By David Veitch
In 2008, as the financial crisis was at its peak, the world’s leading economists, those most able to ensure such a crisis never happens again, met in sleepy New Hampshire at a resort on Squam Lake. The eventual outcome of this meeting, The Squam Lake Report, will serve as the roadmap for financial regulatory reform over the next decade.
The Squam Lake Report, a brief volume running 152 pages, lays out this group of economists’ recommendations regarding financial reform in nine broad areas. The Squam Lake Report aims to inform policymakers going forward; policymakers who, in the past, did not understand, or ignored, a large body of academic research, leading them to design poor financial regulations:
With appropriate new regulations, financial firms can again resume their critical role of matching lenders with borrowers to help raise standards of living around the world. If new regulations are misguided, however, we will continue to be threatened by severe financial crises and the recessions and unemployment that often accompany them, or we will face the even worse prospect of an overregulated and politicized financial system that cannot support a growing economy. We should all hope that policymakers are up to the task. Our book aims to support that effort.
Authored by the economists who attended this meeting, The Squam Lake Report brings a variety of perspectives from individuals who have worked in government, academia, and the private sector. Notable authors include Kenneth French (Tuck School of Business finance professor and past president of the American Finance Association), Raghuram Rajan (Chicago Booth School of Business finance professor and author of Fault Lines), and Robert Shiller (Yale economics professor and author of Animal Spirits).
The Squam Lake Report brings forth a slew of recommendations for policymakers to act upon. These recommendations revolve around two key principles. First, the authors believe that policymakers must pay greater heed to the systemic impacts of their decisions, instead of focusing on firm-specific regulation. Secondly, the authors’ recommendations seek to minimize potential bail-out costs by making banks internalize the various costs which society is currently forced to pay.
- Systemic Regulator
Amongst the nine broad categories of recommendations there are three that truly stand out. First, the authors suggest that governments designate an individual/institution to act as a systemic regulator of markets. This systemic regulator would aim to enact regulation that benefits the entire financial system, not just firms within it.
If one looks back to the fall of Lehman (OTC:LEHMQ) and Bear Stearns, one can see why it is necessary to have a regulator who is looking at the bigger picture. In that scenario, firms prudently reduced lending to these firms when they fell into trouble; however, such prudence by individual institutions eventually led to those firms’ downfalls, and eventually to further systemic instability.
The systemic regulator’s role would be to gather, analyze, and report systemic information, and design regulation that contributes to the financial system’s stability. The authors recommend this role be taken on by the central bank, as they are one of the most independent of government institutions, and a mandate for financial system stability fits well with their current mandates.
- Contingent Capital
The authors also suggest that banks should use a new form of hybrid capital, contingent capital (CoCo’s), in their balance sheets. These CoCo’s would act like long-term debt, but in times of systemic crises (as deemed by the systemic regulator and covenants within the debt itself), would convert to equity. The benefit of such a security is it would recapitalize banks in times of crisis, when they are most desperate for capital.
These securities would address the debt-overhand problem of bank managers in times of crisis; by issuing new equity, most of the benefits would accrue to bondholders. This problem leads to situations where bank executives “play chicken” with regulators, waiting for an unjustified bailout. By mandating that banks use CoCo securities, regulators would eliminate the implicit subsidy to banks’ bondholders that in the event of a crisis they would be bailed out.
- Prime Brokers
Another of the authors’ insights is that one of the root causes of the crisis was a large-scale run by institutional investors and hedge funds on their prime brokers. Central to this cause is the fact that it is nearly impossible during a prime broker’s bankruptcy for investors to withdraw their assets, giving incentive for investors to flee at the first sign of trouble. This contributed to the decline of Bear Stearns when Renaissance Technologies withdrew upwards of $5 billion dollars during the week Bear failed. The reason for these runs is that prime brokers often use client assets for collateral when borrowing, thus losing a clear segregation of clients’ assets from those of the firm.
The authors recommend that prime brokerage regulations be tightened, not to the extent of a full segregation of clients’ and firms’ assets, but to increase liquidity requirements of prime brokers so that they internalize the social costs associated with potential runs.
Overall, The Squam Lake Report does a fantastic job of clearly laying out a set of recommendations about financial regulation going forward. It is structured in such a way that readers go away having a very thorough understanding of the rationale behind the authors’ recommendations. In terms of style, the authors focus on the core ideas behind their recommendations, and only offer historical examples as needed; this keeps the book brief, and lets readers better absorb the authors’ ideas.
The authors also do a commendable job on providing a brief “Econ 101” synopsis of the various issues covered; this makes the book accessible to a wide audience, especially policymakers who may lack such experience. Additionally, the authors make it easy for readers to refer back to concepts in the book by providing one of the most intimidating appendixes ever created for a book barely reaching 150 pages.
It should also be noted that The Squam Lake Report provides a summary of the crisis at the introduction. Most readers, having read numerous retellings of the financial crisis, will be pleasantly surprised at the unique insights that the authors are able to offer. Daresay, this is the most insightful and compact summary of the crisis published to date.
There are a couple of negatives of the book which should be commented on. First, one cannot help but think the perspective offered in The Sqaum Lake Report is, at times, overly academic. For instance, the focus that the authors put on establishing a systemic regulator with far-wielding regulatory power somewhat overlooks the political reality of establishing such a position. With such enormous responsibilities entrusted to such an individual/institution (i.e., declaring when a systemic crisis hits in order to trigger CoCo conversion), it is unlikely such a systemic regulator would not be affected by significant political interference.
Also, the authors may have overestimated the clarity with which their Retirement Savings Label (comparable to a food label) is able to present information about an investment product. As a third-year business student interested in finance, I felt that the authors’ proposed label was somewhat convoluted.
Overall, The Sqaum Lake Report is an excellent read, and is worthwhile for students looking to learn more about economics and financial regulation. Given the targeted recommendations and the leading academics behind them, it is unsurprising that some of them are already being put into action. One would not be surprised if in a decade’s time the majority of the recommendations will be implemented, and in ninety years’ time The Squam Lake Report can be referred to as the defining book of 21st century financial regulation.