It has been more than a year since the Occupy Wall Street protests withered, and Zuccotti Park in lower Manhattan was cleared of tents, bongo drums, and demonstrators venting rage at bankers working steps away. Similar protests petered out in London and dozens of cities from Buenos Aires to Zagreb.

The protests may have failed to overhaul the financial system, but that does not mean that nothing has changed. In the wake of the financial crisis, lawmakers around the world passed thousands of pages of legislation, including the 2010 Dodd-Frank Act, the most comprehensive rewriting of US financial regulation since the Great Depression. Regulators are translating those laws into concrete rules that restrict some types of trading, shore up undercapitalized financial institutions, and create plans in case of bank failures. Centralized clearing has been introduced (if not yet fully implemented) for many derivatives markets and banks have been forced to write "living wills" and to submit themselves to stress tests.

But resentment still simmers. Nearly five years after the financial crisis began in earnest with the collapse of Lehman Brothers, the world's biggest financial institutions remain the scourge of regulators, politicians of all stripes, the media, and the general public. Even recently retired senior bankers are turning on their former paymasters, and shareholders are holding big banks to account more than ever before. While some observers agree that the financial system may have been made more sound, it is clearly far from fixed.

Financial reform: What’s been done, and what remains?

The Squam Lake group is made up of leading academic economists who offer guidance on the reform of financial regulation.  

A systemic regulator: 
One central regulator—ideally, the central bank—should be responsible for overseeing the health and stability of the financial system.
United States: The 2010 Dodd-Frank Act established the Financial Stability Oversight Council, made up of representatives of nine federal agencies. That has prompted concerns about coordination problems.

Europe: The European Systemic Risk Board was established in December 2010. A European banking union remains a contentious issue amid the ongoing eurozone crisis. 
Capital and liquidity ratios: 
Raise capital requirements for big banks, depending on the liquidity of assets and the proportion of debt that is short-term, and impose liquidity requirements on systemically important banks and broker-dealers. 
Basel III, the global regulatory standards agreed upon in 2011, gradually raises capital requirements and liquidity ratios on big banks by 2019, but has raised concerns that banks may be able to manipulate ratio figures. European authorities have finalized a plan for implementing Basel III. The United States has not signed up to Basel III, although regulators have proposed implementing it. A bill proposed by Senators Sherrod Brown (Democrat-Ohio) and David Vitter (Republican-Louisiana) would raise capital requirements much further, to 15 percent. 
Pay: One-fifth of top executives’ pay should be held back in systemically important financial firms, and forfeited if the firm’s capital ratio falls below a specified threshold.  The European parliament voted in March to cap bankers’ bonuses at 100 percent of salary, but the proposal does little to dampen incentives for risk-taking.

UBS announced in February 2013 it would pay part of the bonuses of 6,500 highly compensated employees with bonds. 
Resolution mechanisms: 
Regulators should restructure failing institutions rather than bail them out. Negotiations should begin on a unified international resolution process. Big financial institutions should file “living wills” every quarter.
 US and UK authorities have begun discussions on resolution issues. Dodd-Frank requires big banks to file living wills with regulators: 11 did so in 2012, but regulators have demanded they give more details by October this year. Banks must file living wills to European regulators by the end of 2013.
Money-market funds: 
Fixed net asset value funds should have capital buffers of 3 percent of risk-weighted assets. 
 A 2012 attempt by the US Securities and Exchange Commission to force funds to post capital was abandoned after the industry campaigned against it. The SEC is considering a more modest proposal that may drop any capital requirement.
‘Over-the-counter’ markets: 
Derivative contracts should be cleared centrally by well-capitalized clearing houses.
Dodd-Frank and the European Market Infrastructure Regulation require standardized derivatives to be centrally cleared. In the United States, mandatory clearing for some contracts and market participants began in March 2013. It is due to begin in Europe in 2014. 

The frustration is shared by academics who offered up concrete proposals for how to reform the global financial system. In the early days of the financial crisis, 15 of the world's top economists—four from Chicago Booth, three from Harvard, two from Dartmouth, and colleagues from Stanford, Columbia, Yale, Princeton, Ohio State, and the Brookings Institution—gathered in Squam Lake, New Hampshire, (the picturesque location for the movie On Golden Pond) to map out a long-term plan for reforming financial regulation. Their ongoing recommendations (see box "Financial reform: What's been done, and what remains") have had a strong influence on public policy, not least because two of the original group, Harvard's Jeremy C. Stein and David S. Scharfstein, went on to become White House advisers on financial stability at the time that the Obama administration was formulating the first draft of what became Dodd-Frank. (Stein is currently serving as a Fed governor.)

The World's Biggest Banks

(Continued from preceding page)

Bank of China - $1.88 Trillion

Citigroup - $1.87 Trillion

Agricultural Bank of China - $1.85 Trillion

ING Group - $1.66 Trillion

Santander - $1.62 Trillion

Sumitomu Mitusi Financial Group - $1.6 Trillion

Societe Generale - $1.53 Trillion

UBS - $1.51 Trillion

However, Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance, and a member of the Squam Lake group, says the legislation that Congress ultimately passed was stripped of some of the most important proposals the group had put forward. It offered up the pretense of having solved the problems of the US banking sector and making financial crises extinct. In fact, it left the sector vulnerable to more crises.

The Squam Lake economists generally agree that two fundamental problems that led to the crisis have yet to be fixed. First, incentives for the banks to take excessive risks have not been sufficiently curbed. Second, the system still lacks a robust prearranged resolution authority. We have yet to put in place frameworks to keep banks out of trouble and to deal with banks that, in spite of the rules, still get into trouble. Any comprehensive plan to fix the financial system needs to make financial institutions more robust, prevent problems from spreading, and make regulation clear and consistent.

These points do not fit neatly on protest signs. But to many, Occupy Wall Street's weakness was its lack of focus. If popular anger is to be channeled into fixing the financial system, it may require a new movement, informed by academics and spearheaded by business leaders, shareholders, and others who are closer to the issues. Its proposals and slogans would be better informed, more specifically identifying problems and solutions.

Watch for illiquidity mismatches

In the aftermath of the financial crisis, fingers have been pointed in all directions. Some observers blame homeowners who borrowed beyond their means. For others, it was the fault of greedy banks making risky loans; banks securitizing bundles of loans to disguise their true risk; or swaps traders amplifying these risks. The ultimate cause of the crisis, however—and any financial crisis, for that matter—is, at heart, far simpler: a run.

To understand why, go back 30 years to a paper Diamond wrote with Philip H. Dybvig, then of Yale and now at Washington University in Saint Louis. Diamond and Dybvig constructed a groundbreaking model that highlighted the fundamental fragility of bank liabilities and showed why banks are vulnerable to runs. Banks borrow money short-term (through deposits and overnight loans from other financial institutions, etc.) and lend it out long-term (through mortgages and business loans, etc.), creating a fundamental instability in the business model. The long-term loans are relatively illiquid—banks cannot demand instant repayment. Depositors, by contrast, are given instant liquidity and can withdraw cash from their accounts at any time. In a well-diversified bank, savers usually need money at different times. That enables the bank to retain only a portion of their funds to put in ATM machines and the like, while lending out the rest.

Bad banking behavior

Research by Chicago Booth Associate Professor Amit Seru provides evidence of widespread misrepresentation in the residential mortgage–backed securities market in the run-up to the financial crisis. In a paper written with Tomas Piskorski and James Witkin, both of Columbia University, Seru finds that about 10 percent of mortgages sold by intermediaries from 2002 to 2007 contained false information, much of which could be traced to financial institutions. Investors then used that false information when pricing the assets. 

What if all the savers try to withdraw their money at the same time? The bank does not have enough cash to satisfy all the depositors, since it cannot call back its loans or sell them to generate cash. Unless it can borrow cash or issue equity, the bank fails, and the savers who make it to the bank last leave empty-handed. The public's behavior in financial panics is often seen as wildly irrational, but for each individual saver, participating in a bank run is highly rational. If a depositor believes that every other saver has lost faith in the bank, it is only logical to try to withdraw funds before others do so.

The financial crisis provided example after example of this fragility. There was the 2007 run on the Northern Rock bank in the United Kingdom, the run on US money-market funds in 2008, and the banking crisis this year in Cyprus, in which runs were averted by limiting daily withdrawals. Vulnerability to runs is not exclusive to banks. Other financial institutions, such as money-market funds, are also built on short-term debt used to make longer term investments. At the heart of the financial crisis, in the Squam Lake group's analysis, was a run on the "shadow banking system" of overnight repurchase agreements, money-market mutual funds, broker-dealer relationships, commercial paper financing, and derivatives counterparties.

Echoing a famous Milton Friedman quote about the relationship between inflation and the money supply, Diamond puts it like this: "Financial crises are everywhere and always about short-term debt and the reasons we need to use short-term debt. Borrowing short and lending long, when the long stuff is illiquid, is the reason we have financial crises."

Chicago Booth faculty are forging ahead with theoretical and empirical work that tries to understand financial crises and suggests reforms to avoid them. If banks and similarly structured financial institutions are inherently fragile, the institutions themselves can act to aggravate the problem. In a paper published in 2011, Diamond and Raghuram G. Rajan, Eric J. Gleacher Distinguished Service Professor of Finance, describe how in a financial crisis, some institutions can be forced to sell illiquid assets, such as mortgage-backed securities. Such a "fire sale" can depress the assets' price to such an extent that they might be tempted to "double down" on those now seemingly cheap, if risky assets. The perceived higher rate of return now attached to the illiquid assets could prompt lenders, unless very well capitalized, to use their capital to buy such assets, rather than lend. That could increase rates on new loans and depress lending across the financial system.

The idea that a distressed bank would respond to its impaired state by purchasing more "bad assets" is counterintuitive. The bank in this case is like an investor who buys a stock believing it will go up in price, then buys more of the same stock when the price falls, reckoning that it is now even more of a bargain. Banks in this situation become "illiquidity seekers." This behavior is potentially damaging to the entire financial sector, pushing up expectations of rates of return and adding risk to the system.

Research by Zhiguo He, associate professor of finance and Robert King Steel Faculty Fellow, in collaboration with In Gu Khang and Arvind Krishnamurthy of Northwestern's Kellogg School, provides evidence of "illiquidity seeking" behavior. In the early days of the financial crisis, while hedge funds and broker-dealers were reducing their holding of illiquid securitized assets such as mortgage-backed securities by about $800 billion, insured commercial banks increased their holdings by nearly $550 billion.

Robert W. Vishny, Myron S. Scholes Distinguished Service Professor of Finance, and Andrei Shleifer of Harvard use behavioral finance to shed light on a related phenomenon. In a 1997 paper, they developed a model that explains how irrational exuberance or gloom in financial markets can persist, even when savvy arbitrageurs are there to correct it. When prices are above or below equilibrium because of irrational trading, traders normally use arbitrage to correct those prices. But if those nonequilibrium prices persist, they could prompt customer withdrawals from managed funds. Fear of that happening makes traders less likely to take advantage of such arbitrage opportunities, which keeps market prices inefficient. In more recent work, Vishny and Shleifer argue that financial innovation and securitization may exacerbate market fluctuations.

In explaining his work, Vishny recalls a quote from Chuck Prince, CEO of Citigroup, in July 2007, at a time of growing concerns over the early signs of potential collapse in the leveraged finance market. "When the music stops, in terms of liquidity, things will be complicated," Prince said. "But as long as the music is playing, you've got to get up and dance. We're still dancing." Four months later, Prince resigned, after Citi recorded large losses on collateralized debt obligations and mortgage-backed securities. "Financial innovation and securitization, and reliance on short-term funding collateralized by securities, makes that instability worse," says Vishny.

The fundamental reason for the crisis, then, was a series of illiquidity mismatches between short-term debt and longer-term loans, and related, "runnable" contracts issued by broker-dealers and shadow banks. Diamond and Dybvig argue strongly in favor of deposit insurance, which helps prevent bank runs by reassuring depositors that at least some of their savings are protected regardless of what happens. However, Diamond also thinks the occasional run—or the threat of one—can help keep bankers and regulators on their toes.

"Regulators have to be on the look-out for build-ups of 'borrow short, lend long,'" Diamond says. This is not behavior that occurs solely within the world of chartered banking. While global standard-setters have designated 29 big global banks as "systemically important," regulators should keep watch across the entire financial system, beyond the most obvious sources of trouble.

The World's Biggest Banks

(Continued from preceding page)

Bank of China - $1.88 Trillion

Citigroup - $1.87 Trillion

Agricultural Bank of China - $1.85 Trillion

ING Group - $1.66 Trillion

Santander - $1.62 Trillion

Sumitomu Mitusi Financial Group - $1.6 Trillion

Societe Generale - $1.53 Trillion

UBS - $1.51 Trillion

Get to grips with interconnectedness

The notion of monitoring the entire financial system is playing an increasingly bigger role in mainstream thinking on financial reform, but "macroprudential regulation" lacks the catchiness of "too big to fail." The most controversial actions the US government took in the financial crisis were the bailouts of institutions such as Bear Stearns, AIG, Fannie Mae, and Freddie Mac, and the massive "injections" of taxpayer money that saved many of the large commercial banks. Such institutions were "too big to fail," not just because of their size but their "systemic importance," the notion that their failure would imperil the financial system. To many, the US government's failure to bail out Lehman Brothers is the definitive argument for the necessity of bailouts. But the expectation of bailouts engenders "moral hazard," the phenomenon in which systemically important financial institutions can borrow cheaply and take on unnecessary risk, on the assumption that if disaster hits, they will get a government bailout. Thus, in many analyses, a key problem in global finance is the existence of large, global, systemically important financial institutions that governments feel they have no choice but to bail out in an emergency.

One approach would be to cut these banking leviathans down to size, an idea that has gained considerable traction, with support fueled by every fresh headline about bad banking behavior (see box "Bad banking behavior"). In the United States, for example, Republican Senator John McCain and Democratic Senator Maria Cantwell proposed a "Banking Integrity Act" in 2009 that included a new version of the 1933 Glass-Steagall Act, the law that, until its repeal in 1999, separated commercial banking from riskier investment banking. Eric Holder, US attorney-general, told a Congressional hearing in March of this year that the size of the megabanks made their executives "too big to jail," hampering the government's ability to prosecute. Richard Fisher, president of the Federal Reserve Bank of Dallas, has said the largest financial holding companies should be restructured so each of their corporate entities is "too small to save."

Dodd-Frank included a milder measure of the same impulse: the Volcker Rule (named after Paul Volcker, the former US Fed chairman), which limits commercial banks from proprietary trading. In the United Kingdom, a similar recommendation was made by the Parliamentary Commission on Banking Standards and supported by Mervyn King, the outgoing governor of the Bank of England. A European Union report led by Erkki Liikanen, governor of Finland's central bank, came to the same conclusion.

Even retired bankers have joined the cause. Sandy Weill, John Reed, and Richard Parsons, three former chairmen of Citigroup, and David Komansky, a former chief executive of Merrill Lynch, have all called for the biggest banks to be broken up.

Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and David G. Booth Faculty Fellow, supports the notion of breaking up big banks. Zingales came round to this view because of what he sees as the three fundamental problems of the global financial sector: the transmission mechanism between the banking market and the capital market, the size of the banks, and their undue political influence. In his book, A Capitalism for the People, Zingales emphasizes the political influence of banks and other parts of the financial industry, often overturning standard regulatory prescriptions in the process.

While a recent convert to the idea of a new Glass-Steagall, Zingales sees its limitations, recognizing that it would not have prevented the financial crisis: the institutions at the heart of the crisis, such as Bear Stearns, Lehman Brothers, and Washington Mutual, were either pure investment banks or pure commercial banks. He acknowledges that the ability to merge commercial and investment banks helped to stabilize the financial system, as with Bear Stearns's acquisition by JP Morgan and Merrill Lynch's by Bank of America (mergers that created even bigger banking behemoths along the way). Although he thinks a new Glass-Steagall is necessary, Zingales recognizes it would not, in itself, fix the financial sector.

Some of his colleagues emphasize that size per se is not the problem. Diamond argues that large banks actually aid financial stability. "A big, well-diversified bank is much more stable than a bunch of very small banks," he says. "There's the 'too big to fail' problem and then there's the 'too small to be viable' problem. It's a trade-off." He notes that Canada, a large economy with five big banks, has made it through two recessions with no big bank failures. Largeness, Diamond says, becomes a problem depending on the regulatory context. "You can't have a few big banks with soft-touch regulation. With a few big banks, you need fairly strict regulation."

Randall S. Kroszner, Norman R. Bobins Professor of Economics, says "the issue is much more 'too interconnected to fail' than too big." In Reforming US Financial Markets, the book he wrote with Robert J. Shiller of Yale (another Squam Lake member), Kroszner emphasizes the growth in this interconnectedness, noting that the proportion of financial assets held by depository institutions halved between 1946 and 2006, from 60 percent to 30 percent. This has led to a highly interconnected financial system in which it is not clear how risk is distributed.

Kroszner argues that a new Glass-Steagall could lead to more volatility in key global financial markets, such as those for government securities, in which banks play an important role as market-makers. By banning bank participation and removing the liquidity they provide, these markets could become illiquid and unstable, he says.

In a study of the banking sector in the years before Glass-Steagall's introduction in 1933, Kroszner and Rajan dispute the notion that the law was justified to protect the investing public from conflicts of interest when commercial and investment banking were under one roof. The evidence does not indicate widespread defrauding of investors, the authors note. Public markets and rating agencies were aware of the potential for such conflicts and imposed a market discount on information-intensive securities underwritten by the affiliates.

A new Glass-Steagall would merely shift risk around, rather than address it, Kroszner says. "If the risks aren't undertaken by the banks, they'll be one step away—either funding the banks, like money-market mutual funds, or funded by the banks, like AIG, Lehman Brothers, or Bear Stearns. You'll have pushed the problem off the bank balance sheet, but the crisis showed that isn't necessarily the relevant locus of risk."

Raise capital requirements

John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance, is sympathetic to Zingales's arguments for breaking up the banks. However, Cochrane echoes Kroszner's concern that in practice, banks would engineer their way around either Volcker or Glass-Steagall. And Cochrane—also a Squam Lake member—argues that such measures would treat a symptom rather than the cause of financial crises: the risk of runs highlighted by Diamond and Dybvig. He wants to tackle the problem at its source, using much higher capital requirements and sharply restricting institutions' ability to finance themselves by run-prone short-term debt.

Capital requirements govern where banks get money in the first place: how much money they can raise by deposits and other run-prone short-term debt, and how much money they must raise by selling stock or retaining earnings instead. Basel III, the global regulatory standards promulgated in 2011, raises the minimum ratio of common equity banks must issue to fund themselves to 7 percent of risk-weighted assets by 2019, from just 2 percent in Basel II. The United States imposes additional modest capital charges for systemically important financial institutions. Official "stress tests" in addition to regular supervision are designed to ensure that those capital buffers are sufficient.

The debate over capital has been reinvigorated by The Bankers' New Clothes, a provocative book released in February of this year by Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute for Research on Collective Goods in Bonn, Germany (which Cochrane recently reviewed for the Wall Street Journal). Strip out risk weightings, and Basel III actually requires banks to hold just 3 percent of their assets as equity. Draft legislation in the United States this year proposes hiking capital requirements on the biggest banks to 15 percent, while US regulators want to raise capital ratios on non-US banks. Admati and Hellwig call for an equity ratio of 2o-30 percent.

Anil K Kashyap, Edward Eagle Brown Professor of Economics and Finance and Charles M. Harper Faculty Fellow—and another Squam Lake member—suggests that capital requirements can fluctuate depending on the situation. A 2011 paper Kashyap wrote with Harvard's Stein and Samuel Hanson argues that capital requirements should be higher in normal times, and lower in times of distress. This would allow banks to draw on capital cushions in bad times, rather than shrink assets.

For this system to work, they argue, capital requirements in normal circumstances would have to be much higher. The authors argue that if the market standard for equity-to-assets in bad times is 8 percent, and regulators want banks to be able to absorb losses of 4 percent of assets without facing pressure to shrink their balance sheets, regulators should demand a minimum capital ratio of 12 percent in normal times. Since US banks lost about 7 percent of their assets between 2007 and 2010, according to the International Monetary Fund, Kashyap, Hanson, and Stein suggest that regulators could justify a "good times" capital requirement of as high as 15 percent. The ratio need not be too disruptive: in a 2010 paper also coauthored by Stein and Hanson, Kashyap argues that capital requirements should be raised slowly, enabling banks to fund them with retained earnings. 

Cochrane believes equity ratios should be 50 percent or even 100 percent. "The numerator is clear with capital requirements," he says. "The problem is the denominator, this crazy business of risk-weighting assets and so on. I want to get the numerator so big that we're not arguing about the denominator." A simple figure—say, 20 percent—sounds appealing, but banks can manipulate their assets to appear less risky, begging the question, "20 percent of what?" Cochrane's response is that capital requirements should be so high that banks no longer think of debt as their primary source of financing, changing their basic business model. He also notes that banks with large capital ratios find it much easier to issue new equity after losses, while highly leveraged banks cannot easily find new investors.

Cochrane argues banks should largely fund their investments in illiquid assets such as loans by issuing equity. That would remove the threat of bank runs and demands for government rescues. Where would people put their money? If they want short-term debt, they can hold (and banks can sell) money-market funds backed by treasuries, he says. Rather than being a guaranteed security, investments in banks would resemble equity mutual funds, where people accept risk for their greater return, without runs.

Cochrane reports that all of these issues are a bone of friendly contention in the Booth faculty lunch room. A 2002 paper Kashyap wrote with Rajan and Stein contends that banks that combine deposit-taking with lending are more economically efficient. And in a paper published in 2000, Diamond and Rajan argue debt serves an important function, as a discipline device on bankers' behavior. The need to repay or roll over debt gives banks a stronger incentive to manage risk carefully. Thus Rajan contends that an all-equity bank, disciplined only by the wrath of shareholders, would be more likely to take unwarranted risk. Cochrane is skeptical that short-term debt really is a discipline device. "No one lending overnight to a bank pays attention to credit worthiness, because the chance of you going bankrupt overnight is so little," he says.

Kashyap and others stress that capital requirements must be extended to nonbanks, too, as many traditional banking functions take place outside the regulated banking system. "If you look at where the instability came, it was in a lot of things that aren't called banks," Kashyap says. In a 2010 paper with Richard Berner, now director of the Office of Financial Research in Washington, and Charles A. E. Goodhart of the London School of Economics, Kashyap highlights the consequences of outlawing short-term lending by the private sector, such as pushing such activity into the shadow-banking sector, a less-regulated world of off-balance-sheet financing and nonbank financial intermediaries. Given the presence of shadow banking, very high capital requirements on banks alone would not be sufficient to fix the financial sector, Kashyap argues.

In a 2012 paper, Kroszner argues that very high capital requirements could give a false sense of security to regulators and the public about the safety of the financial system, and might lead to complacency in regulatory reform.

Where economists generally agree is that capital requirement should be higher than the current requirements. Many see Basel III as too weak. Most economists reject the pleas of bankers that equity is more expensive than debt, citing seminal research published in the late 1950s and early 1960s by the late Nobel Laureates Franco Modigliani of MIT and Merton H. Miller, a professor at Chicago Booth from the 1960s to the 1990s. The Modigliani-Miller theorem holds that the mix of debt and equity a firm uses to finance its assets does not change its average cost of financing. A bank with more capital should be safer, so shareholders will not require as high a rate of return. Cochrane says economists' consensus on that idea is more important than debates over the exact level of capital requirement. "Getting the analytical framework right is most of the battle," he says. "The disagreement is like: æHow much oil do you really need in your car?' As long as you've got four quarts, five quarts isn't going to hurt."

Regulate consistently

Two years of furious lobbying by the world's biggest banks paid off in January of this year. In a deal struck with regulators, banks won extra time to comply with the liquidity standards in Basel III, and will get to count a much wider range of assets towards their liquidity buffers, piles of relatively safe assets they can sell in the event of a run. It was a sign that banks will fight with political power and financial innovation to dampen attempts to alter their business models. With that in mind, the Squam Lake recommendations call not just for higher capital buffers, but for more effective enforcement of rules on capital. "Thinking about what capital is and how you measure it is just as important as getting a new percentage," says Diamond. "There's a general view that banks don't keep themselves safe enough. The simplest view is that capital requirements are too low. The more nuanced view is that capital requirements are not well enforced and that banks are not forced to partially recapitalize themselves when they only get a little bit undercapitalized."

More effective enforcement requires more consistent enforcement. Decisions on whether, when, and how to intervene are highly arbitrary, and in practice there are large inconsistencies in regulators' behavior. The failure of Washington Mutual in September 2008 demonstrated the damage that can be inflicted by the tussle between regulators, which delayed timely intervention. According to a Senate investigation, WaMu's failure that same year—the largest bank failure in US history—largely resulted from delayed action due to inconsistent oversight by regulators.

Research by Amit Seru, associate professor of finance, provides empirical evidence of such inconsistency, demonstrating very different regulatory practices between federal and state agencies due to differences in their incentive structures and institutional design. In a paper with Sumit Agarwal of the Federal Reserve Bank of Chicago, David Lucca of the New York Fed, and Francesco Trebbi of the University of British Columbia, Seru finds that federal supervisors were twice as likely as state supervisors to downgrade bank ratings and, in the case of the Federal Reserve, that they were also more cautious in upgrading ratings. Crucially, leniency of state regulators relative to their federal counterparts is shown to be related to delayed corrective actions by regulators.

Politics plays a big role. Zingales and Oliver Hart of Harvard note in a 2011 paper that regulators are under pressure both from politicians and the institutions they regulate. The former could prompt them to close down well-functioning financial institutions for political reasons. The latter could force regulators to be overly cautious about intervening because of intense lobbying or "regulatory capture," when regulatory bodies evolve into agents of the industry they are overseeing. In both cases, regulators could take action—or fail to—for reasons that have little to do with actual risk.

A principal challenge for policymakers, then, is to spell out clearly when firms will be allowed to fail. As Cochrane put it in a 2009 article: "We cannot rely on the good intentions of powerful administrators; Odysseus knew he had to tie himself to the mast. To give government officials the power to bail out firms at their discretion, especially if those officials are elected or political appointees, is practically to guarantee a bailout. In a crisis, everything looks systemic."

In a 2010 paper, Pietro Veronesi, Roman Family Professor of Finance, and Zingales calculate the costs and benefits of the US government's $125 billion preferred equity infusion in the ten biggest US commercial banks in October 2008, plus a three-year guarantee on new unsecured bank debt issues and insurance on all noninterest-bearing deposits. The authors conclude that the action, the largest intervention in the financial sector in US history, increased the value of banks' financial claims by far more than it cost to taxpayers, with a net benefit between $86 billion and $109 billion, chiefly explained by preventing a bank run. "Governments are generally in the business of redistributing value, even if they destroy value in doing so," says Zingales. "When they can create some value, it is impossible to keep them out."

The challenge is providing regulators with a clear trigger for intervention. Squam Lake proposed doing so when capital buffers are breached. Zingales and Hart suggest the market for credit default swaps (CDS)—the structured over-the-counter financial derivatives widely blamed for exacerbating the financial crisis—be used as an "early warning system" to alert regulators when large financial institutions are in trouble. While it is counterintuitive to use the CDS market to prevent another financial crisis, Zingales and Hart note that the CDS market has a track record as a leading indicator of financial stress, providing information ahead of the stock market, bond market, and credit rating agencies.

1-year CDS rates at key dates

BPS of premium to insure against default

Financial Institution 8/15/07 12/31/07 3/14/08 9/29/08
Bank of America 11 29 93 124
Wells Fargo 23 45 113 113
JP Morgan 19 32 141 103
Citigroup 15 62 225 462
Wachovia 14 73 229 527
Goldman Sachs 28 78 262 715
Morgan Stanley 31 129 403 1,748
Merrill Lynch 29 159 410 666
Lehman Brothers 38 100 572 1,128
Bear Stearns 113 224 1,264 118
AIG 31 59 289 821

Source: "A New Capital Regulation for Large Financial Institutions," American Law and Economics Review, V13 N2 2011, Oliver Hart and Luigi Zingales

Should regulators depend on the markets alone to spot trouble building up? Markets can be taken by surprise. Panic can spread quickly. Financial innovation bypasses regulations. Waiting for problems to encroach across a preordained threshold could be dangerous. "You've got to stop the behavior before the market recognizes it," says Vishny.

Ultimately, reforming the financial system may mean disabusing investors of the notion that their investment dollars are completely safe, thereby acknowledging the limits of financial policing. Banks that fail may have to "bail in" wealthy depositors, as happened in Cyprus, where up to 60 percent of uninsured deposits above Ç100,000 will be seized and converted to equity to bolster bank capital levels (although preferably such bail-ins should be a predictable and understood part of investing in banks, not the result of a chaotic negotiation of discretionary actions by politicians). Money-market funds may no longer be able to promise people a safe return when they are taking risks with their cash. Cochrane wants bank investments to be more like securities, with no guarantees. The illusion of security can be damaging. As Vishny notes, "By allowing people to make promises of safety when they're not really safe, we're aiding and abetting that instability."

It is also necessary to standardize regulation internationally. The big banks are increasingly global, yet regulation remains largely national, even if standards—such as Basel III—are set internationally. One jurisdiction might fix its banking problems, but if others do not, there is opportunity for regulatory arbitrage. The longer-term challenge for financial regulators, then, is to establish international rules on oversight and a global resolution authority.

American and British regulators have discussed an agreement for winding up failed banks, including bail-in procedures so that creditors bear losses. But even then, they would have to hope that most of the subsidiaries of the institution are in the United States or the United Kingdom. The European Commission is expected to present an EU-wide bank resolution proposal this year that could form part of a global mechanism. Ideally, authorities in Japan and China would also be involved.

Diamond thinks that such a system would be immensely beneficial to the global financial system. "Governments want to look out for their citizens first. They'd give up their ability to grab from the others, but if we all did that we'd all be better off," he says. "If you had a bail-in resolution authority, and found a way to impose losses so you wouldn't need bailouts, there'd be no incentives to grab assets. That would be great."

Warming to his theme, Diamond thinks the key elements of a global agreement are actually fairly straightforward. "Banks can't have too big a fraction of your claims that are runnable," he says, proposing that international regulators establish capital "floors" accompanied by "ceilings" for how much short-term debt financial institutions can borrow as a fraction of their assets.

"If we had that in a worldwide system, we could harmonize regulation, so we wouldn't have regulatory arbitrage," Diamond says. "And if we had a global financial crisis, we could more quickly resolve it. Then we could get the world financial system back on its feet quickly."

Diamond is not optimistic this can be done soon. "The EU cannot even get its own regulatory process harmonized," he observes. Kashyap concurs. "This is as complicated as a trade negotiation," he says. "It's going to take 10 to 15 years, and since they haven't really started, this isn't going to happen fast." If global regulators are to take up that challenge, however, they would be well advised to keep a close eye on the debates among academic experts.

Additional reading

The Squam Lake Report: Fixing the Financial System (Princeton University Press: May 2010)–Fifteen leading economists outline their plan for financial reform.

A Capitalism for the People: Recapturing the Lost Genius of American Prosperity (Basic Books: June 2012)–Luigi Zingales argues that American capitalism is on its way to becoming a less ideal, more corrupt system. He says the United States must foster truly free and open competition.

Reforming US Financial Markets: Reflections Before and Beyond Dodd-Frank (The MIT Press: April 2011)–In this book written with Yale economist Robert Shiller, Randall S. Kroszner identifies regulatory gaps and focuses on key areas in need of reform.

Fault Lines: How Hidden Fractures Still Threaten the World’s Economy (Princeton University Press: August 2011)–Raghuram G. Rajan, who warned of the global financial crisis before it hit, outlines what it would take to create a more stable world economy.

The Bankers’ New Clothes (Princeton University Press: February 2013)–Stanford’s Anat Admati and Martin Hellwig of the Max Planck Institute provocatively argue in favor of higher capital requirements.

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