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 pri