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The Squam Lake Report

The Squam Lake Report: Fixing the Financial System

Kenneth R. French
Martin N. Baily
John Y. Campbell
John H. Cochrane
Douglas W. Diamond
Darrell Duffie
Anil K Kashyap
Frederic S. Mishkin
Raghuram G. Rajan
David S. Scharfstein
Robert J. Shiller
Hyun Song Shin
Matthew J. Slaughter
Jeremy C. Stein
René M. Stulz
Copyright Date: 2010
Pages: 168
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  • Book Info
    The Squam Lake Report
    Book Description:

    In the fall of 2008, fifteen of the world's leading economists--representing the broadest spectrum of economic opinion--gathered at New Hampshire's Squam Lake. Their goal: the mapping of a long-term plan for financial regulation reform.

    The Squam Lake Reportdistills the wealth of insights from the ongoing collaboration that began at these meetings and provides a revelatory, unified, and coherent voice for fixing our troubled and damaged financial markets. As an alternative to the patchwork solutions and ideologically charged proposals that have dominated other discussions, the Squam Lake group sets forth a clear nonpartisan plan of action to transform the regulation of financial markets--not just for the current climate--but for generations to come.

    Arguing that there has been a conflict between financial institutions and society, these diverse experts present sound and transparent prescriptions to reduce this divide. They look at the critical holes in the existing regulatory framework for handling complex financial institutions, retirement savings, and credit default swaps. They offer ideas for new financial instruments designed to recapitalize banks without burdening taxpayers. To lower the risk that large banks will fail, the authors call for higher capital requirements as well as a systemic regulator who is part of the central bank. They collectively analyze where the financial system has failed, and how these weak points should be overhauled.

    Combining an immense depth of academic, private sector, and public policy experience,The Squam Lake Reportcontains urgent recommendations that will positively influence everyone's financial well-being--all who care about the world's economic health need to pay attention.

    eISBN: 978-1-4008-3580-5
    Subjects: Finance, Economics

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Preface
    (pp. vii-x)
  4. Acknowledgments
    (pp. xi-xiv)
  5. Chapter 1 Introduction
    (pp. 1-32)

    The financial system promotes our economic welfare by helping borrowers obtain funding from savers and by transferring risks. During the World Financial Crisis, which started in 2007 and seems to have ebbed as we write in 2010, the financial system struggled to perform these critical tasks. The resulting turmoil contributed to a sharp decline in economic output and employment around the globe.

    The extraordinary policy interventions during the Crisis helped stabilize the financial system so that banks and other financial institutions could again support economic growth. Though the Crisis led to a severe downturn, a repeat of the Great Depression...

  6. Chapter 2 A Systemic Regulator for Financial Markets
    (pp. 33-43)

    Financial regulations in almost all countries are designed to ensure the soundness ofindividualinstitutions, principally commercial banks, against the risk of loss on their assets. This focus on individual firms ignores critical interactions between institutions. Attempts by individual banks to remain solvent in a crisis, for example, can undermine the stability of the system as a whole. If one financial institution prudently reduces its lending to a second, the loss of funding may cause grave problems for the borrower. We saw this in the World Financial Crisis when Bear Stearns, Lehman Brothers, and the U.K. bank Northern Rock were...

  7. Chapter 3 A New Information Infrastructure for Financial Markets
    (pp. 44-52)

    Information about prices and quantities of assets lies at the heart of well-functioning capital markets. During the World Financial Crisis, it became apparent that many important actors—both firms and regulatory agencies—did not have sufficient information. In this chapter we propose a new regulatory regime for gathering and disseminating financial market information. We argue that government regulators need a new infrastructure to collect and analyze adequate information from systemically important financial institutions. Our new information framework would bolster the government’s ability to foresee, contain, and ideally prevent disruptions to the overall financial services industry. We also suggest that the...

  8. Chapter 4 Regulation of Retirement Savings
    (pp. 53-66)

    Retirement saving is undergoing a fundamental change as employers shift from defined benefit pension plans to defined contribution plans, such as 401(k) accounts. Defined contribution plans have important advantages: they allow households to customize their retirement saving to their own risk preferences and circumstances, they insulate pensioners from potential bankruptcies of their employers, and, although there may be a modest vesting period, they allow workers to move from job to job without risking their pensions.

    These plans also place much greater burdens on consumers to make good financial decisions. There is widespread concern that many households are not up to...

  9. Chapter 5 Reforming Capital Requirements
    (pp. 67-74)

    Banks help allocate society’s limited savings to the most productive investments, and they facilitate the efficient sharing of the risks of those investments. As the World Financial Crisis forcefully reminded us, a breakdown in this process can disrupt economies around the world. Because other financial institutions can step in to fill the gap, the failure of an isolated bank is unlikely to cause serious economy-wide problems. Large banks, however, are rarely isolated. Many are linked through complex webs of trading relationships, so the failure of one large bank can inflict significant losses on others.

    The contamination across institutions is not...

  10. Chapter 6 Regulation of Executive Compensation in Financial Services
    (pp. 75-85)

    Many people argue that inappropriate compensation policies in financial companies contributed to the World Financial Crisis. Some say the overalllevelof pay was too high. Others criticize thestructureof pay, claiming that contracts for CEOs, traders, and other key professionals induced them to pursue excessively risky and short-term strategies.

    In this chapter, we first argue that governments should generally not regulate thelevelof executive compensation in financial institutions.¹ We have seen no convincing evidence that high levels of compensation in financial companies are inherently risky for the companies themselves or the overall economy. Moreover, limits on pay...

  11. Chapter 7 An Expedited Mechanism to Recapitalize Distressed Financial Firms: Regulatory Hybrid Securities
    (pp. 86-94)

    This chapter develops a proposal aimed at sounder restructuring of distressed financial companies. We recommend support for a new regulatory hybrid security that will expedite the recapitalization of banks. This instrument resembles long-term debt in normal times but converts to equity when the financial system and the issuing bank are both under financial stress. The goal is to avoid ad hoc measures such as those taken during the World Financial Crisis, which are costly to taxpayers and may turn out to be limited in effectiveness. The regulatory hybrid security we envision would be transparent, less costly to taxpayers, and more...

  12. Chapter 8 Improving Resolution Options for Systemically Important Financial Institutions
    (pp. 95-108)

    The World Financial Crisis revealed critical holes in the existing regulatory framework for handling large complex financial institutions that become impaired. First, regulators may not have the legal authority to do what is necessary to resolve a distressed institution’s problems, including selling some divisions, closing or liquidating others, renegotiating or abrogating some contracts, and finding parties to manage what is left. Second, even if regulators have the necessary authority over part of the institution, they may not have authority over the whole firm. Holding companies, for example, often have subsidiaries that are incorporated in multiple countries and therefore are governed...

  13. Chapter 9 Credit Default Swaps, Clearinghouses, and Exchanges
    (pp. 109-121)

    As its name suggests, the payoff on a credit default swap (CDS) depends on the default of a specific borrower, such as a corporation, or of a specific security, such as a bond. The value of these instruments is especially sensitive to the state of the overall economy. If the economy moves toward a recession, for example, the likelihood of defaults increases and the expected payoff on credit default swaps can rise quickly. The Depository Trust and Clearing Corporation (DTCC) estimates that in March 2010, the notional amount of credit default swaps outstanding was about $25 trillion. As a result...

  14. Chapter 10 Prime Brokers, Derivatives Dealers, and Runs
    (pp. 122-134)

    As we discuss in Chapter 1, runs by prime brokerage clients and derivatives counterparties were a central cause of the World Financial Crisis. Worried about potential losses, many clients withdrew their assets from brokerage accounts at Bear Stearns and Lehman Brothers in the weeks before these banks failed. Although Morgan Stanley did not fail, it also suffered from the withdrawal of prime brokerage assets. These runs, together with runs by short-term creditors, precipitated Bear Stearns’ and Lehman’s demise.¹ Even if these firms would have failed anyway, the runs made their failures much more sudden and chaotic, and made coherent policy...

  15. Chapter 11 Conclusions
    (pp. 135-152)

    This book should be seen as our collective best answer to the question of how the financial system can be organized to facilitate economic growth without the need for recurring taxpayer support. Our answers are summarized in two broad principles.

    The first principle is that, when developing and enforcing regulations, government officials must consider the implications not only for individual institutions but also for the financial system as a whole. Financial regulations in almost all countries have been designed to ensure that individual institutions, principally commercial banks, will remain sound when they suffer unexpected losses on their assets. This focus...

  16. List of Contributors
    (pp. 153-156)
  17. Index
    (pp. 157-167)