The Squam Lake Group is a non-partisan, non-affiliated group
of academics who offer guidance on the reform of financial regulation.
Our group's first meeting was at New Hampshire's Squam Lake in
fall 2008, amidst 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.
- Comment
on SEC Money Market Fund Proposal September 17, 2013
-
The Securities and Exchange Commission (SEC) asked
for comments on two possible reforms. The first (Alternative One) would
require a floating net asset value (NAV) for all prime institutional
money market funds. The second (Alternative Two) would allow money
market funds to impose liquidity fees and redemption gates if liquid
assets fall below a pre-specified threshold. We argue that the floating
NAV described in Alternative One would not achieve the goal of
materially decreasing the systemic risk posed by MMFs because the NAV
would not reflect actual prices at which investors and the fund itself
could transact in a crisis. Unless the SEC is able to create a system
whereby reported NAVs reflect actual NAVs, investors will have
incentives to run. At a minimum, if this alternative is adopted MMFs
should not be allowed to use amortized cost accounting for instruments
maturing in 60 days or less. We also argue that the liquidity fees and
redemption gates described in Alternative Two could actually exacerbate
run incentives and could be detrimental to financial stability. As we
have written previously, an appropriately sized capital buffer for
prime money market funds would have a more meaningful impact on
financial stability.
- Aligning
Incentives at Systemically Important Financial Institutions
-
UBS recently announced it would
pay part of the bonuses of 6500 highly compensated employees with bonds
that would be
forfeited if the bank does not meet its capital requirements. This memo
underscores the
benefits of contingent deferred compensation and makes recommendations
for how
such compensation should be structured at systemically important
institutions. We also
revise our proposal for contingent convertible bonds, explaining how
these hybrid
bonds can be combined with better designs for deferred compensation to
reduce the
need for future bailouts.
- Squam
Lake Group Letter to the Financial Stability Oversight Council
Regarding
Money Market Funds
-
In
its Proposed Recommendations on Money Market Mutual Fund
Reform, the Financial Stability Oversight Council states that
“Reforms to address the
structural vulnerabilities
of money market mutual funds ('MMFs') are essential to safeguard
financial stability.”
We concur. The structure of MMFs makes them vulnerable to rapid
large-scale
redemptions (“runs”). Our main concern is with prime MMFs
because they
are a key source of short-term financing to large global financial
institutions. A run
on prime MMFs can threaten the ability of these
financial institutions to process payments and to extend credit to
other market
participants, businesses and households. We conclude that a floating
net asset
value would not achieve the goal of materially decreasing the systemic
risk
posed by MMFs because their assets do not have a liquid secondary
market. We believe, as we have written previously, that an
appropriately sized capital buffer for prime money market funds would
achieve the Council’s financial stability goals.
-
David
Scharfstein's Testimony on Money Market Funds, Presented to the Senate
Banking Committee, 6/21/12
-
Scharfstein
argues that the current structure of money market funds creates
fundamental
risks for the financial system. Prime money market funds are a critical
source of short-term funding for large banks. This funding is unstable,
however, because the ability of investors to withdraw their funds on
demand
combined with the fixed NAV structure makes money market funds
susceptible to runs
by their investors. This threat is magnified during periods of stress
to
the financial system, when banks are most in need of funding. Capital
buffers large enough to meaningfully reduce portfolio and run risk are
a desirable next step to improve financial stability.
- The Squam Lake Report: Fixing the
Financial System
- Our book is available from Princeton
University Press and Amazon.Com.
- Reforming
Money Market Funds
-
The current stable-NAV model
for prime money market funds exposes
fund investors and systemically important borrowers to runs like those
that
occurred after the failure of Lehman in September 2008.
This Working Paper argues that, to reduce this risk,
funds should have either
floating NAVs or buffers provided by their sponsors that can absorb
losses up
to a level to be set by regulators.
We
suggest alternative designs for such a buffer, as well as
considerations that
should be taken into account when determining its required size.
- Prime
Brokers and Derivatives Dealers
- Runs by prime-brokerage clients and derivatives
counterparties were a central cause of the global financial crisis.
These runs precipitated the failures of Bear Stearns and Lehman
Brothers by substantially reducing the broker’s liquidity. This Working
Paper, the ninth by the Squam Lake Group, argues for higher regulatory
liquidity requirements for dealer banks that use assets of clients and
counterparties as a source of liquidity.
- Regulation
of Executive Compensation in Financial Services
- Many people argue that inappropriate compensation policies
in financial companies contributed to the global financial crisis. Some
say the overall level of pay was too high. Others
criticize the structure of pay, claiming that
contracts for CEOs, traders, and other professionals induced them to
pursue excessively risky and short-term strategies. This Working Paper
argues that governments should generally not regulate the level of
executive compensation at financial firms. Instead, a fraction of
compensation should be held back for several years to reduce employees’
incentives to take excessive risk.
- Improving
Resolution Options for Systemically Relevant Financial Institutions
- There are critical holes in the existing regulatory
framework for handling large complex financial institutions that become
impaired. We endorse legislation that would give authorities the
necessary powers to effect an orderly resolution. As part of this
authority, every large complex financial institution should be required
to create its own rapid resolution plans, which would be subject to
periodic regulatory scrutiny. These “living wills” would help
authorities anticipate and address the difficulties that might arise in
a resolution.
- Regulation
of Retirement Saving
- Retirement saving is undergoing a fundamental change as
employers shift from defined benefit pension plans to defined
contribution plans, such as 401(k) accounts. Defined contribution plans
have important advantages: they allow households to customize their
retirement saving to their own risk preferences and circumstances, they
insulate pensioners from potential bankruptcies of their employers, and
although there may be a modest vesting period, they allow workers to
move from job to job without risking their pensions. These plans also
place much greater burdens on consumers to make good financial
decisions. But there is widespread concern that many households are not
up to the task. This Working Paper, the sixth in the Squam Lake Group
series, analyzes this concern and recommends measures that will improve
the performance of the nation’s retirement saving system.
- Credit
Default Swaps, Clearinghouses, and Exchanges
- Credit default swaps (CDS) are contracts that provide
protection against the risk of default by borrowers. The failure of one
important participant in the CDS market can destabilize the financial
system by inflicting significant losses on many trading partners
simultaneously. A clearinghouse could in theory reduce counterparty
risk by standing between the buyer and seller of protection, insulating
the counterparties’ exposure to each other’s default. This Working
Paper analyzes the market for credit default swaps and makes specific
recommendations about appropriate roles for clearinghouses and about
how they should be organized.
- A
Systemic Regulator for Financial Markets
- Financial regulations in almost all countries are designed
to ensure the soundness of individual institutions, principally
commercial banks, against the risk of loss on their assets. This focus
on individual firms ignores critical interactions between institutions.
Attempts by individual banks to remain solvent in a crisis, for
example, can undermine the stability of the system as a whole. The
focus on individual institutions can also cause regulators to overlook
important changes in the overall financial system. The solution to this
narrow institutional focus is simple: One regulatory organization in
each country should be responsible for overseeing the health and
stability of the overall financial system. We argue that the central
bank should be charged with this important new responsibility.
- An
Expedited Resolution Mechanism for Distressed Financial Firms:
Regulatory Hybrid Securities
- We recommend support for a new regulatory hybrid security
that will expedite the recapitalization of distressed financial
companies. The new instrument resembles long-term debt in normal times,
but converts to equity when the financial system and the issuing bank
under financial stress. The regulatory hybrid security we envision
would be transparent, less costly to taxpayers, and more effective than
the ad hoc measures taken in the current crisis.
- Reforming
Capital Requirements for Financial Institutions
- We argue that regulators should consider systemic effects
when setting bank capital requirements. Everything else the same,
capital requirements should be proportionately higher for larger banks,
banks that hold more illiquid assets, and banks that finance more of
their operations with short-term debt. But capital requirements are not
free. When designing capital requirements that address systemic
concerns, regulators must weigh the costs such requirements impose on
banks during good times against the benefit of having more capital in
the financial system when a crisis strikes.
- A
New Information Infrastructure for Financial Markets
- Information about prices and quantities of assets lies at
the heart of well-functioning capital markets. In the current financial
crisis, it has become clear that many important actors — both firms and
regulatory agencies — have not had sufficient information. We propose a
new regulatory regime for gathering and disseminating financial market
information. Government regulators need a new infrastructure to collect
and analyze adequate information from large (systemically important)
financial institutions. This new information framework would bolster
the government's ability to foresee, contain, and, ideally, prevent
disruptions to the overall financial services industry.
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2012, 2013 Squam Lake Group •
All Rights Reserved.