Paul

McCulley
Global
Central Bank Focus
After the Crisis: Planning a New Financial Structure
Learning from the Bank of Dad
Based on Comments Before the 19th Annual Hyman Minsky Conference
on the State of the U.S. and World Economies
April 15, 2010
May 2010
Thank you very much. It is an absolute plea-
sure and honor to be here. I gave the keynote
a couple years ago and it was my frst time to
be at the Minsky Conference. I feel that Im
part of a church, and its a good church in
that were on the right side of history. And its
absolutely wonderful to be attending services
with you again.
I want to open up with a little story that
should make everybody in the room feel
particularly good, and then well get into
discussing economics. Harry Markowitz has
been a friend of mine for about a decade.
I became friends with Harry through two
channels. Number one, Rob Arnott of
Research Affliates has an Advisory Panel of
famous academics, such as Harry and Jack
Treynor, that he gets together every year.
Im frequently invited to speak. We spend
two or three days over a weekend together.
Ive also gotten to know Harry because he
and the late great Peter Bernstein were very
close friends. Peter and I were also very
close friends.
Ive been preaching the Minsky Framework
at Robs event for a number of years. And
Harrys always been very, very polite. I spoke
again just this past Sunday morning. After I
fnished, we had a nice Q&A. And Harry said,
Paul, if I had to read one book by Minsky,
which one would it be? And I said, Harry,
please, tell me that youve read at least one
book by Minsky. And he says, No, I havent,
but I think I would like to, and I think Im
probably old enough now.
I promised Harry that I would send him
one personally. And Im quite sure that if
I dont follow up on that, somebody at the
Levy Institute would gladly follow up. So,
the bottom line is that one of the fathers of
the Effcient Market Hypothesis has fnally
decided to attend services at the Church of
Minsky. I think that is a glorious, glorious
moment. Dont you? Harry is an absolutely
delightful man.
From the standpoint of what I want to talk
about tonight, a great deal of it has already
been discussed today. I feel a little bit like St.
Louis Federal Reserve President Jim Bullard
did at lunch when he said that Paul Krugman,
who spoke just before Jim, had already given
90% of his speech. Thats basically true for me
Global Central Bank Focus
Page 2 May 2010
as well. Pauls speech was superb, laying out
six possible culprits in the fnancial crisis.
1

I want to focus on Pauls Number 3, the
Shadow Banking System. Paul was drawing
a lot of his comments today from the work
of Professor Gary Gorton of Yale, which is
absolutely fantastic material. Have a lot of
you read Garys essay, Slapped in the Face
by the Invisible Hand?
2
I see a lot of nods
here. Thats where the phrase that Paul used,
Quiet Period, came from. Gary coined it.
Hed be a great person to have here next year
at the Minsky Conference.
And one of the fascinating things that he
details is the nature of banking. Thats
where I want to start tonight. Lets start
with frst principles. If we do, then I think
we can understand why we shouldnt look
at the conventional banking system and the
Shadow Banking System as separate beasts,
but intertwined beasts.
The essence, or the genius of banking, not just
now, the last century or the century before
that, but since time immemorial, is that the
publics ex-ante demand for assets that trade
on demand at par is greater than the publics
ex-post demand for these types of assets. Let
me repeat this, because this is a frst princi-
ple: The publics ex-ante demand for liquidity at
par is greater than the publics ex-post demand.
Therefore, we can have banking systems
because they can meet the ex-ante demand,
but never have to pony up ex-post. In turn, the
essence or the genius of banking is maturity,
liquidity and quality transformation: holding
assets that are longer, less liquid and of lower
quality than the funding liabilities.
A second principle: A banking system is solvent
only if it is believed by the public to be a going
concern. By defnition, if the publics ex-post
demand for liquidity at par proves to be equal
to its ex-ante demand, a banking system is insol-
vent because a banking system ends up, at its
core, promising something it cannot deliver.
Everyone following me here?
Professor Gorton, in his paper, goes through
how that promise was dealt with during the
19
th
century, before the New Deal Era. There
were panics all the time, otherwise known
as runs, because we didnt have a lender of
last resort and we didnt have deposit insur-
ance. During the 19
th
century, the system
dealt with its reoccurring panics in lots of
novel ways, including clearing houses which
would de facto be a central bank, and suspen-
sion of convertibility of deposits into cash. So
the problems weve been dealing with in the
last couple of years are not new. They go back
to the origin of banking.
The Quiet Period, from the New Deal Era
until the Panic of 2007, was actually unique
in history. And the Quiet Period came about, I
think, for a lot of the reasons that were articu-
lated earlier today in that banks, conventional
banks, after the Great Depression, were con-
sidered to be special. And, in fact, banks are
special. If you think that the banking system
can be guided to stability as if by an invisi-
ble hand, then you are deluding yourself. But,
that is, in fact, what happened with the explo-
sive growth of the Shadow Banking System.
Banking is a really proftable business. In
its most simple form, think in terms of a
bank issuing demand deposits, which are
Page 3
transformation: a very proftable business.
Banks can issue, essentially, perpetual liabili-
ties call them demand deposits and invest
them in longer dated, illiquid loans and secu-
rities, earning a net interest margin. Its a
really, really sweet business.
In the early years of the Quiet Period, we reg-
ulated that really sweet business. I think that
was a really bright idea. In order for that busi-
ness not to be prone to panics and, therefore,
fnancial crises, you needed to have deposit
insurance. Deposit insurance, by defnition,
cannot come about as if by the invisible hand.
Deposit insurance cannot be, cannot be a
private sector activity. It is a public good. The
deposit insurer must be a subsidiary of the
fscal authority. And in extremis, the mone-
tary authority can monetize the liabilities of
the fscal authority. Im not saying that pejo-
ratively. Im not being pejorative at all. Just
descriptive. Bottom line: Deposit insurance
is inherently a public good.
Access to the Feds balance sheet is also
inherently a public good, because the Federal
Reserve is the only entity that can print cur-
rency. So essentially, banking has two public
goods associated with it. Therefore, naturally,
it should be regulated.
That was the Quiet Period Model. And reg-
ulation took the form of what you could do,
how you could do it and how much leverage
you could use in doing it. And, as was men-
tioned by Paul Volcker a number of times
earlier this afternoon, the regulatory burden
that has historically come with being a con-
ventional bank has been actually quite high.
During the early years of the Quiet Period,
guaranteed to trade at par because theyve got
FDIC insurance around them and also because
the issuing bank can rediscount its assets at the
Fed in order to redeem deposits in old-fash-
ioned money, also known as currency.
In fact, lets take a look at the $1 bill I am
holding in my hand. It says right at the very
top, Federal Reserve Note. It also says right
down here, This note is legal tender for all
debts, public and private. This is what the
public ex-ante wants: the knowledge that they
can turn their deposits into these Federal
Reserve Notes. And if the public knows they
can turn them into these notes, they dont.
With me here? If I know I can, I dont.
Now, this is a unique note. This is a Federal
Reserve liability. And, actually, its really
cool. Its missing two things. It doesnt have
a maturity date on it. So, its perpetual. And
it doesnt have an interest rate on it. I would
love to be able to issue these things. It would
make me very, very happy to issue these
things. But it would be against the law! But, in
fact, thats what banks did in the 19
th
century.
They issued currency. After the creation of
the Federal Reserve, it was given monopoly
power to create currency, which I think was
a pretty bright idea. But demand deposits
issued by banks are just one step away from a
Federal Reserve Note.
Conceptually, demand deposits have a
one-day maturity. I can write a check on it,
and it goes out at par tomorrow, if not today.
Demand deposits, conceptually, have a
one-day maturity. But in aggregate, they have
a perpetual maturity. So, therefore, banking
can engage in maturity, liquidity and quality
Global Central Bank Focus
Page 4 May 2010
however, banking was nonetheless a very
proftable endeavor.
There was a quid pro quo, which actually led
to the old joke which was actually said about
the savings and loan industry that banking
was a great job: Take in deposits at 3, lend them
out at 6, and be on the golf course at 3. 3-6-3
banking was a pretty nice franchise. So, there-
fore, bankers had a pretty strong incentive not
to mess it up. Essentially, there were oligopoly
profts in the business. I think Gary Gorton is
actually right on that proposition.
The invisible hand, however, naturally
wanted to get the oligopoly profts associated
with banking while reducing the impact of
some regulation. Thus, the Shadow Banking
System came into existence, where the net
interest margin associated with maturity,
liquidity and quality transformation could be
earned on a much smaller capital base.
And, in fact, thats what happened starting
essentially in the mid-1970s, accelerat-
ing through the 1980s and 1990s, and then
exploding in the frst decade of this century.
The birth of the Shadow Banking System
required that capitalists be able to come up with
an asset which actually for shadow bankers
is a liability that was perceived by the public
as just as good as a bank deposit. Remember,
the public has an ex-ante demand for some-
thing that trades on demand at par. Therefore,
shadow bankers had to be able to persuade
the public that its asset which is actually the
shadow bankers liability was just as good as
the real thing. If they could do that, then they
could have one whale of a good time.
That asset which, again, is the banks lia-
bility needed, in Gary Gortons terms, to be
characterized by informational insensitiv-
ity, meaning that the holder didnt need to
do any due diligence, just taking it on faith
that this asset could be converted at par on
demand. And, in fact, money market mutual
fund shares achieved that status. With one
small exception prior to the Reserve Primary
Fund breaking the buck, they always traded
at par. And if there was any danger they
wouldnt trade at par, the sponsor would step
in and buy out any dodgy asset at par. So,
essentially, the money market mutual fund
industry was at the very core of the growth of
the Shadow Banking System.
It created a liability perceived as just as good
as a demand deposit wrapped with deposit
insurance, issued by a bank with access to
the Fed. It was a great game. But in and of
itself, that didnt lead to the explosive growth
in the Shadow Banking System. There
needed to be another link in the chain. Yes,
money market mutual funds needed an asset
that the public perceived as just as good as a
bank deposit. But they also had to put some-
thing on the other side of the balance sheet.
What went on the other side of the balance
sheet? Money market instruments such as repo
and commercial paper (CP). And under Rule
2a-7, they were allowed to use accrual account-
ing for their assets. The assets didnt have to
be marked to market. So, therefore, 2a-7 funds
could actually maintain the $1 share price,
unless they did something really dumb.
At their peak, money market mutual funds
were about $4 trillion. They are about $3 trillion
Page 5
now. They interacted with the larger Shadow
Banking System. And the largest shadow
banks were the vehicles of investment banks,
funded heavily with repo and CP. So, explo-
sive growth of the Shadow Banking System
was logically the result of the invisible hand
of the marketplace wanting to get the prof-
itability of the regulated banking system,
but without the regulation. Shadow banks
created information-insensitive assets for the
public that were perceived as just as good as
a demand deposit, and then levered the day-
lights out of them into longer, less liquid,
lower-quality assets. And it all worked
swimmingly well, for a while. But then they
embarked on the Forward Minsky Journey.
3

Shadow banks were the predominant place
where securitizations of subprime mortgages
were placed, as well as securitizations of other
types of assets. So the Shadow Banking System
was, essentially, mirroring the banking model,
which had deposits and loans.
Turn the deposit into asset-backed commercial
paper. Turn the loan into a security. What you
end up with is the same vehicle as a bank from
a functional standpoint, but you have it outside
the conventional bank regulatory structure.
Actually, let me correct myself. There was a de
facto regulator in the Shadow Banking System.
They are called the rating agencies.
In order to do the trick of creating a shadow
bank, you had to have the rating agencies
declare that your senior short-dated liabili-
ties were just as good as bank deposits. In fact,
most money market mutual funds get them-
selves rated, and S&P, Moodys, and Fitch do
have particular rules for giving a AAA rating
to a 2a-7 money market fund, mirroring SEC
Rules. But, for the rest of the Shadow Banking
System, the rating agency rules evolved on
the fy, often under the guidance of shadow
bankers themselves. It didnt work out very
well, as the Shadow Banking System became
the lead owner of what was created in the orig-
inate-to-distribute model of mortgage creation.
On August 9, 2007, game over. If you have to pick
a day for the Minsky Moment, it was August
9. And, actually, it didnt happen here in the
United States. It happened in France, when
Paribas Bank (BNP) said that it could not value
the toxic mortgage assets in three of its off-bal-
ance sheet vehicles, and that, therefore, the
liability holders, who thought they could get
out at any time, were frozen. I remember the
day like my sons birthday. And that happens
every year. Because the unraveling started on
that day. In fact, it was later that month that
I actually coined the term Shadow Banking
System at the Feds annual symposium in
Jackson Hole.
It was only my second year there. And I was in
awe, and mainly listened for most of the three
days. At the end, Marty Feldstein always does
the wrap-up. Everybody wanted to talk. And
since I was a newbie, I didnt say anything until
almost the very end. I stood up and (paraphras-
ing) said, Whats going on is really simple.
Were having a run on the Shadow Banking
System and the only question is how intensely it
will self-feed as its assets and liabilities are put
back onto the balance sheet of the conventional
banking system.
Now, I certainly didnt anticipate that it was
going to lead to the debacle that eventually
Global Central Bank Focus
Page 6 May 2010
unfolded. In fact, while the run commenced
on August 9
th
of 2007, it was pretty much an
orderly run up until September 15, 2008. And
it was orderly primarily because the Fed and
here I give the Fed credit, not criticism evoked
Section 13-3 of the Federal Reserve Act in
March of 2008 in order to facilitate the merger
of under-a-run Bear Stearns into JPMorgan.
Concurrently, the Fed opened its balance
sheet to the biggest shadow banks of all, the
investment banks that were primary dealers,
including most important, the big fve. It was
called the Primary Dealer Credit Facility.
Im sure that was an incredibly difficult
decision for the Federal Reserve Board to
make to open its balance sheet to borrow-
ers it didnt regulate. But it was necessary,
because runs are self-feeding; you cant stop
them without the aid of somebody with the
ability to print legal tender. Thats the only
way you can stop it, because only the Fed
can create an asset that will definitionally
trade at par in real time. During a run, thats
what the public wants. A run turns upside
down the genius of banking. A run is when
the publics ex-post demand for liquidity at
par equals its ex-ante demand.
Post-Bear Stearns, fnancial life regained some
sense of normalcy. But then came the run on
Lehman Brothers, and the Fed didnt have the
legal power to implement a Bear-like rescue.
And then the Reserve Fund broke the buck.
That week will be one that we remember for the
rest of our lives. It will also be one that we will
remember where the Fed was at its fnest hour.
The Fed created a whole host of facilities to stop
the run. In fact, they expanded the Primary
Dealer Credit Facility to what are known as
Schedule 2 assets, which meant that dealers
could rediscount anything at the Fed that they
could borrow against in the tri-party repo market.
Concurrently, the FDIC stepped up to the
plate, doing two incredibly important things.
Number one, they totally uncapped deposit
insurance on transaction accounts, which
meant that the notion of uninsured depositors
in transaction accounts became an oxymoron.
If you were in a transaction account, there was
no reason to run. And then the FDIC effec-
tively became a monoline insurer to nonbank
fnancials with its Temporary Liquidity
Guarantee Program (TGLP) allowing both
banks and shadow banks to issue unsecured
debt with the full faith and credit of Uncle
Sam for a 75 basis points fee. No surprise some
$300 billion was issued.
So, bottom line, you had the Fed step up and
provide its public good to the Shadow Banking
System. You had the FDIC step up and do the
same thing with its public good. And as Paul
Volcker was noting this afternoon, you had the
Treasury step up and provide a similar public
good for the money market mutual funds,
using the Foreign Exchange Stabilization
Fund. It was a triple-thick milk shake of social-
ism. And it was good. Again, Im not being
pejorative. Im being descriptive.
Banking is inherently a joint venture between
the private sector and the public sector.
Banking inherently cannot be a solely capital-
istic affair. I put that on the table as an article
of fact. And, in fact, speaking at a Minsky
Conference, I know Im preaching to the con-
verted. Big bank and big government are
part of our catechism. And, in fact, thats
Page 7
exactly what came to the fore to save us from
Depression 2.0.
Let me draw to a few conclusions. How
should we re-regulate the fnancial landscape
as President Bullard was calling it today
to make sure this doesnt happen again? We
must, because the collateral damage to the
global economy has been truly a tragedy.
And I think the frst principle is that if what
youre doing is banking, de jure or de facto,
then you are in a joint venture with the public
sector. Period. If youre issuing liabilities
that are intended to be just as good as a bank
deposit, then you will be considered func-
tionally a bank, regardless of the name on
your door. Thats the frst principle.
Number two, if you engage in these types of
activities call it banking, without making
a big distinction here between conven-
tional banking and shadow banking, as Paul
Krugman intoned this morning in such
size that you pose systemic risk, you will
have higher mandated capital requirements
and you will be supervised by the Federal
Reserve. Yes, I just told you who I think the
top-dog supervisor should be. You will have
tighter leverage and liquidity restrictions:
You will have to live by civilized norms.
In fact, a great deal of what is on the reg-
ulatory reform table right now proceeds
precisely along those lines. If youre going
to act like a bank, youre going to be regu-
lated like a bank. That simple. And maybe
you just might fnd the time to go back to
working on your golf game at 3. That is the
core principle.
There truly is a devil in the details, because
its quite natural that non-bank levered-up
fnancial intermediaries dont want to be
treated like banks. I wouldnt either. But the
truth of the matter is if youre going to have
access to the public goods associated with
banking, then youre going to be treated
like a bank.
In fact, here is an example of this concept in
my own life, which Im sure most of you have
experienced who have older children. When
my son turned 18, he said, Dad, Im now
the age of majority and I can do whatever
I want. I said, Son, thats absolutely true.
However, I still control the Bank of Dad. And
if you want to have access to the Bank of Dad,
there are going to be rules. If you dont want
access to the Bank of Dad, thats fne. But if
you want access to the Bank of Dad, there are
going to be rules.
The Federal Reserve and the FDIC and the
Treasury, together, are the Bank of Dad. And
Mom. I expect regulation to be similar to that
which I have imposed on my son. It doesnt
mean I want to stife his innovation. That
doesnt mean I want to stife his creativity.
I want him to be all he can be. But as long as
hes banking at Bank of Dad, there are going
to be rules.
So theres my regulatory framework for you.
Yes, think in terms of the Federal Reserve and
the FDIC and the Treasury as all providing
public goods to banking. But the Federal
Reserve has got to be at the top of the totem
pole, because the Fed truly is the Bank of Dad.
The entity that can print money has got to be
the lead supervisor. To me, its unambiguously
Past performance is not a guarantee or a reliable indicator of future results. This article contains the current
opinions of the author but not necessarily those of the PIMCO Group. The authors opinions are subject to change without
notice. This article is distributed for informational purposes only. All investments carry risk and may lose value. Forecasts,
estimates, and certain information contained herein are based upon proprietary research and should not be considered as
investment advice or a recommendation of any particular security, strategy or investment product. Information contained
herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced
in any form, or referred to in any other publication, without express written permission of Pacifc Investment Management
Company LLC. 2010, PIMCO. BF096-042310
Facebook
Stay up to date on
PIMCO with Facebook.
Search PIMCO.
twitter
Stay in touch with
PIMCO. Search
PIMCO.
840 Newport Center Drive
Newport Beach, CA 92660
949.720.6000
pimco.com
clear. And the fact that its being debated actu-
ally befuddles me. I operate on the notion that
self-evident truths should be self-evident. But
apparently Washington doesnt operate on
that thesis.
Ive talked too long. I promised you I wouldnt
do this. I was going to talk short and then
have a long Q&A, but Im a Baptist ministers
son, and we cant help ourselves. Regardless
of how simple the sermon may be, it always
goes on too long because the minister always
enjoys giving it more than the audience enjoys
receiving it.
Thank you very much.
Paul McCulley
Managing Director
mcculley@pimco.com
1
http://krugman.blogs.nytimes.com/2010/04/18/six-doctrines-
in-search-of-a-policy-regime/
2
http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf
3
Minsky and Neutral: Forward and In Reverse, Global Central
Bank Focus, December 2007, http://www.pimco.com/LeftNav/
Featured+Market+Commentary/FF/2007/GCBF+Dec+2007.htm