BEYOND THE MINSKY MOMENT

Where Weve Been, Why We Cant Go Back, and the

Road Ahead for Financial Reform

April 2012
of Bard College
Levy Economics
Institute





BEYOND THE MINSKY MOMENT
Where Weve Been, Why We Cant Go Back, and the
Road Ahead for Financial Reform
1


April 2012

1
repared wlLh Lhe supporL of lord loundaLlon granL no. 1080-1003-1 on llnanclal SLablllLy and Clobal and
naLlonal (8e)regulaLlon ln LlghL of Lhe Sub-prlme Crlsls.





2
CCN1LN1S

reface 3

Introduct|on 6

Chapter 1. koots of the Cr|s|sthe M|nsky na|f Century 9

Chapter 2. 8|uepr|nt for a More Stab|e I|nanc|a| System 18

Chapter 3. kegu|at|on |n the M|dst of the Cr|s|s 28

Chapter 4. keregu|at|on w|thout keform of the I|nanc|a| Structure: Dodd-Irank 36

Chapter S. Why We Can't Go 8ack to G|ass-Steaga|| 47

Chapter 6. A|ternat|ves to the Dodd-Irank keforms 34

keferences 72

ke|ated Levy Inst|tute ub||cat|ons 76


3
kLIACL

ln uecember 2007, when mosL analysLs were confldenL LhaL Lhe subprlme morLgage crlsls would be
conLalned" wlLhouL ma[or lmpacL on Lhe flnanclal sysLem, Lhe Levy lnsLlLuLe lssued Worklng aper no.
323, whlch concluded as follows:
1he sLage ls seL for a Lyplcal Mlnsky debL deflaLlon ln whlch poslLlon has Lo be sold Lo
make poslLlon-LhaL ls, Lhe underlylng asseLs have Lo be sold ln order Lo repay lnvesLors.
1hls wlll Lake place ln llllquld markeLs, whlch means LhaL prlce decllnes and, Lhus, Lhe
negaLlve lmpacL on presenL value wlll be even more rapld. ln Lhls envlronmenL, decllnlng
shorL-Lerm lnLeresL raLes can have llLLle lmpacL. . . .
1he damage from a debL deflaLlon wlll be wldespread-borrowers who lose Lhelr
homes, hedge funds LhaL fall, penslons LhaL are reduced-so Lhe neL overall lmpacL wlll
be across a number of dlfferenL secLors. Powever, ln dlfference Lo whaL Alan Creenspan
argued ln defense of flnanclal englneerlng Lo produce more compleLe markeLs-LhaL lL
provlded for a beLLer dlsLrlbuLlon of rlsk across Lhose who are wllllng Lo bear lL-Lhe rlsk
appears Lo be hlghly concenLraLed ln core money cenLer banks who, aL presenL, are
lncreaslngly unable Lo bear lL. 1he led's survey of lendlng condlLlons currenLly suggesLs
LhaL banks are curLalllng lendlng and LlghLenlng credlL condlLlons. 1hls suggesLs LhaL
lendlng Lo households, whose spendlng ln Lhe currenL recovery has been flnanced by
sLrucLured flnance, ls llkely Lo decllne dramaLlcally. lf Lhe avallablllLy of household
flnance collapses, lL ls also llkely LhaL Lhe long predlcLed buL never reallzed
reLrenchmenL of consumer spendlng may become a reallLy, buLLressed by Lhe conLlnued
decllne ln Lhe dollar, produclng rlslng lmporL prlces. 1haL, along wlLh rlslng peLroleum
prlces, wlll furLher reduce real lncomes and make meeLlng morLgage debL servlce LhaL
much more dlfflculL. 1he sysLem Lhus seems polsed for a Mlnsky-llsher sLyle debL
deflaLlon LhaL furLher lnLeresL raLe reducLlons wlll be powerless Lo sLop. . . .
Clven LhaL Lhe crlsls appears Lo be slmllar Lo LhaL whlch led Lo Lhe breakdown of Lhe
flnanclal sysLem Lhrough debL deflaLlon ln Lhe 1930s, a slmllar remedy ln Lhe form of a
8econsLrucLlon llnance CorporaLlon and reregulaLlon of Lhe sysLem would seem Lo be
Lhe mosL efflclenL means Lo prevenL, ln Py Mlnsky's words, l1" from happenlng agaln.
Levy lnsLlLuLe scholars clearly expecLed an alLernaLlve evoluLlon of evenLs, one LhaL would LhreaLen Lhe
very foundaLlons of Lhe flnanclal sysLem and conflrm Mlnsky's Lhesls concernlng Lhe lnevlLablllLy of
ma[or flnanclal crlsls as an endogenous resulL of Lhe operaLlon of Lhe flnanclal sysLem. Along wlLh a
small number of professlonals who had ldenLlfled Lhese condlLlons as a Mlnsky momenL," Levy lnsLlLuLe
scholars conLlnued Lo analyze Lhe causes and lmpllcaLlons of Lhe crlsls on Lhe basls of Lhe laLe Levy
lnsLlLuLe ulsLlngulshed Scholar Pyman Mlnsky's flnanclal fraglllLy hypoLhesls."
As Lhe crlsls evolved and aLLenLlon Lurned Lo Lhe approprlaLe changes ln flnanclal regulaLlon LhaL would
be lmperaLlve Lo reLurn Lhe flnanclal sysLem Lo sLablllLy, Levy scholars hlghllghLed Lhe facL LhaL Mlnsky's


4
lnlLlal research on flnanclal fraglllLy had emerged from hls early work for Lhe Commlsslon on Money and
CredlL and Lhe lederal 8eserve 8oard on Lhe regulaLlon of Lhe flnanclal sysLem. 8ulldlng on Lhls work,
Lhey provlded proposals for reform, and when Lhese were lgnored, consLrucLlve crlLlclsm of Lhe process
of congresslonal debaLe LhaL produced Lhe uodd-lrank AcL.
ln llghL of Lhese Mlnskyan lnslghLs, and ln Lhe lnLeresLs of provldlng guldance for a resLrucLurlng of Lhe
flnanclal sysLem, Lhls monograph Lraces Lhe rooLs of Lhe 2008 flnanclal melLdown Lo Lhe sLrucLural and
regulaLory changes LhaL Lransplred ln Lhe evoluLlon from Lhe 1933 Class-SLeagall AcL Lo Lhe 1999
Cramm-Leach-8llley AcL, and on Lhrough Lo Lhe subprlme-Lrlggered crash. lL evaluaLes Lhe regulaLory
reacLlons LhaL occurred durlng and followlng Lhe global flnanclal crlsls-mosL noLably, Lhe 2010 uodd-
lrank AcL-and aLLempLs, wlLh Lhe help of Mlnsky's work, Lo skeLch a way forward for reregulaLlng and
resLrucLurlng Lhe flnanclal sysLem Lo provlde for Lhe sLablllLy and caplLal developmenL of Lhe economy.
1here are a wlde varleLy of explanaLlons offered for Lhe 2008 melLdown, buL none are sufflclenL Lo
accounL for Lhe crlsls wlLhouL an undersLandlng of Lhe flnanclal sysLem's underlylng brlLLleness, and why
lL had developed. Subprlme morLgages were only Lhe Lrlgger. More fundamenLal was Lhe progress
Loward whaL Mlnsky bapLlzed money manager caplLallsm," a flnanclal sysLem characLerlzed by hlghly
leveraged funds dlrecLed by professlonal lnvesLmenL managers seeklng maxlmum reLurns ln an
envlronmenL LhaL sysLemaLlcally underprlces rlsk. 1he monograph ouLllnes Lhls developmenL and
explalns how money manager caplLallsm seL Lhe sLage for Lhe ouLbreak of Lhe sysLemlc crlsls and debL
deflaLlon Lhrough whlch we are sLlll llvlng.
Whlle Lhe Cramm-Leach-8llley AcL produced a profound change ln flnanclal regulaLlon, formally
abollshlng Lhe new ueal flnanclal regulaLlon LhaL had supporLed flnanclal sLablllLy for aL leasL 20 years
afLer lLs lnLroducLlon, Lhere ls a deeper regulaLory sLory LhaL beglns well before 1999. 8y Lhe Llme Lhe
Cramm-Leach-8llley llnanclal Servlces ModernlzaLlon AcL was passed lnLo law, Lhe unravellng of Lhe
Class-SLeagall reglme was already a falL accompll, due Lo a long sLrlng of admlnlsLraLlve and [udlclal
rullngs LhaL had gradually weakened Lhe reglme's separaLlon of commerclal and lnvesLmenL banklng.
1he sLory of Class-SLeagall's demlse ls noL only an ob[ecL lesson ln Lhe shorL half-llfe of regulaLory
sLrucLures, buL also helps provlde lnslghLs lnLo how-and how noL-Lo move forward wlLh flnanclal
reform. 1he monograph explalns LhaL, desplLe calls for a reLurn Lo Class-SLeagall, we cannoL Lurn back
Lhe clock. As Mlnsky emphaslzed, regulaLlon has Lo maLch Lhe flnanclal sLrucLure of Lhe Llmes, he
belleved LhaL Class was already ouLmoded when lL was lnLroduced. lndeed, Lhls ls probably Lhe faLe of
all flnanclal regulaLlon.
Whlle Congress dld move Lo Lake more comprehenslve sLeps ln 2010, wlLh Lhe passage of uodd-lrank
AcL, an analysls of some of Lhe key provlslons of Lhe AcL suggesLs LhaL uodd-lrank ls noL llkely Lo prevenL
anoLher serlous sysLemlc crlsls.
lf Lhe presenL regulaLory envlronmenL ls unaccepLable, and we cannoL reLurn Lo Lhe new ueal-era
sLrucLure, how do we move forward? Mlnsky's blueprlnL for a more sLable flnanclal sLrucLure ls ln sync
wlLh Lhose who belleve LhaL Lhe only way Lo deal wlLh Lhe problem of banks LhaL are Loo blg Lo
regulaLe, and Loo blg Lo fall" ls Lo break Lhem down lnLo smaller unlLs. Smaller banks, more closely llnked


3
Lo Lhelr borrowers and Lhe communlLy, would provlde Lhe posslblllLy of resLorlng relaLlonshlp banklng-
a banklng model LhaL concenLraLes on Lhe credlLworLhlness of borrowers raLher Lhan on maxlmlzlng Lhe
generaLlon of doubLful asseLs Lo be sold vla securlLlzaLlon, and one LhaL ls far more conduclve Lo Lhe
caplLal developmenL of Lhe economy.
llnally, ln llghL of whaL look llke ma[or hurdles faclng Lhe lmplemenLaLlon of uodd-lrank, Lhe monograph
concludes wlLh a posslble way ouL provlded by modlfylng and exLendlng Mlnsky's ldea for creaLlng a
bank holdlng company sysLem LhaL would preserve some of Lhe feaLures of Class-SLeagall. 1hls could be
accompllshed Lhrough reverslng some of Lhe regulaLory declslons and legal rullngs LhaL allowed for
alLernaLlve sources of llquldlLy creaLlon-a dynamlc LhaL was cenLral Lo undermlnlng Lhe Class-SLeagall
separaLlon of flnanclal lnsLlLuLlons accordlng Lo funcLlon. 1he challenge ls Lo allow banks Lo earn
compeLlLlve raLes of reLurn as Lhey focus on flnanclng caplLal developmenL.
lL remalns Lo be seen how much of Lhe uodd-lrank AcL, an already ouLmoded soluLlon Lo Lhe sLlll-
loomlng problem of flnanclal fraglllLy, wlll survlve Lhe rulemaklng and lmplemenLaLlon process. 1he nexL
crlsls may reveal [usL how lnadequaLe Lhe sLaLus quo regulaLory response has been. lL may be only Lhen,
ln Lhe grlps of Lhe nexL crlsls, LhaL sufflclenL momenLum wlll emerge for fashlonlng flnanclal reforms LhaL
promoLe enLerprlse and lndusLry over speculaLlon.
1he work LhaL ls summarlzed ln Lhe presenL monograph bullL on and exLended Lhe research program
LhaL Mlnsky had lnsLlLuLed durlng hls Lenure aL Lhe lnsLlLuLe unLll hls deaLh ln 1996. Mlnsky recognlzed
Lhe ever-presenL need for Lhe flnanclal sLrucLure Lo be ln concerL wlLh Lhe evoluLlonary naLure of
flnanclal lnnovaLlon. 1he saLlsfacLory performance of a caplLallsL economy depends upon Lhe sulLablllLy
of Lhe sLrucLure of regulaLlon. 8uL Lhe consequences of regulaLory sLrucLures and lnLervenLlons change
over Llme-lnLervenLlons LhaL sLarL ouL belng consLrucLlve can be Lransformed lnLo sources of lnsLablllLy
and lnefflclency. 1he debacle of Lhe securlLlzaLlon of subprlme morLgages, LogeLher wlLh Lhe sllclng and
dlclng of Lhose securlLles and Lhe overlayerlng of derlvaLlve lnsLrumenLs, demonsLraLes LhaL a sLrucLure
of regulaLlon and lnLervenLlon LhaL ls lnlLlally successful can come Lo have perverse consequences.
8ecenL experlences wlLh morLgage-backed securlLles, Lhe assorLed off-balance-sheeL speclal-purpose
vehlcles, and credlL defaulL swaps do noL speak ln favor of lalssez-falre. 8aLher, Lhey supporL Lhe
argumenL LhaL lnLervenLlon cannoL be frozen ln Llme-LhaL lL musL adapL Lo evoluLlonary changes ln
lnsLlLuLlons and pracLlces. Successful caplLallsm requlres boLh a sLrucLure of regulaLlon and a
sophlsLlcaLed awareness of Lhe way proflL-seeklng acLlvlLles drlve changes ln buslness and behavlor.
1he Levy lnsLlLuLe ls graLeful Lo Lhe lord loundaLlon and rogram Cfflcer Leonardo 8urlamaqul for Lhelr
generous supporL of Lhe conLlnued work of lnsLlLuLe scholars ln Lhls lnnovaLlve and orlglnal Mlnskyan
LradlLlon.
ulmlLrl 8. apadlmlLrlou
lteslJeot, levy cooomlcs lostltote


6
IN1kCDUC1ICN

A oew eto of tefotm coooot be slmply o setles of plecemeol cbooqes. kotbet, o tbotooqb,
loteqtoteJ opptoocb to oot ecooomlc ptoblems most be JevelopeJ, pollcy most tooqe
ovet tbe eotlte ecooomlc looJscope ooJ flt tbe pleces toqetbet lo o cooslsteot, wotkoble
woy. llecemeol opptoocbes ooJ potcbwotk cbooqes wlll ooly moke o boJ sltootloo
wotse.
-Pyman . Mlnsky, 5toblllzloq oo uostoble cooomy

lL's been almosL flve years slnce Lhe ouLbreak of Lhe global flnanclal crlsls. SLepplng back and surveylng
Lhe lasL half decade's worLh of pollcy responses ln Lhe unlLed SLaLes, whaL we see before us looks very
much llke Lhe plecemeal" and paLchwork" paLLern of reform LhaL Mlnsky cauLloned agalnsL ln
5toblllzloq oo uostoble cooomy (1986). WhaL's more, lf Lhere ever was any real pollLlcal space for
fundamenLal reform of Lhe flnanclal sysLem, lL has slnce dlsappeared, even as Lhe economlc wounds lefL
by Lhe crlsls conLlnue Lo fesLer. 1he baLLle Lo shape Lhe rule-maklng and lmplemenLaLlon process of Lhe
2010 uodd-lrank AcL ls ongolng, buL as Lhls monograph aLLempLs Lo clarlfy, uodd-lrank-lndeed, Lhe
whole hosL of pollcy reacLlons (and nonreacLlons) slnce 2007-ls largely underglrded by an approach Lo
flnanclal regulaLlon LhaL ls lncompleLe and lnadequaLe.
AnoLher serlous flnanclal crlsls, anoLher so-called Mlnsky momenL," may be requlred Lo reopen Lhe
wlndow of opporLunlLy for reform of Lhe flnanclal sLrucLure LhaL goes beyond Lhe plecemeal and
paLchwork. undersLandlng Mlnsky's work can help us Lo evaluaLe Lhe exlsLlng pollcy responses Lo Lhe
global flnanclal crlsls, Lo undersLand how Lhe crlsls emerged, and Lo help prepare us Lo beLLer selze Lhe
nexL opporLunlLy Lo fundamenLally resLrucLure and reregulaLe Lhe flnanclal sysLem.
uesplLe Lhe well-known phrase, Mlnsky's approach had llLLle Lo do wlLh momenLs." lL was abouL Lhe
susLalned, cumulaLlve processes ln whlch perlods of sLablllLy lnduce an endogenous lncrease ln poLenLlal
flnanclal fraglllLy. lraglllLy provldes Lhe ferLlle ground for flnanclal lnsLablllLy, leadlng Lo a process of debL
deflaLlon and a full-blown Mlnsky crlsls. Whlle Lhe crlsls of 2007-09 was noL, sLrlcLly speaklng, lnevlLable,
Lhe sLrucLural LransformaLlon LhaL Lhe economy had undergone ln lLs LranslLlon Lo whaL Mlnsky called
money manager caplLallsm" rendered Lhe flnanclal sysLem hlghly vulnerable Lo a shock. 1he shock
happened Lo emanaLe from Lhe subprlme morLgage markeL, buL Lhe facL LhaL Lhe subprlme crlsls was
able Lo spread Lo Lhe resL of Lhe flnanclal sysLem and seL off a full-scale bouL of sysLemlc lnsLablllLy and
debL deflaLlon can be explalned by polnLlng Lo a process of susLalned and lncreaslng flnanclal fraglllLy ln
Lhe resL of Lhe flnanclal sLrucLure. 1o undersLand Lhls process, we need Lo look beyond Lhe speclflc
flnanclal lnsLrumenLs lmpllcaLed ln Lhe crlsls Lo an analysls of Lhe evoluLlon of Lhe uS flnanclal sysLem. A
mere analysls of Lhe momenL" ls noL sufflclenL for Lhls purpose.
As Mlnsky emphaslzed beglnnlng wlLh hls earllesL work on flnanclal markeL regulaLlon, lL ls lmposslble Lo
deslgn regulaLlons LhaL lncrease Lhe sLablllLy of flnanclal markeLs lf you do noL have a Lheory of flnanclal
markeL lnsLablllLy. lf Lhe normal" precludes lnsLablllLy, excepL as a random ad hoc evenL, regulaLlon wlll


7
always be deallng wlLh ad hoc evenLs LhaL are unllkely Lo occur agaln. As a resulL, Lhe regulaLlons wlll be
powerless Lo prevenL fuLure lnsLablllLy. lnsLead, Mlnsky argued LhaL whaL was requlred was a Lheory ln
whlch flnanclal lnsLablllLy was a normal occurrence ln Lhe sysLem. Cnly on Lhe basls of such a Lheory
could regulaLlon be deslgned and undersLood.
8y Lhe same Loken, regulaLlon of Lhe sysLem cannoL be effecLlve lf lL ls slmply based on measures
produced Lo remedy and reverse Lhe condlLlons generaLed by Lhe currenL momenL." lL needs Lo
reformulaLe Lhe sLrucLure of Lhe flnanclal sysLem lLself. unforLunaLely, Lhe currenL approach Lo
regulaLlon seeks Lo remedy Lhe presenL momenL by applylng Lo exlsLlng flnanclal lnsLlLuLlons and Lhelr
exlsLlng buslness models a serles of cosmeLlc changes, leavlng Lhe baslc sLrucLure of Lhe sysLem
unchanged ln some cruclal respecLs. lf Lhls were only a Mlnsky momenL," lLs analysls could noL provlde
Lhe basls for effecLlve reregulaLlon. LffecLlve proposals can only emerge from analysls of Lhe longer-Lerm
sLrucLural changes.
As noLed, Mlnsky's Lheory was noL one LhaL dealL ln momenLs buL raLher ln fundamenLal changes ln Lhe
sLrucLure of Lhe flnanclal sysLem and Lhe operaLlons of flnanclal lnsLlLuLlons. 1herefore, Lhe framework
for reregulaLlon musL sLarL wlLh an undersLandlng of Lhe longer-Lerm sysLemlc changes LhaL Look place
beLween Lhe new ueal reforms-prlnclpally, Lhe Class-SLeagall AcL of 1933-and Lhelr formal repeal
under Lhe Cramm-Leach-8llley (CL8) llnanclal Servlces ModernlzaLlon AcL of 1999, An acL Lo enhance
compeLlLlon ln Lhe flnanclal servlces lndusLry by provldlng a prudenLlal framework for Lhe afflllaLlon of
banks, securlLles flrms, lnsurance companles, and oLher flnanclal servlce provlders, and for oLher
purposes."
1he new ueal reforms were eroded by an lnLernal process ln whlch commerclal banks LhaL were glven a
monopoly poslLlon ln deposlL Laklng soughL Lo remove Lhose proLecLlons because unregulaLed banks
were able Lo provlde subsLlLuLe lnsLrumenLs LhaL were more efflclenL buL unavallable Lo regulaLed
banks, slnce Lhey lnvolved securlLles markeL acLlvlLles LhaL would evenLually be recognlzed as
securlLlzaLlon. 8egulaLors and Lhe courLs conLrlbuLed Lo Lhls process by progresslvely rullng LhaL Lhese
acLlvlLles were relaLed Lo Lhe regulaLed acLlvlLles of Lhe commerclal banks, allowlng Lhem Lo reclalm
securlLles markeL acLlvlLles LhaL had been precluded ln Lhe new ueal leglslaLlon. 1he 1999 AcL slmply
made offlclal Lhe de facLo repeal of Lhe 1930s proLecLlons.
ChapLer 1 of Lhls monograph beglns wlLh an ouLllne of Mlnsky's accounL of Lhe evoluLlon of Lhe flnanclal
sysLem Loward a sLage he called money manager caplLallsm" and of Lhls sLage's parLlcular
vulnerablllLles. Whlle besL known for hls analysls and explanaLlon of flnanclal fraglllLy, Mlnsky was
prlmarlly concerned ln hls work Lo provlde guldance for proposals Lo creaLe a flnanclal sLrucLure LhaL
provldes a safe and secure paymenLs sysLem as well as for Lhe caplLal developmenL of Lhe economy.
ChapLer 2 ouLllnes hls vlews on how banks ln parLlcular and Lhe flnanclal sLrucLure ln general should be
organlzed and regulaLed ln Lhe beLLer pursulL of Lhese ob[ecLlves. AgalnsL Lhls background, chapLer 3
examlnes Lhe lmmedlaLe regulaLory reacLlons LhaL were Laken durlng Lhe global flnanclal crlsls. 1hese
plecemeal measures were clearly lnsufflclenL Lo foresLall Lhe crlsls, and ln Lhe afLermaLh Congress
produced more comprehenslve and wlde-ranglng leglslaLlon. ChapLer 4 analyzes some key provlslons of
Lhe uodd-lrank AcL from a Mlnskyan perspecLlve. ulfflculLles ln lmplemenLlng many of Lhe provlslons of


8
Lhe new leglslaLlon have led Lo calls for a reLurn Lo some of Lhe arrangemenLs of Lhe new ueal
regulaLlons. ChapLer 3 explalns why Lhls ls noL a vlable proposal, glven Lhe sLeady eroslon of Class-
SLeagall by a comblnaLlon of [udlclal, admlnlsLraLlve, and regulaLory declslons. And flnally, chapLer 6
conslders a seL of proposals by Mlnsky for a bank holdlng company sysLem LhaL would preserve Lhe
ma[or aLLrlbuLes of Class-SLeagall whlle meeLlng Lhe ob[ecLlves of a sLable LransacLlon sysLem and
provldlng for Lhe caplLal developmenL of Lhe economy. Whlle lL ls unllkely LhaL Lhese changes wlll be
lnLroduced lnLo Lhe currenL CL8 holdlng company sLrucLure, Lhey do provlde Lhe basls for a serles of
reforms LhaL could be lnLroduced wlLhouL ma[or leglslaLlve change and LhaL would provlde for a more
sLable flnanclal sysLem.


9
CnA1Lk 1. koots of the Cr|s|sthe M|nsky na|f Century

A whole hosL of explanaLlons for Lhe 2008 melLdown of Lhe flnanclal sysLem has been offered: lrraLlonal
exuberance, a collapse of eLhlcal behavlor LhaL supporLed greed, lax regulaLlon and overslghL, faulLy
appllcaLlon of accounLlng regulaLlons such as mark Lo markeL prlclng, lnapproprlaLe lncenLlves LhaL
fosLered conLrol fraud, lnLernaLlonal lmbalances LhaL flooded Lhe securlLles markeLs and relnforced an
easy money pollcy and reduced lnLeresL raLes, rlslng lnequallLy LhaL encouraged households Lo borrow
Lo supporL spendlng. unforLunaLely, none of Lhese explanaLlons fully recognlze Lhe sysLemlc naLure of
Lhe flnanclal crlsls ln Lhe unlLed SLaLes and lLs global lmpllcaLlons.
Many accounLs blame Lhe flnanclal collapse on Lhe sharp rlse ln Lhe lssue and securlLlzaLlon of subprlme
morLgages (home loans made Lo rlskler borrowers, Lyplcally low-lncome households), buL LhaL ls much
Loo slmple. AL less Lhan $2 Lrllllon, Lhe LoLal subprlme unlverse was modesL relaLlve Lo Lhe slze of Lhe uS
morLgage markeL, much less as a share of uS Cu, Lhe number of defaulLs was noL, on lLs own, sufflclenL
Lo explaln a crash of Lhe magnlLude LhaL occurred. WhaL allowed Lhls evenL Lo acLlvaLe a global flnanclal
panlc and a resulLlng debL deflaLlon was a long-Lerm bulldup of lnnovaLlve" flnanclal sLrucLures LhaL
evenLually Lransformed lnLo lnsLablllLy of Lhe economy, a process anLlclpaLed by Mlnsky ln hls analysls of
Lhe flnanclal sysLem beglnnlng ln Lhe laLe 1930s.
We should noL vlew Lhe global flnanclal crlsls as slmply a momenL LhaL can be Lraced Lo recenL
developmenLs. 8aLher, as Mlnsky had been argulng for nearly 30 years, whaL we have seen ls a slow
LransformaLlon of Lhe global flnanclal sysLem Loward whaL he called money manager caplLallsm," whlch
flnally collapsed ln 2007. 8aLher Lhan a momenL, lL ls perhaps beLLer called Lhe Mlnsky half-cenLury"
(Wray 2009).
lL ls essenLlal Lo recognlze LhaL we have had a long serles of crlses, and Lhe Lrend has been Loward more
severe and more frequenL crlses: munlclpal bonds ln Lhe mld-1960s, real esLaLe lnvesLmenL LrusLs ln Lhe
early 1970s, developlng counLry debL ln Lhe early 1980s, commerclal real esLaLe, [unk bonds, and Lhe
LhrlfL crlsls ln Lhe unlLed SLaLes (wlLh banklng crlses ln many oLher naLlons) ln Lhe 1980s, sLock markeL
crashes ln 1987, 1989, and agaln ln 2000 wlLh Lhe doL-com busL, Lhe !apanese melLdown of Lhe laLe
1980s, Long-1erm CaplLal ManagemenL, Lhe 8usslan defaulL, and Aslan debL crlses ln Lhe laLe 1990s, and
so on.
lor Mlnsky, Lhe underlylng problem of Lhe posLwar flnanclal sysLem governed by Class-SLeagall
regulaLlon was Lhe emergence of whaL he bapLlzed money manager caplLallsm," a flnanclal sysLem
characLerlzed by hlghly leveraged funds seeklng maxlmum reLurns ln an envlronmenL LhaL sysLemaLlcally
underprlces rlsk and falls Lo provlde flnanclng for Lhe caplLal developmenL of Lhe economlc sysLem.
Money manager caplLallsm ls marked by Lhe poLenLlal for deep lnsLablllLy, wlLh masslve pools of funds
dlrecLed by professlonal lnvesLmenL managers seeklng Lhe hlghesL posslble reLurns, generaLlng
successlve speculaLlve bubbles ln sLocks, real esLaLe, and commodlLles. Lxamples of Lhese managed
lnsLlLuLlonal enLlLles lnclude penslon funds, muLual funds, lnsurance funds, and, more recenLly,
soverelgn wealLh funds. WlLh progresslve ellmlnaLlon of Class-SLeagall regulaLlons and Lhe advenL of


10
llghL Louch" supervlslon of flnanclal lnsLlLuLlons, money managers concocLed lncreaslngly esoLerlc and
opaque flnanclal lnsLrumenLs LhaL qulckly spread around Lhe world. ConLrary Lo Lhe prevalllng vlew LhaL
markeL compeLlLlon and counLerparLy survelllance wlll ensure sLablllLy ln Lhe sysLem, markeLs for
flnanclal asseLs have repeaLedly shown a Lendency Lo generaLe perverse lncenLlves for excess rlsk,
punlshlng Lhe Llmld manager wlLh low reLurns and encouraglng Lhose who Lake hlgher rlsk wlLh a beLLer
opporLunlLy for survlval. 1hose playlng along are rewarded wlLh hlgh reLurns because hlghly leveraged
fundlng drlves up prlces for Lhe underlylng asseLs, wheLher Lhey are doL-com sLocks, Las vegas homes,
or corn fuLures.
Many have accuraLely descrlbed Lhe phenomenon as flnanclallzaLlon"-growlng debL LhaL leverages
lncome flows and wealLh. AL Lhe 2007 peak, LoLal debL ln Lhe unlLed SLaLes reached a record flve Llmes
Cu (versus Lhree Llmes Cu ln 1929), wlLh mosL of LhaL belng Lhe prlvaLe debL of households and flrms.
lrom 1996 unLll 2007, Lhe uS prlvaLe secLor spenL more Lhan lLs lncome every year, excepL durlng Lhe
recesslon LhaL followed Lhe 2000 doL-com busL. llnanclal lnsLlLuLlons' debL also grew specLacularly over
Lhe pasL Lwo decades, LoLallng more Lhan Cu. LxoLlc flnanclal lnsLrumenLs llke credlL defaulL swaps, or
CuSs (beLs on fallure of asseLs, flrms, and even governmenLs), exploded.
1he enLlre flnanclal sysLem had evolved ln a manner LhaL made lL"-an economlc collapse and debL
deflaLlon-posslble. 8lskler pracLlces had been permlLLed by regulaLors and encouraged by rewards and
lncenLlves. 1he comblnaLlon of blg governmenL" deflclLs and blg bank" lnLervenLlons (such as Lhe
Creenspan puL), plus ballouLs of Loo blg Lo fall" lnsLlLuLlons, relnforced Lhe rewards of hlgher-rlsk
sLraLegles whlle ellmlnaLlng any penalLles of loss. 1he absence of depresslons allowed flnanclal wealLh Lo
grow over Lhe enLlre posLwar perlod, lncludlng personal savlngs and penslon funds. 1he managers of all
of Lhese funds needed Lo earn benchmark reLurns or beLLer Lo reLaln Lhelr commlsslons and Lhelr [obs.
As a resulL Lhey were encouraged Lo follow Lhe hlghesL rlsk sLraLegles prevalllng ln Lhe markeL and Lhe
flnanclal secLor conLlnued Lo grow aL raLes hlgher Lhan Cu, as a percenL of value added, Lhe flnanclal
secLor grew from 10 percenL Lo 20 percenL, and lLs share of corporaLe proflLs quadrupled from abouL 10
percenL Lo 40 percenL from 1960 Lo 2007 (nerslsyan and Wray 2010).
WhaL Mlnsky called Lhe money manager" sLage ln Lhe evoluLlon of caplLallsm ushered ln a convergence
of Lhe acLlvlLles of flnanclal lnsLlLuLlons. new ueal reforms had lmposed a segregaLlon of flnanclal
lnsLlLuLlons by funcLlon-commerclal banklng, lnvesLmenL banklng, savlngs and loans, and lnsurance-
and each had Lhelr own llnes of buslness (wlLh heavler supervlslon of commerclal banks and LhrlfLs).
Mlnsky argued LhaL Lhe convergence of Lhe varlous Lypes of banks under Lhe umbrella of Lhe bank
holdlng company, and wlLhln shadow banks," was fueled by Lhe growLh of managed money. Cver Llme,
commerclal banks losL markeL share Lo lnsLlLuLlons sub[ecL Lo fewer consLralnLs on leverage raLlos, on
lnLeresL raLes LhaL could be pald, and over Lypes of ellglble asseLs. Puge pools of managed money
offered an alLernaLlve source of fundlng for commerclal acLlvlLles. llrms would sell commerclal paper or
[unk bonds Lo unregulaLed flnanclal lnsLlLuLlons and hedge funds raLher Lhan borrowlng from banks.
And, lmporLanLly, securlLlzaLlon Look many Lypes of loans off Lhe books of banks and lnLo afflllaLes
(speclal lnvesLmenL vehlcles or speclal-purpose enLlLles-Slvs and SLs) and managed money funds.
8anks conLlnually lnnovaLed ln an aLLempL Lo geL around regulaLlons, whlle governmenL deregulaLed ln a


11
fuLlle efforL Lo keep banks compeLlLlve. ln Lhe end, governmenL gave up and ellmlnaLed funcLlonal
separaLlon ln 1999 wlLh Lhe CL8 AcL.
1hls convergence was also encouraged by Lhe expanslon of Lhe governmenL safeLy neL, or, as Mlnsky puL
lL, by a prollferaLlon of governmenL endorsemenLs of prlvaLe obllgaLlons" (Mlnsky 1992c, 39). lndeed, lL
ls lmposslble Lo Lell Lhe sLory of Lhe currenL crlsls wlLhouL reference Lo Lhe expllclL and lmpllclL
guaranLees glven by Lhe 1reasury Lo Lhe morLgage markeL Lhrough lLs governmenL-sponsored
enLerprlses (lannle Mae and lreddle Mac), Lhrough Lhe sLudenL loan markeL (Sallle Mae), and Lhrough
lederal 8eserve moneLary pollcy ln Lhe form of Lhe Creenspan puL and 8en 8ernanke's greaL
moderaLlon," all of whlch gave markeLs Lhe lmpresslon LhaL Lhe governmenL would never leL Lhem fall.
ln Lhe afLermaLh of Lhe crlsls, Lhe governmenL's guaranLee of llablllLles wenL far beyond lederal ueposlL
lnsurance CorporaLlon (lulC)-lnsured deposlLs and lannle and lreddle guaranLees of morLgage
securlLles Lo cover larger-denomlnaLlon deposlLs as well as money markeL funds, and Lhe led exLended
lender-of-lasL-resorL faclllLles Lo vlrLually all flnanclal lnsLlLuLlons (wlLh ballouLs also golng Lo auLo
companles and so on). 1hls was a foregone concluslon once Class-SLeagall was clrcumvenLed and Lhen
replaced by CL8, and lnvesLmenL banklng, commerclal banklng, and all manner of flnanclal servlces were
consolldaLed ln a slngle flnanclal holdlng company sLrucLure wlLh expllclL governmenL guaranLees over a
porLlon of Lhe llablllLles. llnanclal lnsLlLuLlon lndebLedness grew Lo some 120 percenL of Cu-Lhe
leveraglng and layerlng of naLlonal lncome LhaL Mlnsky addressed-wlLh complex and unknowable
llnkages among regulaLed bank subsldlarles of flnanclal holdlng companles and Lhe unregulaLed shadow
banklng sysLem. Clearly, lf problems developed somewhere ln a hlghly lnLegraLed sysLem, Lhe 1reasury
and led would be on Lhe hook Lo rescue any flnanclal lnsLlLuLlon.
As laLe as Lhe 1990s, Lhe blg lnvesLmenL banks were sLlll parLnershlps, so Lhey were unable Lo dlrecLly
beneflL from Lhe run-up of Lhe sLock markeL-a slLuaLlon slmllar Lo 1929. An lnvesLmenL bank could earn
fees by arranglng lnlLlal publlc offerlngs for sLarL-ups, and lL could Lrade sLocks for oLhers or for lLs own
accounL. 8uL ln Lhe lrraLlonal exuberance of Lhe laLe 1990s, LhaL looked llke small change. Pow could an
lnvesLmenL bank geL a blgger share of Lhe sLock markeL acLlon? ln 1999, Lhe largesL parLnershlps wenL
publlc ln response Lo Lhe repeal of Class-SLeagall. 1he CL8 leglslaLlon shlfLed Lhe balance of power from
lnvesLmenL banks Lo former commerclal banks, whlch could now enLer lnvesLmenL banklng wlLh much
larger balance sheeLs and Lhe beneflL of cheap core deposlL fundlng ln Lhelr regulaLed banklng faclllLles.
Commerclal banks could now provlde cheap, shorL-Lerm fundlng agalnsL a commlLmenL for more
lucraLlve lnvesLmenL banklng buslness. 1he former lnvesLmenL banks Lhus soughL Lo expand Lhelr
fundlng ablllLy by golng publlc Lo ralse funds and moved lnLo proprleLary Lradlng Lo offseL Lhe loss of
revenues from compeLlLlon ln more LradlLlonal lnvesLmenL banklng acLlvlLles. 1hls also offered Lhe
posslblllLy of provldlng lncenLlves Lo lncreased rlsk ln Lhelr Lradlng acLlvlLles ln Lhe form of sLock opLlon
remuneraLlon. LvenLually, lnvesLmenL banks would dlsappear, chooslng Lo become flnanclal holdlng
companles lnsLead.
8efore Lhls LransformaLlon, Lradlng proflLs were a small parL of lnvesLmenL bank revenues. lor example,
before Coldman Sachs wenL publlc, only 28 percenL of lLs revenues came from Lradlng and lnvesLlng
acLlvlLles. As of Aprll 2010, LhaL flgure had grown Lo abouL 80 percenL. Whlle many Lhlnk of Coldman and


12
!Morgan Chase (Lhe lnvesLmenL banks remalnlng afLer Lhe demlse of Lehman 8roLhers, 8ear SLearns,
and Merrlll Lynch, all of whlch folded or were absorbed by oLher flrms) as banks, Lhey are really more
llke huge hedge funds, albelL very speclal ones LhaL now hold bank charLers, granLed durlng Lhe crlsls
when lnvesLmenL banks were havlng Lrouble reflnanclng poslLlons ln asseLs-glvlng Lhem access Lo Lhe
led's dlscounL wlndow and Lo lulC lnsurance. 1haL, ln Lurn, leLs Lhem obLaln fundlng aL near-zero
lnLeresL raLes. lndeed, ln 2009 Coldman spenL only sllghLly more Lhan $3 bllllon Lo borrow, versus $26
bllllon ln lnLeresL expenses ln 2008-a $21 bllllon subsldy Lhanks Lo lLs access Lo cheap, governmenL-
lnsured deposlLs. 1he Lwo remalnlng lnvesLmenL banks were also wldely belleved Lo be backsLopped"
by Lhe governmenL-under no clrcumsLances would Lhey be allowed Lo fall-keeplng sLock prlces up
(see Wray 2010).
ln some ways, Lhlngs were even worse Lhan Lhey had been ln 1929 because Lhe lnvesLmenL banks had
gone publlc, lssulng equlLles dlrecLly lnLo Lhe porLfollos of households and lndlrecLly Lo households
Lhrough Lhe porLfollos of managed money. 1herefore, Coldman or Merrlll could noL slmply [eLLlson one
of lLs unwanLed offsprlng: problems wlLh Lhe sLock or oLher llablllLles of Lhe behemoLh flnanclal
lnsLlLuLlons would raLLle Wall SLreeL and LhreaLen Lhe solvency of penslon and oLher lnvesLed funds. 1hls
flnally became clear Lo Lhe auLhorlLles afLer Lhe problems wlLh 8ear SLearns and Lehman. 1he layerlng
and llnkages among flrms-made opaque by over-Lhe-counLer (C1C) derlvaLlves such as CuSs-made lL
lmposslble Lo leL Lhem fall one by one, as Lhe fallure of one would brlng down Lhe whole house of cards.
1he degree of flnanclal fraglllLy lnherenL ln Lhls conflguraLlon of Lhe flnanclal sysLem may be seen ln Lhe
facL LhaL LoLal flnanclal llablllLles ln Lhe unlLed SLaLes rose Lo abouL flve Llmes Cu (versus 300 percenL ln
1929), so LhaL every dollar of lncome had Lo servlce flve dollars of debL. 1haL ls an average leverage raLlo
of flve Llmes lncome. 1haL ls one way Lo measure leverage. lor, as Mlnsky argued, a low leverage raLlo
ls, hlsLorlcally, Lhe lmporLanL measure for bank proflLablllLy-whlch ulLlmaLely musL be llnked Lo
repaymenL of prlnclple and lnLeresL ouL of lncome flows.
AnoLher measure, of course, ls Lhe raLlo of debL Lo asseLs. 1hls became lncreaslngly lmporLanL durlng Lhe
real esLaLe boom, when morLgage brokers would flnd flnanclng for 100 percenL or more of Lhe value of a
morLgage, on Lhe expecLaLlon LhaL real esLaLe prlces would rlse. 1haL ls a Lrader's, noL a banker's,
perspecLlve, slnce lL relles on elLher sale of Lhe asseL or reflnanclng. A LradlLlonal banker mlghL feel safe
wlLh a caplLal leverage raLlo of 12 Lo 1, wlLh careful underwrlLlng Lo ensure LhaL Lhe borrower would be
able Lo make paymenLs. WlLh equlLy aL rlsk, underwrlLlng ls essenLlal.
Powever, for a morLgage orlglnaLor or securlLlzer who has no plans Lo hold Lhe morLgage, whaL maLLers
ls Lhe ablllLy Lo place Lhe securlLy. Many conslderaLlons Lhen come lnLo play, lncludlng prospecLlve asseL
prlce appreclaLlon, credlL raLlngs, monollne lnsurance, Lhe purchase of CuS proLecLlon, and
overcollaLerallzaLlon" (Lhe lncluslon of asseLs wlLh a hlgher value Lhan Lhe llablllLles lssued ln a
securlLlzaLlon). lL ls noL necessary Lo analyze Lhe deLalls of Lhese complex lnsLrumenLs. WhaL ls
lmporLanL ls LhaL lncome flows Lake a backseaL ln such arrangemenLs, and accepLable caplLal leverage
raLlos are much hlgher. lor money managers, caplLal leverage raLlos are 30 Lo 1, and can reach up Lo
several hundred. 8uL even Lhese large numbers hlde Lhe reallLy LhaL rlsk exposures can be very much
hlgher, slnce many commlLmenLs are noL reporLed on balance sheeLs. 1here are unknown and


13
essenLlally unquanLlflable rlsks enLalled ln Lhe ablllLy of counLerparLles Lo meeL Lhelr commlLmenLs. lor
example, Lhe hedge of Lhe sale of credlL proLecLlon ln a CuS by means of Lhe purchase of an offseLLlng
CuS ls only effecLlve lf Lhe counLerparLy has Lhe capaclLy Lo pay ln Lhe evenL of defaulL. 8ecause balance
sheeLs are llnked ln hlghly complex and uncerLaln ways, Lhe fallure of one counLerparLy can have
repercusslons LhaL lmpacL Lhe enLlre sysLem. 1he fallure of AlC's llnanclal roducLs unlL made Lhls
posslblllLy a reallLy.
Mlnsky's wrlLlngs ln early 1992 addressed Lhe banklng crlsls aL LhaL Llme (whlch followed Lhe 1980s
savlngs-and-loan crlsls), buL mosL of hls polnLs could be applled Lo Lhe conLlnulng evoluLlon of Lhe
flnanclal sLrucLure, whlch flnally collapsed ln 2008. Pe warned LhaL Lhe flnanclal conservaLlsm of Lhe
early posLwar years had ushered ln a new era of pervaslve caslno caplLallsm"-wlLh Lhe leveraged
buyouLs of Lhe laLe 1980s servlng as a good example of Lhe excesses (Mlnsky 1992d: ll, 9). Much of LhaL
boom was drlven by penslon funds, boLh as suppllers of Lhe equlLy base for leveraged buy ouLs and as
Lhe Lakers of Lhe hlgh yleld bonds ([unk bonds). . . . SysLemlc overlndebLedness may well be a legacy of
penslon funds ln Lhe unlLed SLaLes."
Mlnsky argued LhaL Lhe decrease ln Lhe power of banks and Lhe concomlLanL rlse of Lhe power of
lnsLlLuLlonal lnvesLors' managed money had llLLle Lo do wlLh Lhe movemenL Lo deregulaLe banks and
oLher flnanclal lnsLlLuLlons." lnsLead, he blamed Lhe 1979-82 volcker experlmenL ln moneLarlsm LhaL
wlped ouL bank and LhrlfL equlLy, paymenLs-sysLem lnnovaLlons (such as elecLronlc funds Lransfers and
credlL cards) LhaL Look away cheap deposlL sources of bank funds, and Lhe change ln Lhe lnLernaLlonal
clouL of Lhe unlLed SLaLes" as far more lmporLanL (Mlnsky 1992d: ll, 12). 1hus, Mlnsky aLLrlbuLed Lhe
flnanclal secLor's LransformaLlve shlfL away from banklng and Loward managed money, whlch occurred
over a long perlod, Lo complex, and mosLly endogenous, facLors. Whlle deregulaLlon (ln Lhe early 1980s,
and Lhen agaln ln Lhe laLe 1990s, afLer Mlnsky's deaLh) played a role, Mlnsky lnslsLed LhaL Lhls was of
secondary lmporLance.
Cn Lhe eve of Lhe 2008 ldes of SepLember" melLdown, many flnanclal servlces were supposed Lo have
been lnLermedlaLed by efflclenL markeLs." Powever, Lhls shlfL was more apparenL Lhan real, slnce Lhe
domlnanL flnanclal lnsLlLuLlons conLrolled Lhose markeLs and seL Lhe prlces of flnanclal asseLs (ofLen
uslng complex and proprleLary models). A handful of flnanclal behemoLhs provlded Lhe four maln
flnanclal servlces: commerclal banklng (shorL-Lerm flnance for buslness and governmenL), paymenLs (for
households, flrms, and governmenL), lnvesLmenL banklng (long-Lerm flnance for flrms and governmenL),
and morLgages (resldenLlal and commerclal real esLaLe). uebLs were securlLlzed and ulLlmaLely held ln
penslon, unlverslLy endowmenL, and soverelgn wealLh funds.
Cne of Lhe mosL lmporLanL sLrucLural changes LhaL was faclllLaLed by Lhe advenL of money manager
caplLallsm was Lhe shlfL ln lendlng procedures, from lendlng and holdlng Lhe asseL on Lhe balance sheeL
Lo lendlng and selllng Lhe asseL Lo Lhe caplLal markeL. 1he resulLlng orlglnaLe-Lo-dlsLrlbuLe" buslness
model of banks vlrLually ellmlnaLed due-dlllgence assessmenL of credlL worLhlness. ln morLgage lendlng,
lL was replaced by a comblnaLlon of properLy valuaLlon by assessors who were pald Lo overvalue real
esLaLe, by credlL raLlngs agencles who were pald Lo overraLe securlLles, by accounLanLs who were pald Lo
lgnore problems, and by monollne lnsurers whose promlses were noL backed by sufflclenL loss reserves.


14
1he morLgages were onzl schemes from Lhe very beglnnlng: Lhey requlred rlslng real esLaLe prlces as
well as conLlnual access Lo reflnance because borrowers dld noL have Lhe capaclLy Lo servlce Lhe loans
(kregel 2008a). Much of Lhe orlglnaLlon acLlvlLy acLually Look place ouLslde Lhe banks and LhrlfLs, wlLh
morLgage orlglnaLors and brokers wrlLlng morLgages and arranglng for flnance, Lhen selllng Lhem Lo
lnvesLmenL banks who packaged Lhem lnLo collaLerallzed securlLles, Lo be sold Lo lnsLlLuLlonal lnvesLors
and hedge funds. Whlle lannle and lreddle have been sub[ecLed Lo much rldlcule, ln LruLh nelLher of
Lhem made or arranged any of Lhe morLgages, and Lhey only began Lo purchase Loxlc securlLles because
Lhey were encouraged Lo play a role ln prevenLlng whaL was seen as an lmpendlng dlsasLer and Lhe
collapse of Lhe enLlre morLgage markeL.
When decllnlng prlces made lL lmposslble Lo reflnance poslLlons and dellnquencles, and defaulLs on
morLgages rose, Lhe lmpacL was qulckly LransmlLLed back Lo bank balance sheeLs because Lhey held
Lhese securlLles ln warehouse" ln anLlclpaLlon of sale Lhrough securlLlzaLlon, and Lhey were called upon
Lo make good on Lhe proLecLlon of collaLerallzed morLgage securlLles LhaL Lhey had sold vla credlL
defaulL swaps or Lhrough buyback" guaranLees on securlLles Lhey had sold. As credlL LlghLened, Lhese
exposures could noL be reflnanced and Lhere was no markeL ln whlch Lo sell Lhem.
Cne way LhaL flnanclal lnsLlLuLlons devlsed Lo deal wlLh Lhe need Lo sell lnLo a collapslng markeL lnvolved
Lhe creaLlon of collaLerallzed sLrucLures LhaL were deslgned Lo fall-LhaL ls, ln whlch Lhe underlylng
morLgages were deslgned Lo defaulL. 1hese sLrucLures could be fllled wlLh Lhe unwanLed and unsalable
resldenLlal morLgage-backed securlLles held by Lhe banks and sold Lo lnsLlLuLlonal lnvesLors. AL Lhe same
Llme, Lhe morLgage desks of Lhe large lnvesLmenL banks, as well as a number of hedge fund lnvesLors,
belleved LhaL Lhey could proflL from whaL Lhey consldered Lo be Lhe lmpendlng collapse of Lhe enLlre
collaLerallzed morLgage markeL.
Many hedge fund managers had ldenLlfled Lhe onzl naLure of Lhe houslng bubble early on, and
aLLempLed Lo Lake shorL poslLlons on Lhe markeL (see Lewls 2010). MosL of Lhese sLraLegles used Lhe
purchase of credlL defaulL swaps on whaL were consldered Lo be Lhe weakesL collaLerallzed morLgage
obllgaLlons (CMCs) backed by subprlme morLgages. A baslc dlfflculLy ln Laklng a shorL poslLlon ls ln
creaLlng and fundlng Lhe shorL poslLlon. 1hus, Lhe purchase of a CuS requlred perlodlc paymenLs of Lhe
premlum, and as !ohn Maynard keynes was one of Lhe flrsL Lo polnL ouL, Lhe markeL can sLay lrraLlonal
for longer Lhan you can remaln solvenL lf you have Lo fund a shorL poslLlon.
Powever, some managers, ln consorL wlLh Lhe lnvesLmenL banks, produced a scheme Lo creaLe CMCs
LhaL would fall. 1hus, paradoxlcally, Lhe need Lo offseL Lhe lnablllLy Lo sell ouL poslLlons led Lo an
lncrease ln synLheLlc CMCs Lo be used ln sLraLegles Lo produce proflLs by shorLlng Lhe markeL.
A CMC ls arranged ln credlL Lranches, from Lhose raLed lnvesLmenL grade wlLh Lhe lowesL credlL rlsk and
lowesL raLe of reLurn, Lo Lhe resldual or flrsL-loss equlLy or Lrash Lranche, whlch has no offlclal raLlng and
has Lhe hlghesL rlsk and Lhe hlghesL reLurn because lL absorbs lnlLlal losses from arrears or defaulL. An
lnvesLor who purchases Lhe equlLy Lranche of a bespoke synLheLlc CMC runs a hlgh rlsk of loss, agalnsL a
hlgh reLurn. Slnce even Lhe worsL-performlng CMCs usually pay ouL for Lhe flrsL few quarLers, a long
equlLy Lranche poslLlon generaLes Lhe lncome LhaL flnances Lhe shorL poslLlon, represenLed by Lhe CuSs


13
purchased on Lhe mezzanlne Lranches, whlch were expecLed Lo defaulL very qulckly. 1hls was lnsured
because Lhe lnvesLor who provlded Lhe funds for Lhe equlLy Lranche of each deal became Lhe sponsor,
wlLh Lhe ablllLy Lo selecL or Lo advlse Lhe managers of Lhe securlLlzaLlon on Lhelr preference for
morLgage pools wlLh hlgh-rlsk, hlgh-equlLy payouL and Lherefore a hlgh probablllLy of rapld paymenL
fallure. 1hus, Lhe lncome on Lhe long equlLy Lranche covers Lhe premlum paymenLs on Lhe CuS
proLecLlon, so Lhe shorL poslLlon ls creaLed aL zero flnanclng cosL. When Lhe mezzanlne Lranche defaulLs,
Lhe equlLy Lranche ls losL, buL Lhe full value of Lhe lnsured mezzanlne Lranche ls recelved, produclng a
proflL from Lhe collapse of Lhe CMC.
1he shorL speculaLor or a bank seeklng Lo offseL lLs long poslLlon could Lhus beL agalnsL hlgher Lranches
whlle shorLlng Lhe collaLerallzed debL obllgaLlons (CuCs) LhaL Lhey had helped deslgn. 1he llllnols-based
hedge fund MagneLar CaplLal used Lhe lncome from Lhe equlLy Lranche Lo flnance lLs much larger
speculaLlve shorL poslLlon on 888-raLed subprlme bond Lranches-whaL would come Lo be known as Lhe
MagneLar Lrade." As ln Lhe oLher sLraLegles dlscussed above, Lhe poslLlon only provldes Lhe expecLed
galns lf boLh Lhe equlLy and Lhe mezzanlne or hlgher Lranches all defaulL aL around Lhe same Llme.
1he cenLral role played by credlL defaulL swaps ln faclllLaLlng Lhese sLrucLures should be clear. lL also
should be clear LhaL lf Lhey had been regulaLed as lnsurance conLracLs, Lhese sLraLegles would have been
lllegal. WlLh no regulaLlon of CuSs, Lhese sLrucLures were compleLely legal.
8ecall LhaL Lhese speculaLors were noL slmply acLlng on Lhelr bellefs by selllng whaL Lhey LhoughL were
overprlced CMC Lranches, or by buylng CuS coverage for overprlced Lranches, Lhey were ln facL creaLlng
CMCs LhaL were deslgned Lo fall so LhaL Lhey could proflL from Lhelr ensured defaulL. 1hls ls qulLe
dlfferenL from Lhe normal [usLlflcaLlon for allowlng shorL sellers Lo Lake naked poslLlons ln order Lo
provlde equallLy beLween long and shorL poslLlons. lL ls also qulLe dlfferenL from Lhe orlglnal lnLenLlon of
securlLlzaLlon, whlch was Lo package llllquld, unsalable subprlme paper lnLo a sLrucLure LhaL could be
sold as lnvesLmenL-grade paper Lo lnsLlLuLlonal lnvesLors.
1he woll 5tteet Iootool (Mollenkamp and ng 2008) reporLed LhaL MagneLar's consLellaLlon" CMC
lssuance could have been ln Lhe range of $30 bllllon. LxacL flgures are lmposslble Lo deLermlne because
MagneLar never Look a dlrecL role as a manager or underwrlLer/lssuer of a CMC. SmlLh (2010) clLes
lndusLry sources as esLlmaLlng LhaL MagneLar alone was responslble for aL leasL 33, perhaps as much
as 60, of Lhe subprlme bonds lssued ln 2006" (260). As noLed, Lhe Levln SenaLe CommlLLee 8eporL
makes lL clear LhaL MagneLar was noL Lhe only acLor ln Lhls drama, ma[or lnvesLmenL banks were also
acLlve parLlclpanLs, slnce Lhey used such sLrucLures as a meLhod Lo remove doubLful morLgages from
warehouse holdlngs and oLher unsold pleces of prlor LransacLlons.
1he shorL sellers who had correcLly gauged Lhe markeL were proven Lo be correcL, noL because of Lhelr
analyLlcal ablllLy, buL because of Lhelr perfecL foreslghL due Lo Lhe facL LhaL Lhey had consLrucLed deals
LhaL were desLlned Lo fall. MosL of Lhe securlLlzaLlons LhaL were lssued from 2006 onward, and Lhe
morLgage-backed securlLles LhaL enLered CMCs wrlLLen from 2006 onward, were deslgned Lo defaulL.
SmlLh also noLes LhaL Lhe synLheLlc componenL creaLed demand for subprlme loans by a less dlrecL
mechanlsm, by compresslng credlL spreads. 1haL ls a fancy way of saylng Lhey lowered lnLeresL raLes.


16
CredlL defaulL swap spreads and cash bond spreads are llnked vla arblLrage. lf credlL defaulL swap
spreads LlghLen, LhaL ls LanLamounL Lo havlng Lhe prlce of Lhe credlL defaulL lnsurance drop. 1he
proLecLlon wrlLers (guaranLors) recelve less, and Lhe proLecLlon buyers pay less. When LhaL happens,
spreads on Lhe relaLed bonds drop, whlch lowers Lhe cosL of borrowlng" (lbld., 261-62).
ln Lhe afLermaLh of Lhe crlsls lL has become common Lo conslder Lhose who recognlzed and predlcLed
Lhe lnsLablllLy lnherenL ln Lhe subprlme morLgage boom as heroes (see Lewls 2010). 1helr shorL poslLlons
have been consldered as a means of lncreaslng sLablllLy by offseLLlng Lhe excesslve opLlmlsm LhaL
produced Lhe real esLaLe bubble. Powever, many dlsLorLed Lhe markeL ln order Lo proflL from shorL
poslLlons and were ln facL among Lhe ma[or conLrlbuLors Lo Lhe perslsLence of Lhe bubble and lLs spread
Lo flnanclal lnsLlLuLlons around Lhe world. 1he acLlon Lo lncrease Lhe producLlon of synLheLlc CMCs Lo
faclllLaLe Lhelr mezzanlne shorL Lrades acLed Lo reduce credlL defaulL swap cosLs as well as subprlme
bond spreads, lowerlng raLes for subprlme borrowers and prolonglng Lhe lssue of Loxlc morLgages. 1he
use of credlL defaulL swaps ln Lhese speculaLlve sLrucLures lncreased Lhe exposure Lo subprlme
ad[usLable-raLe morLgages and lncreased Lhe evenLual losses Lo much hlgher levels, and Lo many more
players, Lhan would have been Lhe case had CuS securlLlzaLlons been prohlblLed.
And Lhe parLles on Lhe oLher slde of Lhls Lrade were ln large measure Lhe caplLal markeLs players, such as
lnvesLmenL banks, Luropean banks LhaL held Lrlple-A CuC lnvenLory, and lnsurers of varlous sorLs. 1hese
lnsLlLuLlons were all hlghly levered and Lherefore fraglle. All suffered or wlll suffer Lermlnal losses, Lhe
survlvors owe Lhelr exlsLence Lo masslve Laxpayer ballouLs, cenLral bank subsldles, and regulaLory
forbearance.
1hus, even afLer mosL morLgage brokers had sLopped orlglnaLlng doubLful, fraudulenL subprlme
morLgages, lnvesLmenL banks conLlnued Lo creaLe and markeL CMCs LhaL were deslgned by shorL
lnvesLors Lo fall, and Lhese cerLaln-Lo-fall lnvesLmenLs were sold Lo Luropean banks, lnvesLmenL funds,
and even local auLhorlLles who belleved LhaL Lhey were buylng lnvesLmenL-grade AAA asseLs. ln Lhls
case, shorL lnvesLors were noL only expresslng a negaLlve oplnlon on Lhe prospecLs of morLgage-backed
lnsLrumenLs, Lhey were also lncreaslng Lhe supply of lnsLrumenLs LhaL were guaranLeed Lo fall, and
prolonged Lhe purchase of Lhese lnsLrumenLs for abouL Lwo years afLer Lhere were exLreme doubLs
abouL Lhe value of exlsLlng asseLs.
lL seems clear LhaL Lhe shorL sellers dld llLLle Lo curLall Lhe lrraLlonal exuberance of Lhe markeL and
lndeed dld much Lo exLend lL, even provldlng for Lhe creaLlon of lmpalred morLgage asseLs, afLer
orlglnaLors had sLopped lssulng Lhem Lo real borrowers, Lhrough Lhe use of synLheLlc securlLlzaLlons.
1hls ralses Lhe quesLlon of wheLher such acLlvlLy would have been curLalled by Lhe clearlng and Lradlng
of CuS conLracLs ln organlzed lnsLlLuLlons. lL seems clear LhaL lL would have made llLLle dlfference Lo Lhe
sLraLegles LhaL were employed, slnce Lhe opaclLy occurred due Lo Lhe lnfluence of Lhe shorL speculaLor
on Lhe cholces of Lhe reference asseLs made by Lhe manager of Lhe securlLlzaLlon. WheLher or noL Lhe
CuSs LhaL made up Lhe corpus of Lhe sLrucLure were Lraded LransparenLly would have made llLLle
dlfference. Powever, Lhe ablllLy Lo wrlLe naked CuSs was cruclal Lo Lhese sLrucLures. lf naked CuSs had
been lllegal, Lhe synLheLlc CMCs LhaL caused much of Lhe Lrouble could noL have exlsLed.


17
Whlle Lhere ls now a fuller undersLandlng of Lhe fallures of Lhe flnanclal sLrucLure LhaL emerged from Lhe
CL8 AcL's allowlng banks full reln Lo operaLe across all flnanclal markeLs, Lhe approach Lo reregulaLlon
LhaL Lakes Mlnsky's work Lo hearL would look beyond Lhe proxlmaLe Lrlgger for Lhe laLesL crlsls-beyond
Lhe mere subprlme-melLdown momenL-Lo Lhe fraglle flnanclal sLrucLure LhaL developed wlLh Lhe
ascendancy of managed money. As we wlll see ln Lhe nexL chapLer, Mlnsky had a compleLely dlfferenL
vlew of how Lhe sysLem should have evolved from Class-SLeagall and Lhe rlse Lo domlnance of money
manager caplLallsm.


18
CnA1Lk 2.!8|uepr|nt for a More Stab|e I|nanc|a| System

1he crlsls LhaL ls descrlbed ln chapLer 1 was ln large parL a resulL of Lhe process of deregulaLlon LhaL
occurred ln Lhe 1980s. lnsLead of produclng a more sLable flnanclal sysLem, Lhese regulaLory changes led
Lo Lhe repeal of Class-SLeagall ln Lhe 1999 acL Lo enhance compeLlLlon ln Lhe flnanclal servlces lndusLry
by provldlng a prudenLlal framework for Lhe afflllaLlon of banks, securlLles flrms, lnsurance companles,
and oLher flnanclal servlce provlders, and for oLher purposes," beLLer known as Lhe Cramm-Leach-8llley
(CL8) llnanclal Servlces ModernlzaLlon AcL. none of Lhe regulaLory changes LhaL were lnLroduced Lo
replace Class-SLeagall correspond Lo Lhe changes LhaL Mlnsky would have recommended.
8uL Lhere ls anoLher baslc dlfference beLween Class-SLeagall and Lhe laLer regulaLlons LhaL led Lo Lhe
collapse of Lhe sysLem. 1he 1933 leglslaLlon was wrlLLen wlLh a very clear ldea of Lhe causes of Lhe
collapse of Lhe flnanclal sysLem followlng Lhe sLock markeL crash of 1929, and was based on a slmllarly
clear ldea of Lhe deslred sLrucLure of Lhe reformed flnanclal sysLem (see kregel 2009a). 8egulaLlons were
drafLed and lnLroduced Lo produce a flnanclal sLrucLure LhaL would be sLable. 8aslcally, Lhe cause of Lhe
flnanclal collapse was locaLed ln Lhe operaLlons of bank securlLles afflllaLes LhaL used oLher peoples'
money" Lo speculaLe ln caplLal markeLs (ofLen ln Lhe shares of Lhe parenL flrm) and Lo defraud lnvesLors.
1he regulaLlons produced a sysLem ln whlch commerclal banks were forbldden Lo own or operaLe any
such afflllaLe deallng ln securlLles, and banks recelvlng deposlLs from Lhe publlc could noL use Lhem Lo
flnance speculaLlon on prlce changes ln caplLal markeLs.
1here was no such clarlLy ln CL8, whlch was prlmarlly concerned wlLh lncreaslng Lhe efflclency of Lhe
flnanclal sysLem by creaLlng more compeLlLlon-a level playlng fleld-ln whlch banks could compeLe
wlLh oLher flnanclal lnsLlLuLlons. 1hls ralses Lhe quesLlon of whaL Lype of sysLem Mlnsky mlghL have
consldered an approprlaLe replacemenL for Class-SLeagall, whlch he vlewed as ouLmoded and ln need of
revlslon.
Des|gn|ng the f|nanc|a| system for stab|||ty
Mlnsky consldered Lhe followlng Lo be Lhe essenLlal funcLlons of Lhe flnanclal sysLem:
a safe and sound paymenLs sysLem,
shorL-Lerm loans Lo households and flrms and, posslbly, Lo sLaLe and local governmenL,
a safe and sound houslng flnance sysLem,
a range of flnanclal servlces, lncludlng lnsurance, brokerage, and reLlremenL savlngs servlces,
long-Lerm fundlng of poslLlons ln expenslve caplLal asseLs.
1here ls no economlc reason why Lhese servlces should be provlded by a slngle flnanclal lnsLlLuLlon or
conglomeraLe. lndeed, Lhe new ueal reforms of Lhe 1930s almed aL prevenLlng Lhls, whlle Lhe 1999
llnanclal Servlces ModernlzaLlon AcL promoLed lL. Powever, Mlnsky recognlzed LhaL Class-SLeagall had
already become anachronlsLlc by Lhe early 1990s. Pe lnslsLed LhaL any new reforms musL Lake lnLo


19
accounL Lhe acceleraLed lnnovaLlons ln boLh flnanclal lnLermedlaLlon and Lhe paymenLs mechanlsm. Pe
belleved Lhese changes were largely markeL drlven, and noL due Lo deregulaLlon. 1o some degree, Lhe
1999 AcL codlfled whaL had already Laken place.
Some of Mlnsky's recommendaLlons may be dlscerned ln conslderaLlons (especlally 1992d) of a uS
1reasury proposal (uSu1 1991) for modernlzlng" Lhe flnanclal sysLem. 1he 1reasury documenL made
recommendaLlons for safer, more compeLlLlve banks" LhaL lncluded sLrengLhenlng" deposlL lnsurance,
weakenlng Class-SLeagall and sLaLe llmlLs on branchlng, allowlng corporaLlons Lo own banks, and
consolldaLlng regulaLory supervlslon ln Lhe 1reasury aL Lhe expense of reduclng Lhe role of Lhe led.
Mlnsky argued LhaL Lhe 1reasury proposal was aL besL superflclal because lL lgnored shadow banks.
Whlle he was crlLlcal of Lhe approach Laken Lo rescue Lhe lulC (recall LhaL mosL LhrlfLs had falled and
many of Lhe largesL banks were ln dlfflculLy as a resulL of Lhe collapse ln real esLaLe lnvesLmenLs aL Lhe
end of Lhe 1980s), he agreed LhaL deposlL lnsurance had Lo be sLrengLhened. Pe argued LhaL weakenlng
Class-SLeagall and removlng llmlLaLlons on bank branchlng represenLed an aLLempL Lo flx someLhlng
LhaL ls noL broke," because small- and medlum-slze banks are more proflLable due Lo Lhelr pracLlce of
relaLlonshlp banklng. Pe saw no reason Lo allow or promoLe Lhe rlse of hegemonlc flnanclal lnsLlLuLlons
operaLlng ln naLlonal or lnLernaLlonal markeLs and provldlng a broad scope of flnanclal servlces. As many
oLhers have long argued, Lhe economles of scale assoclaLed wlLh banklng are achleved aL Lhe slze of
relaLlvely small banks.
Mlnsky was noL swayed by Lhe 1reasury's argumenL LhaL banks were becomlng uncompeLlLlve because
Lhey could noL branch across sLaLe llnes or because cerLaln pracLlces were prohlblLed Lo Lhem. Pe
belleved LhaL repeallng Lhese consLralnLs would slmply reduce Lhe proflLablllLy of Lhe smaller,
relaLlonshlp-orlenLed banks. Pe recognlzed LhaL Lhe smaller banks would lose markeL share anyway, due
Lo compeLlLlon from shadow banks. Pence, Lhe soluLlon would noL be found ln promoLlng blgger, less
proflLable banks LhaL were noL lnLeresLed ln relaLlonshlp-orlenLed banklng. 8aLher, Mlnsky argued ln
favor of allowlng greaLer scope Lo Lhe acLlvlLles of Lhe small communlLy banks. We mlghL call Lhls
lnLenslfylng" banklng by allowlng each small lnsLlLuLlon Lo provlde a greaLer range of servlces, as
opposed Lo promoLlng branchlng and Lhe concenLraLlon of power ln Lhe hands of a few large bank
holdlng companles wlLh a varleLy of subsldlarles.
romot|ng the cap|ta| deve|opment of the economy
ln Mlnsky's vlew, caplLal developmenL of Lhe economy can be lll done" ln Lwo maln ways: Lhe
SmlLhlan" way and Lhe keyneslan way." 1he flrsL refers Lo mlsallocaLlon": Lhe wrong lnvesLmenLs are
flnanced by Lhe flnanclal sysLem. 1he second refers Lo an lnsufflclency of lnvesLmenL, whlch leads Lo a
level of aggregaLe demand LhaL ls Loo low Lo promoLe hlgh employmenL. 1he 1980s suffered from boLh,
buL mosLly from an lnapproprlaLe flnanclng of lnvesLmenL, especlally ln Lhe boom ln commerclal real
esLaLe lnvesLmenL LhaL lefL large amounLs of unlnhablLed or parLlally flnlshed houslng and commerclal
real esLaLe pro[ecLs. (Pe also argued LhaL Lhe leveraged-buyouL boom of Lhe 1980s was anoLher example
of lll done" flnance because lL loaded cash cows" wlLh unservlceable debL.) Mlnsky would surely have
consldered Lhe properLy boom of Lhe 2000s lll-done," SmlLhlan" caplLal developmenL, slnce far Loo
much flnance flowed lnLo Lhe commerclal and resldenLlal real esLaLe secLor.


20
ln Lhe 1980s, Lhe deregulaLed LhrlfLs, whlch dld noL hold morLgages and had pracLlced lenlenL
underwrlLlng sLandards, had fundlng capaclLy LhaL flowed lnLo commerclal real esLaLe, ln Lhe 2000s, Lhe
reach for yleld ln Lhe presence of susLalned perlods of low pollcy raLes led Lo demand for rlsky (hlgh-
reLurn) asseL-backed securlLles LhaL provlded much of Lhe lmpeLus for Lhe developmenL of subprlme
lendlng. Mlnsky argued LhaL Lhe way Lhe morLgages were packaged made lL posslble Lo sell off a package
of morLgages aL a premlum and enable Lhe orlglnaLor and Lhe lnvesLmenL banklng flrms Lo walk away
from Lhe deal wlLh a neL lncome and no recourse from Lhe holders. 1he lnsLrumenL orlglnaLors and Lhe
securlLy underwrlLers dld noL hazard any of Lhelr wealLh on Lhe longer-Lerm vlablllLy of Lhe underlylng
pro[ecLs. Cbvlously, ln such packaged flnanclng Lhe selecLlon and supervlsory funcLlons of lenders and
underwrlLers are noL as well done as Lhey mlghL be lf Lhe forLunes of Lhe orlglnaLors were aL hazard over
Lhe longer Lerm (see Mlnsky 1992b, 22-23).
1he lmpllcaLlon for regulaLlon ls obvlous: good underwrlLlng ls promoLed when Lhe underwrlLer ls fully
exposed Lo Lhe longer-Lerm rlsks. Mlnsky always sLressed Lhe lmporLance of Lhe skepLlcal banker Lo
sysLem sLablllLy: When we go Lo Lhe LheaLer we enLer lnLo a consplracy wlLh Lhe players Lo suspend
dlsbellef. 1he flnanclal developmenLs of Lhe 1980s [and 1990s and 2000s!] can be vlewed as LheaLer:
promoLers and porLfollo managers suspended dlsbellef wlLh respecL Lo where Lhe cash would come
from LhaL would [valldaLe] Lhe pro[ecLs belng flnanced. 8ankers, Lhe deslgnaLed skepLlc ln Lhe flnanclal
sLrucLure, placed Lhelr crlLlcal faculLles on hold" (Mlnsky 1992a, 37). As a resulL, Lhe caplLal developmenL
was noL done well. uecenLrallzaLlon of flnance may well be Lhe way Lo relnLroduce Lhe necessary
skepLlclsm.
ln Mlnsky's vlew, decenLrallzaLlon of lendlng, plus malnLalnlng Lhe lender's exposure Lo rlsk, could
reorlenL lnsLlLuLlons back Loward relaLlonshlp banklng. ?eL, mosL regulaLory changes lnLroduced ln
recenL years have favored lncreased concenLraLlon. 1he lssues surroundlng Lhe response Lo lnsLlLuLlons
LhaL are Loo blg Lo fall" daLes back Lo Lhe problems creaLed ln Lhe 1970s by Lhe rapld expanslon of
banks such as ConLlnenLal llllnols, and glves an obvlous advanLage Lo Lhe blggesL banks. 1hese banks
beneflL from flnanclng cosLs below Lhose of smaller lnsLlLuLlons because of Lhe lmpllclL guaranLee LhaL
Lhey wlll be rescued by governmenL lnLervenLlon. Small local banks wlll be sub[ecL Lo hlgher cosLs as
Lhey aLLempL Lo offseL Lhls dlsadvanLage by aLLracLlng more local deposlLs, openlng more offlces Lhan
necessary. 1hey wlll also face hlgher cosLs for wholesale" deposlLs ln naLlonal markeLs. Lven ln Lhe case
of lulC-lnsured brokered deposlLs (whlch carry no defaulL rlsk), smaller banks pay more slmply because
of Lhe markeL's percepLlon LhaL Lhey are rlskler, slnce Lhey wlll be resolved raLher Lhan rescued lf Lhey
face dlfflculLy.
As a resulL of Lhe led's response Lo Lhe crlsls ln 2008, falled lnsLlLuLlons were resolved lnLo larger banks,
and whaL were formerly nondeposlL-Laklng lnvesLmenL banks have become flnanclal holdlng companles
LhaL can ln prlnclple aLLracL lulC-lnsured deposlLs Lo flnance Lhelr operaLlons. A small bank ls hard
pressed Lo compeLe wlLh Lhese large lnsLlLuLlons.


21
now to restore re|at|onsh|p bank|ng
Pow can Lhe sysLem be reformed Lo favor smaller, geographlcally dlspersed, relaLlonshlp banks LhaL
seem Lo be more conduclve Lo promoLlng Lhe caplLal developmenL of Lhe economy?
llrsL, lL would be useful Lo reduce governmenL proLecLlons for less deslrable banklng acLlvlLles. 1he
governmenL currenLly provldes Lwo lmporLanL klnds of proLecLlon: llquldlLy and solvency. LlquldlLy ls
mosLly provlded by Lhe led, whlch lends reserves aL Lhe dlscounL wlndow and buys asseLs (ln Lhe pasL,
Lhese asseLs were mosLly governmenL debL, buL ln recenL years Lhe led has boughL prlvaLe debL as well).
8efuslng Lo provlde llquldlLy ls noL Lhe rlghL way Lo dlsclpllne Lhe flnanclal sysLem. Mlnsky always
advocaLed exLendlng dlscounL wlndow operaLlons Lo lnclude a wlde range of flnanclal lnsLlLuLlons. lf Lhe
led had lenL reserves wlLhouL llmlL Lo all flnanclal lnsLlLuLlons when Lhe crlsls flrsL hlL, Lhe llquldlLy crlsls
probably could have been resolved more qulckly. Pence, Lhls klnd of governmenL proLecLlon should noL
be resLralned.
1he second klnd of proLecLlon, agalnsL defaulL, ls more problemaLlc. ueposlL lnsurance guaranLees full
paymenL on cerLaln classes of deposlLs-now up Lo $230,000. 1hls guaranLee ls essenLlal for clearlng aL
par and for malnLalnlng a safe and secure paymenLs sysLem. 1here ls no good reason Lo llmlL lulC
lnsurance Lo $230,000, so Lhe cap should be llfLed. 1he quesLlon ls, whlch Lypes of lnsLlLuLlons should be
allowed Lo offer such deposlLs? Cr raLher, whlch Lypes of asseLs would be ellglble for flnanclng uslng
lnsured deposlLs? Some conslderaLlons would lnclude rlsklness of asseLs, maLurlLy of asseLs, and
wheLher purchase of Lhe asseLs fulfllls Lhe publlc purpose: Lhe caplLal developmenL of Lhe economy.
8lsky asseLs puL Lhe lulC on Lhe hook, slnce lL musL pay ouL dollar for dollar, buL lf Lhe lulC resolves a
falllng lnsLlLuLlon, lL recelves only cenLs on each dollar of asseLs. ln hls dlscusslon of Lhe 1reasury's
proposal for resculng Lhe lulC, Mlnsky made clear LhaL cosL Lo Lhe 1reasury" (Mlnsky 1992d, 6) should
noL be a ma[or concern (anoLher reason for removlng Lhe cap: lL ls noL lmporLanL Lo llmlL Lhe 1reasury's
losses Lo Lhe flrsL $230,000 of a deposlL).
lor Lhe same reason, whlle rlsklness of asseLs flnanced by lssulng lnsured deposlLs should be a concern,
poLenLlal losses for Lhe lulC are noL Lhe problem. As Mlnsky argued, Lhese guaranLees are ln facL Lhe
responslblllLy of Lhe lederal 8eserve, whlch wlll always be able Lo meeL Lhem. lurLher, Lhe maLurlLy of
asseLs ls no longer a concern lf Lhe led sLands ready Lo lend reserves as needed, a bank could always
meeL deposlL wlLhdrawals by borrowlng reserves aL Lhe dlscounL wlndow, so lL would noL need Lo sell
longer-Lerm asseLs. Pence, Lhe ma[or argumenL for llmlLlng Lhe ablllLy of flnanclal lnsLlLuLlons Lo flnance
asseL poslLlons by lssulng lnsured deposlLs ls LhaL governmenL has a leglLlmaLe lnLeresL ln promoLlng Lhe
publlc purpose. 8anks should be prevenLed from lssulng lnsured deposlLs ln a manner LhaL causes Lhe
caplLal developmenL of Lhe counLry Lo be lll done."
8anks LhaL recelve governmenL proLecLlon ln Lhe form of llquldlLy and (parLlal) solvency guaranLees are
essenLlally publlc-prlvaLe parLnershlps. 1hey promoLe Lhe publlc purpose by speclallzlng ln acLlvlLles LhaL
Lhey can perform more compeLenLly Lhan Lhe governmenL can. Cne of Lhese ls underwrlLlng: assesslng
credlLworLhlness and bulldlng relaLlons wlLh borrowers LhaL enhance Lhelr wllllngness Lo repay. Cver Lhe
pasL decade, a bellef LhaL underwrlLlng ls unnecessary flowered and Lhen collapsed. llnanclal
lnsLlLuLlons dlscovered LhaL credlL-raLlng scores could noL subsLlLuLe for Lhe due dlllgence lnvolved ln Lhe


22
credlL assessmenL requlred for successful underwrlLlng, ln parL because Lhose scores can be
manlpulaLed, buL also because Lhe ellmlnaLlon of relaLlonshlp banklng changes Lhe behavlor of
borrowers and lenders. 1hls means LhaL pasL defaulL raLes become lrrelevanL Lo assesslng rlsk (as credlL
raLlng agencles seem Lo have dlscovered). lf banks were noL lnvolved ln credlL assessmenL and
underwrlLlng, why would Lhe governmenL need Lhem as parLners? 1he governmenL could [usL flnance
dlrecLly Lhose acLlvlLles LhaL lL percelves Lo be ln Lhe publlc lnLeresL: home morLgages, sLudenL loans,
sLaLe and local governmenL lnfrasLrucLure, and even small-buslness acLlvlLles (commerclal real esLaLe
and worklng caplLal expenses). Where underwrlLlng ls noL seen Lo fulflll a publlc purpose, Lhen Lhe
governmenL can slmply cuL ouL Lhe mlddleman.
lndeed, Lhls was lnlLlally Lhe approach employed for sLudenL loans, and lL ls lnsLrucLlve LhaL lL has been
resLored ln Lhe PealLh Care and LducaLlon 8econclllaLlon AcL of 2010. When Lhe governmenL guaranLees
deposlLs as well as loans (e.g., morLgages and sLudenL loans), Lhe banks' role becomes merely Lo provlde
underwrlLlng.
kestor|ng prof|tab|||ty to re|at|onsh|p-based bank|ng
1he problem banks have faced over Lhe pasL Lhree or four decades ls Lhe cream sklmmlng" of Lhelr
buslness by unlnsured flnanclal lnsLlLuLlons-Lhe shadow banks. unlnsured checkable deposlLs ln
managed funds, such as money markeL muLual funds (MMMls), offered a hlgher-earnlng and relaLlvely
convenlenL alLernaLlve Lo lnsured deposlLs, allowlng much of Lhe paymenLs sysLem Lo bypass banks. ln
Mlnsky's vlew, credlL cards also dlverLed Lhe paymenLs sysLem away from banklng (alLhough Lhe larger
banks now domlnaLe Lhe credlL card buslness).
AL Lhe same Llme, banks were squeezed on Lhe oLher slde of Lhelr balance sheeL by Lhe developmenL of
Lhe commerclal paper markeL, whlch allowed flrms Lo borrow shorL Lerm aL lnLeresL raLes below Lhose
on bank loans (someLlmes, flrms could even borrow more cheaply Lhan some banks). Larger banks
recapLured some of LhaL buslness ln fees earned by provldlng credlL llne guaranLees for lssuers of
commerclal paper.
8uL Lhese compeLlLlve pressures caused banks Lo abandon expenslve relaLlonshlp banklng ln favor of Lhe
orlglnaLe-Lo-dlsLrlbuLe model. 1here ls no slmple soluLlon Lo Lhese compeLlLlve pressures, alLhough
Mlnsky offered some ldeas. lor one, he argued LhaL Lhe paymenLs sysLem should be a proflL cenLer for
banks: Cne weakness of Lhe banklng sysLem cenLers around Lhe Amerlcan scheme of paylng for Lhe
paymenLs sysLem by Lhe dlfferenLlal beLween Lhe reLurn on asseLs and Lhe lnLeresL pald on deposlLs. ln
general Lhe admlnlsLraLlon of Lhe checklng sysLem cosLs some 3.3 percenL of Lhe amounL of deposlLs
sub[ecL Lo check. lf Lhe checklng sysLem were an lndependenL proflL cenLer for banks, Lhen Lhe banks
would be ln a beLLer poslLlon Lo compeLe wlLh Lhe money funds" (Mlnsky 1992a, 36).
lL may noL be deslrable Lo reLurn Lo Lhe condlLlons of Lhe early posLwar perlod, when banks and LhrlfLs
monopollzed Lhe paymenLs sysLem, however, ln Lhe 1800s Lhe federal governmenL ellmlnaLed prlvaLe
banknoLes by placlng a Lax on Lhem. ln a slmllar manner, LransacLlon Laxes could be placed on paymenLs
made Lhrough managed funds, or Lhese funds could be made sub[ecL Lo formal regulaLlon by Lhe led


23
and legal reserve requlremenLs and preferenLlal LreaLmenL glven Lo paymenLs made Lhrough banks, Lo
resLore a compeLlLlve edge. ln addlLlon, banks could be offered lower, subsldlzed fees for use of Lhe
led's clearlng sysLem. Mlnsky (1992d) also held ouL some hope LhaL by subsLlLuLlng deblL cards for
checks, banks could subsLanLlally lower Lhelr cosLs and lncrease Lhelr proflLs from operaLlng Lhe
paymenLs sysLem, alLhough Lhls seems Lo have been concenLraLed more on lncreaslng charges LhaL
reduclng cosLs.
arL of Lhe problem Loday ls LhaL Lhe led requlres LhaL a porLlon of a bank's fundlng come from reLall
deposlLs. As menLloned above, Mlnsky belleved Lhls causes local banks Lo lncur excesslve cosLs by
openlng more offlces Lhan necessary ln order Lo compeLe for reLall deposlLs. arL of Lhe reason for Lhe
new ueal's 8egulaLlon C was preclsely Lo ellmlnaLe compeLlLlon for such deposlLs, on Lhe bellef LhaL lL
ralsed Lhe cosLs of such funds and allowed large reserve clLy banks Lo aLLracL Lhe deposlLs from smaller
rural banks and lnvesL Lhem ln sLock markeL speculaLlon raLher Lhan leavlng Lhem for supporL of local
borrowers.
1he blggesL brand name" banks more easlly aLLracL reLall deposlLs, and Lhey also have Lhe advanLage
LhaL Lhey are percelved Lo be safer. 1hls advanLage could be ellmlnaLed lf banks could fund Lhemselves
by borrowlng reserves on demand aL Lhe led, aL Lhe led's overnlghL lnLeresL raLe-plus any frown
cosLs."
2
Some, lncludlng Mlnsky's one-Llme Levy colleague 8onnle hllllps (1993a, 1993b), have called
for a reLurn Lo Lhe 100 percenL money proposal of lrvlng llsher and MllLon lrledman, whereby deposlL-
lssulng banks would be allowed Lo hold only led reserves and 1reasury debL as asseLs. Mlnsky argued
LhaL Lhls proposal loses slghL of Lhe maln ob[ecL: Lhe caplLal developmenL of Lhe economy. 1he key role
of banklng ls lendlng or, beLLer, flnanclng" (Mlnsky 1992a, 36-37). Whlle he dld noL re[ecL Lhe narrow
bank proposal, he belleved LhaL lL would deal only wlLh Lhe perlpheral problem of Lhe safeLy and
soundness of Lhe paymenLs and savlngs sysLems, and could noL dlrecLly address promoLlon of Lhe caplLal
developmenL of Lhe economy. Powever, Lo Lhe degree LhaL Lhe paymenLs sysLem could be made a proflL
cenLer, Lhls would help Lo promoLe relaLlonshlp banklng.
A|ternat|ve fund|ng source for re|at|onsh|p bank|ng
1he problem ls Lo separaLe Lhe use of deposlL funds Lo supporL Lhe caplLal developmenL of Lhe economy.
8aLher Lhan uslng deposlLs, banks mlghL slmply borrow aL Lhe led Lo flnance Lhelr poslLlons ln asseLs.
8ecall Lhe SmlLhlan problem and Lhe keyneslan problem: banks mlghL flnance Lhe wrong pro[ecLs, and
Lhey mlghL noL flnance Lhe rlghL amounL. Cpenlng Lhe dlscounL wlndow Lo provlde an elasLlc supply of
reserve fundlng ensures LhaL banks can flnance poslLlons ln as many asseLs as Lhey deslre aL Lhe led's
LargeL raLe. (As dlscussed above, Lhe led would lend reserves on demand and remove flnanclng by
means of reLall deposlLs.) 1hls does noL guaranLee LhaL we have solved Lhe keyneslan problem, slnce
banks mlghL flnance Loo much or Loo llLLle acLlvlLy Lo achleve full employmenL. Cfferlng banks unllmlLed
fundlng addresses only Lhe llablllLy slde of banklng, lL leaves Lhe asseL slde open. lL ls somewhaL easler Lo
resolve Lhe Loo much" parL of Lhe keyneslan problem: Lhe led or anoLher regulaLor can slmply lmpose

!
"lor Lhls reason, Warren Mosler (2010) has called for Lhe ellmlnaLlon of any requlremenL LhaL banks malnLaln a
speclfled proporLlon of Lhelr fundlng ln Lhe form of reLall deposlLs.


24
consLralnLs on bank purchases of asseLs when banks are flnanclng Loo much acLlvlLy. lor example,
durlng Lhe recenL real esLaLe boom lL was obvlous (excepL, apparenLly, Lo malnsLream economlsLs and Lo
many aL Lhe led) LhaL lendlng should be curLalled.
1he problem here ls LhaL Lhe orLhodox response Lo Loo much lendlng ls Lo ralse Lhe federal funds LargeL
raLe. And because borrowlng ls noL very lnLeresL senslLlve, especlally ln a euphorlc boom, raLes musL rlse
sharply Lo have much effecL. lurLher, ralslng raLes confllcLs wlLh Lhe led's goal of malnLalnlng flnanclal
sLablllLy, slnce-as Lhe volcker experlmenL showed-lnLeresL raLe hlkes LhaL are sufflclenLly large Lo klll a
boom are also large enough Lo cause severe flnanclal dlsrupLlon (someLhlng llke Lhree-quarLers of all
LhrlfLs were drlven Lo Lechnlcal lnsolvency durlng Lhe LhrlfL crlsls). ln facL, Mlnsky argued LhaL Lhe early
1990s banklng crlsls was due Lo Lhe afLermaLh of Lhe volcker experlmenL of a decade earller. lndeed,
Lhls recognlLlon ls parL of Lhe reason LhaL Lhe Creenspan and 8ernanke led Lurned Lo graduallsm," a
serles of very small raLe hlkes LhaL are well Lelegraphed. unforLunaLely, markeLs have plenLy of Llme Lo
prepare and Lo compensaLe for raLe hlkes, whlch means LhaL lendlng ls even less lnLeresL senslLlve.
lor Lhese reasons, raLe hlkes are noL an approprlaLe means of conLrolllng bank lendlng. lnsLead, Lhe
conLrols should be dlrecL: ralslng down paymenLs and collaLeral requlremenLs, and even lssulng cease-
and-deslsL orders Lo prevenL furLher flnanclng of some acLlvlLles. lL was generally belleved LhaL lmposlng
caplLal requlremenLs would be a more efflclenL way Lo regulaLe bank lendlng: hlgher caplLal
requlremenLs should noL only make banks safer buL also consLraln bank lendlng, unless Lhe banks can
access caplLal markeLs Lo ralse more equlLy caplLal. nelLher clalm was correcL. Plgher caplLal
requlremenLs were lmposed ln Lhe afLermaLh of Lhe LhrlfL flasco, and codlfled ln Lhe 8asel agreemenLs.
8aLher Lhan consLralnlng bank purchases of asseLs, banks slmply moved asseLs and llablllLles off Lhelr
balance sheeLs.
8asel also lmposed rlsk-ad[usLed welghLlngs for caplLal requlremenLs Lo encourage banks Lo hold less
rlsky asseLs, for whlch Lhey were rewarded wlLh lower caplLal requlremenLs. unforLunaLely, Lhe
regulaLlons had unlnLended consequences slnce Lhe banks supporLed proflLs by lendlng ln Lhe rlsklesL
poslLlons ln each class and worked wlLh lnvesLmenL banks Lo creaLe credlL guaranLees LhaL reduced or
ellmlnaLed caplLal requlremenLs.
llnally, Mlnsky (1986) argued LhaL, all else belng equal, hlgh caplLal raLlos necessarlly reduce Lhe reLurn
on equlLy (and hence, Lhe growLh of neL worLh), so lL ls noL necessarlly Lrue LhaL hlgher caplLal raLlos
lmprove bank safeLy, slnce Lhey mean lower proflLablllLy. lndeed, wlLh hlgher caplLal raLlos banks musL
selecL a hlgher rlsk/reLurn asseL porLfollo Lo achleve a LargeLed reLurn on equlLy (1ymolgne and Wray
2009). Agaln, lf regulaLors wanL Lo consLraln Lhe growLh raLe of lendlng, dlrecL credlL conLrols may be
more efflclenL.
Solvlng Lhe SmlLhlan problem may Lhus requlre dlrecL overslghL of a bank's acLlvlLy, mosLly on Lhe asseL
slde of lLs balance sheeL. llnanclal acLlvlLles LhaL furLher Lhe caplLal developmenL of Lhe economy need
Lo be encouraged, Lhose LhaL cause lL Lo be lll done" need Lo be dlscouraged. Cne of Lhe reasons LhaL
Mlnsky wanLed Lhe led Lo lend reserves Lo all comers was so LhaL prlvaLe lnsLlLuLlons would be ln Lhe


23
bank"-LhaL ls, lndebLed Lo Lhe led. As a credlLor, Lhe led would be able Lo ask Lhe banker Lhe quesLlon,
Pow wlll you repay me?
1he lederal 8eserve's powers Lo examlne are lnherenL ln lLs ablllLy Lo lend Lo banks
Lhrough Lhe dlscounL wlndow. As a lender Lo banks, elLher as Lhe normal provlder of Lhe
reserve base Lo commerclal banks (Lhe normal operaLlon prlor Lo Lhe greaL depresslon)
or as Lhe poLenLlal lender of lasL resorL, cenLral banks have a rlghL Lo knowledge abouL
Lhe balance sheeL, lncome and compeLence of Lhelr cllenLs, banks and bank
managemenLs. 1hls ls no more Lhan any bank belleves lL has Lhe rlghL Lo know abouL lLs
cllenLs. (Mlnsky 1992d, 10)
1he led would ask Lo see evldence for Lhe cash flow LhaL would enable Lhe bank Lo servlce loans. lL ls
common pracLlce for a cenLral bank Lo lend agalnsL collaLeral, uslng a halrcuL" Lo favor cerLaln klnds of
asseLs (e.g., a bank mlghL be able Lo borrow 100 cenLs on Lhe dollar agalnsL governmenL debL buL only
73 cenLs agalnsL a dollar of morLgage debL). CollaLeral requlremenLs and halrcuLs can be used Lo
dlsclpllne banks-Lo lnfluence Lhe klnds of asseLs Lhey purchase.
LxamlnaLlon of a bank's books also allows Lhe led Lo look for rlsky pracLlces and keep abreasL of
developmenLs. 1he led falled Lo appreclaLe Lhe rlsk of Lhe crlsls LhaL began ln 2007, ln parL because lL
generally supplled reserves ln open markeL operaLlons raLher Lhan aL Lhe dlscounL wlndow. lorclng
prlvaLe banks lnLo Lhe bank" gave Lhe led more leverage over Lhelr acLlvlLles. lor Lhls reason, Mlnsky
opposed Lhe 1reasury's proposal Lo sLrlp Lhe led of some of lLs responslblllLy for Lhe regulaLlon and
overslghL of lnsLlLuLlons. lf anyLhlng, he would have lncreased Lhe led's role, and used Lhe dlscounL
wlndow as an lmporLanL Lool for overslghL.
romot|ng an a|ternat|ve to megabanks: Commun|ty deve|opment banks
Mlnsky worrled LhaL Lhe Lrend Loward megabanks may well allow Lhe weakesL parL of Lhe sysLem, Lhe
glanL banks, Lo expand, noL because Lhey are efflclenL buL because Lhey can use Lhe clouL of Lhelr large
asseL base and cash flows Lo make llfe uncomforLable for local banks: predaLory prlclng and corners [of
Lhe markeL] cannoL be ruled ouL ln Lhe Amerlcan conLexL" (Mlnsky 1992d, 12). lurLher, slnce Lhe slze of
loans depends on Lhe caplLal base, blg banks have a naLural afflnlLy for Lhe blg deals," whlle small banks
servlce smaller cllenLs: A 1 bllllon dollar bank may well have 80 mllllon dollars ln caplLal. lL Lherefore
would have an 8 Lo 12 mllllon dollar maxlmum llne of credlL. . . . [ln Lhe uS] conLexL Lhls means Lhe
normal cllenL for such banks ls a communlLy or smaller buslness: such banks are small buslness
developmenL corporaLlons" (lbld.).
lor Lhls reason, Mlnsky advocaLed a proacLlve governmenL pollcy Lo creaLe and supporL small
communlLy developmenL banks (Cu8s) (Mlnsky eL al. 1993). very brlefly, Lhe argumenL advanced was
LhaL Lhe caplLal developmenL of Lhe naLlon and of communlLles ls fosLered vla Lhe provlslon of a broad
range of flnanclal servlces. unforLunaLely, many communlLles, lower-lncome consumers, and smaller
and sLarL-up flrms are lnadequaLely provlsloned wlLh Lhese servlces. lor example, many communlLles


26
hosL far more check-cashlng ouLleLs and pawnshops Lhan bank offlces. Many households do noL even
have access Lo Lhe LransacLlon sysLem because Lhey do noL have a checklng accounL.
Small buslnesses ofLen flnance acLlvlLles uslng credlL card debL. lndeed, some credlL card companles
offer speclal credlL card servlces ln supporL of Lhe flnanclng of small buslnesses LhaL do noL have access
Lo bank lendlng. Mlnsky's proposal would creaLe a neLwork of small communlLy developmenL banks Lo
provlde a full range of servlces for underserved communlLles and small buslnesses:
a paymenL sysLem for check cashlng and clearlng, and for credlL and deblL cards,
secure deposlLorles for savlngs and LransacLlon balances,
household flnanclng for houslng, consumer debLs, and sLudenL loans,
commerclal banklng servlces for loans, payroll servlces, and advlce,
lnvesLmenL banklng servlces for deLermlnlng Lhe approprlaLe llablllLy sLrucLure
for Lhe asseLs of a flrm, and placlng Lhose llablllLles, and (6) asseL managemenL
and advlce for households. (Mlnsky eL al. 1993, 10-11)
1he lnsLlLuLlons would be kepL small, local, and proflLable. 1hey would be publlc-prlvaLe parLnershlps,
wlLh a new lederal 8ank for CommunlLy uevelopmenL 8anks creaLed Lo provlde equlLy and Lo charLer
and supervlse Lhe Cu8s. Lach Cu8 would be organlzed as a bank holdlng company. Such lnsLlLuLlons
have long been presenL ln Lurope, servlng speclal groups such as farmers (8alffelsen banks), small
buslnessmen (cooperaLlve banks), and local resldenLs (frlendly socleLles). AlmosL all of Lhese lnsLlLuLlons
were muLual banks, LhaL ls, Lhe deposlLors and cllenLs of Lhe banks were Lhe owners and beneflclarles.
romote enterpr|se and |ndustry over specu|at|on
Cver pasL decades, Lhe bellef LhaL markeLs work Lo promoLe Lhe publlc lnLeresL" galned ln popularlLy.
Mlnsky was skepLlcal. Pe belleved LhaL lL was necessary Lo make lndusLry" more lmporLanL Lhan
speculaLlon."
3
lf lnvesLmenL ls mlsdlrecLed, we noL only wasLe resources buL also geL a boom-and-busL
Lra[ecLory. lf lnvesLmenL ls Loo low, we noL only suffer from unemploymenL buL also achleve proflLs Loo
low Lo supporL commlLmenLs, leadlng Lo defaulL. lurLher, when proflLs are low ln lndusLry," problems
arlse ln Lhe flnanclal secLor, slnce commlLmenLs cannoL be meL. ln LhaL case, lndlvldual proflL-seeklng
behavlor leads Lo lncoherenL resulLs, as flnanclal markeLs, labor markeLs, and goods markeLs all reacL ln
a manner LhaL causes wages and prlces Lo fall, generaLlng a debL deflaLlon. unforLunaLely, Lhlngs are noL
beLLer when lnvesLmenL ls Loo hlgh: lL generaLes lncreased layerlng of flnanclal commlLmenLs and hlgh
proflLs LhaL reward unnecessary lnnovaLlon, leadlng Lo greaLer rlsk Laklng and evenLually produclng a
flnanclal sLrucLure LhaL ls Loo fraglle. As Mlnsky always argued, Lhe really dangerous lnsLablllLy ln a

3
Lcholng keynes (1936), 1he poslLlon becomes serlous when enLerprlse becomes Lhe bubble on a whlrlpool of
speculaLlon" (chap. 12, 139).




27
caplLallsL economy ls ln Lhe upward dlrecLlon-Loward a boom. 1haL ls whaL makes a debL deflaLlon
posslble, as asseL prlces become overvalued and Loo much unservlceable debL ls lssued.
M|nsky's comprehens|ve stab|||ty po||cy
AlLhough Mlnsky ls besL known for hls analysls of flnanclal lnsLablllLy and hls recommendaLlons for
cenLral bank reform (Lo have Lhe cenLral bank focus on flnanclal sLablllLy and llmlL lLs lnLervenLlons ln
areas besL lefL Lo flscal pollcy: conLrolllng Lhe level of economlc acLlvlLy and, ln parLlcular, Lhe level of
goods prlces), he belleved LhaL flnanclal sLablllLy would requlre more comprehenslve pollcy reforms. An
lnapproprlaLe flnanclng of lnvesLmenL and caplLal asseL ownershlp are Lhe ma[or desLablllzlng lnfluences
ln a caplLallsL economy. 1hus, Lhe subsLlLuLlon of employmenL for lnvesLmenL as Lhe proxlmaLe ob[ecLlve
of economlc pollcy ls a precondlLlon for flnanclal reforms almed aL decreaslng lnsLablllLy." 1he
emphasls on lnvesLmenL and 'economlc growLh' raLher Lhan on employmenL as a pollcy ob[ecLlve ls a
mlsLake. A full-employmenL economy ls bound Lo expand, whereas an economy LhaL alms aL
acceleraLlng growLh Lhrough devlces LhaL lnduce caplLal-lnLenslve prlvaLe lnvesLmenL noL only may noL
grow, buL may be lncreaslngly lnequlLable ln lLs lncome dlsLrlbuLlon, lnefflclenL ln lLs cholces of
Lechnlques, and unsLable ln lLs overall performance" (Mlnsky 2008 [1986], 330).
lor Mlnsky, supporL of employmenL could be besL secured Lhrough a dlrecL CovernmenL LmploymenL
CuaranLee rogram ln whlch Lhe governmenL offered employmenL Lo all Lhose wllllng and able Lo work
aL a wage near Lhe prevalllng mlnlmum. 1he ldea was Lo supporL Lhe cash flows LhaL valldaLe asseLs
Lhrough acLual sales raLher Lhan Lhrough lncreaslng borrowlng or lncreaslng prlces. 1he Levy lnsLlLuLe
has conLlnued Lo pursue Lhls parLlcular llne of research (see under 8elaLed Levy lnsLlLuLe ubllcaLlons
below: november 2011 8esearch ro[ecL 8eporL, ollcy noLe 2012/2, ubllc ollcy 8rlef no. 120, and
Worklng apers nos. 649, 630, 633, 633, 639, 681, 706, and 707).
When faced wlLh Lhe currenL crlsls, largely drlven by household borrowlng Lo supporL consumpLlon
spendlng, Mlnsky would cerLalnly have replled LhaL lf consumpLlon had been flnanced by wages
lncreaslng ln sLep wlLh producLlvlLy raLher Lhan belng Lransferred Lo Lhe flnanclal secLor, much of Lhe
crlsls could have been avolded. Consumer debL would have been lower, and lf banks had Lransferred
Lhelr hlgher earnlngs Lo Lhelr reserves raLher Lhan paylng large bonuses, Lhelr caplLal sLrucLure would
have been more solld. lor Mlnsky, Lhe lmpacL of Lhe flnanclal lnsLablllLy of lncome dlsLrlbuLlon would
have been a ma[or facLor.
llnally, Mlnsky was also a flrm bellever ln Abba Lerner's concepL of funcLlonal flnance"-LhaL ls, LhaL
Lhe governmenL budgeL should have full employmenL raLher Lhan balance as lLs ob[ecLlve. 1he budgeL
balance, surplus, or deflclL becomes largely lrrelevanL once Lhe lmpacL of governmenL spendlng on
prlvaLe secLor budgeL balances and on lLs ablllLy Lo meeL lLs flnanclal commlLmenLs ls recognlzed. 1hus,
Mlnsky would have much preferred LhaL Lhe recenL lncrease ln budgeL expendlLures were dlrecLed flrsL
Lo households faclng reduced lncomes and an lmpalred ablllLy Lo meeL Lhelr morLgage commlLmenLs,
raLher Lhan dlrecLly Lo Lhe banks Lo remove Lhe lmpalred morLgages from Lhelr balance sheeLs. 8uL Lhls
slmple approach reflecLs hls baslc bellef LhaL boLh Lhe governmenL and Lhe flnanclal sysLem exlsL Lo
serve Lhe prlvaLe clLlzen, and noL vlce versa.


28
CnA1Lk 3. kegu|at|on |n the M|dst of the Cr|s|s

Cne of Lhe llLLle-noLlced aspecLs of Lhe crlsls ls LhaL lL lnvolved a progresslve regulaLory response as lL
evolved from dlsrupLlon ln Lhe subprlme markeL Lo Lhe full-scale melLdown and vlrLual lnsolvency of Lhe
enLlre flnanclal sysLem. 1he evoluLlon of Lhe crlsls and lLs correspondlng regulaLory reacLlons Look place
ln sLages, lnLerspersed wlLh whaL appeared Lo be Lhe sysLem's reLurn Lo normalcy. 1hree sLages can be
dlscerned: (1) regulaLlon and supervlslon, (2) securlLlzaLlon, and (3) a run on lnvesLmenL banks. Lach
sLage can be assoclaLed wlLh a parLlcular fallure of regulaLory supervlslon. lL Lhus became posslble Lo
argue aL each sLage LhaL all LhaL was necessary was Lhe approprlaLe appllcaLlon of exlsLlng regulaLlons,
and LhaL noLhlng more needed Lo be done. 1hls scenarlo progressed unLll Lhe collapse of Lehman
8roLhers broughL abouL a full-scale recesslon and aLLenLlon Lurned Lo supporL of Lhe real economy and
employmenL, leavlng more fundamenLal flnanclal reregulaLlon ln Lhe background unLll Lhe uodd-lrank
AcL (see chapLer 4). 1hls chapLer focuses on Lhe more lmmedlaLe regulaLory and pollcy reacLlons Lo Lhe
crlsls.
AfLer Lhe 2006 reversal of house prlce lncreases and Lhe Lrlgger of lnLeresL raLe ad[usLmenLs lncluded ln
opLlon morLgages, lncreaslng defaulL raLes led Lo Lhe lnsolvency of large morLgage orlglnaLors such as
new CenLury and CounLrywlde. As a resulL, ln Lhe sprlng of 2007 markeL aLLenLlon was focused on Lhe
regulaLlons governlng morLgage lendlng. 1hls was Lhe sLage ln whlch Lhe crlsls was consldered Lo have
been conLalned." Losses were conLalned" ln Lhe sense LhaL Lhey were prlmarlly absorbed by Lhe
households who could no longer meeL Lhelr paymenLs on nonLradlLlonal morLgages. 1he bankrupLcy
[udge deallng wlLh new CenLury recommended LhaL managemenL be Lrled for fraud and requlred Lo
repay bonuses LhaL had been pald agalnsL flcLlLlous proflLs generaLed by lnaccuraLe and probably
fraudulenL bookkeeplng pracLlces. ln uecember, Lhe SecurlLles and Lxchange Commlsslon (SLC)
announced LhaL lL would press charges agalnsL Lhree members of Lhe flrm's Lop managemenL. 1he led
evenLually responded by amendlng 8egulaLlon Z (1ruLh ln Lendlng) under Lhe Pome Cwnershlp and
LqulLy roLecLlon AcL (PCLA) ln !uly 2008.
Long before Lhe led moved Lo acL, Lhe lmpacL of morLgage defaulLs had reduced Lhe value of Lhe
morLgages conLalned ln Lhe securlLlzed asseLs LhaL had been orlglnaLed by banks. 1hls caused losses ln
Lhe securlLlzed sLrucLures and dlrecLed aLLenLlon Lo Lhe monollne lnsurers and Lhe conLlngenL llquldlLy
guaranLees, credlL defaulL swaps, and oLher C1C derlvaLlve conLracLs LhaL were supposed Lo cover Lhese
losses. As many banks had also provlded slmllar guaranLees, Lhe losses meanL Lhey had Lo be recognlzed
on Lhelr balance sheeLs and charged agalnsL Lhe banks' caplLal base under exlsLlng caplLal adequacy
requlremenLs. ln response Lo Lhese losses, banks were able Lo lssue new equlLy Lo ralse addlLlonal
caplLal Lo cover losses, and Lhe vlew prevalled LhaL Lhe crlsls had been overcome. 1hls was relnforced by
Lhe led-englneered rescue of 8ear SLearns vla a pass-Lhrough loan from !Morgan Chase. 1hls supporL
was evenLually lnsLlLuLlonallzed ln a speclal lederal 8eserve rlmary uealer CredlL laclllLy LhaL was
exLended Lo all uS governmenL securlLles dealers, and Lhen supplemenLed by Lhe 1erm SecurlLles
Lendlng laclllLy for prlmary dealers.


29
llnally, ln SepLember 2008, Lhe lnsolvency of Lehman 8roLhers's morLgage and real esLaLe unlLs
produced a compleLe collapse of shorL-Lerm money markeLs, lncludlng MMMls. 1hls Llme, Lhe problem
faclng Lhe sysLem was consldered Lo be llquldlLy, noL caplLallzaLlon, and Lhe response was a full lulC
guaranLee of vlrLually all shorL-Lerm llablllLles of flnanclal lnsLlLuLlons ln Lhe sysLem, Lhe openlng of Lhe
dlscounL wlndow Lo all prlvaLe secLor buslness, and a declslon allowlng vlrLually all asseLs Lo serve as
collaLeral. 1he alm was Lo avold an old-sLyle deposlL run on flnanclal lnsLlLuLlons. 1he led allowed lLs
balance sheeL Lo expand Lo absorb Lhe flnanclal asseLs LhaL Lhe prlvaLe secLor was no longer wllllng Lo
hold. As 8lchard kahn had polnLed ouL long ago, lL ls Lhe role of Lhe banklng sysLem Lo hold Lhe asseLs
LhaL Lhe publlc chooses noL Lo hold, and lL ls Lhe role of Lhe cenLral bank Lo hold Lhe asseLs LhaL Lhe
prlvaLe flnanclal sysLem chooses noL Lo hold. 1he led Lhus llquefled Lhe porLfollo holdlngs of Lhe prlvaLe
secLor by provldlng reserves ln exchange. lor Lhe banks, Lhls lnvolved expanslon of Lhelr reserve accounL
balances and, ln addlLlon, Lhe led sLarLed Lo offer lnLeresL on Lhe gross reserve poslLlons of Lhe banks ln
order Lo lncrease Lhe llquldlLy of lnLerbank lendlng (see kregel 2008b).
1he dlfflculLy wlLh Lhls response Lo Lhe crlsls ls LhaL Lhe agencles ln charge of overslghL were conLlnually
reacLlng Lo a parLlcular fallure of Lhe exlsLlng sysLem and aLLempLlng Lo provlde changes ln regulaLlon Lo
resLore Lhe normal funcLlonlng of Lhe parLlcular secLor LhoughL Lo have been Lhe source of Lhe problem.
lf LhaL problem was subprlme morLgages, Lhe Lhlnklng wenL, Lhen lnLroduce regulaLlons Lo deal wlLh Lhe
problems creaLed by subprlme morLgages, lf Lhe problem was caplLal adequacy, revlse Lhe caplLal
adequacy regulaLlons, lf Lhe problem was lnsufflclenL llquldlLy, lnLroduce more sLrlngenL llquldlLy
requlremenLs. 8uL lf Lhe normal" funcLlonlng of Lhe sysLem ls Lhe problem, Lhen slmple repalr wlll never
produce reregulaLlon of Lhe sysLem.
Stage one: kegu|at|on and superv|s|on of mortgage |end|ng
Whlle lL has been argued LhaL morLgage lendlng was sub[ecL Lo lax regulaLlon, Lhls ls noL preclsely Lrue. lL
would be more accuraLe Lo say LhaL exlsLlng regulaLlons were noL applled and LhaL supervlslon was lax
by deslgn raLher Lhan by overslghL. Accordlng Lo Lhe MorLgage 8rokers AssoclaLlon, MorLgage brokers
are regulaLed by more Lhan Len federal laws, flve federal enforcemenL agencles and aL leasL forLy-nlne
sLaLe regulaLlon and llcenslng sLaLuLes. Moreover, morLgage brokers, who Lyplcally operaLe as small
buslness owners, musL also comply wlLh a number of laws and regulaLlons governlng Lhe conducL of
commerclal acLlvlLy wlLhln Lhe sLaLes" (ulnham 2006).
4


4
MorLgage brokers are governed by a hosL of federal laws and regulaLlons. lor example, morLgage brokers musL
comply wlLh: Lhe 8eal LsLaLe SeLLlemenL rocedures AcL (8LSA), Lhe 1ruLh ln Lendlng AcL (1lLA), Lhe Pome
Cwnershlp and LqulLy roLecLlon AcL (PCLA), Lhe lalr CredlL 8eporLlng AcL (lC8A), Lhe Lqual CredlL CpporLunlLy
AcL (LCCA), Lhe Cramm-Leach-8llley (CL8) AcL, and Lhe lederal 1rade Commlsslon AcL (l1C AcL), as well as falr
lendlng and falr houslng laws. . . . AddlLlonally, morLgage brokers are under Lhe overslghL of Lhe ueparLmenL of
Pouslng and urban uevelopmenL (Puu) and Lhe lederal 1rade Commlsslon (l1C), and Lo Lhe exLenL Lhelr
promulgaLed laws apply Lo morLgage brokers, Lhe lederal 8eserve 8oard, Lhe lnLernal 8evenue Servlce, and Lhe
ueparLmenL of Labor" (ulnham 2006).


30
ln addlLlon,
MorLgage brokers are llcensed or reglsLered and musL comply wlLh prellcensure and
conLlnulng educaLlon requlremenLs and crlmlnal background checks ln forLy-nlne sLaLes
and Lhe ulsLrlcL of Columbla. AddlLlonally, over half of Lhese sLaLes requlre noL only
morLgage broker llcensure, buL Lhe llcensure or reglsLraLlon of brokers' lndlvldual loan
offlcers as well. An lncreaslng number of sLaLes are requlrlng Lhese orlglnaLors Lo pass
LesLs ln order Lo become llcensed. (ulnham 2006)
Powever,
1he same ls noL Lrue for Lhe Lhousands of loan offlcers employed by morLgage bankers
and oLher lenders, who are exempL ln mosL sLaLes from loan offlcer llcenslng sLaLuLes.
Whlle Lhe Cfflce of Lhe CompLroller of Lhe Currency exempLs deposlLory lnsLlLuLlons
from sLaLe llcenslng requlremenLs, Lhe sLaLes conLlnue Lo lncrease Lhelr regulaLlon of
morLgage brokers and Lhelr lndlvldual loan offlcers. Many sLaLes also exempL lenders
from llcenslng lf Lhey are approved by lannle Mae or Puu, whlch sub[ecLs Lhose lenders
and Lhelr employees Lo slgnlflcanLly less regulaLlon Lhan mosL morLgage brokers. As
small buslnessmen and women, morLgage brokers musL also comply wlLh numerous
predaLory lendlng and consumer proLecLlon laws, regulaLlons and ordlnances (l.e., uuA
laws). Agaln, Lhls ls noL Lrue for a greaL number of deposlLory banks, morLgage bankers,
morLgage lenders and Lhelr employed loan offlcers, whlch remaln exempL due Lo federal
agency preempLlon. Many sLaLes also sub[ecL morLgage brokers Lo overslghL, audlL
and/or lnvesLlgaLlon by morLgage regulaLors, Lhe sLaLe's aLLorney general, or anoLher
sLaLe agency, and ln some lnsLances all Lhree. (ulnham 2006)
Consumer proLecLlon organlzaLlons have provlded exLenslve evldence concernlng Lhe fallure of
regulaLory agencles Lo apply exlsLlng regulaLlons (see CenLer for 8esponslble Lendlng 2009). Lven before
Lhe lnLroducLlon of Lhe CL8 AcL ln 1999, bank holdlng companles had opened morLgage afflllaLes, or
purchased lndependenL consumer flnance companles LhaL had enLered Lhe markeL for subprlme
morLgages. Lven Lhough Lhe led was granLed responslblllLy for Lhe supervlslon of bank holdlng
companles, lL declded LhaL Lhese afflllaLes would noL be supervlsed for compllance wlLh federal laws
proLecLlng borrowers slnce Lhey had noL been prevlously sub[ecL Lo regulaLlon. ln !anuary 1998, Lhe
8oard of Covernors of Lhe lederal 8eserve SysLem unanlmously declded Lo formallze a long-sLandlng
pracLlce Lo noL rouLlnely conducL consumer compllance examlnaLlons of nonbank subsldlarles of bank
holdlng companles" or lnvesLlgaLe consumer complalnLs relaLlng Lo Lhese subsldlarles" (l88 1998). 1hls
declslon was Lhen applled Lo any nonbank flnanclal lnsLlLuLlon LhaL became Lhe afflllaLe of a bank
holdlng company. A 1999 reporL by Lhe Ceneral AccounLlng Cfflce (CAC) warned LhaL Lhe led's declslon
creaLed a lack of regulaLory overslghL," because Lhe led alone was ln a poslLlon Lo supervlse Lhe
afflllaLes. lLs role as regulaLor of bank holdlng companles was sLrengLhened ln CL8, buL was only
exerclsed for morLgages orlglnaLed Lhrough Lhe banklng afflllaLe of Lhe holdlng company.


31
1hus, [usL as banks were movlng Lhelr caplLal exposure Lo morLgage lendlng off balance sheeL Lhrough
Lhe creaLlon of SLs, Lhey moved Lhese acLlvlLles ouLslde Lhe purvlew of regulaLors by creaLlng and
acqulrlng morLgage afflllaLes LhaL were Lechnlcally regulaLed, buL had been declared ouLslde Lhe purvlew
of led supervlslon. As a resulL, around 13 percenL of Lhe naLlonal LoLal of subprlme loans made beLween
2004 and 2007 by bank afflllaLes were de facLo unregulaLed, even Lhough Lhe lederal 8eserve had de
[ure power Lo do so. A 2000 [olnL reporL on predaLory lendlng by Lhe 1reasury ueparLmenL and Lhe
ueparLmenL of Pouslng and urban uevelopmenL had noLed Lhe fallure of Lhe led Lo use lLs auLhorlLy Lo
lnvesLlgaLe evldence of abuslve lendlng pracLlces and urged a pollcy of LargeLed examlnaLlons, long
before Lhe currenL abuses commenced (uSu1 and Puu 2000).
Stage two: Mortgage secur|t|zat|on
AlLhough home prlces had sLopped rlslng ln many areas by early Lo mld 2006, and defaulLs and
foreclosures had reached a sufflclenL level Lo cause dlsLress and evenLual bankrupLcy for some of Lhe
larger morLgage orlglnaLors (such as new CenLury) ln Lhe flrsL quarLer of 2007, lL was only Lhe dlscovery
of Lhe conLlngenL llablllLles LhaL many large flnanclal holdlng companles had lssued Lo arms-lengLh" Slvs
LhaL ushered ln Lhe second phase of Lhe morLgage crlsls. lL ls lnLeresLlng LhaL aL Lhls sLage Lhe vlablllLy of
Lhe securlLlzed subprlme loan vehlcles, Lhelr Lrlple-A credlL raLlngs, and Lhe role of monollne lnsurers
and credlL defaulL swaps ln supporLlng Lhose raLlngs had yeL Lo fully appear. 8aLher, lL was Lhe absence
of varlable-lnLeresL Slvs on Lhe reporLed balance sheeLs of banks and Lhe regulaLlons LhaL governed Lhelr
accounLlng procedures. 1hese enLlLles were Lhe resulL of Lwo Lrends ln Lhe flnanclal markeLs of Lhe
1980s LhaL broke Lhe barrlers beLween flxed-lnLeresL securlLles and equlLles Lhrough Lhe lnvenLlon of Lhe
[unk bond.
ln 1998, Lwo ClLlbank employees, SLephen arLrldge-Plcks and nlcholas Sossldls, seL up a fund LhaL
would lssue shorL-Lerm commerclal paper and medlum-Lerm noLes Lo lnvesLors and Lhen use Lhe money
Lo buy Lhe hlgher-yleldlng, longer-Lerm CuCs of commerclal real esLaLe or credlL card recelvables LhaL
were [usL belng perfecLed. 1he fund's asseLs would belong Lo Lhe holders of Lhe medlum-Lerm noLes,
who would be responslble for Lhe fund's debL lf Lhe commerclal paper fundlng dlssolved. 1he asseLs
would Lhus sLay off Lhe bank's balance sheeL buL would generaLe fees by orlglnaLlng Lhe asseLs and
organlzlng and servlclng whaL was Lo become Lhe model for Lhe Slv and a ma[or desLlnaLlon for bank-
securlLlzed subprlme loans.
1he second elemenL LhaL supporLed Lhe use of Slvs was Lhe regulaLory response Lo Lhe use of off-
balance-sheeL enLlLles afLer Lhe Lnron bankrupLcy. Lnron had used Lhese SLs, creaLed by lLs lnvesLmenL
bankers, for a dlfferenL purpose: Lhe generaLlon of lncome from flcLlLlous sales LhaL allowed Lhe
company Lo manlpulaLe lLs reporLed earnlngs flgures and, Lhus, lLs sLock prlce. lor banks, on Lhe oLher
hand, Lhe advanLage ln Lhls procedure lay ln Lhe ablllLy Lo remove Lhe asseLs sold Lo Lhese enLlLles from
Lhelr consolldaLed reporLlng, Lhereby reduclng or ellmlnaLlng Lhe amounL of regulaLory caplLal LhaL had
Lo be held agalnsL Lhem. 1he regulaLory ad[usLmenL Lo accounLlng requlremenLs for off-balance-sheeL
enLlLles were Lhus drlven by dlfferenL needs and Lo ellmlnaLe a dlfferenL problem Lhan was aL lssue aL
Lnron. 1he resulLlng changes provlded subsLanLlal supporL for Lhe use of such enLlLles by banks afLer Lhe
new regulaLlons were lnLroduced ln 2002.


32
1he uS AccounLlng SLandards 8oard resLrlcLed Lhe use of off-balance-sheeL accounLlng ln Lhe wake of
Lnron. 1he orlglnal rules had been based on Lhe share of equlLy ownershlp ln Lhe enLlLy. 1he share aL
whlch consolldaLlon would be requlred was seL by lnLerpreLaLlon aL 3 percenL of LoLal equlLy. 1hus,
Lnron was noL requlred Lo consolldaLe any speclal enLlLy ln whlch lL had less Lhan 97 percenL of Lhe
equlLy ownershlp. 1he problems aL Lnron were creaLed by Lhe facL LhaL lLs employees were provldlng
Lhe 3 percenL wlLh funds lenL Lo Lhem by otoo.
1he new llnanclal AccounLlng SLandards 8oard (lAS8) accounLlng rules moved away from a slmple share
of owners' equlLy and concenLraLed on effecLlve conLrol Lhrough Lhe ablllLy Lo lnfluence Lhe dally
operaLlons of Lhe company and Lhe asslgnmenL of loss lf Lhere were a decllne ln asseL values. 1hls
revlslon creaLed Lhe caLegory of varlable lnLeresL enLlLy," or vlL, as Lhe posL-Lnron verslon of Lhe SL
LhaL had led Lo LhaL company's demlse. 1he Slv creaLed by Lhe ClLlbankers provlded a perfecL example of
a quallfylng vlL, slnce Lhe orlglnaLlng bank had no equlLy lnLeresL, nor dld lL bear Lhe flrsL rlsk of loss lf
Lhe commerclal paper could noL be rolled over and Lhe asseLs sold aL a loss. 1hey Lhus became a
reposlLory for Lhe Lrlple-A Lranches of Lhe securlLlzed subprlme morLgage obllgaLlons, buL Lhey were noL
reporLed on any ma[or bank's consolldaLed balance sheeL, nor dld Lhe asseLs requlre provlslon of bank
caplLal.
When Lroubles wlLh subprlme morLgage loans became an lssue for bank solvency ln Lhe summer of
2007, Slvs dldn'L appear Lo be affecLed because lL was LhoughL LhaL few had lnvesLed ln collaLerallzed
asseLs LhaL conLalned subprlme loans. ln !uly, Moody's lnvesLors Servlce consldered Slvs an oasls of
calm ln Lhe subprlme maelsLrom" (Shenn 2007). Powever, by laLe !uly, a bank afflllaLe seL up by Cerman
bank lk8 ueuLsche lndusLrlebank reporLed fundlng dlfflculLles, and ln AugusL, Cheyne llnance (a $6.6
bllllon Slv operaLed by a London hedge fund) began llquldaLlng asseLs Lo repay debLs. Cn SepLember 6,
ClLlbank announced LhaL lLs Slvs had llLLle subprlme exposure, buL LhaL lL was also selllng asseLs.
1hus, Lhe subprlme morLgage lendlng carrled ouL by a large bank holdlng company could escape
supervlslon lf lL Look place ln a morLgage afflllaLe. 1he morLgages Lhe afflllaLe generaLed could escape
markeL scruLlny lf Lhey were packaged lnLo CMCs LhaL were sold Lo Slvs LhaL were noL sub[ecL Lo
supervlslon of caplLal adequacy and were regulaLed, lf aL all, under Lhe SLC secLlon 144a prlvaLe
placemenL exempLlon. Sales of such asseLs are consldered prlvaLe LransacLlons, whose conLenLs and
deLalls need only be provlded Lo Lhe resLrlcLed, quallfled, professlonal hlgh-neL-worLh lnvesLors ln such
securlLles.
Agaln, Lhere was no lack of formal regulaLlon. lndeed, Lhe Slvs were made posslble by reregulaLlon LhaL
was supposed Lo prevenL Lhe klnd of abuse of off-balance-sheeL enLlLles LhaL had occurred under Lnron.
Many banks had wrlLLen llquldlLy puLs, slmllar Lo backup llnes of credlL, Lo Lhe lssue of commerclal paper
by a prlvaLe company LhaL requlred Lhe banks Lo cover Lhe dlfference beLween Lhe llquldaLlon value of
Lhe subprlme CMCs and Lhe commerclal paper falllng due. When Lhe lmpllcaLlons of Lhese conLracLs
were made publlc, Lhe response was a uS 1reasury proposal Lo creaLe a rescue enLlLy funded by prlvaLe
banks, slmllar Lo LhaL creaLed for Lhe Long-1erm CaplLal ManagemenL resoluLlon, Lo absorb Lhe asseLs
and prevenL Lhelr sale whlle urglng banks Lo recaplLallze ln order Lo cover any poLenLlal losses. AL Lhls
sLage, many large banks soughL caplLal ln[ecLlons from soverelgn wealLh funds or wealLhy lndlvldual


33
lnvesLors such as Mlddle LasLern oll shelks and Warren 8uffeL. ln Lhe end, many banks slmply Look Lhe
asseLs back onLo Lhelr balance sheeLs, glven LhaL mosL sLlll carrled Lrlple-A raLlngs. Agaln, Lhe response
was Lo provlde a remedy LhaL relnforced Lhe appllcaLlon of exlsLlng regulaLlons and repalred Lhe damage
from faulLy appllcaLlon by replenlshlng bank caplLal. 1he dlscusslon focused on Lhe acLlve or passlve
ablllLy of Lhe orlglnaLlng bank Lo lnfluence day-Lo-day operaLlons, and on requlrlng an ongolng
assessmenL of Lhe classlflcaLlon of varlable lnLeresL enLlLles when Lhe rlsk exposure of Lhe bank changes
over Llme. 8aslcally, Lhe soluLlon was slmply seen as provldlng enough caplLal Lo allow Lhe banks Lo Lake
Lhe asseLs back on Lhelr balance sheeLs and meeL resldual losses due Lo Lhe relaLlvely small proporLlon
of subprlme morLgages lnvolved.
1hus, by laLe 2007 - early 2008, lL was agaln belleved LhaL Lhe subprlme exposure problem was well
conLalned-well conLalned because lL was belleved LhaL Lhe sysLem would now reverL Lo normal, havlng
Laken care of Lhe subprlme morLgage dlfflculLles and Lhe off-balance-sheeL afflllaLes. 1he sLage was seL
for Lhe Lhlrd phase of Lhe crlsls, whlch began ln March wlLh Lhe collapse of 8ear SLearns and ended wlLh
Lhe bankrupLcy of Lehman ln SepLember, brlnglng Lhe enLlre flnanclal sysLem Lo a halL.
Stage three: A run on |nvestment banks
1he Lhlrd sLage of Lhe crlsls occurred noL ln Lhe LradlLlonal fashlon of a deposlL run (alLhough Lhere were
llnes of deposlLors seeklng Lo remove Lhelr funds from norLhern 8ock ln Lhe unlLed klngdom). 8aLher, lL
occurred ln Lhe lnvesLmenL banklng secLor, Lhe secLor LhaL ls supposed Lo be elLher lmmune Lo such
panlcs or, lf lL does experlence dlfflculLy, able Lo resolve bankrupLcy wlLhouL dlsrupLlng Lhe paymenLs
sysLem. 1he appllcaLlon of mark-Lo-markeL accounLlng has played a subsLanLlal role ln Lhe dlscusslons of
Lhe evoluLlon of Lhe crlsls. lLs genesls, however, provldes a clue Lo Lhe problems LhaL were faced ln Lhls
sLage.
Mark-Lo-markeL accounLlng was orlglnally applled by Lhe SLC ln assesslng caplLal requlremenLs for
broker-dealer lnvesLmenL banks. 1he ldea was LhaL a broker-dealer would, ln general, flnance lLs
lnvenLory wlLh shorL-Lerm fundlng. 1he classlc case ln Lhe pre-CL8 world was Lhe speclallsL on Lhe new
?ork SLock Lxchange who flnanced lnvenLory of sLock by uslng lL as collaLeral for call money borrowed
from an lnsured, deposlL-Laklng new ?ork bank. Slnce fundlng had Lo be renewed dally (or, lndeed, on
call" by Lhe lender), Lhe collaLeral had Lo be reprlced (marked Lo markeL) every day Lo ensure LhaL lLs
value was sufflclenL Lo repay Lhe borrowlng from Lhe banks. 1he caplLal requlremenL was Lhe equlvalenL
of Lhe halrcuL on Lhe value of Lhe securlLles-Lhe margln of error-Lo ensure LhaL Lhe broker-dealer was
Lruly solvenL and could meeL all of lLs shorL-Lerm obllgaLlons. 1he vlablllLy of any lnvesLmenL bank Lhus
depended on Lhe value of lLs lnvenLory of asseLs and lLs ablllLy Lo reflnance Lhose asseLs on a more or
less conLlnuous shorL-Lerm basls. We have already seen how ln Lhe second sLage of Lhe crlsls doubLs
over Lhe value of Lhe asseLs held by Slvs led Lo dlfflculLy ln reflnanclng vla Lhe fallure of lnvesLors Lo roll
over Lhelr asseL-backed commerclal paper. 1haL experlence led Lo doubLs abouL Lhe ablllLy of
commerclal banks Lo meeL Lhelr lendlng commlLmenLs ln supporL of subprlme morLgage asseLs, buL Lhe
enLlre flnanclal sysLem was operaLlng on Lhe same basls of borrowlng shorL-Lerm funds Lo flnance Lhe
orlglnaLlon, underwrlLlng, and, subsequenLly, open poslLlons ln morLgage asseLs.


34
Cne of Lhe maln characLerlsLlcs of Lhe deregulaLlon LhaL broughL abouL Lhe eroslon of Lhe secLlon 20
resLrlcLlons on bank acLlvlLles was Lhe creaLlon of Lhe securlLles repurchase (or repo") markeL ln whlch
banks would lend agalnsL collaLeral, lnlLlally governmenL securlLles. 1hls meanL LhaL an unlnsured
flnanclal lnsLlLuLlon could flnance lLs asseLs holdlngs Lhrough a repurchase agreemenL wlLh an lnsured
commerclal bank. ln Lhls arrangemenL, Lhe bank was lendlng shorL Lerm Lo flnance speculaLlve holdlngs
of governmenL and oLher securlLles. LvenLually, lnvesLmenL banks learned LhaL Lhey could lend Lo Lhelr
cllenLs, such as hedge funds, Lo supporL Lhelr speculaLlve poslLlons by lendlng Lhe securlLles of Lhe hedge
funds Lhey held as collaLeral-a procedure known as rehypoLhecaLlon.
lL was Lhus posslble for a hedge fund Lo aLLaln leverage raLlos of 20 Lo 40 Llmes lLs caplLal by borrowlng
from an lnvesLmenL bank uslng Lhe securlLles lL was speculaLlng on as collaLeral, wlLh Lhe lnvesLmenL
bank Lhen ralslng Lhe funds lL lenL Lo Lhe hedge fund by uslng Lhe securlLles as collaLeral for a repo from
an lnsured bank LhaL was lLself leveraglng by a slmllar amounL uslng Lhe securlLles held as collaLeral for
Lhe hedge fund cllenL. ln Lhls relaLlonshlp beLween Lhe hedge fund and lLs banker, called a prlme
brokerage accounL, Lhe lnvesLmenL bank noL only provlded Lhe hedge fund wlLh leveraged fundlng for lLs
lnvesLmenLs buL also handled Lhe execuLlon of lLs Lrades and oLher Lechnlcal and admlnlsLraLlve servlces,
all of whlch earned fee and commlsslon lncome for Lhe bank. 1he maln polnL ls LhaL an lncreaslngly long
chaln of shorL-Lerm lendlng or flnanclal layerlng was supporLlng speculaLlve poslLlons ln long-Lerm asseLs
wlLh lncreaslng leverage. AL Lhe basls of Lhe sysLem was a deposlL-Laklng bank afflllaLe of a flnanclal
holdlng company. 1he subprlme morLgage obllgaLlons LhaL were belng funded were also servlng as
collaLeral. 1hls sysLem would have been exLremely fraglle and sub[ecL Lo collapse even lf Lhe morLgage
asseLs had been perfecLly sound-whlch Lhey were noL.
lndeed, Lhe problems on Lhe asseL slde wenL beyond Lhe lncreaslng number of defaulLs due Lo Lhe
onerous Lerms and fraudulenL morLgage orlglnaLlon acLlvlLy. A collaLerallzed obllgaLlon ls noL a sLandard
securlLy, LhaL ls, Lhe llablllLy of a charLered prlvaLe corporaLlon. 8aLher, lL ls an lndependenL flnanclal
lnsLlLuLlon, usually a LrusL, and lL lssues securlLles whose credlL raLlng ls deLermlned by Lhe sLrucLure of
Lhe llablllLles and Lhe owners' equlLy. 1hls owners' equlLy" was Lhe medlum-Lerm noLe ln Lhe Slv. ln a
CMC lL ls Lhe equlLy Lranche (usually no more Lhan 4 or 3 percenL of Lhe LoLal asseL value) LhaL ls usually
supplemenLed by a guaranLee glven by a monollne lnsurer who has far less Lhan 1 percenL of asseLs
agalnsL lLs llablllLles, or by a CuS wrlLLen by anoLher bank or by, say, Amerlcan lnLernaLlonal Croup (AlC),
ln whlch case Lhe reserve was nonexlsLenL. 1he Lrlple-A credlL raLlngs LhaL were glven Lo 90 Lo 93
percenL of Lhe value of Lhe asseLs lssued as securlLles were Lhus Lhe equlvalenL of belng reserved by
shorL-Lerm money. 8orrowlng by Lhe lnsurers would be requlred Lo meeL Lhe guaranLees. 1herefore,
Lhere was leverage on boLh sldes of Lhe balance sheeLs of flnanclal lnsLlLuLlons-Lhelr asseLs were
leveraged and Lhelr llablllLles were leveraged.
When quesLlons were ralsed, flrsL abouL Lehman and Lhen abouL AlC, lL was as lf Lhe shorL-Lerm loans
and margln guaranLees were called on boLh sldes of Lhe balance sheeL and Lhe resulL was Lhe equlvalenL
of a bank run, noL on deposlL bank subsldlarles, buL on Lhe nondeposlL-Laklng lnvesLmenL banks
provldlng prlme brokerage servlces. Slnce Lhe deposlL banks were already faclng caplLal consLralnLs due
Lo Lhelr own Slvs, Lhey could noL provlde fundlng Lo meeL Lhe margln calls, and had Lo borrow from
oLher lnvesLmenL banks Lo do so. Powever, all flnanclal lnsLlLuLlons were seeklng alLernaLlve fundlng for


33
Lhelr asseL holdlngs, as were Lhe lnsurers. Pedge funds, fearlng loss of Lhelr asseLs held ln prlme
brokerage accounLs, soughL assurance of Lhe solvency of Lhelr prlme brokers, and sLarLed Lo wlLhdraw
Lhelr funds from Coldman Sachs and Morgan SLanley. laced wlLh Lhe lmposslblllLy of reLurnlng Lhe cash
and asseLs ln Lhe accounLs (slnce Lhey were pledged as repo collaLeral or lenL vla rehypoLhecaLlon Lo
oLher lnsLlLuLlons) Lhe only alLernaLlve would have been Lo aLLempL Lo ralse cash by selllng asseLs ln
condlLlons ln whlch Lhere were no buyers. 1hls would have led Lo zero prlces and Lhe appllcaLlon of
mark-Lo-markeL ln Lhese condlLlons would have clearly led Lo lnsolvency of Lhe enLlre sysLem.
Whlle much has been wrlLLen abouL Lhe dlfflculLy of ldenLlfylng neL credlL exposures due Lo Lhe use of
CuSs, Lhe real complexlLy and layerlng ln Lhe sysLem derlves from Lhe exlsLence of securlLles lendlng,
repo flnanclng, and rehypoLhecaLlon. lf all lenders had soughL Lo close Lhelr poslLlons, Lhe only
alLernaLlve would have been Lo aLLempL Lo ralse cash by selllng asseLs ln condlLlons ln whlch Lhere were
no buyers. 1hls would have led Lo zero prlces, and Lhe appllcaLlon of mark-Lo-markeL ln Lhese condlLlons
would have clearly led Lo lnsolvency of Lhe enLlre sysLem.
lL was aL Lhls sLage LhaL Lhe 1reasury and Lhe led declded LhaL a sysLemlc soluLlon was requlred Lo
supporL asseL prlces, Lhls was achleved Lhrough Lhe requesL Lo Congress for 1roubled AsseL 8ellef
rogram (1A8) fundlng and Lhe led declslon Lo lend Lo any and all lnsLlLuLlons Lo allow Lhem Lo meeL
shorL-Lerm fundlng requlremenLs. lL handsomely proved Mlnsky's rule LhaL Lhe sLablllLy of an lnsLlLuLlon
depends only on Lhe llquldlLy of lLs cushlon of safeLy, and ln Lhe absence of a cash cushlon, lLs ablllLy Lo
sell asseLs for cash LhaL only Lhe led can provlde ln unllmlLed amounLs.
lL ls perhaps paradoxlcal LhaL Lhere was no absence of regulaLlons governlng Lhe flnanclal lnsLlLuLlons
LhaL engaged ln Lhe bulldup of flnanclal layerlng and pyramldlng on an ever-decllnlng cushlon of safeLy.
1he response was Lo Lry Lo lmprove and beLLer apply Lhose regulaLlons whlle lmplemenLlng shorL-Lerm
llquldlLy measures Lo sLablllze asseL values. 1he fundamenLal problem was belleved Lo have been Lhe
collapse ln asseL prlces creaLed by Lhe dlsappearance of markeL llquldlLy, raLher Lhan any lnherenL
problem wlLh Lhe asseLs Lhemselves. Powever, lf Lhe asseLs are lnsolvenL, as are Lhe lnsLlLuLlons LhaL
hold Lhem, Lhls approach cannoL provlde for Lhe recovery of Lhe sysLem. 1he fallure Lo recognlze Lhls
facL has been aL Lhe rooL of Lhe fallure Lo provlde any meanlngful sysLemlc reform. As long as Lhe pollcy
ls Lo provlde sufflclenL llquldlLy ln Lhe hope LhaL asseL prlces wlll reLurn Lo levels LhaL allow banks Lo
remaln solvenL wlLh approprlaLe caplLal ln[ecLlons Lo offseL losses, Lhere can and wlll be no meanlngful
reform or regulaLlon of Lhe flnanclal sysLem.



36
CnA1Lk 4. keregu|at|on w|thout keform of the I|nanc|a| Structure: Dodd-Irank

1he Lwo ma[or plllars of Lhe 2010 uodd-lrank AcL are regulaLlons Lo beLLer manage Lhe rlsks underLaken
by large, sysLemlcally slgnlflcanL" flnanclal lnsLlLuLlons, and Lhe means Lo force Lhem lnLo bankrupLcy
llquldaLlon wlLhouL Lhe need for anyLhlng buL Lemporary publlc asslsLance. uodd-lrank Lhus suggesLs a
parLlcular vlew of Lhe cenLral weakness of Lhe uS flnanclal sLrucLure: noL Lhe slze and lnLegraLlon of
mulLlfuncLlon lnsLlLuLlons, buL Lhe absence of a mechanlsm Lo allow all bank and nonbank flnanclal
lnsLlLuLlons Lo fall wlLhouL publlc asslsLance. under uodd-lrank, banks wlll be allowed Lo funcLlon more
or less as before Lhe crlsls (wlLh Lhe excepLlon ever-weakenlng volcker rule" resLrlcLlons) buL Lo be
sub[ecL Lo clear rules on Lhelr rapld dlssoluLlon raLher Lhan Lhelr resoluLlon.
A Mlnskyan analysls of uodd-lrank, moLlvaLed by Lhe ldea LhaL dlsrupLlon ls a naLural consequence of
Lhe operaLlon of Lhe flnanclal sysLem, would suggesL LhaL regulaLors should be concerned boLh wlLh Lhe
slze of banks and wlLh Lhelr operaLlons as mulLlfuncLlon flnanclal servlce provlders. llnanclal lnnovaLlon
wlll always be drlven by regulaLory arblLrage, and as a resulL Lhere can be no assurance LhaL regulaLlons
of Lhe sorL conLalned ln uodd-lrank can make large flnanclal lnsLlLuLlons safe from crlsls.
1he I|nanc|a| Stab|||ty Cvers|ght Counc||
Cne of Lhe cenLerpleces of Lhe uodd-lrank leglslaLlon ls Lhe creaLlon of Lhe llnanclal SLablllLy CverslghL
Councll (lSCC). lL has Lhe ob[ecLlve of provldlng collecLlve accounLablllLy for ldenLlfylng rlsks and
respondlng Lo emerglng LhreaLs Lo flnanclal sLablllLy. 1o help mlnlmlze Lhe rlsk of a nonbank flnanclal
flrm LhreaLenlng Lhe sLablllLy of Lhe flnanclal sysLem, Lhe lSCC has Lhe mandaLe and auLhorlLy Lo ldenLlfy
all sysLemlcally lmporLanL lnsLlLuLlons, boLh flnanclal and nonflnanclal, LhaL conLrlbuLe excesslve rlsk Lo
Lhe operaLlon of Lhe flnanclal sysLem. lL also has Lhe ablllLy Lo apply regulaLlons ln addlLlon Lo Lhose
sLlpulaLed by Lhelr appllcable regulaLory agency. 1he lSCC ls mandaLed Lo ldenLlfy emerglng rlsks Lo
flnanclal sLablllLy vla requesLs for daLa and analyses from Lhe Cfflce of llnanclal 8esearch, whlch was
also creaLed by Lhe AcL, and Lo formulaLe and complle daLabases of flnanclal lnformaLlon from all markeL
parLlclpanLs Lo ald ln Lhe ldenLlflcaLlon of unsLable flnanclal pracLlces and condlLlons.
1he ldea of ldenLlfylng speclflc lnsLlLuLlons as sysLemlcally slgnlflcanL lgnores Mlnsky's explanaLlon of Lhe
endogenous creaLlon of sysLemlc rlsk-namely, LhaL lL ls noL speclflc Lo lnsLlLuLlons, buL raLher ls Lhe
resulL of how Lhe sysLem evolves over Llme and how lLs sLrucLure changes ln response Lo regulaLlon and
lnnovaLlon. 1he real problem ls Lo ldenLlfy Lhe endogenous accreLlon of fraglle flnanclng sLrucLures, and
Lo recognlze Lhelr poLenLlal lmpacL on sysLemlc sLablllLy.
1he Vo|cker ru|e
MosL of Lhe regulaLory acLlons ln Lhe uodd-lrank AcL call for measures Lo correcL dlfflculLles LhaL have
emerged from Lhe mulLlfuncLlon banklng LhaL was permlLLed by Cramm-Leach-8llley. 1he lSCC ls
responslble for lmplemenLlng Lhe mosL lmporLanL of Lhese measures, Lhe so-called volcker rule"
provlslons seL ouL ln secLlon 619 of Lhe AcL LhaL call for llmlLaLlons on Lhe use of proprleLary funds for


37
flnanclal speculaLlon by banklng enLlLles LhaL beneflL from federal lnsurance, or any expllclL or lmpllclL
governmenL guaranLees. 1he separaLlon of Lhe use of deposlLors' funds for bank buslness-lendlng
operaLlons and Lhe use of deposlLs for any operaLlons ln securlLles markeLs excepL Lhose provlded as a
complemenL Lo cllenL servlces was Lhe fulcrum of Lhe Class-SLeagall regulaLlons. 1he lnLenLlon was Lo
prevenL banks from uslng reLall deposlL funds, guaranLeed by Lhe new governmenL deposlL lnsurance
fund, for speculaLlve Lradlng. Such acLlvlLy was Lo be llmlLed Lo nonlnsured lnvesLmenL banks whose
parLners used Lhelr own caplLal resources Lo generaLe lncome by underwrlLlng and Lradlng ln securlLles.
ln Lhe 1980s, mosL lnvesLmenL banks were Lransformed lnLo llmlLed-llablllLy corporaLlons and evenLually
became bank holdlng companles, ellmlnaLlng Lhe relaLlon beLween Lhe klnd of lnvesLmenL acLlvlLy
(commerclal loans or securlLles) and Lhe klnd of fundlng (deposlLs or own caplLal) ln dlsLlncL Lypes of
flnanclal lnsLlLuLlon (commerclal or lnvesLmenL banks).
Slnce lL ls no longer posslble under Lhe 1999 AcL Lo separaLe Lhe use of deposlL funds from Lhe
proprleLary Lradlng flnanced by bank caplLal, such Lradlng can produce losses LhaL [eopardlze Lhe bank's
ablllLy Lo repay deposlLors, and would Lhus requlre Lhe lulC Lo meeL Lhe losses creaLed by Lradlng rlsks
LhaL were underLaken and should be borne by Lhe bank's owners and managers. 1he volcker rule Lhus
seeks Lo preclude Lhe use of Lhe caplLal of Lhe flnanclal lnsLlLuLlon for Lhe purposes of proprleLary
Lradlng-LhaL ls, Lradlng ln whlch Lhe bank acLs as prlnclpal-lf Lhe bank quallfles for any governmenL
supporL for losses Lo lLs deposlLors. 1he lnLenLlon of Lhe rule ls Lo prevenL banks from uslng any of lLs
deposlLs or caplLal funds Lo Lake leveraged rlsks on poslLlons whose value ls deLermlned by changes ln
Lhe prlce of flnanclal asseLs, and, ln parLlcular, Lo llmlL Lhe use of leverage LhaL has been a LradlLlonal
parL of such acLlvlLles. ln general, Lhe leverage LhaL ls assoclaLed wlLh speculaLlve and arblLrage acLlvlLles
ls ln nonlnsured areas such as repo markeLs and oLher commerclal borrowlng, so Lhe rule lmpllclLly seeks
Lo llmlL Lhe leverage LhaL can be generaLed by fundlng proprleLary Lradlng ln repo markeLs or ln under-
marglned or nonmarglned C1C derlvaLlves sLrucLures.
Slnce Lhe rule would exclude bank acLlvlLles LhaL provlde servlces Lo cllenLs, Lhere ls also dlfflculLy ln
deLermlnlng when such precluded acLlvlLles are requlred for supporLlng cllenL requesLs for servlces and
when Lhey are slmply for Lhe bank's own acLlvlLles. lor example, a bank provldlng forelgn exchange or
lnLeresL raLe hedglng servlces may flnd lL necessary Lo warehouse such conLracLs ln order Lo provlde Lhe
besL execuLlon for cllenLs, and lL would be dlfflculL Lo dlfferenLlaLe such acLlvlLles from pure proprleLary
speculaLlon. All Lhese dlfflculLles were avolded under Class-SLeagall's slmple proscrlpLlon on securlLles
Lradlng by lnsured deposlL-Laklng banks. 1he dlfflculLles ln Lhe lnLerpreLaLlon of Lhe volcker rule would
Lhus seem Lo sLem from an aLLempL Lo relnLroduce Class-SLeagall separaLlon of acLlvlLles wlLhln Lhe
Cramm-Leach-8llley AcL ln whlch Lhey are permlLLed.
Some of Lhe dlfflculLles ralsed by Lhe volcker rule are dealL wlLh ln anoLher of Lhe ma[or areas of uodd-
lrank regulaLlon: Lhe ablllLy of banks Lo operaLe and acL as dealers ln derlvaLlve conLracLs, and Lhe
formal Lransfer of derlvaLlves clearlng and Lradlng Lo regulaLed markeL lnsLlLuLlons. 1he former deals
wlLh Lhe so-called Llncoln amendmenL" LhaL soughL Lo prohlblL banks acLlve ln Lhe swaps markeLs from
recelvlng varlous forms of federal asslsLance," lncludlng federal deposlL lnsurance and access Lo Lhe led
dlscounL wlndow or any led credlL faclllLy. Powever, Lhe amendmenL also creaLed dlfflculLles due Lo Lhe


38
reLenLlon of exlsLlng Cramm-Leach-8llley leglslaLlon and emerged wlLh a push-ouL" provlslon LhaL
allowed lnsured enLlLles Lo conLlnue Lhelr derlvaLlves acLlvlLles under cerLaln condlLlons.
1he regulaLlon forblds federal asslsLance for a generlc caLegory, swaps enLlLles," LhaL ls deflned as any
swap dealer, securlLy-based swap dealer, ma[or swap parLlclpanL, [or] ma[or securlLy-based swap
parLlclpanL." ln Lurn, swap dealers and securlLy-based swap dealers are persons or enLlLles LhaL hold
Lhemselves ouL as swap dealers, make markeLs ln swaps, regularly enLer lnLo swaps wlLh counLerparLles
as an ordlnary course of buslness for Lhelr own accounLs, or engage ln any acLlvlLy causlng Lhem Lo be
commonly known ln Lhe lndusLry as swap dealers or markeL makers. Powever, even lf an enLlLy ls noL
classlfled as a swaps dealer," lL may noneLheless be classlfled as a ma[or swap parLlclpanL" or ma[or
securlLy-based swap parLlclpanL" and sub[ecL Lo Lhe regulaLlon lf lL malnLalns subsLanLlal poslLlons" ln
swaps, or lf lL possesses ouLsLandlng swaps LhaL creaLe subsLanLlal counLerparLy exposure LhaL could
have serlous adverse effecLs on Lhe flnanclal sLablllLy of Lhe uS banklng sysLem or flnanclal markeLs.
Slnce Lhls provlslon, whlch ls Lo come lnLo effecL ln !uly 2012, would creaLe subsLanLlal dlfflculLles for
banks ln provldlng derlvaLlves-based cllenL servlces, or ln uslng such lnsLrumenLs Lo hedge Lhelr own
rlsks vla Lhe use of derlvaLlve conLracLs, Lhe push-ouL provlslon would allow banks Lo reLaln lederal
lnsurance and supporL lf Lhelr swap acLlvlLles are carrled ouL Lhrough an afflllaLe. 1he lnsured enLlLles
could Lhen dlrecLly engage ln Lhelr own and cerLaln cllenL-based hedglng acLlvlLles wlLhouL belng
classlfled as swap dealers. 1he afflllaLes may be creaLed by any deposlLory lnsLlLuLlon LhaL ls parL of
elLher a bank holdlng company or a savlngs-and-loan holdlng company, on condlLlon LhaL Lhe afflllaLe
complles wlLh secLlons 23A and 238 of Lhe lederal 8eserve AcL and any oLher requlremenLs LhaL Lhe
CommodlLy luLures 1radlng Commlsslon (Cl1C), SLC, and led may deLermlne necessary. ln effecL, Lhls ls
Lhe equlvalenL of Lhe secLlon 20 exempLlon under Class-SLeagall LhaL permlLLed commerclal banks
llmlLed securlLles-markeL acLlvlLles.
1he acLlvlLles LhaL can be engaged ln by Lhe lnsured enLlLy lLself lnclude acLlng as prlnclpal ln swaps wlLh
cusLomers ln connecLlon wlLh orlglnaLlng loans for Lhose cusLomers, engaglng ln de mlnlmls" swaps
deallng, enLerlng swap agreemenLs for Lhe purposes of hedglng and oLher slmllar rlsk mlLlgaLlng
acLlvlLles dlrecLly relaLed Lo Lhe lnsured deposlLory lnsLlLuLlon's acLlvlLles", and acLlng as swaps enLlLles
for acLlvlLles lnvolvlng raLes or reference asseLs LhaL are permlsslble for lnvesLmenL by a naLlonal bank.
Agaln, Lhese mlrror exempLlons LhaL had already been approved under Class-SLeagall and dld much Lo
undermlne lLs appllcaLlon. 8egulaLlons speclfylng Lhe formal conLenL of Lhese llmlLs and deflnlLlon are Lo
be formulaLed by Lhe SLC and Cl1C as approprlaLe.
Swaps and futures regu|at|on
1hese exempLlons do noL, however, apply Lo CuSs unless Lhey are cleared Lhrough derlvaLlves-clearlng
regulaLlons LhaL are called for under Lhe AcL. 1he flnanclal lndusLry foughL hard Lo llmlL reforms on Lhe
Lradlng of CuSs Lo Lhe requlremenL LhaL Lhey be cleared, argulng LhaL Lhls would be sufflclenL Lo ensure
safeLy. Powever, Mlchael Creenberger (2010) has argued LhaL, whlle clearlng regulaLlons would help Lo
ensure caplLal adequacy of Lradlng parLners, Lhls alone ls noL sufflclenL proLecLlon. lor example,
Creenberger sLaLes LhaL Lhe followlng regulaLlons are necessary as well: Lransparency of prlclng and of


39
Lhe Lradlng parLy ldenLlLles, prudenLlal and compeLency regulaLlon of lnLermedlarles, adequaLe self-
regulaLlon by Lhe lndusLry Lo help regulaLors, compleLe record keeplng, prohlblLlons on fraud and
manlpulaLlon, full dlsclosure Lo regulaLors and counLerparLles, and compeLenL prlvaLe enforcemenL. 1hls
would creaLe a sLrucLure slmllar Lo sLock markeL rules, regulaLlons, and operaLlng procedures. Lxchange
Lradlng, sLrlcL anLlfraud requlremenLs LhaL are enforced by sLaLe and federal governmenLs, and bans on
abuslve" CuSs LhaL are deslgned Lo cause economlc ln[ury (Lhrough bankrupLcy) were seen Lo be
needed Lo prevenL a repeaL of Lhe problems LhaL led up Lo Lhe crlsls.
1he full lmplemenLaLlon of Lhe volcker and Llncoln amendmenLs requlres provlslons Lo shlfL C1C Lradlng
ln derlvaLlves onLo federally mandaLed clearlng mechanlsms and regulaLed markeLs. 1he AcL Lhus calls
for Lhe creaLlon of a comprehenslve framework for Lhe regulaLlon, clearlng, and exchange Lradlng of C1C
derlvaLlves. now deflned as swap" conLracLs, federal leglslaLlon has always excluded Lhem from slmllar
formal regulaLlons LhaL orlglnaLed ln Lhe lnlLlal regulaLlon of fuLures conLracLs ln 1922. 1hls ls due ln parL
Lo Lhe facL LhaL fuLures conLracLs were lnlLlally developed ln Lhe agrlculLural secLor and Lhus were
sub[ecL Lo commodlLy fuLures Lradlng regulaLlon monlLored by Lhe Cl1C, whlle oLher derlvaLlves
conLracLs were prlmarlly flnanclal and Lherefore under Lhe regulaLory rubrlc of Lhe SLC. 1hus, alLhough
fuLures conLracLs, wheLher of a flnanclal or a commodlLy naLure, could noL be legally Lraded ouLslde of a
formally regulaLed markeL wlLhouL a speclflc exempLlon, oLher derlvaLlves were always fully exempL and
Lherefore developed ln Lhe C1C markeL. 1he currenL regulaLlon Lhus seeks Lo apply Lhe exchange and
clearlng regulaLlons of fuLures Lo vlrLually all sLandardlzed swap conLracLs.
Whlle swaps and fuLures represenL slmllar Llme" conLracLs, swaps, unllke fuLures, were cusLomlzed Lo
Lhe speclflc commerclal hedglng needs of buslnesses and flnanclal lnsLlLuLlons, and, as noLed, flnanclal
lnsLlLuLlons lnlLlally acLed as lnLermedlarles brlnglng LogeLher swap counLerparLles ln prlvaLe bllaLeral
negoLlaLlons. Slnce mosL of Lhese conLracLs were negoLlaLed wlLhouL exchange of prlnclpal, rlsk
exposure was llmlLed Lo marglnal changes ln Lhe markeL prlce of Lhe conLracLs and prescrlpLlve
regulaLlon was noL consldered necessary. As banks began Lo Lake on prlnclpal poslLlons as
counLerparLles Lo cllenL requesLs, Lhey also accepLed rlsk on Lhe nonperformance of counLerparLles, buL
Lhls was also consldered mlnlmal. 1he mosL popular swaps conLracLs were lnLeresL raLe and lorex
swaps, whlch were generaLed by Lhe breakdown of Lhe 8reLLon Woods sysLem of flxed exchange raLes
and have slnce become an lnLegral parL of Lhe hedglng ln Lhe flexlble lnLeresL and exchange raLes ln Lhe
lnLernaLlonal flnanclal sysLem. As Lhey lncreased ln volume, Lhe lnLernaLlonal Swaps and uerlvaLlves
AssoclaLlon provlded sLandardlzed Lerms and documenLaLlon, reduclng Lhe need for speclflc condlLlons
and bllaLeral negoLlaLlon.
1he deflnlLlon of swaps ln Lhe AcL covers mosL commonly Lraded C1C derlvaLlves, lncludlng opLlons on
lnLeresL raLes, currencles, commodlLles, securlLles, lndlces, and varlous oLher flnanclal or economlc
lnLeresLs or properLy, conLracLs ln whlch paymenLs and dellverles are dependenL on Lhe occurrence or
nonoccurrence of cerLaln conLlngencles (e.g., a credlL defaulL swap), and swaps on raLes and currencles,
LoLal reLurn swaps, and varlous oLher common swap LransacLlons.
uue Lo Lhe parallel developmenL of commodlLy-based and flnanclal-based conLracLs, Lhe AcL deflnes and
provldes for a common approach Lo securlLy-based swaps," whlch are generally swap LransacLlons


40
lnvolvlng a slngle securlLy or loan, or a narrow-based securlLy lndex. ln broad Lerms, Lhese wlll be
regulaLed by Lhe SLC and commodlLy swaps" wlll be regulaLed by Lhe Cl1C, preservlng Lhe hlsLorlcal
dlvlslon of labor beLween Lhe Lwo agencles.
AnoLher hlgh-volume area of Lhe markeL LhaL could be consldered a prlme example of conLracLs LhaL
mlghL beneflL from regulaLed markeL Lradlng are forelgn exchange swaps and forward conLracLs. 1hese
conLracLs are prlmarlly Lhe domaln of banks and are currenLly exempL from regulaLory overslghL. 1hey
wlll be sub[ecL Lo regulaLlon under uodd-lrank. Powever, glven Lhe ma[or parLlclpaLlon of banks ln
provldlng cllenL servlces and Lhe LradlLlonal absence of regulaLlon slnce Lhe breakdown of Lhe 8reLLon
Woods sysLem, Lhe AcL provldes Lhe 1reasury secreLary wlLh Lhe power Lo exclude Lhem from regulaLlon
lf Lhe conLracLs negoLlaLed have noL been sLrucLured Lo evade Lhe reach of Lhe leglslaLlon.
8anks, dealers, and oLher flnanclal lnsLlLuLlons acLlve ln Lhe derlvaLlves markeLs may be classlfled as
(securlLy) swap dealers"-LhaL ls, any person who holds hlmself ouL as a dealer ln swaps, makes a
markeL ln swaps, regularly enLers lnLo swaps wlLh counLerparLles as an ordlnary course of buslness for
hls own accounL, or engages ln any acLlvlLy causlng hlm Lo be commonly known ln Lhe Lrade as a dealer
or markeL maker ln swaps-and wlll become sub[ecL Lo reglsLraLlon and record-keeplng requlremenLs.
Clven Lhe promlnenL role ln provldlng cllenL servlces, a number of lnsLlLuLlons wlll be exempL from
classlflcaLlon as (securlLy) swap dealers: an lnsured deposlLory lnsLlLuLlon, Lo Lhe exLenL lL offers Lo enLer
lnLo a swap wlLh a cusLomer ln connecLlon wlLh orlglnaLlng a loan wlLh LhaL cusLomer, an enLlLy LhaL
buys or sells swaps for such person's own accounL, elLher lndlvldually or ln a flduclary capaclLy, and noL
as parL of a regular buslness", and an enLlLy LhaL engages ln a de mlnlmls quanLlLy" of swap deallng ln
connecLlon wlLh LransacLlons wlLh or on behalf of lLs cusLomers.
1he ma[or obllgaLlon of swap dealers wlll be Lhe appllcaLlon of mlnlmum caplLal sLandards and lnlLlal
and varlaLlon margln requlremenLs for swaps LhaL are noL cleared as requlred by Lhe approprlaLe
prudenLlal regulaLory agency or commlsslon.
Dea||ng w|th |nso|vent |nst|tut|ons
1he ma[or secLlons of Lhe AcL do llLLle Lo reverse Lhe Lrend Loward larger and larger mulLlfuncLlon bank
conglomeraLes. 1he AcL aLLempLs Lo deal wlLh Lhe lncreased rlsks presenLed by such lnsLlLuLlons,
wheLher caused by moral hazard or slmple managemenL deflclencles, by creaLlng a sysLem for Lhe
dlssoluLlon of such lnsLlLuLlons when Lhey become lnsolvenL. lndeed, Lhe overarchlng Lheme of Lhe AcL ls
noL so much Lo prevenL crlses as Lo preclude Lhe posslblllLy of uslng publlc funds ln meeLlng losses or
resculng lnsolvenL lnsLlLuLlons. 1hls ls undersLandable conslderlng Lhe crlLlclsm of Lhe use of Lhe 1A8
program Lo susLaln and recaplLallze lnsolvenL flnanclal lnsLlLuLlons whlle lnsolvenL households were
forced lnLo foreclosure. Congress clearly wanLed Lo wash lLs hands of any responslblllLy for Lhe use of
publlc funds ln supporL of flnanclal lnsLlLuLlons.
1he absence of a common legal framework for deallng wlLh lnsolvenL lnsLlLuLlons was one of Lhe maln
dlfflculLles noLed by regulaLors ln respondlng Lo Lhe recenL crlsls. lor example, Lhe lederal 8eserve has
argued LhaL lL had no mandaLe Lo acL ln Lhe case of Lehman 8roLhers, whlle Lhe 1reasury had no


41
mandaLe Lo lmpose bankrupLcy on AlC. ln Lhe absence of clear lulC auLhorlLy Lo resolve nonlnsured,
nonbank flnanclal lnsLlLuLlons, dlrecL governmenL supporL appeared Lo be Lhe sole alLernaLlve. 1lLle ll of
Lhe uodd-lrank AcL ls meanL Lo meeL Lhls dlfflculLy Lhrough Lhe creaLlon of an orderly llquldaLlon
auLhorlLy" (CLA) LhaL glves Lhe lulC power Lo selze conLrol of such lnsLlLuLlons on Lhe deLermlnaLlon by
Lhe 1reasury secreLary LhaL Lhey LhreaLen Lhe flnanclal sLablllLy of Lhe unlLed SLaLes. lL mandaLes Lhe
lulC Lo llquldaLe such deslgnaLed lnsLlLuLlons so as Lo maxlmlze Lhe value recelved from Lhe dlsposlLlon
of Lhe company's asseLs, mlnlmlze any loss, mlLlgaLe Lhe poLenLlal for serlous adverse effecLs Lo Lhe
flnanclal sysLem, ensure Llmely and adequaLe compeLlLlon and falr and conslsLenL LreaLmenL of bldders
on asseLs and deposlLs, and prohlblL dlscrlmlnaLlon.
Accordlng Lo Lhe AcL, lmplemenLlng orderly llquldaLlon requlres LhaL Lhe lulC deLermlne LhaL such acLlon
ls necessary for purposes of Lhe flnanclal sLablllLy of Lhe unlLed SLaLes, and noL for Lhe purpose of
preservlng Lhe covered flnanclal company, ensure LhaL Lhe shareholders of a covered flnanclal company
do noL recelve paymenL unLll afLer all oLher clalms and Lhe ueposlLors lnsurance lund are fully pald,
ensure LhaL unsecured credlLors bear losses ln accordance wlLh Lhe prlorlLy of clalms, ensure LhaL Lhe
managemenL and board of dlrecLors responslble for Lhe falled condlLlon of Lhe covered flnanclal
company are removed (lf sLlll presenL aL Lhe Llme aL whlch Lhe lulC ls appolnLed recelver), and noL Lake
an equlLy lnLeresL ln or become a shareholder of any covered flnanclal company or any covered
subsldlary.
AnoLher reason for Lhe use of dlrecL governmenL lnLervenLlon ln Lhe recenL crlsls was Lhe need for rapld
acLlon ln order Lo prevenL furLher deLerloraLlon of Lhe flnanclal condlLlon of Lhe lnsLlLuLlons ln dlfflculLy
and Lhe rlsk of conLaglon. Powever, under CLA, Lhe deLermlnaLlon by Lhe 1reasury secreLary has Lo be
made on recommendaLlon of cerLaln deslgnaLed federal regulaLory auLhorlLles (such as Lhe lSCC) and
wlLh an evaluaLlon of why Lhe lnsLlLuLlon should noL be dealL wlLh under Lhe 8ankrupLcy Code, and afLer
consulLaLlon wlLh Lhe presldenL. 1he AcL also requlres LhaL before Lhe 1reasury secreLary can make Lhe
deLermlnaLlon LhaL Lhe lulC should be appolnLed recelver, he or she musL flrsL make a requlslLe serles of
speclflc underlylng flndlngs, lncludlng LhaL Lhe company ls ln defaulL or ls ln danger of defaulL, LhaL
should Lhe company so defaulL, Lhe resoluLlon of Lhe company under Lhe oLherwlse appllcable federal or
sLaLe law would have serlous adverse consequences for Lhe flnanclal sLablllLy of Lhe unlLed SLaLes, LhaL
Lhere are no prlvaLe secLor alLernaLlves avallable LhaL would avold such adverse consequences, LhaL
Lhere are no lnapproprlaLe poLenLlal effecLs on Lhe clalms or lnLeresLs of credlLors, counLerparLles, or
shareholders LhaL would resulL from such appolnLmenL, and LhaL Lhe selzure of such company under an
CLA wlll prevenL or oLherwlse llmlL damage Lo Lhe flnanclal sLablllLy of Lhe unlLed SLaLes (analysls musL
conslder Lhe effecLlveness of such selzure ln mlLlgaLlng Lhe poLenLlal adverse effecLs on Lhe flnanclal
sysLem, Lhe cosL of such resoluLlon Lo Lhe general fund of Lhe 1reasury, and Lhe poLenLlal of such selzure
and resoluLlon for lncreaslng excesslve rlsk Laklng golng forward).
ln Lhe vlew of !oshua 8osner (2011), Lhere ls a fundamenLal flaw ln Lhe CLA process caused by Lhe facL
LhaL lL creaLes Lwo dlfferenL reglmes under whlch a large flnanclal flrm can be wound up: LradlLlonal
bankrupLcy and Lhe CLA. Pe noLes LhaL Lhe value of a flrm ln lLs golng concern" sLaLe ls dependenL on
Lhe resoluLlon process employed when lL falls. All nonflnanclal flrms and mosL flnanclal lnsLlLuLlons use
Lhe 8ankrupLcy Code, commerclal banks use Lhe lederal ueposlL lnsurance AcL, broker-dealers use Lhe


42
SecurlLles lnvesLor roLecLlon AcL. 1here may be dlfferenL sysLems for dlfferenL Lypes of flrms, buL Lhere
are noL, and Lhere should noL be, mulLlple processes for Lhe same flrm. ln sum, Lhe absoluLe worsL Lhlng
LhaL regulaLors can do ls exacLly whaL Lhey're dolng now: slgnallng Lo Lhe publlc and Lhe markeLs, ex
anLe, whlch flrms wlll cause sysLemlc lnsLablllLy and Lhen provldlng a uS 1reasury-funded ballouL
scheme Lhrough Lhe Crderly LlquldaLlon AuLhorlLy. Where lnvesLors have greaL cerLalnLy and clarlLy
abouL Lhe worklngs of Lhe uS bankrupLcy process, Lhe CLA's dangerous sub[ecLlvlLy, lncreased opaclLy,
preference for shorL-Lerm credlLors, and amblgulLy ln how lL wlll LreaL slmllarly slLuaLed credlLors wlll
only lncrease Lhe uncerLalnLy among credlLors of a falllng lnsLlLuLlon and cause necessary rlsk caplLal Lo
pause aL preclsely Lhe Llme Lhls caplLal ls mosL needed.
1he CLA provlslon also mandaLes LhaL Lhe flnanclal lndusLry pay (afLer Lhe facL) for Lhe cosLs of any such
dlssoluLlon acLlvlLy underLaken by Lhe lulC. 1he powers granLed Lo Lhe lulC as Lhe llquldaLor are Lhus
very slmllar Lo Lhose currenLly ln use for lnsured lnsLlLuLlons, lncludlng, where necessary, Lhe ablllLy Lo
conLlnue Lhe operaLlons of a deslgnaLed lnsLlLuLlon by means of an unencumbered brldge bank. 1he AcL
empowers Lhe lulC Lo esLabllsh such rules and regulaLlons as lL deems necessary or approprlaLe for
lmplemenLlng an CLA. 1hls ls one area ln whlch lLs operaLlons concernlng lnsured and nonlnsured
deslgnaLed lnsLlLuLlons wlll dlffer. ln lLs resoluLlon of normally lnsured deposlLary lnsLlLuLlons, Lhe lulC
has consldered Lhe asseLs Lransferred by any lnsLlLuLlon Lo an arm's-lengLh Sv vla sLrucLured flnanclng
securlLlzaLlon as clalmable by secured credlLors. Powever, Lhe agency has lndlcaLed LhaL lL does noL
lnLend Lo apply Lhls procedure ln lmplemenLlng Lhe new CLA, Lhus proLecLlng asseLs Lransferred Lo a
speclal enLlLy from Lhe llquldaLlon.
Cne of Lhe dlfflculLles faced by Lhe lulC ln deallng wlLh Lhe resoluLlon of large banks ls Lhe llmlLed slze of
Lhe deposlL lnsurance funds (much llke Lhe lederal Savlngs and Loan lnsurance CorporaLlon ln Lhe
1980s). Whlle Lhe ulLlmaLe source of funds ls Lhe federal governmenL, and Lhus Lhe lederal 8eserve, Lhe
ldea ls LhaL lL should be self-flnanclng, based on lnsurance premla charged Lo Lhe lnsured lnsLlLuLlons.
Clven Lhe lelLmoLlf of Lhe AcL Lo ellmlnaLe Lhe use of publlc funds Lo rescue Lhe flnanclal sysLem, uodd-
lrank mandaLes measures Lo lncrease Lhe slze of Lhe lnsurance fund, as well as measures Lo adapL Lhe
premla Lo Lhe rlsk LhaL lnsLlLuLlons lnLroduce lnLo Lhe sysLem.
1he AcL, ln secLlon 334, Lhus ralses Lhe mlnlmum deslgnaLed reserve raLlo (uu8) of fund asseLs Lo
lnsured deposlLs, whlch Lhe lulC musL seL each year, Lo 1.33 percenL (from Lhe former mlnlmum of 1.13
percenL), and removed Lhe upper llmlL on Lhe u88 (whlch was formerly capped aL 1.3 percenL) and
Lherefore on Lhe slze of Lhe fund, requlred LhaL Lhe fund reserve raLlo reach 1.33 percenL by SepLember
30, 2020 (raLher Lhan 1.13 percenL by Lhe end of 2016, as formerly sLlpulaLed), requlred LhaL, ln seLLlng
assessmenLs, Lhe lulC offseL Lhe effecL of requlrlng LhaL Lhe reserve raLlo reach 1.33 percenL by
SepLember 30, 2020, raLher Lhan 1.13 percenL by Lhe end of 2016, on lnsured deposlLory lnsLlLuLlons
wlLh LoLal consolldaLed asseLs of less Lhan $10 bllllon, ellmlnaLed Lhe requlremenL LhaL Lhe lulC provlde
dlvldends from Lhe fund when Lhe reserve raLlo ls beLween 1.33 percenL and 1.3 percenL, and
malnLalned Lhe lulC's auLhorlLy Lo declare dlvldends when Lhe reserve raLlo aL Lhe end of a calendar
year ls aL leasL 1.3 percenL, ln addlLlon Lo granLlng Lhe lulC sole dlscreLlon ln deLermlnlng wheLher Lo
suspend or llmlL Lhe declaraLlon or paymenL of dlvldends. 1he lulC has acLed Lo exceed Lhe
requlremenLs of Lhe AcL, ralslng Lhe u88 Lo 2 percenL ln 2011.


43
1he AcL also requlres LhaL Lhe lulC amend lLs regulaLlons Lo redeflne Lhe assessmenL base used for
calculaLlng deposlL lnsurance assessmenLs. under uodd-lrank, Lhe assessmenL base musL, wlLh some
posslble excepLlons, equal average consolldaLed LoLal asseLs mlnus average Langlble equlLy. 1he lulC
has proposed ellmlnaLlng rlsk caLegorles and Lhe use of long-Lerm debL lssuer raLlngs for large
lnsLlLuLlons, uslng a scorecard meLhod Lo calculaLe assessmenL raLes for large and hlghly complex
lnsLlLuLlons, and reLalnlng Lhe ablllLy Lo make a llmlLed ad[usLmenL afLer conslderlng lnformaLlon noL
lncluded ln Lhe scorecard. 1he flnal rule wlll deflne a large lnsLlLuLlon as an lnsured deposlLory lnsLlLuLlon
LhaL had asseLs of $10 bllllon or more as of uecember 31, 2006 (unless, by reporLlng asseLs of less Lhan
$10 bllllon for four consecuLlve quarLers slnce Lhen, lL has become a small lnsLlLuLlon), or LhaL had asseLs
of less Lhan $10 bllllon as of uecember 31, 2006, buL has slnce held $10 bllllon or more ln LoLal asseLs for
aL leasL four consecuLlve quarLers, wheLher or noL Lhe lnsLlLuLlon ls new. ln almosL all cases, an lnsured
deposlLory lnsLlLuLlon LhaL has held $10 bllllon or more ln LoLal asseLs for four consecuLlve quarLers wlll
have a CAMLLS raLlng, however, ln Lhe rare evenL LhaL such an lnsLlLuLlon has noL yeL recelved a CAMLLS
raLlng, lL wlll be glven a welghLed average CAMLLS raLlng of 2 for assessmenL purposes unLll acLual
CAMLLS raLlngs are asslgned. An lnsured branch of a forelgn bank ls excluded from Lhe deflnlLlon of a
large lnsLlLuLlon.
3

Cn Lhe lnsurance provlded by Lhe ueposlLors lnsurance lund, Lhe AcL calls ln Lhe lulC Lo fully lnsure Lhe
neL amounL LhaL any member or deposlLor aL an lnsured credlL unlon malnLalns ln a nonlnLeresL-bearlng
LransacLlon accounL. Such amounL shall noL be Laken lnLo accounL when compuLlng Lhe neL amounL due
Lo such member or deposlLor. 1he normal lnsurance level remalns aL $230,000 for each separaLe,
normal lnLeresL-bearlng accounL.
Many commenLaLors have suggesLed LhaL whlle Lhe lulC was unwllllng Lo lnLervene Lo resolve Loo blg
Lo fall" lnsLlLuLlons, lL was cerLalnly able Lo do so. 1hls poslLlon has been made very forcefully by 1homas
Poenlg (2009), former presldenL of Lhe lederal 8eserve ulsLrlcL 8ank of kansas ClLy, on Lhe basls of hls
experlence ln deallng wlLh Lhe resoluLlon of ConLlnenLal llllnols 8ank. 1o faclllLaLe Lhe ablllLy of Lhe lulC
Lo deal wlLh Lhese very large flnanclal lnsLlLuLlons (whlch, as already noLed, uodd-lrank conslders a facL
of llfe), Lhe AcL mandaLes Lhe formulaLlon of so-called llvlng wllls" ln Lhe form of Lhe preparaLlon of
resoluLlon plans and credlL exposure reporLs.
1he AcL calls upon Lhe 8oard of Covernors of Lhe lederal 8eserve Lo requlre nonbank flnanclal
companles and bank holdlng companles LhaL lL supervlses Lo perlodlcally reporL Lhe plan of such
company for rapld and orderly resoluLlon ln Lhe evenL of maLerlal flnanclal dlsLress or fallure, whlch shall
lnclude: lnformaLlon regardlng Lhe manner and exLenL Lo whlch any lnsured deposlLory lnsLlLuLlon
afflllaLed wlLh Lhe company ls adequaLely proLecLed from rlsks arlslng from Lhe acLlvlLles of any nonbank
subsldlarles of Lhe company, full descrlpLlons of Lhe ownershlp sLrucLure, asseLs, llablllLles, and
conLracLual obllgaLlons of Lhe company, ldenLlflcaLlon of Lhe cross-guaranLees Lled Lo dlfferenL

3
uS regulaLors use a raLlng scale of 1 Lo 3 based on a serles of lndlcaLors Lo assess Lhe soundness of a bank. 1hey
lnclude (C) caplLal adequacy, (A) asseL quallLy, (M) managemenL, (L) earnlngs, (L) llquldlLy, and (S) senslLlvlLy Lo
markeL rlsk.


44
securlLles, ldenLlflcaLlon of ma[or counLerparLles, and a process for deLermlnlng Lo whom Lhe collaLeral
of Lhe company ls pledged.
ln addlLlon, Lhe AcL calls for credlL exposure reporLs coverlng Lhe naLure and exLenL Lo whlch Lhe
company has credlL exposure Lo oLher slgnlflcanL nonbank flnanclal companles and slgnlflcanL bank
holdlng companles, and Lhe naLure and exLenL Lo whlch oLher slgnlflcanL nonbank flnanclal companles
and slgnlflcanL bank holdlng companles have credlL exposure Lo LhaL company.
1he led and Lhe lulC wlll revlew Lhese reporLs, and lf, based on Lhelr revlew, Lhe resoluLlon plan of a
nonbank flnanclal company supervlsed by Lhe 8oard of Covernors or a bank holdlng company ls noL
credlble or would noL faclllLaLe an orderly resoluLlon of Lhe company, shall noLlfy Lhe company of Lhe
deflclencles ln Lhe resoluLlon plan, Lhe company shall resubmlL Lhe resoluLlon plan wlLhln a Llmeframe
deLermlned by Lhe led and Lhe lulC wlLh revlslons demonsLraLlng LhaL Lhe plan ls credlble and would
resulL ln an orderly resoluLlon, lncludlng any proposed changes ln buslness operaLlons and corporaLe
sLrucLure Lo faclllLaLe lmplemenLaLlon of Lhe plan.
1he llvlng wlll" ls Lhus deslgned Lo show ex anLe LhaL some flrms are Loo blg Lo fall, and wlll clearly puL
Lhe ma[or burden on large mulLlfuncLlon banks wlLh complex global operaLlons, such as ClLlgroup, 8ank
of Amerlca, !Morgan Chase, Coldman Sachs, and Morgan SLanley. Shella C. 8alr, Lhe former head of Lhe
lulC, has suggesLed LhaL Lhe lnablllLy of a blg bank Lo provlde a credlble resoluLlon plan would be a
condlLlon for requlrlng LhaL lL be broken up by Lhe LransformaLlon of lLs forelgn operaLlons lnLo forelgn
subsldlarles sub[ecL Lo forelgn regulaLors, ln order Lo reallgn lLs legal sLrucLure and, lf necessary, make lL
easler for regulaLors Lo llquldaLe Lhe bank: lf Lhey can'L show Lhey can be resolved ln a bankrupLcy-llke
process . . . Lhen Lhey should be downslzed now" (quoLed ln Clark 2011). 1he alm of orderly llquldaLlon ls
Lo avold a repeaL of 2008, when Lhe 8ush admlnlsLraLlon balled ouL AlC and oLher flrms buL noL Lehman
8roLhers. Lehman's bankrupLcy vlrLually froze caplLal markeLs.
Mlnsky promoLed smaller banklng lnsLlLuLlons as a way Lo ensure LhaL local managemenL and local
knowledge could be used ln Lhe assessmenL of credlLworLhlness. Pe favored Lhe lmposlLlon of Lhe
orlglnaLe-and-hold banklng model, whlch would have lncenLlve sLrucLures LhaL promoLed flnanclal
sLablllLy raLher Lhan rlsk Laklng. llnally, he belleved LhaL promoLlon of small-Lo-medlum-slze flnanclal
lnsLlLuLlons would be more conslsLenL wlLh a general pollcy blased agalnsL concenLraLlon of economlc
power-ln boLh Lhe flnanclal and nonflnanclal secLors. Pe would Lhus have been less wllllng Lo
emphaslze an CLA and resoluLlon plans and more ln favor of breaklng up Lhe large flnanclal holdlng
companles. lL ls lnLeresLlng LhaL under Class-SLeagall, banks were glven one year Lo dlvesL Lhemselves of
Lhelr securlLles afflllaLes and oLher prohlblLed acLlvlLles, and Lhere were no dlfflculLles ln meeLlng Lhls
LlmeLable.
rov|s|on of ||qu|d|ty
1he maln lnsLrumenL of lederal 8eserve supporL durlng Lhe crlsls was lLs auLhorlLy Lo open Lhe dlscounL
wlndow ln urgenL and exlgenL clrcumsLances, as sLlpulaLed ln secLlon 13(3) of Lhe lederal 8eserve AcL, Lo
vlrLually any flnanclal or nonflnanclal lnsLlLuLlon agalnsL vlrLually any Lype of collaLeral. As a resulL of Lhe


43
express deslre of Congress Lo ensure LhaL no supporL be glven Lo falllng flnanclal lnsLlLuLlons, Lhe uodd-
lrank AcL seeks Lo ensure LhaL Lhe led's dlscreLlon Lo provlde emergency supporL Lo lnsolvenL
lnsLlLuLlons does noL clrcumvenL an CLA. 1he AcL Lhus calls on Lhe 8oard of Covernors, ln consulLaLlon
wlLh Lhe SecreLary of Lhe 1reasury, Lo esLabllsh Lhe pollcles and procedures Lo ensure LhaL any
emergency lendlng program or faclllLy ls for Lhe purpose of provldlng llquldlLy Lo Lhe flnanclal sysLem,
and noL Lo ald a falllng flnanclal company, and LhaL Lhe securlLy for emergency loans ls sufflclenL Lo
proLecL Laxpayers from losses and LhaL any such program ls LermlnaLed ln a Llmely and orderly fashlon.
1he pollcles and procedures esLabllshed by Lhe 8oard shall requlre LhaL a lederal reserve bank asslgn,
conslsLenL wlLh sound rlsk managemenL pracLlces and Lo ensure proLecLlon for Lhe Laxpayer, a lendable
value Lo all collaLeral for a loan execuLed by a lederal reserve bank" (Sec. 1101[a]).
ln addlLlon, Lhe AcL requlres Lhe led Lo esLabllsh procedures Lo prohlblL borrowlng from programs and
faclllLles by lnsolvenL borrowers. lurLher, lL llmlLs Lhe ablllLy of Lhe 8oard Lo esLabllsh any emergency
faclllLy wlLhouL Lhe prlor approval of Lhe 1reasury secreLary, and, lf approval ls obLalned, Lo reporL wlLhln
seven days Lo Lhe SenaLe CommlLLee on 8anklng, Pouslng, and urban Affalrs and Lhe Pouse CommlLLee
on llnanclal Servlces, provldlng Lhe [usLlflcaLlon for Lhe asslsLance, Lhe ldenLlLy of Lhe reclplenLs, Lhe
daLe, amounL, and form ln whlch Lhe asslsLance was provlded, and compleLe parLlculars of Lhe
asslsLance. 1he parLlculars lnclude duraLlon, collaLeral pledged and Lhe value Lhereof, all lnLeresL, fees,
and oLher revenue or lLems of value Lo be recelved ln exchange for Lhe asslsLance, any requlremenLs
lmposed on Lhe reclplenL wlLh respecL Lo employee compensaLlon, dlsLrlbuLlon of dlvldends, or any
oLher corporaLe declslon ln exchange for Lhe asslsLance, Lhe expecLed cosLs Lo Lhe Laxpayers of such
asslsLance, and slmllar lnformaLlon wlLh respecL Lo any ouLsLandlng loan or oLher flnanclal asslsLance, Lo
be reporLed every 30 days.
And lf such reporLlng were noL sufflclenL, Lhe AcL glves Lhe compLroller general of Lhe unlLed SLaLes Lhe
power Lo conducL audlLs, lncludlng onslLe examlnaLlons, of Lhe 8oard of Covernors, a lederal 8eserve
8ank, or a credlL faclllLy, lf Lhe compLroller deLermlnes LhaL such audlLs are approprlaLe, solely for Lhe
purpose of assesslng, wlLh respecL Lo a credlL faclllLy or a covered LransacLlon, Lhe operaLlonal lnLegrlLy,
accounLlng, flnanclal reporLlng, and lnLernal conLrols governlng Lhe credlL faclllLy or covered LransacLlon,
Lhe effecLlveness of Lhe securlLy and collaLeral pollcles esLabllshed for Lhe faclllLy or covered LransacLlon
ln mlLlgaLlng rlsk Lo Lhe relevanL lederal 8eserve 8ank and Laxpayers, wheLher Lhe credlL faclllLy or Lhe
conducL of a covered LransacLlon lnapproprlaLely favors one or more speclflc parLlclpanLs over oLher
lnsLlLuLlons ellglble Lo uLlllze Lhe faclllLy, and Lhe pollcles governlng Lhe use, selecLlon, or paymenL of
Lhlrd-parLy conLracLors by or for any credlL faclllLy or Lo conducL any covered LransacLlon.
lrom hls very early work on Lhe reform of Lhe led dlscounL wlndow, Mlnsky argued LhaL Lhe emergency
acLlons provlded by secLlon 13(3) should be made permanenL and parL of Lhe ordlnary operaLlon of Lhe
dlscounL wlndow. lor Mlnsky, Lhe reason was qulLe obvlous: Lhere ls only one flnanclal lnsLlLuLlon LhaL
does noL face a llquldlLy consLralnL, and LhaL ls Lhe lederal 8eserve. As Chalrman 8ernanke has
relLeraLed, Lhe led has Lhe ablllLy Lo provlde llquldlLy aL Lhe push of a compuLer key. ln a complex,
layered flnanclal sysLem ln whlch every lnsLlLuLlon's llablllLles musL have a hlgher llquldlLy premlum Lhan
lLs asseLs, all lnsLlLuLlons ulLlmaLely rely on Lhe banklng sysLem for supporL ln Lhe case of a shorLfall of
cash lnflows and Lhe need Lo reflnance Lhelr llablllLles. And Lhe banklng sysLem relles on Lhe led. 1hus,


46
llmlLlng dlscounL lendlng Lo Lhe banks means allowlng a llquldlLy crlsls Lo morph lnLo an lnsolvency crlsls
ln Lhe resL of Lhe flnanclal sysLem before lL reaches Lhe banks and access Lo Lhe dlscounL wlndow
becomes an opLlon. 8eLLer Lo lend dlrecLly Lo Lhe lnsLlLuLlons faclng llquldlLy dlfflculLles. lndeed, Lhls ls
whaL Lhe led dld ln Lhe currenL crlsls, and lL ls Lhe source of Lhe crlLlclsm LhaL Lhe agency was balllng ouL
lnsolvenL lnsLlLuLlons. Powever, Lhe problem was LhaL Lhe led exLended Lhe reach of Lhe dlscounL
wlndow only afLer a crlsls broke ouL. lL provlded supporL only afLer 8ear SLearns was ln dlfflculLy, buL
Lhen exLended supporL Lo all equlvalenL lnsLlLuLlons. 1he same was Lrue ln Lhe case of Lehman, whlch
was allowed Lo fall-and tbeo Lhe wlndow was opened Lo oLher broker-dealer lnsLlLuLlons. lor Mlnsky, lL
would have been much beLLer Lo open Lhe wlndow Lo Lhese lnsLlLuLlons as a maLLer of course, whlch
mlghL have prevenLed Lhelr decllne lnLo lnsolvency. use of Lhe llquldlLy faclllLles early on also could have
been made LransparenL, leavlng Lhe led less open Lo Lhe crlLlclsm LhaL lL was plcklng wlnnlng and losers.
Cpenlng Lhe wlndow would have provlded Lhe led wlLh a wlndow" onLo Lhe operaLlons of Lhe
lnsLlLuLlons seeklng supporL, whlch would have alerLed lL much more qulckly Lo Lhe condlLlon of Lhelr
balance sheeLs. lnsLead of conLlnually argulng LhaL Lhe crlsls was conLalned, Lhe led, had lL been Lhe
lender Lo all flnanclal lnsLlLuLlons, would have known much earller how much Lhe decllne ln house prlces
and Lhe markeLs for securlLlzed sLrucLure had lmpacLed all flnanclal lnsLlLuLlons.
lull lmplemenLaLlon of uodd-lrank wlll requlre over 200 rule-maklng provlslons by regulaLory agencles,
over 60 speclal reporLs and, and an addlLlonal 22 reporLs. lL Lhus places noL only ma[or responslblllLy for
success of Lhe AcL ln Lhose bodles responslble for wrlLlng Lhe speclflc rules buL also an even greaLer
burden on Lhe supervlslon of Lhose rules. 1hus, Lhe flnal form wlll be largely deLermlned by Lhe
lnLeracLlon beLween Lhe pollLlcal lncenLlve for reform and Lhe ablllLy of Lhe varlous governmenL agencles
Lo fulflll Lhe lnLenLlons of Lhe leglslaLlon and Lhe supervlsory bodles Lo monlLor compllance.
1he mosL lmporLanL falllng ls LhaL lL leaves ln place Lhe underlylng buslness model for flnanclal
lnsLlLuLlons and Lhe conLradlcLlons lnherenL ln Lhe 1999 CL8 leglslaLlon LhaL were aL Lhe core of Lhe
crlsls. lndeed, Lhe underlylng loglc of Lhe led and 1reasury rescue operaLlons has been Lo resLore Lhls
sysLem. neverLheless, as Lhe nexL chapLer explalns, Lhe answer ls noL slmply Lo aLLempL Lo rewlnd Lhe
regulaLory process LhaL led from Class-SLeagall Lo Lhe llnanclal Servlces ModernlzaLlon AcL.



47
CnA1Lk S. Why We Can't Go 8ack to G|ass-Steaga||

8ecenLly, a number of auLhorlLaLlve volces have called for a reLurn Lo Lhe new ueal Class-SLeagall
leglslaLlon as Lhe mosL approprlaLe response Lo Lhe 1999 llnanclal Servlces ModernlzaLlon AcL's fallure
Lo provlde sLablllLy of Lhe flnanclal sysLem. Powever, a clear undersLandlng of Lhe 1933 8anklng AcL,
along wlLh subsequenL regulaLory lnLerpreLaLlon and leglslaLlon, suggesLs LhaL Lhls would be dlfflculL, lf
noL lmposslble. A new Class-SLeagall AcL would have Lo be subsLanLlally dlfferenL from Lhe orlglnal, and
some of Lhe lnLernal sLrucLural conLradlcLlons LhaL led Lo lLs demlse remedled.
What was G|ass-Steaga|| try|ng to do?
llrsL, lL ls lmporLanL Lo noLe LhaL Lhe leglslaLlon, produced ln sllghLly less Lhan Lhree monLhs, was
consldered a sLopgap measure LhaL was enacLed followlng Lhree years of crlsls. lL drew exLenslvely on
reform proposals LhaL had been under dlscusslon slnce Lhe esLabllshmenL of Lhe naLlonal MoneLary
Commlsslon ln 1908 and Lhe subsequenL creaLlon of Lhe lederal 8eserve SysLem. lndeed, Lhe maln
proposal-Lhe separaLlon of banklng and flnance-had been puL forward by Louls u. 8randels (1914) ln
hls famous condemnaLlon of Lhe Lurn-of-Lhe-cenLury flnanclal sysLem.
1he SenaLe CommlLLee on 8anklng and Currency reporL on Lhe AcL emphaslzes Lhe lnLenLlon Lo
consLrucL a blll Lo correcL Lhe lmmedlaLe abuses" raLher Lhan prepare a compleLely comprehenslve
measure for Lhe reconsLrucLlon of Lhe u.S. banklng sysLem. A good summary
6
of Lhese lmmedlaLe
abuses" ls conLalned ln Lhe declslon of Lhe ulsLrlcL of Columbla ClrculL CourL of Appeals: A.C. 8ecket, loc.
v. 8ootJ of Covetoots of tbe leJetol kesetve 5ystem (1982). 1he baslc abuses were deposlL-Laklng banks'
underwrlLlng of and lnvesLmenL ln securlLles, lendlng Lo flnance Lhe acqulslLlon of securlLles, and margln
lendlng Lo reLall cllenLs for Lhe purchase of securlLles. 1he lnLegrlLy of Lhe publlc's holdlng of deposlLs ln
banks was Lo be ensured by prohlblLlng deposlL-Laklng banks from Lhese acLlvlLles, and by prevenLlng
any flnanclal lnsLlLuLlon engaged ln Lhese prohlblLed acLlvlLles from Laklng deposlLs from Lhe publlc.
1he comprehens|ve measures
Whlle Lhe ConsLlLuLlon forblds sLaLes Lhe rlghL Lo lssue debL or currency, lL does noL prohlblL Lhem from
charLerlng banks. 1he Clvll War-era naLlonal 8ank AcL soughL Lo reduce Lhe role of sLaLe banks by
llmlLlng Lhe lssue of naLlonal bank noLes Lo federally charLered banks. 8uL sLaLe banks responded by
offerlng cllenLs checkable deposlLs, and by Lhe Lurn of Lhe 20Lh cenLury, sLaLe banks were domlnanL. 1hls
was parLly due Lo a 1902 rullng by Lhe CompLroller of Lhe Currency llmlLlng lnvesLmenLs by naLlonal
banks Lo any slngle borrower and curLalllng Lhe rlghL of Lhe large new ?ork naLlonal banks Lo deal ln and
underwrlLe securlLles. SLaLe banks were noL sub[ecL Lo Lhese resLrlcLlons, and naLlonal charLer banks
formed sLaLe-charLered afflllaLes Lo evade Lhem. lL was Lhe acLlvlLles of Lhese securlLy afflllaLes LhaL

6
1hls source has been chosen noL because lL ls consldered correcL buL raLher because lL ls represenLaLlve of whaL
Lhe courLs have consldered Lo be Lhe essence of Lhe new ueal leglslaLlon and Lhus Lhe basls for legal
lnLerpreLaLlon.


48
produced mosL of Lhe fraud and malfeasance durlng Lhe 1920s sLock markeL boom and LhaL many
experLs consldered Lo be Lhe cause of Lhe CreaL Crash.
1o remove Lhls abuse, secLlon 20 of Lhe 1933 AcL speclfles LhaL no member bank shall be afflllaLed ln
any manner . . . wlLh any corporaLlon, assoclaLlon, buslness LrusL, or oLher slmllar organlzaLlon engaged
prlnclpally ln Lhe lssue, floLaLlon, underwrlLlng, publlc sale, or dlsLrlbuLlon aL wholesale or reLall or
Lhrough syndlcaLe parLlclpaLlon of sLocks, bonds, debenLures, noLes, or oLher securlLles" (l88 1933,
398). 1hus, Lhe more comprehenslve measures" referred Lo by Lhe SenaLe commlLLee lnvolved Lhe
ellmlnaLlon of Lhls dual sysLem of regulaLlon by sLaLe governmenLs and Lhe federal governmenL. ln
parLlcular, Lhe prohlblLlon applled by mosL sLaLes Lo branch banklng, and Lhe declslon of federal
regulaLors Lo respecL Lhls rule, produced a predomlnance of small unlL" banks ln Lhe unlLed SLaLes. 1hls
was ofLen LhoughL Lo be a conLrlbuLory facLor ln Lhe lnsLablllLy of Lhe uS sysLem as compared Lo Lhe
Canadlan, whlch had a small number of large banks and emerged from Lhe 1930s wlLhouL ma[or
flnanclal crlsls. 1o remedy Lhese more fundamenLal problems would requlre unlfylng regulaLlon aL Lhe
federal level, posslbly along Lhe llnes of a consLlLuLlonal amendmenL or some equally far-reachlng
measure necesslLaLlng a long posLponemenL of acLlon" (A.C. 8ecket 1982).
Correct|ng the man|fest abuses produces a f|nanc|a| structure
AlLhough consldered sLopgap measures, Lhe resLrlcLlons on Lhe lmmedlaLe abuses had very clear
consequences for Lhe sLrucLure of Lhe flnanclal sysLem. Cne seL of flnanclal lnsLlLuLlons would be
responslble for Laklng deposlLs from Lhe publlc and maklng shorL-Lerm loans Lo commerclal and
lndusLrlal borrowers Lhrough Lhe creaLlon of credlL ln Lhe form of new deposlL accounLs. A second seL of
lnsLlLuLlons would be charged wlLh Lhe long-Lerm flnanclng of caplLal lnvesLmenL Lhrough Lhe lnlLlal
underwrlLlng and secondary dlsLrlbuLlon and Lradlng of securlLles: bonds and equlLy.
SecLlon 21 of Lhe 1933 AcL slmply formallzes Lhls dlfference beLween Lhe shorL-Lerm and long-Lerm
forms of flnance for Lhe prlvaLe secLor. lL provldes member banks wlLh a monopoly on deposlL buslness,
sub[ecL Lo perlodlc examlnaLlon by Lhe CompLroller of Lhe Currency or by Lhe lederal reserve bank of
Lhe dlsLrlcL" and Lo Lhe requlremenL LhaL each bank make and publlsh perlodlc reporLs of lLs condlLlon"
(l88 1933, 398).
lollowlng 8randels's admonlLlon, Lhe lnLenLlon was Lo shleld publlc deposlLs from exposure Lo or use ln
any securlLles markeL acLlvlLles, and, ln parLlcular, Lo prevenL member banks from ownlng or deallng ln
equlLy or formlng afflllaLes Lo do so. 1hus, Lhe operaLlonal dlfference beLween commerclal and
lnvesLmenL banks resLs on Lhe former's ablllLy Lo recelve deposlLs and Lhe llmlLlng of Lhelr lnvesLmenLs
Lo shorL-Lerm, self-llquldaLlng buslness loans.
Powever, P. arker Wlllls's (1921) analysls of Lhe acLlvlLy of commerclal banks noLes LhaL Lhelr mosL
lmporLanL funcLlon ls noL Lhe slmple recelpL of publlc deposlLs buL raLher Lhe creaLlon of llquldlLy for lLs
borrowers Lhrough Lhe accepLance funcLlon, Lhls allows Lhe bank Lo earn lncome ln Lhe form of a neL
lnLeresL margln, less charge-offs for bad loans. 8anks noL only recelve and preserve deposlLs buL also


49
creaLe llquldlLy Lhrough leverage, and Lhey are recompensed for Lhls by Lhe premlum on Lhelr deposlLs
relaLlve Lo Lhelr asseLs and by Lhelr ablllLy Lo scruLlnlze Lhe solvency of borrowers.
1hus, whlle Lhe 1933 AcL llmlLs Lhe recelpL of deposlLs" Lo member banks, lL also llmlLs banks' ablllLy Lo
use and creaLe deposlLs Lo creaLe llquldlLy for Lhelr cllenLs Lo parLlcular Lypes of lnvesLmenLs-whaL are
generally called commerclal and lndusLrlal (C&l) loans.
Powever, commerclal banks are noL unlque ln Lhe creaLlon of llquldlLy. Whlle a commerclal bank creaLes
llquldlLy by ensurlng LhaL lLs llablllLles have a hlgher llquldlLy premlum Lhan lLs asseLs and Lhus can
always be exchanged for currency, lnvesLmenL banks also provlde llquldlLy by ensurlng LhaL Lhe llablllLles
Lhey underwrlLe have a hlgher llquldlLy premlum Lhan Lhe caplLal asseLs Lhey flnance and Lhus can be
boughL or sold ln organlzed markeLs wlLhouL a greaL varlaLlon ln prlce. 1hey do Lhls by ensurlng an acLlve
and llquld secondary markeL for securlLles Lhrough Lhelr broker-dealer acLlvlLles as markeL makers. 1he
1933 AcL provlded monopoly proLecLlon for a parLlcular means of provldlng llquldlLy Lhrough deposlL
creaLlon, buL lL dld noL glve commerclal banks a monopoly on Lhe creaLlon of llquldlLy.
1he v|ab|||ty of the commerc|a|-bank bus|ness mode| under the 1933 8ank|ng Act
naLlonal banks suffered from compeLlLlon from alLernaLlve forms of llquldlLy creaLlon even before Lhelr
operaLlons were resLrlcLed Lo shorL-Lerm commerclal and lndusLrlal loans ln Lhe 1933 AcL-and had
already begun Lo expand Lhelr lendlng lnLo longer-Lerm maLurlLles. 1he flnanclal sysLem also evolved
beyond Lhe slmple sLrucLure envlsaged by Lhe 8anklng AcL as a resulL of a process of lnnovaLlon and
compeLlLlon beLween regulaLed and unregulaLed banks. ln any evenL, boLh Lhe proLecLed deposlL
buslness and Lhe creaLlon of llquldlLy based on deposlL creaLlon were eroded by compeLlLlon from
nonmember lnvesLmenL banks LhaL were noL resLrlcLed Lo a parLlcular buslness model. lndeed, lL was
noL Lhe recelpL of cusLomer currency deposlLs LhaL had Lo be proLecLed buL raLher llquldlLy creaLlon, or
Lhe accepLance funcLlon, lf Lhe separaLlon of commerclal and lnvesLmenL banks was Lo be susLalnable.
Cnce lnvesLmenL banks could provlde Lhese llquldlLy-creaLlng servlces more cheaply Lhan regulaLed
banks, Lhe laLLer's buslness model became unLenable, and wlLh lL Lhe loglc of Lhe Class-SLeagall
separaLlon of commerclal and lnvesLmenL banklng.
G|ass-Steaga|| created a monopo|y that was bound to fa||
lor supporLers of free-markeL llberallsm, Lhe decllne of member banks as Lhe provlders of llquldlLy
Lhrough lnsured deposlL creaLlon was slmply an expresslon of Lhe lnefflclencles of a de facLo carLel on
deposlL Laklng. lor example, kenneLh L. ScoLL (1981) noLed LhaL Lhe 1933 AcL underLook Lo creaLe a
buyers' carLel among banks, resLralnlng compeLlLlon among Lhem for demand deposlLs and for Llme and
savlngs deposlLs. And, accordlng Lo Ceorge C. kaufman (1988), Lhe AcL was blaLanLly anLlcompeLlLlve,
and economlsLs generally agreed LhaL mosL of lLs resLrlcLlons were no longer necessary, aL leasL for
resLrlcLlng rlsk.
Powever, Lhe eroslon of Lhe proLecLlons afforded member banks' deposlL buslness was as much due Lo
Lhe consclous declslons of regulaLors and leglslaLors Lo weaken and suspend Lhe proLecLlons of Lhe AcL-
Lhus provldlng expllclL supporL for Lhe compeLlLlve lnnovaLlons of nonmember banks-as lL was Lo Lhe


30
Lrlumph of markeL forces over monopoly. lndeed, Class-SLeagall gave unregulaLed lnvesLmenL banks a
monopoly over securlLles markeL acLlvlLles, some of whlch could be made funcLlonally equlvalenL Lo Lhe
deposlL buslness and llquldlLy creaLlon of regulaLed banks wlLh Lhe lnLroducLlon of flnanclal lnnovaLlon.
Cha||enges to monopo|y protect|on: 1hr|fts and asset secur|t|zat|on
An lnlLlal challenge Lo member banks' monopoly on Lhe recelpL of deposlLs came from savlngs-and-loan
banks. Savlngs banks were consldered lnvesLmenL banks, so Lhey were excluded from Lhe 1933 AcL and
Lhe 8egulaLlon C llmlLs on deposlL lnLeresL raLes for lnsured member banks. When lnLeresL raLes sLarLed
Lo cllmb along wlLh lnflaLlon, LhrlfLs were provlded a means of compeLlng wlLh member banks for
lnsured deposlLs-buL wlLh fewer consLralnLs as a resulL of deregulaLlon. 1he end resulL was Lhe savlngs-
and-loan crlsls, whlch led Lo Lhe collapse of Lhe lndusLry.
8uL Lhe real challenge Lo member banks' monopoly on llquldlLy creaLlon came from Lhe exLenslon of
asseL securlLlzaLlon Lo encompass loans Lo buslnesses aL lower flnanclng spreads Lhrough rlsk reducLlon
and redlsLrlbuLlon. llrsL, corporaLe lssue of commerclal paper dlsplaced borrowlng from commerclal
bank loans, and Lhe guaranLeed one-dollar neL asseL value of llablllLles of money markeL funds provlded
a subsLlLuLe for member bank deposlLs. LeglslaLors ln 1933 could noL have foreseen Lhe rlse of
commerclal paper as a subsLlLuLe for commerclal and lndusLrlal loans or MMMls as a subsLlLuLe for
reLall deposlLs, and member banks could noL respond by enLerlng Lhose markeLs.
Powever, ln 1984 Lhe Supreme CourL ruled LhaL Lhe lederal 8eserve had Lhe auLhorlLy Lo allow
regulaLed banks Lo acqulre brokers as a subsldlary ln a bank holdlng company (see 5ecotltles loJostty
Assoclotloo 1984), and ln 1983 Lhe led ruled LhaL bank holdlng companles could acqulre as subsldlarles
flrms LhaL offered boLh brokerage and lnvesLmenL advlce Lo lnsLlLuLlonal cusLomers. SubsequenL
lnLerpreLaLlons furLher relaxed Lhe AcL's secLlon 20 resLrlcLlons, and Lhen expressly allowed regulaLed
banks Lo engage ln securlLlzaLlon vla afflllaLlon wlLh companles underwrlLlng commerclal paper,
munlclpal revenue bonds, and securlLles backed by morLgages and consumer debLs-as long as Lhe
afflllaLe dld noL prlnclpally engage ln Lhose acLlvlLles.
1he baslc concepL used by MMMls was generallzed ln asseL-backed securlLlzaLlon.
7
1hls concepL was
soon exLended Lo Lhe securlLlzed flnanclng of a wlde range of corporaLe llablllLles. 1he remuneraLlon
from Lhls acLlvlLy comes from ldenLlfylng any markeL mlsprlclng of rlsk (l.e., rlskless arblLrage"). lnsLead
of a spread beLween borrowlng and lendlng raLes deLermlned by Lhe bank's ablllLy Lo assess credlL rlsk
and Lhus ensure Lhe llquldlLy of lLs llablllLles, rlskless arblLrage requlres [usL Lhe opposlLe process. Pere,
lL ls Lhe poollng, dlverslflcaLlon, and sLrucLurlng of Lhe speclal-purpose enLlLy's asseLs LhaL reduces rlsk,
along wlLh Lhe dlsLrlbuLlon of Lhe asseLs lnLo a large and acLlve markeL LhaL lncreases llquldlLy and
converLs hlgh-raLe, rlsky asseLs lnLo lower-raLe, less rlsky asseLs. ln addlLlon Lo Lhe lncome generaLed
from Lhe lnLeresL spread beLween long-Lerm asseLs and shorLer-Lerm llablllLles, fees and commlsslons
resulL from Lhe orlglnaLlon of Lhe loan, Lhe underwrlLlng of Lhe securlLles, and Lhe servlclng of Lhe
sLrucLure lLself.

7
1hls ls an lssue LhaL Mlnsky consldered cruclal buL dld noL dlscuss ln greaL lengLh ln hls publlshed work, see
Mlnsky 2008.


31
1he declslon by Lhe SLC Lo exempL securlLlzaLlon sLrucLures from reporLlng as sLand-alone flnanclal
lnsLlLuLlons opened an alLernaLlve paLhway for member banks Lo organlze and operaLe afflllaLes LhaL
were nelLher regulaLed nor consolldaLed for flnanclal reporLlng purposes. Agaln, regulaLors could have
halLed Lhe developmenL of asseL-backed securlLles, buL lnsLead chose Lo suspend regulaLlons ln order Lo
allow member banks Lo parLlclpaLe ln Lhelr orlglnaLlon and sale.
1he response to cha||enges from nonmember banks
1o remedy Lhe compeLlLlve dlsadvanLages, member banks were allowed exLenslve exempLlons from Lhe
secLlon 20 and 21 lnLerdlcLlons agalnsL deallng ln securlLles and wlLh securlLy afflllaLes, erodlng Lhe sLrlcL
segregaLlon provlded by Lhe orlglnal 1933 leglslaLlon. 1he comblned lmpacL of money markeL funds,
exempLlons for securlLles afflllaLes, and sLrucLured securlLlzaLlon ls Lo provlde llablllLles wlLh a hlgher
llquldlLy premlum Lhan asseLs. 1he lmpacL of Lhese sLrucLures was Lo allow nonlnsured lnsLlLuLlons Lo
challenge Lhe monopoly glven commerclal banks Lo make Lhelr llablllLles more llquld Lhan Lhelr asseLs
Lhrough Lhe use of deposlL lnsurance and balance sheeL regulaLlon. 1hey also lncreased sysLem llquldlLy
wlLhouL Lhe same regulaLory prudenLlal measures lmposed on banks Lo ensure Lhe llquldlLy and prlce of
deposlL llablllLles. under Lhe uS regulaLory sysLem, money markeL deposlL accounLs and regulaLed bank
deposlLs are consldered equlvalenL, yeL Lhe former are regulaLed by Lhe SLC and lssued by lnvesLmenL
banks, whlle Lhe laLLer are regulaLed by Lhe led and Lhe Cfflce of Lhe CompLroller of Lhe Currency (CCC)
and lssued by commerclal banks.
1he ||bera||z|ng power of "|nc|denta| powers"
AlLhough compeLlLlve lnnovaLlon played an lmporLanL role ln breaklng down Lhe segregaLlon of deposlL
Laklng and securlLles acLlvlLles, lL was Lhe legal and admlnlsLraLlve lnLerpreLaLlons of secLlon 16 LhaL
ulLlmaLely evlsceraLed Class-SLeagall and Lhe proLecLlons lL provlded Lo Lhe buslness model envlsaged
for commerclal banks. SecLlon 16 accorded regulaLed banks all such lncldenLal powers . . . necessary Lo
carry on Lhe buslness of banklng" (l88 1933, 396). MosL of Lhe excepLlons LhaL enabled commerclal
banks Lo meeL Lhe compeLlLlon from nonlnsured banks and caused Lhe progresslve eroslon of Class-
SLeagall came ln laLer lnLerpreLaLlons of Lhe phrase lncldenLal powers," especlally by Lhe CCC.
8

1he overall lmpacL of Lhese rullngs lald Lhe basls for Lhe creaLlon of proprleLary Lradlng by banks for Lhelr
own accounL, as well as derlvaLlves deallng and Lhe provlslon of sLrucLured derlvaLlve lendlng-boLh of
whlch led Lo Lhe rapld growLh of Lhe C1C markeL ln credlL derlvaLlves. aradoxlcally, Lhe [usLlflcaLlon was
Lo provlde regulaLed lnsLlLuLlons, whlch were supposed Lo have a monopoly advanLage, a level playlng
fleld wlLh lnvesLmenL banks.

8
1hls language was orlglnally lnLroduced ln secLlon 8 of Lhe naLlonal 8ank AcL of 1863 granLlng naLlonal
assoclaLlons all such lncldenLal powers as shall be necessary Lo carry on Lhe buslness of banklng," buL lL made no
reference aL all Lo securlLles, see krooss 1969, 2:1386. 1here has been exLended debaLe concernlng wheLher Lhese
powers are resLrlcLed Lo Lhose expressly menLloned ln Lhe law or are sub[ecL Lo lnLerpreLaLlon. ln pracLlce, Lhe
declslon ls lefL wlLh Lhe CCC, creaLed ln Lhe same leglslaLlon. A 1993 Supreme CourL declslon (Notloos8ook of
Nottb cotolloo, N.A. v. votloble Aooolty llfe losotooce co.) afflrmed Lhe CCC's full power Lo lnLerpreL secLlon 8.


32
1he regu|atory dynam|c of |nnovat|on and protect|on
1he regulaLory dynamlc ln Lhe posLwar perlod was one ln whlch nonregulaLed lnvesLmenL banks devlsed
lnnovaLlons LhaL were more compeLlLlve Lhan Lhose LhaL could be offered by regulaLed commerclal
banks. ln Lhls envlronmenL, Lhe monopoly proLecLlons placed on deposlL buslness by Lhe 1933 AcL
became a hlndrance Lo Lhe commerclal banks' survlval. 8egulaLed lnsLlLuLlons argued for Lhe ellmlnaLlon
of regulaLlons unLll Lhere was vlrLually no dlfference ln Lhe acLlvlLles of lulC-lnsured commerclal banks
and lnvesLmenL banks. As a resulL, Lhe baslc prlnclples of Lhe AcL were evlsceraLed even before Lhe
llnanclal Servlces ModernlzaLlon AcL formally suspended Class-SLeagall's proLecLlons ln 1999.
1hls de facLo suspenslon of Class-SLeagall had anoLher consequence for Lhe sLablllLy of Lhe flnanclal
sysLem. LlquldlLy creaLlon was lncreaslngly Lransferred from deposlL creaLlon by commerclal banks
sub[ecL Lo prudenLlal regulaLlon, Lo securlLlzed sLrucLures LhaL were exempL from reporLlng and
regulaLlon because Lhey were consldered caplLal markeL acLlvlLles and (usually) exempL from even SLC
overslghL-each one of Lhese sLrucLures could be consldered a ghosL or shadow" bank. 1hus, Lhe
llquldlLy crlses ln 1998 and 2008 produced, noL a run on banks, buL a collapse of securlLy values and
lnsolvency ln Lhe securlLlzed sLrucLures, and Lhe wlLhdrawal of shorL-Lerm fundlng from Lhe shadow
banks. 1he safeLy neL creaLed Lo respond Lo a run on bank deposlLs was LoLally lnadequaLe Lo respond Lo
a caplLal markeL llquldlLy crlsls.
1he challenge LhaL Lhls new sysLem of llquldlLy creaLlon ralses for Lhose who would resLore Class-
SLeagall ls Lwofold: how can commerclal banks compeLe wlLh lnvesLmenL banks ln provldlng flnance for
buslness borrowers lf Lhey cannoL deal and Lrade ln securlLles, and how can regulaLlons be wrlLLen Lo
prevenL a repeaL of Lhe collapse of resLrlcLlons on securlLles Lradlng? ln parLlcular, Lhe quesLlon of
lncldenLal powers," Lhe real Achllles heel of Lhe 1933 AcL, musL be resolved. And even lf Lhese problems
could be resolved, lL would sLlll leave open Lhe fundamenLal reform LhaL was bypassed by Lhe orlglnal
AcL-Lhe relaLlon beLween sLaLe and naLlonal charLers and regulaLlons.
If there |s no way back, |s there a way forward?
A reLurn Lo Class-SLeagall Lhus presenLs a conundrum. Slnce Lhe acLlvlLles LhaL currenLly provlde Lhe
leasL cosLly meLhod of shorL-Lerm buslness flnanclng are fundamenLally llnked Lo securlLles markeL
acLlvlLles, Lhey would be prohlblLed Lo regulaLed banks. ln addlLlon, lL would appear lmposslble Lo
leglslaLe monopoly proLecLlons slmllar Lo Lhose of 1933 for deposlLs wlLhouL acLlve monlLorlng and Lhe
prohlblLlon of compeLlLlve lnnovaLlons by nonregulaLed lnsLlLuLlons. Slmllarly, a separaLlon of shorL-Lerm
bank flnanclng acLlvlLy from long-Lerm fundlng ln securlLles markeLs would requlre prohlblLlng Lhe
sLrucLured flnanclng and derlvaLlves LhaL have largely ellmlnaLed Lhls dlsLlncLlon by converLlng long-Lerm
asseLs lnLo llquld, shorL-Lerm llablllLles. 1hus, an alLernaLlve source of revenue would have Lo be found
for regulaLed banks, requlrlng regulaLors, leglslaLors, and Lhe [udlclary Lo agree on Lhe preclse deflnlLlon
of permlsslble banklng acLlvlLles and Lhe lncldenLal powers requlred Lo carry Lhem ouL.
8esolvlng Lhls problem wlll noL be easy. nelLher a resLoraLlon of Lhe currenL sysLem, wlLh beLLer
regulaLlon, nor a reLurn Lo 1933 wlll sufflce. Cne approach would be Lo recognlze Lhe acLlvlLy of deposlL
Laklng as a publlc servlce and Lo regulaLe lL as a publlc uLlllLy, wlLh a guaranLeed reLurn on regulaLed


33
cosLs. 1hls approach would probably lnvolve lncreased cosLs for LransacLlon servlces or some form of
governmenL subsldy. AlLernaLlvely, a Lax on nonLransacLlon banks could provlde Lhls subsldy, raLher Lhan
uslng lL as a fund Lo ball ouL unregulaLed falled banks. AnoLher posslblllLy would be Lo deflne Lhe
buslness of banklng as Lhe creaLlon of llquldlLy Lhrough Lhe accepLance funcLlon of cllenL llablllLles. 1he
experLlse of banklng would Lhen be reLurned Lo mlnlmlzlng charge-offs by lmprovlng Lhe credlL
assessmenL of borrowers. All oLher forms of llquldlLy creaLlon would fall wlLhln Lhe realm of lnvesLmenL
banklng. Pere, experLlse would be ln arblLraglng markeL lmperfecLlons, LhaL ls, rlsk, lnLeresL raLes,
exchange raLes, and so forLh. under such a dlvlslon, MMMls would be a permlsslble commerclal bank
acLlvlLy.
A furLher approach would recognlze LhaL Lhe ConsLlLuLlon reserves Lhe provlslon of currency Lo Lhe
governmenL, and Lhere ls no reason for Lhe ma[or parL of Lhls obllgaLlon Lo be ouLsourced Lo Lhe prlvaLe
secLor.
9
1he safekeeplng of wealLh and LransacLlon servlces could Lhus be provlded as a publlc servlce by
a regulaLed uLlllLy-say, Lhrough a naLlonal glro paymenLs sysLem-ellmlnaLlng Lhe need for deposlL
lnsurance and Lhe lender-of-lasL-resorL funcLlon of Lhe lederal 8eserve. 8oLh shorL- and long-Lerm
flnance and fundlng could Lhen be provlded by prlvaLe lnvesLmenL funds or LrusLs monlLored by
securlLles regulaLlons, buL wlLhouL Lhe need for a governmenL guaranLee. rlvaLe savlngs would Lhen
llmlL lnvesLmenL flnanclng, and Lhe beneflLs of Lhe banks' accepLance funcLlon would be losL. 1he
conundrum noLed above remalns unresolved.


9
lndeed, many economlsLs have seen Lhls as Lhe ma[or source of lnsLablllLy ln Lhe flnanclal sysLem. lor example,
Penry CalverL Slmons (1948 [1934], 34-33) noLes Lhe usurpaLlon by prlvaLe lnsLlLuLlons (deposlL banks) of Lhe
baslc sLaLe funcLlon of provldlng Lhe medlum of clrculaLlon (and of prlvaLe 'cash' reserves). lL ls no exaggeraLlon Lo
say LhaL Lhe ma[or proxlmaLe facLor ln Lhe presenL crlsls ls commerclal banklng. . . . Chaos arlses from rellance by
Lhe sLaLe upon compeLlLlve conLrols ln a fleld (currency) where Lhey cannoL posslbly work.


34
CnA1Lk 6. A|ternat|ves to the Dodd-Irank keforms

1he Cut|ook for Imp|ementat|on of Dodd-Irank
Some Lwo years afLer Lhe adopLlon of Lhe uodd-lrank AcL, lLs lmplemenLaLlon ls sLlll far from compleLe.
And desplLe Lhe facL LhaL one of Lhe ma[or ob[ecLlves of Lhe leglslaLlon was Lo remove Lhe LhreaL LhaL
banks LhaL are Loo blg Lo fall" (181l) would requlre a Laxpayer ballouL, Lhe flnanclal sysLem has become
even more concenLraLed and Lhe largesL banks even larger. Accordlng Lo Lhe presldenL of Lhe lederal
8eserve 8ank of uallas, uodd-lrank . . . may acLually perpeLuaLe an already dangerous Lrend of
lncreaslng bank lndusLry concenLraLlon" (llsher 2012, 1). lndeed, Lhe Lop flve flnanclal conglomeraLes
now accounL for over 30 percenL of LoLal lndusLry asseLs, and Lhree of Lhem are over or near Lhe 10
percenL llmlL on Lhe share of naLlonal deposlLs seL by Lhe 1994 8legle-neal AcL llberallzlng branch
banklng (see Lhe flgures presenLed ln 8osenblum 2012).
And as recovery from Lhe deep recesslon caused by Lhe 2008 flnanclal crlsls seems more vlslble, and
mosL flnanclal lnsLlLuLlons have recovered sufflclenLly Lo repay Lhe flnanclal supporL LhaL recelved under
Lhe 1roubled AsseL 8ellef rogram, Lhe speclflc rules LhaL wlll be promulgaLed by governmenL regulaLory
agencles and are requlred Lo make uodd-lrank operaLlonal are faclng lncreaslng reslsLance from Lhe
flnanclal servlces lndusLry. uue Lo sLaff and fundlng shorLages ln regulaLory agencles and Lhe sheer
number of regulaLlons Lo be flnallzed, mosL wlll noL be approved or lmplemenLed on Lhe LlmeLable
requlred by Lhe leglslaLlon.
SupporL for Lhls reslsLance and addlLlonal delays have come from Lhe [udlclal sysLem. A rullng by Lhe u.C.
ClrculL CourL of Appeals (ln 8osloess koooJtoble v. 5ecotltles ooJ xcbooqe commlssloo, No. 10-1J05
10
)
has vacaLed a SecurlLles and Lxchange Commlsslon (SLC) rule because lLs analysls of Lhe cosLs of Lhe
regulaLlon was noL sufflclenLly exLenslve. A second sulL has been broughL agalnsL Lhe CommodlLy
luLures 1radlng Commlsslon's (Cl1C) rule on derlvaLlves poslLlon llmlLs.
11
A recenL reporL suggesLs LhaL a
large ma[orlLy of Lhe rule proposals currenLly under dlscusslon do noL meeL Lhe courL's requlremenLs on
lmpacL assessmenL and could be successfully challenged (see CCM8 2012).

10
Cn !uly 22, 2011, Lhe u.S. CourL of Appeals for Lhe ulsLrlcL of Columbla (Lhe 'u.C. ClrculL') found LhaL Lhe
SecurlLles and Lxchange Commlsslon ('SLC') acLed arblLrarlly and caprlclously ln adopLlng proxy voLlng rules, 8ule
14a-11. AlLhough Lhe SLC's adopLlng release devoLed 60 pages Lo a cosL-beneflL analysls of Lhls rule, Lhe u.C.
ClrculL vacaLed 8ule 14a-11 on Lhe basls LhaL Lhe SLC 'falled adequaLely Lo conslder [8ule 14a-11's] effecL upon
efflclency, compeLlLlon, and caplLal formaLlon.' . . . ln reachlng Lhls concluslon, Lhe courL sharply crlLlclzed Lhe SLC's
efforLs, aL one polnL calllng Lhem 'unuLLerably mlndless'" (klnl and rocLor 2011, 1).
11
Cn uecember 2, 2011, Lhe lnLernaLlonal Swaps and uerlvaLlves AssoclaLlon, lnc. and Lhe SecurlLles lndusLry and
llnanclal MarkeLs AssoclaLlon flled a legal challenge Lo Lhe CommodlLy luLures 1radlng Commlsslon's (Cl1C) flnal
rules LhaL llmlL Lhe poslLlons LhaL lnvesLors may own ln cerLaln commodlLles. . . . [1]he AssoclaLlons conLend LhaL
Lhe Cl1C's declslon-maklng process ln enacLlng Lhe 8ule was procedurally flawed. Among oLher deflclencles, Lhe
Cl1C adopLed Lhe 8ule wlLhouL maklng flndlngs as Lo Lhe necesslLy and approprlaLeness of Lhe poslLlon llmlLs, as
requlred by sLaLuLe. lurLhermore, Lhe Cl1C falled Lo conducL any meanlngful cosL-beneflL analysls and lacked a
reasoned basls for lLs rule" (lototes Moqozloe 2011).


33
1hls goes beyond more speclflc lndusLry complalnLs abouL parLlcular regulaLlons, such as Lhe deflnlLlon
of a swaps Lrader or proprleLary Lradlng, and suggesLs LhaL Lhe uodd-lrank leglslaLlon may be Loo
exLenslve, Loo compllcaLed, and Loo concerned abouL ellmlnaLlng speclflc pasL abuses Lo ever be
compleLed by regulaLors, lmplemenLed by supervlsors, or respecLed by bank compllance execuLlves.
lndeed, lL has been represenLed as a verlLable paradlse for regulaLory arblLrage.
1he resulL has been a call for a more fundamenLal revlew of Lhe framework of flnanclal sysLem
leglslaLlon. Some have even suggesLed a reLurn Lo a regulaLory framework closer Lo Class-SLeagall's
separaLlon of lnsLlLuLlons by funcLlon. LasL year's presenLaLlon Lo Lhls conference (Levy lnsLlLuLe 2011)
called speclflcally for a revlew of Lhe 1999 AcL Lo enhance compeLlLlon ln Lhe flnanclal servlces lndusLry
by provldlng a prudenLlal framework for Lhe afflllaLlon of banks, securlLles flrms, lnsurance companles,
and oLher flnanclal servlce provlders, and for oLher purposes," beLLer known as Lhe Cramm-Leach-8llley
(CL8) AcL, whlch has been one of Lhe maln causes of Lhe creaLlon of flnanclal conglomeraLes LhaL are
Loo blg Lo fall." Allowlng Lhe creaLlon of flnanclal holdlng companles Lo deal wlLh Lhe full range of
flnanclal servlces made Lhem noL only much larger, buL also much more complex, and Lhus more dlfflculL
Lo regulaLe and supervlse.
ChapLer 2 revlewed Pyman Mlnsky's assessmenL of a 1991 1reasury proposal for modernlzaLlon of Lhe
flnanclal sysLem. Pe reLurned Lo Lhese conslderaLlons ln hls revlew of posslble posL-Class-SLeagall
regulaLory reform ln a serles of papers ln 1993. ln parLlcular, he noLed LhaL one llLLle-appreclaLed beneflL
of Lhe 1933 AcL was LhaL Lhe scope of permlsslble acLlvlLles by a deposlLory lnsLlLuLlon was Lo be llmlLed
Lo whaL examlners and supervlsors could readlly undersLand. . . . lL was noL so much Lhe dlfferences and
rlsklness as lL was Lhe ease of undersLandlng Lhe operaLlons LhaL led Lo Lhe separaLlon of lnvesLmenL and
commerclal banklng" (Mlnsky 1993a, 3). ln oLher words, Class-SLeagall's llmlLs on Lhe slze and acLlvlLles
of flnanclal lnsLlLuLlons would enable supervlsors, examlners, and regulaLors Lo undersLand Lhe
lnsLlLuLlons' operaLlons. Whlle uodd-lrank seeks Lo llmlL governmenL ballouLs of large flnanclal
lnsLlLuLlons, lLs Crderly LlquldaLlon AuLhorlLy" glves preference Lo Lhe use of lederal ueposlL lnsurance
CorporaLlon (lulC) resoluLlon procedures for merglng falled lnsLlLuLlons wlLh larger ones on Lhe
presumpLlon LhaL larger lnsLlLuLlons have a beLLer ablllLy Lo absorb new deposlLs and a lower llkellhood
of fallure. 8uL Lhls ls preclsely whaL has led Lo Lhe creaLlon of a smaller number of larger and larger
lnsLlLuLlons, many of whlch surpass Lhe 8legle-neal llmlLaLlons placed on Lhe share of deposlLs of LhaL an
lnsLlLuLlon absorblng a resolved bank's deposlLors may hold.
12
And Lhls wlll only make Lhe resulLlng
sysLem more dlfflculL Lo regulaLe and Lhe [ob of Lhe supervlsors monlLorlng compllance LhaL much more
dlfflculL.
1he lederal 8eserve 8ank of uallas (8osenblum 2012) has proposed LhaL Lhe mosL effecLlve way Lo
slmpllfy supervlslon of Lhe flnanclal sysLem ls Lo break up Lhe large, complex flnanclal lnsLlLuLlons. 8uL
Lhls proposal deals only wlLh Lhe slze of flnanclal lnsLlLuLlons, lL does noL lndlcaLe whaL Lhe sLrucLure of
Lhe smaller lnsLlLuLlons should be. CreaLlng a greaLer number of smaller, lndependenL flnanclal holdlng

12
lndeed, a number of lnfluenLlal ulsLrlcL lederal 8eserve presldenLs have argued LhaL exlsLlng lulC auLhorlLy
would have been sufflclenL Lo deal wlLh Lhe resoluLlon of Lhe larger flnanclal lnsLlLuLlons durlng Lhe crlsls, see, for
example, Poenlg (2009) and llsher (2010). Well before Lhe crlsls, leldman and SLern (2003) proposed LhaL lulC
resoluLlon could be used Lo prevenL Lhls process, buL Lhls provlslon was noL lncluded ln uodd-lrank.


36
companles would noL necessarlly slmpllfy supervlslon lf Lhese companles were sLlll deallng ln mulLlple
Lypes of complex, lnLerconnecLed flnanclng acLlvlLles lnvolvlng sLrucLured lendlng lnsLrumenLs. Slmply
maklng lnsLlLuLlons smaller need noL make Lhem safer and more sLable lf Lhey are permlLLed Lhe same
range of acLlvlLles lnvolvlng Lhe same Lypes of flnanclal lnsLrumenLs LhaL produced Lhe flnanclal crlsls.
And ln Lhe absence of effecLlve anLlLrusL leglslaLlon,
13
breaklng up Lhe larger lnsLlLuLlons would ln all
llkellhood slmply engender anoLher process of concenLraLlon by merger and acqulslLlon slmllar Lo LhaL
seen afLer Lhe suspenslon of branchlng resLrlcLlons.
14
Slmply breaklng up Lhe blg 181l banks lnLo smaller
banks ls noL sufflclenL Lo resLore sLablllLy Lo Lhe sysLem.
As noLed ln chapLer 2, Mlnsky was a flrm bellever ln Lhe unlL" relaLlonshlp" banklng sysLem LhaL
prevalled ln Lhe unlLed SLaLes unLll Lhe 1970s, and whlch was broughL Lo a deflnlLlve end by Lhe volcker
lmplemenLaLlon of money supply managemenL Lo flghL lnflaLlon, creaLlon of reglonal" glanL banks
under Lhe 8legle-neal leglslaLlon faclllLaLlng branch banklng, and Lhen Lhe CL8 AcL, whlch allowed large
naLlonal conglomeraLe banks.
ln hls subsequenL conslderaLlon of posslble posL-Class-SLeagall conflguraLlons of Lhe flnanclal sysLem,
Mlnsky accepLed LhaL Lhe sysLem would be a unlversal bank" sysLem or a bank holdlng company"
sysLem. Pe favored Lhe laLLer conflguraLlon and suggesLed LhaL Lhe slmpllclLy and Lransparency lnherenL
ln Class-SLeagall could be preserved wlLhln a bank holdlng company sLrucLure by resLrlcLlng Lhe asseLs
and llablllLles of Lhe separaLe subsldlarles. ln a number of documenLs prepared for Lhe mld-1990s
dlscusslons on reformlng Class-SLeagall, Mlnsky proposed, Cne or more subsldlarles of a posL Class-
SLeagall bank holdlng company wlll have moneLary llablllLles. 1hese subsldlary lnsLlLuLlons wlll en[oy
proLecLlons from Lhe cenLral bank and Lreasury whlch guaranLee LhaL Lhelr moneLary llablllLles wlll noL
fall Lo a dlscounL from Lhelr face value. . . . ln exchange for Lhls proLecLlon Lhe asseLs Lhey can own wlll
be resLrlcLed. A represenLaLlve posL Class SLeagall bank holdlng company wlll have speclallzed flnanclal
subsldlarles whlch lnclude noL only a comblnaLlon of commerclal, lnvesLmenL and merchanL banklng
subsldlarles buL also a sampllng of more speclallzed flnanclal lnsLlLuLlons such as credlL card operaLlons,
paymenL operaLlons, flnance companles and Lhe brokerlng and underwrlLlng of lnsurance. Lach
subsldlary wlll have a dedlcaLed equlLy, whlch proLecLs Lhe holders of Lhe llablllLles of Lhe subsldlary"
(Mlnsky 1993c, 3).
1he lmpllcaLlons of such a sysLem are LhaL, once Lhe dlsLlncLlon beLween Lhe paymenLs and flnanclng
operaLlons of banks ls recognlzed, lL follows LhaL posL Class SLeagall banklng flrms wlll be sLrucLured as
bank holdlng companles ln whlch Lhe paymenLs subsldlary ls clearly separaLed from Lhe flnanclng
subsldlarles. ln exchange for Lhls proLecLlon Lhe asseLs of Lhe paymenLs subsldlary wlll be llmlLed Lo
governmenL debL and lnLeresL earnlng accounLs aL Lhe lederal 8eserve: Lhe asseLs of Lhe paymenLs
banks wlll noL lnclude buslness and household llablllLles" (10-11). 1hus, Lhe holdlng company sLrucLure

13
1he exlsLlng anLlLrusL leglslaLlon was wrlLLen for a segmenLed sysLem such as Class-SLeagall and has never been
revlsed Lo deal wlLh Lhe problems of slze and compeLlLlveness creaLed by CL8. See kregel (2009b).
14
1he hlsLory of deregulaLlon ln Lhe unlLed SLaLes has been Lo provlde an lnlLlal perlod of lncreased enLry and
compeLlLlon, only Lo be followed by lncreased bankrupLcles and consolldaLlon, resLorlng lndusLry concenLraLlon Lo
even hlgher levels. 1he alrllne lndusLry ls exemplary of Lhls Lrend, whlch was also followed ln LelecommunlcaLlons,
energy, LransporL, eLc.


37
of posL Class SLeagall banklng [would] qulLe naLurally lead Lo 100 money" (12), as was proposed by
Penry Slmons (1934) and lrvlng llsher (1933) ln Lhe 1930s and by !ames 1obln (1987) and 8oberL LlLan
(1987) ln Lhe 1980s.
ln Lhls approach, a slngle subsldlary would be dedlcaLed Lo Lhe provlslon of deposlL-Laklng LransacLlons
servlces, whlle oLher subsldlarles would provlde lnvesLmenL and merchanL banklng servlces. lf all
subsldlarles were sufflclenLly and separaLely caplLallzed, Lhere could be no problem of balllng ouL" Lhe
speculaLlve acLlvlLles Lo save Lhe paymenLs sysLems, Lhere would be no posslblllLy of uslng cusLomer
deposlLs for proprleLary Lradlng and speculaLlon, and wlLh approprlaLe balance sheeL resLrlcLlons on Lhe
LransacLlons subsldlary, Lhe moral hazard creaLed by deposlL lnsurance could be even be ellmlnaLed.
1he "v|s|on" of the econom|c system
lL ls clear LhaL Mlnsky meanL for Lhls proposal Lo be a means by whlch a posslble posL Class-SLeagall
reform could besL provlde whaL he consldered Lhe baslc ob[ecLlves of Lhe flnanclal sysLem-Lo supporL
Lhe caplLal developmenL of Lhe economy and Lo provlde a safe and secure paymenL sysLem-because ln
such a reformed sysLem Lhe paymenLs and Lhe flnanclng of Lhe caplLal developmenL of Lhe economy
funcLlons wlll Lherefor[e] be separaLed ln a posL Class SLeagall banklng sLrucLure" (Mlnsky 1993c, p. 8).
8uL such a proposal lmplled a meLhod of provldlng for Lhe sysLem's caplLal developmenL" LhaL dlffered
radlcally from LhaL whlch had been Lhe basls for Lhe economlc sysLem up Lo LhaL polnL. lor Mlnsky, Lhe
caplLal developmenL of Lhe sysLem meanL more Lhan [usL Lhe gross accumulaLlon of caplLal sLock or Lhe
growLh of naLlonal lncome, buL raLher a broader lnLerpreLaLlon of Lhe advancemenL of Lhe economy,
lncludlng maxlmlzlng Lhe level of employmenL and an equlLable dlsLrlbuLlon of lncome. 8ulldlng on
!oseph SchumpeLer's 1beoty of cooomlc uevelopmeot (1934), Mlnsky proposed an explanaLlon of more
or less susLalned caplLallsL expanslon ln Lhe 19Lh and 20Lh cenLurles, lnLerrupLed by perlodlc crlses ln
whlch Lhe producLlon lnLerdependencles and flnanclng arrangemenLs and convenLlons would break
down, leavlng ln Lhelr place condlLlons for renewed expanslon. ln such a sysLem, equlllbrlum would be
malnLalned, noL by markeL-based prlce ad[usLmenL, buL by a new conflguraLlon of producLlve and
flnanclal relaLlons.
Pe also Look from SchumpeLer Lhe ldea LhaL lL was Lhe loglc of caplLallsL expanslon LhaL would produce
Lhese dlsrupLlons. Whlle any economlc or pollLlcal sysLem could suffer from random, exLernal shocks or
pollLlcal upheaval, lL would be lmposslble, by assumpLlon of Lhelr naLure, elLher Lo explaln Lhem or Lo
provlde a means of counLerlng Lhem unless Lhey could be foreseen. ln general, such shocks would only
dlsLurb exlsLlng relaLlons LhaL could be reesLabllshed ln a recovery. ln Mlnsky's vlew, however, Lhe
endogenous dlsrupLlons would change Lhe underlylng flnance and growLh dynamlc of Lhe sysLem, wlLh a
Lransformed economy emerglng Lo resume lLs expanslonary paLh. 1hls was noL a Lheory of buslness
cycles, buL of SchumpeLerlan economlc developmenL, of conLlnuous, evoluLlonary change drlven by Lhe
generaLlon of flnanclal lnsLablllLy Lhrough Lhe very mechanlsms used by Lhe flnanclal sysLem Lo supporL
Lhe caplLal developmenL of Lhe economy.


38
1he lmporLance of Lhls lnnovaLlve process
13
led Mlnsky Lo Lhe vlew LhaL lL needs Lo be undersLood now
LhaL developmenL flnanclng lnvolves Laklng rlsks. . . . 1he need ls for a regulaLory and supervlslng
auLhorlLy for Lhe flnanclal sysLem LhaL accepLs LhaL flnanclng developmenL opens Lhe sysLem Lo losses
LhaL have Lhe poLenLlal for adversely affecLlng Lhe safeLy and securlLy of Lhe economy's paymenL
faclllLles. 1o allow for Lhls posslblllLy Lhe regulaLors need Lo Lry Lo lnsulaLe Lhe paymenLs sysLem from
Lhe consequences of such losses. 1he problem Lherefore ls Lo provlde for proLecLlon of Lhe paymenLs
sysLem from Lhe consequences of Lhe losses whlch may ensue from developmenL flnanclng." As a resulL,
Mlnsky characLerlzed Lhe role of Lhe flnanclal sysLem as servanL Lo Lwo muLually confllcLed masLers:
any caplLallsL banklng and flnanclng sysLem" ls drawn beLween Lwo masLers" LhaL lL needs Lo serve:
one masLer requlres assurance LhaL Lhe flnanclng needed for Lhe caplLal developmenL of Lhe economy
wlll be forLhcomlng and Lhe second masLer requlres assurance LhaL a safe and secure paymenLs
mechanlsm wlll be provlded" (Mlnsky 1994, 10-11).
Mlnsky's adapLaLlon of Lhe Slmons/llsher proposal may Lhus be seen as an aLLempL Lo ensure flnanclal
sLablllLy by separaLlng flnanclal lnsLlLuLlons by funcLlon, or masLer," so LhaL each would serve only one
masLer. 8anks LhaL provlde paymenL servlces can be made perfecLly safe and secure by requlrlng 100
percenL reserves ln governmenL currency and coln or oLher rlsk-free governmenL llablllLles.
16
1he
flnanclng of Lhe caplLal developmenL of Lhe economy would Lhen Lake place vla reLalned earnlngs of
corporaLlons or by means of lnvesLors' conscrlpLlons commlLLed Lo flnanclng speclflc prlvaLe buslness
acLlvlLles. Crganlzed and supervlsed as an lnvesLmenL LrusL," such an lnsLlLuLlon would have a 100
percenL raLlo of caplLal Lo asseLs and Lhus should noL be consldered a LhreaL Lo Lhe flnanclal sLablllLy of
Lhe economlc sysLem.
ln such a perfecLly separaLed, dual sysLem Lhere would be nelLher a deposlL-credlL mulLlpller, nor
leverage, nor creaLlon of llquldlLy. lL would reflecL Lhe ldea LhaL Lhe flnanclal sysLem should operaLe so
as Lo creaLe lrledrlch Payek's ldea of neuLral" money, ln whlch all lnvesLmenL declslons are Lhe
consequence of Lhe volunLary savlngs declslons of lndlvlduals. 1he Wlckselllan alLernaLlve formulaLlon of
Lhls condlLlon ls Lhe equallLy of Lhe nomlnal raLe of lnLeresL and Lhe real" raLe of reLurn on lnvesLmenL.
ln Lhls approach, Lhere are no moneLary" dlsLurbances Lo Lhe equlllbrlum ln Lhe real" economy, as
savlngs deLermlne loanable funds LhaL llmlL lnvesLmenL. A flnanclal sysLem LhaL was regulaLed vla a 100
percenL reserve requlremenL on deposlLs and a 100 percenL raLlo of caplLal Lo asseLs for lnvesLmenL
LrusLs would Lhen appear Lo resolve Lhe confllcLlng ob[ecLlves noLed by Mlnsky. Cne lnsLlLuLlon would
provlde Lhe safe and secure means of paymenL, whlle anoLher would provlde for Lhe flnanclng of Lhe
real caplLal developmenL of Lhe economy by lnLermedlaLlng and lnvesLlng prlvaLe savlngs.
8uL such a sysLem could nelLher ensure Lhe sLablllLy of Lhe real economy nor assure sLablllLy of Lhe
caplLal flnanclng lnsLlLuLlons, slnce Lhe real lnvesLmenLs chosen could sLlll fall Lo produce Lhe anLlclpaLed

13
Mlnsky (1992b, noLe 11) sLressed LhaL hls emphasls upon Lhe caplLal developmenL of Lhe economy as Lhe prlme
problem LhaL economlc Lheory need address mlghL besL be called SchumpeLerlan."
16
8uL such proposals are noL new. 1he naLlonal 8anklng AcL was based on governmenL llablllLles backlng Lhe lssue
of naLlonal banknoLes. ln any evenL, lL dld noL provlde Lhe promlsed guaranLee of sLablllLy, prlmarlly because of Lhe
varlablllLy of Lhe securlLles' value. Mlnsky's proposal would provlde for a governmenL guaranLee Lo supporL Lhe
mark-Lo-markeL value of Lhe asseLs, see kregel 1996.


39
raLe of reLurn, and secLoral overlnvesLmenL and flnanclal bubbles could sLlll exlsL lf Lhere were herdlng
behavlor by Lhe lnvesLmenL advlsers of Lhe LrusLs LhaL produced procycllcal flnanclng behavlor. 1here
would always be a rlsk of lnvesLors calllng on Lhe governmenL Lo save Lhem from flnanclal ruln.
17

Narrow bank|ng and a "monetary product|on economy"
lor Mlnsky and SchumpeLer, such a narrow banklng" sysLem could noL be consldered a modern
caplLallsL" sysLem, lL would be akln Lo whaL !ohn Maynard keynes deflned as a real wage," as opposed
Lo a moneLary producLlon," economy.
18
ln a moneLary economy, lL ls Lhe role of Lhe flnanclal secLor Lo
ensure Lhe flnanclng of Lhe acqulslLlon and conLrol of caplLal asseLs by lncreaslng Lhe llquldlLy of Lhe
llablllLles of Lhe buslness secLor.
8uL more lmporLanL, such a sysLem would creaLe a problem ln a dlmenslon oLher Lhan whaL ls now
called macroprudenLlal" regulaLlon. 1he llablllLles of Lhe flnanclal sysLem would be composed of
household savlngs allocaLed Lo lnvesLmenL fund shares flnanclng real lnvesLmenLs, Lo Lhe holdlng of
deposlLs ln Lhe narrow banks backed by governmenL debL or currency and coln, and Lo holdlng
governmenL-lssued coln and currency. 8uslness secLor savlngs would be allocaLed Lo reLalned earnlngs
flnanclng, deposlLs ln narrow banks, or governmenL lssues of currency and coln. 1hls would mean LhaL
LoLal prlvaLe savlng would exceed lnvesLmenL by Lhe prlvaLe secLor's holdlngs of narrow bank deposlLs
and governmenL currency, creaLlng a Lendency Loward deflaLlon or recesslon. rlce and/or ouLpuL
sLablllLy would Lhen requlre an exogenous addlLlon Lo demand Lo offseL Lhls lmbalance, such as mlghL be
provlded by governmenL expendlLures flnanced by Lhe lssue of elLher currency or governmenL bonds, lf
such lssues were held as reserves for Lhe narrow banks or Lhe dlrecL dlscounLlng of buslness secLor
llablllLles. AlLernaLlvely, Lhe cenLral bank could engage ln Lhe dlrecL flnanclng of publlc or prlvaLe secLor
lnvesLmenL expendlLures. 1he macroprudenLlal" sLablllLy of Lhe flnanclal sysLem would Lhen requlre Lhe
appllcaLlon of whaL Abba Lerner (1943) called funcLlonal flnance." 1he slze of Lhe deflclL creaLlng Lhe
addlLlonal governmenL means of paymenL requlred for macroprudenLlal sLablllLy would be deLermlned
by Lhe prlvaLe secLor holdlngs of narrow bank deposlLs and currency, ad[usLed for Lhe currenL accounL
poslLlon.
1hus, whaL Mlnsky belleved was Lhe ma[or facLor sLablllzlng Lhe posLwar Class-SLeagall sysLem-Lhe
exlsLence of a 8lg CovernmenL" deflclL provldlng a floor under prlvaLe secLor lncomes-would be even
more lmporLanL ln a narrow banklng sysLem holdlng company sLrucLure Lhan lL was under Class-SLeagall.
lndeed, Mlnsky's use of Lhe keynes-kaleckl proflLs equaLlon was meanL Lo show LhaL lL ls prlmarlly Lhe
generaLlon of corporaLe lncome LhaL resulLs from lnvesLmenL expendlLures LhaL allows currenL proflLs Lo
cover Lhe cash flows assoclaLed wlLh Lhe llablllLles lssued Lo flnance lnvesLmenL. lL ls Lhe level of buslness
lnvesLmenL and governmenL neL expendlLure LhaL generaLe Lhe cash flow LhaL valldaLes Lhe corporaLe
llablllLles and produces Lhe real source of flnanclal sLablllLy ln Lhe sysLem.

17
Aslde from Lhe LheoreLlcal dlfflculLles ln formulaLlng Lhe correspondence of real and money raLes (see Myrdal
1939) or neuLral money (see Sraffa's [1932] crlLlclsm of Payek's neuLral money proposals).
18
lndeed, as noLed above (chapLer 2), ln hls earller wrlLlng (Mlnsky 1992a, 36-37) he dlsmlssed [n]arrow banks,
100 money and oLher devlces for loslng slghL of Lhe maln ob[ecL: 1he caplLal developmenL of Lhe economy [and]
Lhe key role of banklng [ln] lendlng or beLLer flnanclng."


60
ln Lhe absence of a large governmenL secLor Lo supporL lncomes, debLs could noL be valldaLed ln a
narrow bank holdlng company sLrucLure. 8uL, even more lmporLanL, lL would be lmposslble ln such a
sysLem for banks Lo acL as Lhe handmalden Lo lnnovaLlon and creaLlve desLrucLlon by provldlng
enLrepreneurs Lhe purchaslng power necessary for Lhem Lo approprlaLe Lhe asseLs requlred for Lhelr
lnnovaLlve lnvesLmenLs. ln Lhe absence of prlvaLe secLor llquldlLy" creaLlon, Lhe cenLral bank would
have Lo provlde flnanclng for prlvaLe secLor lnvesLmenL LrusL llablllLles, or a governmenL developmenL
bank could flnance lnnovaLlon Lhrough Lhe lssue of debL moneLlzed by Lhe cenLral bank. 1o meeL Lhe
requlremenLs of Lhe Lwo masLers," such a sysLem would have Lo comblne keynes's ldea of Lhe
soclallsaLlon of lnvesLmenL" wlLh Lhe soclallsaLlon" of Lhe LransacLlons and paymenLs sysLem. 1hls
suggesLs LhaL ln order Lo saLlsfy Mlnsky's Lwo masLers" Lhe real problem LhaL musL be solved lles ln Lhe
way LhaL regulaLlon governs Lhe provlslon of llquldlLy ln Lhe flnanclal sysLem.
1he "two masters" are S|amese tw|ns
ln Lhe modern caplLallsL sysLem LhaL Mlnsky analyzed ln hls flnanclal fraglllLy hypoLhesls, Lwo dlfferenL
Lypes of flnanclal lnsLlLuLlons provlde Lhe llquldlLy requlred for Lhe flnanclng of SchumpeLerlan creaLlve
desLrucLlon. 1he conLrol of real asseLs by producLlve enLerprlses can be flnanced Lhrough Lhe lssue by a
flnanclal lnsLlLuLlon of llablllLles LhaL can be used as a means of paymenL ln lleu of Lhe coln and currency
lssued by Lhe governmenL. 1hls ls whaL ls commonly known as deposlL creaLlon," and lL has LradlLlonally
been provlded by whaL ln Lhe Class-SLeagall regulaLory sysLem were called commerclal" banks.
AlLernaLlvely, producLlve enLerprlses can lssue securlLles Lhrough Lhe servlces of flnanclal lnsLlLuLlons
LhaL provlde llquldlLy by acLlng as prlmary and secondary markeL-makers offerlng Lo buy and sell Lhe
securlLles aL announced bld-ask spreads and ln sLandard amounLs. 1hese have LradlLlonally been known
as lnvesLmenL" or merchanL banks.
Mlnsky consldered deposlL creaLlon Lhe baslc acLlvlLy of banks. Pe deflned lL as Lhe accepLance
funcLlon": 8anklng ls noL money lendlng, Lo lend, a money lender musL have money. 1he fundamenLal
banklng acLlvlLy ls accepLlng, LhaL ls, guaranLeelng LhaL some parLy ls credlLworLhy. A bank, by accepLlng
a debL lnsLrumenL, agrees Lo make speclfled paymenLs lf Lhe debLor wlll noL or cannoL. . . . A bank loan ls
equlvalenL Lo a bank's buylng a noLe LhaL lL has accepLed" (Mlnsky 2008, p. 236). 1hus, for Mlnsky Lhe
baslc acLlvlLy of a bank ls noL Lhe safekeeplng of deposlLors' coln and currency, nor ls lL Lhe lnvesLmenL
of deposlLors' funds because of an lnformaLlonal advanLage. 8aLher, a bank's baslc acLlvlLy ls Lhe
creaLlon of lLs own llablllLles, whlch are used Lo acqulre Lhe llablllLles of producLlve enLerprlses LhaL lL
has accepLed"-LhaL ls, whose paymenL lL has guaranLeed. A narrow bank on Lhls deflnlLlon ls noL a
bank, buL slmply a safe house or plggy bank for governmenL lssue of coln and currency.
Why banks are un|que ||qu|d|ty creators
Mlnsky noLed LhaL a bank's llablllLles have Lo be vlewed as embodylng more of keynes's llquldlLy
premlum Lhan Lhelr asseLs (Lhe llablllLles LhaL Lhey accepL and hold as asseLs ln Lhelr loan books) lf Lhey
are Lo earn lncome from a poslLlve neL lnLeresL spread, or carry" (lbld., 277). 1hls credlL enhancemenL"
funcLlon allows banks Lo lncrease Lhe llquldlLy of Lhe llablllLles Lhey accepL and Lhus lncrease llquldlLy of


61
Lhe whole sysLem. 8anks effecLlvely Lurn Lhe llablllLles LhaL sLand behlnd flxed real caplLal asseLs lnLo
currency means of paymenL.
1he successful operaLlon of Lhls baslc funcLlon of banklng Lhus depends cruclally on Lhe llquldlLy of bank
llablllLles, and Lhls depends cruclally on Lhe assurance LhaL bank llablllLles can always be used as an
equlvalenL means of paymenL LhaL Lhe borrower can use Lo acqulre conLrol over real goods, servlces,
and caplLal asseLs. 1hls means LhaL bank llablllLles have Lo be consldered as a perfecL subsLlLuLe for
governmenL lssued coln and currency.
19

lL ls Lo ensure Lhls subsLlLuLablllLy LhaL banks also lssue Lhelr llablllLles ln exchange for governmenL coln
and currency of Lhe publlc. 1haL ls, Lhey offer a LransacLlon or paymenLs servlce Lo cllenLs. 1hese deposlL
llablllLles are a slmple borrowlng operaLlon LhaL provldes no credlL enhancemenL or llquldlLy creaLlon.
8ank balance sheeLs Lhus conLaln Lwo dlfferenL, yeL ldenLlcal, promlses Lo pay Lhe holder currency and
coln. Cne ls backed by a llablllLy, Lhe promlse of a producLlve buslness operaLlon Lo pay, Lhe oLher ls
(parLlally) backed by an asseL, Lhe cusLomer's deposlLed coln and currency. 1he flrsL funcLlon lncreases
sysLem llquldlLy because lL lncreases Lhe llquldlLy of Lhe lssuer of Lhe llablllLy, Lhe second does noL, slnce
Lhe deposlLor exchanges one Lype of means of paymenL for whaL ls a guaranLeed equlvalenL. 1hese
promlses are LreaLed as equlvalenL because Lhey are boLh llablllLles of Lhe bank and carry Lhe bank's
pledge Lo exchange Lhem on slghL for coln or currency on an equal basls. Slnce boLh of Lhese deposlL
llablllLles are Lhe basls of Lhe paymenLs sysLem and serve as a sLore of exlsLlng value for lndlvlduals, Lhe
essenLlal funcLlon of Lhe flnanclal sysLem ln creaLlng Lhe llquldlLy requlred for flnanclng Lhe caplLal
developmenL of Lhe economy ls lnevlLably [olned wlLh Lhe provlslon of Lhe means of paymenL. 1he Lwo
masLers" musL of necesslLy cohablL ln a slngle lnsLlLuLlon. 1he confllcL beLween Lhem cannoL be solved
Lhrough separaLlon.
1he second Lype of llquldlLy generaLlon ls Lhe acLlvlLy of flnanclal lnsLlLuLlons ln provldlng for Lhe prlmary
dlsLrlbuLlon and secondary Lradlng of Lhe equlLy and flxed-lncome llablllLles lssued by flrms Lo flnance
Lhe caplLal developmenL of Lhe economy. lL ls Lhls funcLlon LhaL keynes hlghllghLed: [1]he llquldlLy of
lnvesLmenL markeLs ofLen faclllLaLes, Lhough lL someLlmes lmpedes, Lhe course of new lnvesLmenL. lor
Lhe facL LhaL each lndlvldual lnvesLor flaLLers hlmself LhaL hls commlLmenL ls 'llquld' (Lhough Lhls cannoL
be Lrue for all lnvesLors collecLlvely) calms hls nerves and makes hlm much more wllllng Lo run a rlsk. lf
lndlvldual purchases of lnvesLmenLs were rendered llllquld, Lhls mlghL serlously lmpede new lnvesLmenL.
. . . So long as lL ls open Lo Lhe lndlvldual Lo employ hls wealLh ln hoardlng or lendlng money, Lhe
alLernaLlve of purchaslng acLual caplLal asseLs cannoL be rendered sufflclenLly aLLracLlve . . . excepL by
organlslng markeLs whereln Lhese asseLs can be easlly reallsed for money" (keynes 1936, 160-61).
ln a prlmary dlsLrlbuLlon such as a boughL deal," Lhe underwrlLlng flnanclal lnsLlLuLlon provldes a
guaranLee of Lhe prlce Lhe lssuer wlll recelve for Lhe llablllLles and Lhus Lhe amounL of funds Lo be ralsed
by Lhe lssue. 1he underwrlLer wlll buy for lLs own balance sheeL any securlLles LhaL cannoL be sold Lo Lhe
publlc aL Lhe guaranLeed prlce. 1he underwrlLer Lhereby guaranLees LhaL he wlll be able Lo exchange Lhe
lssuer's llablllLy for coln and currency or a deposlL accounL held ln a bank by Lhe purchaser, or by

19
lL ls for Lhls reason LhaL banks are ofLen characLerlzed as publlc-prlvaLe" parLnershlps.


62
Lransferrlng a deposlL of hls own. 1hus, lf Lhe lssue ls noL fully sold, Lhe underwrlLer wlll have Lo geL a
bank Lo elLher accepL" Lhe unsold securlLles as collaLeral agalnsL Lhe lssue of a demand deposlL LhaL Lhe
underwrlLer Lransfers Lo Lhe lssuer or use lLs own deposlLs. ln elLher case, Lhe LransacLlon requlres Lhe
parLlclpaLlon and Lransfer of bank llablllLles and Lhe poLenLlal access Lo bank llquldlLy Lo ensure Lhe
guaranLee of llquldlLy. 1he accepLance" funcLlon of Lhe underwrlLer ls Lhus dlrecLly dependenL on belng
able Lo sell Lhe securlLles Lo Lhe publlc or Lo convlnce a bank Lo accepL" Lhem ln exchange for a
LransacLlons deposlL.
1he same Lhlng ls Lrue for Lhe operaLlon of flnanclal lnsLlLuLlons ln provldlng llquldlLy ln Lhe secondary
securlLles markeLs. lor example, Lhe broker-dealers who operaLe ln provldlng llquldlLy Lo Lhe secondary
markeLs as offlclally deslgnaLed speclallsLs" or dealers" quoLe bld-ask prlces on sLocks and hold
lnvenLorles LhaL flucLuaLe as Lhey acL as neL buyer or seller ln provldlng for an orderly markeL." 1hese
lnvenLorles of asseLs are flnanced vla call" loans, flnanced by banks' accepLance" of Lhe speclallsL's
lnvenLory as collaLeral. 1hus, ln general, Lhe llquldlLy LhaL ls provlded ln Lhe prlmary and secondary
caplLal markeLs ls dlrecLly or lndlrecLly dependenL on Lhe llquldlLy generaLed by Lhe accepLance"
funcLlon of deposlL-lssulng banks.
ln engaglng ln Lhls creaLlon of llquldlLy for Lhe caplLal developmenL of Lhe economy, Lhe banks are
always shorL" governmenL-lssued coln and currency (ln pracLlce, cenLral bank reserves). 1o cover Lhls
poLenLlal shorL poslLlon, Mlnsky noLed LhaL banks make flnanclng commlLmenLs because Lhey can
operaLe ln flnanclal markeLs Lo acqulre funds as needed, Lo so operaLe Lhey hold asseLs LhaL are
negoLlable ln markeLs and hold credlL llnes aL oLher banks. 1he normal funcLlonlng of our enLerprlse
sysLem depends upon a large array of commlLmenLs Lo flnance, whlch do noL show up as acLual funds
lenL or borrowed, and money markeLs LhaL provlde connecLlons among flnanclal lnsLlLuLlons" (Mlnsky
2008 [1986], 236).
Slnce Lhls markeL-supporL mechanlsm Lo acqulre funds as needed ls noL fall-safe, cenLral banks provlde
banks wlLh access Lo reserves Lhrough Lhe dlscounL wlndow, where Lhe cenLral bank accepLs" Lhe
asseLs held by Lhe bank ln exchange for governmenL means of paymenL. 1hls means LhaL Lhe ulLlmaLe
source of llquldlLy ln Lhe sysLem ls Lhe cenLral bank accepLance" funcLlon known as lender of lasL
resorL."
Along wlLh Lhe clear recognlLlon of Lhls funcLlon ln Lhe 8anklng AcL of 1933, an addlLlonal mechanlsm
was lnLroduced Lo ensure Lhe llquldlLy of bank llablllLles: a federal deposlL lnsurance guaranLee flnanced
vla an assessmenL of Lhe slze of a bank's deposlL llablllLles LhaL creaLes a LrusL fund Lo be used Lo provlde
coln and currency Lo Lhe deposlLors of a bank LhaL falls Lo meeL lLs commlLmenLs. lL has usually been Lhe
case LhaL Lhe deposlLors of a falled bank have Lhelr lnsured credlLs Lransferred Lo a solvenL bank LhaL
absorbs Lhe falllng bank, raLher Lhan belng dlrecLly relmbursed by Lhe lnsurance fund for Lhe lnsured
value of Lhelr deposlLs. 8uL, as Mlnsky observed, lL ls nelLher Lhe exlsLence nor Lhe slze of Lhe LrusL fund
LhaL provldes Lhe llquldlLy guaranLee for Lhe deposlLs. ulLlmaLely, lL ls Lhe wllllngness of Lhe cenLral bank
Lo creaLe reserves agalnsL Lhls governmenL agency guaranLee. 1hus, lL ls always Lhe cenLral bank ln lLs
role as lender of lasL resorL LhaL provldes Lhe ulLlmaLe source of llquldlLy for Lhe banks LhaL are regulaLed


63
and lnsured. And lL ls Lhese banks LhaL provlde Lhe ulLlmaLe llquldlLy Lo Lhe resL of Lhe flnanclal sysLem,
whlch ln normal Llmes does noL have access Lo Lhe cenLral bank.
Creators of "f|ct|t|ous" ||qu|d|ty: shadow "banks"
Mlnsky (2008 [1986]) noLed LhaL [o]ur complex flnanclal sLrucLure conslsLs of a varleLy of lnsLlLuLlons
LhaL lever on owners' equlLy and normally make on Lhe carry, LhaL ls, borrowlng aL a lower raLe Lhan
Lhelr asseLs can earn" (277). Whlch ls Lo say, Lhere are lnsLlLuLlons LhaL engage ln Lhe same Lype of
acLlvlLy as banks buL wlLhouL Lhe ablllLy Lo borrow coln and currency from Lhe general publlc, and Lhus
wlLhouL Lhe ablllLy Lo offer Lhelr own lnsured llablllLles as a subsLlLuLe means of paymenL. Slnce Lhey
cannoL provlde paymenLs servlces, Lhelr fundamenLal acLlvlLy ls borrowlng and lendlng Lo one anoLher,
Lhus lncreaslng whaL Mlnsky called flnanclal layerlng", LhaL ls, Lhe lssue of flnanclal llablllLles Lo acqulre
Lhe llablllLles of oLher flnanclal lnsLlLuLlons.
1he llquldlLy of a llablllLy lssued by any nonbank flnanclal lnsLlLuLlon wlll Lhen be deLermlned by lLs
ablllLy Lo flnance lL-LhaL ls, Lo borrow ln order Lo hold Lhe llablllLy-and Lhls wlll ulLlmaLely depend on
access Lo Lhe llquldlLy of a deposlL-creaLlng bank. ln a consolldaLed vlew of Lhe flnanclal sysLem, every
llablllLy ln Lhe nonbank flnanclal sysLem, as well as Lhe shorL-Lerm llablllLles of Lhe nonbank nonflnanclal
sysLem, are all ulLlmaLely dependenL on Lhe llquldlLy creaLed by Lhe deposlL-Laklng, lnsured banks. 1hls
means LhaL a fallure Lo meeL a paymenL commlLmenL by any lnsLlLuLlon ln Lhe flnanclal sysLem wlll have
an lmpacL on all Lhe oLhers ln Lhe sysLem, and wlll ulLlmaLely depend on Lhe llquldlLy provlded by Lhe
banklng sysLem.
lor Mlnsky, a condlLlon of flnanclal dlsLress" wlll occur when any lndlvldual flnanclal lnsLlLuLlon cannoL
meeL lLs obllgaLlons on lLs balance sheeL llablllLles." 1hls may evolve lnLo a flnanclal crlsls" when a very
slgnlflcanL subseL of Lhe economy ls ln flnanclal dlsLress" and 'a sllghL dlsLurbance' ln money flows
creaLes such wldespread flnanclal dlsLress LhaL flnanclal crlsls ls LhreaLened" and flnanclal fraglllLy ls
Lransformed lnLo flnanclal lnsLablllLy." AL each sLage ln Lhe evoluLlon Loward lnsLablllLy, flnanclal
lnLermedlarles become more rellanL on oLher flnanclal lnsLlLuLlons, and ulLlmaLely banks, Lo reflnance
Lhelr llablllLles. As Mlnsky noLed, A key Lo Lhe generaLlon of flnanclal crlsls ls wheLher Lhe holders of
markeLable securlLles who have large scale debLs ouLsLandlng can reflnance or musL llquldaLe Lhelr
poslLlons when Lhey need cash" (Mlnsky 1964, 266). 1he worsL Lhlng LhaL could happen Lo Lhe solvency
of any flnanclal lnsLlLuLlon ls a forced sale of lLs asseLs ln order Lo acqulre cash. lmaglne whaL would
happen Lo asseL values, lf Lhere were a need Lo llquldaLe governmenL bond poslLlons by Lhe governmenL
bond dealers or lf Lhe sales flnance companles were suddenly Lo Lry Lo sell Lhelr porLfollos of consumer
lnsLallmenL paper on some markeL. ln order Lo prevenL Lhls Lype of forced llquldaLlon of asseLs, Lhe
flnanclal lnLermedlarles proLecL Lhemselves by havlng alLernaLlve flnanclng sources, l.e., by havlng 'de
facLo' lenders of lasL resorL. 1hese de facLo lenders of lasL resorL ulLlmaLely musL have access Lo Lhe
lederal 8eserve SysLem ln Llmes of poLenLlal crlsls" (Mlnsky 1964, 376).
lL ls for Lhls reason LhaL Mlnsky proposed more acLlve use of Lhe dlscounL wlndow, and recommended
LhaL flnanclal lnsLlLuLlons always be ln Lhe bank"-LhaL ls, borrowlng from Lhe wlndow-because Lhls
provldes dlrecL lnformaLlon Lo Lhe cenLral bank abouL Lhe asseLs Lhe bank holds as lLs cushlon of safeLy.


64
Pe also recommended LhaL Lhe wlndow be open Lo all flnanclal and nonflnanclal lnsLlLuLlons slnce Lhelr
condlLlon ulLlmaLely depends on Lhe lnsured, regulaLed banks. lL would Lhus be more efflclenL Lo provlde
Lhe fundlng dlrecLly, raLher Lhan lndlrecLly Lhrough Lhe banks and Lhe banks Lo Lhelr cllenLs. lndeed, Lhls
ls preclsely whaL Lhe lederal 8eserve was forced Lo do ln order Lo sLem Lhe collapse of llquldlLy ln Lhe
recenL crlsls.
kegu|ators d|scover M|nsky
1he recenL 8ank for lnLernaLlonal SeLLlemenLs CommlLLee on Lhe Clobal llnanclal SysLem reporL on
global llquldlLy (CClS 2011) clearly reflecLs Lhls vlew of llquldlLy ln Lhe flnanclal sysLem. lL noLes Lhe baslc
dlfference beLween whaL lL calls offlclal" llquldlLy, provlded by Lhe cenLral bank, and prlvaLe llquldlLy,
provlded by prlvaLe flnanclal lnsLlLuLlons who provlde markeL llquldlLy Lo securlLles markeLs, for
lnsLance Lhrough markeL-maklng acLlvlLy, or provlde fundlng llquldlLy Lhrough, for example, lnLerbank
lendlng. 1he condlLlons under whlch Lhese lnLermedlarles can fund Lhelr balance sheeLs, ln Lurn, depend
on Lhe wllllngness of oLher prlvaLe secLor parLlclpanLs Lo provlde fundlng or markeL llquldlLy" (4). 1he
reporL dlsLlngulshes beLween markeL llquldlLy, Lhe ablllLy Lo Lrade an asseL or flnanclal lnsLrumenL aL
shorL noLlce wlLh llLLle lmpacL on lLs prlce," and fundlng llquldlLy, Lhe ablllLy Lo ralse cash elLher vla Lhe
sale of an asseL (someLlmes called balance sheeL llquldlLy) or by borrowlng." 1hls lnLerdependence
underllnes Lhe endogenous characLer of prlvaLe llquldlLy. AL Lhe macroeconomlc level, prlvaLe llquldlLy ls
Lhus closely relaLed Lo moneLary llquldlLy or fundlng condlLlons, as reflecLed ln varlous moneLary and
credlL aggregaLes or measures of Lhe cosL of fundlng. 1he creaLlon and desLrucLlon of prlvaLe llquldlLy ls
closely relaLed Lo leveraglng and deleveraglng by prlvaLe lnsLlLuLlons. uependlng on Lhelr ablllLy or
wllllngness Lo Lake rlsks and provlde maLurlLy or currency LransformaLlon servlces, flnanclal lnsLlLuLlons
can boLh dampen or ampllfy moneLary sLlmull provlded by cenLral banks or provlde sLlmull of Lhelr own.
. . . 1hls glves rlse Lo a pronounced sLaLe dependency of prlvaLe global llquldlLy. ln Lhe exLreme, general
uncerLalnLy abouL Lhe vlablllLy of banks and oLher flnanclal lnsLlLuLlons can lead Lo a drylng-up of prlvaLe
fundlng, and Lhe prlvaLe, endogenous componenL of global llquldlLy dlsappears alLogeLher" (4-3).
1he means of creat|on of "f|ct|t|ous" ||qu|d|ty
Mlnsky's proposal for Lhe posL Class SLeagall" holdlng company sysLem noL only ellmlnaLes Lhe creaLlon
of llquldlLy from Lhe LransacLlons funcLlon of Lhe sysLem, buL also does so for Lhe subsldlarles flnanclng
Lhe sysLem's caplLal developmenL. 8uL Lhe posL-Class-SLeagall sysLem LhaL emerged afLer Lhe 1999 CL8
AcL evolved ln a very dlfferenL way. lL noL only preserved Lhe creaLlon of llquldlLy by Lhe deposlL-Laklng
subsldlarles of Lhe holdlng companles, buL also valldaLed a pleLhora of dlverse sLrucLures LhaL were
lnLroduced Lo provlde addlLlonal llquldlLy lnLo Lhe sysLem as a resulL of Lhe compeLlLlon beLween
commerclal and lnvesLmenL banks. uodd-lrank ls slmply an addlLlonal sLep ln Lhe process descrlbed by
Mlnsky ln whlch a ballouL of Lhe flnanclal lnsLlLuLlon valldaLes Lhe pracLlces LhaL orlglnally creaLed Lhe
dlfflculLles.
20


20
Lvery Llme Lhe led proLecLs a flnanclal lnsLrumenL lL leglLlmlzes Lhe use of Lhls lnsLrumenL Lo flnance acLlvlLy, lL
Lhus prepares Lhe way for Lhe nexL expanslon of llquldlLy and Lhe nexL flnanclal crlsls" (Mlnsky 2008 [1986], 106).


63
lndeed, Lhe recenL crlsls can be descrlbed as Lhe collapse of flcLlLlous" llquldlLy creaLed by Lhese
sLrucLures, Lhe fallure of Lhe banklng secLor Lo provlde sufflclenL llquldlLy Lo prevenL Lhe onseL of a debL
deflaLlon" (whaL Mlnsky deflned as Lhe ulLlmaLe aLLempL Lo access llquldlLy by selllng poslLlon Lo make
poslLlon", LhaL ls, selllng asseLs ln order Lo redeem llablllLles), and flnally, Lhe lnablllLy of Lhe lederal
8eserve Lo lnLervene sufflclenLly qulckly Lo ensure Lhe provlslon of llquldlLy for Lhe non-bank flnanclal
lnsLlLuLlons whlch could noL flnd supporL from Lhe lnsured banks.
1here were Lhree parLlcular sLages ln Lhe evoluLlon of Lhese nonbank llquldlLy-creaLlng sLrucLures LhaL
are lmporLanL for undersLandlng Lhe recenL flnanclal crlsls. 1he flrsL was Lhe rapld expanslon ln Lhe
number and varleLy of lnsLlLuLlons LhaL lever on owners' equlLy" and Lhelr lnLroducLlon of lnnovaLlons
LhaL allowed Lhem Lo earn more Lhan Lhe slmple carry or neL lnLeresL spread. 1he second was Lhe rapld
lncrease ln Lhe use of Lhls llquldlLy Lo fund lncreased flnanclal layerlng ln Lhe flnanclal secLor. 1he Lhlrd
was Lhe lncrease ln Lhe use of llquldlLy Lo lend agalnsL poslLlons whose reLurn was deLermlned by an
expecLed change ln prlces (l.e., caplLal galns) raLher Lhan Lhe producLlon of lncome, buL whlch had
vlrLually no correspondlng C1C or organlzed markeL Lo deLermlne prlces.
1hls Lendency Loward Lhe lncrease ln flcLlLlous sysLem llquldlLy emerged ln Lhe 1980s as nonlnsured,
nonregulaLed flnanclal lnsLlLuLlons encroached on Lhe proLecLed deposlL buslness of commerclal banks
and Lhe commerclal banks soughL Lo proLecL Lhelr earnlngs by developlng nonregulaLed sources of
llquldlLy generaLlon. 1he mosL emblemaLlc of Lhese alLernaLlve sources of llquldlLy ls Lhe money markeL
muLual fund (MMMl), whlch lssues shares wlLh a flxed neL presenL value of one dollar Lo flnance Lhe
purchase of shorL-Lerm commerclal paper, Lhus provldlng Lhe equlvalenL of a slghL deposlL ln a
regulaLed, lnsured commerclal bank. lL ls a clone of a bank, and operaLes ouLslde Lhe regulaLory reglme
governlng banks. lL provldes Lhe same LransformaLlon of llllquld buslness debL lnLo a subsLlLuLe for coln
and currency, and can offer beLLer reLurns and lower lendlng cosLs because of Lhe lack of regulaLlon.
Powever, Lhe llquldlLy so creaLed ls flcLlLlous, slnce lL depends on Lhe ablllLy of commerclal flrms Lo meeL
Lhelr paymenLs on commerclal paper, yeL Lhe fund shares are prlced as lf Lhey were more llquld Lhan
lnsured bank deposlLs. 1he problem wlLh Lhe MMMl ls LhaL, ln conLrasL Lo a commerclal bank LhaL can
creaLe deposlLs LhaL are a subsLlLuLe for coln and currency by granLlng a commerclal loan, a muLual fund
cannoL auLomaLlcally fund commerclal paper by lendlng Lo Lhe flrm. lL has Lo sell a muLual fund share Lo
Lhe general publlc ln exchange for a slghL deposlL on an lnsured bank, or for coln and currency. lL cannoL
engage ln Lhe accepLance funcLlon LhaL Mlnsky conslders Lhe foundaLlon of Lhe sysLem of flnanclng
caplLal developmenL. A muLual fund share cannoL buy a Lrlp on Lhe subway.
Largely ln response Lo Lhe lnLroducLlon of caplLal requlremenLs, ln Lhe laLe 1980s regulaLed, lnsured
banks creaLed arm's-lengLh" sLrucLured lnvesLmenL vehlcles (Slvs) Lo reduce Lhe asseLs held on balance
sheeLs and Lo lncrease Lhelr reLurn on equlLy. An Slv purchases sLrucLured asseLs or morLgages from Lhe
orlglnaLlng banks and flnances Lhem Lhrough Lhe lssue of shorL-Lerm asseL-backed commerclal paper
and some medlum-Lerm equlLy noLes. 1he Slv earns Lhe lnLeresL spread beLween Lhe shorL-Lerm paper
lssued Lo fund Lhe acqulslLlon of Lhe long-Lerm sLrucLured asseLs, augmenLed by leverage creaLed from
overselllng Lhe commerclal paper. !usL as ln Lhe case of Lhe MMMl, Lhe Slv cannoL creaLe Lhe fundlng of
lLs asseLs, lL musL sell lLs paper Lo Lhe publlc ln exchange for a slghL deposlL or coln and currency. AL Lhelr


66
peak, Lhe asseL-backed commerclal paper lssued by Slvs accounLed for a Lhlrd of Lhe LoLal asseL-backed
commerclal paper markeL.
1he shlfLlng of asseLs from regulaLed, lnsured banks' balance sheeLs Lhus provlded a beneflL by reduclng
Lhelr caplLal requlremenLs and lncreaslng Lhelr fee lncomes above Lhe neL lnLeresL marglns. lL also
creaLed an lncrease ln flcLlLlous sysLem llquldlLy, slnce an Slv has no llne of credlL wlLh Lhe orlglnaLlng
bank (as ls Lhe case wlLh Lhe lssue of generlc commerclal paper) and no access Lo Lhe cenLral bank ln Lhe
case of a runoff ln lLs commerclal paper as lnvesLors decllne Lo roll over Lhelr lnvesLmenLs (Lhe
equlvalenL of a deposlL draln" for a bank). ln case of dlsLress an Slv wlll be forced Lo sell lLs asseLs. 1he
llquldlLy creaLed by Lhe Slvs was Lhus flcLlLlous. AfLer argulng LhaL LhaL Lhey were noL formally
commlLLed Lo backlng Lhe commerclal paper lssued by Lhe Slvs LhaL Lhey had creaLed, managed, and
admlnlsLered, Lhe banks evenLually admlLLed a de facLo responslblllLy and Look Lhe asseLs back onLo
Lhelr balance sheeLs, Lhus conflrmlng Mlnsky's rule LhaL llquldlLy ln Lhe sysLem ls always dependenL on
deposlL banks. lL ls lmporLanL Lo noLe LhaL whlle Lhe ma[orlLy of asseLs ln Slvs were collaLerallzed
morLgage asseLs, Lhey were orlglnally creaLed Lo allow collaLerallzaLlon of Lhe banks' credlL card
recelvables, auLo loans, sLudenL loans, and so forLh, all of whlch were sub[ecL Lo Lhe same lncreaslng
fraglllLy as Lhe morLgage-backed asseLs.
AnoLher source of flcLlLlous llquldlLy and a popular meLhod of movlng asseLs off balance sheeLs Lo
lncrease lncome was asseL securlLlzaLlon. 1hls lnvolves Lhe creaLlon of a formally lndependenL speclal
purpose enLlLy-llke an lnvesLmenL LrusL-LhaL lssues llablllLles, usually flxed lnLeresL, whose proceeds
are used Lo acqulre flxed-lncome asseLs. 1he asseLs purchased from Lhe orlglnaLlng bank are used as
collaLeral for Lhe llablllLles lssued Lo fund Lhem. varlous comblnaLlons of lncome from Lhe asseLs can be
sLrucLured Lo creaLe dlfferenL levels of rlsk assoclaLed wlLh Lhe dlfferenL class, or Lranche," of llablllLy.
1he alm ls Lo creaLe, Lhrough Lranchlng, a sLrucLure ln whlch Lhe asseLs produce a hlgher reLurn Lhan
pald on Lhe llablllLles. 8uL, as Mlnsky observed, LhaL should mean LhaL Lhe llablllLles have a hlgher
llquldlLy premlum Lhan Lhe asseLs. LlquldlLy ls Lhus creaLed by ensurlng LhaL a large proporLlon of Lhe
llablllLles has a hlgher credlL raLlng Lhan Lhe asseLs LhaL supporL Lhem. 1hls ls achleved by credlL
enhancemenL", LhaL ls, by overcollaLerallzaLlon" (Lhe value of Lhe asseLs ls greaLer Lhan Lhe llablllLles
lssued), by Lhe purchase of credlL defaulL swap (CuS) proLecLlon, or by purchaslng a guaranLee from a
monollne lnsurer LhaL ls sufflclenL Lo convlnce a naLlonally recognlzed sLaLlsLlcal raLlng organlzaLlon Lo
provlde Lhe ma[orlLy of Lhe llablllLles wlLh an lnvesLmenL-grade raLlng, allowlng penslon funds, lnsurance
companles, and LrusLs Lo purchase llablllLles backed by asseLs LhaL Lhey would noL be permlLLed Lo buy
dlrecLly because Lhelr credlLworLhlness ls Loo low. Pere, Lhe llquldlLy ls provlded by placlng asseLs lnLo a
sLrucLure LhaL Lransforms Lhem lnLo more llquld llablllLles. unllke Lhe Slv, Lhere ls llLLle maLurlLy
LransformaLlon ln Lhls process, raLher, lncome ls generaLed by Lransformlng llllquld, hlgher-yleldlng
asseLs lnLo llquld, low-yleldlng asseLs. Agaln, Lhls ls flcLlLlous llquldlLy, slnce lL depends on Lhe
performance of Lhe underlylng asseLs or Lhe condlLlons of Lhe enLlLles LhaL provlde Lhe credlL
enhancemenL. Slnce boLh Lhe lssuers of CuSs and Lhe monollne lnsurers provlsloned agalnsL Lhe rlsk


67
represenLed by Lhe lnvesLmenL-grade raLlng of Lhe llablllLles raLher Lhan Lhe much hlgher rlsk of Lhe
underlylng asseLs, Lhese guaranLees were lnsufflclenL Lo ensure Lhe llquldlLy of Lhe llablllLles.
21

uerlvaLlves, wheLher of Lhe plaln-vanllla varleLy or embodled ln sLrucLured lendlng vehlcles, also provlde
flcLlLlous llquldlLy, slnce Lhey provlde Lhe posslblllLy of creaLlng Lhe equlvalenL of ownershlp exposure Lo
an asseL wlLh only a mlnlmum margln paymenL. 1hus, lnsLead of borrowlng from a bank Lo lnvesL ln an
asseL, lL ls posslble Lo Lake a long poslLlon by buylng an C1C or exchange-Lraded derlvaLlve wlLh only a
small margln paymenL on Lop of Lhe opLlon premlum. 8egulaLed commerclal banks were orlglnally
allowed Lo deal ln derlvaLlves on governmenL securlLles slnce Lhelr lnLermedlaLlon was permlLLed by
Class-SLeagall. 8uL Lhe Cfflce of Lhe CompLroller of Lhe Currency, ln a serles of admlnlsLraLlve rullngs,
evenLually opened Lhe way Lo deallngs ln derlvaLlves on all Lypes of asseLs, provldlng for Lhe creaLlon
and domlnance of lnsured banks ln C1C derlvaLlves deallng (see kregel, 2010).
AnoLher mechanlsm cenLral Lo Lhe recenL crlsls was Lhe so-called secLlon 20" exempLlon LhaL allowed
banks Lo creaLe securlLy afflllaLes" Lo deal ln securlLles lf lncome from Lhese acLlvlLles dld noL consLlLuLe
Lhelr prlnclpal" source of revenue (see kregel 2010). Slnce banks were permlLLed Lo deal ln governmenL
securlLles under Class-SLeagall, Lhe prlnclpal source of lncome Look Lhe form of runnlng a maLched-book
repurchase buslness LhaL creaLed llLLle rlsk, and could be grossed up Lo produce any deslred revenue Lo
cover" Lhe lncome generaLed from securlLles Lradlng. 1hls allowed banks Lo engage ln whaL would
become proprleLary Lradlng, and, more lmporLanL, creaLed Lhe repo" markeL, ln whlch an lnvesLor
wlLhouL caplLal could Lake a poslLlon ln an asseL LhaL was funded by Lhe use of Lhe asseL as collaLeral.
1he only flnanclal commlLmenL was Lo flnd Lhe funds Lo cover Lhe small or nonexlsLenL halrcuL" applled
Lo Lhe value of Lhe asseL ln deLermlnlng how much would be lenL agalnsL lL. Slnce such conLracLs were
overnlghL or exLremely shorL Lerm, Lhey agaln augmenLed Lhe llquldlLy of long-Lerm, less llquld asseLs. (lL
ls worLh noLlng LhaL Lhe repo markeL had been a perslsLenL source of fraudulenL acLlvlLy and regulaLory
dlfflculLy over many years prlor Lo Lhe recenL crlsls.
22
)
All of Lhese lnnovaLlve sLrucLures greaLly lncreased Lhe ablllLy of Lhe sysLem Lo creaLe and flnance Lhe
holdlng of, and speculaLlon ln, new Lypes of exoLlc flnanclal asseLs. lor Lhls reason, Lhey are ofLen
descrlbed as consLlLuLlng a shadow" banklng sysLem, buL Lhey were noL banks and Lhey dld noL creaLe
llquldlLy" ln Lhe same way as a regulaLed bank-LhaL ls, Lhrough Lhe guaranLee of provlslon of means of
paymenL. 1hls flcLlLlous llquldlLy depended more on parLlcular movemenLs ln Lhe prlces of Lhe asseLs and
Lhe ablllLy Lo sell Lhem as requlred Lhan on Lhelr ablllLy Lo produce lncome. When Lhese prlce
anLlclpaLlons were noL reallzed, lL was lmposslble Lo generaLe llquldlLy Lhrough Lhe sale of underlylng
asseLs wlLhouL creaLlng decllnes ln prlces LhaL produced loss and poLenLlal lnsolvency. lndeed, mosL of
Lhese asseLs were long Lerm, wlLh no formal or lnformal markeLs or markeL makers. noL only were Lhere
no markeLs ln whlch Lo sell Lhem, Lhere were no markeL makers or prlces Lo value Lhe asseLs. 1helr very

21
lL ls Lelllng LhaL Lhe SLC appears Lo have belleved LhaL Lhe raLlng of securlLles by raLlng agencles provlded an
assessmenL of Lhelr llquldlLy": securlLles LhaL were raLed lnvesLmenL grade by a credlL raLlng agency of naLlonal
repuLe, Lyplcally were more llquld and less volaLlle ln prlce Lhan securlLles LhaL were noL so hlghly raLed" (Adelson
2007).
22
1hls llsL ls noL exhausLlve. lor example, rehypoLhecaLlon of collaLeral and securlLles lendlng ln prlme brokerage
accounLs also augmenL sysLem llquldlLy aL no cosL or aL only a small halrcuL on value.


68
exlsLence and value depended on flcLlLlous llquldlLy, and when lL dlsappeared, so dld Lhelr value.
ulLlmaLely, Lhe llquldlLy requlred Lo supporL Lhese asseLs depended on Lhelr accepLance by lnsured
banks. lf banks were noL wllllng Lo provlde lL, Lhen lL had Lo be provlded by Lhe cenLral bank lf an
ouLrlghL debL deflaLlon was Lo be avolded.
ln Lhe recenL crlsls, Lhe facL LhaL many bank holdlng companles were also lnvolved ln Lhe creaLlon of Lhls
shadow" llquldlLy severely llmlLed Lhe ablllLy of Lhelr banklng subsldlarles Lo provlde llquldlLy supporL,
slnce Lo do so would have requlred lncreaslng borrowlng from deposlLors raLher Lhan accepLlng Lhe
llablllLles of anoLher unlL ln Lhe holdlng. A slngle lnsLlLuLlon cannoL provlde accommodaLlon Lo lLself,
slnce lL would [usL be Lransferrlng losses from one unlL Lo anoLher, [eopardlzlng lLs ablllLy Lo aLLracL
cusLomer core" deposlLs.
L|qu|d|ty was not used to prov|de for the cap|ta| deve|opment of the economy
1he baslc dlfflculLy caused by Lhe recenL exploslon of flcLlLlous llquldlLy ls LhaL lL was used prlmarlly Lo
flnance Lhe acqulslLlon of flnanclal asseLs LhaL dld noL represenL real caplLal asseLs or Lhe expecLed
fuLure lncome from real asseLs buL raLher an anLlclpaLed appreclaLlon ln Lhe prlce of Lhe asseLs-an
appreclaLlon LhaL was drlven by Lhe lncrease ln flcLlLlous llquldlLy. 1he sLablllLy of Lhese poslLlons was
agaln dependenL on a parLlcular paLLern of prlce change. And many ln Lhe lndusLry recognlzed Lhese
sLrucLures as lmpllclL onzl" schemes (see McCulley 2007). When Lhese anLlclpaLed prlce movemenLs
were noL reallzed, many of Lhe sLrucLures ln whlch marglns were llnked Lo Lhe value of Lhe poslLlon
generaLed an lncreased demand for accommodaLlon for a poslLlon whose value was decllnlng. 1hus, Lhe
demand for llquldlLy lncreased wlLh a decllne ln Lhe value of Lhe poslLlon and Lhe decllne ln Lhe amounL
of flcLlLlous llquldlLy lL could provlde. 1he facL LhaL Lhere were no markeLs Lo provlde evaluaLlons of Lhe
worLh of Lhe poslLlons made lL more dlfflculL Lo assess rlsks, leadlng Lo an ofLen lnapproprlaLe lncrease ln
halrcuLs and margln calls, and reduclng llquldlLy aL preclsely Lhe momenL Lhe sLrucLures requlred
addlLlonal llquldlLy Lo remaln vlable.
ln slmple Lerms, Lhe shadow sysLem creaLed llquldlLy Lo fund holdlngs of flnanclal asseLs and Lo generaLe
lncomes from Lradlng asseLs ln order Lo explolL prlce dlfferences, raLher Lhan Lo generaLe lncome and
employmenL. As Mlnsky polnLed ouL, a borrower's balance sheeL represenLs a flow dlmenslon LhaL ls
cruclal Lo lLs sLablllLy: Lhe balance beLween Lhe flnanclng cosLs of Lhe llablllLles relaLlve Lo Lhe lncome
generaLed by Lhe asseLs. lor a buslness flrm, Lhls ls buslness lncome from ouLpuL, employmenL, and Lhe
sale of ouLpuL. lor a flnanclal lnsLlLuLlon flnanclng Lhe flrm, lLs lncome ls derlvaLlve of Lhe flrm's lncome.
Powever, mosL of Lhe lendlng ln Lhe recenL crlsls was lendlng by one flnanclal lnsLlLuLlon Lo anoLher ln
order Lo flnance Lhelr holdlngs of flnanclal asseLs and lncome generaLed by slmple prlce volaLlllLy. 1hls ls
flnanclal layerlng" wlLhln Lhe sysLem and represenLs Lhe lncreased flnanclal fraglllLy LhaL was generaLed
by Lhls creaLlon of flcLlLlous" llquldlLy.
What |s wrong w|th current regu|atory proposa|s?
1he baslc error ln Lhe currenL regulaLory approach embodled ln uodd-lrank ls LhaL lL does very llLLle Lo
llmlL Lhe creaLlon of flcLlLlous llquldlLy or Lo redlrecL Lhe creaLlon of LhaL llquldlLy Lo Lhe flnanclng of Lhe


69
caplLal developmenL of Lhe sysLem.
23
uodd-lrank seeks Lo llmlL Lhe exposure of governmenL Lo Lhe
consequences of anoLher collapse of regulaLed, lnsured lnsLlLuLlons, requlrlng Lhe laLLer Lo hold hlgher
levels of equlLy caplLal ln order Lo meeL Lhe losses creaLed by a debL deflaLlon caused by a reversal ln
anLlclpaLed prlces. 8uL caplLal ls meanL Lo be a reserve Lo ensure solvency of Lhe lnsLlLuLlons, and Lhe
lnsolvencles LhaL were avolded ln Lhe recenL crlsls were creaLed by excesslve llquldlLy creaLlon. 1he
ablllLy Lo creaLe llquldlLy depends on Lhe flnanclng lnsLlLuLlon engaglng ln Lhe accepLance funcLlon. Cnly
a regulaLed bank offerlng lnsured deposlLs can do Lhls. Avoldlng anoLher crlsls wlll Lhus depend on
llmlLlng Lhe means of flcLlLlous" llquldlLy creaLlon noLed above.
As Mlnsky's proposal above suggesLs, Lhe way Lo make banks Lruly safe ls for every subsldlary of Lhe
bank holdlng company Lo carry a 100 percenL reserve raLlo and a 100 percenL caplLal raLlo. 8uL no
amounL of caplLal can subsLlLuLe for Lhe creaLlon of Lhe llquldlLy requlred for Lhe caplLal developmenL of
Lhe sysLem. 1hls ls parLlcularly Lrue for nonbank lnvesLmenL LrusL sLrucLures LhaL are lmpllclLly 100
caplLallzed.
Cne way Lo do lL would be Lo modlfy Mlnsky's proposal by placlng llmlLaLlons noL only on Lhe asseLs and
llablllLles of Lhe subsldlarles buL also on Lhe number and funcLlons of Lhe subsldlarles of a flnanclal
holdlng company. Poldlng companles provldlng LransacLlon servlces, a sLore of value, or flnanclng (for
houslng, consumers, or shorL-Lerm buslness flnanclng of commerclal paper) would Lhen be llmlLed Lo
acLlvlLles closely relaLed Lo llquldlLy creaLlon. A separaLe group of holdlng companles, wlLh Lhe
approprlaLe relaLed seLs of acLlvlLles, would provlde underwrlLlng and caplLal markeL servlces for Lhe
flnanclng of producLlve lnvesLmenL. 1he alm would be Lo llmlL each Lype of holdlng company Lo a range
of acLlvlLles LhaL are sufflclenLly llnked Lo Lhelr core funcLlon, and Lo ensure LhaL each company were
small enough Lo be effecLlvely managed and supervlsed (see kregel 2008).
As proposed ln lasL year's Levy lnsLlLuLe reporL (Levy lnsLlLuLe, 2011), some of Lhe dlfflculLles creaLed by
uodd-lrank are due Lo Lhe aLLempL Lo lnLroduce Class-SLeagall-Lype provlslons lnLo Lhe 1999 CL8 AcL
wlLhouL revlslLlng lLs maln provlslons relaLlng Lo Lhe revlslon of Lhe 1936 8ank Poldlng Company AcL. A
reallsLlc aLLempL Lo preclude Loo blg Lo fall" banks would seem Lo requlre revlslon of CL8.
8uL such a revlslon would be boLh Llme-consumlng and dlfflculL ln Lhe presenL pollLlcal envlronmenL. A
more expedlLlous meLhod of reform LhaL could replace uodd-lrank would be Lo ask lf Lhere were any
reason why Lhe flcLlLlous-llquldlLy sLrucLures LhaL have grown up ln Lhe process of deregulaLlon are
necessary Lo Lhe operaLlon of Lhe economy. lndeed, mosL of Lhe llquldlLy-creaLlng sLrucLures menLloned
above were generaLed by Lhe resLrlcLlons on acLlvlLy caused by Lhe segmenLaLlon of flnanclal funcLlons
and compeLlLlon beLween commerclal and lnvesLmenL banks. Slnce Lhe CL8 AcL ellmlnaLed any such
dlsLlncLlon, Lhe [usLlflcaLlon for mosL of Lhese sLrucLures loses cogency.

23
Cne of Lhe greaLesL deflclencles ln Lhe new 8ank for lnLernaLlonal SeLLlemenLs regulaLlons on llquldlLy ls LhaL
Lhey seL llquldlLy requlremenLs for flnanclal lnsLlLuLlons raLher Lhan llmlLlng Lhe flnanclal lnsLlLuLlons LhaL creaLe
llquldlLy. 1he former are speclous for as keynes remlnded, Lhere ls no such Lhlng as sysLem llquldlLy, whlle lL ls
posslble Lo resLrlcL Lhe operaLlon of lnsLlLuLlons LhaL provlde llquldlLy. lL ls also llkely LhaL Lhey wlll dlsLorL Lhe prlces
of Lhe asseLs LhaL saLlsfy Lhls requlremenL as usually happens wlLh any dlvlslon beLween regulaLory and
nonregulaLory asseLs.


70
lor example, ls Lhere any reason why MMMls should exlsL lndependenL of banks? 1hey could be
ellmlnaLed by a slmple rullng reverslng Lhe orlglnal courL declslon LhaL commerclal paper was a securlLy
and Lhus could noL be operaLed by commerclal banks under Class-SLeagall. under CL8, Lhere ls no
reason for Lhem Lo exlsL, and Lhey could be Lransformed lnLo regulaLed, lnsured lnsLlLuLlons by a slmple
declslon of Lhe llnanclal SLablllLy CverslghL Councll.
1here ls also no reason why securlLlzaLlon should exlsL ln lLs presenL form. lndeed, lf Lhese sLrucLures
were regulaLed llke oLher flnanclal lnsLlLuLlons and sub[ecL Lo Lransparency and reporLlng, Lhey would ln
all probablllLy noL be vlable (see kregel 2010). As suggesLed by Lew 8anlerl (1996), one of Lhe lnnovaLors
ln securlLlzaLlon, Lhere are some asseLs LhaL should noL and cannoL be successfully securlLlzed. 1hus, Lhe
asseLs LhaL are permlLLed ln securlLlzed sLrucLures should be sub[ecL Lo regulaLlon. lL ls lnsLrucLlve LhaL
governmenL-sponsored enLerprlses oversaw Lhe securlLlzaLlon of conformlng" morLgage asseLs wlLhouL
dlfflculLy as long as Lhey meL Lhe sLrlcL condlLlons for lncluslon. lL Lhus follows LhaL some securlLlzed
sLrucLures cannoL be effecLlvely rlsk raLed, and credlL raLlngs should noL be permlLLed as an lndlcaLlon of
Lhelr sulLablllLy for cerLaln porLfollos.
8epurchase agreemenLs should be regulaLed so LhaL Lhey do noL fund speculaLlve flnanclal lnsLlLuLlons,
such as proprleLary Lradlng desks or hedge funds. 1he supposed need for collaLerallzed deposlLs of large
slze could be easlly meL by exLendlng deposlL lnsurance Lo all deposlLs. 8epos have been Lhe source of
fraud and lnsLablllLy LhroughouL Lhelr hlsLory, even when Lhey were prlmarlly resLrlcLed Lo rlsk-free
governmenL securlLles. 1hey could slmply be reclasslfled as loans and regulaLed as such.
uerlvaLlves have become an lnLegral parL of Lhe modern flnanclal sysLem, and hardly any poslLlon ls
underLaken or flnanclng lnsLrumenL creaLed wlLhouL Lhe lncluslon of a derlvaLlves poslLlon. 1he problem
ls LhaL whlle Lhey dlsperse rlsk and provlde hedglng, Lhey ofLen hlde Lhe Lrue rlsk Lo Lhe purchaser.
1radlng on regulaLed exchanges wlll noL change Lhe lack of Lransparency concernlng rlsk exposure. 1he
problem could be reduced lf derlvaLlves poslLlons were fully marglned.
1hese measures would noL guaranLee sysLem sLablllLy, as new mechanlsms of flcLlLlous llquldlLy would
qulckly be lnvenLed. 8uL Lhey could be easlly lnLroduced by slmply reverslng Lhe regulaLory and legal
declslons LhaL allowed Lhem Lo come lnLo exlsLence, prlmarlly ln order Lo provlde for a more level
playlng fleld beLween commerclal and lnvesLmenL banks. 1he level playlng fleld was secured by Lhe CL8
AcL, whlch rendered Lhese measures ouLdaLed and unnecessary. 1hey should have been repealed when
Lhe acL was approved or, beLLer, by revlslon of Lhe acL lLself. LlLher approach would provlde a degree of
regulaLory conLrol over flcLlLlous llquldlLy creaLlon and Lhus sLem Lhe reflexlve lmpacL of lLs collapse on
asseL prlces. 1hls would also requlre flnanclal lnsLlLuLlons Lo seek oLher forms of lncome, among Lhem,
lendlng Lo supporL Lhe caplLal developmenL of Lhe economy.
All of Lhese declslons are wlLhln Lhe remlL of exlsLlng regulaLory agencles or Lhe lSCC and could be
lmplemenLed rapldly and wlLhouL Lhe delays surroundlng Lhe lmplemenLaLlon of uodd-lrank.


71
Addendum by way of conc|us|on: Serv|ng two mastersthe conundrum of regu|at|on
Much of Lhe lnnovaLlon LhaL has occurred ln Lhe Class-SLeagall sysLem was parL of an aLLempL by
regulaLed banks Lo lncrease Lhelr reLurn on equlLy. And much of Lhe deregulaLlon ln Lhe flnanclal sysLem
was lnLroduced ln order Lo allow commerclal banks Lo augmenL Lhelr lncome and compeLe wlLh less
regulaLed lnvesLmenL banks. lronlcally, some foresaw Lhls problem as leadlng Lo Lhe dlsappearance of
commerclal banklng (see kregel 1997). lnsLead, lL ls Lhe lnvesLmenL banks LhaL have dlsappeared as a
resulL of CL8.
lor any flnanclal lnsLlLuLlon, lLs reLurn on equlLy ls deLermlned by Lhe reLurn on asseLs mulLlplled by Lhe
raLlo of asseLs Lo bank equlLy, beLLer known as leverage. 1he problem LhaL commerclal banks faced was
Lhe decllne ln Lhe share of sysLem asseLs LhaL were belng flnanced by bank llquldlLy, along wlLh Lhe
decllne ln neL marglns on Lhls buslness. 1hus, deregulaLlon provlded a way Lo lncrease leverage, buL Lhe
creaLlon of bank holdlng companles LhaL could use Lhls lncreased leverage Lo lmprove sysLem llquldlLy
and Lhus lnflaLe Lhe amounL of lncome produced led Lo greaLer flnanclal fraglllLy and evenLual collapse.
An lncrease ln caplLal raLlos does noLhlng Lo lncrease Lhe reLurns Lo LradlLlonal llquldlLy creaLlon by
means of accepLance lendlng. 8aLher, lL wlll slmply lead Lo an lncrease ln leverage or Lo greaLer
consolldaLlon, as banks seek Lo lmprove Lhelr boLLom llne by ralslng Lhe prlce of servlces. An alLernaLlve,
whlch Mlnsky suggesLed, ls for banks Lo access Lhe cenLral bank dlrecLly for reserves Lo hedge Lhelr shorL
cash poslLlons resulLlng from deposlL creaLlon. 1hls would preclude Lhe need for offerlng reLall deposlLs
as Lhe base mechanlsm for generaLlng reserves.
1he conundrum of regulaLlon ls Lo flnd a way Lo allow banks Lo concenLraLe on flnanclng Lhe caplLal
developmenL of Lhe economy Lhrough llquldlLy creaLlon whlle aL Lhe same Llme provldlng secure
LransacLlons servlces wlLh Lhe comblnaLlon earnlng raLes of reLurn on caplLal LhaL are compeLlLlve wlLh
oLher forms of caplLal lnvesLmenL. lncreaslng Lhe amounL of caplLal requlred and Lhus Lhe lncome LhaL
musL be earned would appear Lo be a sure lncenLlve Lo lnnovaLe ln Lhe dlrecLlon of hlgher leverage and
flcLlLlous llquldlLy, or Lo charge more for Lhe provlslon of LransacLlons servlces.
llnally, macroprudenLlal regulaLlon has Lo recognlze Lhe lmporLance, flrsL noLed by Marrlner Lccles, of
Lhe lmpacL of Lhe employmenL raLe and Lhe governmenL budgeL on Lhe level of llquldlLy and Lhe
solvency of flnanclal lnsLlLuLlons. As Mlnsky conLlnually emphaslzed, Lhe success of Lhe Class-SLeagall
sysLem was due as much Lo Lhe exlsLence of 8lg CovernmenL as a complemenL Lo Lhe lender-of-lasL-
resorL funcLlon of Lhe cenLral bank as lL was Lo Lhe resLrlcLlons placed on Lhe asseLs LhaL deposlL-Laklng
lnsLlLuLlons could hold.


72
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Sponsored LnLerprlses of Lhe Pouse CommlLLee on llnanclal Servlces. 1be kole of cteJlt kotloq
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_______. 2009b. Obsetvotloos oo tbe ltoblem of 1oo 8lq to loll/5ove/kesolve. ollcy noLe 2009/11.
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77
kLLA1LD LLV INS1I1U1L U8LICA1ICNS

Worklng aper no. 323 | uecember 2007
1he naLural lnsLablllLy of llnanclal MarkeLs"

ubllc ollcy 8rlef no. 93 | !anuary 2008
Mloskys cosbloos of 5ofety. 5ystemlc klsk ooJ tbe ctlsls lo tbe u5 5obptlme Mottqoqe Motket

Worklng aper no. 333 | Aprll 2008
Changes ln Lhe uS llnanclal SysLem and Lhe Subprlme Crlsls"

Worklng aper no. 343 | SepLember 2008
Macroeconomlcs MeeLs Pyman . Mlnsky: 1he llnanclal 1heory of lnvesLmenL"

Worklng aper no. 347 | CcLober 2008
Mlnsky and Lconomlc ollcy: 'keyneslan' All Cver Agaln?"

ollcy noLe 2008/4| CcLober 2008
A 5lmple ltoposol to kesolve tbe ulstoptloo of coootetpotty klsk lo 5bott-1etm cteJlt Motkets

ollcy noLe 2008/3 | CcLober 2008
wlll tbe loolsoo 8olloot ltoJoce tbe 8osls fot Aootbet Mlosky Momeot?

ubllc ollcy 8rlef no. 99 | March 2009
1be ketoto of 8lq Covetomeot. lollcy AJvlce fot lteslJeot Obomo

Worklng aper no. 337 | March 2009
8ackground ConslderaLlons Lo a 8egulaLlon of Lhe uS llnanclal SysLem: 1hlrd 1lme a Charm? Cr SLrlke
1hree?"

Worklng aper no. 338 | Aprll 2009
Managlng Lhe lmpacL of volaLlllLy ln lnLernaLlonal CaplLal MarkeLs ln an uncerLaln World"

Worklng aper no. 360 | Aprll 2009
1he Soclal and Lconomlc lmporLance of lull LmploymenL"

ubllc ollcy 8rlef no. 100 | Aprll 2009
lts 1bot vlsloo 1bloq. wby tbe 8olloots Ateot wotkloq, ooJ wby o New lloooclol 5ystem ls NeeJeJ

Worklng aper nos. 373.1-2 | AugusL 2009
SecurlLlzaLlon, ueregulaLlon, Lconomlc SLablllLy, and llnanclal Crlsls, arLs l-ll"

Worklng aper nos. 374.1-4 | AugusL 2009
A CrlLlcal AssessmenL of Seven 8eporLs on llnanclal 8eform: A Mlnskyan erspecLlve, arLs l-lv



78
ubllc ollcy 8rlef no. 103 | AugusL 2009
lloooclol ooJ Mooetoty lssoes os tbe ctlsls uofolJs

Worklng aper no. 378 | SepLember 2009
Money Manager CaplLallsm and Lhe Clobal llnanclal Crlsls"

Worklng aper no. 380 | CcLober 2009
An AlLernaLlve vlew of llnance, Savlng, ueflclLs, and LlquldlLy"

ubllc ollcy 8rlef no. 103 | CcLober 2009
lt lso't wotkloq. 1lme fot Mote koJlcol lollcles

ollcy noLe 2009/9 | CcLober 2009
8ooks koooloq wllJ. 1be 5obvetsloo of losotooce by llfe 5ettlemeots ooJ cteJlt uefoolt 5wops

ollcy noLe 2009/11 | uecember 2009
Obsetvotloos oo tbe ltoblem of 1oo 8lq to loll/5ove/kesolve

ubllc ollcy 8rlef no. 107 | !anuary 2010
No Coloq 8ock. wby we coooot kestote Closs-5teoqoll's 5eqteqotloo of 8ookloq ooJ lloooce

Worklng aper no. 383 | lebruary 2010
ls 8eregulaLlon of Lhe llnanclal SysLem an Cxymoron?"

Worklng aper no. 386 | lebruary 2010
ls 1hls Lhe Mlnsky MomenL for 8eform of llnanclal 8egulaLlon?"

Worklng aper no. 387| lebruary 2010
1he Clobal llnanclal Crlsls and Lhe ShlfL Lo Shadow 8anklng"

Cne-ager no. 2 | May 2010
kefotms wltboot lolltlcloos. wbot we coo uo 1oJoy to 5ttolqbteo Oot floooclol Motkets

Cne-ager no. 3 | May 2010
1be 5pectte of 8ookloq

Worklng aper no. 602 | !une 2010
llscal 8esponslblllLy: WhaL LxacLly uoes lL Mean?"

Worklng aper no. 603 | !une 2010
ueLecLlng onzl llnance: A 8evoluLlonary Approach Lo Lhe Measure of llnanclal lraglllLy"

Worklng aper no. 612 | AugusL 2010
WhaL uo 8anks uo? WhaL Should 8anks uo?"

ubllc ollcy 8rlef no. 113 | SepLember 2010
wbot 5boolJ 8ooks uo? A Mloskyoo Aoolysls



79
Worklng aper no. 637 | november 2010
llnanclal SLablllLy, 8egulaLory 8uffers, and Lconomlc CrowLh: Some osLrecesslon 8egulaLory
lmpllcaLlons"

Cne-ager no. 6 | november 2010
Mloskys vlew of copltollsm ooJ 8ookloq lo Ametlco

Worklng aper no. 643 | uecember 2010
CuanLlLaLlve Laslng and roposals for 8eform of MoneLary ollcy CperaLlons"

Worklng aper no. 649 | !anuary 2011
llscal ollcy LffecLlveness: Lessons from Lhe CreaL 8ecesslon

Worklng aper no. 630 | !anuary 2011
llscal ollcy: Why AggregaLe uemand ManagemenL lalls and WhaL Lo uo abouL lL

Worklng aper no. 633 | March 2011
llnanclal keyneslanlsm and MarkeL lnsLablllLy""

Worklng aper no. 634 | March 2011
Measurlng MacroprudenLlal 8lsk: llnanclal lraglllLy lndexes"

Worklng aper no. 633 | March 2011
A Mlnskyan 8oad Lo llnanclal 8eform"

Worklng aper no. 639 | March 2011
Mlnsky Crlsls"

Worklng aper no. 661 | March 2011
Mlnsky's Money Manager CaplLallsm and Lhe Clobal llnanclal Crlsls"

Worklng aper no. 662 | March 2011
1he llnanclal Crlsls vlewed from Lhe erspecLlve of Lhe 'Soclal CosLs' 1heory"

ubllc ollcy 8rlef no. 117 | Aprll 2011
lts 1lme to kelo lo tbe leJ

8esearch ro[ecL 8eporL | Aprll 2011
Mlosky oo tbe keteqolotloo ooJ kesttoctotloq of tbe lloooclol 5ystem.
wlll uoJJ-ltook lteveot lt ftom noppeoloq Aqolo?

Worklng aper no. 681 | AugusL 2011
Lessons We Should Pave Learned from Lhe Clobal llnanclal Crlsls buL uldn'L"

resenLaLlon | SepLember 2011
Cn Lhe ollLlcal Lconomy of Lhe Cerman oslLlon ln Lhe Luropean uebL Crlsls"


80
ubllc ollcy 8rlef no. 120 | CcLober 2011
woltloq fot tbe Next ctosb. 1be Mloskyoo lessoos we lolleJ to leoto

8esearch ro[ecL 8eporL | november 2011
ultect Iob cteotloo fot 1otboleot 1lmes lo Cteece

Worklng aper no. 698 | uecember 2011
$29,000,000,000,000: A ueLalled Look aL Lhe led's 8allouL by lundlng laclllLy and 8eclplenL"

Cne-ager no. 23 | uecember 2011
529,000,000,000,000. A uetolleJ look ot tbe leJs 8olloot of tbe lloooclol 5ystem

Worklng aper no. 706 | lebruary 2012
lnflaLlonary and ulsLrlbuLlonal LffecLs of AlLernaLlve llscal ollcles: An AugmenLed Mlnskyan-kalecklan
Model"

Worklng aper no. 707 | lebruary 2012
1he Luro Crlsls and Lhe !ob CuaranLee: A roposal for lreland"

Worklng aper no. 709 | lebruary 2012
1oo 8lg Lo lall: MoLlves, CounLermeasures, and Lhe uodd-lrank 8esponse"
ollcy noLe 2012/2 | March 2012
loll mploymeot tbtooqb 5oclol ottepteoeotsblp. 1be Nooptoflt MoJel fot lmplemeotloq o Iob
Cootootee

ubllc ollcy 8rlef no. 123 | Aprll 2012
A uetolleJ look ot tbe leJs ctlsls kespoose by looJloq loclllty ooJ keclpleot