The Squam Lake Report:
Reforming the Financial System
Reforming the Financial System
By Dougal Williams
December 28, 2010
December 28, 2010
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Ken French and Robert Shiller were among a group of leading economists who, in the fall of 2008, convened what was to become known as the Squam Lake Group. Their recently released and much-talked about book offers its authors’ collective best answer to a defining question of our day: How can the financial system be organized to facilitate economic growth without the lingering need for government bailouts and other recurring taxpayer support? The authors’ answers boil down to two broad principles:
- Focus on the system, not just individual firms — When developing and enforcing regulations, government officials must consider their implications not only for individual institutions but also for the financial system as a whole.
- Minimize “socialization of losses” — Regulators must create conditions that force them to internalize the costs of their own failure, minimizing the likelihood of bailouts that impose those costs on taxpayers and the broader economy.
Recommendations supporting these principles are as follows:
- Appoint a systemic regulator for financial markets — A regulator, such as the Federal Reserve Bank, should be tasked with overseeing the health and stability of the overall financial system. Such a regulator would need adequate resources, independence and an explicit mandate to maintain the stability of the financial system. Its goal should be to prevent financial crises without stifling financial innovation or long-term economic growth. Long before the recent financial crisis, such a competent systemic regulator would have flagged Fannie Mae/Freddie Mac as a source of risk for the system, triggering action to mitigate those dangers.
- Institute a new information infrastructure for financial markets — Require all large financial institutions to report, according to standardized measures, asset positions and risks each quarter. This information must be shared across regulatory agencies (SEC, Fed, FDIC, CFTC), and, after a proper time lag, released to the private sector. Annually, the systemic regulator should prepare a “risk of the financial system” report for the legislature. Such a report might have induced more prudent choices among regulators, financial firms, home builders and buyers in the run-up to the 2008 crisis.
- Regulate retirement savings — Standardize disclosures of mutual funds offered in defined contribution plans to encourage comparison-shopping based on more than just past performance. Highlight expenses and exclude past performance from the standard disclosure label. Automatically enroll employees unless they explicitly opt out, make default contribution rates high, and only allow the standard part of an employees’ contribution to be invested in diversified, low-cost products. Strictly limit the amount of company stock that can be held in a defined-contribution account. This is vastly different from common practices before the financial crisis. At the time of Bear Stearns’ takeover, for example, employees were estimated to have held more than 30% of its outstanding shares.
- Reform capital requirements — Capital requirements should be higher, all else equal, for larger banks, banks whose positions are less liquid, and banks that finance more of their operations with short-term debt. Under these reforms, Bear Stearns and Lehman Brothers both would have been required to hold more capital during their pre-crisis expansions.
- Regulate executive compensation in the financial services industry — Governments should not regulate the amount of executive compensation, but rather the structure. Systemically important financial institutions should withhold a significant share (a fixed dollar amount, not a share of stock or options) of each senior manager’s total annual compensation for several years. Employees would forfeit these holdbacks if the firm goes bankrupt or receives extraordinary government assistance. Compensation holdbacks would have generated more pressure for Lehman to find a buyer without government support, and clawbacks on Bear Stearns’ $17 billion in employee compensation over the five years before it was absorbed by JP Morgan would have reduced the risk of the Fed’s guarantee of the deal.
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