The academic solution to financial reform

by Roger Parloff, senior editor

FORTUNE -- On Wednesday, fifteen leading academic economists unveiled a succinct, slender and, for the most part, readable volume containing their consensus recommendations on how to fix our financial system.

It's called the Squam Lake Report, named after the scenic New Hampshire lake where the group held their first pow-wow in November 2008. The dons convened at the behest of Kenneth R. French, a finance professor at Dartmouth, who asked them to join him in trying to figure out just what had gone wrong and how laws and regulations could be changed to improve the way markets function. Among the invitees were noted scholars from the Brookings Institution, the University of Chicago, Columbia, Harvard, Ohio State, Princeton, Stanford, and Yale. (They are listed at the end of this article.)

The central principles that guided their recommendations, French explained, were that (1) we need some regulators or supervisors focusing on the soundness of the financial system itself, and not merely on the soundness of individual financial institutions; and (2) financial firms need to be forced to cover the costs of their own failures when they do occur, rather than saddling those on taxpayers. The second principle, of course, is directed toward ending the "horrible policy" of having institutions that are Too Big To Fail, a policy in which financial institutions' gains are privatized, while their losses are socialized.

At a conference Wednesday marking the release of their book, French said that in selecting the fifteen members of the Squam Lake Group he was careful to make sure that they came from across the political spectrum, including some Republicans, some Democrats, and at least one libertarian.

With the conference fortuitously occurring between games six and seven of the NBA Championships, the Squam Lake economists were swiftly dubbed the "Lakers."

Although the conference did not literally take place in an ivory tower, the conference organizers found the next best thing: the elegant "Teatro" room of the Italian Academy at Columbia University, a neo-Renaissance palazzo. The conference's culmination was a tortuously diplomatic keynote speech by Federal Reserve Chairman Ben Bernanke, who expressed tentative, qualified appreciation for the Squam Lake recommendations, calling them "valuable."

In his opening remarks, professor French stressed that the Squam Lake Report was "totally collaborative," in that almost every participant had in some way touched almost every chapter, and that all members "agreed with at least the spirit of every one of the recommendations."

The good news is that most of the recommendations broadly correspond to at least some provision being considered in either the House or Senate financial reform bills (or both), suggesting that legislators are at least wrestling with some of the right problems.

The high-altitude recommendations, on the other hand, leave lots of room for devils to arise in the details. Still, the fact that consensus among any 15 economists was possible at all suggests that some financial reform legislation may be passable, and the Squam Lake Report sheds much light on the theoretical framework out of which that legislation is growing.

What follows are some highlights from the Sqam Lake recommendations.

A central regulator should oversee the health and stability of the whole financial system. The Lakers think that the entity best qualified to perform this super-regulatory function is the central bank -- i.e., in the U.S., the Federal Reserve. (The House and Senate bills currently contemplate the creation of a Financial Stability Oversight Council, composed of all the existing regulatory bodies, but with the Federal Reserve seeming to play the lead role.)

The Squam Lake super-regulator (or "macro-prudential regulator," as he was often referred to at the conference) would be empowered to gather detailed financial information from all the key, big, interconnected players in the financial system, including hedge funds, broker-dealers, insurance companies, investment banks, bank holding companies, and, of course, banks. (Similarly, the Congressional bills would give the oversight council power to oversee all systemically important financial institutions.) The expanded breadth of oversight is intended to address one perceived cause of the recent financial crisis: the growth of a shadow-banking sector that performed bank-like functions and transmitted bank-like risks, but weren't subject to the safeguards of bank regulation.

Capital requirements for financial institutions should be strengthened. The Lakers would make capital requirements contingent on the liquidity of assets being held by the bank (the less liquid the assets, the more capital needed), and also on the proportion of the institution's debt that is short-term (the more it relies on short-term debt, the higher its capital requirements would have to be). The congressional bills contemplate strengthening capital requirements for systemically important financial institutions, but the details are still unclear.

Executive compensation should be subject to "holdbacks." Though the Lakers oppose any government meddling with the levels of executive compensation, they propose a tough structural reform, which they would apply across a broad swath of the "senior managers" at key financial institutions. They recommend that as much as 20% of a manager's total compensation be withheld -- placed in a figurative lockbox -- for a set number of years, to be paid out only if and when the institution manages to get through that period without having gone bankrupt or been bailed out by the government.

While corporate governance types have long tried to align management's incentives with the shareholders through the award of options or restricted stock, the Squam Lake group is here proposing something refreshingly different: aligning the executives' incentives with those of the taxpayer. If we taxpayers have to pay to bail out a company due to the unwise risks its executives took, all those executives have to shell out money, too -- specifically, one-fifth of everything they earned for a set number of years.

Though the congressional legislation is considering some "clawback" provisions that might be available under special circumstances, like fraud, it does not currently contemplate any "holdbacks."

Financial institutions should invest in "contingent capital." The group recommends that regulators "aggressively encourage" key financial institutions to invest in what they call "regulatory hybrid securities." These would be long-term debt obligations that automatically convert into equity in the event that both the institution and the economic system reach a certain defined level of financial stress. The idea is to force the institution to foot the bill in advance of setting up an automatic recapitalization mechanism that it can draw upon in times of need.

Although many variants of this idea have gained favor in academic circles, there is little agreement on what the triggering mechanism should be. The bond might simply specify, for instance, that if an institution's share price fell to a certain level, the conversion would be triggered. The Squam Lakers fear, however, that such a set-up might prompt short-sellers to game the system in undesirable ways. Accordingly, they call for a two-step trigger. For the conversion to occur, not only must some measure of stress be met vis-à-vis the individual institution, but also some measure of systemic stress -- most likely an official declaration by the Federal Reserve chairman.

At a Q&A period at the conference, representatives of several hedge funds vehemently opposed this proposal, protesting that any regulator's declaration of a state of "systemwide stress" would violently spook the market and send investors running for cover, greatly exacerbating whatever turbulence the economy was experiencing.

Regulators need expanded "resolution" authority over financial institutions. The Lakers believe that regulators must be given the authority to put troubled non-bank financial institutions into an orderly resolution process (a bankruptcy, essentially) analogous to the authority the Federal Deposit Insurance Corporation already has vis-à-vis banks. The House and Senate bills would, in fact, give the FDIC expanded powers along these lines.

Financial institutions should execute "living wills." This would be a document, updated every quarter, that would to provide the resolution authority with detailed guidance on how to proceed in the event that worst comes to worst and the institution must be seized. As bizarre as this concept may sound, the congressional legislation is also currently toying with the idea of requiring financial institutions to draft "living wills," too.

As envisioned by the Squam Lakers, the living will would include "detailed and full descriptions of the institution's . . . contractual obligations . . . ; a list of major counterparties; . . . a few major distress scenarios, and the likely resolution processes under each scenario; [and] a list of potential parties that could take over the institution's contractual obligations at low cost." Although most of the living will would remain confidential, "crucial parts" would have to be made public, including the "number of days needed for resolution and the main impediments to or uncertainties associated with promptly dismantling the institution."

Well, I don't know about that last one. But the rest of these ideas we'll definitely be hearing more about in the days ahead.

For those scoring at home, here's the complete line-up for the Squam Lake squad: Kenneth R. French (Dartmouth); Martin N. Baily (Brookings); John Y. Campbell (Harvard); John H. Cochrane (Chicago); Douglas W. Diamond (Chicago); Darrell Duffie (Stanford); Anil K. Kashyap (Chicago); Frederic S. Mishkin (Columbia); Raghuram G. Rajan (Chicago); David S. Scharfstein (Harvard); Robert J. Schiller (Yale); Hyun Song Shin (Princeton); Matthew J. Slaughter (Dartmouth); Jeremy C. Stein (Harvard); René M. Stulz (Ohio State). To top of page

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