[CROSSTALK] >> The U.S. was a developing country in Bagehot's day. And, as a, as a consequence, the need for long term finance to build the railroads, to, to build buildings, to, to, to build factories, to build homes, you know, the need for long term finance was extreme. Okay. And so the banks, acceded to that. The banks made long term loans. the banks held corporate bonds. they, they made these kinds of loans on land, you know, all kinds of long term, long term loans. They didn't confine themselves to short term discounts, the way the British banks did. Okay? So, an American bank looked like, looked like this. Okay? They had bonds, okay? They had loans. Sometimes these loans to sort of prettify their balance sheet, might say they're six month loans. But if you looked more carefully at them, they were never intended to be paid back. They were six month loans, which six months from now would be renegotiated and extended and rolled over. So, they had long term loans essentially and long term bonds and they didn't have many short term bills at all, okay, in Bagehot's day. The way, so how could they be banks? You know. What did they, how did they manage? You know? If, if this is the theory of banking, that you need to have liquidity by having short-term bills, how did they manage? They managed by holding reserves, cash reserves, but also by having a sophisticated system of inter-bank borrowing and lending. remember I mentioned these bankers' balances, corresponded balances. Bankers balances. Okay? And [COUGH] and and so, so let's suppose that this is a deficit then. So it has to make a payment to another bank, so this is where the liquidity comes in. Surplus bank here. [SOUND] And so the surplus bank, let's say they both have deposits here. Okay. The surplus bank also has bonds and loans and cash reserves. Okay. And let's suppose that the surplus bank actually is the, is the issuer of these bank, these bankers balances. So these are a, like a deposit. I'm talking here about the American system before there was a central bank. So that's even more of a trouble. Right. Not only do they, do they have all these long term things, so their liquidity is an issue, but they don't even have a central bank. They can't go to the central bank when they need extra reserves. they have to rely on each other, on other, on other banks only. And here is how they did it. if you need to make, if the deficits means, means that Ben needs to make a payment to the surplus bank. It's either paying in cash, its either paying in bankers balances or very interestingly, it is doing some inter bank borrowing through essentially repo. What they did was to use these bonds as collateral for borrowing from other banks. And that basically is what a repo is. Okay? A repo, a repo is a paired, sale purchase of a, of a, of a, of a, of an asset. But it's a way of borrowing secured from, from someone else where you transfer this collateral to them. And then when, when you pay back the loan, you get the collateral back. Okay, so these were kind, they weren't sophisticated repos like today, but it was basically the economics of it. It was, it was some kind of purchased agreement. So if there was a payment, it would be either plus cash, here minus bankers balances on this side or plus repo here. Yes. >> You know this is I guess more historical, but if, if the US was a, was a developing nation at the time. This was a common trend where a lot of people would need to take long term loans, then presumably a lot of these banks would be deficit banks. Did the central bank come in and serve as the surplus bank here or? >> There was no central bank. So, so how did, was it just the case that. >> When I say deficit bank, what I mean is, is, if for example, this bank, you know, people are withdrawing their deposits, or moving them here, that means that bank has to make a payment to the, to the surplus bank. Okay. So it's not about the whole system being in deficit, the way, the way banks make loans, to, for long term loans is the way banks always make loans which is by expanding their balance sheet by, by saying, here's a loan. I'm going to create to your credit a deposit account and you and you and then you're going to pay me back here. A loan here. So it's not, they don't need to borrow the funds from the central bank or anything like that. That, that's not the sense in which they're,they're a deficit bank. There deficit bank at the clearing, you know. So that if, if the person who gets that loan spends it to buy stuff, you know, from New York, okay, that deposit gets transferred to New York, and now this bank has a problem. How can I, how can I pay the New York bank where this is being? And so you either transfer reserves. Okay? Or, you're, you're using some of the banker's balances in your correspondent money center bank. but those are also like reserves. Or, if need be, you take this bond. And you use it as collateral to borrow, to borrow the reserves back, basically, so that you don't need to transfer any reserves. So it's an, it's an interbank borrowing market. There's something even more interesting about this. You, you've heard the rating agencies. Heard a lot about rating agencies, right, with the shadow banking, that somehow they put triple a on stuff that was garbage and so forth. The origin of the, of the, of the rating agencies is in this period, okay, of American history, before there was central banking. Because the banks are having to make payments to each other. They don't want to do credit analysis on every single one of these bonds right, and so they hire this rating agency. The rating agencies spring up to say, okay, we're going to tell you these bonds are, are unlikely to default in the next year. Okay. I think they'll be current on their payment in the next year. Not saying that these are good assets forever. But that if you do a short term, use them as collateral, short term, you're probably going to be okay, okay? Or not, okay? And so, the rating of the bond went into the terms of the repo and all of that. So the rating agencies were there to support the fact that we didn't have a discount mechanism, that we didn't have a central bank or anything like that. That's what they were for. That's where they originated. Okay. And they were originally, you would if you were any one of these banks, if you were any bank, okay, you would pay Moody's. And you would get a big book that listed all the bonds. And so if somebody is offering you a bond as collateral, you just look up in your book [SOUND] and you say oh, there it is. Okay, well so therefore, here's how much money I'll lend you again. So, it, it, it, it made it so that you didn't have to do any credit analysis. You could just, you could just look at the, look at Moody's. And it was a way of doing settlement of using bonds to secure. You know if, if you have a relationship with another bank. Right? You can use bankers balances. That's unsecured. This is unsecured borrowing lending. Right? This is secure borrowing lending. This you can do with some foreign, some bank in New York that never heard of you. You. Okay. they don't want to know anything about you. But, if you give them some railroad bond, that's in the Moody's book, Okay. Fine. They'll lend you money against that. Okay. So, this is the origin of, of rating agencies in the, in the United States. You can see that the capital market and the money market, okay, are completely intertwined here. This is shadow banking. This is sort of shadow banking, before the Fed. Nineteenth-century shadow banking. And, this is what, when they, when every now and then there'd be a crisis. In 1907, there was a crisis. And so when they reformed banking, they said, let's get rid of this system. Let's adopt this system. Okay? Let's make, let, let's say that banks have to, have to use these short-term bills. And we'll have a Fed that will discount these short- term bills. You remember, we talked about all of this. But it never worked, because no one was issuing these bills. There were never enough bills. What the, the US needed long-term finance. Okay. I think you could make an argument that the Fed the mistake the Fed made in 1929, okay, was that it allowed the shadow banking system to collapse. It thought it was a good, good thing to let it collapse. Let's just let this, is our chance to get rid of all of this. And we didn't support the shadow banking system. They said, we'll just do the discounts of short term high quality bills, that will do. But we're not going to support you if you have mortgage credit or bonds or something like that. That's improper for banks to, to have. Okay? And as a consequence they brought down the whole U.S. banking system and in fact, the world, the world financial system. From this point of view, we are very fortunate in 2007, okay, that the central bank did not say, I'm not going to backstop the, I'm not going to backstop the shadow banking system. They did backstop the shadow banking system. Even though a lot of it was in Europe, as a matter of fact. Okay this stuff here, you notice there on the, on the, there I'm showing there's no, there's no arrow from the Federal Reserve Bank to the shadow banking system. Okay. The link between the shadow banking system and the Federal Reserve Bank, are those red things, the liquidity put. Okay, there were liquidity puts between the shadow banking system and Citi bank, and other traditional banks. And that's how, that's how the shadow banking system got onto the balance sheet of the traditional banking system, and that's how it got onto the banking, the, the balance sheet of a Fed. The shadow banking stuff that is good or bad, good cholesterol or bad cholesterol as, as, as Loretta del Turner says. There's this, this is a very old debate. Right? The Fed, the Fed thought that this was bad shadow banking system and it didn't support it. Okay, the people who created the Fed thought it was a bad shadow banking system. And they tried to create something that, that didn't actually fit American, American needs. and so it continued on as it was before. Okay, they pasted a kind of central bank onto, onto the system that operated like this, instead of thinking, how can we have a central bank that will support a system like this. This is exactly, I think, the moment we are in history now, okay, where we have to be, have to be thinking, how can we have a central bank that supports a system like this, okay. in a, In a time of crisis not, not, imagine a world that's not like this. The world is like this. The world is like this today.
