Review: Plumbing the Squam Lake Report

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?

The purpose of financial regulation should be to create a more stable financial structure by imposing rules that constrain the inherent instability of the system and by encouraging behavior that leads to stability. While it is true that the financial system cannot be made crisis-proof, policy can restrain the excesses of finance—as it did in the early post-war period. The belief that markets will discipline financial institutions into achieving the society’s good while pursuing their self-interest has been discredited and should be abandoned. Regulation that polishes the financial system around the edges is insufficient,  and sadly this is all that the Squam Lake Report proposes we do. Fundamental changes are necessary to prevent the financial sector from taking down the whole economy over and over again.

Policy prescriptions should not be based on what is costly and what is not costly for the financial firms, but rather on what serves the public purpose. Banks are certainly profit- seeking institutions, but they are more importantly private-public partnerships. Their liabilities are guaranteed by the government, and they have access to a lender of last resort. Publicly protected institutions shouldn’t be allowed to engage in any activity that doesn’t serve the public purpose. The general guideline for regulatory overhaul should be to isolate publicly protected commercial banks from the non-regulated non-protected institutions and have them engage in traditional banking activities–deposit issuance and underwriting of loans.

Do large banks serve a public purpose? A large portion of these institutions’ income comes from non-bank activities, such as trading. The large banks don’t lend to Main Street. They are merely engaged in speculative, fee-based activities that are not useful for the society as a whole. A progressive policy aimed at solving the issue of too big to fail would break down every institution that is considered to be “systemically important” into smaller functional pieces. Too-big-to-fail institutions shouldn’t be allowed in a democratic society. And limiting what banks can do will effectively limit their size. If the shadow banks want to be large and engage in risky activities, they can. But if their managers’ bets are unsuccessful, their creditors and shareholders will have to take the loss not the public. Again, this can be achieved by isolating the protected and regulated institutions from the shadow banks to avoid the pass-through of lender of last resort assistance from commercial banks into other institutions.

Does securitization serve a public purpose? Some would say that it does because it makes credit more democratic. But if anything, the current crisis has demonstrated that democratization of credit simply meant giving credit to the people who cannot afford to pay it back. This kind of “democratization” is not useful. There is no reason why banks shouldn’t hold loans on their books until maturity. Keeping loans on their books makes them willing to conduct thorough credit analysis and actually be motivated about being repaid.

Some analysts have rightly argued that banks should be forbidden to buy or sell credit default insurance as they don’t serve any public purpose either. These are merely a vehicle for the financial sector for redistributing wealth and reaping massive profits. CDS allow the lender to be paid even when the borrower defaults, thus making the bank indifferent to the creditworthiness of the borrower. The solution to the CDS problem is to make big banks net out gross CDS positions among themselves and then forbid publicly protected institutions from issuing or buying CDS. (See Auerback and Wray, 2009)

If banks believe that securitization, CDS, off-balance sheet activities are absolutely necessary for their activities, they can choose: either continue business as usual and lose their public protection, or keep their bank charter but only engage in publicly useful activities.

Regulation can and has been effective. But the de-supervision and lack of enforcement of the already existing regulations that we have witnessed in the period leading to the current debacle demonstrate the need not only for good rules but for committed regulators. Thus, only people who believe in the effectiveness of regulation should serve as regulators.

That these proposals will seem radical to some is only a measure of how far to the right debate on such matters has moved in the past 30 years. The recent crisis has demonstrated that the time is long past for it to move back again. The system remains fragile, and it would be tragic if took yet another crisis to bring about fundamental change.