There have been in history many banking crisis where banks are subjected to a run. Depositors lose faith in the bank, and the bank runs out of money. During a bank run, everybody goes to the bank and demands their money at the same time. And banks can't handle this. So government regulators long ago impose in the United States and in other countries reserve requirements that banks have to keep a certain amount of cash on reserve to meet any sudden increase in demand from their depositors. And so the government then put a requirement that was binding, banks would hold some reserves anyway because they recognize the risk. But the government in the United States put reserve requirements high enough that banks were forced to hold more than they wanted. Excess reserves are the reserves that banks hold beyond what they're required to hold by regulation. And it's an interesting chart. They never did hold any excess, well actually you can't see it. >> Right, there's a small blip. >> There's a little blip, yeah. But basically when you make a regulation, it's either binding or it's not. If it's binding, that means they don't want to hold that much. Why don't they want to hold excess reserves? Well because they didn't pay any interest. And so banks like to lend out the money so they didn't want to. But then, suddenly, they started holding excess reserves. And why is that? Very simple explanation. You see this gray shaded area, that represents the recession. In fact, this is the Great Recession. These are relatively minor recessions. This is the big one. And it was so bad that in many countries all over the world, Central Banks cut interest rates as far as they could, and that was zero in order to stimulate the economy. So the problem is, now, banks don't care. They can only invest at zero. >> It's like putting it under your mattress. >> Yeah, the banks have no place to go with this money. So they think, why we won't just leave it in reserves?. We don't care, so we're holding much more reserve than the Central Bank requires. And you can really see it. They were holding, this is in the millions of dollars. So this is a huge, [LAUGH] a huge amount of money held in reserved. And it has just kept going up. It's really remarkable that there's so much cash just lying around now and not being lent out. And interest rates are, well, they've come up a little bit. This chart ends but they're so close to zero anyway that banks don't see lending opportunities that appeal to them. Also, regulation has made it harder for them to make risky loans. So, this is the source of our concerns about what's called secular stagnation. That there's something different about now, compared to any other time, going back decades, what's different is, there's just no place to invest. You wouldn't leave money lying around, earning zero interest. These are professional finance people running banks. They're letting it just lie there, earning nothing. So it's a sign of some kind of fundamental weakness in the world economy, that came on with the financial crisis. Moral hazard and adverse selection are fundamental issues. Let's put it the context of fire insurance, all right. If you open up a company that insures home against burning down, you run two risks. One of them is moral hazard. That's the risk that one of your, you sold the policy to someone who owns a house to insure that house against fire. Then, the person deliberately burns the house down in order to collect. That's a real problem, although you might be able to prove that it was arson but maybe not. Maybe the guy can make it look real, normal. So the protection against that kind of moral hazard is, don't insure the full value of the house. Make it always in the interest of the home buyer to sell the house rather than burn it down. The other thing is adverse selection. If you're doing fire insurance, even if people are moral and ethical, and they won't play tricks on you, it could be that people might know that their house is not fire proof, that their house is in danger of burning down. So all the people will flock to you who have homes that are in danger of burning down. And so, you will get a selected part of the potential insurance market. It's always the worst for you, so what do you do about that? You have to carefully examine the kinds of property and you'll get a fire expert to look and see whether this house is different from others. And you have to then maybe add a little bit more to the premium than you would normally charge because you're worried about adverse selection. Now how can I relate it to this? >> [LAUGH] >> Now some people will say when I look at this, that all this money is sitting in the bank's reserves not earning any interest. But then I say, I look around, I can see interest rates that are higher than that. That are higher than zero, well above zero. Like for example, so called junk bonds. They might pay an interest of 10%, even now. So what's going on here? Well, this could be considered adverse selection. If you go up to the, at this time in history when interest rates are practically zero. And you go out and say, no, I'm going to invest in high interest rate loans. You might be suffering an adverse selection problem. You might be suffering the problem that some of these borrowers are going to burn their house down or they're very subject to fires or disasters. And so you will always see what look like investment opportunities, but for professional bankers, they're not opportunities. You can as a bank, you can advertise, we're making loans at a good interest rate. Who's going to come to you? If business is bad, it's going to be these, I hate to say it, losers. [LAUGH] People who are not good prospects. So the banks then, because of fear of adverse selection having gotten worse, when nobody else is lending, you think, am I going to be the guy who goes out there and makes these loans? Not now, I'm going to wait too. >> And so in both of these cases there's kind of either an asymmetry of information or the inability to monitor. Let's say the homeowner when you're insuring them. So in the same lecture you'd also mentioned a very key point that the institution of banking is, in some ways, helps to mitigate these frictions. So I was wondering if you could kind of talk about that a little? >> Any business in insurance or banking or finance more generally, has to worry about adverse selection, moral hazard, and they have to worry about their being manipulated or deceived. So what you need is a business that invest in information. And invest in trusting relationships, so a well-run bank will have local offices in every city. The local banker then gets involved with people in that city. He or she plays golf with them, hears the gossip, gets to know important people in that regional economy. And then when someone comes for a loan you can call up your friend and say, what do you think of this guy? And then you develop a relationship with the borrower as well. You have coffee with him, you say hi when you meet him on the street. >> Right. >> And you can judge the expression on his face. [LAUGH] Whether he's doing well or not. And bankers then use their gut intuition and their information to decide whether to make loans, or whether to take risks. >> Okay.
