baf 604 nlc first project (squam lake report) firas frangie

7/31/2019 Baf 604 Nlc First Project (Squam Lake Report) Firas Frangie

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Table of Contents

INTORDUCTION ........................................................................................................................................ 2A UNIFIED SYSTEMIC REGULATOR ..................................................................................................... 3

CLOSING THE INFORMATION GAP ....................................................................................................... 4

REGULATION OF RETIREMENT SAVINGS .......................................................................................... 4

CAPITAL REQUIREMENTS ...................................................................................................................... 6

EXECUTIVE COMPENSATION REFORM .............................................................................................. 9

RECAPITILIZATION THREW CONTINGENT CAPITAL .................................................................... 10

IMPROVING RESOLUTION OPTIONS .................................................................................................. 11

CREDIT DEFAULT SWAPS, CLEARINGHOUSES, AND EXCHANGES ............................... ............ 12PRIME BROKERS AND RUNS ................................................................................................................ 13

FINAL WORD............................................................................................................................................ 14

REFRENCES .............................................................................................................................................. 16


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INTORDUCTION

The Squam Lake Report is a brief volume that consists of the recommendations of a think tank of

15 leading financial economists in an attempt to provide direction on financial system reforms that might

help anticipate and alleviate future Systemic Crisis. The report was written in 2008 in response to the

crisis that was ongoing at that time. It is good to note that getting 15 scholars to agree on 37

recommendations is something worth of appraisal. However, one cannot but point that the report is

somehow disjoint in its arrangement of chapters. I articulate that this slight disorder is because of the

limitations of making 15 experts agree. This disjoint attribute has not prevented the report from being

very constructive and direct in addressing very important policies and sensible issues relevant to reform.

The paper has two central principles that the recommendation have been built on. The first is that

policymakers have to consider how new regulations will affect not only individual firms, but also the

financial setup as a whole. The second principal states that firms should be responsible for the costs of

their failure and excessively risky positions. This principal aims at protecting taxpayers, the innocent

bystanders, from the wrong doings of irresponsible corporate planning on the behalf of greedy market

participants. These two principles can be considered the core of what is really the Squam Lake Groups

philosophy . Yet the report has its shortcomings. The text has omitted some significant issues and also

turned a blind eye on others Furthermore, it does not suggest additional research on the issues it mentions

lightly. All the positives and negatives of this volume will be addressed thoroughly in my referee report.

The Squam Lake Report consists of 11 chapters organized in a disjoint manner (in my opinion). The firstchapter contains a brief introduction and then starts with a prelude of how the crisis started and a clear

description of the economic phenomenon; like conflict of interests and bank runs, which prevailed and led

to the collapse. Then each area of possible reform is provided with its own chapter. The last chapter, 11,

is a conclusion and a view on how the recommendations would have helped, had they been used to curb

the financial crisis.


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A UNIFIED SYSTEMIC REGULATOR

I support this set of recommendations concerning a unified systemic regulator and the role to be

handed to the Federal Reserve. The authors provide convincing arguments to support this

recommendation. The separation of the roles of systemic regulator and financial regulator is necessary.

The authors argue that the United States security exchange commission SEC is a legally oriented, rule

enforcing regulator and is ill-equipped to cope with a systemic crisis (p.25). Thus it should deal only with

consumer protection issues and business-practices regulation. Such regulation is politically charged and

influenced by consumer protection activists and lobbying. That is why the SEC is called a financial

regulator. On the other hand, the role of the systemic regulator suites the Central Bank more. There are

many reasons behind this role. Macroeconomic policy and systemic regulation are both drawn from the

disciplines of macroeconomics and financial economics. That is why macroeconomic stability meshes

well with the role of systemic regulation.

I draw some concerns over the time needed and to the legislation process to implement this plan of a

single systemic regulator for financial markets. New legislation can take a lot of time and change is

always agonizing. Also there is some disagreement between economists over this issue. The legendary

Chairman of the Board of Governors of the Federal Reserve Allan Greenspan disagrees on handing the

role of a systemic regulator to one explicit agency. I quote him below.

Forecasters as a group will almost certainly miss the onset of the next financial crisis, as they have so

often in the past, and I presume any newly designated "systemic regulator" also will. (Greenspan, 2010).

Ben Bernanke, the current Chairman of the Federal Reserve also stated a concern similar to Greenspan in

his speech at the Squam Lake Conference in New York, on 16 June 2010.

However, giving all macroprudential responsibilities to a single agency risks creating regulatory blind

spots, as in the United States, at least the skills and experience needed to oversee the many parts of our complex financial system are distributed across a number of regulatory agencies. Rather than

concentrating all macroprudential authorities in a single agency, we prefer that all regulators be

required to routinely factor macroprudential considerations into their supervision, thus helping ensure

that risks to financial stability can be addressed wherever they arise (Bernanke, 2010)


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CLOSING THE INFORMATION GAP

In chapter 3 the authors call for a new information infrastructure mainly to close information gaps

that existed prior to the crisis. Those information gaps prevent officials from determining the systemically

important institutions that pose risk on the whole financial setup. Improved information collection and

infrastructure will encourage firms to enhance their risk management.

The report recommends that all large financial institutions, including those with limited oversight such as

hedge funds, report about risk and assets position on a quarterly basis. The information collection and

analysis should be standardized to maximize its value. The analysis is done by the systemic regulator and

shared with different regulatory boards. After some time lag the information collected by the systemic

regulator should be released to the private sector. This increased public disclosure of information will

provide investors and analysts with hindsight of individual firms str engths and vulnerabilities, thereby

facilitating more effective market discipline. The information collection and dissemination will be done

by the systemic regulator and this makes the recommendation a subset of the call for a systemic regulator.

In my opinion, this idea can be implemented and does not have any significant downside. After all,

information collection and analysis exists in modern financial market practices. The release of

information by the systemic regulator to the public can reduce adverse selection problem and moral

hazard problem in financial markets by reducing asymmetric information. The report is aware of the need

for new legislation in order for the new information infrastructure is put into action.

REGULATION OF RETIREMENT SAVINGS

The new trend in retirement saving is defined contribution plans that can be customized to suite

holders risk preferences and allow workers to change jobs without risking their pension. Households

usually are not qualified for making good financial decisions. The authors recommendations are aimed at

helping households make sound decisions concerning retirement planning. They suggest an innovativestandardized disclosure label that will assist in comparison shopping. The label must state simple and

meaningful measures of long term risk, and list the costs associated with the plan.


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The proposed label can function as a tool of government regulation to increase information. This measure

will decrease adverse selection problem because it encourages truthful information production and

disclosure.

Evidence of financial planning mistakes by households is well documented. First, older adults have much

more at stake since they control far more financial resources (as a fraction of total assets, including

present value of future labor income) than people in their 20s. Second, older adults cannot bounce back

from their mistakes, since cognitive and physical impairments frequently make it difficult to return to

work. Third, young adults may make financial mistakes, but they rarely have severe cognitive

impairments. Being a foolish 20-year-old credit card user probably bears little comparison to the

financial dangers posed by dementia. For example, we regularly hear stories about friends agin g

relatives who lend/give a substantial fraction of their wealth to con artists (Sumit Agarwal, 2009)


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CAPITAL REQUIREMENTS

Here we encounter a very big Title. Bigger banks with higher risk positions and illiquid assets

require larger capital requirements. Potential systemic problems are bigger if one large bank that holds

risky assets defaults. Such large institutions are called Too Big to Fail or TBTF. In 2007 Lehman

Brothers, AIG, Bear Stearns, and Government -Sponsor ed Enterprises (Freddie Mac and Fannie Mae)

where all dubbed TBTF.

Darrell Duffie explains the TBTF in one of his papers:

During the recent financial crisis, major dealer banks that is; banks that intermediate markets for

securities and derivatives, suffered from new forms of bank runs. The most vivid examples are the 2008

failures of Bear Stearns and Lehman Brothers. Dealer banks are often parts of large complex financial

organizations whose failures can damage the economy significantly. As a result, they are sometimes

considered "too big to fail" (Duffie, 2010)

These bank runs spread system wide panic which reflected very negatively on markets worldwide

eventually leading to a financial crisis. Until today the world economy suffers as a result. The

connectivity characteristic of TBTF institution like Goldman Sachs and its Credit Default Swaps Insurer

AIG led to a chaotic bailout by the Fed. The New York State Attorney General Andrew

Cuomo announced in March 2009 that he was investigating whether AIG's trading counterparties

improperly received government money. Corporations reap the benefits of government interventions with

taxpayers money.

The Squam Lake group suggests increased capital requirements in the light of the two principles the

report is built on. The first is to protect the system from individual failures which affects the whole nation.

The second Principal is that firms should be responsible for the costs of their failure and excessively risky

positions. Bank who want to engage in risky schemes simply have to provide adequate capital to covertheir failure (if they do fail).

Allan Greenspan, in his paper, The Crisis , summarizes that capital, liquidity, and collateral are a key for

facing all crisis leading factors:


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Capital, liquidity, and collateral, in my experience, address almost all of the financial regulatory

structure shortcomings exposed by the onset of the crisis. In retrospect, there has to be a level of capital

that would have prevented the failure of, for example, Bear Stearns and Lehman Brothers. (If not 10

percent, think 40 percent.) Moreover, generic capital has the regulatory advantage of not having to

forecast which particular financial products are about to turn toxic. Certainly investors did not foreseethe future of subprime securities or the myriad other broken products. Adequate capital eliminates the

need for an unachievable specificity in regulatory fine tuning. (Greenspan, 2010)

The Basel Committee on Banking Supervision in its most recent report defines a metric called Liquidity

Coverage ratio. This report has been published in late 2010 in the light of events of the 2008 financial

crisis.

Liquidity coverage ratio

This metric aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets

that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute

liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid assets should enable

the bank to survive until day 30 of the proposed stress scenario, by which time it is assumed that

appropriate actions can be taken by management and/or supervisors, and/or the bank can be resolved in

an orderly way.

The Liquidity Coverage Ratio (LCR) builds on traditional liquidity coverage ratio methodologies" used

internally by banks to assess exposure to contingent liquidity events. Net cumulative cash outflows for the

scenario are to be calculated for 30 calendar days into the future. The standard would require that the

value of the ratio be no lower than 100% (i.e. the stock of liquid assets should at least equal the estimated

net cash outflows). Banks are expected to meet this requirement continuously and hold a stock of

unencumbered, high quality assets as defense against the potential onset of severe liquidity stress. Banks

and supervisors are also expected to be aware of any potential mismatches within the 30-day period and

ensure that sufficient liquid assets are available to meet any cashflow gaps throughout the month. (Basel

II, 2010)


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I am convinced by these set of recommendations but one cannot but spot some related concern. What if

some banks are not able to assemble adequate capital requirements? This will lead to a sale of assets and

perhaps a process of deleveraging. Threw deleveraging banks decrease lending which leads to an adverse

selection problem. More capital requirements also mean more idle cash that could have been invested and

used efficiently.


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EXECUTIVE COMPENSATION REFORM

Compensation in the financial services industry became highly controversial in early 2009 amid

revelations that Merrill Lynch paid substantial year-end bonuses to its executives and employees after

receiving Federal bailout funds and just prior to completion of its acquisition by Bank of America. The

outrage heightened following the revelation that AIG (which had received over $170 billion of federal

bailout funds) was in the process of paying $168 million in retention bonuses to its executives. The

anger over these bonuses coupled with suspicions that the Wall Street bonus culture is a root cause of

excessive risk taking that helped create the ongoing global financial crisis has led to an effective

prohibition on cash bonuses for participants in the governments Troubled Asset Relief Program (TARP),

and is leading us today towards more-sweeping regulation of compensation in financial services firms.

(Murphy, 2009)

Events like the mentioned above create a moral hazard problem. As a result, executives have an incentive

to engage in risky positions as long as they will not bear the cost of their failure. This will increase the

probability of bank failures that leads to systemic risk. The result is privatized gains and socialized losses.

The Squam Lake report recommendations on this issue are very clear. The report draws an important

distinction between the level and the structure of executive compensation. The authors recommend that

governments should not regulate the level of executive compensations in financial firms. They argue that

the market does not allocate human capital perfectly, but it certainly does it better then government

policy. The report goes further and recommends that firms should hold a significant share of senior

managers compensation in cash, and that employees would forfeit their holdbacks in case of bankruptcy

or government assistance. This will induce management to find private solutions for their firms problems

to salvage their compensations.


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RECAPITILIZATION THREW CONTINGENT CAPITAL

At the beginning of this chapter, the authors point out three reasons behind the suggestion for an

expedited restructuring mechanism. In short, because of the debt overhang problem and the possibility of

a government bailout, banks prefer to reduce lending, sell assets if possible, or simply wait, rather than

recapitalize themselves and maintain their lending capacity (p.53).

Then the authors move to propose a new financial instrument, which is called regulatory hybrid securities

(also known as Reverse convertible Bonds). It is aimed at facilitating the restructuring of troubled

financial institutions. These Bonds convert to equity under specific predefined conditions called

triggers. The triggers are a declaration by the systemic regulator that the economy is suffering from a

systemic crisis, and a breach in one of the covenants by the bank in the Hybrid Security contract. This

automatic conversion will transform an insolvent bank into a well capitalized bank at the cost of the banks

investors.

As a result troubled banks would not need capital injections from the government, and the government

would not have to purchase the assets of troubled banks. Finally, the prospect of a conversion of long-

term debt to equity is likely to make short-term creditors and other counterparties more confident about a

banks future.

Alan S. Blinder of Princeton University addresses this kind of security:

In the first place, reverse convertible debt is likely to be quite expensive. Notice that buyers of such

securities win in good states of nature and lose in bad states. That payoff structure is likely to be

positi vely correlated with most of their other portfolio returns, and to have a high beta to boot. So

buyers of reverse convertibles will demand high expected returns, maybe very high ones. For this reason,

regulators will have to force SIFI 1s to issue them which is, by the way, one good way to penalize TBTF

status. (Blinder, 2010)

I am personally skeptical about the first trigger, the declaration by the systemic regulator that a systemic

crisis exists. First, there is more than one regulator, and until one regulator for financial markets is set,

this recommendation cannot be achieved. On page.56 the authors discuss the conversion rate from debt to

1 Systemically Important Financial Institutions.


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This appraisal has turned into government policy reform in 2009 in the U.S Treasury Department report

for rebuilding financial supervision and regulation.

Rapid Resolution Plans. The Federal Reserve also should require each Tier 1 FHC 2 to prepare and

continuously update a credible plan for the rapid resolution of the firm in the event of severe financial

distress. Such a requirement would create incentives for the firm to better monitor and simplify its

organizational structure and would better prep are the government, as well as the firms investors,

creditors, and counterparties, in the event that the firm collapsed. The Federal Reserve should review the

adequacy of each firms plan regularly. (The U.S Treasury Department, 2009)

CREDIT DEFAULT SWAPS, CLEARINGHOUSES, AND EXCHANGES

In April 29 the Depository Trust and Clearing Corporation estimated the market for credit default

swaps to be worth $28 trillion. As a result of this large market and the sensitivity of CDS payoffs to

economic conditions, large exposure to CDS can lead to Systemic risk. It is advised by the report that

CDS should be cleared through central clearinghouses for many reasons. The clearinghouse insulates the

two parties from exposure risk. Also, when using clearinghouses the demand for collateral pledged by

both parties of a CDS contract decreases, leaving more capital available which would have otherwise

been left idle. The report calls for fortifying clearinghouses with appropriate collateral and capital

requirements and that they are subject to ongoing regulatory oversight. Furthermore, the report

pronounces that the existence of multiple clearing houses increases counterparty risk. They back this view

with research done by Darrell Duffie and Hoaxing Zhu, of Stanford University.

We show whether central clearing for a particular class of derivatives reduces counterparty exposures

and collateral demands. For plausible cases, adding a new CCP dedicated to only one class of

derivatives, such as credit default swaps (CDS), reduces netting efficiency, thereby increasing average

exposure to counterparty default, or increasing collateral demand, or both. (Darrell Duffie, Haoxiang

Zhu, 2010)

2 Financial Holding Company


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PRIME BROKERS AND RUNS

Prime brokerage firms are prone to client runs at the first sign of trouble. Clients rush to withdraw

their assets which brokers use as access to financing and liquidity. When too much assets have been

withdrawn by clients, the prime broker faces difficulty in finding new financing which results in selling

assets for cash. This led to the downfall of Lehman Brothers and Bear Stearns in 2008 because assets

belonging to their clients were not segregated from the banks' own money, but used to lend to other

clients, or as collateral for the banks' dealings. Such practices enable banks to do more business and

generate more fees, but increase the danger they pose to society. The report recommends the segregation

of clients assets in separate accounts from the a ssets of the broker.

This will reduce the incentive for clients to run and withdraw their funds and in turn will decrease moral

hazard. Because of the potential systemic cost of a run and its contagious nature, society bears the cost

and its consequences, thus the segregation will protect taxpayers. The disadvantage is that the money in

the segregated account will be idle and not used in an efficient investment.


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FINAL WORD

Given that 15 leading academics stand behind this admirable paper, it is unsurprising that some of

recommendations of the Sqaum Lake Report are already being put into action. One can read the U.S.

Treasury Departments Financial Regulatory Reform report is sued in late 2009 and can find that the

majority of recommendations are on the legislation track.

As a business graduate student, after reading this report I could point some important omissions and

questions that need further attention and research.

1. The rating agencies role in the financial crisis: Debt ratings play a major role in pricing of debt

securities. Issuers who employ credit ratings agencies to rate their bonds expect a good rating,

while investors and regulators worry that the rating agency might bias its ratings upward to attract

more business from the issuers. This is a conflict of interest that the report fails to address or has

turned a blind eye onto it.

2. Tradeoff between Innovation and Safety: The report does mention this issue in brief. There are

two views: the first is the view that overregulation stifles innovation, the second views under

regulation as systemically risky and dangerous. The first favor standardization of contracts and

the second want to encourage customization and OTC trading. A systemically important issue

like this deserves more discussion in the report.

3. Shadow banking system: the report does mention its role in the upheaval of the crisis but does not

propose any recommendation towards it. It is known that the shadow banking system is lightly

regulated. This characteristic, in my opinion, suggests the need for further research into it. Such

useful research was conducted by four academics in 2010. I quote them below:

This system performs the same functions as traditional banking, but the names of the players are

different, and the regulatory structure is light or nonexistent. In its broadest definition, shadow

banking includes such familiar institutions as investment banks, money-mark mutual funds

(MMMFs), and mortgage brokers; some rather old contractual forms, such as sale-and-

repurchase agreements (repos); and more esoteric instruments such as asset-backed securities

(ABSs), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP).

(GARY GORTON, ANDREW METRICK, ANDREI SHLEIFER, DANIEL K. TARULLO,

2010)


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4. Poor risk controls at major financial institutions: the report does not mention or suggest

recommendations at improving internal risk control of firms. Poor risk management has

contributed greatly to the crisis. This demands major changes not only in public policy, but alsoin private corporate governance.

5. CDS problem: The report completely fails to admit that the credit default swaps were purely

speculative trading arrangements that serve no economic function. CDS activity is of no obvious

benefit to anyone other than speculators, which has led the German chancellor, Angela Merkel,

and the French president Nicolas Sarkozy to ban some types of it.

6.

Political aspect: arent Freddie Mac and Fannie Mae government sponsored organizations? In myopinion they became GSO only to serve the political agenda of providing a home for every

American which started under the Bush administration. Also, establishing a unified systemic

regulator with such enormous responsibilities makes it unlikely that such a systemic regulator

would not be affected by political interference.

Nobody claims to hold the ultimate solution for avoiding financial crisis in the future, but at least

the Squam lake Report helps by pointing major issues that need reform and reconsiderations. I

salute the 15 economists for their effort in bringing together this report.


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REFRENCES

Basel II. (2010). International framework for liquidity risk measurement, standards and monitoring. Basel: Bank for International Settlements.

Bernanke, B. S. (2010, June 16). Remarks on The Squam Lake Report fixing the financial system(speech). New York.

Blinder, A. S. (2010). The Squam Lake Report: Fifteen Economists in Search of Financial Reform. Princeton University.

Darrell Duffie, Haoxiang Zhu. (2010). Does a Central Clearing Counterparty Reduce Counterparty Risk? Graduate School of Business Stanford University.

Duffie, D. (2010). The Failure Mechanics of Dealer Banks. American Economic Association.

GARY GORTON, ANDREW METRICK, ANDREI SHLEIFER, DANIEL K. TARULLO. (2010). Regulating the Shadow Banking System. Brookings Papers on Economic Activity.

Greenspan, A. (2010). The Crisis. Brookings Papers on Economic Activity.

Murphy, K. (2009). Compensation Structure and Systemic Risk. University of Southern California-Marshall School of Business.

Sumit Agarwal, J. C. (2009). The Age of Reason: Financial Decisions over the Life-Cycle with Implications for Regulation. Brookings papers on Economic Activity.

The U.S Treasury Department. (2009). U.S. Treasury Department: "Financial Regulatory Reform - A New Foundation". U.S Treasury Department.

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