and contagion, the second c is correlation, i would like to think of correlation with capital and deleveraging, a big shock in real estate prices. Its the economy. It turns out that the real estate assets, relaxed and simultaneously and Economic Research that says when that happens the Financial Institutions are going hold mortgages and leverage 101. The title contagin. The problem that needed to be fixed was that banks needed more capital and the sooner they got it and the more capital they got, the more rapidly the Financial System would recover and my summary of the doddfrank act was that while the doddfrank act did encourage policies to make banks have more capital, mainly what it did impose a lot of regulations on the Financial System so that the authors of the doddfrank had a trade nawf mandating more capital and they chose to mandate more capital than regulation but scotts view has changed my view on that and as he points out, if you have a capital problem or even if you dont have a capital problem, you are going to have a panic but charles and ricardo are going to tell you that if you do have a capital problem and it keeps getting worse, before the Financial Institutions collapsed or declared bankruptcy from back of capital, people are going to try to pull money out. When that happens youre going to have a panic and the panic is not only going to hit the bank that maybe was truly undercapitalized and going to create a cr irrcion the response thats necessary this contagion or this panic and they pretty much have to be provided by the fed. And so hal scotts book comes in and says, if you look at the doddfrank act what youre going to find, its not just imposing regulations for regulation sake, but theres a misguided theory behind it and the theory behind it is that the fed lender of last resort Facility Needs to be curtailed and needs to be harder for the fed to provide liquidity support to Financial Institutions that may well need to be recapitalized but in the meantime you have a panic going on and you need to address that panic with some very strong immediate action. So he spills out this scenario in great detail and changes the way i think about the financial crisis and makes me worry whether our fed has the tools that it will need to fight the next financial crisis specially if it will happen if it originates outside of the Banking System that the fed itself is most capable of making lender of last resort. Thats a big picture. Theres interesting chapters in the book that describe the more details about what i just said so let me mention a few of them. First of all, in talking about connectedness, he paints a beautiful picture of Lehman Brothers and Lehman Brothers itself is an incredibly fragile institution. Theres huge important connections between the the Holding Company and subsidiaries and the result of that is that if problems start within Lehman Brothers there is a connectedness problem, these problems are going to spread throughout Lehman Brothers and Lehman Brothers itself as he paints in a detailed picture, Lehman Brothers itself collapsed in a very connected way. But the sense in which connectedness was not so important in the financial crisis, when you look to see how the financial crisis spread from Lehman Brothers to the rest of the economy it didnt spread through connections, it didnt spread lehman was defaulting to another Goldman Sachs and goldman defaulted to the next one and the economy blew up that way. Lehman brothers collapsed rather neatly through internal but department spread through the rest of the system. It spread through the rest of the system through panic, the reserve fund held lehman assets and they declined in value, the investors in that Money Market Fund lost the money, what happened . The investors who invested in the other Money Market Funds panicked, pulled the money out of those funds, even though didnt invest in lehman assets at all. He paints a very interesting picture of how fragile lehman was within itself and the fragility was not what made things spread into the system. If you look at the collapse of bear stearns, it collapsed in a way that was similar to lehman and you didnt have the panic at the time. The panic waited until it occurred later. Interesting thoughts about connectedness. Let me talk about correlation, capital. I think that the financial crisis of 2008 was largely a problem with capital and the book has some interesting chapters on contingent capital, a way to deal with this. It also has chapters on orderly resolution. One minute. One minute left. Orderly resolution and bailout and tarp and how that happened. But i will end my comments with just note of contingent capital, one area that i slightly disagree with the book. Contingent capital doesnt need to be a longterm liability of the bank. It can be shortterm. The key feature of contingent capital is that it has to be replaced, that is the bank when your maturity contingent capital and matureses but the bank cant replace it with new contingent capital, right there its going to be replaced and converted into equity. It doesnt have to be longterm. The second thing about it that i sort of disagree with he says contingent capital, security that is will convert into equity when the bank into trouble is some one conversion proposal. If that happens, that could amplify panic and i think thats not quite right because one interesting thing about contingent capital is panic makes the contingent Capital Investors not roll over the capital so that it converts. All of a sudden theres a massive inflow of new equity that the Banking System has gotten from the converging contingent capital so that will stop panics and not make them worse. We should think about and we should certainly think about, worry about the ability of the fed to exercise the powers that it needs to act as last resort next time the financial crisis occurs. Thank you, pete. [applause] in his new book connectedness and contagion al scott reminds us that historically the most important function is provision, lender of last resort or llr for short was the reason that most Central Banks were originally created. And yet doddfrank comes along and sort of cuts off the Federal Reserves ability to effectively lender of last resort lending for much of the economy. Im going to focus remarks on lender of last resort. In this book how hal does a superb job, all large Financial Institutions are connected. Theres really no surprise there but contagion is a property that wellbeing of one firm not necessarily connected to the firm in question. For example, reserve breaks and Lehman Brothers need liquidity assistance from parents to immediate redemption. The classic example of contagion, run healthy unconnected banks, the Federal Reserve wide range of powers in recent financial prosays has been portrayed as a taxpayer bailout of the Financial Sector, as sequence the doddfrank placed new limits on the Federal Reserve powers. Fundamentals that should be allowed to fail. The rub is you cant tell the difference between a firm that deserves liquidity support and one that isnt and judgment call can be open to criticism. Why let lehman fail and save aig next week. This created a lot of problems. And is given regulatory rhetoric. They are quick to highlight these market forces. Almost never described as such, a bank run is the most fundamental of all market discipline forces. Many scholarly papers explain how banks fragile business model, investing longterm loans was a market innovation, not a mistake. Government safety nets, investors require banks to fund themselves with shortterm liabilities, this fragility imposed discipline decisions, banker with inadequate liquidity, and not for very long. Regulators espouse enthusiasm for market discipline and argue they need lots of tools and discretion to prevent bank loans and fire sales, suggesting those prices are stacked against discretionary lender of last resort powers. The political stepping point maybe not lender of last resort so much as free and discretionary nature of prior that arrangements. Congress and the Federal Reserve should Work Together to develop a new approach the relies on a market where institutions pay taxpayers to purchase liquidity before it is needed. To discuss the next few minutes, Federal Reserve should be required to sell liquidity options, liquidity options are options to be presented to the Federal Reserve and exercise appropriate collateral and receive a loan to the fed. One that allows for the Term Exchange of collateral, bank loans to the fed and get treasury in return and one that allows collateral, there is security lending, and repo lending option. They are sold at regular productions and should be traded in secondary markets thereafter. They have specified Exchange Terms that are less generous than those in the private security and lending and repo market, the price of these liquidity options would request shadow emergency liquidity. If Bank Coverage ratio and Stable Funding ratios these new rules on systemically important institutions, and we could create a Natural Market for these options. This would drastically improve risk over current selfinsurance approach for liquidity insurance which i will mention. If we do this with market terms emergency liquidity access would no longer be a special privilege but only exercise of liquidity insurance on agreedupon terms. The purchase of these liquidity options and their use should be open to all Financial Institutions, nonbanks has well, liquidity crisis subsequently to develop terms of liquidity contracts could be adjusted to allow the fed to provide all emergency liquidity the economy needed to lower the rate over the market rate, change collateral terms and adapt options to sell them and meet the liquidity demands of the economy. This approach would remove the need for the Federal Reserve to determine whether or not an institution is solvent, seeking liquidity support if they have the collateral to honor the contract. Taxpayer losses, setting appropriate haircuts and creating Federal Reserve priority on any borrowing institutions, and for these problems, and brings this up and talks about a proposal in the book, i would like to see folks take that up in more detail. It solves many problems we discuss in the book, discusses an important issue and gives us food for thought about the right way forward. I find ll are the most distressing problem created by doddfrank. Thank you to all the commenters, some time to respond in any way you like, always thinking, our mentioned Musical Chairs when challenged after the crisis to come up with an a metaphor for panic, Musical Chairs is a natural one. Imagine a game of Musical Chairs that has 500 in the Financial System, one of the problems is there are a lot of actors, 500 people playing Musical Chairs, but 700 chairs and the music played is a charming mozart serenade. Everybody easily find a chair, we call that high liquidity. The music shifts to raucous of noxious popular music and 400 chairs are removed leaving 500 players and 300 chairs and that is a good picture of what happens. The legitimacy of Central Bank Independence which is underneath a lot of this. To me, Peter Wallace and and i discussed coauthoring a piece on contagion and peter said to me i dont have a problem with that but the rest of the powers exercise supervision and regulation so if you are critical of that i will join you. What i would say is i think Central Bank Independence of the fed is more undermined in my view by all these other powers, supervision more than paul, as your point is, we need to know in advance the beauty of last resort, by options if you know it exists you wont have a problem. Mario draghi says i know what it takes and this facility. As long as the power is there it is not going to work, as long as people are uncertain what will happen they will do it. The other thing about that proposal, if you dont have these options you go into a situation, lehman doesnt have the option, the option they will run on to protect themselves, you have to have Critical Mass of acceptance of the options and opinion of this option to solve the problem. The liquidity coverage ratio and funding ratio rules to allow the use of options in replacing instruments and the banks will have some and you have secretary market, they could buy them from the banks that dont need them and when you observe, and open up the auction, sell more, you have monitoring devices in the secondary market, to purchase or dealer Financial Institutions to purchase and stockpile liquidity options and seldom to people and they charge people and you know the price and you see the demand for liquidity, the fed would not be caught flat footed when the commercial paper market, wondering what is going on. You would see the marketplace liquidity skyrocketing and deny their is a liquidity problem and make adjustments. With that provocative thought we have a lot of fun talking to each other. I want have one more question, lending lehman money to buy options. We have time for one or two more. Will you wait for the microphone to come to you . Thank you. I am a lawyer in new york. I hate to say this about a Harvard Law School professor but i think this is terrific. I went to Harvard Law School. It is excellent. I had the same issues and the same concerns during this whole doddfrank development, part of doddfrank is fine, capital enhancement, trying to eliminate incentives, moral hazard, not very successful. The key thing you focused on his tying the hands of the fed and the treasury, they are very wrapped up and this was made worse by the aig case where the fed said they didnt have 133 authority in the case of lending to aig and taking that stock. It is not a security interest, the judge is totally wrong and if you are you have to come to a question. My friends at the fed also think section 133 has amended does not tie their hands very much, wishful thinking, the Resolution Authority why would the fed i dont have a problem here. Do you want to undermine confidence or the institution. And and concerned about this, and, professor scotts book, you know what they allow wall street again, this is toxic. This will take time. We have come to adjournment, or any member im intrigued, and in dealing with the crisis, and issue been bernanke things is the most difficult for stigma, one benefit of it, you get around that problem, to start the auction, that would be built in the front. If the fed proposed that, you want to give them advanced protection and a promise to bail them out. In the political system today. I agree. Occasionally on the hill to testify, they are paying for the right to have protection and it is not free any longer. And get around it. The sense that you raised serious and deep problems in the book that need addressing, thank you very much to members of the panel. Ask us in the informal setting, thanks to the panel. [applause] [inaudible conversations] [inaudible conversations] booktv records hundreds of other programs throughout the country all year long. Here are the events we are covering this week. The political divide in america. That is what booktv is covering this week. Many of these eventss are open to the public, look for them to air in the near future on booktv on cspan2. You are watching booktv on cspan2, television for serious readers. Here is a look at our primetime lineup tonight following live coverage of the National Book festival. We kick off the evening at 9 00 pm eastern time with Lawrence Kudlow and his coauthor discussing similarities between economic policies of the jfk and reagan administrations. 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