10. Financial System Challenges & Opportunities

the following content is provided under a Creative Commons license your support will help MIT OpenCourseWare continue to offer high quality educational resources for free to make a donation or to view additional materials from hundreds of MIT courses visit MIT opencourseware at ocw.mit.edu 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 they're actually officially 84 or 85 people registered for this class I'm intrigued to see if fifty nine papers came in a minute ago human nature being human nature these are just the statistics on this class and 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 or not I will take less time I want to compliment everybody they were good I mean there's a good engagement a good dialogue you will see occasionally that I don't give you everything you want back but 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 handed in on the 23rd class that is your right that is your option it's just it's just gonna be hard or on Sabrina Toledo I mean it great 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 gonna be horse sure 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 and just to serve 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 that if you chose if you chose choose in the future to take know number 15 I know November 15th because we're gonna have it's gonna 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 it's we're fortunate that Jeff Sprecher who's the chief executive officer of the IntercontinentalExchange and Kelly Lafleur who is the chief executive officer backed they're gonna come and 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 well 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's Brecker that week who's from scratch created a 50 billion market cap company in 20 years so those are my comments the papers are generally good really looking for critical reasoning ground truths where do you take something some of you brought a great narrative voice by the way I have to compliment there were a couple a couple handful that I really found you're really good writers in addition to be good business students so those are my thoughts today I'm gonna go through oh and we have we have an interesting guest next Tuesday but I'm not gonna say anything more than that you'll you'll find it fun Tuesday the 16th what's that nakamoto Satoshi Nakamoto no no any other guesses I'm not giving any clues but I will tell you you'll have fun next Tuesday the 16th be a guest you will not see it any other class so today I want to talk a lot Tom's thinking about it right intrigued we're gonna talk a little bit about finance now just as a way of background I've spent 39 years and fine yet so this is just my chance to take 80 minutes to talk about finance with all of you we did have readings it 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 format 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 are its credit what are what's capital markets again a broad sort of genzler's view of it may be but 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 is kind of the co finance officer was also sitting on the firm like risk committee and 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 Oh a crisis some perspective from a guy who lived through it and then some of the opportunities in the blockchain world will try to wrap and be out of here at 3:55 as usual so the study questions which now I know there's probably fifty eight papers on this in the in the inbox I think but does anybody want to lend a hand I mean it's it's getting shorter it's only twenty people in this list now but that means that 25% of you are thinking that class participation is not that important we're gonna 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 it's uh Monica want to help me out at all yeah I'm not here so I'm good trade offs that I talked about in my paper with that we saw from one of the articles 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 that kind of deregulated the space that allowed for that happen Monica's raising two things from it's probably from the Harvard paper but two things that about income disparities and also the concentration and anything else that people took from that Harvard I know it was a little dense but the the paper is that he ended up is that no you sure alkaline what's your first name is a listener thank you it was that that act in 1994 that essentially caused who's the catalyst for just massive consolidation of the financial services industry and so that that's what ultimately led to just disproportionate wages or disproportion economic rents 94s and ringing a bell I mean the gramm-leach-bliley was 1999 and I don't know if there was something in 94 that 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 5060 years ago you had the local drugstores now we have the big change like see the accent and the like so I just mentioned 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 51 of the 50 states literally that started to break down in this night late 70s it started riegle-neal and 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 because I want to come back here but next to Darren do you see that as manipulation or just an opportunity get some oligopoly stick or monopolistic rents and I'm just of just deserting the word manipulation [Music] compared to other markets that were consolidated and regulated such as Canada every entrepreneurs desire in a business context maybe not in a moral sense is to be able to collect economic rents like you start at as a disrupter and along the journey you would actually wish to become somebody collects excess profits or becomes the monopolist I'm not speaking that 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 it was a hand here yes compares also concentration by regulation or concentration by deregulate the market are able to [Music] finance poorly because of its centrality and it is 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's also non financial firms that try to do the same thing into finance so big tech right now you know you think about Apple pay or think of Ali Baba in China that then ant financial is one of the most significant so so sometimes it comes the other way if you can leverage a network leverage your your centrality to market and and add products but I agree with you it goes both ways though other comments from the readings Isabella and I know one of the articles the interview talked about like we need to further regulate and restructure the banks people trying to overturn so like it's not really going in that direction but right so there's an ebb and flow of regulation and we'll chut 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's an ebb and flow now it's much more complicated today in a sense and Isabella's just mentioning that dodd-frank passed in the US was a post crisis reform that would be a time of purity you would think well maybe bill the public through its legislative body will lean end of doing more regulation and then as you move away from a crisis moment you see some easing up and that there's always sort of an oscillation over the over the decades why don't we take one more which basically highlight perfectly so on the positive side if you look at Citi Citigroup what it's trying to do is trying to provide universal services so it's a one-stop shop for all your financial services whereas whereas it's argued that one of the things that should have been done for the crisis was to break it up because the problem with having the universal shop is that raising something about the city group our city Corp that became a sense of a one-stop shop a shopping center of financial products and maybe should have broken up but who wants to tell me what Sheila Bair who was the head of the Federal Deposit Insurance Corporation said because she in that interview with Sheila she talked about city alpha she said she almost like it's not obviously one because she's been through that crisis and pretty much brokered that deal and to because she throws in political maneuvers so it's hard to tell think profits are good dividends a robust they've got big tax cuts they should be building their capital buffers right but you you mean it's hard to tell where Sheila is on Citicorp for instance now so sheila bair who is a kid was you know to her core as a Kansas Republican who worked for Senator Bob Dole who was then when she worked for a majority leader in the US Senate on the Republican side it's kind of a bit of a prairie populist if if those terms means something to the class and and she got into the role of running the FDIC and saw early but 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 u.s.

When the crisis really hit hard she was part alternately of the team not at 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 you know at that next level in our multifaceted regulatory system in the US and I read her reading and also just knowing her personally and I was with her last Friday at a conference that I guess she arranged in Washington about the crisis I think her reading was was what alpha saying I think it's but if you're correct she is a political actor and is proud of that I mean that's her her lifeblood and where she's been for 30 years but she's also deeply a policy person and and tied to sort of populist vain and you know she would have probably preferred to see city 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 this central role when we simplify it all down to it's its essence we have a dozen masters of Finance in here so what are they teaching and what sandy Lowe teaching I don't know is anybody taking Andy's intro class or now nobody wants to tell me the role of Finance here here we go are you a master finance student yeah a BA who's a master finance Oh No all right what's the role of Finance very simple it's like elevator stuff help Society whatsit intermediating the two things that intermediates and finance students 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 of it around it is an hourglass Wall Street is sitting right at the neck of the hourglass intermediaries I thank who what's your name what's it 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 where I'm going to list four but what are the functions of Finance as opposed to a role anybody else there were other he ends up sure capital allocation I'll take that it's not what I was looking for it's good marketing capital allocation market making chairman payment providing liquidity I'm agreeing with all of them you should read 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 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 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 or 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 gonna throw us bit up here six or seven sectors but what are the sectors you think about is maybe some of you worked in it's like easy management sure it's asset management Anton that's two sectors commercial banking and brokers that asset management all right so I put commercial banks sometimes in the US we have seven or eight thousand credit unions and nine thousand commercial banks investment banks and brokerage firms in Europe in many countries there they're universal banks and they're inside commercial but they perform a little bit different function commercial bags think about taking depositors money and then lending the central thing about commercial banks is a credit allocation pricing of alloc of credit underwriting of credit the center thing about investment banks is about still has underwriting but it's usually related to market based rather than using their own balance sheet but market base securities and brokerage insurance is a risk transformation I need to be covered if I get into a 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 the 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 on one day but you know I think about the different sectors when you're thinking about use cases for blockchain it could be in 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 [Music] good answer so Carla's primary market is when an issuer like an ad 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 a secondary market Hugo later so primary markets secondary markets it's relevant not only because they have different market structures and different ecosystems but they had tend to have a little bit different regulation as well what which has the higher volume in the interesting the the secondary markets have much more volume than the primary markets the ratio is not the same market a market so 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 very illiquid or not tradable secondary markets whereas like equity markets highly liquid equity markets all the actions 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 a loan 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 Marg and the profits the earnings non-technical term sorry I include in capital markets the asset managers that are in fees the the black rocks infidelities or the small asset managers as well and then all the infrastructure the exchanges the clearing houses and the like so again finance to sort of drill back to where we were earlier have Ledger's and payment systems who's going to remind me what a a ledger is it's easy stuff no Ledger's wait wait no 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 as on vocabularies Ledger's because Ledger's matter to blockchain and blockchain matters to Ledger's I'm not saying that there is no use for blockchain technology absent Ledger's but I'm hard-pressed to think you know 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 why you need the complexity of this database structure you could use other database structures to keep it even though Stewart Hebert has that wonderful blockchain that's published in the New York Times for notaries so Ledger's are records of economic activity and financial relationships they are embedded in every part of Finance insurance companies have Ledger's investment banks have Ledger's central banks have Ledger's if they're been in every part and they've been around for thousands of years and they're right at the center of blockchain because the UT exocet and Bitcoin is a form of a ledger and there's an account based ledger in aetherium 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 Garry to alpha you don't have to answer this question the kira payment system is moving money for me to have alpha what is it doing it's transferring good Kelly its I'm breaking it down it is a transfer the cure is absolutely right it's transferring value from Gary for 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 meant alpha is positive so it's amending and recording Ledger's it's also these systems they have to first authorize something they have to do something called clearing and we're gonna 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 a authorizing clearing recording and the key word for blockchain is final transfer the reason blockchain might have application is it as a way to finally move money I don't mean finally like over the centuries I mean if I would have moved money to alpha through the US banking system it might not move for several days blockchain is an application that it 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 post financial crisis it's not part of like the 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 debt or prison is Kyle or Priya you would basically have to go to jail if you didn't pay your time to work so Kyle is mentioning the debtor prison was that you'd 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 certainly recently I know I 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 this horrible thought what what did we do when people couldn't pay their debts and how bankruptcy laws reflect because bankruptcy laws are 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 there we don't have regulation because of block J and we don't necessarily need a new set of regulations it's because finance is so central to economies we've been grappling with regulation for a long time now you saw this this little framework before but I restocked it this isn't this is now the stock I think of in terms of financial regulation Financial Stability is first and and while you can't see closely this is a bank run and a wonderful picture by Dorothea Lange called white angel breadline 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 this the money in in-house and how do we make sure that we don't have 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 that if the tulip bulbs in Holland I guess but we also had incredible boom-and-bust periods around the South Sea this this 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 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 it's frankly more something in the last 30 or 40 years as money has moved to digitized electronic means governments have 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 ruse in the 1930s it 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 you found more of that yes please it's American I should remember your first name ge ge he's 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 thousand years but the research that you can read CAD rogoff's book I don't know if any of you have ever read ken Roelofs book was his wonderful book about the history of crises and economic cycles that came out for four to six years ago and I could get you the name of it but finance adds to and leads to booms and busts booms and bust existed well before fiat currency and banking but there's booms and busts in the cycle and some financial stability in essence is trying to smooth out the cycles that you'd 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 checkland the sovereign in terms of currency and that's where G your question about inflation so if if if the sovereign could deflate if this 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 institutions assets are what what is it what are financial intermediaries assets if you look at a balance sheet they line loans British well deposits are usually on the liability side but you capital human capital and somebody else yeah all right one more I mean loans these are all good answers ant investments the difference between a commercial balance sheet or a non-financial balance sheet and a financial balance e-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 like movies and and and software development but and a financial balance sheet almost all financial balance sheets you look at all their assets or other financial assets alone is a financial asset of securities of financial asset a deposit is this secure their 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 the right-hand side of the balance sheet is a bunch of liabilities and a little bit of capital and so they're 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 you know looking like this we've sort of done but done down going down this path or 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 banknotes instead of Fiat notes and so forth but it's just forms of technology and the modern money fiat currency is just another level 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 dead or prison to where we are now yes their relationship with technology innovation hasn't been that true in the recent years up until the recent up showing of incumbents I was surprised I think Eric's raising at least three points but maybe there's four or five and I missed them that the 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 one point two is they seem to be slow at adaptation that they're really kind of lumbering of the bunch of of legacy systems and and and they're slow those were the two main points maybe there's a third or fourth I would I would concur though I wouldn't overemphasize the first they had to grapple with what it meant when when the telegraph wires came and the telephones came I mean maybe not in the same maybe it has accelerated but it was still and and it's said that they said that the people that did the best in the London Stock Exchange about two hundred years ago the battle the Battle of Waterloo happened does anybody know where the battle were Lou I mean it's before me too I wasn't around that so thank you as I could you what's that and Belgium but who was the great general who was who 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 of the time so I'm just saying the intersection of Technology and Finance but 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 go all the Chairman's gonna pull out his carrier pigeon story again and they said please don't call a high-frequency trade or 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 a 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 we'll see that's not it's that's not a question I'm going to answer you all get to answer that in your final projects and and and I suspect you're gonna be narrower if your project does disrupt and build a whole Bank I look forward to reading the project but I suspect you're gonna 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 but I leave it to the creative minds in this class fiat currency we've talked about it so it's a liability of commercial banks and central banks it's accepted for taxes and legal tender I do this in in terms of 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 Ledger's sorry had to get that in there but Ledger's at the central bank that has an entry that there's nine thousand 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 six hundred commercial banks in the UK and I don't know the number or there's a thousand 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 Ledger's from from the proto cuneiform the IBM 360 in 1961 revolutionised finance an IBM was not only the best disrupter company but it was revolutionising finance that IBM 360 really started to get adopted a lot of finance in 1970s in the 1960s there was the paperwork problem the New York Stock Exchange had to shut down for a couple days in the late 60s because they basically had too much paper physical limitations for finance payment and settlement systems have come along that's Thomas Jefferson writing a check to himself but a check from Thomas Jefferson to himself in 1809 was a forum to change to ledger accounts tell X believe it or not there was still some telex machines when I started at Goldman Sachs in 1979 I was six I was 21 but telex machines were very big innovation in the 1950s it allowed for the communication and sending around now overcome by the important technologies later all of these technologies were before the big boom and what I'll call and cryptic photography and how to secure communications and and 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 and his son 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 and 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 gonna go on this slide would be talked about but does anybody want to just have some fun and name what's 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 all right AIG he we've got two of the eight back and good we had three of the eight this is good let's see how we're going Daniel thank you big data big data all right that's not one but yes yes I can with great with it I didn't put up there but say RPI RP yeah you want to tell the class what RP is yes robotic processing automation Hugo now Oh cuz it was taste test taken machine learning yes alright so AI machine learning blockchain nobody said cloud because now you will also take cloud for granted and so maybe clouds shouldn't even be on this page but it's still served changing some open API I'm sorry so you're saying you're saying that Leonardo is saying in Brasil you can't put certain information on the cloud it's probably true in 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 ten years ago it wasn't so it's it's still sort of shifting and probably bought country by country jurisdiction by jurisdiction and I suspect in a lot of countries the the official sector doesn't even know what's in the cloud but and then the other biometrics were mentioned interesting nobody mentioned chatbots one of my favorites but chatbots is a big piece of what's going on in finance and so forth you know like chat bots you go 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 you said you like chat BOTS alright 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's going to spend a lot of technology and money and ingenuity and some Sloan MIT group will solve that that it's a better cost number experienced just an observation for anybody listening if this film has ever seen you know credit let me–just suitors say what's credit eyerly are already defined this but what 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's probably good to probably goes back twenty thousand thirty thousand 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 a hundred and forty year chart and just if you can't see it we are currently the debt in the u.s.

Is about three hundred and fifty percent of our economy our economy's twenty trillion and debt totals around seventy trillion just easy easy math for these days when did it peak the last time was in 1929 at three hundred percent we zipped past three hundred percent we had the 2008 crisis it's sort of been coming back down I'm not suggesting we're gonna come all the way back down one hundred and forty percent but I I raised this chart to say debt in modern economies is a big part of how economies work the u.s. total credit market you know 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 u.s.

Bond market now the US bond markets only about forty trillion and the debt markets sixty seven what's the difference between those two what's that so this is the bond market that's the credit market so all that government debts 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 you got to get rid of the double counting and there's all sorts of questions of double counting and so forth forty trillion dollar 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 about 360 percent 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 third well today it might not be as good maybe but it's hovering around thirty trillion I think it was up to 32 or 33 trillion what is it done poorly today again yeah but it gives you a sense it's it's not just the US that are is about these numbers this is how financing of non-financial corporations in the four big jurisdictions the US is four 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 percent 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 I I didn't do the research sift Moe which is the securities industry association puts out a report annually and I grab these from the cipa report that came out two weeks ago so I 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 gonna go through this but I have two slides here one is the equity market wins 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 percent is direct about a third is through mutual funds and about 12 or 15 percent is through pension funds but it's kind of households own a lot of the equity and finance firms owned a bunch of the debt this ruff-ruff guidance any of you Masters of Finance you can tell me if you know going off the rails and also a household debt and then I'll stop with the slides just because I household debt is primarily mortgage debt the orange on here is all the mortgage debt we're at about nine trillion dollars and mortgage debt but red red is what you all probably identify with yeah 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 u.s.

Is now one and a half trillion dollars I'm just expressing my own public policy perspective but it's it's not I don't think this is 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 today I'm just expressing a point of view it did not used to be like this this is 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 u.s. it's 328 million Americans there's about 1 in 1.6 1.7 per population but auto loans and mortgage and and mortgages or to the left access or 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 a chi is home equity revolving these are the four big slip streams of household debt mortgages 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 pulling 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 risk if you were managing goldman sachs you'd be worried about on a daily basis not whether the uro is going to crash not that but broad topical rest what are the three or four big risk credit risk operations any other counterparty risk human capital that's a good one I like it it's usually not taken up at 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 type of market risk credit and underwriting credit is 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 even if firms blow it they usually do it and usually the Board of Directors understands it my experience and looking at failed firms its liquidity funding and settlement risk liquidity means can I sell something when I want to sell it where could 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 look what it he dries up so it's a crazy thing to model it's a very tough thing I mean great economist 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 bucks 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 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 tip with some people call it tail risk but I'm not talking about the price I'm talking about that all your correlations in your model just you throw them out the window and those for 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 getting earning excess returns when I'm in finance and you know one in a hundred times my firm's gonna go bankrupt but that's just that's the risk I take Kelly [Music] 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 that banks and and insurance companies are all focused on legal and compliance and reputational risk literally if you went back thirty years ago people would not be managing reputational legal risk at their risk committee but a well-run risk committee two big bank takes all these things every one of these categories should go up to the risk committee in somewhere another Dan and then I'm going to try to do Kelly's question in something that you talked about speaking Dan's asked about political risk classic sort of thinking is is that you don't manage that at a risk committee you might manage it in your your Washington or Brussels or London office dealing with with and there's policy risks 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 it is and certainly for big banks there was a lot of expiration risk in in earlier decades crises you can see the hourglass is kind of broken and it's broken right at the neck we're finances here's some just I hate to say 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'll have some list that you can I didn't go to Wikipedia I just said oh yeah there was that Latin tech crisis I did go to the internet to remind myself wait 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 what happened in you know in ten minutes or less no 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 as to a bank is making a loan or insurance company is taking a risk it's whenever somebody takes a risk you have to sort of sort of make some probability weighting how what's that wrist like let's take a bank will I get repaid you're not gonna get repaid on a hundred percent of the loans but underwriting is this concept of sort of sorting that out or an insurance the underwriting risk of the house burning down and so forth they were a weak underwriting standards and on top of that a lot of bad practices and predatory lending Kyl question do you think that the predatory lending and accepting extending loans because it is a symptom of willingness to take on more risk or being unaware of the raises sort of whatever we call it the $64,000 question in the middle of bed 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 was 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 the the major investment banks the Lehman Brothers and some of the others that were underwriting a lot of the subprime mortgages we're aware that there were no dock loans no document loans was called no doc loans that the the down payments were shrinking because that was susceptible to math that you could see that restore and lower down payments but I don't think that they knew everything that was going on on the street the really bad action I testified in the US Congress in the spring of 2000 as a department of secretary under secretary 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 made recommendations and Ned Gramlich over at the Federal Reserve was very helpful Andrew Cuomo at the Department of Housing who's 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 the broad community the policy community in the banking community tended to look the other way partly because there was so much profits and partly because in the in the upside of a boom it feels like it's it's it's 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 bet we didn't bang the table enough maybe now there I was testifying I left and that that was that you know Al Gore is running to succeed Bill Clinton and you know I 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 into 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 set bubble in the stock market the internet bubble burst and we kind of moved that it that 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 and and Fed chair pal a little bit at odds about where should interest rates go and the Federal Reserve is moving interest rates up in the u.s.

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 it's a tug of war and we're seeing that play out a little now so we had 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 and also the interconnectedness the 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 alright where's my five or ten million dollar bonus I'm saying if you're running the department I mean if 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 Brodus and and those have been written about widely academically I mean we do have a lot of asymmetric incentive structures and backing furnish what about the rating agency so I would absolutely say their incentive structures within those two words a lots packed thank you rating agencies got paid for issuing ratings but they not you know give some money back if you got it wrong so it's it's 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 we're not going to get it rid of that conflicts of interest there's there's always somebody in finance who wants to separate their customer from their money that's it's the nature of things but in a sense Starbucks wants to separate you when they say do you want the large cup instead or the grande instead of the large so that's the nature of Commerce and and and it's just you want some market base and and regulatory things that feel back so multiple failure 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 what James what was the first one that failed in your country what's that Northern Rock so you know where did that where did that but the timber was dry it was like like the fire was gonna go but the system could maybe withstand one failure Northern Rock or Bear Stearns but by the summer of o8 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's just it was teetering and then of course if anybody remembers by September 15th or something it was it was just this the system would have collapsed without government intervention this 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 then or even the 1930s it's likely we have blown out to twenty or thirty percent unemployment in this country and there some of your countries that is the case you you you saw it happen I don't know all the countries represented here but so that's my little quick read of the financial crisis but if any this wasn't meant to be a lecture on it but I thought well why not throw it in its finance any questions on that peuta crisis but if you have to gauge the state of the financial like US finances right now what do you think are we in a better place than we were ten years ago yes we're in a better place than we did ten years ago yes in a number of ways but as Sheila beers 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 what we had no eight and you hadn't in Iceland when the bank's 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 the debt upon that asset class is higher than the valuation on the asset class and that's usually leads to some either calamitous outcome or government bailouts and and it takes a while debt debt loud bubbles a debt left bubble is much harder so back to today I think we have a bit of a bubble because 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 is 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 the middle-income America Middle income Europe in particular is not sharing as much I think that 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 – 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 Shelagh Bears point was we did a bunch of things bailing out big institutions we didn't have help home owners enough I think factually she's correct and then you have to say or the yeah chips correct but we did provide trillions of dollars to support for big institutions and not for individuals and and there's where the debate is and all the challenges I think it's correct Tim Geithner wrote a book if you ever get a chance to read it it's very lively and easy read about the crisis and he said sometimes it's like you know bailing out the arsonist you know they I think those were as Tim's exact words in his book but if I'm wrong sorry Tim for misquoting but mehar public policy challenge that Ben Bernanke and Tim and others were facing at that point time but I think Sheila's right factually and then I leave for you the policy debate let me just mention the financial sector I'm closing on this legacy cup store in interphase when you're thinking about any blockchain solutions as Eric said it's legacy or 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 is probably less likely you're gonna be able to tuck in but if there's big economic rents like 22.7% on payments and the like that might be a place you can tuck in with a new disrupter 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 gonna bail out a bad blockchain idea and I'm not looking for a bunch of ideas about you know scams and frauds but there are wide acceptance and there's seven and a half percent of the US economy and similar numbers probably five to seven percent of most economies are in finance by the way because the capital markets and the equity markets are about five hundred percent of the economy it's about a hundred trillion dollars when you add up all those other slides financier and seven and a half percent so that's about one and a half percent Vig that that's an old term from you know the gambling house what's the Vig what's the take finance takes about seven and a half percent divided by over about five hundred percent or it's about one and a half percent 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 gonna skip through this next week's readings October 16th you'll have a surprise guest you'll have some with the surprise guests 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 he testified in 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 gonna talk about the economics of block jane i'm going to focus more on christian Catalina's paper but Paul Krugman is his is a 2-page slept down these are kind of the the Bitcoin and blockchain minimalist and next Thursday is a little bit towards the maximalists but I want to talk about the economics what I'll call Act two so I thank you I'm supposed to let you go I've gone two minutes over so [Applause]

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