The Squam Lake Report (Princeton University Press) is a set of recommendations by 15 leading economists on reforming the financial system. Considering the magnitude of the recent financial crisis, it is surprising how little change the book proposes.
Certainly, the first step in devising a set of recommendations for reform is to understand what went wrong, something the authors set out to do in their first chapter. They list a number of factors that may have contributed to the crisis but take no stand on their relative importance. They believe that their recommendations will help make the system more stable, although not crisis-proof, even if they don’t completely understand the origins of the current crisis. While a few of the recommendations are intended for guiding the financial system towards stability, most are only useful for when a financial crisis has already erupted.
Perhaps the best recommendation is for a systemic regulator with an explicit mandate of maintaining financial stability. As financial institutions are increasingly involved in activities outside their traditional domain, having a systemic regulator makes sense. But the report recommends that the central bank be that regulator—which is logical, since the Fed’s discount window gives it a good view of financial institution balance sheets. The problem, at least in case of the U.S., is that the Federal Reserve had the authority to regulate key aspects of the financial system when the last meltdown occurred, but chose not to exercise that authority. For instance, the Fed had had the power to regulate all mortgage lenders since 1994.
The question now is whether the culture of deregulation that has prevailed at the Fed for at least the past 25 years will allow it to transform itself into a good regulator. The FDIC has a better track record of being tough on the financial sector, and may well be better suited for the job.
The report is also big on transparency. For instance, it proposes that large financial institutions, including hedge funds, “report information about asset positions and risks to regulators each quarter.” Having better-informed regulators is certainly important but only goes so far. The magnitude of fraud during the last crisis demonstrates the difficulty of relying on information reported by the institutions themselves and underscores the importance of active regulation (The Repo 105 transactions used by Lehman, Citibank and Bank of America were merely the tip of the iceberg in the accounting gimmicks used by these institutions to mask their true positions.) The authors don’t seem to recognize the role of fraud in the financial sector and offer no recommendation on how to deal with it.
A whole chapter of the Squam Lake Report is devoted to regulating retirement savings, which is timely and appropriate considering that pension funds have been among the biggest losers in the current crisis. The crux of the Squam Lake proposal is to require investment products offered in defined contribution plans to have a standardized disclosure of costs and risks, to increase deductions from workers’ pay and to restrict default investment alternatives to low-fee, diversified products. These are sensible ideas but won’t insulate retirement savings from a crisis, because in a crisis asset classes (except for Treasuries) tend to crash in unison. At such times, diversification doesn’t help.
Furthermore, diversification (already required by federal pension law) was a major contributor to the bubble economy of the past decade as pension funds hunted for financial products uncorrelated with stocks. Overall, I don’t see merit in their pension reform proposal. The best solution would be to eliminate tax advantages for pension plans and instead boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. See Nersisyan and Wray (2009) for more on the trouble with the pensions.
The report also calls for higher capital requirements for major institutions, another reasonable idea that wouldn’t have helped much last time around, when the market for asset-backed securities froze and their prices collapsed. Under such circumstances, only impractically high capital requirements would have made any difference. Besides, an institution can face liquidity issues even if it’s highly capitalized. Bear Stearns, before its collapse, had enough capital but couldn’t finance its asset positions for want of willing lenders.
The report also recommends that financial institutions issue long-term debt instruments that convert into equity under specified conditions. This would automatically recapitalize banks if they got into trouble. But again, higher capital levels cannot prevent a crisis. Besides, one of the proposed conversion triggers is the declaration by the systemic regulator that the financial system is in a crisis. But a crisis is not always so easy to spot. When Bear Stearns failed, some people said the problem wouldn’t spread. Later, the consensus was that it wouldn’t go beyond subprime mortgages. If the regulator proclaims at soe point that there is a risk of a systemic crisis, this itself might freeze the markets and make institutions unwilling to lend to each other. Giving the disease a name, in other words, might well kill the patient.
Although a whole chapter of the book is devoted credit default swaps (CDS), there is no recommendation that would make CDS safer for the financial system. The authors oppose limiting CDS trades to entities that hold the underlying security on the basis that this will make derivative markets less liquid, raising costs. They propose merely to encourage financial institutions to clear CDS and other derivative contracts through clearinghouses as well as to trade them in exchanges (rather than making such arrangements mandatory).
Again, the response seems wholly inadequate to the scale of the hazard. Derivatives create counterparty risk out of thin air and vastly magnified the recent crisis. Without CDS the subprime mortgage industry couldn’t have grown to the proportions it did. Getting rid of CDS would make it hard for financial institutions to hide risks from regulators, and make investors more cautious when investing in asset-backed securities.
Despite their deliberations, the Squam Lake economists overlook some important aspects of the financial structure that ought to be reformed. Securitization and off-balance sheet activities that were largely to blame for the current debacle are not even mentioned. It wasn’t until securitization that the shadow banking sector exploded. Securitization creates major incentive problems by separating risk from responsibility. Off-balance sheet activities allow financial institutions to avoid capital requirements and use more leverage. And while the authors seem to recognize the costs associated with having too-big-to-fail institutions that are systematically dangerous, they have no prescriptions for what needs to be done about them.
The authors are acutely conscious that regulation often has unintended consequences, yet as they implicitly recognize (by proposing regulations), this doesn’t mean there shouldn’t be rules. What should these rules look like? continue reading…
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