10. Financial System Challenges & Opportunities

10. Financial System Challenges & Opportunities

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visit MIT OpenCourseWare at ocw.mit.edu. GARY GENSLER: Thanking
everybody to coming back. I think there'll be a few
people coming in late, still hitting the send
button on the papers. I want to thank everybody
that submitted papers before the ninth class,
because I actually had a chance to read those 26.

Since there are actually
officially 84 or 85 people registered for this
class, I'm intrigued to see if 59 papers
came in a minute ago. Human nature being human
nature, these are just the statistics on this class. And as far as those of
you who may have seen, I chose that part
of the experience here is actually eyes on– meaning my eyes on your papers– and giving comments. If you don't want the comments,
you just want a grade, you can always give me a
heads up and send me an email, and I will take less time. I want to compliment everybody. They're good. I mean, there is a good
engagement, a good dialogue. You will see occasionally
that I don't give you everything you want back. But a couple observations. It's really an
opportunity, on any topic you want to choose in the
second half of the semester up to maybe the 23rd class,
please, if 70 of you hand it in on the 23rd class,
that is your right, that is your option, it's just– it's just going to be
harder on Sabrina, Thalita, and me to grade.

But it's to use
critical reasoning about that week's topic. So let me just mention two or
three things some of you did– I'm not going to be harsh
about it– but some of you did that's not what
I'm looking for. I'm not looking for just
addressing the three study questions. The three study questions
are about us together here. And just to sort of talk. Secondly, I'm not
looking for you to take a reading
from six weeks earlier and describe that reading,
or three weeks earlier. So if you choose, in the
future, to take November 15th– I know November 15th,
because we're going to– it's going to be our second
time with outside speakers, and it's a really
important time, if you look at that class, to
write something on that class when it's– we're fortunate enough
that Jeff Sprecher, who is the Chief Executive Officer
of the Intercontinental Exchange, and Kelly Loeffler,
who is the Chief Executive Officer of Bakkt, are going
to come and do a class with us about payment systems and what
ICE and the New York Stock Exchange is trying to
do in payment systems.

I'm just using that. If you write about that,
it's really about that, not about everything earlier. And when we get
earlier, I'll probably say more about that class. And we were
fortunate to have one of America's true
great entrepreneurs join us in Jeff
Sprecher that week. Who has, from scratch,
created a $50 billion market cap company in 20 years. So those were my comments. The papers were generally good. Really looking for critical
reasoning, ground truths. Where did you take something? Some of you brought a great
narrative voice, by the way. I have to compliment. There were a couple–
a handful that I really found you're really good
writers and in addition to being good business students.

So those are my thoughts today. I'm going to go through– oh, and we have we have an
interesting guest next Tuesday, but I'm not going to say
anything more than that. You'll find it fun. Tuesday the 16th. STUDENT: Nakamoto? GARY GENSLER: What's that? STUDENT: Nakamoto? GARY GENSLER: Nakamoto! Satoshi Nakamoto. No, no. Any other guesses? I'm not giving any clues,
but I will tell you you will have fun next
Tuesday the 16th. It will be a guest you will
not see at any other class. So today, I want to talk about– Ah, Tom's thinking
about it, right? Intrigued. We're going to talk a
little bit about finance. Now, just as a
way of background, I've spent 39 years in finance. So this is just my chance
to take 80 minutes to talk about finance with all of you. We did have readings
that will tie into it. So overview, we're going
to talk a little bit about the readings, of
course, as we always do. Three slices of finance
for a moment– finance and financial institutions.

What is a financial institution? What does that word mean,
and how do we think about it? Finance and regulation,
finance and technology. So three quick
slices of finance. What is credit? What's capital markets? Again, a broad sort of
Gensler's view of it, maybe, but still I
think you could– it's grounded in
academic literature. Then what are the risks? I spent a bunch of
time at Goldman Sachs. One of the last things I did as
kind of the cofinance officer was also sit on the
firm-wide risk committee. And so sort of
bringing insight into, what is risk
management in finance? Or at least in the capital
market side of finance.

And crises. I'm going to spend a couple
of minutes on the OA crisis. Some perspective from a
guy who lived through it. And then some of
the opportunities in the blockchain world. We'll try to wrap and be out
of here at 3:55, as usual. So this study questions– which, now I know there's
probably 58 papers on this in the inbox, I think. But does anybody
want to lend a hand? I mean, it's getting shorter. It's only 20 people
on this list now. But that means
that 25% of you are thinking that class
participation is not that important.

We're going to have to find a
way that if somebody's still on this list in a while
that I don't give somebody a terrible grade. Because 30% of the grade
is class participation. I just say that. I'm humorous about it. I'm willing to work
with people that, if your language skills aren't
there and you're just shy, or you have an issue. But does Monica want
to help me out at all? STUDENT: Yeah. So, I'm back here. So one of the trade offs that
I talked about in my paper was that we saw from
one of the articles that, as bankers were
making more money, there is a greater
income disparity that we saw in the entire sector. And then one of the other
things I talked about, as some of these
institutions combined, they created like these huge
conglomerates and the act kind of deregulated
the space that allowed for that to happen.

raising two things, probably from the Harvard paper, but
two things that about income disparities and also
the concentration. Anything else that people
took from that Harvard– I know it was a little
dense, but the paper? Is that a hand up? Is that– no? You sure? Oh, come on. What's your first name? STUDENT: Cece [INAUDIBLE]. Sorry, I'm not in
the class list. [INAUDIBLE] visiting
MIT and hoping I can audit this class today. GARY GENSLER: All
right. [? Cece ?] is here as a listener. Thank you. Do you want– STUDENT: Dan. GARY GENSLER: Dan. STUDENT: Yeah, in the
Harvard paper, I just thought was interesting.

It was that that act in 1994
that essentially caused– it was the catalyst for
just massive consolidation of the financial
services industry. And so that's what ultimately
led to disproportionate wages, or disproportionate
economic rents, when related to productivity. GARY GENSLER: OK. So can you remind me which act? Because '94 isn't
ringing a bell. I mean, the
Gramm-Leach-Bliley was 1999, and I don't know if there
was something in '94 that– [INTERPOSING VOICES] GARY GENSLER: What's that? STUDENT: Riegle-Neal.

GARY GENSLER: Riegle-Neal. OK. So Dan's raising that it's
also regulation and law has a lot of effect on it. Consolidation is happening
in many industries. Finance is not separate
from those industries. 50, 60 years ago, you
had the local drugstores, now we have the big chains
like CVS and the like. So I just mention that the
consolidation happens a lot. One thing that I would say
on the other side of that, having actually watched
and observed some of it, is there was the desire
to merge a lot of banking. But the US, in contrast
to other countries, didn't have interstate banking. All the way into
the 1970s, banks had to be within their own– one of the 50 states, literally. That started to break
down in the late '70s.

It started– Riegle Neal in
'94, pretty much then it was, Katie bar the door, we
could have national banking. And then by 1999,
we also could have commercial banking and
investment banking together, which is Gramm-Leach-Bliley. I'm sorry. I want to come back
here, but next to Dan. STUDENT: I was going to say that
basically, the paper basically went through a process
of elimination of what could explain the
higher economic rents, and basically checked
everything off the list. It said it was basically
a bit of manipulation, because there was more
power by the banks that had consolidated. GARY GENSLER: Right. Erin, do you see that
as manipulation or just an opportunity to get some
oligopolistic or monopolistic rents? And I'm just discerning
the word manipulation– STUDENT: Yeah. I guess what they were– yeah, I mean I think it's– I mean manipulation in
the sense that, higher– maybe taking advantage
in a way that wouldn't exist in a market
that wasn't so consolidated compared to other markets
that were consolidated and regulated, such as Canada.

Because he made a
lot [INAUDIBLE].. GARY GENSLER: I would note that
every entrepreneur's desire, in a business context,
maybe not in a moral sense, is to be able to
collect economic rents. Like you start out
as a disruptor, and along the journey,
you would actually wish to become somebody
who collects excess profits or becomes the monopolist. I'm not speaking
that you literally want to take
advantage of people, but you do want to sort
of collect excess rents. And so it's a sort of
natural transformation. I'm sorry, there
was a hand here. STUDENT: Yeah, similar to what
Eric said last, compare also– concentration by
regulation, or concentration by deregulating the market,
and by regulating it, incumbents are able
to take more risks. And that is bad for
financial systems. GARY GENSLER: Right. Brotish? STUDENT: Not from the paper,
more from personal experience.

So the way I see it is
the financial institutions are increasingly trying
to be at the center of a lot of
different [INAUDIBLE] of different business. And with many
innovative products, they are kind of connected
like people across the industry chain. So they kind of [INAUDIBLE]
some sort of accountability with [INAUDIBLE] valuations. And when a financial
institution is at risk, it connects all the different
players in the value chain. GARY GENSLER: Right. So Brotish is raising also
that finance, partly because of its centrality
in the economy, tries to add other products
or add other things and be at the center of the
value proposition or chain. I would contend there is
also non-financial firms that try to do the same
thing into finance. So big tech right now– you think about Apple Pay,
or think of Alibaba in China. But then Ant Financial is
one of the most significant. So sometimes it
comes the other way. If you can leverage a network,
leverage your centrality to a market and add products.

But I agree with you, it
goes both ways, though. Other comments
from the readings? Isabella? STUDENT: [INAUDIBLE]
articles also was sort of the idea of
innovation ahead of regulation. The nice thing about
bringing in new technology is that it does take
time for the government to actually regulate it. And I know one of the
articles, or the interview talked about needing to further
regulate and restructure the banks. That's not something that's
going to happen, especially with people trying to overturn–
is it the Dodd-Frank act? Yes. So it's not really
going in that direction, but it's something people
talk about it a lot. GARY GENSLER: Right. So there is an ebb and
flow of regulation, and we'll chat in
a couple minutes. Regulation in finance has been
around for thousands of years. I mean, literally,
back when the Hammurabi code was being written, there
were regulated interest rates. We went through a
long period in Europe where actually it was illegal
to charge an interest rate, for hundreds of years
in different societies.

So there is an ebb and flow. Now it's much more
complicated today. In a sense. And Isabel was just
mentioning that Dodd-Frank, passed in the US, was
a post crisis reform. That would be a time, a
period you would think, well, maybe the public, through
its legislative body, will lean into doing
more regulation. And then as you move away
from a crisis moment, you see some easing up. And there is always sort of an
oscillation over the decades. Why don't we take one more? STUDENT: So I think one of
the other interesting things that the article brought up
was the case of Citigroup, which basically highlights
the tradeoff perfectly. So on the positive
side, if you look at Citigroup, what
it's trying to do is it's trying to provide
universal services. So it's a one stop shop for
all your financial services. Whereas [INAUDIBLE]
argued that one of the things that
should have been done post crisis was to break it up. Because the problem with having
the universal one-stop shop is that, if it fails, then
it's an obligation on the fed actually prevent it.

raising something about Citigroup or
Citicorp that became, in a sense, a one
stop shop, a shopping center of financial
products, so maybe it should've been broken up. But who wants to tell
me what Sheila Bair, who was the head of the Federal
Deposit Insurance Corporation, said? Because in that interview with
Sheila, she talked about Citi. Alpha? STUDENT: She said
she almost, I guess, regrets not letting
them restructure and letting them fail,
because it created this sort of a moral
protection that people thought that [INAUDIBLE] large
[INAUDIBLE] shouldn't survive. GARY GENSLER: Kelly, were you
going to add something to that? STUDENT: Yeah, I was.

I thought her interview was– it's kind of hard to weed
out what she's really saying, because it's toned with
little strings of bias. Obviously, one, because she's
been through that crisis and pretty much brokered
that deal, and two because she throws in
political maneuvers. So it's hard to
tell what she thinks is necessarily best for the
health of the financial system. Like she says, bank profits
are good, dividends are robust. They've got big tax
cuts, they should be building their capital bunkers.

So– GARY GENSLER: Right. But you mean it's hard
to tell where Sheila is on Citicorp, for instance? STUDENT: Well, and
also the state of, like, how a lot of what she says
is the banks too big to fail. GARY GENSLER: So Sheila
Bair, who was to her core as a Kansas Republican,
who worked for Senator Bob Dole, who was then, when
she worked for him, majority leader in the US Senate
on the Republican side, is kind of a bit of
a prairie populist, if those terms mean
something to the class. And she got into the
role of running the FDIC and saw early– frankly a little
earlier than most– that there was a
problem going on in mortgage financing and credit
lending and the ease of credit in the US.

When the crisis
really hit hard, she was part ultimately of the team. Not the head,
usually the Chairman of the Federal Reserve, and
the Secretary of the Treasury. Or in any country, it's
usually the finance minister and the head of the
central bank who is somewhere in a war
room sort of setting, literally, in crisis and rolling
conference calls and meetings trying to sort through things. But Sheila was certainly
at that next level in our multifaceted
regulatory system in the US. And I read her reading, and also
just knowing her personally– I was with her last
Friday at a conference, which I guess she arranged in
Washington about the crisis. I think her reading was
what Alpha's saying. I think it's– but
you're correct, she is a political actor
and is proud of that. I mean, that's her lifeblood and
where she's been for 30 years. But she's also deeply
a policy person and tied to a sort of
populist vein in her– she would have
probably preferred to see Citi restructured or
taken over because of what Alpha said, that there is
a quote "moral hazard," that the markets
might think, well there's always going
to be a bailout waiting for the largest of the banks.

That would be the translation
of what she said there. Let me let me hit upon, so
what is the role of finance? What's the central role
when we simplify all down to its essence? We have a dozen masters
of finance in here. So what are they teaching? And what's Andy Lowe teaching? I don't know. Is anybody taking Andy's
intro class or no? Nobody wants to tell
me the role of finance? Here, here we go. Are you a master
of finance student? STUDENT: No, MBA. GARY GENSLER: You're an MBA. Who's a master of finance? Oh no! All right. What's the role of finance? Very simple. It's like elevator stuff. STUDENT: I guess
it's [INAUDIBLE] like different
functions of [INAUDIBLE] GARY GENSLER: All right, so
intermediary, helps society. What's it intermediating? The two things it intermediates?
[? M ?] finance students? STUDENT: They allocate
resources and also risk. GARY GENSLER:
Resources and risk.

So they move,
allocate and price. Really importantly,
price allocate and move money and risk. Just easy pictures. Money is something
of value and risk. And you will see this hourglass
on a whole bunch of slides because I've thought about
finance for the whole 40 years I've been around
it as an hourglass. Wall Street is sitting right
at the neck of the hourglass. Intermediaries. I thank– what's your name? What's that? Joey. Intermediaries of financial
assets and liabilities. Because there's both sides
of the balance sheet. They can move around
assets or they can move around
liabilities, again at the neck of the hourglass. So what are the key
functions of finance? I'm going to list four, but what
are the functions of finance? As opposed to a role? Anybody else? There were other hands up. Sure. STUDENT: Capital allocation. GARY GENSLER:
Capital allocation. I'll take that. It's not what I was
looking for but it's good. STUDENT: Market making. GARY GENSLER: Market making. Capital allocation,
market making. [INAUDIBLE]? STUDENT: Payment.

GARY GENSLER: Payment. STUDENT: Providing liquidity. GARY GENSLER:
Providing liquidity. I'm agreeing with all of them. You should have
written my slides. I should revise the slides. So I say it's
basically investments, basically the store
of value, and credit– in essence, borrowing value. Remember what money is. I know Ross is
looking at me like– it's the two sides of– we have this social
concept of money that goes back
thousands of years. And at some point in time, what
if I want to store the value or borrow the value? It's the two sides of the– it's, again, centered
on a social construct.

And thus, financial
intermediaries sit right at the
neck of the hourglass and transform risk as well. It could be a bank
that's transforming risk, short term deposits are then
lent or loaned out long. So right at the center
of the banking system, the commercial banking system. Is what's called
maturity transformation– short term deposits
versus long term lending. And it's not something
we're going to do away with. In fact, we should say,
that's a good thing. But because there's
maturity transformation, you can also have what's
known a run on the bank. What are the key sectors? I'm going to throw a bit up
here, six or seven sectors. But what are the sectors
you think about as– maybe some of you worked in? This is easy. STUDENT: Insurance. GARY GENSLER: Insurance, one. I don't remember your name. STUDENT: Ross. GARY GENSLER: Ross. STUDENT: Asset management. GARY GENSLER: Asset management. Insurance, asset management. Anton? STUDENT: Banking broker. GARY GENSLER: Oh, that's two
sectors– commercial banking and brokers. STUDENT: Private equity. GARY GENSLER: Private equity. I would call that
asset management.

All right. So I put commercial banks. Sometimes in the US we have
7,000 or 8,000 credit unions and 9,000 commercial banks. Investment banks
and brokerage firms. In Europe and many countries,
there are universal banks and there are inside
commercial banks. But they perform a little
bit different function. Commercial banks think about
taking depositors' money and then lending. The central thing
about commercial banks is a credit allocation,
pricing of credit, underwriting of credit. The center thing about
investment banks is about– it still has underwriting,
but it's usually related to market based, rather
than using their own balance sheet, but market based
securities and brokerage.

Insurance is a risk
transformation. I need to be covered if I
get into an auto accident. I need to be covered
if my house burns down. So thus I buy that insurance,
classic forms of insurance. And then all forms
of asset management and collective
investment vehicles. I make it as two
different buckets, because a collective investment
vehicle is when you actually put something into a
shared balance sheet, like a mutual fund. Asset managers are really
just getting paid a fee, but the two overlap. And of course all the
infrastructure of exchanges and clearinghouses. It might end up employing a
quarter of you in one day, but I think about the
different sectors. When you're thinking about
use cases for blockchain, it could be an any
one of these sectors, in any one of these functions. Financial markets
or capital markets. What's the difference between
primary markets and secondary markets? STUDENT: Kyle. GARY GENSLER: Kyle. STUDENT: Primary
markets was when you issue a share
that's new to the world, like you bring a company public. GARY GENSLER: All right. I'm going to pause you there. Good answer. So Kyle says primary
market is when an issuer– if I can add a word– an issuer is issuing a
security for the first time and receiving something of
value which we call money.

That's primary. Primary because it's
the first issuance. What's the secondary market? Hugo? STUDENT: [INAUDIBLE] GARY GENSLER: Training
of those later. So primary markets,
secondary markets. It's relevant not only because
they have different market structures and
different ecosystems, but they tend to have a little
bit different regulation as well. Which has the higher
volume in the– STUDENT: Secondary market. GARY GENSLER: Secondary markets. STUDENT: There are too many
issues [INAUDIBLE] the market. [INAUDIBLE] maybe
some interval issue. But [INAUDIBLE] it's [INAUDIBLE] GARY GENSLER: Well,
what's interesting though, the secondary
markets have much more volume than the primary markets. The ratio is not the
same market to market. Some markets, there's
a lot of profitability. If you're thinking
about finance and where you can make your own
businesses and money, there's a lot of juice
in the primary market. There's a lot of activity
and various illiquid or not tradable
secondary markets. Whereas like equity markets,
highly liquid equity markets, all the action is in
the secondary market.

Apple I don't think has
done any primary issuance in well over a decade, maybe a
couple of decades in the equity markets. But certainly the secondary
market for Apple stock is quite robust. Whereas there's some
things that it's only about the primary market. Alone, syndication is
really a primary market, and there's not a lot of
trading of secondary loans. So it's not all in one place. And again, when you're thinking
about use cases, that matters. Because is it high
volume or low volume? Is there a lot of juice? Juice is the margin of
profits to earnings. Non-technical term, sorry. I include in capital
markets the asset managers that earn fees, the
BlackRocks and Fidelitys or the small asset
managers, as well. And then all the
infrastructure– the exchanges, the clearinghouses and the like. So again, finance,
to sort of drill back to where we were earlier,
have ledgers and payment systems.

Who's going to remind
me what a ledger is? It's easy stuff. No. Ledgers. Wait, wait, no. STUDENT: It can
record transactions. Priya. GARY GENSLER: Priya. STUDENT: Record transactions. GARY GENSLER: A record
of transactions. I know you're tired
and you're quiet, but if I were to
give you an exam, one of the 20 questions I
would give you on vocabulary is ledgers. Because ledgers matter to
blockchain, and blockchain matters to ledgers. I'm not saying that there is no
use for blockchain technology absent ledgers, but
I'm hard pressed to think of a really good
use case within finance, at least, unless you have
some ledger, some recordation of things of value.

If you're keeping a
record of things of value, then the immutable
nature of blockchain becomes more relevant. If it's not things
of value, I'm just saying I'm a little bit
harder pressed to say, well, you need the complexity
of this database structure. You could use other database
structures to keep it, even though Stuart Haber has
that wonderful blockchain that's published in The New
York Times for notaries. So ledgers are records
of economic activity and financial relationships. They are embedded in
every part of finance. Insurance companies
have ledgers, investment banks have ledgers,
central banks have ledgers. They are embedded in every
part and they have been around for thousands of
years, and they're right at the center
of blockchain because the UTXO set in
Bitcoin is a form of a ledger. And there's an account
based ledger in Etherium. What is a payment and
settlement system? Anybody want to give it a shot? Alpha I'm going to
move money to you.

A payment system is moving
money from Gary to Alpha. You don't have to
answer this question. [? Kiera. ?] Payment system is
moving money from me to Alpha. What is it doing? It's transferring? Good. Kelly? STUDENT: I'm just going back to
our second class, but a method to amend and report
the changes to letters? GARY GENSLER: Right. I'm breaking it down. It is a transfer. But [? Keira ?] is
absolutely right. It's transferring
value from Gary– from me to Alpha. But Kelly's right. It's amending two ledgers. It's going to amend the
ledger on my side negative and hopefully amend
Alpha's positive. So it's amending and
recording ledgers. It's also– these
systems, they have to first authorize something. They have to do something
called clearing. And we're going to get to all
of these later in the semester. You might think, oh, that's
the boring stuff about finance. It's the back office. But authorizing,
clearing, recording. And the key word for
blockchain is final transfer.

The reason blockchain
might have application is it is a way to
finally move money. I don't mean finally
like over the centuries. I mean, if I were to move money
to Alpha through the US banking system, it might not
move for several days. Blockchain is an application
that could have more immediacy. Final settlement. Finance and regulation. We talked a little
bit about this when we were talking
about the readings, but it's long been part
of public policy debates. This is not new. It's not just a post
financial crisis.

It's not part of like the
post-industrial economies of the globe. It has been true for
thousands of years. Sometime to the point that
people went to prison. Does anybody know
what debtor prison is? Kyle or Priya? STUDENT: You would
basically have to go to jail if you
didn't pay your debts off in a certain amount of time, to
work off your debt [INAUDIBLE] be there. GARY GENSLER: So
Kyle is mentioning that debtor prison
was that you literally had to go to jail if you
didn't pay off your debts. Do you know when that
went away in the US or in Europe or in
China, in any country? STUDENT: Disturbingly recently. GARY GENSLER:
Disturbingly recently? STUDENT: [INAUDIBLE] GARY GENSLER: No, I thought
it was 18th century.

But you're saying you
think was 19th century. I haven't researched when
debtor prison finally went away. But so regulation also
is this horrible thought. What did we do when people
didn't pay their debts, and how bankruptcy
laws reflect– because bankruptcy
laws are a social construct, in essence,
that you don't go to jail, but you have an opportunity
to work through those debts. I just highlight this
that it's not a new thing. Blockchain isn't the– we
don't have regulation because of blockchain, and
we don't necessarily need a new set of regulations. Because finance is so
central to economies, we've been grappling with
regulation for a long time. Now you saw this little
framework before, but I restacked it. This is now the stack
I think of in terms of financial regulation. Financial stability is first. And while you can't
see closely, this is a bank run and
a wonderful picture by Dorothea Lange called
"White Angel Bread Line." But this is basically
financial stability is probably the first and
foremost thing that regulation around finance has been
for a couple of centuries.

It's how do we make sure that
the banks have backing when they take the money in house? And how do we make sure that we
don't have a calamitous thing? And even before Fiat currency,
well before Fiat currencies, we had economic cycles
that had boom and bust. Like in the 17th century,
the tulip bulb craze– the tulip bulbs in
Holland, I guess. But we also had incredible
boom and bust periods around the South Sea,
the stock companies that were being created over
exploration and so forth.

Protecting the
public, just as we've talked about in blockchain, I
would say that non-blockchain, there's a lot more emphasis
on consumer protection, a tremendous amount of emphasis
on consumer protection. Of course, we've talked
about investor protection and so forth. The illicit activity
conversation we've had all around blockchain
is important around finance, but it's not the leading– it's not the tip of the spear. It's not where this
debate has been over the decades or centuries. It's frankly more something
in the last 30 or 40 years. As money has moved to
digitized electronic means, governments have
stood up more emphasis on any money laundering
laws, Bank Secrecy Act laws and the like.

But if you look at the
history of like 19th century or early 20th century
financial regulation, there was a little
bit about guarding against illicit activity. But by and large, most of
the regulatory regimes– even in the 1930s, during the
financial crisis of its time, the Great Depression, most
of it was about bank runs, shoring up the banking system,
standing up deposit insurance and protecting the investors. And it was this concept of money
laundering and so forth was– it's when we move
from physical forms of cash to electronic forms
that you found more of that. Yes, please. STUDENT: In a public
policy discussion, how is financial
stability defined? Is it like more inflation? GARY GENSLER: That's
a very good question. Remember your first name? Jihee. Jihee is asking, is
financial stability about inflation or otherwise? It does include inflation, but
financial stability is broader.

In essence, it's the thought
of, does the financial system lead to instability
in the economy? And what is true, again,
for probably a couple of thousand years, but the
research that you can read– Ken Rogoff's book. I don't know if any of you have
ever read Ken Rogoff's book. It was a wonderful book
about the history of crises and economic cycles that
came out 4 to 6 years ago, and I could get
you the name of it. But finance adds to and
leads to booms and busts. Booms and busts existed
well before Fiat currency and banking, but there's
booms and busts in the cycle. And so financial
stability, in essence, is trying to smooth out
the cycles you would say.

Central banks came
along initially in the late 17th century. But then, by the
early 20th century, most nations had central banks
as a check on the sovereign in terms of currency. And that's where, Jihee your
question about inflation. So if the sovereign
can deflate– if the currency could be
devalued through inflation, that can lead to instability. But it's all forms
of instability, particularly because leverage
is at the center of finance. Leverage meaning that a
financial institution's assets are what? What are financial
intermediaries' assets? If you look at a balance sheet– Eilon? STUDENT: Loans. GARY GENSLER: Loans. Brotish? STUDENT: Deposits? GARY GENSLER: Well, deposits are
usually on the liability side. But [INAUDIBLE]? STUDENT: Capital? GARY GENSLER: Capital.

You mean capital
and somebody else? STUDENT: Yeah. GARY GENSLER: All
right, one more. I mean, loans– these
are all good answers. Anton? STUDENT: [INAUDIBLE] GARY GENSLER: What's that? STUDENT: The security
they're investing in. GARY GENSLER: The
securities– investments. The difference between a
commercial balance sheet, or a non-financial balance sheet
and a financial balance sheet, easy to figure this out. Commercial balance sheets
have physical assets. They own plants, equipment. In the old days– I mean, now it's
intangible assets, like movies and
software development. But and a financial
balance sheet, almost all financial
balance sheets you look at, all their assets are
other financial assets.

A loan is a financial asset, a
security is a financial asset, a deposit is a security–
they're assets. They have a little bricks and
mortar, maybe a little bit of goodwill or
intellectual property, and a lot of other
financial assets. And they're– the right hand
side of the balance sheet is a bunch of liabilities and
a little bit of capital. And so they're levered. And that leads to instability. Finance and technology. I contend finance has long been
in a symbiotic relationship with technology. It just depends on the
technology of its time. Blockchain is just
in that long history. And we've talked about it. Money started looking like this. We've sort of gone
down this path. Then technology came along,
and it could look like this. But it's all technological
evolution, or at times revolution, that we went
from that to paper money. Now sometimes
technology veers off and we have private bank
notes instead of Fiat notes and so forth.

But it's just forms
of technology. And the modern
money, Fiat currency, is just another evolution in
technology and regulation. So that's why I'm
saying it's sort of– finance, regulation,
and technology all have this symbiotic
bit together, from debtor prison
to where we are now. And thankfully, we don't
have debtor prison. Yes? STUDENT: Yes. [INAUDIBLE] a
consequence of reading the readings for today's class. I was kind of thinking
that maybe it's the very nature of the financial
market and its configuration. Big companies with very
high barriers of entry, because of the regulation
and the substantial capital requirements, that their
relationship with technology innovation has been that
fluid in the recent years up until the recent showing
of FinTech startups. Because there's a certain
sense of complacency, in the sense that
they've been approaching technology innovation. You see current incumbents– and I was surprised by kind of
noticing the same [INAUDIBLE] here in the United States.

Big banks still use
really old legacy systems. And they can innovate,
but incrementally. They put the brand new
mobile application– GARY GENSLER: So Eric– I think Eric's raising
at least three points, but maybe there's four or
five and I missed some. That concept that,
yes, finance has always been about
technology, but do you think something's accelerated
in the last period of time? That it's even more
about technology? That's Point 1. Point 2 is, they seem to
be slow at adaptation, that the really
kind of lumbering of the bunch of legacy systems. And they're slow. Those were the two main points. Maybe there's a third or fourth. I would concur,
though I wouldn't overemphasize the first. They had to grapple with what it
meant when the telegraph wires came and the telephones came.


I mean, maybe not in the same– maybe it has accelerated,
but there's still– and it's said that– they said that the people that
did the best in the London Stock Exchange about 200 years
ago, the Battle of Waterloo happened. Does anybody know where
the Battle of Waterloo– I mean, it's before me too. I wasn't around then. Thank you. Is that good? What's that? STUDENT: [INAUDIBLE] in Belgium. GARY GENSLER: In Belgium. But who was the great general? STUDENT: Washington? GARY GENSLER: Wellington. So it's said that Lord
Wellington sent carrier pigeons back to London. This is supposedly a real story. Those carrier pigeons
carried the information, and the traders in London
who got the carrier pigeons traded before others
knew the results. The carrier pigeons, in a
sense, were the technology at the time.

So I'm just saying the
intersection of technology and finance, particularly for
those who have the best carrier pigeon, it works. Now I used to use
this story sometimes at hearings, when high
frequency traders would be coming in front of the
Commodity Futures Trading Commission. And they'd go, oh, the
chairman is going to pull out his carrier pigeon story again. And they said, please don't
call a high frequency trader a carrier pigeon company. But my point is is, I
think you're right, Eric. I think it's accelerated, but
it's not that it wasn't– and I do think that the big incumbents
are sometimes slow to adapt, and that's part of the
opportunity of blockchain. Blockchain may not be better
than what they're doing, but blockchain might be
the tool of a disruptor to get someplace that
the incumbents are too invested in their current
legacy system to get there. So it might be that
opportunity to get underneath what they're doing. Eilon. STUDENT: Are you talking
about building a bank that's built on blockchain as
an opportunity to disrupt the banking industry? Or using the blockchain within
the activities [INAUDIBLE]..

see, that's not a question I'm going to answer. You all get to answer that
in your final projects. And I suspect you're
going to be narrower– if your project is, disrupt
and build a whole bank, I look forward to
reading the project. But I suspect you're going to
be a little bit more targeted, and that the most
successful opportunities, to the extent any
will be successful– and most will fail– but to the extent
any are successful, my hunch will be more
targeted than that. But I leave it to the
creative minds in this class. Fiat currency
we've talked about. It's a liability of
commercial banks. It's central banks. It's accepted for
taxes and legal tender. I do this in terms
for repetition. Because if this is a
class today about finance, I can't do it without
talking about Fiat currency.

And yes, it relies on
a system of ledgers. Sorry. Had to get that in there. But ledgers at the
central bank, that has an entry that– there's
9,000 commercial banks in the US. I don't mean to leave
out any other country, but the form and
fashion is the same. If there's 600 commercial
banks in the UK, and I don't know the number,
or there's 1,000 in China, it's always sort
of that same thing. One big ledger at the central
bank and then every bank, commercial bank, has
a reserve account, and that reserve account
is on the master ledger at the central bank in essence. So this is just some of
the technology of ledgers, from the proto cuneiform. The IBM 360 in 1961
revolutionized finance. And IBM was not only the
best disruptor company, but it was
revolutionizing finance. That IBM 360 really started to
get adopted in a lot of finance in the 1970s.

In the 1960s, there was
the paperwork problem. The New York Stock
Exchange had to shut down for a couple of days in the late
'60s, because they basically had too much paper. Physical limitations
for finance. Payment and settlement
systems have come a long way. That's Thomas Jefferson
writing a check to himself. But a check from Thomas
Jefferson to himself in 1809 was a form to change
two ledger accounts. Telex, believe it or
not, there was still some telex machines when
I started at Goldman Sachs in 1979. I was 6. I was 21. But telex machines were
a very big innovation in the 1950s that allowed
for the communication and sending around. Now they're overcome by the
important technologies later. All of these technologies
were before the big boom and what I'll call
encryptography, and how to secure
communications, and the whole form of public
key and private key cryptography and other forms of
cryptography, all of which are used in banking
today pre blockchain.

Almost everything that's
done in blockchain has some form of
cryptography that's being used for it and with it. So blockchain, in a sense, is
just possibly a new technology using cryptography and
using databases and doing it in a different way. And the question is, can we can
we find use cases in finance through that? So what are some of
the technologies today? And this is not
a fintech course. If it was a fintech
course, every one of the things that are
going to go on this slide would be talked about. But does anybody want to just
have some fun and name what's going on in fintech world? Blockchain is one of the eight
things I'm going to list. Anybody want to do
some guesses here? STUDENT: AI. GARY GENSLER: All right, AI. Jihee. STUDENT: Biometrics. GARY GENSLER: Biometrics.

We've got two of the eight. STUDENT: [INAUDIBLE]
open banking. GARY GENSLER: Oh good, banking. Good. We have three of the eight. This is good. I want to see how we're going. Daniel, thank you. STUDENT: Big data. GARY GENSLER: Big data. All right. That's not– yes, yes. I'm agreeing with it. I didn't put it up there. What's that? RPI? STUDENT: RPA. GARY GENSLER: RPA. You want to tell the
class what RPA is? STUDENT: Robotic
Processing Automation. GARY GENSLER: Yes, Robotic
Processing Automation. Hugo? No? Oh, [INAUDIBLE] taken. STUDENT: Machine learning. GARY GENSLER: Machine
learning, yes. All right, so AI, machine
learning, blockchain. Nobody said cloud, because
now you all sort of take cloud for granted. And so maybe cloud shouldn't
even be on this page. But it's still sort of
changing some, open API.

I'm sorry? STUDENT: [INAUDIBLE] we
have a lot of revelations about putting data on the cloud. At least in Brazil, we
cancel any data [INAUDIBLE].. And we just can't put– GARY GENSLER: So
you're saying that– STUDENT: [INAUDIBLE]. We do have a cloud,
a private cloud that we use, but it's
not not the same as– GARY GENSLER: So Leonardo
is saying, in Brazil, you can't put certain
information on the cloud. That's probably true
of many countries. It's certain information. But a lot of bank
information, a lot of financial information
in most countries are now up in the cloud. 10 years ago it wasn't. So it's still sort of
shifting, and probably but country by country,
jurisdiction by jurisdiction. And I suspect, in
a lot of countries, the official sector doesn't
even know what's in the cloud.

And then the other,
biometrics are mentioned. Interestingly, nobody mentioned
chat bots, one of my favorites. But chat bots is a
big piece of what's going on in finance
and so forth. You don't like chat bots, Hugo? How many people like chat bots? Can I see a show of hands? So what is it that
you like about– Tom, what do you
like about chat bots? STUDENT: If I'm going to go
through a robotic system, whether it's like an
automated press button, I would rather go through
the automated system that gives me the answer.

end up [INAUDIBLE].. GARY GENSLER: Eric, you
said you like chat bots? STUDENT: Yeah, but not
from the customer side, but from the other side. [LAUGHTER] GARY GENSLER: All right. From the customer
side, how many people really kind of don't
like chat bots? Right? I mean, it's not a great
customer experience. But maybe that's
where somebody is going to spend a lot
of technology and money and ingenuity and
some Sloan MIT group will solve that, that it's a
better customer experience. Just an observation
for anybody listening if this film is ever seen. Credit. Let me just [INAUDIBLE] say. What's credit? I earlier already defined this. But what is credit? It's basically borrowing
something of value, but importantly,
with an agreement to give it back later. As old as time can be.

It probably goes back
20,000, 30,000 years. Some of the earliest
writing is about what it is. But here's a chart about
US private and public debt as a percentage of GDP. It's based on the
Federal Reserve numbers. I got a chart– I looked hard for this– 140 year chart. And if you can't see it, we are
currently– the debt in the US is about 350% of our economy. Our economy is $20
trillion, and debt totals around $70 trillion.

Just easy, easy
math for these days. When did it peak? The last time was
in 1929 at 300%. We zipped past 300%. We had the 2008 crisis. It's sort of been
coming back down. I'm not suggesting we're
going come all the way back down 140%. But I raise this chart to
say, debt in modern economies is a big part of
how economies work. The US total credit market– now those are the slices. Government, commercial,
financial, household. Each about one fourth in the US. It would break out a little bit
different in other countries, of course. And then here's
the US bond market. Now, the US bond market
is only about $40 trillion and the debt market is $67. What's the difference
between those two? What's that? So this the bond market. That's the credit market. So all of that government
debt is in the bond market, but a lot of the commercial
debt is bank loans.

And you're right. A lot of the household paper
is also then securitized. So you've got to get rid of
some of the double counting. And there's all sorts of
questions of double counting and so forth. $40 trillion bond market. But the total is
closer to $70 trillion by Federal Reserve statistics. I thought it'd be just
interesting to say, what's the bond and equity
markets around the globe? Our bond and equity markets
combined are about 360% of our economy. The EU and China, you can see– now, that might mean that
we have an overvalued stock market. Our stock market right
now is about 30– well, today it might
not be as good. But it's hovering
around $30 trillion. I think it was up to
$32 or $33 trillion. Has is it done
poorly today again? Yeah. But it gives you a sense. It's not just the US that
are about these numbers. This is how financing of
non-financial corporations in the four big jurisdictions. The US is far more
securities-focused, meaning we have very
well-developed bond and equity markets. And loans, as you can see,
only provide about 11% or 12% of funding for commercial– if you're a small company,
you get your borrowings from a bank.

If you're a big company, you go
out in the securities market. James? STUDENT: Are these
publicly traded companies or just any company? GARY GENSLER: I didn't
do the research. SIFMA, which is a securities
industry association, puts out a report
annually and I grabbed these from the SIFMA report
that came out two weeks ago. So I could look at the
report, but I don't know.

I think it's more
than public companies. I think this is
broadly the economy– I'm not going to
go through this. But I have two slides here–
one is the equity market, one the bond market– to say,
the holders of US bonds, pretty diverse. But it's a lot of other
financial companies. Who holds bonds? It's a lot of other
financial companies. Whereas equities is households. It's either household–
directly a household through a mutual
fund or a household through their pension. Now only 40% is direct. About 1/3 is through mutual
funds and about 12% or 15% is through pension funds. But it's kind of households own
a lot of the equity and finance firms own a bunch of the debt. Rough, rough guidance. Any of you masters
of finance, you can tell me if I'm
going off the rails. And also, a household debt– and
then I'll stop with the slides. Household debt is
primarily mortgage debt. The orange on here is
all the mortgage debt.

We're out about $9
trillion in mortgage debt. But red– red is what you
all probably identify with. You don't have to self tell
me, but you're probably all in the red. That's the student debt. Student debt in the US is
now $1.5 trillion dollars. And I'm just expressing my
own public policy perspective, but it's not– I don't think it's good to
mortgage everybody who's just going through college
and graduate school. But that's a bigger
public policy debate, and I'm just expressing
a point of view. It did not used to be like this. Here's an interesting chart to
me is the number of accounts. Again, US, we could have
gotten broader countries.

There's 500 million
credit cards in the US. There's 328 million
Americans, and about 1 and– 1.6, 1.7 per population. But auto loans and mortgages,
which are the left access, are 70 or 80 million. So these are big markets. These are just numbers of
people who have an auto loan or a number of auto loans. These are numbers of mortgages. And then HE is Home
Equity, revolving. These are the four big slip
streams of household debt. Mortgage is number one. Student debt, number
two, unfortunately. Credit cards and
then home equity. And auto loans are– I can't see on this chart, but
auto loans are behind them. Let's talk about risk. This is a couple of ideas from
my time in risk management. Anybody want to give me the
three big risks, if you were managing Goldman Sachs, you'd be
worried about on a daily basis? Not whether the euro is going to
crash, but broad topical risk. What are the three
or four big risks? Addy? STUDENT: Market risk.

GARY GENSLER: Market risk. STUDENT: Credit risk
and operating risk. GARY GENSLER: All right. Market risk, credit
risk, operations. Any others? STUDENT: Counterparty risk. GARY GENSLER: Counterparty risk. STUDENT: Human capital. GARY GENSLER: Human capital. That's a good one. I like it. It's usually not taken up
in a risk committee though. It's an important risk though,
but it's not usually taken up. So what do I have? Market risk. All sorts of
different market risk. Credit and underwriting. Credit is, will
somebody pay me back? Underwriting is usually,
have I judged the risk well? So it could be an
insurance risk as well as underwriting securities. Three things I didn't
hear from you all. I'm not surprised I
didn't hear, but these are the three that lead to crises. Market risk, credit risk
and underwriting risk. Even if firms blow it,
they usually do it. And usually the board of
directors understands it.

My experience in
looking at failed firms, it's liquidity funding
and settlement risk. Liquidity means,
can I sell something when I want to sell it? Or can I buy a hedge or
cover when I want to cover? Funding is, can I
roll over my funding? Because so much of finance
is about short term funding and long term assets. And it's usually
misunderstanding liquidity in a crisis. You can sell things all day
long when things are good. But when markets start
to get frail and thin, your liquidity dries up. So it's a crazy thing to model. It's a very tough thing. I mean, great economists, great
finance academics can model it. But at the end of the
day, it's a little tough because it goes away fast. And it's kind of a funny
mathematical formula when you see something just go away. And the math doesn't matter. When you can't sell something,
and you think it was worth $98, and you can't sell it for $88. And the other big one is
model risk or correlations.

And you can build a
correlation matrix around all sorts of
financial assets, and it can work in most markets. It can work in a market which
I'll say out to two or three standard deviations
from the norm. But will your
correlation matrix still work when you're in a
market environment that's four or five standard
deviations out from the norm? I'm sorry. Think of a bell shaped
curve, and just think of– some people call it tail risk. But I'm not talking
about the price. I'm talking about all your
correlations in your model, just throw them out the window. And those four– liquidity,
funding, and settlement and correlation,
in my experience is kind of where firms get
into a bunch of trouble. Or they're not.

Maybe it's not actually
a bug but it's a feature. It's sort of saying, I'm
embedding all this risk. This is why I'm earning excess
returns when I'm in finance. And 1 in 100 times, my
firm's going to go bankrupt. But that's just–
that's the risk I take. Kelly? STUDENT: I know we're
going to talk about this in the next unit, but
can you talk a little bit about how well stress testing
within banks addresses these? GARY GENSLER: OK. So I've got operation
and cyber risk. It would have been
operational in the past, and now everybody's
all focused on cyber. And it's the right thing. It's a big risk the banks and
insurance companies are all focused on. Legal and compliance
and reputational risk. Literally, if you went
back 30 years ago, people would not be managing
reputational, legal risk at their risk committee. But a well-run risk
committee at a big bank takes all these things–
every one of these categories should go up to
the risk committee in some way or another. Dan and then I'm going to
try to do Kelly's question.

STUDENT: Of course
this isn't something that a company could
control, but can you talk about political
risks in kind of context? It might impact– GARY GENSLER:
Generally speaking– Dan just asked about
political risk– classic sort of thinking is
that you don't manage that at a risk committee. You might manage it in
your Washington or Brussels or London office dealing with– and there's policy risk,
that the policies can change, the regulations can change. You try to influence it
and get ahead of changes that lower your profit margins. But you usually aren't going to
be managing it in the same way here. So Dan, you're right. There's political risk. There's a second thing,
which is expropriation risk.

In many countries, it's
no longer a big challenge. But it is. And certainly, for
big banks, there is a lot of expropriation
risk in earlier decades. Crises. You can see the hourglass
is kind of broken, and it's broken right at
the neck where finance is. Here's some just– I hate to say it, but in my
memory, I hope all of you have such a rich career
that in 30 or 40 years you can be teaching
somewhere like MIT but you will have this. No matter what
country you live in, you will have some
list that you can– I didn't go to Wikipedia. I just said, oh, yeah, there
was that Latin debt crisis. I did go to the internet to
remind myself what years. And in the 1970s, I
was in high school. But I'm just saying
that, I actually remember all of these crises. They happen. They come, they go,
they're part of it. Let me just mention something
about the subprime mortgage crisis 2008. So what's my quick take on it? Like what happened? You know, in 10 minutes or less.

But I'll take any questions. One, I think at the core were
weak underwriting practices, mostly in the real estate
sector for housing. Underwriting is the word– a bank is making a loan,
or an insurance company is taking a risk. It's whenever
somebody takes a risk, you have to sort of make
some probability weighting. What's that risk like? Let's take a bank. Will I get repaid? You're not going to get
repaid 100% of the loans, but underwriting is this concept
of sort of sorting that out. Or in insurance,
the underwriting risk of a house burning
down and so forth.

There were weak
underwriting standards. And, on top of it, a lot of
bad practices and predatory lending. Kyle? STUDENT: Just a question. Do you think that the
predatory lending and accepting loans when maybe you won't
be able to pay it back, as well as extending
loans, is a symptom of willingness to
take on more risk or being unaware of the
risk that you're taking? GARY GENSLER: So Kyle
raises sort of a– whatever you want to call it– the
$64,000 question in the middle of bad risk management. I mean, because we could
go back to this page. Every one of these
pieces of risk management you can't do perfectly. It's only so susceptible
to higher math. Every one of these,
there's math around. But poor risk management
can be just not even being aware that
the risk is there. I think that's what
your question was like. Was there just an unawareness
that there were such bad things going on in the street? Or was it– well,
we're aware of it but we're willing
to take that risk? I think it was a bit of both.

I think that the major
investment banks– the Lehman Brothers
and some of the others, they were underwriting a lot
of the subprime mortgages– were aware that there
were no doc loans. No document loans. It was called no doc loans. That the down payments
were shrinking. Because that was susceptible
to math, that you could see there was lower and
lower down payments. But I don't think that
they knew everything that was going on the street,
the really bad action. I testified in the US Congress
in the spring of 2000, as the Secretary,
Undersecretary, about predatory lending. It wasn't that I was prescient. I was asked to testify. And we did a big study between
the Department of Housing and the Department of Treasury.

And we went out. We had public hearings
in a bunch of cities, and we wrote a report
and made recommendations. And Ned Gramlich over
at the Federal Reserve was very helpful. Andrew Cuomo at the
Department of Housing, who is now governor
of New York, and I was running point at Treasury. So it was known, in a sense. But I think a lot of the broad
community, the policy community and the banking community,
tended to look the other way. Partly because there
were so much profits and partly because, in
the upside of a boom, it feels like it's
never going to turn, and that that even
a small report like we did in the spring of 2000– in fairness, we didn't bang
the table enough maybe.

There I was testifying, and
I left, and that was that. You know? Al Gore is running to
succeed Bill Clinton. The administration couldn't
have gotten a law changed, even if we tried at that time. But nonetheless, that's– so
I think sometimes it's a bit of both, from
personal experience. But back to the crisis. So I think that weak
underwriting and predatory lending mixed in to have
a subprime mortgage crisis and then a big housing bubble. But also beyond that– beyond that, easy credit. Easy credit partly because
interest rates were so low. We came out of the
late part, the 1990s. We went from an asset
bubble in the stock market, the internet bubble
burst, and we kind of moved that bubble valuation
into the housing market. The Federal Reserve
lowered interest rates, kept interest rates low for a
very long time to kind of keep the economy going. And we even see now President
Trump and Fed chair Powell a little bit at odds about
where should interest rates go. And the Federal Reserve
is moving interest rates up in the US now.

But there's always that sort of
dynamic, a little back pressure in every country. We like to think we have
independent central banks. But in some countries,
it's a tug of war and we're seeing that
play out a little now. So we have easy credit
for a long time, partly supplied by
foreign governments. Even China, in a sense. I mean, people were willing
to buy the US paper. But also financial derivatives.

Credit default swaps in
particular led to a lot more leverage and also
the interconnectedness. The derivatives tied
everybody together a lot more. Part of the leverage
was also accepting model based capital rules at banks. The other thing
is I think we had a lot of poor risk management,
back to Kyle's point. So poor risk management
incentive structures.

The basic incentive structure
at banks have a lot of bonuses. And some of you worked at banks. But on some level, it's sort
of heads I win, tails you lose. I mean, if you put a big
position on and it pays off, and you're a trader, and
you're managing the mortgage desk at Lehman and it pays off,
you say, all right, where's my $5 or $10 million bonus? I'm saying if you're
running the department. I mean, hopefully some
of you will do that. But if you're on the other
side, and the firm fails, they don't say, please give me
back that $5 or $10 million. So there's asymmetric
incentive structures. And those have been written
about widely, academically. I mean, we do have a lot
of asymmetric incentive structures in banking. Brotish? STUDENT: [INAUDIBLE] GARY GENSLER: So Brotish asked,
what about the rating agencies? So I was absolutely
say, their incentive structures– within those
two words, a lot's packed.

Thank you. Rating agencies got paid
for issuing ratings, but they're not– you
know, give some money back if you got it wrong. So it's perverse
incentive structures, both in terms of
the bonus structure, employment, payment structure,
rating agencies, fees. Inherently, finance has a
lot of conflicts of interest. We're not going to get rid of
that, conflicts of interest. There's always
somebody in finance who wants to separate their
customer from their money. It's the nature of things. But in a sense, Starbucks
wants to separate you when they say, do you
want the large cup– or the grande
instead of the large. So that's the
nature of commerce. And it's just that,
you want some market base and regulatory
things to [INAUDIBLE].. So multiple failures
started to happen. In the US, Bear Stearns
started to fail in 2007. So well before the epicenter
of all of this, you had– in the UK– James? What was the first one that
failed in your country? What's that? STUDENT: [INAUDIBLE] GARY GENSLER: So where did– where did– but
the timber was dry.

It was like the fire
was going to go, but the system could maybe
withstand one failure, Northern Rock or Bear Stearns. But by the summer of '08, in
this country when the large financial mortgage companies,
Fannie Mae and Freddie Mac, had to go into receivership
around Labor Day of 2008, it was teetering. And then, of course,
if anybody remembers, by September 15th or
something, it was just– the system would have collapsed. Without government intervention,
the system would have fully– we were kind of– And we would have been
in one of those moments from the 18th or 19th
century where we– or even the 1930s,
where it's likely we would have blown
out the 20% or 30% unemployment in this country.

And some of your countries,
that is the case. You saw it happen. I don't know all the
countries represented here. So that's my little quick
read of the financial crisis. But this wasn't meant
to be a lecture on it, but I thought, well,
why not throw it in? It's finance. Any questions on that? Hugo? STUDENT: Not exactly
on the crisis. But if you have to gauge
the state of the financial– like of US finances right
now, what do you think? Are we in a better place
than we were 10 years ago? GARY GENSLER: So Hugo is asking
if we're in a better place than we were 10 years ago.

Yes, in a number of ways. But as Sheila Bair's
writing said, in other ways, it's not all that different. So I think that we have high
valuations in the stock market. But it's not a
levered asset class. So real estate bubbles
usually are very– higher probability that
a real estate bubble will lead to
calamitous outcomes, because there's a lot of
borrowing against the asset bubble. So when we had no
aid, and you had– in Iceland, when
the banks failed. In many countries, when
you see huge failures, it's when you have a real estate
bubble with a lot of borrowings against it. When the revaluation comes,
the debt on that asset class is higher than the valuation
on the asset class. And that usually leads to
some either calamitous outcome or government bailouts,
and it takes a while. Debt bubbles. A debt [INAUDIBLE]
bubble is much harder. So back to today, I think
we have a bit of a bubble.

We've had low interest
rates for a long time. We've had pretty
good economic growth, even though it's not
fully and equally shared. But a lot of economic growth. I think the banking
sector is stronger. It's more Capital. One of the results of the
reforms in Europe and the US, there's a lot more
capital in the system, meaning less leverage. But on the other hand,
the banking sector is a bit more concentrated. And concentration leads
to additional risk. The other thing,
and this is maybe my feeling is, as we're not
sharing the economic well-being broadly in the economy,
that middle income America, middle income
of Europe in particular is not sharing as much, I think
that hurts us in two ways. One is, if we have the
downturn, there's not as much– all economies these days
are led by consumption. There's not as much ability
to respond with consumption. And two, I think it also
tears at our social fabric. And now I'm talking more
about the political, but it's sort of– there's
less of a social fabric for consensus when things hit. Sorry. STUDENT: Going and touching
on the consumption aspect, I think Sheila mentioned
that consumer spending was a part of the financial crisis.

And she suggested that
instead of providing relief to the banks, what the
government should have done is provide relief to
consumers instead. I was wondering what
your take on that is. GARY GENSLER: So Sheila
Bair's point was, we did a bunch of things
bailing out big institutions. We didn't help
home owners enough. I think factually she's correct. And then you have to say,
are the adjectives correct? Like we did provide trillions
of dollars of support for big institutions
and not for individuals. And there is where the debate
is and all the challenge is. I think it's correct– Tim Geithner wrote a book. If you ever get a
chance to read it, it's a very lively and
easy read about the crisis. And he said, sometimes,
it's like, you know, bailing out the arsonist. I think those were Tim's
exact words in his book, but if I'm wrong, sorry
Tim for misquoting you. But it's a hard public
policy challenge that Ben Bernanke
and Tim and others were facing at that point.

But I think Sheila
is right factually. And then I leave for
you the policy debate. Let me just mention. The financial sector– I'm closing on this– legacy customer interface. When you're thinking about
any blockchain solutions, as Eric said, it's legacy. Are they slow? Are they moving slow? It's got to be data
intensive at some point. I don't think blockchain
has a lot of use if it's not data intensive. Are there economic rents? If there aren't
economic rents, it's probably less likely you're
going to be able to tuck in.

But if there's big
economic rents, like 2.7% on payments and the
like, that might be a place you can tuck in with a
new disruptor strategy. Sometimes there's
concentrated risk. We talked about that. Or the infrastructure costs. I know there was earlier
talk about counterparty risk and so forth. The good news is there's
a wide acceptance of adoption of new tech. I'm not going to say it's going
to bail out a bad blockchain idea, and I'm not looking
for a bunch of ideas about scams and frauds. But there are wide acceptance. And there's 7.5%
of the US economy, and similar numbers– probably
5% to 7% of most economies are in finance. By the way, because the capital
markets and the equity markets are about 500% of the economy–
it's about $100 trillion when you add up all
those other slides– finance earns 7.5%. So that's about 1.5% vig. That's an old term
from a gambling house.

What's the vig? What's the take? Finance takes about 7.5%
divided by over about 500%. Or it's about 1 and 1/2%. That's not true everywhere,
but asset management might take 50 or
80 basis points. Banking might take wider. But largely, that's
the opportunity that I keep mentioning. Let me just mention
one more thing. I'm going to skip through this. Next week's readings. October 16th, you'll
have a surprise guest.

You'll have some fun
with the surprise guest. I guarantee you. I guarantee if you just
want to have some fun, you'll remember next
Tuesday for a while. But I added an additional
reading that's from today. Nouriel Roubini testified in
front of the Senate Banking Committee today. I read it before
I came to class. I can't say it's required,
it's just additional. But it is lively. And he just does a slap down
on blockchain technology. But for those of
you who read it, that will be part of our
discussion next Tuesday as well. Because we're going to
talk about the economics of blockchain. I'm going to focus more on
Christian Catalini's paper. But Paul Krugman, his
is a two-page slap down. These are kind of the Bitcoin
and blockchain minimalists. And next Thursday is a little
bit towards the maximalists. But I want to talk about
the economics, what I'll call Act 2.

So I thank you. I'm supposed to let you go. I've gone two minutes over. So– [APPLAUSE] .

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