The Squam Lake Report The Squam Lake Group is 15 academics who have come together to offer guidance on the reform of financial regulation. Our group first convened in the fall of 2008, amid the deepening capital markets crisis. Although informed by this crisis—its events and the ongoing policy responses—the group is intentionally focused on longer-term issues. We aspire to help guide reform of capital markets—their structure, function, and regulation. We base this guidance on the group’s collective academic, private sector, and public policy experience. Kenneth R. French Raghuram G. Rajan Dartmouth College University of Chicago Martin N. Baily David S. Scharfstein Brookings Institution Harvard University John Y. Campbell Robert J. Shiller Harvard University Yale University John H. Cochrane Hyun Song Shin University of Chicago Princeton University Douglas W. Diamond Matthew J. Slaughter University of Chicago Dartmouth College Darrell Duffie Jeremy C. Stein Stanford University Harvard University Anil K Kashyap René M. Stulz University of Chicago Ohio State University Frederic S. Mishkin Columbia University The Squam Lake Report Fixing the Financial System Kenneth R. French, Martin N. Baily, John Y. Campbell, John H. Cochrane, Douglas W. Diamond, Darrell Duffie, Anil K Kashyap, Frederic S. Mishkin, Raghuram G. Rajan, David S. Scharfstein, Robert J. Shiller, Hyun Song Shin, Matthew J. Slaughter, Jeremy C. Stein, René M. Stulz PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD Copyright © 2010 Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW press.princeton.edu All Rights Reserved Library of Congress Cataloging-in-Publication Data The Squam Lake report : fixing the financial system / Kenneth R. French . . . [et al.]. p. cm. Includes index. ISBN 978-0-691-14884-7 (hbk. : alk. paper) 1. Financial crises— Prevention. 2. Finance—Government policy. 3. Capital market— Government policy. I. French, Kenneth R. HB3722.S79 2010 332.1—dc22 2010009897 British Library Cataloging-in-Publication Data is available This book has been composed in ITC Garamond Std Printed on acid-free paper. ∞ Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 Contents Preface vii Acknowledgments xi CHAPTER 1: Introduction 1 CHAPTER 2: A Systemic Regulator for Financial Markets 33 CHAPTER 3: A New Information Infrastructure for Financial Markets 44 CHAPTER 4: Regulation of Retirement Savings 53 CHAPTER 5: Reforming Capital Requirements 67 CHAPTER 6: Regulation of Executive Compensation in Financial Services 75 CHAPTER 7: An Expedited Mechanism to Recapitalize Distressed Financial Firms: Regulatory Hybrid Securities 86 CHAPTER 8: Improving Resolution Options for Systemically Important Financial Institutions 95 CHAPTER 9: Credit Default Swaps, Clearinghouses, and Exchanges 109 vi • CONTENTS CHAPTER 10: Prime Brokers, Derivatives Dealers, and Runs 122 CHAPTER 11: Conclusions 135 List of Contributors 153 Index 157 Preface The Squam Lake Group is 15 leading financial economists who came together to offer guidance on the reform of fi- nancial regulation. The group first met for a weekend in the fall of 2008 at a remote and scenic retreat on New Hamp- shire’s Squam Lake. The World Financial Crisis was then at its peak. Although informed by this crisis—its events and the ongoing policy responses—the group has intentionally focused on longer-term issues. We have aspired to help guide the evolving reform of capital markets—their struc- ture, function, and regulation. This guidance is based on our collective academic, pri- vate sector, and public policy experience. Members include eight of the nine most recent presidents of the American Finance Association (including the current president and the president-elect), a former Federal Reserve Governor, a former Chief Economist of the International Monetary Fund, and former members of the Council of Economic Advisers under President Bill Clinton and President George W. Bush. The group has been united and motivated by a common concern: that policymakers often misunderstand or ignore the large body of academic knowledge that could guide sound regulatory reform, resulting in poorly designed poli- cies with unintended consequences. viii • PREFACE After the initial Squam Lake meeting, the group worked to develop specific proposals targeted at policymakers around the world. We collaborated through emails, phone calls, and meetings. The breadth of expertise in the group led to many interesting and sometimes spirited discussions. But all members of the group came to agree on a growing list of urgent and important recommendations. Through- out, the group has been staunchly nonpartisan, with no business or political sponsor. As agreement was reached on a topic, we crafted a white paper summarizing our analysis and recommendations, and then worked to have it inform policy conversations in real time. Members of the group have been actively engaged in the policy process at the highest level around the world. In the United States, members have briefed Democratic and Republican Senators and Representatives and testified be- fore both chambers of Congress. We have consulted with officials at the Federal Reserve Board, the Federal Reserve Bank of New York, the Treasury Department, the Coun- cil of Economic Advisers, the European Central Bank, the Bank for International Settlement, and the Securities and Exchange Commission, and with the President of Korea. Members of the group have also made presentations at the Bank of England, Her Majesty’s Treasury, the Banque de France, and the European Commission, and we have had meetings with individual policymakers from many other countries. This book collects and briefly explains the group’s pol- icy recommendations. The introduction highlights features of the World Financial Crisis that shaped our recommenda- PREFACE • ix tions and previews connections among all of them. Sub- sequent chapters present our proposals on specific issues. The concluding chapter describes two key principles that summarize our proposals and explores how these propos- als would have mitigated the World Financial Crisis. Finally, we discuss some challenges that may impede the adoption of our proposals.