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Reforming Global Finance: The Squam Lake Papers

Speakers: Martin N. Baily, Senior Fellow, Economic Studies, The Brookings Institution; Former Chairman, Council of Economic Advisers, Kenneth R. French, Carl E. and Catherine M. Heidt Professor of Finance, Tuck School of Business, Dartmouth College, and Matthew J. Slaughter, Adjunct Senior Fellow for Business and Globalization, Council on Foreign Relations; Associate Dean for the MBA Program and Professor of International Economics, Tuck School of Business, Dartmouth College
Presider: Sebastian Mallaby, Director, Maurice R. Greenberg Center for Geoeconomic Studies; Deputy Director, David Rockefeller Studies Program; and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations
May 26, 2009, Washington D.C.
Council on Foreign Relations

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SEBASTIAN MALLABY: Thanks to all of you for braving the weather. We're going to -- I think the -- you know, the good news on the economy is that there are green shoots; the bad news is that the over- the-horizon question of how you prevent the financial sector from blowing up again I think is something on which there is no clear consensus. When you lack a consensus or ideas, you turn to the smartest people in academia to fill it, and so that's what this panel is about.

With me we have, starting over there, Matt Slaughter, who's an adjunct senior fellow here at the council, and also at the Tuck School at Dartmouth. We have Martin Baily from the Brookings Institution, former chairman of the Council of Economic Advisers. And next to me is Ken French, also of the Tuck School, and author of some of the groundbreaking work on asset pricing. And more broadly, these three people represent a group, the Squam Lake group on financial regulation.

So my first question, to Ken, is going to be, what is the Squam Lake group?

KENNETH R. FRENCH: Thank you very much, Sebastian. The Squam Lake Working Group on Financial Regulation -- that's the whole long title -- is a group of 15 of us who are nonaffiliated, except for our academic -- (audio break) -- in this case, Brookings -- relationships; nonpartisan.

We got together back in October, and it was sort of -- I made the initial phone calls trying to draft people, get them involved. And the idea was, we fully expected there would be plenty -- advice, lots of op-eds, lots of academic papers, about how to get out of the current crisis. Okay, the world is exploding, everybody's going to run in trying to solve the current crisis.

But we could fully anticipate, just like after the Great Depression, the government -- policymakers around the world were going to rewrite all the financial regulations; and decided there really wasn't that much academic -- (audio break) -- on what those regulations ought to look like. So the pitch I made was, look, they're about to write the rules that our children and grandchildren are going to have to live under for the next 50 years. Let's get involved. Let's offer some guidance.

So in a nutshell, that's what the group's about. We're nonpartisan, nonaffiliated. We're skipping this crisis and saying, going forward, what should regulations look like -- both with the aim of (reducing ?) -- (audio break) -- probability of future crises and -- (audio break) -- the cost should we ever deteriorate back into a crisis like we currently have.

MALLABY: Okay. So you have a group of 15 academics, and the idea is to create these -- this series of short papers. You've done four so far. They're on the council website. There are four or so more coming, I think.

Let's go first to Martin Baily and ask about your idea for a systemic risk regulator, because that's an idea which has also been talked about a lot here in Washington.

Are there ways in which your proposal, you think, differs from what's being talked about, both in Congress and from the administration, or is there a lot of overlap there?

MARTIN NEIL BAILY: Well, as I said, (the amount of ?) overlap -- let me say -- well, you describe it as mine. It's not. It's obviously the Squam Lake Group. We've agreed pretty much together. We've been able to hammer out an agreement on this.

So let me describe briefly what it is. And yeah, I think there are some differences, particularly with respect to the role of the Federal Reserve. I apologize if I glance at my notes. As I get into this and into the swing of this, I'll lose my stage fright. But at the moment, I'm going to refer to my notes.

Part of the problem with regulation, as it's happened so far, and what got us into the crisis that we got into is that regulators focused on a single institution or a small group of institutions, and did not pay sufficient attention to what the impact of that failure on that -- of that one institution might be if it went down, and in particular, what some of the interlinkages among the institutions were.

I think went Lehman went down, for example, there really was not the realization of the extent to which it would impact not only counterparties within the United States, but counterparties in London and around the world, so that the overall impact turned out to be much larger than just the collapse of Lehman itself, which was not -- you know, it was a big institution, but was not that big an institution.

So we feel there needs to be somebody -- and we think it should be the Federal Reserve -- that has the responsibility to say, first of all, are there institutions that are big enough, or interconnected enough, that their failure could bring down or could at least endanger the whole system? And we think there are, and therefore a need for a particular body to be watching over the whole system, not just watching whether the one institution will survive or not.

So the primary goal of the systemic regulator should be to prevent a financial crisis. Remember, we've had banks and financial institutions go down before. We had Continental Illinois go down, a large bank, did not bring about a financial crisis in itself. So this would be the case. Yes, you can let those go down, but is that going to be a situation where we need a regulator saying no, we have enough of a crisis within the system as a whole but more needs to be done.

The second thing is that systemic regulator needs to design and implement a set of financial regulations with a systemic focus. So rather than just having this is what a bank should do, or this is what a financial institution should do, in order to make sure that it survives or it stands a reasonably good chance of surviving, or it's not taking excessive risk on its own, what other rules may be necessary in order to make sure that the system as a whole survives?

So this crisis prevention role of the systemic regulator is the paramount thing. We argue -- one of the examples, just make that a bit more specific, we argue elsewhere that banks should be required to hold hybrid securities. These are securities that convert to equity even though they may start out as bonds.

I don't want to go into the details of those, because we'll talk about more of that later. But that's the kind of regulation that would make the whole system more stable rather than just a single institution more stable.

MALLABY: Do you favor having the Federal Reserve do this?

BAILY: That was going to be my last comment. I wasn't going to talk forever, Sebastian.

We think that the Federal Reserve is the right institution to do that. And we think that generally central banks are the right institution to do that. Why should the Federal Reserve do it?

Well, let me start backwards by saying, well, why shouldn't the Federal Reserve do it? I think there is concern here in Washington now that the Fed has gotten too much power, in other words, that they're running too much of the system.

Under the governing statutes of the Federal Reserve, they can almost sort of do anything under exigent circumstances. So I think there's a concern naturally in Congress. Hey, wait a minute. This is our money. The Federal Reserve may be putting some of our money at risk.

And there's a sense that maybe we need to rein the Federal Reserve in a little bit. We think nevertheless despite those concerns, which may be legitimate when taxpayers' money is at stake, that really the Federal Reserve is the only organization that has the kind of expertise, the kind of range of people, the authority, the status.

The fact that it is involved in the banking system, that it is a lender of last resort, that it is in constant contact with central banks, around the world, these are some of the reasons why it really should be the Federal Reserve or the central bank that plays this role.

MALLABY: It's quite remarkable that Ron Paul, not normally seen as a sort of central figure, in a bill to regulate the Fed, can get 179 co-sponsors. Presumably if that's a mark of the, you know, drift in Washington, loading yet more responsibility on the Fed, making it more of a target, has some risk. But you think the risk is justified by the upside.

BAILY: Well, I think, if Ron Paul is on that side, I think, we're in good shape here.

MALLABY: It was more the 179 co-sponsors I was talking about, but yeah.

Matt, it seems to me that you guys have, actually, two different papers relating to this. You've got one talking about the need for a systemic-risk regulator, another one talking about sort of one of the things that this would do, namely to generate information.

There seems to be a bit of a gap in the debate in Washington: that people talk about the institution; they don't get into the information that this institution would need to generate. Can you talk a bit about that paper?

MATTHEW J. SLAUGHTER: Sure. So one of the things that, as our group began its conversations, that many of us were struck by was how many regulatory agencies now, they focus on individual institutions, the solvency of that institution, the potential taxpayer burden that institution will create. But there's not information that's gathered to understand links across those institutions: links in terms of the counterparty risk, so, if one firm fails, the risks that's going to present to other firm; and also information not just in terms of counterparty risk but also risk in terms of what we -- kind of -- talk about fire-sale prices, so the issue that when one failing institution might sell assets, the links that creates across other institutions, even temporarily, in terms of movements in asset prices.

I think a good example of that in the current crisis that motivated our thinking was the fact that the difficulties that AIG was facing were largely difficulties that AIG itself presented to different regulators as its crisis inside the firm was rising.

So we talk about the need for a greater set of information to be collected among financial regulators. And again, a lot of this authority would lie with the systemic regulator.

But we discussed the need to balance some tradeoffs: to balance the timeliness versus the reporting burden across all systemically important institutions, the need to have this information then be shared across the different regulators, including the systemic regulator.

And one of the proposals we make on information collection is, with some time delay and some aggregation, having this information be turned back over to the private market participants as well, as a complement to the oversight that might be provided by the regulators.

MALLABY: You know, there's a couple of objections to this that one hears, and I want to focus on one particularly. One is simply that -- can you get enough of this information for it to be meaningful? So to the extent that you're really trying to figure out, is a certain trade -- let's say buying Latin American equities in a leveraged way -- is this trade crowded such that people might exit it very quickly and cause a spiraling effect?

To really understand that, you have to know whether some Thai trading company has an ambitious chief financial officer that's decided to go massively long. I mean, there are lots of stories of particular markets where people, completely out of left field -- you know, one employee of Sumitomo cornering the copper market, the Hunt brothers cornering the silver market -- isn't there a problem that even the most omniscient systemic regulator wouldn't know enough to really be able to spot the systemic risks?

SLAUGHTER: That may well be the case. So a couple of issues that came out of our deliberations in this particular paper -- one is, again, there's limited regulatory capacity. Despite good motivations and good efforts of a lot of regulators, they may miss some of those issues -- which, again, is why we like the principle of -- with appropriate time delays and aggregation -- sharing this information with other analysts in the private market.

And then second -- it speaks a bit to Martin's point about the role of the systemic regulator -- is, information alone may be necessary for better regulation; it won't be sufficient, and trying to manage expectations that having this information alone won't necessarily eliminate all these sorts of problems, like the examples you give.

BAILY: And if I can just interject, you may not have information from the Malaysian copper, or whatever example was that you were using. But if you have information from the systemic institutions or from the banks more generally in your own economy; and you have a systemic regulator who has the power to aggregate that information; and that you find out that a lot of your big banks have very large stakes in this Malaysian whatever it was; then that tells you something, and allows you perhaps to function, even if you didn't have the particular information about what was going on in the rest of the world, because you can see that there's a lot of people in your regulated institutions that are taking important stakes.

MALLABY: Well, that gets to the second objection I was going to bring up, which is, okay, if your answer to this -- you know, the incredibly splintered nature of financial activity -- you know, you've got whatever, a sovereign wealth fund in Dubai doing something -- if you're answer is that look, a lot of this activity is routed through a smaller number of big brokers, and therefore, if you got to the brokers, you're going to have a lot of the picture; by the same token, when you go to the brokers and say, "Gee or hello, I'm the government. I've looked at systemic risk across the system, and I figured out that this Latin American equity rate, boy, that's overcrowded, and its dangerous, and you should really deleverage," isn't the broker going to say, "Wait a second. I'm Goldman Sachs. I've got offices in, you know, a hundred and something countries. I do all of these trades for everybody. I know exactly how the market is positioned. I know more than you do, and who are you to tell me that I should get out of this trade? And furthermore, if you do tell me to get out of this trade, guess what. My European rival, Deutsche Bank, whoever it is, is going to clean up, and you, the U.S. government, are going to be destroying the profitability of a U.S. company."

I mean, isn't that a lobbying fight that the systemic regulator will lose?

FRENCH: It's not clear why they should lose that fight. If Deutsche Bank wants to take that, if the German government allows them to take that systemic risk, what they're really saying is, we're allowing shareholders of Deutsche Bank to capture part of the taxpayers' value in Germany, and if it turns out that if the U.S. taxpayers don't subsidize Goldman Sachs, and that become unprofitable as a result, then we shouldn't do that. That -- if Germany wants to subsidize their bank in that fashion, there's nothing we can do. In any -- exactly the same fashion, if some competitor chooses to sell below cost, I can gnash my teeth, but I suffer, and that's the best I can do.

So if it really is the case that bad deals get exported to foreign countries because the foreign taxpayers are willing to subsidize their banks that's not an excuse for us to subsidize our banks.

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MALLABY: Let's get to another issue which Martin mentioned briefly, Ken, which is this regulatory hybrid security. It's a bit of a mouthful, but it speaks to the issue of, how do you work out institutions when they are failing?

What we've seen is that, with the one example of one which was allowed to go down, Lehman, there were such catastrophic ripple effects through the system that the lesson regulators will be tempted to draw is, whatever you do, don't let anyone go down -- in which case everybody's too big to fail, and we're in real trouble in the future.

FRENCH: Yeah.

MALLABY: So you have an idea which I think is a little bit different to what other people are talking about in Washington.

FRENCH: Yeah. The moral-hazard problem is huge. So right now, to be a bit provocative, the banks that want to give their money back -- the TARP money back to the government -- probably could not -- many of them -- could not afford to do that, except for the fact that if they do go down again, the government will give them money back.

So what do I mean by that? The interest rate that they're able to borrow at includes the call that they have on the taxpayers. So what we'd like to do is instead create an environment in which we at least reduce the value of that call, reduce the moral hazard. One way to do that is to improve the resolution mechanisms. So it's really -- it -- the FDIC does wonderful stuff, but as you get incredibly complicated financial institutions, trying to unwind those, rearrange those, becomes very difficult.

And what we're proposing we call "regulatory hybrid convertibles." And the idea there is basically, we have a debt contract. And debt is really valuable in a bank's capital structure because it imposes a lot of discipline on management. They know they're going to have to make these payments. So debt is a good thing to have in the bank's capital structure. But it's a bad thing when we run into this systemic crisis, because it can push the bank over the cliff.

What our convertible security does is it requires a double trigger. If we're in the midst of a financial crisis and a financial institution violates some bond covenant, at that point this debt converts immediately to equity. So you basically say, okay, we've got this debt, which imposes all that good discipline on management -- except for the double situation in which you're in a financial crisis AND the bank violates some bond covenant. At that point, the debt converts at a fixed rate over to equity, and you've eliminated that big huge burden.

Some of you have probably heard about the "debt overhang" problem. This is -- what the debt-overhang problem is is, I owe my bondholders most of the value of the firm. If I then go out and sell more equity, most of what that does is increase the value of the bonds. It increases the likelihood that the bonds are going to pay off, because I've capitalized the firm more than it was.

If most of that value is going to go to the bondholders, what that means is it's going to dilute the heck out of the existing shareholders. They don't want to do it. So they do not want to sell equity. The Congress is out there demanding these folks sell equity, and they're sitting there saying, "Well, we'd like to, but we can't." They don't really want to. And the reason they don't want to is because of this debt-overhang problem.

What this does is basically recapitalize the bank, convert the debt to equity, and simultaneously solve that debt-overhang problem.

MALLABY: Do you think that this is something that will be taken up? Is this -- do you get a sense that --

FRENCH: We need a change in the law, for one thing. What we would like is, in the U.S. for example, interest -- (audio break) -- interest that the banks would pay is typically tax-deductible. It's a business expense. It's not clear whether this convertible hybrid security here is actually -- the interest would be tax-deductible or not. So we need clarification on the law.

That's the only change that you actually need out there, regulatory change, for banks to be able to do this.

But without some coercion in some fashion, from the government, banks aren't going to be anxious to do it. And the reason banks aren't going to be anxious to do it is again right now they have a claim on the taxpayer. And our whole -- one of our big themes is to reduce the claims of the financial institutions on the taxpayers. And this is a way to do that.

BAILY: But Ken, I mean, they're going to be faced probably either with higher capital requirements or something like that.

FRENCH: That's right.

BAILY: And then doesn't that give them incentive to do this?

FRENCH: One lever we can use -- one lever we -- one lever the regulators can use is, change capital requirements and say, okay, this counts toward your capital, if you use this hybrid security here, because in the case in which we need it to be equity, it will be equity. Or at least in a systemic crisis, it will be equity.

MALLABY: Matt, do you want to comment?

SLAUGHTER: The one thing I'd add is, this resolution mechanism; we see the security not as obviating the need for the FDIC or other institutions like that. If anything, this will be a complement to the good work the FDIC does.

And again there's -- the nature of the business, of financial firms, means that the resolution mechanism of bankruptcy, which we see in automobiles these days and lots of other industries, is one that has not been proven viable for a lot of financial services companies.

So having the security in place and having it have that kind of regulatory support would hopefully help going forward stabilize the financial system overall.

MALLABY: Martin, you also have another paper -- you collectively, I mean -- on bank capital itself. And perhaps you could elaborate a bit on that one.

BAILY: With respect to -- I'm confused. Which one are you referring to? I thought we were talking about the hybrid.

(Cross talk.)

MALLABY: Well, moving on from the hybrid, you have another paper on the types of -- the ways to think about how much capital an institution would need. Any of you can weigh in on this.

FRENCH: I can jump in, if you want.

MALLABY: Okay.

BAILY: Why don't you jump in and let me pick up?

FRENCH: Again the idea here -- this is bank capital requirements. And the idea again is, if you look at capital requirements that are in place, in the U.S. and in many places around the world, they view the problem from an institution-specific perspective.

So the government stands behind the bank; lender of last resort in that sense. And it's trying to protect the taxpayers from the bank's claim; if things go bad, we'll bail you out. But they're thinking about it from a specific bank's perspective.

A good example: In Europe, you get rewarded for being large, because effectively diversification kicks in. And essentially you get less -- (audio break) -- as a result of diversification which implicitly says, the larger you are, the lower the effective capital requirement.

From a too-big-to-fail perspective, that's the opposite of what you want. Too big to fail is really bad from a moral hazard problem, so what you'd like is, everything else the same, raise the capital requirements as financial institutions get large.

If you look at the capital structure of these large banks, roughly 25 percent of their assets are financed with overnight paper, so very short term; we're rolling it over all the time. What that means is, if they stumble, those overnight lenders, they just pull their capital back. Okay? Pull the capital back; now we have a crisis.

So what we ought to do is penalize the banks with higher capital requirements for using short-term debt. Okay? So it's those sorts of things where you think systemically -- okay, what are the risks involved that banks can impose on the whole system, rather than just focus on, gee, what's the uncertainty specific to this bank -- and design capital requirements from that perspective.

MALLABY: So the capital requirement goes up if you have more short-term financing. It goes up if you're too big to fail.

FRENCH: And it would also go up if you're holding less liquid assets.

MALLABY: Right.

FRENCH: So this goes back to that notion of fire sales. That, you know, I create a systemic problem if I dump lots of illiquid assets on the market trying to reduce my risk. That imposes costs on the other banks in the system. And so I want each bank to bear that potential cost that they might create.

BAILY: Can I interject, now that you've unfrozen my brain? One of the things that was interesting about the crisis was that -- when Northern Rock went down, for example. And certainly initially, at least, their portfolio of mortgages was not a bad portfolio. They did not have the kind of problems that we had had, of subprime, bad lending. So they had a pretty good portfolio. Also they took deposits, so they had a pretty good deposit base. But then they had realized that if they borrowed in the overnight market, they could issue more and more mortgages and make lots and lots of money by borrowing at 30 basis points over LIBOR in the overnight market.

So the problem that they created, then, was, as soon as that trust went down and they had to borrow at 200 or 300 basis points over LIBOR, they completely lost their capability and they went down. So the ability to borrow overnight should have changed the capital requirements that went with it.

And then there's obviously the quality of the portfolio. If they had had bad assets or if we have a financial institution that has bad assets, then you have to improve also the capital ratio that goes with it.

MALLABY: Matt, maybe you could just pan out a bit on this. I mean, you know, I think a lot of this debate on more capital and also sort of relating the capital both to the liquidity of your assets and to the type of funding you have and whether you're too big, these ideas are percolating in Washington.

But then as well there's the question of, you know, should you have -- how much more capital should be required? I mean, Greenspan once testified, right after the LTCM failure, in Congress and said: Gee, Congress, if you'd like me to avoid -- if we'd like to avoid future LTCM-type failures, we can go back to Civil War-era capital requirements, 40 percent capital requirements. I guarantee, with 40 percent capital requirements, we won't have too many blowouts.

But you wouldn't want to go there, because the implications for growth would be too severe. If the cost of capital was driven up that much by those capital requirements, you know, you would be hurting everybody's living standards.

Now, you know, in light of the pain inflicted by a crisis that stemmed in part from thin capital cushions, I think everyone's willing to revisit that issue of how much capital is reasonable.

And it relates to the question of what is the overall cost benefit in financial innovation. What do we get out of all this high- tech finance? And to what extent have we prepared to take risks that now and again there will be a blowout? Do any of you want to weigh all that? Matt first and --

SLAUGHTER: So I'd offer a thought that I think is common to the group and is shared across the four memos we discussed, which is, as a group, we recognize the very large value that financial innovation has created for the U.S. economy and the global economy. I mean, again, the global piece of this, globalization of capital markets, has generated a lot of benefits. Allocating pools of savings to investment opportunities, sharing risk differently -- those are benefits we want to preserve.

And again, the theme that we've articulated of trying to protect the financial system -- as a group, I think we struggled to find ways through policy to allow the financial system to function well and yet allow there to be some waxing and waning of the performance of individual firms. Just like in other industries, that creative destruction process in financial services is part of what generates the overall gains. And in the policies we're proposing, we're thinking of ways that we can mitigate the failure of one firm from spilling over to the broader financial system.

BAILY: I'd like to make a comment, which is not a Squam- related comment per se, although I suspect a lot of the group would agree. And that is that financial globalization has been the key ingredient in overall globalization and that overall globalization has been key to a lot of the productivity growth and the improvement in living standards that we've seen not only in the United States but around the world.

And so to have -- I think you need large institutions to operate the global financial system, and I think that system has to operate effectively in order to allow the trade and investment which is sustaining living standards in the rest of -- in the real economy.

FRENCH: Let me jump in and take your question from a different tack, which is Greenspan's argument that 40 percent capital is a really bad thing compared to -- let me frame as compared to LTCM's leverage. So at 40 percent we got leverage of about 2-1/2-to- 1. LTCM -- some of you in the room probably know better than --

MALLABY: Thirty-to-1. Thirty-to-1.

FRENCH: Thirty-to-1?

MALLABY: Until it went wrong, and then it was a hundred-to- 1. (Its steady state ?) was 30-to-1 --

FRENCH: Yeah, I was going to say a hundred to 200.

MALLABY: -- latest, yeah. I mean, 30's a lot.

FRENCH: But I mean, we saw lots of banks enter the crisis at 30- or 40-to-1, particularly outside the U.S.

If you force me to 2-1/2-to-1, or 40- or a hundred-to-1, those are my only two choices, I might go with 2-1/2-to-1.

So -- and I'm not so convinced that debt really has value, okay, as a disciplining force, but a lot of it, I think, is a combination of misperception that debt is -- I believe debt is not merely as cheap as many of the practitioners out there believe. They simply get confused about Miller-Modigliani, the fundamental principle of finance.

And then the other thing that I keep coming back to is, one of the reasons they perceive debt to be so cheap is large financial institutions aren't bearing the whole cost of the debt. If things go wrong, taxpayers come and bail them out -- "too big to fail." That's a horrible thing, and yet, you know, that creates this incentive for them to take on more debt, because they're not really bearing all the cost.

So the goal is, set up an environment in which they have to bear all those costs. Then you'll get less leverage.

MALLABY: There are two papers which I think you are working on, and which maybe people want to ask questions about in a second. Let me just ask about one of them before we open it up to the audience.

So the two -- one is about executive compensation, and the other one is about, I believe, the CDS market. And with credit default swaps and over-the-counter instruments generally, there is a lot of consensus, both in Europe and in the U.S. that we need to move towards clearinghouses, centralized clearinghouses. But although there is both activity on this in Europe and in the U.S., there doesn't seem to be that much collaboration on it.

And Ken, I know you've got some strong views on what you give up when you do not collaborate across the Atlantic on this stuff.

FRENCH: There's really two points that we're making in our CDS memo. One point has to do with this collaboration, and the idea, basically -- right now, if you go out in the marketplace, there is -- first, netting is the idea that if the three of us make a chain of credit default swaps -- so Martin buys protection from Matt, I buy protection from Martin -- Martin's essentially neutral here, if we're on the same named borrower, the same underlying instrument. Martin's essentially neutral, and yet unless we let him out of the two contracts we have, the existence of Martin in the middle is creating counterparty risk. If he fails as a result of something else that he's doing in his business, it can screw things all up.

Well, the market has actually recognized this. Even without a clearinghouse, the market would say: Well, we'll arrange things that will allow Martin to net. Okay? It's a mechanical process. It's not as easy as having a clearinghouse, but it happens.

And then the cool thing that happens is, if Martin and Sebastian have a different contract, unrelated to the credit default swap that we did, they may actually be able to net across those different contracts.

An issue that we're worried about -- one of the issues that we're worried about -- is fragmentation within clearinghouses or across clearinghouses. So to take a simple example, Martin does his first trade over in Europe and uses the European clearinghouse for the trade with Matt. Then he does the trade with me in the U.S. and clears that trade here.

In the current market, he could have cleared that off the exchange -- so he'd get out, and it's just a direct trade between Matt and myself. If we have fragmented clearinghouses, what you end up with is, we've lost the opportunity to net that trade out, because he's got cleared at one house over there, cleared at another house over here. We've lost netting. And then, even worse, if we have dedicated credit-default-swap clearinghouses, then you lose the opportunity to clear across different derivative contracts, different types.

So one of our pleas here is, sure, that's great, you know, go do clearinghouses, but don't do a hundred of them. You know, if one or two is good, that doesn't mean a hundred would be great. And what we're worried about is this proliferation or fragmentation of clearing, in which you'd really lose a lot of the benefits.

MALLABY: So the message is that there are network effects in netting.

Let's go to the audience. Please state your name and wait for the microphone. And I can see a question in the front. And I should have said at the beginning, this is on the record.

Peter Ackerman.

QUESTIONER: Hi. I'm Peter Ackerman. I'm on the board of the council. I want to just touch on two things briefly. But first I want to thank you for the exercise, because I think you're doing precisely the right thing --

MR. : Thank you.

MR. : Thank you.

QUESTIONER: -- to leap over where we are now and to think about what the system should look like.

Three things that I think you're going to find problematic, and I'm going to touch on two of them real quickly. The first is capital requirements based on liquidity; there's all -- there's a whole host of problems based on that one that we can talk about. Capital -- a systemic regulator regulating concentration risk around the world, I think you're going to find that there's a lot of difficulty in that.

But the thing I think you're going to find the most difficulty in is your concept of a hybrid security. I've just learned about it a few minutes ago, and I've been thinking it through in my mind. It works great for the regulator, but I don't believe there'll be a buyer, and let me tell you why.

I don't believe that buyers buy mandatory convertibles. Because you have two universes of buyers. You have a bond buyer, and you have an equity buyer. So the mandatory convertible becomes convertible when things are horrible, which means the stocks -- is extremely low.

So first of all, the buyer of a bond needs to have it as a bond because he might be a financial institution that basically can't record it as a bond if it has a force-conversion process. And the equity holder is suddenly looking at a bond at the worst possible moment that turns into equity, and that equity is therefore in greater jeopardy and less attractive than equity that doesn't have that mandatory convertible provision.

What I think you should look into -- and I've mentioned this before very briefly, Ken -- is that banks in the past have done something called 3(a)(9) exchanges, where you basically take your equity as it is today and issue it for debt.

That's -- because that tension is unresolved, that you talked about correctly, that debt's trading at significant discounts. So if you have, for example, a debt that's trading at 50 cents, and you have a Citibank stock at the very bottom that's at 1, and you offer 600 shares of the -- Citibank shares for the $50 (sic) stock, and -- what you're doing is you're giving the bondholder a premium. He's -- for some amount, he's willing to be a -- an equity holder at his choice, and you'll pick off people who will.

But if you do a sequence of these -- and I've done this before -- what you'll find is that the equity will go up and the bonds will go up, but you'll essentially get that debt-equity recapitalization to where you need it to be.

But securities that are designed as mandatory convertibles to start with, I don't think you're going to find the buyers, so.

MALLABY: Anybody want to --

FRENCH: We're -- we have enough faith in the marketplace -- I guess as an -- as economists we're supposed to -- that we think you're right; it's a chicken-and-egg problem. Getting this market up and going may be difficult.

But we think at -- the initial price may have to be low, but we do think eventually this market can get up and running. We don't think it's all going to be done voluntarily. You're thinking about it from the demand side, and we fully respect the difficulty on the demand side.

We also think there's going to be difficulty on the supply side, because what the -- what it does on the supply side is it forces the security holders of the financial institutions to bear their own costs. So there's going to have to be some coercion, and the result will be a lower price than the long-term price, is our guess. But at some price, you would buy these bonds.

QUESTIONER: It's structurally -- they're structurally defective.

FRENCH: That doesn't mean -- well, let me offer the bond to you now. At 2 cents for the hundred dollars, is there anyone in the room that will buy this bond? (Laughter.) My guess is, there's a price at which you will buy.

MR. : Right. Right. But if the price --

BAILY: Yeah, if the price is too low, though, Ken, then it's not attractive.

FRENCH: Then we're only -- then we're only arguing --

MALLABY: Then there are other mechanisms.

FRENCH: I totally agree. And what we need to --

BAILY: There are other mechanisms.

FRENCH: We need to find that resolution.

BAILY: Can I answer your question about international cooperation? I was at a meeting with a senior Treasury official and somebody said, "What do you think about international cooperation?" And he said, "We're all in favor of it." And there was a -- sort of a general laugh around the room.

I think that there's probably a lot more cooperation between the U.K. and the U.S. than there used to be, and maybe -- that may be almost enough. If those two entities can agree on a regulatory structure and on a way of exchanging information, then you will have covered quite a bit.

I think there's also globally a considerable amount of interest in making sure that offshore entities can't be created that just will evade these regulations. So obviously international cooperation is going to be a difficult thing. Basel demonstrates that international cooperation takes a long time, doesn't always work very well. But I think under the current environment we will at least get an exchange of information, which may be what we need in these circumstances.

MR. : You're absolutely right. That's why I'm just saying that to use the systemic regulator for just looking at the concentration risk of what's inside portfolios, that's really not where you want to be. And I don't think you're really mitigating risks that way. The risks -- the myriad of other risks, for sure, cooperation's very important, identically ratios, that sort of thing.

MALLABY: Let's go to another question. I see one at the back over there on this side.

QUESTIONER: Yeah, Chris Hayes from The Nation magazine. In terms of the risks of size, I just wanted to talk a little bit about the sort of political power issue, which is that there's technical issues vis- a-vis how things get regulated, and there's a political issue about whether those regulations are implemented and whether they're captured.

And it seems like part of the down-side risk of institutions that are too large is not just whatever technical risks they pose in terms of being regulated, but the actual amount of political power they accrue that makes them practically unregulateable.

And I wonder how much you have thought about, in sort of sketching out an architecture for regulation, the actual political problem of regulatory capture, which I think -- I think we can all admit that there were a lot of regulators that really missed the ball in the last 10 years, that were there, that missed things that they could have done, and how that's not going to replay itself if we have institutions that have the amount of concentrated political power that our current institutions have.

MALLABY: Anyone want to take a crack at that?

FRENCH: Well, there was -- there clearly was -- that became an issue with Fannie and Freddie, that they spent an enormous amount on lobbying, and allegedly that created an environment in which they were not appropriately regulated. I don't want to particularly get into that argument here.

But Congress did pass, I think, rules that said they were not allowed to lobby in quite the same way, so it may be possible that if you become an institution that is too big to fail, that there are restrictions on the lobbying activities that you can follow.

FRENCH: We're -- there's a whole range from the political spectrum in this group. We have enough libertarians that -- they're always worried about regulatory capture. And I guess, pragmatically, even a few liberals worry about regulatory capture. (Laughter.) But I understand that, but it's sort of -- the libertarians are always worried, all the time, about regulatory capture for whatever we recommend.

But pragmatically, if your choice is to throw up your hands and say, well, the big guys are going to be able to run amok anyway, I think it becomes expensive for them to do things. It's not -- it's not free for them to try to coerce the system.

So what you do is -- I mean, and if you read the memos, we actually say we anticipate these people will be arguing against this, and here's their -- the case they'll make. So we at least try to think through. We're not -- you know, I don't think we can anticipate who will have enough clout, though, to prevent things from happening, but we can predict who's going to fight to try to make that happen.

SLAUGHTER: And real briefly, if I may, we're sort of agnostic. We acknowledge the economic benefits of size in this industry, like a lot of others. There's scale economies and economies of scope. So it's not that there's an inherent -- big is necessarily bad. Our perspective across the memos is thinking there's different ways in which large institutions are going to prevent -- present larger systemic risks, and therefore capital requirements for them should be larger. It's the larger institutions that will be reporting in to the information mechanism that we imagine, as opposed to much smaller banks.

And that, again, in an ideal world, a large -- with an appropriate regulatory framework, a large institution that struggles, like a large institution in any other industry -- hopefully that will work itself out in the marketplace without the kind of regulatory capture that you rightly point out.

BAILY: And again, if your regulatory structure undermines competition, then you're going to get much more regulatory capture. So maintaining -- even though I think you can have a number of large institutions that are still competitive, and that helps you, I think, a great deal.

MALLABY: Person in the aisle here. Away from the microphone, please.

QUESTIONER: Thank you. My name is Mark Feldman with -- (inaudible). I just -- for the non-specialists among us, what -- how do you see the political future of these ideas? How do they fit in with where the administration is going and where the Hill is going?

FRENCH: How about one of the guys from Washington?

SLAUGHTER: We're hoping -- I'll defer to Martin a bit, but -- we're hoping that some of these ideas are taken up. So our goal of the group, I will acknowledge, is to try to inform the policy conversations both in the executive branch, with the relevant committees in Congress, through forums like this.

The pace of reform and the direction is -- will reside with certain obvious individuals who run committees in certain parts of the government. So we'll see.

QUESTIONER: What are they thinking about?

BAILY: I think there's a substantial effort that's being made to try to put forward these ideas. That's -- obviously this group is one. There are others that are working, and I think this group -- probably the stuff that we're writing is being read in the administration, certainly by the economists within the administration.

So I think, from that point of view, it is being -- you know, we're having a chance. We have a voice in this debate.

It's hard, obviously, to know what Congress is going to do, but I think there is also quite a lot of interest in Congress in learning and understanding the issues better, because I think it's not just a matter of -- obviously, a lot of congressmen and -women are very angry at what's happened and they want to punish and all that kind of thing, but I think there's also a lot of hunger to learn more. So I think we have a potential role to play there, too.

QUESTIONER: Robert Solomon, Brookings guest scholar and Federal Reserve Board retiree. I enjoyed your comments very much. What I observed is that you focused almost entirely on the institutions that are regulated and need to be regulated. I didn't hear very much about the nature of the instruments that have been used, and some of which were responsible for the crisis that we have. I mean, credit default swaps were mentioned once, but don't we need -- did I miss something, or shouldn't we -- don't we also need to regulate the nature of the instruments as well as the nature of the institutions?

FRENCH: What do you have in mind by the nature of the instruments? What would you regulate? Would you rule things out?

QUESTIONER: Well, I'm asking you whether we should or not I don't know. You're the expert.

FRENCH: Well, I wouldn't argue that I'm the expert, but I'll speak as an individual now. We've talked as a group, but we don't have a committed position as a group. But as an individual, I don't think there's anything that's, like, atomic in financial instruments; it's simply how those instruments are used that can create problems. So I wouldn't look at it and say let's rule out credit default swaps, let's rule out all leverage or let's rule out whatever instrument that one might choose to rule out.

BAILY: Mortgages that reset very aggressively are one candidate that people have mentioned.

FRENCH: I would like people to be informed. And in fact, we're working on a memo now on consumer protection. And what we're -- one of the things we're focusing on is what we keep calling our nutrition label. We think the label that you read on packaged foods here in the U.S. is wonderful. I can pick it up and I see, "Geez, this is going to cost me 600 calories," you know? "This one's only going to cost me 400 calories. Oh, I'll take this one."

Something that communicates the risk associated with some of these products would be tremendous. And the key for us -- talk about regulatory capture -- the key for us is to try to figure out a way to communicate valuable information that isn't easy to manipulate. And right now we're struggling with that, is there a way to actually communicate that. Calories are easy to measure. Risk of a mortgage, particularly when I can construct all sorts of really bizarre things, not so easy to communicate.

BAILY: The Federal Reserve has already made some changes in the way that they're regulating some of those mortgages.

So I think some of that, because I think it's different when you're dealing with sophisticated instruments that are traded, among reasonably sophisticated individuals, as compared to a mortgage that's going to someone who may not know a lot about the financial implications.

I'm sorry, I think I interrupted you.

SLAUGHTER: No.

I was just going to add one more though which is, at least for me but I think many in the group, we see value in diversity of innovation in financial services, like a lot of other industries.

It's difficult for us at least, as a group, to foresee where that next crisis might come from. And acknowledging that, one of the -- we have some language in the memo, on systemic regulator, pointing out that's an institution that hopefully that role will be given that's very, what's the metaphor, kind of blue-sky-thinking capability to try to think about where particular products might create problems in the future.

(Cross talk, laughter.)

MALLABY: Larry Meyer.

QUESTIONER: Larry Meyer, Macroeconomic Advisers.

Martin, I'd like to probe a little bit more the concept of a systemic regulator that you've set forth. You talked about the Fed watching and gathering information.

Now, below the surface or maybe on the surface perhaps was that the systemic regulator would also have direct supervisory responsibility for all systemically important institutions. So I wonder if that is part of the story.

Do you recommend that we retain otherwise the disaggregated form of supervision we have, of financial institutions, with separate regulators of broker-dealers and banks and insurance companies?

Let me stop there.

BAILY: Well, let me make a quick comment and then get my colleagues to chime in as well.

First of all, in general, there was a proliferation of regulators already. So in some sense, adding a new set of regulators is probably not what we needed. There were rooms full of regulators at Citibank, at B of A, all these places that may have gotten into trouble.

So it's more a question of what the function of the regulators, who they were, what tasks they were performing, the extent to which they communicate information, amongst the different regulators, that I think is more important.

Go ahead.

QUESTIONER: (Off mike.)

MALLABY: In other words, different bits of AIG were regulated by different supervisors, allowing for arbitrage between them.

BAILY: AIG is a bit of a special case. (Inaudible.) Need some help from my colleagues here. I mean, it had a perfectly good insurance business, which was heavily regulated and required substantial capital requirements and as far as I know is probably still working just fine. And then it took CDSes and ran to hell with them.

And -- so I agree with Ken. I think there's -- that there's good things about CDSs, but they obviously were not being effectively used and being effectively regulated. But I don't see why that's an argument against a systemic regulator. So I'm -- I've lost your train of thought.

QUESTIONER: I'm asking you -- I'm asking you, what should the power of the systemic regulator be? What should it do?

MALLABY: Well, you -- in one of your papers you do make quite a good argument, I think, to the extent that you've got a natural tendency in any regulator to focus on the day-to-day business of catching people who break a specific rule, and not to kind of rise up above that everyday thing and sort of say, well, where is there a gap in the rules?

And so for this reason I think you want to separate your systemic regulator from the sort of everyday regulator and -- because the everyday regulator will be captured by the pressing needs of the day- to-day.

FRENCH: Yeah. That's it exactly. I mean, our perspective is, the systemic regulator is more -- I don't want to say in the background, because they're aggregating all the information. But it's more of a background sort of regulator, overseeing the whole system, than a --

MALLABY: This --

BAILY: And it can issue a report on the state of the financial system. I mean, I don't think, (Dave ?) or Larry, that there's a lack of authority to do something about an institution that's getting into trouble. What we needed to -- what we needed was a systemic regulator, which was going to tell us when we had developed systemic risks because of what was happening in either a single institution or in a group of interconnected institutions.

MALLABY: But -- yeah?

QUESTIONER: To follow up -- I mean, what you're saying is you're going to take the -- you're going to take the current responsibilities of the Fed for bank holding companies away from it? Or you're going to extend it to other systemically important institutions? Do you want the Fed to have an active role? Or is it just reading reports and tabulating data?

MALLABY: Yeah, I mean, that's a very good question. So if you want the Fed to do the systemic job because the Fed is best equipped to do it, don't you, by extension, have to take other stuff away from the Fed? I think that's really a -- that's a tough issue.

FRENCH: Yeah, but I don't have an opinion. I'm uninformed.

SLAUGHTER: No -- so I'd offer a couple opinions.

One is, the group did not take a stance on -- I think of your specific question, Larry, on what roles the systemic regulator should take relative to the existing regulatory agencies. Practically speaking, we envision the role of the systemic regulator housed at a central bank as requiring an addition of resources to allow them to have the relevant people and resources to conduct that role.

And in terms of information that will be collected in this framework that we talk about, conditional on any country's initial structure of regulators, one of the thing (sic) we want the systemic regulator to do is to help ensure that that information is flowing more freely across those different other regulators.

MALLABY: So -- but then you would not be taking existing supervisory responsibilities away from the Fed.

SLAUGHTER: No.

MALLABY: It would still carry on doing what it's doing.

BAILY: I think the Fed would still have supervisory authority over the money-center banks. But there would be a separate entity within the Fed which would have the job of monitoring and issuing information about the systemic risk.

And that information would then be given to the people that are regulating these money-center banks.

MALLABY: Another question. Right here, yes.

QUESTIONER: Thanks, Sebastian. Camille Caesar, from Commerce. On the talk of improving or increasing capital standards, I was wondering, how do you take into account the differences in asset classes in different economies? I mean, asset-backed securities vary so much in quality, and how do you -- you know, how do you start to take that into account?

MALLABY: You mean regulating capital versus assets, versus risk assets; and if it's risk assets, who measures the risk?

SLAUGHTER: That's more detail than the group has gotten into on that specific question, so we can all take our own stab at it. But I'll speak for myself now. It's an incredibly challenging problem. I mean, we've seen Basel I, Basel II. That's basically -- those systems are in place trying to figure out, okay, what's the risk created by these different types of assets. And you know, that's a challenge that people will keep working toward.

What we're trying to do in our capital requirements memo is instead come in and say rather than just simply focus on the risk that these specific assets contribute to a bank, let's think more systemically, and just change the overall perspective so that we think of it from a systemic perspective rather than an individual bank's risk perspective.

MALLABY: There's a question in the back there. Yes, there you are.

QUESTIONER: Hi. Nancy Jacqueline, Johns Hopkins SAIS. You mentioned the problem of banks financing themselves and the short-term wholesale market and the risk that poses when they can't roll over the funding. I wonder if you'd like to comment on Sheila Bair's announced change in the assessment model, where assessments are not going to be based on deposit amounts, but rather on asset size, with a cap being set linked to the amount of deposits the bank has; so that in a sense she's making higher assessments on precisely that source of funding of banks, as well as other sources of funding that are not stable, long- term deposits.

MALLABY: So a higher assessment on short-term funding. Or larger.

QUESTIONER: They're assessments based on assets. The old assessment rule is you assess based on deposit base. Instead, FDIC assessments are going to be based on asset size, with a cap put on related to the amount of those assets that are funded by a long-term deposit base. So that you're having to pay more in FDIC assessments based on, in a sense, the riskiness of that other funding. So she's basically doing something about, it seems to me, the problem we have. Rather than putting capital charges on for those risks, she's saying you have to pay more for your deposit insurance.

BAILY: I'll make a back-handed comment, which is, first of all, I'm not in such a big hurry to undertake some of these longer- term reforms that we're talking about. So I'm not in a big rush to say exactly what some of these things -- and that may reflect some of the answers that we've given here. We want to create some of the principles which are then going to be fleshed out over time.

I think Sheila Bair is to be applauded for some of the creative proposals that she has put forward. One might like to see her operating more effectively within the overall system so that it's more of a coordinated process with Treasury. So I don't know that I want to specifically comment on what she's -- what she's doing.

MALLABY: There's one here.

Yeah. Thank you.

QUESTIONER: I'm Robert Herzstein, a Washington lawyer. Could you -- I'd like to pose a hypothetical to you and see how it would be handled. Suppose there is a -- your system is in place, there's a firm in Germany that behaves exactly as AIG has behaved, and there's another firm in France that behaves exactly as Citibank has behaved, and both of them pose a great deal of systemic risk, not only in their own countries, but elsewhere. How would your system avoid the problems we've had in the past?

FRENCH: I'll start on that one. It's not obvious that our system would solve that problem, but I hope our system would identify those problems. So the information structure that we're proposing the counterparties to -- was it Germany's AIG? We would like them to be providing information that they're making trades with Germany's AIG, so that the regulator could aggregate it up and say, hey, guys, there's a lot of exposure here to this one counterparty, and we may be needing to do something to manage that exposure.

So if nothing -- I mean, right, our understanding is, AIG walked in the day after Lehman failed and said, you know, we have a serious problem here, and that was the first that the regulators were aware of this huge exposure. We would at least like to have put an information structure in place so they won't be shocked by your German AIG, in that environment.

SLAUGHTER: And I'd add two things to that. One is, although a lot of us reside and work in the United States, a lot of the memos and principles we've articulated across the memos, we imagine applying to a lot of countries other than the United States. So on Ken's point, one could imagine an information infrastructure in the United States that would have some -- not to sound naive, but some points of contact with the information infrastructure in Germany and France and in other countries.

And the second thing I'd say on this, again, is it might be regulators that discover that information and try to make it aware to people. But again, we see value in the information that's collected and sharing it with the private sector, because it can mean incentives of a lot of companies in the private sector to try to also analyze and understand the information that these regulators are collecting.

FRENCH: Yeah, it's -- the AIG case is an interesting one. It's my understanding that Goldman anticipated there might be a problem with AIG, and they'd actually bought credit default swaps against AIG. The government was sort of caught flat-footed there. But Goldman said, you know, we've taken these big counterparty positions or CDS positions with AIG; what if AIG goes down? Let's protect ourselves by buying credit default swaps on them. Which they had done.

So, what we want is information out there in the public sector, and with that dissemination of information, you get lots more eyes thinking about these same issues.

MALLABY: Well, by my watch, we're almost out of time. So I'm going to close it up here, thank all of you for braving the weather, remind you that on cfr.org/cgs, for Center for Geoeconomic Studies, you can read all these papers in their full -- (inaudible) -- and thank our three speakers who have come today. (Applause.)

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