The Squam Lake report: Fixing the financial system

The Squam Lake Report: Fixing the Financial System

Volumn , Issue , 2010, Pages

  French, Kenneth R ^a,b   Baily, Martin N ^c,d   Campbell, John Y ^e   Cochrane, John H ^f,g,h   Diamond, Douglas W ^b,g   Duffie, Darrell ⁱ   Kashyap, Anil K ^f   Mishkin, Frederic S ^j   Rajan, Raghuram G ^f,h   Scharfstein, David S ^k   Shiller, Robert J ^l   Shin, Hyun Song ^m   Slaughter, Matthew J ^a   Stein, Jeremy C ^e   Stulz, René M ⁿ  

^a DARTMOUTH COLLEGE   (United States)

^b AMERICAN ACADEMY OF ARTS AND SCIENCES   (United States)

^c MCKINSEY AND COMPANY   (United States)

^d BROOKINGS INSTITUTION   (United States)

^e HARVARD UNIVERSITY   (United States)

^f UNIVERSITY OF CHICAGO   (United States)

^g NATIONAL BUREAU OF ECONOMIC RESEARCH   (United States)

^h American Finance Association   (United States)

ⁱ STANFORD UNIVERSITY   (United States)

^j Och Spine at New York Presbyterian Hospitals   (United States)

^k HARVARD BUSINESS SCHOOL   (United States)

^l YALE UNIVERSITY   (United States)

^m PRINCETON UNIVERSITY   (United States)

ⁿ OHIO STATE UNIVERSITY   (United States)

more..

Author keywords

[No Author keywords available]

Indexed keywords

EID: 84884098867     PISSN: None     EISSN: None     Source Type: Book    
DOI: None     Document Type: Book

References (57)

1. For a review and analysis of the early developments in the World Financial Crisis, see "Symposium: The Early Phases of the Credit Crunch," Journal of Economic Perspectives 23, no. 1 (Winter 2009).
2. Robert Battalio and Paul Schultz, "Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban's Impact on Equity Option Markets" (manuscript, University of Notre Dame, 2009).
3. Zhiguo He, in Gu Khang, and Arvind Krishnamurthy, "Balance Sheet Adjustments in the 2008 Crisis" (manuscript, Kellogg Graduate School of Management, Northwestern University, and the University of Chicago Booth School of Business, 2010).
4. Practitioners typically use the term "arbitrage" to describe trades that have low risk and high expected profit. As Andrei Shleifer and Robert Vishny emphasize in "The Limits of Arbitrage," Journal of Finance 52 (1997): 25-55, a lack of capital can limit investors' ability to exploit such arbitrage opportunities.
5. This brief explanation ignores important complications, such as transaction costs and default risk.
6. Tommaso Mancini Griffoli and Angelo Ranaldo, "Limits to Arbitrage during the Crisis: Funding Liquidity Constraints and Covered Interest Parity" (working paper, Swiss National Bank, 2009).
7. Nicolae Garleanu and Lasse Heje Pedersen, "Margin-Based Asset Pricing and Deviations from the Law of One Price" (working paper, New York University, 2009), look at arbitrage between corporate bonds and Treasury bonds. This arbitrage uses credit default swaps to eliminate the default risk of the corporate bond so that its yield should be comparable to that of a government security.
8. Arvind Krishnamurthy, "Debt Markets in Crisis," Journal of Economic Perspectives (forthcoming, 2010), describes trades using collateralized borrowing to arbitrage differences between fixed- and floating-rate investments. The arbitrage in this case uses swap contracts to convert floating interest rate payments into fixed interest rate payments.
9. Mark Mitchell and Todd Pulvino, "Arbitrage Crashes and the Speed of Capital"(working paper, 2009), study the pricing of convertible debt securities. In this case, they do not present a genuine arbitrage trade in the sense of generating investment strategies that yield identical cash flows. Rather, they describe nearly equivalent cash flows that hedge funds normally bet will converge, and study the properties of the returns from these investment strategies. In each of these papers there are large swings in arbitrage and near-arbitrage profits in the fall of 2008.
10. Murillo Campello, John R. Graham, and Campbell R. Harvey, "The Real Effects of Financial Constraints: Evidence from a Financial Crisis," Journal of Financial Economics (forthcoming, 2010).
11. V. V. Chari, Lawrence Christiano, and Patrick Kehoe, "Facts and Myths about the Financial Crisis of 2008" (manuscript, University of Minnesota and Northwestern University).
12. Victoria Ivashina and David Scharfstein, "Bank Lending During the Financial Crisis of 2008," Journal of Financial Economics (forthcoming, 2010).
13. Douglas W. Diamond and Raghu Rajan, "Fear of Fire Sales and the Credit Freeze" (National Bureau of Economic Research Working Paper No. 14925, 2009).
14. One classic way to produce frequent small profits and occasional large losses is to sell deep out-of-the-money put options. When a trader sells a deep out-of-the-money put, he receives a payment in exchange for a commitment to buy an asset for much less than it is currently worth. The option will almost always expire worthless and the trader will pocket the money received for selling it. Occasionally, however, the price of the asset will fall sharply and the trader will be forced to buy the asset at a large loss.
15. Myron B Slovin, Marie E. Sushka, and John A. Polonchek, "The Value of Bank Durability: Borrowers as Bank Stakeholders," Journal of Finance 48 (1993): 247-66.
16. Ben Bernanke, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review 73 (1983): 257-76, famously argued that disorderly liquidation of banks exacerbated the Great Depression.
17. Andrei Shleifer and Robert Vishny, "Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance 47, no. 4 (September 1992): 1343-66, emphasize the importance of asset fire sales. Shleifer and Vishny argue that fire sales played an important role in the Crisis in "Unstable Banking," Journal of Financial Economics (forthcoming, 2010), and "Asset Fire Sales and Credit Easing" (National Bureau of Economic Research Working Paper No. 15652, 2010).
18. Gary B. Gorton and Andrew Metrick develop the analogy between modern and classic bank runs in "Securitized Banking and the Run on Repo" (National Bureau of Economic Research Working Paper No. 15223, 2009) and in "Haircuts" (National Bureau of Economic Research Working Paper No. 15273, 2009).
19. Darrell Duffie, "The Failure Mechanics of Dealer Banks," Journal of Economic Perspectives (forthcoming, 2010), discusses the complexities surrounding bank failures in the context of the modern financial system. This paper also clarifies the mechanisms that can generate what we have called modern bank runs.
20. Ben Bernanke, "The Global Saving Glut and the U.S. Current Account Deficit," http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/, 2005, emphasizes the role of emerging market savings.
21. Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas, "An Equilibrium Model of Global Imbalances and Low Interest Rates," American Economic Review 98 (2008): 358-93, provide a formal model.
22. John B. Taylor,Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Stanford, CA: Hoover Press, 2009), instead emphasizes the role of loose monetary policy.
23. John Y. Campbell, ed., Asset Prices and Monetary Policy (Chicago: University of Chicago Press), debate whether monetary policy can identify and lean against asset-price bubbles.
24. Efraim Benmelech and Jennifer Dlugosz, "The Credit Rating Crisis," NBER Macroeconomics Annual 2009 (Cambridge, MA: National Bureau of Economic Research, forthcoming).
25. Carmen Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).
26. This is an example of the general human tendency, emphasized by a string of observers from Howard Kunreuther to Richard Posner, to spend too little time and effort preparing contingency plans to handle rare catastrophic events.
27. Alan Blinder, The Quiet Revolution: Central Banking Goes Modern (New Haven, CT: Yale University Press, 2004).
28. Sumit Agarwal, John C. Driscoll, Xavier Gabaix, and David Laibson, "The Age of Reason: Financial Decisions over the Life Cycle and Implications for Regulation," Brookings Papers on Economic Activity (Fall 2009)
29. James J. Choi, David Laibson, and Brigitte C. Madrian, "$100 Bills on the Sidewalk: Suboptimal Investment in 401(k) Plans" (unpublished working paper, Yale University and Harvard University, 2009).
30. John Y. Campbell, "Household Finance," Journal of Finance 61 (2006): 1553-1604, provides a general survey of household investment mistakes.
31. One promising approach to this problem starts by allocating securities to five asset classes: stock, cash (such as money market accounts), Treasury bonds, corporate bonds, and inflation-protected securities. We then split the return on each investment into the return on its asset class (or mix of asset classes) and an investment-specific component. We assume any mean reversion happens at the asset-class level. Thus, an investment's tenyear variance is the historical ten-year variance of its asset class (or mix of asset classes) plus ten times the annual variance of its investment-specific return. This simple approach ignores issues that might be important in other applications, such as risk management, but it offers a standardized and robust way to compare long-term investments. Finally, to prevent employees from drawing inappropriate inferences from past returns, when calculating the range of ten-year outcomes we would use the same expected return for all investments in a particular asset class. For example, the calculations might assume the expected real return on all stocks is 5 percent.
32. For example, the long-term standard deviation on the U.S. stock market is around 20 percent per year. If a mutual fund invested in U.S. stocks has the same 20 percent volatility, the margin of error is 40 percent for the one-year average return, 17.9 percent for the five-year average, and 12.6 percent for the ten-year average return. Again speaking loosely, if the true expected return is 10 percent, the one-year average return will be between -30 percent and 50 percent, the five-year average return will be between -7.9 percent and 27.9 percent, and the ten-year average return will be between -2.6 percent and 22.6 percent about 95 percent of the time. These calculations are based on the standard formula that assumes returns are independently distributed in successive years. Margins of error for the difference between a fund and market performance are typically smaller, and can be reported when a fund chooses to report that difference.
33. Brigitte C. Madrian and Dennis F. Shea, "The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior," Quarterly Journal of Economics 116 (2001): 1149-87. Richard Thaler and Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press, 2008), argue for broader use of default options to improve economic and social outcomes.
34. Of course, governments are currently the dominant shareholder in many banks around the world, and while they are, it may be appropriate for them to advise management on compensation and other strategic issues. We discuss this issue below.
35. Kevin J. Murphy discusses these examples in his testimony, "Compensation Structure and Systemic Risk," before the U.S. House of Representatives Committee on Financial Services ( June 11, 2009).
36. Regulators impose capital requirements on financial institutions to reduce the likelihood these institutions will become distressed. In Chapter 5, we argue that regulators should consider systemic effects when designing capital requirements.
37. Mark J. Flannery, "No Pain, No Gain? Effecting Market Discipline via 'Reverse Convertible Debentures,' " in Hal S. Scott, ed., Capital Adequacy Beyond Basel: Banking, Securities, and Insurance (Oxford: Oxford University Press, 2005).
38. D. Duffie and H. Zhu, "Does a Central Clearing Counterparty Reduce Counterparty Risk?" (working paper, Graduate School of Business, Stanford University, July 1, 2009).
39. H. Bessembinder and W. Maxwell, "Markets: Transparency and the Corporate Bond Market," Journal of Economic Perspectives 22 (2008): 217-34
40. A. K. Edwards, L. E. Harris, and M. S. Piwowar, "Corporate Bond Market Transaction Costs and Transparency," Journal of Finance 62 ( June 2007): 1421-51
41. M. Goldstein, E. Hotchkiss, and E. Sirri, "Transparency and Liquidity: A Controlled Experiment on Corporate Bonds," Review of Financial Studies 20 (2007): 235-73
42. R. Green, B. Hollifield, and N. Schurhoff, "Financial Intermediation and the Costs of Trading in an Opaque Market," Review of Financial Studies 20 (2007): 275-314.
43. Darrell Duffie, "The Failure Mechanics of Large Dealer Banks," Journal of Economic Perspectives 24 (February 2010): 51-72.
44. SEC Rule 15c3-3 requires prime brokers in the United States to collect their clients' free credit balances "in safe areas of the broker-dealer's business related to servicing its customers" or to otherwise deposit the funds in a reserve bank account to prevent commingling of customer and firm funds. "Free credit balances" are the cash that a client has a right to demand on short notice. The text of the SEC rules is available on-line from multiple sources, including the Securities Lawyer's Deskbook, published by the University of Cincinnati College of Law. The text of Rule 15c3-2, on customers' free credit balances, can be found at http://www.law .uc.edu/CCL/34ActRls/rule15c3-2.html. Rule 15c3-3, on "Customer Protection- Reserves and Custody of Securities," can be found at http://www .law.uc.edu/CCL/34ActRls/rule15c3-3.html.
45. Manmoham Singh and James Aitken, "Deleveraging after Lehman- Evidence from Reduced Rehypothecation" (unpublished working paper WP/09, International Monetary Fund, 2009); and Andrew Ross Sorkin, Too Big to Fail (New York: Viking, 2009).
46. Sean Farrell, "Hedge Funds with Billions Tied Up at Lehman Face Months of Uncertainty," The Independent, October 6, 2008
47. James Mackintosh, "Lehman Collapse Puts Prime Broker Model in Question," Financial Times, September 24, 2008; and Singh and Aitken, "Deleveraging after Lehman."
48. Darrell Duffie, "The Failure Mechanics," for details.
49. In an interest rate swap, a customer may promise to pay a floating rate in exchange for a fixed rate of payments. If interest rates rise, payments flow from customer to bank, and the customer must post collateral to guarantee those payments. A credit default swap is essentially insurance on a bond: The buyer of protection pays a premium, say 2 percent of face value per year, and in return the seller of protection promises to cover a bond default. If the bond becomes riskier, the seller has to post additional collateral with the buyer, so that if the seller defaults the buyer can get a new contract at the now higher premium.
50. International Swaps and Derivatives Association, ISDA Margin Survey 2009 (ISDA Technical Document, New York, 2009).
51. Brad Hintz, Luke Montgomery, and Vincent Curotto, U.S. Securities Industry: Prime Brokerage, A Rapidly Evolving Industry (technical report, Bernstein Research, March 13, 2009).
52. Basel Committee, "International Framework for Liquidity Risk Measurement, Standards and Monitoring" (Bank of International Settlements, Basel, December 17, 2009), http://www.bis.org/publ/bcbs165.pdf.
53. for example, SEC Office of Inspector General, SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program, SEC Report 446-A, September 25, 2008. This report would have received greater public attention had it not been released at the height of the World Financial Crisis.
54. Kate Kelly, "Lost Opportunities Haunt Final Days of Bear Stearns: Executives Bickered Over Raising Cash, Cutting Mortgages," Wall Street Journal, May 27, 2008, A1.
55. Compensation data taken from page 130 of the November 2007 Bear Stearns SEC 10K filing, http://www.bearstearns.com/includes/pdfs/ investor_relations/proxy/10k2007.pdf.
56. Alan Greenspan, "Proposals for Improving the Regulation of the Housing Government Sponsored Enterprises," February 24, 2004, testimony to the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 108th Cong., 1st sess., www.federalreserve.gov/boarddocs/testimony/ 2004/20040224/default.htm.
57. "The Specter of Lehman Shadows Trade Partners: Derivatives Pacts Remain in Limbo for Municipalities, Firms," Wall Street Journal, September 17, 2009, C1, http://online.wsj.com/article/SB125313981633417557 .html.