In any economic crisis, politicians want a solution and they want it fast. Little time is spent searching for the root cause because addressing it would require a lengthy overhaul of the system. From academics, however, we expect a methodical search for the truth and advice about what represents the best solution, even if that solution is not expedient. In that spirit, a number of leading financial economists decided to form a working group to provide the best ideas for addressing the global financial crisis. Meeting first at Squam Lake, New Hampshire, in the fall of 2008, the group produced a set of concrete recommendations for educating policymakers and moving the debate forward with the best proposals from academe. The suggestions that emerged from this ambitious and noble project touch on many of the key issues that must be considered in any attempt to improve the financial system.

The Squam Lake Report: Fixing the Financial System  is divided into nine sections, built around the group’s key proposals. Each section begins with a review of the key topics and then presents explicit recommendations. The contributors focus on four critical issues:

• Conflict of interest (agency) problems
• Bankruptcy and disorderly liquidations
• Bank runs and financing
• The conflict between regulatory structure and financial innovation

A brief review of the book’s major recommendations provides a flavor of how this esteemed group would attempt to minimize or even prevent future crises.

The Squam Lake group strongly advocates the creation of systemic regulators. Although this issue is important, the group provides no clear definition of systemic risk and does not specify what these regulators should do. Bubbles need to be identified, but most important—in the words of William McChesney Martin, Jr., the late Fed chairman—someone must “take away the punch bowl just as the party gets going.”

Another major recommendation is to form a new information infrastructure. Few could argue for less information, but the book does not address the issue of what could have been done to avert the global financial crisis if additional information had been available. For example, most of the pertinent information on real estate lending excesses was readily accessible.

In a section devoted to improved regulation of retirement savings, the group offers eight separate recommendations, all of which are useful but seem misplaced in a short book that should properly focus on the financial crisis. The need for investor protection regulation is independent of the crisis.

The group also addresses bank capital requirements, an extremely important area ripe for reform. Key recommendations focus on the need for a bank’s capital requirements to be conditioned on its overall soundness, as reflected by its size, the liquidity of its assets, and the extent of its reliance on short-term financing. The group recommends avoiding regulation of the level of executive compensation at financial firms in favor of a greater emphasis on increasing the proportion of deferred compensation. Deferred compensation, say the economists, should be at risk and forfeited if the bank receives government assistance. They also argue that any recapitalization should take the form of hybrid securities that convert from debt to equity in the event of a financial crisis or violation of a financial covenant.

Another recommendation emphasizes bank restructuring over bailout. Detailed planning for the demise of a financial institution is essential to reducing social costs. This plan could take the form of a living will that tells regulators how a firm is to be dismantled in the event of a financial crisis. To provide clarity in the restructuring during a crisis, banks should be encouraged to use a clearinghouse for trading credit default swaps. The resulting dissemination of trading data would have the additional benefit of reducing the costs of trading. In the group’s view, there is also a need for better overall regulation of prime brokers, who are at the center of leveraged trading by hedge funds.

Although the economists agree on the key themes in their discussion of solutions, there is less agreement on the causes of the crisis. In fact, the group’s failure to address this critical issue is one of the book’s limitations. The reader gets a description of  what  happened but no deep insight into  why it happened. Basing reforms solely on the failure of the system without considering the causes limits the ability to determine the effectiveness of the reforms. ¹

In addition to the causes of the crisis, a number of other key issues are ignored in  The Squam Lake Report . Although a focused set of recommendations will necessarily not cover every relevant issue, a startling number of central policy problems are not addressed in any of the group’s recommendations. Many of these issues have a much larger potential impact on the financial system’s future than does the promulgation of new regulations. Some of these issues are political hot buttons that our leading scholars must confront even if there is no agreement on the solutions.

For example, the group does not explore the role of rating agencies, certainly an important topic given that they are the basis of the Basel II risk weights. In the run-up to the crisis, banks loaded up on AAA structured deals only to find that the risks were significantly greater than expected. The rating agencies’ incentive structure is problematic, the potential for gaming is substantial, and huge information asymmetries exist.

The economists also avoid the idea that financial institutions that are “too big to fail” are simply too big. The group recommends that large banks be better capitalized and more heavily taxed to compensate for social costs, but the issue of size should also be a topic for discussion. Banking scale is extremely pertinent, whether it is seen as a problem of systemic risk or, from a populist perspective, as an issue of power. The trade-off between systemic risk and economies of scale, breadth, and diversification is a foundational issue in global banking regulation. Another omission is the relevance of the shadow banking system. Corporate loans increasingly originate outside the traditional bank network, yet the book contains no discussion of the multiple channels of lending.

Though further afield, monetary policy is also absent. Many have argued that the root cause of the bubble was loose monetary policy, but the key recommendation that has emerged from the crisis is to house the systemic risk group at the Fed. The special role of government-sponsored enterprises in the housing market, with the attendant privatizing of profits and socializing of risks, is a critically important issue. Fannie Mae and Freddie Mac are in receivership, yet the book does not address the resulting risk transfer. This 800-pound gorilla continues to distort the mortgage market.

The roles of boards of directors and shareholders are also neglected, yet the associated monitoring and oversight issues are fundamental to the workings of a capitalist system. The group makes no recommendations concerning the need for directors and shareholders to bear responsibility for excessive risk taking. Remarkably, the financial crisis has produced no significant upheaval in the boardrooms of leading financial institutions, and the largest shareholders have not asserted their voting rights to advocate changing the system.

Finally, nothing is mentioned about the failure of the regulatory agencies to perform their function. Admittedly, more resources are needed and new rules are in order, but there appears to be no acknowledgment of regulatory failures—as the passive excuse goes, “Mistakes were made.” Perhaps the regulators were captured by their industries, but this possibility is not broached.

Certain themes run throughout  The Squam Lake Report . A key one is the ultimate problem with the current financial system: Gains are privatized but losses are socialized. Also pervading all aspects of the financial crisis are the issues of incentives in financial markets, problems of asymmetric information, moral hazard, and adverse selection. These notions have long been central to the study of finance.

The most valuable take-away from this short book is that regulation creates mechanisms that either exacerbate or diminish incentive and information problems. Poorly constructed incentive and regulatory structures often lead to unintended consequences. Fundamental to all these issues is the theme that misdirected incentives produce bad behavior. When informational asymmetries exist, misallocation problems arise and create an environment in which crises ferment. Comparing the new financial regulations with the Squam Lake proposals, we can clearly see that the revamped financial regulatory framework still fails to address fully the key problems of incentive and information structures.

The Squam Lake Report  is an important book in a growing library of commentary on the worst financial crisis since the Depression. It delivers good and clearly written recommendations and reviews most of the key issues surrounding the crisis. But the book lacks a sense of boldness and originality in its recommendations, which limits its effectiveness as an advocacy document. A sense of indignation about what has failed in the markets is missing.

In ancient Greece, philosophers often met their demise by following the truth. I am left with the feeling that the Squam Lake group does not want to weaken its ability to influence policy by disrupting existing power structures. Academics who do not show greater anger over the failure of the regulatory system, the impotence of private market mechanisms, and their own inability to get the economics right resemble, in their tameness, the regulators who are co-opted by their industries.

—M.S.R.