today about investment banking, which is a subject of some

interest around here. First, I thought I

would--there's been so much news;

I want to just briefly comment about what's going on in the

world today with our financial crisis.

Notably, I think that this is the--it could be the biggest

financial crisis since The Great Depression and as evidence of

that, we're seeing a lot of talk

about what changes should be made.

I think it reminds me of the very basic fact that we live in

a financial world that was created in the wake of The Great

Depression. So many of our financial

institutions were created in the 1930s because that was a time

when everything was being shaken up and it was a time when people

were willing to consider something really different.

If you just look back where various of our

institutions--when they were created--it's most likely to be

in the 1930s. We are not yet at such a

crossroads. The financial situation is not

as bad as it was in the 1930s, but it's getting bad and as a

result we're starting to see proposals for big change.

Notably, on Monday, the Treasury Department,

under Secretary Henry Paulson, announced a proposal for

fundamental change in our financial markets.

This proposal, if implemented,

might be the biggest change since The Great Depression.

However, the news is calling it dead on arrival;

it's unlikely that the Paulson proposal will be implemented

partly because it's being proposed by a Republican

administration--well, not just Republican,

just an administration that's coming to an end and we're

having an election. This Paulson proposal probably

has very little chance of being implemented as is,

but it's put in to change the discussion and it's going to be

talked about a lot and I suppose it will influence what happens.

The interesting thing is that the next President of the United

States will likely have a mandate for big changes.

Maybe it's just as well that Fabozzi, et al.

are slow to do a second edition of their book because if they

got it out this year it would be a bad year to get it out because

everything is changing. I studied the Paulson proposal

carefully, since I'm writing a New York Times column about it,

which will appear Sunday. Reading the various

commentaries about the proposal, I had the impression that not

many of them are very--thinking very deeply about it.

They typically--they like to talk about the politics of it

and this thing, that it's dead on arrival or

it's--someone said it's an amateurish proposal.

All the groups that stand to win or lose from it are all

figuring out what it does to them and they're taking the

positions out of self-interest. So, I wanted to write something

that was more perspicacious, if I could manage that.

The interesting thing is, actually everyone calls it the

Paulson proposal, but it was apparently mostly

written by a young man who is in his early thirties.

You may not consider that young, but I think that is

young. He could have taken this course

from me ten years–actually,

he didn't go to Yale. I looked it up;

he went to American University, both undergraduate and--his

name is David Nason--undergraduate and then he

got a law degree at American University.

Then he just went to work for the government.

As far as I know, he doesn't publish;

he's not in the newspapers, but he's gotten the ear of the

Treasury Secretary. They spent many weekends

together figuring out what should be done about the system

and they wrote up a proposal. I like many aspects of it;

actually, it's an interesting proposal.

It's not so much what's in the proposal as it is that this is

the time for reconsideration. One interesting thing that they

proposed is that we should have what they call "objectives based

regulation."

We have--this is David Nason and Henry Paulson,

although it's not signed by them, it's signed by The

Treasury. So, The Treasury–it's

called a blueprint, a blueprint for reform of our

financial regulation.

It's built around what they call "objectives based

regulation." That means that the different

regulators should each have their own objective,

so they have a three-part proposal.

The market stability regulator, which would make sure that the

markets don't freeze up on us--we don't have a systemic

crisis. There would be a prudential

financial regulator and then, three, there would be a

business conduct regulator, so that's the main part of the

proposal. What they're doing is

emphasizing the different objectives of regulators.

The market stability is going to be the Fed,

but it's not just banking. They want it to be--the Fed's

role would be broadened so that it's not just a banking

regulator, it's the whole financial system.

It's supposed to be maintaining the stability of the system.

Then the prudential financial regulator is supposed to

regulate--it's supposed to aim at protecting the U.S.

interest in various institutions that are guaranteed

by the government, such as banks that are

federally-insured or enterprises that have government guarantees

or apparent government guarantees,

like Fannie Mae and Freddie Mac. Then the business conduct

regulator is supposed to regulate--what I saw is it would

be aimed at--consumer protection;

that it would make sure that businesses are protecting

individuals. I find this interesting because

it calls to mind some of the problems we had with the

subprime crisis. One very important problem was,

in the U.S. we have regulation divided up

in crazy archaic ways. Different agencies were formed

at different times and they have specific missions.

For example, we have the Office of the

Comptroller of the Currency. The OCC was founded in 1863 to

supervise national banks but it only supervises national banks.

Well, why not state chartered banks or why not credit unions

or other things? Well, it's just an accident of

history. So, what these people are

proposing is that we merge various agencies so that--define

new agencies of the government that are separated by these

different objectives; so, an objective defines an

agency--a regulatory agency.

What they want to do is merge the OCC and the OTS merger;

that's one of the proposals. I wonder why they don't carry

it further, but that's the thing they emphasized.

The OCC is Office of the Comptroller of the

Currency--regulates national banks.

The OTS is the Office of Thrift Supervision;

it regulates savings banks. So, we put the two

together--that sounds sensible, I guess.

Why are they separate? Various other things that they

talked about had that form. They want to merge the

Securities and Exchange Commission and the Commodity

Futures Trading Commission. The Securities and Exchange

Commission is the principal government regulator for

securities. They make sure that everything

is on the level and working right.

They help prevent fraud, misrepresentation,

manipulation of information in stocks and bonds.

The CFTC is the Commodity Futures Trading Commission and

it regulates our futures markets.

There has been, over the years,

a lot of turf battles between the SEC and the CFTC because

it's sometimes unclear whether something is a security or a

futures. For example,

when they started trading stock index futures,

both these agencies thought it was in their turf because it

involved both stock indexes and futures.

Anyway, Paulson is proposing merging these.

That makes sense and it seems like getting rid of some of this

division of regulatory agencies is very beneficial.

The division is what hampered regulators from dealing with the

financial subprime crisis. People knew that a lot of bad

loans were being made or loans were being made to people who

shouldn't be getting them. Low-income people were being

given adjustable rate mortgages with very low starter rates,

called "teaser rates," that would be raised in the future.

They were given them with--in such a way that after the rates

were raised, they likely couldn't afford to pay the

mortgage anymore or they'd be under great stress in trying to

do so. So, a family that bought a

house--a low-income family buys a house they can barely afford

it, then the rates go up on them.

The parents would have to take out second jobs to try

to--they're just going to go bankrupt when that happens.

It was, in some cases, unethical and it was plainly a

problem and yet the regulatory agencies in the U.S.

weren't stopping it. Another reason why the

regulatory agencies weren't stopping these problems was

because they often saw their mission in different terms.

When I gave a talk at the OCC in 2005, I was asking them

about, why aren't you policing these mortgages?

Their first answer was, well you have to remember we

were set up in Abe Lincoln's day to manage the national

banks--that's our mission. I may be overstating their

answer, but I got that flavor from them.

You want us to go out and protect consumers,

well of course that's a nice mission, but that's not our

mandate.

I think that what Paulson and Nason want to do is to create a

separate business conduct agency that is aimed at consumer

protection. So, it would be working

parallel with these other agencies to--but their job would

be to represent the consumer and that sounds like a good idea to

me. The thing I stressed in my

column was the market stability regulator, which is the Fed.

What they want to do is expand the actions of the Fed,

so that they're not--you can describe the Federal Reserve or

any central bank, traditionally,

as a banker's bank. Remember, I told you the story

of how the first--the Bank of England was the first central

bank and it made banks keep deposits at the Bank of England.

In other words, the banks were like customers

of the Bank of England; they had to keep deposits there

and the Bank of England watched them to make sure that they were

behaving responsibly and had authority over them because it

had market power. Well, the Fed is like that now,

but what Paulson and Nason wanted to do is make it more

than a banker's bank. They want it to be a bank for

the whole financial system. That's what's already happening.

In fact, it's just happening rapidly as we speak.

I mean, in this last month, things have changed.

The Fed has never given loans to anyone other then a

depository institution that is a bank until last month,

except they did so in the Depression.

There was this long gap in the 1930s;

the Fed was making loans to private companies that were not

banks and then they stopped doing that, until last month.

They created the--I mentioned it last time,

the Term Securities Lending Facility and the Primary Dealers

Credit Facility, which are lending outside the

banking system. What Paulson wants to do is

make that official that the Fed is no longer just a central

bank; it's a market stability

regulator. This is going to be very

controversial, but I think it's a good thing

to raise. In my opinion,

this is the trend anyway and I think we're going that way.

The problem is that in a modern financial economy,

we have so much instability, which is already built into the

system, that we rely on something like a central bank to

do things that help stabilize markets.

I think that we're probably going that way anyway and I

think that in the next presidential administration

we'll see an expansion of the role of the Fed.

I wish the Fed had behaved better in the recent crisis in

the sense--they didn't seem to recognize the bubbles that we

had in the stock market in the '90s and the housing in the

2000s. If they are our market

stability regulator, you'd hope that they could do a

better job. But, they're what we have and I

think that we should probably give them the authority to do

that job and I think that's what we need to do.

I was generally positive about their Treasury proposal.

Another thing that they want to do, which has been talked about

for some time. Yes?

Student: [Inaudible] Professor Robert

Shiller: Yeah. He asked, why do the news media

think that the crisis is already over?

Secondly, why do they think we can prevent--that's

paraphrasing. I don't know if the news media

are concluding anything, but you do see--we have

seen---over recent years, we've seen a lot of suggestions

that the turning point is just around the corner and the news

media report that. I think there's a bias towards

optimism among business economists or among business

people in general. It's not considered good form