The Squam Lake Group

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.

If it is available, a description of a member's compensated outside (non-academic) activities can be found by clicking his name.

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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