Fixing Finance: Reactions and Over-Reactions

Speakers:
Peter R. Fisher BlackRock
Benn Steil Council on Foreign Relations
David S. Scharfstein Harvard Business School
Presider:
Alan S. Murray Wall Street Journal
Audio
Transcript

ALAN MURRAY:  Okay, can I get your attention, please?  Welcome to the second session of the CFR symposium on fixing finance.  I'm supposed to remind you to completely turn off your cell phones and various devices.  Not just put them on vibrate, completely turn them off.  I guess that means you can't Twitter from this meeting.  Sorry.  I'm sorry, I see some active Twitterers out there, I know.

Remind everyone that this session is an on-the-record session.  We're going to take about 35 minutes to talk among ourselves, and then we will open it up to questions.

We're very fortunate today to have three men who have spent a good deal of time thinking about and writing about how to fix our financial system in various forms. Benn Steil has done it for the council; David Scharfstein has done it as part of the Squam Lake Group and is going to tell us where Squam Lake is and why he did it there at some point; and Peter Fisher is at BlackRock and has written on the subject and has also worked closely with The Wall Street Journal on our Future of Finance initiative.  So three different but very well-informed perspectives on the topic.

And we're going to spend most of the session looking forward.  But before we start, gentlemen, I'd like to ask all three of you, one of the things that strikes me about this discussion is if you put people together to talk about any of the other big policy issues that we face -- health care reform, education reform, Social Security reform -- you'll get a bunch of proposals on the table that are all the same proposals we've been talking about for 20 years.

In this issue, however, the thinking has changed and changed pretty dramatically because of the events of the last two years.  And what that seems to suggest is that until the events of the last two years we had it all wrong.  How did we get it so wrong?  Why was our thinking about financial markets and how to regulate them so off?

Peter Fisher.

PETER R. FISHER:  Well, I don't know that it was.  We've had some big mistakes in how we regulate the financial services industry.  But I do want to begin, at the risk of annoying some, that we have to understand monetary policy was much too easy.  And if we don't begin with that admission, we're going to end up fixing a lot of things that we're broke.  And I think some of the reactions you're seeing now are ignoring that fact.

Monetary policy creates huge incentive effects.  Risk was mispriced.  That's because monetary policy wanted it to be mispriced.  It incented people to take more risk than they would otherwise take, early in this decade, in particular.

MURRAY:  Well, no, I was going to say, David, if that's it, then let's just get monetary policy right and we don't have to talk about all these other things.  It would make more time to boat and swim at Squam Lake.  (Laughter.)

DAVID S. SCHARFSTEIN:  There's a rule in New Hampshire, I think, which is that if you get more than 10 people together to talk about finance, you have to name it after the place that you're in.  (Laughter.)  But it is a lot of money.  There was a lot of money on the table.  And you asked, you know, how did we get it wrong?  You can't eliminate the hypothesis that there was some regulatory capture involved, that, you know, rules get determined, in part, by the players with a lot of money at stake.  And Basel II has elements of it that were manipulated and were created.

MURRAY:  But I don't remember anybody running around screaming, as Basel II was being done, this is regulatory capture.  I mean, maybe the capture was so complete that there wasn't anyone left to complain about.

SCHARFSTEIN:  There were folks that were looking at it that had issues with it.

MURRAY:  Benn.

BENN STEIL:  I have a lot of sympathy with Peter's comments.  I mean, if you look at real inflation-adjusted interest rates over the period 2003 to 2005 that were negative for most of that period, which is historically very unusual, you'd have to go back to the '70s to find a circumstance like that.  And it also emphasized that there have been many, many cases in the history, both of recent and relatively ancient, where inflation was relatively moderate at the time of crisis, but you had a huge boom in assets prices.  Latin America, Asia in the 1990s, the U.S. in the 1920s, inflation was exceptionally moderate for most of the decade, but there was massive credit booms during that period.

I guess I would emphasize another factor that I think was extremely important that's not being talked about, which is taxation policy which has provided enormous incentives for building up debt on the corporate side.  An equity-financed investment will face an effective tax rate; a debt-financed investment will face an effective tax rate of about negative 6 percent.  So that obviously gives companies, in particular financial institutions, enormous incentive to fund themselves with debt rather than equities.

MURRAY:  Yeah, and we're going to come back to that because that's among the most provocative of the proposals you folks have put on the table.  We'll see how people in here feel about eliminating tax benefits to debt and home mortgages.  But before we do, let's talk about, David, let's go back to capital requirements because you talked about regulatory capture and Basel II.  We thought Basel II was an answer, now we think Basel II was the problem.  How do we fix capital requirements to prevent the kind of episode that we've had in the last two years?

SCHARFSTEIN:  Well, look, it's really hard to prevent these things.  But it's clear that, you know, Basel II and the capital requirements have, you know, insufficient accounting for systemic risk.  And so it's important -- we think, in the Squam Lake Group which is a group of 15 academics that have kind of come together to think about financial regulation -- that it's important to have higher capital standards for larger financial institutions, for those that are holding more illiquid assets and when they're funding those assets with short maturity liabilities.  I mean, there's others that have suggested that.  But I think, clearly, Basel II needs to be reformed or capital requirements need to be reformed to take account of the systemic risks.

MURRAY:  The other thing, Benn, that you've written about is that the capital requirements that right now they're procyclical and they should be countercyclical.

STEIL:  They're very procyclical.  That allows financial institutions to build up the financial risks that they take on a very thin base of capital when asset prices are rising.  But when asset prices start falling, it forces them to raise capital very quickly in an environment when it becomes extremely scarce.  And that's precisely the problem that we've run into over the past two years.  So that needs to be turned on its head.

MURRAY:  Go ahead, I know what you're going to say.

FISHER:  I think we've got to think harder than we are about the incentive effects that risk-based capital creates.  So the existing capital rules provided a sufficient incentive for the whole financial services industry to game the risk categories, get crummy, badly originated assets into certain risk buckets, and now they can make more money.  And so the incentive effect, if you don't, it undermines the system.

So any regime of risk-based capital has got to have more disciplined credit underwriting at the front end or it's simply a faulty foundation.  It just doesn't work.  It's lopsided.

MURRAY:  That's what I thought you were going to say.  You have written that it doesn't do any good to impose higher capital standards on institutions that make loans to people who can't repay them.

FISHER:  Yes, it just doesn't matter.  It doesn't matter whether you have six, eight, 10 or 12 or whether you've got procyclical or countercyclical.  If you're lending money to people who can't pay you back, it doesn't work.  Now --

MURRAY:  I guess none of us thought that we had to teach institutions how to do their jobs.  Yeah, thank you.  (Laughter.)

FISHER:  The whole reason we supervise banks and financial firms is because we know that they will be tempted to chase the wider margins on loans to riskier borrowers without properly accounting for the higher probability of default.  We know they'll do that.  We've known for 300 years that's what they'll do.  And so if you don't capture it through underwriting discipline at the front end of the machine, you just end up with garbage in, garbage out.

Imagine our only answer to highway safety was having really expensive air bags.  You've got a lot of terrible accidents on the highway, terrible carnage, and all we do is say, let's have more expensive air bags, that will give people the right incentive that when they're in a crash they'll lose a lot of money.  No.  We should have driving, we should think about the brakes and the steering of financial firms.  And I'm afraid it's all ideology, as was said in the prior panel.  There's this ideology we can do this with capital requirements, and we can't.  And as a long as we keep going down this path, we're going to create the next blow up.

MURRAY:  So you're saying things really haven't changed, thinking hasn't changed enough, thinking we can fix it with capital standards.

FISHER:  The U.S. -- I mean, everyone is reverting to type.  The U.S., we're trying to finance consumers.  In China, they're building roads and bridges and hospitals and schools, investment deepening, and bank supervisors want more capital.  Everyone's just reverting to type.

MURRAY:  David.

SCHARFSTEIN:  I think Peter is right that there's a limit to what you can do with capital requirements.  I mean, I think that's absolutely right.  I mean, the whole financial system is set up, I mean, the people in the financial system are set up and rewarded to do arbitrage, whether it's real arbitrage or regulatory arbitrage or whatever kind of, you know, sort of taking on, you know, systemic risk that looks like arbitrage.  That's what the system is kind of set up to do, and that's how people are rewarded.  So there is a limit to the capital requirements.

Now, another way to go is to make sure that the penalties for failure are greater.  So you know, one way to go is, you know, one of the things we've seen is that, you know, creditors and counterparties have gotten bailed out.  And the question is, can we come up with better resolution mechanisms so that creditors and counterparties are not bailed out and the market itself and the creditors and counterparties provide the discipline in the system?

So one of the things that we've proposed in the Squam Lake -- so one mechanism is just a better resolution mechanism for non-bank financial institutions.  And you know, the Obama administration has made a proposal along those lines.  It's not clear where it's going.

MURRAY:  Yeah, I want to go into your solution.  But before we do, let's test the hypothesis a little bit then.  I mean, so what we're saying is that institutions make bad loans because they know at the end of the day they're going to get bailed out.  I mean, do you buy that?

STEIL:  I think that there's some truth to that, absolutely.  Therefore, I think part of the focus has to be on controlling leverage.  But we haven't done a very good job in thinking about what leverage is in different situations.  Let me give a very specific example -- Northern Rock, that's the failed British bank that caused the first run on British banks since the mid 1900s.  If you tried to measure Northern Rock's leverage according to the definition of capital that the regulators use, right before the crisis, they weren't really significantly leveraged.  But if you measured their leverage the way an investor would look at it, that is, you just looked at the equity base, you would have realized that this institution was doomed to failure.

Now, why is that?  In a crisis where it looks like the institution is about to fail, the equity holders have very perverse incentives.  They're the last ones to get paid off, but they're the ones that control the company, so they have every incentive to roll the dice, looking for salvation, and the market knows that.  So the market will ignore every other measure of capital and just focus in laser-like on common equity, but regulators were missing that fact.

MURRAY:  Peter, then let's go back to resolution mechanisms.  So the resolution mechanism then becomes critical to how you eliminate the bad incentives in the system.

SCHARFSTEIN:  Right.  And I think the effect of the leverage is a little more subtle in the sense that it's partly that, particularly during a crisis, there's a rolling-the-dice effect that you see.  But it's also that there is less discipline on the part of the suppliers of capital to financial institutions if they know that, you know, at the end of the day they're going to get bailed out.

So if we had a better resolution mechanism that -- and everyone's terrified of another Lehman -- but if we had a better resolution mechanism, FDIC-like resolution mechanism whereby creditors and counterparties could be dealt with.  And I think every financial institution needs --

MURRAY:  If we had that, could we eliminate "too big to fail?"

SCHARFSTEIN:  It's always hard to eliminate "too big to fail," I mean, really what we have is not "too big to fail," it's really too systemic to fail.  There's too much interconnection.  So there's a sense in which every financial institution needs to come up with its own funeral plan, you know.  Where are all the dead bodies, and what are all the connections?  And we need to understand those better so that failure becomes a possibility.

FISHER:  Well, I think that's a good example of what may have morphed over the last decade or two, which is we thought the capital structure that the investors agreed to gave you that road map.  We thought we knew the equity guys got in first and then there was a subordinated and then preferred and then common.  And we thought we knew where all the other creditors were going to fall.  And we haven't yet tested a bankruptcy regime yet through this great crisis.

And I think there really are two different philosophies.  We have to think about fixing the system.  And it's not about less or more, you know, re-regulation, overregulation.  But can we enforce a capital structure that everyone agrees to in advance and have that be the funeral that we agree to?  And I'm a little nervous.  The answer that says, let's have a benevolent despot in Washington who's going to resolve financial firms and will tell us what the capital structure is, how the losses will be apportioned after the accident, isn't really the same thing.  I don't know how that's going to get us to a more stable financial system by making the capital structure less predictable.  It's actually, can we get it more predictable by making it something that can be enforced and we all can live with?

MURRAY:  But how do you do that?

FISHER:  Well, I think one of the issues is trading exposures and long-term intermediation of credit on one balance sheet.  And so people think they want to find a new Glass-Steagall, and I think that's the wrong way to come at this subject.  That's not the issue.  That was a failed theory from a long time ago.  But I think it is a real issue, if we're going to have some financial agents try to intermediate credit across a long period of time and run that maturity mismatch, that's one kind of form of intermediation.

The other is being members of the trading community and trading, rolling the dice with everyone.  I mean, you need another kind of capital to do that.  And we've let the major financial intermediaries use one pool of capital for both those activities.  And over the last two years, we've seen the authorities, with the exception of Lehman, decide, oops, we don't want to find out what happens if we go to bankruptcy, we're going to stop the clock because we don't want those trading counterparties not to get paid off -- Bear Stearns, AIG.  And so they end up filling the hole with public monies.

And now we're in this betwixt and between, we haven't yet had a funeral.  And so I think being clearer on the capital structure.  I think we've made a mistake on letting trading exposures insert themselves as senior creditors is what it comes down to.

SCHARFSTEIN:  But that's sort of where you get the distinction between -- I mean, the FDIC, you know, has a resolution mechanism for banks.  And I think it's worked fine.  The issue is we've got bank holding companies where we don't have a resolution mechanism.  And I don't think there's any particular reason to believe, you know, if the FDIC can basically get it right, I don't think there's any particular reason to believe that another authority would get it wrong for bank holding companies.

FISHER:  Well, I think it's much easier in the case of banks.  We know depositors are going to be made whole, and everyone else stands somewhere way behind the depositors and the federal government.  I think it's much more complicated when you look at the levels of different types of debt that the big bank holding companies have issued, I think it's not at all clear that there's going to be a way for some benevolence.

MURRAY:  Why, David, why is it any easier for a resolution authority to do that than for a bankruptcy court to do that?

SCHARFSTEIN:  Well, the problem is the bankruptcy courts take time.  And there's a big difference between, you know -- a financial institution doesn't have time.  So you can -- financial institutions requires, on a daily basis, being able to raise capital and to deploy that capital.  And so there's constantly having to go to the market.  I mean, you can't let a Chapter 11 process happen for financial institutions.

MURRAY:  (Inaudible) -- streamlined process.

SCHARFSTEIN:  Yeah, you've got to have a streamlined process.

FISHER:  I think the best way to get a streamlined process is tell all the trading counterparties they're subordinated.  Now they'll demand collateral.  If everyone has got a trading exposure against a big financial firm knows I'm subordinated --

Murray:  Won't be protected.

Fisher:  -- you're not protected, you're going to demand enough initial and variation margin that you'll be protected.  Now we can run them through bankruptcy because all the trading exposures will be tied down.

MURRAY:  Is anyone proposing that?  You are.  (Laughter.) Right. What keeps that idea from being adopted?

FISHER:  I think we're going to have -- I think ideas like it are out there.  I mean, if you talk about moving credit-default-swap exposures into a central counterparty that will demand collateral, that's part of the answer.  So it's moving in that direction, and I'm just --

MURRAY:  Let's talk --

STEIL:  We did in fact demand more collateral of AIG, and they had a big dispute about it obviously because AIG couldn't put up more collateral.

MURRAY:  Let's talk about credit-default swaps because if the fundamental problem here is interconnectedness, that obviously has a lot to do with it, then what needs to be done?

STEIL:  Well, the big problem in the credit default swaps was clearly the counterparty risk management.  The procedures for unwinding positions actually played themselves out quite well.  I think it's definitely the right way to go to move certain OTC contracts that have become highly standardized and are traded in high volume onto central clearinghouses.

My big concern right now is that the U.S. and the EU are engaged in a competition to produce the jurisdiction for these instruments.  The OTC markets was legitimately global before this crisis.  It was a private market that used private contract based on public enforcement.  That is, if there were a dispute, the parties would settle their dispute in a -- (inaudible) -- common law court or a New York state common law court, whatever they picked.

But now the EU is trying to create its own OTC derivatives market jurisdiction in competition with the U.S.  And I'm very worried about how that's going to play out.

MURRAY:  David.

SCHARFSTEIN:  Well, I think most people are in agreement that we need to go to a clearinghouse kind of structure.  I think the central question there is, how much competition are we going to have in the clearinghouses?  I mean, the value of the clearinghouse is, you know, you reduce significantly the counterparty risk and you allow for netting of, you know, kind of long and short positions.

The issue, though, is that if you have multiple clearinghouses, you end up losing some of the value of netting.  And then there's a question about, do you want to have specifically just the CDS or all kinds of derivatives?  So you might want to have interest-rate swaps and CDS in the same clearinghouse because it allows for better netting.  I mean, there's some research that showed that if you did it just for CDS, you'd actually make things worse.

MURRAY:  Peter, is a clearinghouse enough?

FISHER:  No.  It's not not enough because there's another problem.  The CDS market is really one label that covers a multitude of risks.  And at one end of the spectrum, there's some CDS contracts that are almost like equity options.  At the other end of the spectrum are something that's not at all like equity options, it's just insurance.  People are writing insurance on stuff they can't possibly trade their way out of.  There's no liquidity found in what blew up AIG.  They were writing insurance on highly idiosyncratic mortgage risk.

And we permit them to operate in that market as if they can trade their way out of it, and they can't.  That's an illusion.  And I think we've got to bifurcate the market.  We've got to take those CDS contracts where both the CDS contract and the underlying bond or recovery value, approximates, both trade on an exchange.  Get them on an exchange where there's daily, continuous, transparent price discovery throughout the day, and that's fine.  Now we're going to rely on the central clearinghouse to protect that risk.

Everything else that can't get there has got to be reserved as if it is an insurance product, as if you're writing insurance, you've got to hold enough capital against it, you're never going to trade your way out of this, there's no liquidity out there.  Whoever is the writer who's holding the bag on writing that insurance has got to reserve against that.

MURRAY:  The result would be a pretty dramatic reduction in the CDS market.

FISHER:  It would be.  I think a lot of the market, in volume terms, is in the stuff that's almost liquid enough to get on exchanges.  A lot of the risk that's blown people up is down here with the stuff that's not.  Let me point out a test, though.  If the central counterparty is going to work and protect itself, it's going to have to protect itself against daily intraday volatility -- intraday volatility.  To do that, it has to have continuous and transparent price discovery.  So you're really talking about moving it to an exchange.

It's a false half-way house to say we can put it on a central counterparty because the central counterparty won't be able to protect itself without very detailed data on intraday volatility.

MURRAY:  You wanted to say something?

SCHARFSTEIN:  The social value of CDS -- this is not the greatest thing since sliced bread, right?  So I mean, doing lots of stuff to protect it and make sure that you can do all this sort of customized stuff doesn't seem to me to be, you know, we shouldn't be bending over backwards to do it.  So if stuff gets forced onto an exchange and, as a result, we can't do customized CDS, I don't think that's the greatest cost to bear.

MURRAY:  So dramatic reduction in the CDS market doesn't bother you.

SCHARFSTEIN:  No.

MURRAY:  Does it bother you?

STEIL:  Absolutely not.  It's a very poor instrument to trade on exchanges.  It's one reason why I'm happy it's moving in that direction.  Margining for essentially an insurance contract is absolutely ludicrous.  So that's why I'm very concerned that regulators are going to focus on CDSs and ignore the wider question of how we deal with counterparty risk in the OTC-derivatives market.  This is just one example of an OTC-derivatives contract.

MURRAY:  And so, how would you address the broader issue?

STEIL:  Well, first of all, I think there needs to be a cooperative approach between the U.S. and the EU because this market is legitimately transatlantic, and we can't afford to bifurcate it.  We need to have some agreement that once certain OTC contracts that are reasonably standardizable reach a certain volume, that the regulators have a right to turn to the ISTA members, the International Swaps and Derivatives Association members, and say, right, this particular contract needs to be transitioned to a clearinghouse structure.  We're not going to tell you that it has to be an exchange.  It can be a clearinghouse that is owned cooperatively by banks.  There are many examples of that, both in the United States and Europe.  But we need the clearinghouse both so we can monitor risk buildup -- AIG, the Fed and the Treasury had no idea what their exposures were at the time that they appealed to them for aid -- to (novate ?) trades, that is to make the clearinghouse the central counterparty on the trades, to net the trades and finally to absorb default risk in the event that one of the participants --

MURRAY:  Okay.  Now, this partly gets back to the systemic regulator question, right?  I mean, it's one thing to have transparency and have all that information out there, but the Fed not only had no idea, they weren't entirely sure it was their job.  Does a systemic regulator fix that, Peter?

FISHER:  I mean, I don't have an objection to the concept.  I just want to know what's in the bag before I sign up for it.  And so is the systemic risk regulator going to tell everyone on the highway, slow down to 40 miles an hour now?  I mean --

MURRAY:  They worked all that out up at Squam Lake.  (Laughs.)

FISHER:  I think it's sort of a place we put our confidence until we know what sort of rules we'd like to see enforced.  So I can't say I think it's a bad idea, I just don't know quite what it is yet.

MURRAY:  David, enlighten me.

SCHARFSTEIN:  Well, it's clear they have to get it worked out.  But I mean, someone, I mean, some group needs to be looking at systemic risk, you know.  And it's going to take a while to figure out what that's going to be.  You know, our Squam Lake group, after much back and forth, you know, thought that the Fed was in the best position, the central banks more generally in the best position, to, you know, understand the systemic risks, measure it, provide information about it, you know, to the market, and basically require that, you know, sort of collection of information around systemic exposures, and then let market participants know what that is.

MURRAY:  It's potentially a vast increase in the Fed's power.  Was your group comfortable with that?  And was there anything you would take away from the Fed just because of bandwidth or because of conflicts of interest?

SCHARFSTEIN:  It would be a huge responsibility for the Fed.  I mean, I think the idea is that they're better positioned than any of the other regulators to do it.  They interact with the key players on a routine basis in the markets.  They're already supervising these institutions.  So we'd obviously need to, you know, increase the resources available to the Fed to make that happen.  And you know, of course, there are downsides to it.  I mean, it's a lot of responsibility.  You have potential politicization of it.

FISHER: But are we going to let them rewrite all the rules in real time?  Or are we just going to have them go capture information?  I mean, regulator means rule writer.  So are we going to let them override the SEC and the CFTC or not?  I mean, I think we ought to settle on that before we talk about it as a serious proposal.  And it would be quite something in Washington to put all that power in one basket.  I'm skeptical Congress is going to let that happen.  And then we're going to get the worst of both worlds.  Everyone's going to think they're the systemic risk regulator and they're actually not going to have the authority to do it.

MURRAY:  Well, let me ask the question from a somewhat different direction because I always thought, until this debate began, that the Fed did have that power.  In other words, the Fed doesn't regulate mortgage brokers.  But if the Fed had stood up in 2000 and said, you know what?  This idea of lending people 100 percent of the value of their house and having negative amortization is not really a very good idea.  If Alan Greenspan had said that, it would have had real effects.  So I guess I ask the question from a different direction.  Are we asking the Fed to do something dramatically different from what we've always asked them to do?

STEIL:  I think we need to disabuse ourselves of the notion that there's an institutional fix to this particular crisis or type of crisis.  The notion that if we assign new responsibilities or different responsibilities to the Fed, the SEC, the CFTC, the credit rating agencies, that somehow we won't get into this problem again.  A little thought experiment.  Imagine if all those institutions had been run by proteges of Nouriel Roubini.  What would that have meant?  It would have meat that, over the course of the past decade, monetary policy would have been much, much tighter, credit would have been much more restrictive, a lot of mortgage-backed securities that were given AAA ratings would have gotten XXX ratings.  (Laughter.)  I mean, all these Roubinis would have been hauled before Congress to explain to the American people why American companies were being denied credit, why American investment banks were being put at a competitive disadvantage vis-a-vis their European counterparts and, most importantly, why low-income households were being denied access to mortgages.

MURRAY:  So we just throw up our hands and say, bubbles happen, and live with them?

STEIL:  No.  As you know, my report emphasized looking at specifically incentives, in other words, that come from a monetary policy, that come from the taxation system, the way we regulate capital standards.  We need to focus on the incentives.

MURRAY:  Before we leave the -- I'm going to open it up to questions in just a minute.  But you brought up the credit rating agencies.  We haven't really talked about that.  Spectacular failure, what went wrong and how do you fix it?

STEIL:  Well, first, we have to recognize that they didn't perform materially worse than most forecasters.  I mean, forecasters in general did a bad job with this particular crisis.  The problem is that we've assigned them the role of gatekeeper to the financial markets.  And that's where the problem lies.  I think we need to extract them from the regulatory operators, in particular from the capital standards regime.

There are other metrics we can use to evaluate how risky a particular debt contract is besides what Moody's or Standard & Poor's might have to say about it.  For example, the assets yield vis-a-vis Treasuries.  There are many metrics we can use.  We don't have to rely on these particular agencies.

FISHER:  I'd go a little further.  I think we've got to recognize this is another little piece of received historical ideology.  Eighty years ago we thought equity was complicated and debt was simple.  So we'll have a few rating agencies tell us what bonds institutional investors should buy and how they should price them.  Flash forward 80 years.  Citigroup issues, what, two classes of common stock and hundreds of different slices of debt.  Debt is infinitely more complicated than equity.  It is an illusion to allow institutional investors to outsource the decision of what to buy and how to price it.  We've got to break down that fallacy and move even further in the direction of taking them out of the regulatory apparatus.

MURRAY:  It's not like the system of equity analysts has been a spectacular success.

FISHER:  No, but we know that.  We know there are thousands of opinions.  (Laughter.)  No, it's serious to take away the informature of government and official sanction that goes along with the rating agencies, that lets the money market industry, of which BlackRock has got a big part, just rely on what they tell us.  And we've got to break that down so people can go back to --

MURRAY:  So too many institutions simply abrogated their responsibility to --

FISHER:  This how we're set up.  Yes.

STEIL:  The Fed does that, as you know.  They often say, we'll only take AAA securities for this, that or the other lending operation.

MURRAY:  Without taking a look. You would think that it would be sort of a fundamental rule in this business that you don't buy something that you cannot comprehend, right?  (Laughter.)

Before we open it up, monetary policy.  If the fundamental problem here was a  monetary policy is too loose, I have a hard time getting my head around how the solution is what we've been doing for the last year, which is, you know, increasing the monetary aggregates at a pace that we've never seen before in my lifetime.  Can one of you gentlemen solve that for me?  (Laughter.)  Or are we just setting ourselves up for the next episode?

FISHER:  If the wrinkle that we have to worry about is whether deflation expectations can get sticky, the Fed's relied for 15, 20 years on the idea that inflation expectations were sticky at about 2 percent.  So we can look out and understand which way the world was going.

If deflation expectations are to get sticky and consumers and borrowers start assuming prices are going to fall 2 percent a year, we're going to be in a very, very bad place.  And you can tell by the way central bankers are behaving that that's what they're afraid of.

So if if turns out it was just a bad dream, as maybe it was in 2003, then we'll be worried about inflation.  But that really will be the good outcome.

MURRAY:  So that's the good news.

FISHER:  Yeah.

SCHARFSTEIN:  What he said.  (Laughter.)

MURRAY:  You all agree.

STEIL:  I'm much less sanguine than Peter.  I am not worried about deflationary expectation.  If you look at the default swaps on U.S. Treasuries, if you look at the gold price, there are clear indications that investors are concerned about an inflationary future.  Nobody is concerned about it over the next six months.  But looking out a year or two further, there are reasons to be exceptionally concerned about inflation.

FISHER:  From the low-end consumption in 2001 to the high in inflation was July 2008, so the last recession gave us a seven-year lag from the low-end consumption to the high in inflation.  Do you think it's going to be faster this time with a kind of global outlook we have?

STEIL:  Look at the Fed's balance sheet.  Look at the way that it's expanded.  It may very well hit $3 trillion very soon.  It's very difficult to imagine how they will unwind that in a timely manner as the velocity of money increases back towards a normal level.

MURRAY:  One other issue before we open up, and that's the issue of corporate governance.  Fascinating to see an institution like AIG, which was in the business of judging risk, seem to have no capability to look at its corporate risk, to look at the risk of its total portfolio.  I gather that's not that uncommon among financial firms.  Was there a failure of corporate governance here?  And is there anything that could be done to improve it?

SCHARFSTEIN:  Corporate governance is a tough question.  I mean, you talk about independent directors, knowledgeable directors.  I mean, I think if you look at Goldman Sachs which, you know, probably has very high-quality risk management, and you look at the board, I mean, there are people on the board that, you know, just on the face of it, you would argue don't really know anything about finance.  So it's not --

MURRAY:  Maybe that was the magic answer.  (Laughter.)

SCHARFSTEIN:  Maybe that was the magic answer, right.  I'm not sure.  But the other issue, though, that when you think about what the board is supposed to do, the board is supposed to, in normal times, is supposed to represent shareholders.  Shareholders have, in financial institutions, give that they're highly leveraged, there's incentives to take risk.  So it's not obvious that kind of, you know, incentivizing the board and making the board be the guardian of shareholder interests actually leads to the outcomes that we want.

I mean, the question is whether or not the objective for a financial institution or the board should be, rather than, you know, shareholder value maximization, some other thing which is kind of like institutional value maximization.

MURRAY:  Interesting.  Well, that's what you're saying.  That's why you're saying you have to have strong regulators because the shareholder governance system doesn't work for financial institutions.

FISHER:  Yeah.  I think AIG, I'm taking a big step back, it's a pretty -- the big risk-management failures are conceptual, not computational.  They thought they were going to have one subsidiary engaged in an unregulated insurance business and arbitrage their AAA rating and not get into trouble.  Well, as soon as you state it that way, you know you're going to get into trouble, right, because there's sort of an infinite regress on how far they go and try to arbitrage the AAA rating in one subsidiary.

So you know, maybe they should have had more integrated risk management and analytics across the whole platform, maybe their directors could have been better.  But that flaw is right there in front of your nose once you state it that way.

MURRAY:  Let's open it up.  Right here.  Please, identify yourself before you ask your question.

QUESTIONER:  My name is Halid Azim (ph).  My question is on transparency.  Is there a way -- if the issue is underwriting standards, is there a way to discriminate and differentiate the quality of the information put out by these firms and the efficiency of them and punish the ones taking excessive risk and reward those that are taking prudent risk?

FISHER:  Not that we can do easily, and we've overestimated our ability to do that, I think.  But you think about the (server ?) farms around the world that are in the business of looking at trade and prices and calculating capital requirements, we don't have anything like that 20-year history of both intellectual input and technological input going into credit, just thinking about the different ways of measuring credit.  So we're way behind where we ought to be.  And no, it's very hard to get the transparency look.  I've spent 20 years thinking we could get better disclosure from financial firms, and I'm skeptical about that, that we're actually going to get far enough.  But I think we're just years and years and years behind getting smart people and technology to try to think about credit underwriting in a much more disciplined way, I'll be honest.  But we're way behind.

MURRAY:  Right here.

QUESTIONER:  I'm Gregory Marrish (sp).

How do you reconcile then the conclusions of this panel with the one before?  Because, as Mr. Fisher has expressed very eloquently, and the other gentlemen support, I think, the cost of capital in -- private capital should go up because it was mispriced -- it was a derivative of low interest rates, and, on the other hand, we're trying to promote global growth.

It seems to me that whatever idea of trend-growth people have in their mind is something that is not achievable, or at least in the short- to medium-term you can't reconciled both.  I don't know what you --?

FISHER:  Well, I think what we're struggling with is real rates are going to be higher than we'd like.  That's why you see central banks throwing their balance sheets into the breach.  And we're nervous that the real rates we're looking at are too high for our expectations for growth.  But, our expectations for growth are going to have to give.

That's why I think we're so -- I'm so frightened that -- and I think the comments made earlier about the 'mistakes made were 31 to 33, not 29,' I think the mistakes we'll look back on 10 years from now are ones that drove up the real cost of capital, that added to uncertainty rather than reduced it.

So, yeah, that's the tension we're struggling with right here.  I mean, the most frightening thing I've seen in the last year was yesterday's Wall Street Journal, the story on Chrysler.  An unnamed government official said, quote, "We don't need banks or bondholders to make cars," close quote.  -- (inaudible) -- very clear, we need banks and bondholders more than anyone because we're a debtor nation.  We need them to do everything we do.

But, if you start driving up the real cost of capital by injecting uncertainty premiums and saying, "we don't care about banks and bondholders," it's going to be a pretty expensive world if we finance it all on the equity side of the ledger.  More of it has to be there than was.  But, pretty frightening.

MURRAY:  Either of you want in on that?

STEIL:  A lot of our consumption, our spending at the state and city level over the course of the decade was based on debt at a very low cost of capital.  That's, hopefully, not coming back.  And this is my concern, conceptually, about this idea of fiscal stimulus to breach the output gap.  In other words, to get us where we -- back to where we were in, say, 2007, before the crisis unfurled.  We're not going to get back to that --

MURRAY:  We don't want to get back there, at least very rapidly.

STEIL:  Certainly we don't want to get back to that state on the basis we got there before -- that is, through debt-financed --

MURRAY:  Liquidity.

STEIL:  -- consumption.  And we have to accept the fact that the level of consumption that we were enjoying in 2007 was based on imaginary wealth, not wealth that we're going to be able to reconstruct.

MURRAY:  David?

SCHARFSTEIN:  I agree.  But, one thing I think we -- I just want to challenge you on a little bit, is that, I mean, I don't think we can say that banks and bondholders have gotten too raw a deal in the last, you know, six months.  I mean, I don't think the comment from the unnamed source was exactly on target.

But, I don't think we've had a massive rewriting of the rules of how banks and bondholders -- (inaudible) --

FISHER:  Investors are going to take lots of losses; and they'll take more losses; and that will be part of the resolution.  But, if we have senior administration officials who think we don't need banks and bondholders to get our way out of this, we're in really deep trouble.

MURRAY:  Question right there.

QUESTIONER:  David Bheim (sp), Columbia Business School.

After the last great crash we instituted formal requirements in the stock market because it was thought that excessive leverage in the market for stocks was part of what happened in the '20s.  This time what went wrong was excessive leverage in the market for bonds and for houses, where margin requirements feel to extremely low levels -- in the case of houses, actually, below zero.  Below zero -- negative.

Can't a systemic regulator make a contribution to helping financial institutions with better underwriting standards by setting formal margin requirements for bonds and for houses?  Why shouldn't we do that?

FISHER:  I think that's a very good point.

I think the failure, though, is making initial and variation margin high enough in the credit default swap market, because that ended up being the driver.  People were willing to absorb the risks of the badly underwritten houses.  So, you've got to get it across.  But, then let's talk about margin regulations across the board in all asset classes, and say that's what we're going to try to fix.

MURRAY:  But, that's what we -- that's what we should do.  Right, David?

SCHARFSTEIN:  I didn't follow the --

MURRAY:  The margin regulations across the board in all asset classes.  I mean, that's what -- that's part of what you were --

SCHARFSTEIN:  No, I mean, clearly we need to have margin requirements in large asset classes.  But, I mean, it works in most instances.  I mean, you know, in CDS, I mean, most counterparties are posting collateral --

FISHER:  Not enough.

SCHARFSTEIN:  Not enough.  But, when it's done right, that's what -- I mean, we need to require it, and we need to, you know, to get it to be complete.

MURRAY:  Right back there.

QUESTIONER:  Brian Cavanaugh, Medley Capital.

The first question I have is regarding governance.  We made the point earlier that it's not a good idea to take them through bankruptcy -- you don't have enough time, in the case of financial institutions.  And yet in bankruptcy that's where someone other than equity holders have management's fiduciary obligation.

Is there some regime for governance with financial institutions, where -- (inaudible) -- the bottom 20 percent of the capital structure selects the board, as opposed to just the equity, or make some sort of construct like that based upon historical fluctuation of the overall enterprise values?

MURRAY:  David, is that how your resolution authority would work?

SCHARFSTEIN:  Well, that's -- the resolution authority is more, sort of, after the fact.  You're sort of suggesting, kind of, before the fact, does the -- should the creditors have a say, you know, in governance.

I mean, one of the things that you see with bonds that are issued by financial institutions is that they're -- I mean, they're obviously rated very highly, and they typically don't have any covenants.  I mean, the typical way a bondholder would get some control is through covenants of some sort.  And it's interesting that in this financial crisis -- did not trigger any kind of covenant on long-term bonds, because there really weren't any.

So, you know, I'm not sure what the answer is -- you know, whether or not it's wise to have bondholders with a vote.  But, I mean, it is -- it is clear to me that, you know, with equity holders, clearly their incentives are not aligned with the bondholders.  I think we need systems whereby bondholders are at risk, and, therefore, evaluating credit.  And, as a result, they sort of --  The other way to do is they sort of penalize financial institutions that have too much leverage by charging them higher rates.

We've, sort of, lost that because of the, you know, the problem with the bailout of -- bondholders expect to get repaid.

FISHER:  I don't have an answer here, but this morning's FT front page story on the GM bonds and the CDS holders, who will get a much bigger payout if the bonds go into default than they will to a restructuring, is a complete rewriting, in our mental model, of the capital structure.

We've got to kind of understand what that means for incentive structures for working out troubled companies and decide if we like it or not.  I mean, maybe we like it, maybe we don't like it.  I haven't been able to think it all the way through yet, but it's a very changed process, and changes the rules of the game.

SCHARFSTEIN:  You're talking about the empty creditor problem?

FISHER:  Yeah, the empty creditor problem --

SCHARFSTEIN:  Okay.

FISHER:  -- yeah.  But, that's a big change in the rules of the road and what it means to try to work a company out.  And we've got to put all those pieces on the table and try to sort them out.

QUESTIONER:  Andy Husar (sp), Federal Reserve Bank of New York.

I have a question regarding the lack of consensus about the future of banking, and Mr. Fisher's point about people -- (inaudible) --.  Take, for example, securitization at the moment.  The regulators have proposed in Basel II a series of changes that will curtail securitization significantly by the end of 2010, at the same time as central bankers have proposed programs like TALF, that are aimed at awakening the securitization markets.

I'm wondering how the panel views the conversation playing out, and who will be the final arbiter of what that structure of banking will look like in the future?  Thank you.

STEIL:  Yeah, they're contradictory.

I mean, we had an artificially inflated level of securitization in recent years because of the fact that if a financial institution -- a bank, keeps an asset like a loan on its balance sheet, it has to put aside relatively expensive capital to support it.   So, obviously, they have an enormous incentive to keep it off the balance sheet and sell it off to those who don't bear those sort of capital requirements.

So, you're absolutely right that those two policies are pushing in opposite directions.  My personal view is that we need policies, going forward, that will oblige issuers of securities to maintain some sort of material economic interest in them.  In other words, again, until we align incentives properly.

MURRAY:  Skin in the game -- skin in the game.

STEIL:  Absolutely, skin in the game.  And it won't just change the way securitization works, but it will make financial institutions think more seriously about alternatives to securitization that have a lot of securitization's benefits without its systemic costs.  For example, --

MURRAY:  Such as?

STEIL:  -- covered bonds.  That's something that's gotten a lot of play over the course of the recent crisis.  The financial institution that issues a covered bond is backing that bond with assets that it is keeping on its balance sheet.  So, it has an incentive to monitor, for example, repayments in the case of a mortgage.  So, it has a lot of the benefits of securitization without the cost, in terms of skewed incentives.

SCHARFSTEIN:  It seems to me one of the issues with skin in the game, I mean, isn't there a basic problem, which is that a lot of banks had, actually, too much skin in the game?  I mean, they had -- if you had required them -- they actually ended up holding a lot of these, so-called triple-As.

STEIL:  Well, that's because they couldn't distribute the stuff.  They never --

SCHARFSTEIN:  That's not the -- I don't think that's the only reason.  And it's not just that they couldn't distribute.  I mean, I think there was a little bit of this 'acquire an arbitrage' kind of approach.

I mean, the issue with securitization, going forward, is I think that there was an under-appreciation, you know, of the systematic risk associated with these triple-A rated securities.  I mean, the situation in which you actually default on a triple-A securitized product that's, you know, been tranched, is the situation in which the economy is doing extremely badly.

And so the notion that you would just get rewarded maybe 30 or 40 basis points above Treasuries for holding the systematic risk -- I mean, I think there's now, hopefully, an appreciation that that's just not enough of a premium to want to hold those triple-A securities.

So, I mean, going forward, I mean, I think that there is going to be a higher premium required on, you know, these rated securities.  As a result, issuers are going to be less interested in issuing them and, hopefully, the volume of these kind of triple-A tranche securities are going to be less, or there's going to be more protection built into those triple-A securities -- those allegedly triple-A securities.

MURRAY:  Right here.

QUESTIONER:  I'm Irene Meister (sp).

You have focused, as a panel, on a variety of many different problems that you are focusing, and they're all different.  If I were to ask the panel, in a very simple question:  As a panel, are you pessimistic or optimistic that we'll get out of this problem altogether?

(Laughter.)

FISHER:  All pessimists, stand up.  (Laughs.)

We'll each take a -- I mean, there are two very different problems.  There's the real economy problem and the financial sector problem.

I'm pretty worried about the middle term -- two, three years from now, for the real economy, that we'll just never get growth going fast enough.  The household balance sheet has to just be so constrained that that takes awhile.  But, it won't be -- we won't be collapsing at the rate we were for the last six months, so it'll feel a little better.

I'm nervous about the financial sector, and that we don't think hard enough -- as Benn would say, about incentives, and we start deferring to the authorities to tell us what to do, and we get more -- try to fix the highway system by having a policeman on every corner, or every car having two drivers.  I don't think that will be a particularly safe highway system.

So, I'm a little nervous about the middle-term for the financial sector.

MURRAY:  David, a pessimist, optimist?

SCHARFSTEIN:  I try to be optimistic.

But, I mean, I'm worried that we kind of move along, over the next few years, in this kind of, you know, non-crisis like --  We claim victory, that there's not, like, a September panic, and we kind of, you know, hobble along for the next several years.  Things don't look so terrible.  They don't look like September of 2008.

And I worry a little bit that we don't end up rethinking the financial system and coming up with better -- whether it's incentives or it's regulation, that we sort of satisfice (sic) and live with what we have, and then we kind of get back to the old situation.

STEIL:  Oversimplifying, there were two basic ways that we could have approached the problem when the crisis started unfurling in 2007.  One is to clean up the bad assets on the banks' balance sheets.

It would have cost us close to $2 trillion to get the stuff off; replace the old owners at the banks with new owners at the banks -- in other words, who would have wiped out their equity; and then we would have started all over again with a well-capitalized banking system.  What would have looked -- in terms of the shingles on the door, a lot like it looks now, but it would have had completely different owners.  And, of course, we'd be, as a nation, about $2 trillion poorer, but we would have been able to move on.

We didn't want to go that route, so instead we're using a very messy and uncertain mix of extreme fiscal and monetary measures that I think are going to lead to problems down the road.  That is, I see this crisis having multiple phases.  I'm reasonably optimistic that we're going to have an economic recovery of sorts later this year, but then I'm also quite convinced that we're going to see problems in the U.S. Treasury market; we're going to see problems with the dollar; and then, about six months to a year later, we're going to start seeing problems with inflation.

MURRAY:  That's a really interesting point.  One of the things about the dichotomy that you just laid out is that the government's not being very straightforward with us about it.

We've been told by two successive Treasury secretaries that the problem was the first problem -- we have to get the bad toxic assets off the balance sheets of the banks.  We've had a succession of programs that were supposed to do that.  As far as I can tell, they're all still there, Peter.

Is the problem getting the toxic assets off the balance sheets of banks?  Or can we deal with the problem by muddling through?

FISHER:  It would be -- I mean, we tried -- the financial sector got way over levered, so it starts de-levering.  And we didn't like that because asset prices fall.  And the banking system, as a whole, tries to -- the financial system tries to shrink.  It sells the assets.  It can only sell the asset to itself.  So, the only way you shrink is by having prices fall.  We didn't like that, so the Fed tried to slow it down with easy monetary policy of special liquidity.

Now we've tried to shift the assets to the government's balance sheet.  If you did that quickly enough -- and to be very simple about it, that's what Sweden did, Sweden did it quickly, got them over to the government -- then you arrest the decline in asset values.

We didn't do it quickly enough --

MURRAY:  Is that what we should have done?

FISHER:  If Congress would have written a $2 trillion check, then -- and you've --

MURRAY:  But, would that have been the best way to deal with the problem?

FISHER:  Yes.  I think we all agree.

MURRAY:  David, do you agree with that?

SCHARFSTEIN:  Well, the only way you would have gotten them off the balance sheet is if you had paid a premium for them.  I mean, the banks aren't going to sell their assets at the true value.  And so, you know, that's what they transfer to the banks.  And is that fair?  Is that right?  It's hard to know.

MURRAY:  Ricky, and then right here.

QUESTIONER:  (Off mike.)  If you look at the past few financial-

Sorry, Ricky Tiger-Helfer (sp).

If you look at the last few financial crises you see that we made a judgment in the '80s to change the interest rate structure, leading, in large part, to the S&L crisis.  That was a policy judgment made at the government level.  We made a judgment in the late '70s to recycle petro-dollars through the banking system.

That led to -- almost directly, the sovereign debt crisis, where, to refresh your recollection in 1983, 100 percent of the capital of the 10 largest U.S. banks were exposed to loans to countries that could not be repaid.  That took into the early '90s to resolve.

There was a policy judgment made -- at the Fed, in the Treasury, wherever, in the early 2000s that we would create a monetary policy with extremely low interest rates and low cost of capital.

The response of the markets was very predictable, actually.  Clients are asking for a higher return.  How do you get it?  Higher risk.  You create more and more instruments that yield higher risk.

So, the problem really is in the policy judgments that are made.  I do not think, though, that if you now say we're going to give the market -- and the market will respond, and will take those policy judgments and run with them.  And it's gotten us into predictable trouble in all of these decades.

So, if you say that you are going -- and I have served at two -- I'm an ex-bank regulator and have served in the government, so I've worked on all of those crises.  And the Asian financial crisis is a somewhat similar situation.  So, if you say that you're going to adopt incentives that will lead the market to do contrary things, they will game those incentives just as they've gamed the capital -- (inaudible) -- because that's what markets do.  That's part of the beast.

So, I honestly don't think -- and if you look, looking at corporate governance, if you look at boards, and you look at the C.E.O.s that approved these instruments, that literally could not be fully understood or explained, you realize that you are going to have to have some kind of regulatory structure that essentially pulls back, and creates and recognizes when you're going to have a lower return; there is, in fact, going to be more regulation of some sort.

Now, whether we've got anybody that can do that is the open question.  But, I question whether incentives alone can be the solution, and I just want some response on that.

MURRAY:  Benn?

STEIL:  Well, with regard to monetary policy, I agree with you entirely.  And I'm very skeptical that in the future, if we go back to such an extreme low interest rate policy, that any form of regulatory intervention is going to be able to blow against that sufficiently, particularly when cheap credit is very, very popular, not just on Main Street but in Washington.

The reason I put the emphasis on incentives is not that I believe that they're always foolproof and that they can't be gamed, it's that I have even less confidence in institutions.

FISHER:  I think that the nub of the issue there is whether we think the Fed will be the good systemic risk regulator if the issue was preventing subprime mortgage origination from exploding in 2004 and '05, when the Fed is putting its foot on the accelerator.  And the late Ned Gramlich tried.  He tried to persuade Alan --

MURRAY:  And they said no.

FISHER:  -- Greenspan to slow it down.  And so if you -- that's my emphasis on underwriting standards.  You need an authority -- a regulatory body that will lean against whatever wind the Fed is throwing off.  And that's part of the incentive structure, though -- someone whose job it is to get up in the morning and make sure someone's enforcing underwriting standards.  That creates an incentive for bankers.  You don't just rely on monetary impulses.

MURRAY:  (Off mike.)  Right here.

QUESTIONER:  John Bradimus (sp), New York University; former chairman of the New York Fed; 3rd Congressional District of Indiana.

What comment do you have to make, if any, on President Obama's economic policy?  I yield back the balance of my time.

(Laughter.)

FISHER:  It's a broad -- that's a broad subject.  Who wants --

MURRAY:  No, but you've already touched on a piece of it.  This administration is extraordinary, in my experience, in the lack of private sector representation in the high -- in high positions in the government.  And that comment about, "we don't need --

FISHER:  Banks and bondholders.

MURRAY:  -- banks and bondholders" is indicative of that.

FISHER:  I find it interesting that, clearly, part of the Treasury is working very hard to stabilize the banking system, and another part thinks it's irrelevant.  I think the fiscal stimulus program is -- the big fiscal stimulus is the most important thing, and I think they focused on that on day-one.

I don't think we fix the underlying crisis in our economy until we stabilize the household balance sheet -- that is, until households feel confident that their income stream is understood and stable, and they then know how to borrow against that, and they're not -- they don't have too high a debt burden against that future income.

And so stabilizing income in the economy is the most important thing to the equation.  I think the administration focused on that right out of the box.  I think Congress has hamstrung them on what we all think are -- two of us out of three thought would be the better answer:  If the government had a big enough checkbook, if Secretary Geithner did he could have been more aggressive in how he dealt with the banks.  He might not have bailed out the equity holders.  He might have been somewhat less kind to them.

But, Congress isn't giving him that option.  So, subject to the constraint that he doesn't have that bigger checkbook, I think the programs they're working on are pretty good -- subject to, they're very hard to implement and they may be messy, but he does have the first best option.  That would be my simple summary.

MURRAY:  Either of you want to jump in on that?

SCHARFSTEIN:  I mean, it's a huge question.  (Laughs.)  I mean, you know -- but, I mean, the challenges are big challenges.  I mean, you basically have had this huge wealth shock to individuals.  We've got to readjust consumption levels -- that's happening.  And so, you know, an economic stimulus package that is geared towards, you know, increasing spending and helping the economy, without -- at the same time that you've got what should be reduced consumption, because of this wealth shock.  I mean, it's a tough -- it's a tough road to go

STEIL:  I'd just concentrate on two initiatives of Treasury.  One, which I think was quite good; and the other, I have doubts about -- the stress tests.  Although, I think they were certainly too easy, they did inject a very welcomed measure of transparency into the discussion about the general condition of the banks, which I think was extremely welcome.

I think we do, today, have a better idea, about which institutions are reasonably strong and which are not, than we had a few months ago.  And I think that's very welcome and I think, to some significant degree, that's underpinned the rise in the marketplace.

I'm much more skeptical about the so-called "Geithner plan" to get toxic assets off the books of the banks.  I think it has far too many complexities in it, and I think it tries to resolve too many problems simultaneously.  And at the end of the day, it probably will, in my view, never even get off the ground.  There are too many reasons why banks will be reluctant to sell, and too many reasons why investors will be reluctant to participate.

MURRAY:  Questions?  Right here.

QUESTIONER:  Hi.  Elizabeth Bramwell (sp).

There are so many initiatives that are being encouraged here, such as redistribution of wealth; raising taxes on corporations; raising taxes on individuals; making it more difficult for manufacturing to, basically, go forward; we're going to have higher utility costs; you know, increased unionization, and all of that.

So, I wonder how all these other initiatives really work into improving our financial system?

MURRAY:  We're still on the broader economic policy questions.

Did you get into that at Squam Lake when you -- (inaudible) --

(Laughter)

SCHARFSTEIN:  (Laughs.)  You know, we do finance.  We do the financial system, and the economy.

(Laughter)

MURRAY:  You know what you know.  (Laughs.)

SCHARFSTEIN:  We know what we know.

(Cross talk.)

SCHARFSTEIN:  (Laughs.)

FISHER:  I think it's very hard for us to see how all those things are go to come back -- (inaudible).

So, you raise a litany of other initiatives the administration is pursuing.  How far they'll go with each of them itself is hard to predict.  And that the macro issue, for me I guess is, will that benefit aggregate demand sooner than it raises uncertainty premium?  And I don't know the answer.

MURRAY:  Benn, you put a couple of pretty big fiscal pots on the table here.  If we eliminate the tax preference for the mortgage deduction and for other debt securities -- you also, by the way, raise a whole bunch of money.

STEIL:  Yes, which would be a desirable way to do it.

I think mortgage interest tax deductibility should be phased out (sic ?) over time.  We shouldn't institute it tomorrow, but it should start to be phased in from the beginning of 2010.

It doesn't fulfill any, in my view, legitimate policy objectives.  For example, low-income households can't take advantage of mortgage interest tax deductibility because they don't pay income tax.  So, it just provides artificial incentives for people to buy bigger homes, with more debt, than they otherwise would.

MURRAY:  On a scale of 1 to 10, where 10 is it happens, and 1 is "not in a million years," where do you put that one?

STEIL:  0.01.

(Laughter.)

MURRAY: Yeah.  (Laughs.)

Last question right there.

QUESTIONER:  Brian Cavanaugh, again.

Last question is regarding incentives.  And we've talked earlier about the countercyclical capital requirements as a potential idea.  But, other than that, what ideas do you all have, both for the private sector and for the regulators, to make sure they don't get, kind of, on the bandwagon with the rest of the bulls or lemmings?

STEIL:  Okay, can I just focus on one issue, with regard to capital standards?  The whole debate about mark-to-market, or fair value accounting, I think two issues have to be distinguished:  mark-to-market accounting, and how that relates to -- in terms of how regulatory policy works, capital standards.

The problem, in my view, is not mark-to-market accounting.  Investors want mark-to-market accounting.  If they believe it's unduly pessimistic they can adjust for that in their evaluation.  The problem is that it reflexively feeds into capital requirements, so that regulators are obliged to use those measures in order to tell banks how much capital they need to raise.

So, the problem is on the regulatory side.  We don't need to obliterate mark-to-market accounting in order to change the way in which regulators intervene to force banks to raise more capital.

MURRAY:  Final thoughts -- either of you?

FISHER:  The incentives structure I care most -- I mentioned earlier about trading exposure should be subordinated.  I think that would be a very powerful incentive effect.  Maybe it goes along with capital requirements, but that would be mine.

SCHARFSTEIN:  I mean, incentives are important, but I mean, I think that basic fundamental conflict between equity and debt is there.  And, at the end of the day, we do need regulation -- we need systemic regulation.  And it would be nice if we could avoid it, but it's the nature of the beast.  So, I think we're, it's important to think -- it's important to rethink our regulations in a pretty serious way.

MURRAY:  Gentlemen, thank you very much.

Thank all of you.

(Applause.)

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THIS IS A RUSH TRANSCRIPT.

ALAN MURRAY:  Okay, can I get your attention, please?  Welcome to the second session of the CFR symposium on fixing finance.  I'm supposed to remind you to completely turn off your cell phones and various devices.  Not just put them on vibrate, completely turn them off.  I guess that means you can't Twitter from this meeting.  Sorry.  I'm sorry, I see some active Twitterers out there, I know.

Remind everyone that this session is an on-the-record session.  We're going to take about 35 minutes to talk among ourselves, and then we will open it up to questions.

We're very fortunate today to have three men who have spent a good deal of time thinking about and writing about how to fix our financial system in various forms. Benn Steil has done it for the council; David Scharfstein has done it as part of the Squam Lake Group and is going to tell us where Squam Lake is and why he did it there at some point; and Peter Fisher is at BlackRock and has written on the subject and has also worked closely with The Wall Street Journal on our Future of Finance initiative.  So three different but very well-informed perspectives on the topic.

And we're going to spend most of the session looking forward.  But before we start, gentlemen, I'd like to ask all three of you, one of the things that strikes me about this discussion is if you put people together to talk about any of the other big policy issues that we face -- health care reform, education reform, Social Security reform -- you'll get a bunch of proposals on the table that are all the same proposals we've been talking about for 20 years.

In this issue, however, the thinking has changed and changed pretty dramatically because of the events of the last two years.  And what that seems to suggest is that until the events of the last two years we had it all wrong.  How did we get it so wrong?  Why was our thinking about financial markets and how to regulate them so off?

Peter Fisher.

PETER R. FISHER:  Well, I don't know that it was.  We've had some big mistakes in how we regulate the financial services industry.  But I do want to begin, at the risk of annoying some, that we have to understand monetary policy was much too easy.  And if we don't begin with that admission, we're going to end up fixing a lot of things that we're broke.  And I think some of the reactions you're seeing now are ignoring that fact.

Monetary policy creates huge incentive effects.  Risk was mispriced.  That's because monetary policy wanted it to be mispriced.  It incented people to take more risk than they would otherwise take, early in this decade, in particular.

MURRAY:  Well, no, I was going to say, David, if that's it, then let's just get monetary policy right and we don't have to talk about all these other things.  It would make more time to boat and swim at Squam Lake.  (Laughter.)

DAVID S. SCHARFSTEIN:  There's a rule in New Hampshire, I think, which is that if you get more than 10 people together to talk about finance, you have to name it after the place that you're in.  (Laughter.)  But it is a lot of money.  There was a lot of money on the table.  And you asked, you know, how did we get it wrong?  You can't eliminate the hypothesis that there was some regulatory capture involved, that, you know, rules get determined, in part, by the players with a lot of money at stake.  And Basel II has elements of it that were manipulated and were created.

MURRAY:  But I don't remember anybody running around screaming, as Basel II was being done, this is regulatory capture.  I mean, maybe the capture was so complete that there wasn't anyone left to complain about.

SCHARFSTEIN:  There were folks that were looking at it that had issues with it.

MURRAY:  Benn.

BENN STEIL:  I have a lot of sympathy with Peter's comments.  I mean, if you look at real inflation-adjusted interest rates over the period 2003 to 2005 that were negative for most of that period, which is historically very unusual, you'd have to go back to the '70s to find a circumstance like that.  And it also emphasized that there have been many, many cases in the history, both of recent and relatively ancient, where inflation was relatively moderate at the time of crisis, but you had a huge boom in assets prices.  Latin America, Asia in the 1990s, the U.S. in the 1920s, inflation was exceptionally moderate for most of the decade, but there was massive credit booms during that period.

I guess I would emphasize another factor that I think was extremely important that's not being talked about, which is taxation policy which has provided enormous incentives for building up debt on the corporate side.  An equity-financed investment will face an effective tax rate; a debt-financed investment will face an effective tax rate of about negative 6 percent.  So that obviously gives companies, in particular financial institutions, enormous incentive to fund themselves with debt rather than equities.

MURRAY:  Yeah, and we're going to come back to that because that's among the most provocative of the proposals you folks have put on the table.  We'll see how people in here feel about eliminating tax benefits to debt and home mortgages.  But before we do, let's talk about, David, let's go back to capital requirements because you talked about regulatory capture and Basel II.  We thought Basel II was an answer, now we think Basel II was the problem.  How do we fix capital requirements to prevent the kind of episode that we've had in the last two years?

SCHARFSTEIN:  Well, look, it's really hard to prevent these things.  But it's clear that, you know, Basel II and the capital requirements have, you know, insufficient accounting for systemic risk.  And so it's important -- we think, in the Squam Lake Group which is a group of 15 academics that have kind of come together to think about financial regulation -- that it's important to have higher capital standards for larger financial institutions, for those that are holding more illiquid assets and when they're funding those assets with short maturity liabilities.  I mean, there's others that have suggested that.  But I think, clearly, Basel II needs to be reformed or capital requirements need to be reformed to take account of the systemic risks.

MURRAY:  The other thing, Benn, that you've written about is that the capital requirements that right now they're procyclical and they should be countercyclical.

STEIL:  They're very procyclical.  That allows financial institutions to build up the financial risks that they take on a very thin base of capital when asset prices are rising.  But when asset prices start falling, it forces them to raise capital very quickly in an environment when it becomes extremely scarce.  And that's precisely the problem that we've run into over the past two years.  So that needs to be turned on its head.

MURRAY:  Go ahead, I know what you're going to say.

FISHER:  I think we've got to think harder than we are about the incentive effects that risk-based capital creates.  So the existing capital rules provided a sufficient incentive for the whole financial services industry to game the risk categories, get crummy, badly originated assets into certain risk buckets, and now they can make more money.  And so the incentive effect, if you don't, it undermines the system.

So any regime of risk-based capital has got to have more disciplined credit underwriting at the front end or it's simply a faulty foundation.  It just doesn't work.  It's lopsided.

MURRAY:  That's what I thought you were going to say.  You have written that it doesn't do any good to impose higher capital standards on institutions that make loans to people who can't repay them.

FISHER:  Yes, it just doesn't matter.  It doesn't matter whether you have six, eight, 10 or 12 or whether you've got procyclical or countercyclical.  If you're lending money to people who can't pay you back, it doesn't work.  Now --

MURRAY:  I guess none of us thought that we had to teach institutions how to do their jobs.  Yeah, thank you.  (Laughter.)

FISHER:  The whole reason we supervise banks and financial firms is because we know that they will be tempted to chase the wider margins on loans to riskier borrowers without properly accounting for the higher probability of default.  We know they'll do that.  We've known for 300 years that's what they'll do.  And so if you don't capture it through underwriting discipline at the front end of the machine, you just end up with garbage in, garbage out.

Imagine our only answer to highway safety was having really expensive air bags.  You've got a lot of terrible accidents on the highway, terrible carnage, and all we do is say, let's have more expensive air bags, that will give people the right incentive that when they're in a crash they'll lose a lot of money.  No.  We should have driving, we should think about the brakes and the steering of financial firms.  And I'm afraid it's all ideology, as was said in the prior panel.  There's this ideology we can do this with capital requirements, and we can't.  And as a long as we keep going down this path, we're going to create the next blow up.

MURRAY:  So you're saying things really haven't changed, thinking hasn't changed enough, thinking we can fix it with capital standards.

FISHER:  The U.S. -- I mean, everyone is reverting to type.  The U.S., we're trying to finance consumers.  In China, they're building roads and bridges and hospitals and schools, investment deepening, and bank supervisors want more capital.  Everyone's just reverting to type.

MURRAY:  David.

SCHARFSTEIN:  I think Peter is right that there's a limit to what you can do with capital requirements.  I mean, I think that's absolutely right.  I mean, the whole financial system is set up, I mean, the people in the financial system are set up and rewarded to do arbitrage, whether it's real arbitrage or regulatory arbitrage or whatever kind of, you know, sort of taking on, you know, systemic risk that looks like arbitrage.  That's what the system is kind of set up to do, and that's how people are rewarded.  So there is a limit to the capital requirements.

Now, another way to go is to make sure that the penalties for failure are greater.  So you know, one way to go is, you know, one of the things we've seen is that, you know, creditors and counterparties have gotten bailed out.  And the question is, can we come up with better resolution mechanisms so that creditors and counterparties are not bailed out and the market itself and the creditors and counterparties provide the discipline in the system?

So one of the things that we've proposed in the Squam Lake -- so one mechanism is just a better resolution mechanism for non-bank financial institutions.  And you know, the Obama administration has made a proposal along those lines.  It's not clear where it's going.

MURRAY:  Yeah, I want to go into your solution.  But before we do, let's test the hypothesis a little bit then.  I mean, so what we're saying is that institutions make bad loans because they know at the end of the day they're going to get bailed out.  I mean, do you buy that?

STEIL:  I think that there's some truth to that, absolutely.  Therefore, I think part of the focus has to be on controlling leverage.  But we haven't done a very good job in thinking about what leverage is in different situations.  Let me give a very specific example -- Northern Rock, that's the failed British bank that caused the first run on British banks since the mid 1900s.  If you tried to measure Northern Rock's leverage according to the definition of capital that the regulators use, right before the crisis, they weren't really significantly leveraged.  But if you measured their leverage the way an investor would look at it, that is, you just looked at the equity base, you would have realized that this institution was doomed to failure.

Now, why is that?  In a crisis where it looks like the institution is about to fail, the equity holders have very perverse incentives.  They're the last ones to get paid off, but they're the ones that control the company, so they have every incentive to roll the dice, looking for salvation, and the market knows that.  So the market will ignore every other measure of capital and just focus in laser-like on common equity, but regulators were missing that fact.

MURRAY:  Peter, then let's go back to resolution mechanisms.  So the resolution mechanism then becomes critical to how you eliminate the bad incentives in the system.

SCHARFSTEIN:  Right.  And I think the effect of the leverage is a little more subtle in the sense that it's partly that, particularly during a crisis, there's a rolling-the-dice effect that you see.  But it's also that there is less discipline on the part of the suppliers of capital to financial institutions if they know that, you know, at the end of the day they're going to get bailed out.

So if we had a better resolution mechanism that -- and everyone's terrified of another Lehman -- but if we had a better resolution mechanism, FDIC-like resolution mechanism whereby creditors and counterparties could be dealt with.  And I think every financial institution needs --

MURRAY:  If we had that, could we eliminate "too big to fail?"

SCHARFSTEIN:  It's always hard to eliminate "too big to fail," I mean, really what we have is not "too big to fail," it's really too systemic to fail.  There's too much interconnection.  So there's a sense in which every financial institution needs to come up with its own funeral plan, you know.  Where are all the dead bodies, and what are all the connections?  And we need to understand those better so that failure becomes a possibility.

FISHER:  Well, I think that's a good example of what may have morphed over the last decade or two, which is we thought the capital structure that the investors agreed to gave you that road map.  We thought we knew the equity guys got in first and then there was a subordinated and then preferred and then common.  And we thought we knew where all the other creditors were going to fall.  And we haven't yet tested a bankruptcy regime yet through this great crisis.

And I think there really are two different philosophies.  We have to think about fixing the system.  And it's not about less or more, you know, re-regulation, overregulation.  But can we enforce a capital structure that everyone agrees to in advance and have that be the funeral that we agree to?  And I'm a little nervous.  The answer that says, let's have a benevolent despot in Washington who's going to resolve financial firms and will tell us what the capital structure is, how the losses will be apportioned after the accident, isn't really the same thing.  I don't know how that's going to get us to a more stable financial system by making the capital structure less predictable.  It's actually, can we get it more predictable by making it something that can be enforced and we all can live with?

MURRAY:  But how do you do that?

FISHER:  Well, I think one of the issues is trading exposures and long-term intermediation of credit on one balance sheet.  And so people think they want to find a new Glass-Steagall, and I think that's the wrong way to come at this subject.  That's not the issue.  That was a failed theory from a long time ago.  But I think it is a real issue, if we're going to have some financial agents try to intermediate credit across a long period of time and run that maturity mismatch, that's one kind of form of intermediation.

The other is being members of the trading community and trading, rolling the dice with everyone.  I mean, you need another kind of capital to do that.  And we've let the major financial intermediaries use one pool of capital for both those activities.  And over the last two years, we've seen the authorities, with the exception of Lehman, decide, oops, we don't want to find out what happens if we go to bankruptcy, we're going to stop the clock because we don't want those trading counterparties not to get paid off -- Bear Stearns, AIG.  And so they end up filling the hole with public monies.

And now we're in this betwixt and between, we haven't yet had a funeral.  And so I think being clearer on the capital structure.  I think we've made a mistake on letting trading exposures insert themselves as senior creditors is what it comes down to.

SCHARFSTEIN:  But that's sort of where you get the distinction between -- I mean, the FDIC, you know, has a resolution mechanism for banks.  And I think it's worked fine.  The issue is we've got bank holding companies where we don't have a resolution mechanism.  And I don't think there's any particular reason to believe, you know, if the FDIC can basically get it right, I don't think there's any particular reason to believe that another authority would get it wrong for bank holding companies.

FISHER:  Well, I think it's much easier in the case of banks.  We know depositors are going to be made whole, and everyone else stands somewhere way behind the depositors and the federal government.  I think it's much more complicated when you look at the levels of different types of debt that the big bank holding companies have issued, I think it's not at all clear that there's going to be a way for some benevolence.

MURRAY:  Why, David, why is it any easier for a resolution authority to do that than for a bankruptcy court to do that?

SCHARFSTEIN:  Well, the problem is the bankruptcy courts take time.  And there's a big difference between, you know -- a financial institution doesn't have time.  So you can -- financial institutions requires, on a daily basis, being able to raise capital and to deploy that capital.  And so there's constantly having to go to the market.  I mean, you can't let a Chapter 11 process happen for financial institutions.

MURRAY:  (Inaudible) -- streamlined process.

SCHARFSTEIN:  Yeah, you've got to have a streamlined process.

FISHER:  I think the best way to get a streamlined process is tell all the trading counterparties they're subordinated.  Now they'll demand collateral.  If everyone has got a trading exposure against a big financial firm knows I'm subordinated --

Murray:  Won't be protected.

Fisher:  -- you're not protected, you're going to demand enough initial and variation margin that you'll be protected.  Now we can run them through bankruptcy because all the trading exposures will be tied down.

MURRAY:  Is anyone proposing that?  You are.  (Laughter.) Right. What keeps that idea from being adopted?

FISHER:  I think we're going to have -- I think ideas like it are out there.  I mean, if you talk about moving credit-default-swap exposures into a central counterparty that will demand collateral, that's part of the answer.  So it's moving in that direction, and I'm just --

MURRAY:  Let's talk --

STEIL:  We did in fact demand more collateral of AIG, and they had a big dispute about it obviously because AIG couldn't put up more collateral.

MURRAY:  Let's talk about credit-default swaps because if the fundamental problem here is interconnectedness, that obviously has a lot to do with it, then what needs to be done?

STEIL:  Well, the big problem in the credit default swaps was clearly the counterparty risk management.  The procedures for unwinding positions actually played themselves out quite well.  I think it's definitely the right way to go to move certain OTC contracts that have become highly standardized and are traded in high volume onto central clearinghouses.

My big concern right now is that the U.S. and the EU are engaged in a competition to produce the jurisdiction for these instruments.  The OTC markets was legitimately global before this crisis.  It was a private market that used private contract based on public enforcement.  That is, if there were a dispute, the parties would settle their dispute in a -- (inaudible) -- common law court or a New York state common law court, whatever they picked.

But now the EU is trying to create its own OTC derivatives market jurisdiction in competition with the U.S.  And I'm very worried about how that's going to play out.

MURRAY:  David.

SCHARFSTEIN:  Well, I think most people are in agreement that we need to go to a clearinghouse kind of structure.  I think the central question there is, how much competition are we going to have in the clearinghouses?  I mean, the value of the clearinghouse is, you know, you reduce significantly the counterparty risk and you allow for netting of, you know, kind of long and short positions.

The issue, though, is that if you have multiple clearinghouses, you end up losing some of the value of netting.  And then there's a question about, do you want to have specifically just the CDS or all kinds of derivatives?  So you might want to have interest-rate swaps and CDS in the same clearinghouse because it allows for better netting.  I mean, there's some research that showed that if you did it just for CDS, you'd actually make things worse.

MURRAY:  Peter, is a clearinghouse enough?

FISHER:  No.  It's not not enough because there's another problem.  The CDS market is really one label that covers a multitude of risks.  And at one end of the spectrum, there's some CDS contracts that are almost like equity options.  At the other end of the spectrum are something that's not at all like equity options, it's just insurance.  People are writing insurance on stuff they can't possibly trade their way out of.  There's no liquidity found in what blew up AIG.  They were writing insurance on highly idiosyncratic mortgage risk.

And we permit them to operate in that market as if they can trade their way out of it, and they can't.  That's an illusion.  And I think we've got to bifurcate the market.  We've got to take those CDS contracts where both the CDS contract and the underlying bond or recovery value, approximates, both trade on an exchange.  Get them on an exchange where there's daily, continuous, transparent price discovery throughout the day, and that's fine.  Now we're going to rely on the central clearinghouse to protect that risk.

Everything else that can't get there has got to be reserved as if it is an insurance product, as if you're writing insurance, you've got to hold enough capital against it, you're never going to trade your way out of this, there's no liquidity out there.  Whoever is the writer who's holding the bag on writing that insurance has got to reserve against that.

MURRAY:  The result would be a pretty dramatic reduction in the CDS market.

FISHER:  It would be.  I think a lot of the market, in volume terms, is in the stuff that's almost liquid enough to get on exchanges.  A lot of the risk that's blown people up is down here with the stuff that's not.  Let me point out a test, though.  If the central counterparty is going to work and protect itself, it's going to have to protect itself against daily intraday volatility -- intraday volatility.  To do that, it has to have continuous and transparent price discovery.  So you're really talking about moving it to an exchange.

It's a false half-way house to say we can put it on a central counterparty because the central counterparty won't be able to protect itself without very detailed data on intraday volatility.

MURRAY:  You wanted to say something?

SCHARFSTEIN:  The social value of CDS -- this is not the greatest thing since sliced bread, right?  So I mean, doing lots of stuff to protect it and make sure that you can do all this sort of customized stuff doesn't seem to me to be, you know, we shouldn't be bending over backwards to do it.  So if stuff gets forced onto an exchange and, as a result, we can't do customized CDS, I don't think that's the greatest cost to bear.

MURRAY:  So dramatic reduction in the CDS market doesn't bother you.

SCHARFSTEIN:  No.

MURRAY:  Does it bother you?

STEIL:  Absolutely not.  It's a very poor instrument to trade on exchanges.  It's one reason why I'm happy it's moving in that direction.  Margining for essentially an insurance contract is absolutely ludicrous.  So that's why I'm very concerned that regulators are going to focus on CDSs and ignore the wider question of how we deal with counterparty risk in the OTC-derivatives market.  This is just one example of an OTC-derivatives contract.

MURRAY:  And so, how would you address the broader issue?

STEIL:  Well, first of all, I think there needs to be a cooperative approach between the U.S. and the EU because this market is legitimately transatlantic, and we can't afford to bifurcate it.  We need to have some agreement that once certain OTC contracts that are reasonably standardizable reach a certain volume, that the regulators have a right to turn to the ISTA members, the International Swaps and Derivatives Association members, and say, right, this particular contract needs to be transitioned to a clearinghouse structure.  We're not going to tell you that it has to be an exchange.  It can be a clearinghouse that is owned cooperatively by banks.  There are many examples of that, both in the United States and Europe.  But we need the clearinghouse both so we can monitor risk buildup -- AIG, the Fed and the Treasury had no idea what their exposures were at the time that they appealed to them for aid -- to (novate ?) trades, that is to make the clearinghouse the central counterparty on the trades, to net the trades and finally to absorb default risk in the event that one of the participants --

MURRAY:  Okay.  Now, this partly gets back to the systemic regulator question, right?  I mean, it's one thing to have transparency and have all that information out there, but the Fed not only had no idea, they weren't entirely sure it was their job.  Does a systemic regulator fix that, Peter?

FISHER:  I mean, I don't have an objection to the concept.  I just want to know what's in the bag before I sign up for it.  And so is the systemic risk regulator going to tell everyone on the highway, slow down to 40 miles an hour now?  I mean --

MURRAY:  They worked all that out up at Squam Lake.  (Laughs.)

FISHER:  I think it's sort of a place we put our confidence until we know what sort of rules we'd like to see enforced.  So I can't say I think it's a bad idea, I just don't know quite what it is yet.

MURRAY:  David, enlighten me.

SCHARFSTEIN:  Well, it's clear they have to get it worked out.  But I mean, someone, I mean, some group needs to be looking at systemic risk, you know.  And it's going to take a while to figure out what that's going to be.  You know, our Squam Lake group, after much back and forth, you know, thought that the Fed was in the best position, the central banks more generally in the best position, to, you know, understand the systemic risks, measure it, provide information about it, you know, to the market, and basically require that, you know, sort of collection of information around systemic exposures, and then let market participants know what that is.

MURRAY:  It's potentially a vast increase in the Fed's power.  Was your group comfortable with that?  And was there anything you would take away from the Fed just because of bandwidth or because of conflicts of interest?

SCHARFSTEIN:  It would be a huge responsibility for the Fed.  I mean, I think the idea is that they're better positioned than any of the other regulators to do it.  They interact with the key players on a routine basis in the markets.  They're already supervising these institutions.  So we'd obviously need to, you know, increase the resources available to the Fed to make that happen.  And you know, of course, there are downsides to it.  I mean, it's a lot of responsibility.  You have potential politicization of it.

FISHER: But are we going to let them rewrite all the rules in real time?  Or are we just going to have them go capture information?  I mean, regulator means rule writer.  So are we going to let them override the SEC and the CFTC or not?  I mean, I think we ought to settle on that before we talk about it as a serious proposal.  And it would be quite something in Washington to put all that power in one basket.  I'm skeptical Congress is going to let that happen.  And then we're going to get the worst of both worlds.  Everyone's going to think they're the systemic risk regulator and they're actually not going to have the authority to do it.

MURRAY:  Well, let me ask the question from a somewhat different direction because I always thought, until this debate began, that the Fed did have that power.  In other words, the Fed doesn't regulate mortgage brokers.  But if the Fed had stood up in 2000 and said, you know what?  This idea of lending people 100 percent of the value of their house and having negative amortization is not really a very good idea.  If Alan Greenspan had said that, it would have had real effects.  So I guess I ask the question from a different direction.  Are we asking the Fed to do something dramatically different from what we've always asked them to do?

STEIL:  I think we need to disabuse ourselves of the notion that there's an institutional fix to this particular crisis or type of crisis.  The notion that if we assign new responsibilities or different responsibilities to the Fed, the SEC, the CFTC, the credit rating agencies, that somehow we won't get into this problem again.  A little thought experiment.  Imagine if all those institutions had been run by proteges of Nouriel Roubini.  What would that have meant?  It would have meat that, over the course of the past decade, monetary policy would have been much, much tighter, credit would have been much more restrictive, a lot of mortgage-backed securities that were given AAA ratings would have gotten XXX ratings.  (Laughter.)  I mean, all these Roubinis would have been hauled before Congress to explain to the American people why American companies were being denied credit, why American investment banks were being put at a competitive disadvantage vis-a-vis their European counterparts and, most importantly, why low-income households were being denied access to mortgages.

MURRAY:  So we just throw up our hands and say, bubbles happen, and live with them?

STEIL:  No.  As you know, my report emphasized looking at specifically incentives, in other words, that come from a monetary policy, that come from the taxation system, the way we regulate capital standards.  We need to focus on the incentives.

MURRAY:  Before we leave the -- I'm going to open it up to questions in just a minute.  But you brought up the credit rating agencies.  We haven't really talked about that.  Spectacular failure, what went wrong and how do you fix it?

STEIL:  Well, first, we have to recognize that they didn't perform materially worse than most forecasters.  I mean, forecasters in general did a bad job with this particular crisis.  The problem is that we've assigned them the role of gatekeeper to the financial markets.  And that's where the problem lies.  I think we need to extract them from the regulatory operators, in particular from the capital standards regime.

There are other metrics we can use to evaluate how risky a particular debt contract is besides what Moody's or Standard & Poor's might have to say about it.  For example, the assets yield vis-a-vis Treasuries.  There are many metrics we can use.  We don't have to rely on these particular agencies.

FISHER:  I'd go a little further.  I think we've got to recognize this is another little piece of received historical ideology.  Eighty years ago we thought equity was complicated and debt was simple.  So we'll have a few rating agencies tell us what bonds institutional investors should buy and how they should price them.  Flash forward 80 years.  Citigroup issues, what, two classes of common stock and hundreds of different slices of debt.  Debt is infinitely more complicated than equity.  It is an illusion to allow institutional investors to outsource the decision of what to buy and how to price it.  We've got to break down that fallacy and move even further in the direction of taking them out of the regulatory apparatus.

MURRAY:  It's not like the system of equity analysts has been a spectacular success.

FISHER:  No, but we know that.  We know there are thousands of opinions.  (Laughter.)  No, it's serious to take away the informature of government and official sanction that goes along with the rating agencies, that lets the money market industry, of which BlackRock has got a big part, just rely on what they tell us.  And we've got to break that down so people can go back to --

MURRAY:  So too many institutions simply abrogated their responsibility to --

FISHER:  This how we're set up.  Yes.

STEIL:  The Fed does that, as you know.  They often say, we'll only take AAA securities for this, that or the other lending operation.

MURRAY:  Without taking a look. You would think that it would be sort of a fundamental rule in this business that you don't buy something that you cannot comprehend, right?  (Laughter.)

Before we open it up, monetary policy.  If the fundamental problem here was a  monetary policy is too loose, I have a hard time getting my head around how the solution is what we've been doing for the last year, which is, you know, increasing the monetary aggregates at a pace that we've never seen before in my lifetime.  Can one of you gentlemen solve that for me?  (Laughter.)  Or are we just setting ourselves up for the next episode?

FISHER:  If the wrinkle that we have to worry about is whether deflation expectations can get sticky, the Fed's relied for 15, 20 years on the idea that inflation expectations were sticky at about 2 percent.  So we can look out and understand which way the world was going.

If deflation expectations are to get sticky and consumers and borrowers start assuming prices are going to fall 2 percent a year, we're going to be in a very, very bad place.  And you can tell by the way central bankers are behaving that that's what they're afraid of.

So if if turns out it was just a bad dream, as maybe it was in 2003, then we'll be worried about inflation.  But that really will be the good outcome.

MURRAY:  So that's the good news.

FISHER:  Yeah.

SCHARFSTEIN:  What he said.  (Laughter.)

MURRAY:  You all agree.

STEIL:  I'm much less sanguine than Peter.  I am not worried about deflationary expectation.  If you look at the default swaps on U.S. Treasuries, if you look at the gold price, there are clear indications that investors are concerned about an inflationary future.  Nobody is concerned about it over the next six months.  But looking out a year or two further, there are reasons to be exceptionally concerned about inflation.

FISHER:  From the low-end consumption in 2001 to the high in inflation was July 2008, so the last recession gave us a seven-year lag from the low-end consumption to the high in inflation.  Do you think it's going to be faster this time with a kind of global outlook we have?

STEIL:  Look at the Fed's balance sheet.  Look at the way that it's expanded.  It may very well hit $3 trillion very soon.  It's very difficult to imagine how they will unwind that in a timely manner as the velocity of money increases back towards a normal level.

MURRAY:  One other issue before we open up, and that's the issue of corporate governance.  Fascinating to see an institution like AIG, which was in the business of judging risk, seem to have no capability to look at its corporate risk, to look at the risk of its total portfolio.  I gather that's not that uncommon among financial firms.  Was there a failure of corporate governance here?  And is there anything that could be done to improve it?

SCHARFSTEIN:  Corporate governance is a tough question.  I mean, you talk about independent directors, knowledgeable directors.  I mean, I think if you look at Goldman Sachs which, you know, probably has very high-quality risk management, and you look at the board, I mean, there are people on the board that, you know, just on the face of it, you would argue don't really know anything about finance.  So it's not --

MURRAY:  Maybe that was the magic answer.  (Laughter.)

SCHARFSTEIN:  Maybe that was the magic answer, right.  I'm not sure.  But the other issue, though, that when you think about what the board is supposed to do, the board is supposed to, in normal times, is supposed to represent shareholders.  Shareholders have, in financial institutions, give that they're highly leveraged, there's incentives to take risk.  So it's not obvious that kind of, you know, incentivizing the board and making the board be the guardian of shareholder interests actually leads to the outcomes that we want.

I mean, the question is whether or not the objective for a financial institution or the board should be, rather than, you know, shareholder value maximization, some other thing which is kind of like institutional value maximization.

MURRAY:  Interesting.  Well, that's what you're saying.  That's why you're saying you have to have strong regulators because the shareholder governance system doesn't work for financial institutions.

FISHER:  Yeah.  I think AIG, I'm taking a big step back, it's a pretty -- the big risk-management failures are conceptual, not computational.  They thought they were going to have one subsidiary engaged in an unregulated insurance business and arbitrage their AAA rating and not get into trouble.  Well, as soon as you state it that way, you know you're going to get into trouble, right, because there's sort of an infinite regress on how far they go and try to arbitrage the AAA rating in one subsidiary.

So you know, maybe they should have had more integrated risk management and analytics across the whole platform, maybe their directors could have been better.  But that flaw is right there in front of your nose once you state it that way.

MURRAY:  Let's open it up.  Right here.  Please, identify yourself before you ask your question.

QUESTIONER:  My name is Halid Azim (ph).  My question is on transparency.  Is there a way -- if the issue is underwriting standards, is there a way to discriminate and differentiate the quality of the information put out by these firms and the efficiency of them and punish the ones taking excessive risk and reward those that are taking prudent risk?

FISHER:  Not that we can do easily, and we've overestimated our ability to do that, I think.  But you think about the (server ?) farms around the world that are in the business of looking at trade and prices and calculating capital requirements, we don't have anything like that 20-year history of both intellectual input and technological input going into credit, just thinking about the different ways of measuring credit.  So we're way behind where we ought to be.  And no, it's very hard to get the transparency look.  I've spent 20 years thinking we could get better disclosure from financial firms, and I'm skeptical about that, that we're actually going to get far enough.  But I think we're just years and years and years behind getting smart people and technology to try to think about credit underwriting in a much more disciplined way, I'll be honest.  But we're way behind.

MURRAY:  Right here.

QUESTIONER:  I'm Gregory Marrish (sp).

How do you reconcile then the conclusions of this panel with the one before?  Because, as Mr. Fisher has expressed very eloquently, and the other gentlemen support, I think, the cost of capital in -- private capital should go up because it was mispriced -- it was a derivative of low interest rates, and, on the other hand, we're trying to promote global growth.

It seems to me that whatever idea of trend-growth people have in their mind is something that is not achievable, or at least in the short- to medium-term you can't reconciled both.  I don't know what you --?

FISHER:  Well, I think what we're struggling with is real rates are going to be higher than we'd like.  That's why you see central banks throwing their balance sheets into the breach.  And we're nervous that the real rates we're looking at are too high for our expectations for growth.  But, our expectations for growth are going to have to give.

That's why I think we're so -- I'm so frightened that -- and I think the comments made earlier about the 'mistakes made were 31 to 33, not 29,' I think the mistakes we'll look back on 10 years from now are ones that drove up the real cost of capital, that added to uncertainty rather than reduced it.

So, yeah, that's the tension we're struggling with right here.  I mean, the most frightening thing I've seen in the last year was yesterday's Wall Street Journal, the story on Chrysler.  An unnamed government official said, quote, "We don't need banks or bondholders to make cars," close quote.  -- (inaudible) -- very clear, we need banks and bondholders more than anyone because we're a debtor nation.  We need them to do everything we do.

But, if you start driving up the real cost of capital by injecting uncertainty premiums and saying, "we don't care about banks and bondholders," it's going to be a pretty expensive world if we finance it all on the equity side of the ledger.  More of it has to be there than was.  But, pretty frightening.

MURRAY:  Either of you want in on that?

STEIL:  A lot of our consumption, our spending at the state and city level over the course of the decade was based on debt at a very low cost of capital.  That's, hopefully, not coming back.  And this is my concern, conceptually, about this idea of fiscal stimulus to breach the output gap.  In other words, to get us where we -- back to where we were in, say, 2007, before the crisis unfurled.  We're not going to get back to that --

MURRAY:  We don't want to get back there, at least very rapidly.

STEIL:  Certainly we don't want to get back to that state on the basis we got there before -- that is, through debt-financed --

MURRAY:  Liquidity.

STEIL:  -- consumption.  And we have to accept the fact that the level of consumption that we were enjoying in 2007 was based on imaginary wealth, not wealth that we're going to be able to reconstruct.

MURRAY:  David?

SCHARFSTEIN:  I agree.  But, one thing I think we -- I just want to challenge you on a little bit, is that, I mean, I don't think we can say that banks and bondholders have gotten too raw a deal in the last, you know, six months.  I mean, I don't think the comment from the unnamed source was exactly on target.

But, I don't think we've had a massive rewriting of the rules of how banks and bondholders -- (inaudible) --

FISHER:  Investors are going to take lots of losses; and they'll take more losses; and that will be part of the resolution.  But, if we have senior administration officials who think we don't need banks and bondholders to get our way out of this, we're in really deep trouble.

MURRAY:  Question right there.

QUESTIONER:  David Bheim (sp), Columbia Business School.

After the last great crash we instituted formal requirements in the stock market because it was thought that excessive leverage in the market for stocks was part of what happened in the '20s.  This time what went wrong was excessive leverage in the market for bonds and for houses, where margin requirements feel to extremely low levels -- in the case of houses, actually, below zero.  Below zero -- negative.

Can't a systemic regulator make a contribution to helping financial institutions with better underwriting standards by setting formal margin requirements for bonds and for houses?  Why shouldn't we do that?

FISHER:  I think that's a very good point.

I think the failure, though, is making initial and variation margin high enough in the credit default swap market, because that ended up being the driver.  People were willing to absorb the risks of the badly underwritten houses.  So, you've got to get it across.  But, then let's talk about margin regulations across the board in all asset classes, and say that's what we're going to try to fix.

MURRAY:  But, that's what we -- that's what we should do.  Right, David?

SCHARFSTEIN:  I didn't follow the --

MURRAY:  The margin regulations across the board in all asset classes.  I mean, that's what -- that's part of what you were --

SCHARFSTEIN:  No, I mean, clearly we need to have margin requirements in large asset classes.  But, I mean, it works in most instances.  I mean, you know, in CDS, I mean, most counterparties are posting collateral --

FISHER:  Not enough.

SCHARFSTEIN:  Not enough.  But, when it's done right, that's what -- I mean, we need to require it, and we need to, you know, to get it to be complete.

MURRAY:  Right back there.

QUESTIONER:  Brian Cavanaugh, Medley Capital.

The first question I have is regarding governance.  We made the point earlier that it's not a good idea to take them through bankruptcy -- you don't have enough time, in the case of financial institutions.  And yet in bankruptcy that's where someone other than equity holders have management's fiduciary obligation.

Is there some regime for governance with financial institutions, where -- (inaudible) -- the bottom 20 percent of the capital structure selects the board, as opposed to just the equity, or make some sort of construct like that based upon historical fluctuation of the overall enterprise values?

MURRAY:  David, is that how your resolution authority would work?

SCHARFSTEIN:  Well, that's -- the resolution authority is more, sort of, after the fact.  You're sort of suggesting, kind of, before the fact, does the -- should the creditors have a say, you know, in governance.

I mean, one of the things that you see with bonds that are issued by financial institutions is that they're -- I mean, they're obviously rated very highly, and they typically don't have any covenants.  I mean, the typical way a bondholder would get some control is through covenants of some sort.  And it's interesting that in this financial crisis -- did not trigger any kind of covenant on long-term bonds, because there really weren't any.

So, you know, I'm not sure what the answer is -- you know, whether or not it's wise to have bondholders with a vote.  But, I mean, it is -- it is clear to me that, you know, with equity holders, clearly their incentives are not aligned with the bondholders.  I think we need systems whereby bondholders are at risk, and, therefore, evaluating credit.  And, as a result, they sort of --  The other way to do is they sort of penalize financial institutions that have too much leverage by charging them higher rates.

We've, sort of, lost that because of the, you know, the problem with the bailout of -- bondholders expect to get repaid.

FISHER:  I don't have an answer here, but this morning's FT front page story on the GM bonds and the CDS holders, who will get a much bigger payout if the bonds go into default than they will to a restructuring, is a complete rewriting, in our mental model, of the capital structure.

We've got to kind of understand what that means for incentive structures for working out troubled companies and decide if we like it or not.  I mean, maybe we like it, maybe we don't like it.  I haven't been able to think it all the way through yet, but it's a very changed process, and changes the rules of the game.

SCHARFSTEIN:  You're talking about the empty creditor problem?

FISHER:  Yeah, the empty creditor problem --

SCHARFSTEIN:  Okay.

FISHER:  -- yeah.  But, that's a big change in the rules of the road and what it means to try to work a company out.  And we've got to put all those pieces on the table and try to sort them out.

QUESTIONER:  Andy Husar (sp), Federal Reserve Bank of New York.

I have a question regarding the lack of consensus about the future of banking, and Mr. Fisher's point about people -- (inaudible) --.  Take, for example, securitization at the moment.  The regulators have proposed in Basel II a series of changes that will curtail securitization significantly by the end of 2010, at the same time as central bankers have proposed programs like TALF, that are aimed at awakening the securitization markets.

I'm wondering how the panel views the conversation playing out, and who will be the final arbiter of what that structure of banking will look like in the future?  Thank you.

STEIL:  Yeah, they're contradictory.

I mean, we had an artificially inflated level of securitization in recent years because of the fact that if a financial institution -- a bank, keeps an asset like a loan on its balance sheet, it has to put aside relatively expensive capital to support it.   So, obviously, they have an enormous incentive to keep it off the balance sheet and sell it off to those who don't bear those sort of capital requirements.

So, you're absolutely right that those two policies are pushing in opposite directions.  My personal view is that we need policies, going forward, that will oblige issuers of securities to maintain some sort of material economic interest in them.  In other words, again, until we align incentives properly.

MURRAY:  Skin in the game -- skin in the game.

STEIL:  Absolutely, skin in the game.  And it won't just change the way securitization works, but it will make financial institutions think more seriously about alternatives to securitization that have a lot of securitization's benefits without its systemic costs.  For example, --

MURRAY:  Such as?

STEIL:  -- covered bonds.  That's something that's gotten a lot of play over the course of the recent crisis.  The financial institution that issues a covered bond is backing that bond with assets that it is keeping on its balance sheet.  So, it has an incentive to monitor, for example, repayments in the case of a mortgage.  So, it has a lot of the benefits of securitization without the cost, in terms of skewed incentives.

SCHARFSTEIN:  It seems to me one of the issues with skin in the game, I mean, isn't there a basic problem, which is that a lot of banks had, actually, too much skin in the game?  I mean, they had -- if you had required them -- they actually ended up holding a lot of these, so-called triple-As.

STEIL:  Well, that's because they couldn't distribute the stuff.  They never --

SCHARFSTEIN:  That's not the -- I don't think that's the only reason.  And it's not just that they couldn't distribute.  I mean, I think there was a little bit of this 'acquire an arbitrage' kind of approach.

I mean, the issue with securitization, going forward, is I think that there was an under-appreciation, you know, of the systematic risk associated with these triple-A rated securities.  I mean, the situation in which you actually default on a triple-A securitized product that's, you know, been tranched, is the situation in which the economy is doing extremely badly.

And so the notion that you would just get rewarded maybe 30 or 40 basis points above Treasuries for holding the systematic risk -- I mean, I think there's now, hopefully, an appreciation that that's just not enough of a premium to want to hold those triple-A securities.

So, I mean, going forward, I mean, I think that there is going to be a higher premium required on, you know, these rated securities.  As a result, issuers are going to be less interested in issuing them and, hopefully, the volume of these kind of triple-A tranche securities are going to be less, or there's going to be more protection built into those triple-A securities -- those allegedly triple-A securities.

MURRAY:  Right here.

QUESTIONER:  I'm Irene Meister (sp).

You have focused, as a panel, on a variety of many different problems that you are focusing, and they're all different.  If I were to ask the panel, in a very simple question:  As a panel, are you pessimistic or optimistic that we'll get out of this problem altogether?

(Laughter.)

FISHER:  All pessimists, stand up.  (Laughs.)

We'll each take a -- I mean, there are two very different problems.  There's the real economy problem and the financial sector problem.

I'm pretty worried about the middle term -- two, three years from now, for the real economy, that we'll just never get growth going fast enough.  The household balance sheet has to just be so constrained that that takes awhile.  But, it won't be -- we won't be collapsing at the rate we were for the last six months, so it'll feel a little better.

I'm nervous about the financial sector, and that we don't think hard enough -- as Benn would say, about incentives, and we start deferring to the authorities to tell us what to do, and we get more -- try to fix the highway system by having a policeman on every corner, or every car having two drivers.  I don't think that will be a particularly safe highway system.

So, I'm a little nervous about the middle-term for the financial sector.

MURRAY:  David, a pessimist, optimist?

SCHARFSTEIN:  I try to be optimistic.

But, I mean, I'm worried that we kind of move along, over the next few years, in this kind of, you know, non-crisis like --  We claim victory, that there's not, like, a September panic, and we kind of, you know, hobble along for the next several years.  Things don't look so terrible.  They don't look like September of 2008.

And I worry a little bit that we don't end up rethinking the financial system and coming up with better -- whether it's incentives or it's regulation, that we sort of satisfice (sic) and live with what we have, and then we kind of get back to the old situation.

STEIL:  Oversimplifying, there were two basic ways that we could have approached the problem when the crisis started unfurling in 2007.  One is to clean up the bad assets on the banks' balance sheets.

It would have cost us close to $2 trillion to get the stuff off; replace the old owners at the banks with new owners at the banks -- in other words, who would have wiped out their equity; and then we would have started all over again with a well-capitalized banking system.  What would have looked -- in terms of the shingles on the door, a lot like it looks now, but it would have had completely different owners.  And, of course, we'd be, as a nation, about $2 trillion poorer, but we would have been able to move on.

We didn't want to go that route, so instead we're using a very messy and uncertain mix of extreme fiscal and monetary measures that I think are going to lead to problems down the road.  That is, I see this crisis having multiple phases.  I'm reasonably optimistic that we're going to have an economic recovery of sorts later this year, but then I'm also quite convinced that we're going to see problems in the U.S. Treasury market; we're going to see problems with the dollar; and then, about six months to a year later, we're going to start seeing problems with inflation.

MURRAY:  That's a really interesting point.  One of the things about the dichotomy that you just laid out is that the government's not being very straightforward with us about it.

We've been told by two successive Treasury secretaries that the problem was the first problem -- we have to get the bad toxic assets off the balance sheets of the banks.  We've had a succession of programs that were supposed to do that.  As far as I can tell, they're all still there, Peter.

Is the problem getting the toxic assets off the balance sheets of banks?  Or can we deal with the problem by muddling through?

FISHER:  It would be -- I mean, we tried -- the financial sector got way over levered, so it starts de-levering.  And we didn't like that because asset prices fall.  And the banking system, as a whole, tries to -- the financial system tries to shrink.  It sells the assets.  It can only sell the asset to itself.  So, the only way you shrink is by having prices fall.  We didn't like that, so the Fed tried to slow it down with easy monetary policy of special liquidity.

Now we've tried to shift the assets to the government's balance sheet.  If you did that quickly enough -- and to be very simple about it, that's what Sweden did, Sweden did it quickly, got them over to the government -- then you arrest the decline in asset values.

We didn't do it quickly enough --

MURRAY:  Is that what we should have done?

FISHER:  If Congress would have written a $2 trillion check, then -- and you've --

MURRAY:  But, would that have been the best way to deal with the problem?

FISHER:  Yes.  I think we all agree.

MURRAY:  David, do you agree with that?

SCHARFSTEIN:  Well, the only way you would have gotten them off the balance sheet is if you had paid a premium for them.  I mean, the banks aren't going to sell their assets at the true value.  And so, you know, that's what they transfer to the banks.  And is that fair?  Is that right?  It's hard to know.

MURRAY:  Ricky, and then right here.

QUESTIONER:  (Off mike.)  If you look at the past few financial-

Sorry, Ricky Tiger-Helfer (sp).

If you look at the last few financial crises you see that we made a judgment in the '80s to change the interest rate structure, leading, in large part, to the S&L crisis.  That was a policy judgment made at the government level.  We made a judgment in the late '70s to recycle petro-dollars through the banking system.

That led to -- almost directly, the sovereign debt crisis, where, to refresh your recollection in 1983, 100 percent of the capital of the 10 largest U.S. banks were exposed to loans to countries that could not be repaid.  That took into the early '90s to resolve.

There was a policy judgment made -- at the Fed, in the Treasury, wherever, in the early 2000s that we would create a monetary policy with extremely low interest rates and low cost of capital.

The response of the markets was very predictable, actually.  Clients are asking for a higher return.  How do you get it?  Higher risk.  You create more and more instruments that yield higher risk.

So, the problem really is in the policy judgments that are made.  I do not think, though, that if you now say we're going to give the market -- and the market will respond, and will take those policy judgments and run with them.  And it's gotten us into predictable trouble in all of these decades.

So, if you say that you are going -- and I have served at two -- I'm an ex-bank regulator and have served in the government, so I've worked on all of those crises.  And the Asian financial crisis is a somewhat similar situation.  So, if you say that you're going to adopt incentives that will lead the market to do contrary things, they will game those incentives just as they've gamed the capital -- (inaudible) -- because that's what markets do.  That's part of the beast.

So, I honestly don't think -- and if you look, looking at corporate governance, if you look at boards, and you look at the C.E.O.s that approved these instruments, that literally could not be fully understood or explained, you realize that you are going to have to have some kind of regulatory structure that essentially pulls back, and creates and recognizes when you're going to have a lower return; there is, in fact, going to be more regulation of some sort.

Now, whether we've got anybody that can do that is the open question.  But, I question whether incentives alone can be the solution, and I just want some response on that.

MURRAY:  Benn?

STEIL:  Well, with regard to monetary policy, I agree with you entirely.  And I'm very skeptical that in the future, if we go back to such an extreme low interest rate policy, that any form of regulatory intervention is going to be able to blow against that sufficiently, particularly when cheap credit is very, very popular, not just on Main Street but in Washington.

The reason I put the emphasis on incentives is not that I believe that they're always foolproof and that they can't be gamed, it's that I have even less confidence in institutions.

FISHER:  I think that the nub of the issue there is whether we think the Fed will be the good systemic risk regulator if the issue was preventing subprime mortgage origination from exploding in 2004 and '05, when the Fed is putting its foot on the accelerator.  And the late Ned Gramlich tried.  He tried to persuade Alan --

MURRAY:  And they said no.

FISHER:  -- Greenspan to slow it down.  And so if you -- that's my emphasis on underwriting standards.  You need an authority -- a regulatory body that will lean against whatever wind the Fed is throwing off.  And that's part of the incentive structure, though -- someone whose job it is to get up in the morning and make sure someone's enforcing underwriting standards.  That creates an incentive for bankers.  You don't just rely on monetary impulses.

MURRAY:  (Off mike.)  Right here.

QUESTIONER:  John Bradimus (sp), New York University; former chairman of the New York Fed; 3rd Congressional District of Indiana.

What comment do you have to make, if any, on President Obama's economic policy?  I yield back the balance of my time.

(Laughter.)

FISHER:  It's a broad -- that's a broad subject.  Who wants --

MURRAY:  No, but you've already touched on a piece of it.  This administration is extraordinary, in my experience, in the lack of private sector representation in the high -- in high positions in the government.  And that comment about, "we don't need --

FISHER:  Banks and bondholders.

MURRAY:  -- banks and bondholders" is indicative of that.

FISHER:  I find it interesting that, clearly, part of the Treasury is working very hard to stabilize the banking system, and another part thinks it's irrelevant.  I think the fiscal stimulus program is -- the big fiscal stimulus is the most important thing, and I think they focused on that on day-one.

I don't think we fix the underlying crisis in our economy until we stabilize the household balance sheet -- that is, until households feel confident that their income stream is understood and stable, and they then know how to borrow against that, and they're not -- they don't have too high a debt burden against that future income.

And so stabilizing income in the economy is the most important thing to the equation.  I think the administration focused on that right out of the box.  I think Congress has hamstrung them on what we all think are -- two of us out of three thought would be the better answer:  If the government had a big enough checkbook, if Secretary Geithner did he could have been more aggressive in how he dealt with the banks.  He might not have bailed out the equity holders.  He might have been somewhat less kind to them.

But, Congress isn't giving him that option.  So, subject to the constraint that he doesn't have that bigger checkbook, I think the programs they're working on are pretty good -- subject to, they're very hard to implement and they may be messy, but he does have the first best option.  That would be my simple summary.

MURRAY:  Either of you want to jump in on that?

SCHARFSTEIN:  I mean, it's a huge question.  (Laughs.)  I mean, you know -- but, I mean, the challenges are big challenges.  I mean, you basically have had this huge wealth shock to individuals.  We've got to readjust consumption levels -- that's happening.  And so, you know, an economic stimulus package that is geared towards, you know, increasing spending and helping the economy, without -- at the same time that you've got what should be reduced consumption, because of this wealth shock.  I mean, it's a tough -- it's a tough road to go

STEIL:  I'd just concentrate on two initiatives of Treasury.  One, which I think was quite good; and the other, I have doubts about -- the stress tests.  Although, I think they were certainly too easy, they did inject a very welcomed measure of transparency into the discussion about the general condition of the banks, which I think was extremely welcome.

I think we do, today, have a better idea, about which institutions are reasonably strong and which are not, than we had a few months ago.  And I think that's very welcome and I think, to some significant degree, that's underpinned the rise in the marketplace.

I'm much more skeptical about the so-called "Geithner plan" to get toxic assets off the books of the banks.  I think it has far too many complexities in it, and I think it tries to resolve too many problems simultaneously.  And at the end of the day, it probably will, in my view, never even get off the ground.  There are too many reasons why banks will be reluctant to sell, and too many reasons why investors will be reluctant to participate.

MURRAY:  Questions?  Right here.

QUESTIONER:  Hi.  Elizabeth Bramwell (sp).

There are so many initiatives that are being encouraged here, such as redistribution of wealth; raising taxes on corporations; raising taxes on individuals; making it more difficult for manufacturing to, basically, go forward; we're going to have higher utility costs; you know, increased unionization, and all of that.

So, I wonder how all these other initiatives really work into improving our financial system?

MURRAY:  We're still on the broader economic policy questions.

Did you get into that at Squam Lake when you -- (inaudible) --

(Laughter)

SCHARFSTEIN:  (Laughs.)  You know, we do finance.  We do the financial system, and the economy.

(Laughter)

MURRAY:  You know what you know.  (Laughs.)

SCHARFSTEIN:  We know what we know.

(Cross talk.)

SCHARFSTEIN:  (Laughs.)

FISHER:  I think it's very hard for us to see how all those things are go to come back -- (inaudible).

So, you raise a litany of other initiatives the administration is pursuing.  How far they'll go with each of them itself is hard to predict.  And that the macro issue, for me I guess is, will that benefit aggregate demand sooner than it raises uncertainty premium?  And I don't know the answer.

MURRAY:  Benn, you put a couple of pretty big fiscal pots on the table here.  If we eliminate the tax preference for the mortgage deduction and for other debt securities -- you also, by the way, raise a whole bunch of money.

STEIL:  Yes, which would be a desirable way to do it.

I think mortgage interest tax deductibility should be phased out (sic ?) over time.  We shouldn't institute it tomorrow, but it should start to be phased in from the beginning of 2010.

It doesn't fulfill any, in my view, legitimate policy objectives.  For example, low-income households can't take advantage of mortgage interest tax deductibility because they don't pay income tax.  So, it just provides artificial incentives for people to buy bigger homes, with more debt, than they otherwise would.

MURRAY:  On a scale of 1 to 10, where 10 is it happens, and 1 is "not in a million years," where do you put that one?

STEIL:  0.01.

(Laughter.)

MURRAY: Yeah.  (Laughs.)

Last question right there.

QUESTIONER:  Brian Cavanaugh, again.

Last question is regarding incentives.  And we've talked earlier about the countercyclical capital requirements as a potential idea.  But, other than that, what ideas do you all have, both for the private sector and for the regulators, to make sure they don't get, kind of, on the bandwagon with the rest of the bulls or lemmings?

STEIL:  Okay, can I just focus on one issue, with regard to capital standards?  The whole debate about mark-to-market, or fair value accounting, I think two issues have to be distinguished:  mark-to-market accounting, and how that relates to -- in terms of how regulatory policy works, capital standards.

The problem, in my view, is not mark-to-market accounting.  Investors want mark-to-market accounting.  If they believe it's unduly pessimistic they can adjust for that in their evaluation.  The problem is that it reflexively feeds into capital requirements, so that regulators are obliged to use those measures in order to tell banks how much capital they need to raise.

So, the problem is on the regulatory side.  We don't need to obliterate mark-to-market accounting in order to change the way in which regulators intervene to force banks to raise more capital.

MURRAY:  Final thoughts -- either of you?

FISHER:  The incentives structure I care most -- I mentioned earlier about trading exposure should be subordinated.  I think that would be a very powerful incentive effect.  Maybe it goes along with capital requirements, but that would be mine.

SCHARFSTEIN:  I mean, incentives are important, but I mean, I think that basic fundamental conflict between equity and debt is there.  And, at the end of the day, we do need regulation -- we need systemic regulation.  And it would be nice if we could avoid it, but it's the nature of the beast.  So, I think we're, it's important to think -- it's important to rethink our regulations in a pretty serious way.

MURRAY:  Gentlemen, thank you very much.

Thank all of you.

(Applause.)

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