Clever Geek Handbook
12 November 2025

Integrating Corporate Risk Management

Recommendation

Many corporate officers deal with risk, from treasurers and risk managers to CFOs. But since each department faces risks of a different type, risk management in many cases is an ad hoc affair. Prakash Shimpi’s vision of integrated risk management not only consolidates the risk-management practices of an entire firm, but also blends capital management and risk management into a single, cohesive framework. This framework is the centerpiece of Shimpi’s book, which also provides readers with a comprehensive look at current risk-management practices, old and new tools for managing risk, and likely future developments in the field. While the topic at hand is complex and built of often-unfamiliar jargon, Shimpi manages to present the material in an accessible and engaging manner that will satisfy financial experts but won’t intimidate novices. BooksInShort recommends this book not only to the obvious audience of risk managers, treasurers and c-level executives, but also to mid-level managers and students, who will need an increasingly sophisticated understanding of the topic as risk management becomes an ever-larger component of basic corporate strategy.

Take-Aways

  • The goal of integrated risk management (IRM) is to achieve maximum risk reduction at a minimum cost.
  • The Insurative Model captures the relationship between capital and risk by equating all of a firm’s capital to the amount necessary to cover its risks.
  • Risk mapping - cataloging and quantifying risks - is more art than science.
  • As distinctions blur between capital markets, risk management and insurance, companies can capitalize on new approaches that bridge these disciplines.
  • Advanced integrated risk management efforts require cooperation between a corporate treasurer, risk manager and chief financial officer.
  • Insurance-linked securities (ILSs) provide a new source of affordable insurance coverage and a new opportunity for investors.
  • Advances in analytical models and the standardization of risk management practices are accelerating the development of IRM.
  • Enterprise earnings protection, which indemnifies a company for deviations in earnings from projected levels, is the ultimate integrated product.
  • The creation of the chief risk officer (CRO) role is a major step in the growth of integrated risk management.

Summary

IRM Foundations

Because risk and opportunity go hand in hand, companies face a staggering array of risks. Managing these risks is sensible because it reduces a firm’s chances of experiencing financial distress and shields it from unanticipated events that disrupt its plans. While many executives contend with specific types of risk, risk management should be integrated and consolidated (ideally under a chief risk officer) to achieve maximum risk reduction at a minimum cost.

“Risk is the lifeblood of a corporation. It provides the opportunity to turn a profit, but raises the specter of ruin.”

Risk is not avoidable, but it is manageable. Companies seek to manage risks in several basic ways: risk avoidance (deciding not to undertake risky endeavors), risk reduction (preventing and controlling risks by using safety devices, protective techniques and diversification), risk transfer (insuring or hedging), and risk retention (absorbing certain risks in a cost-effective fashion.)

“A constant and close cooperation must develop between those responsible for directing activities, those responsible for raising capital to fund those activities, and those responsible for covering the risks that the activities entail.”

It is critical for firms to coordinate their efforts in all of these areas in order to make coherent risk-management decisions. For example, a firm might spend hundreds of thousands of dollars insuring its plants and equipment against accidental losses that would be far less devastating than a shift in interest rates, against which it might have no protection. Integrated risk management (IRM) provides the framework to articulate these critical relationships.

The Insurative Model

Intuition tells us that capital and risk are related, but conventional financial theory treats them separately. By considering capital structure and insurance in isolation, we fail to account for the important connections between them. The Insurative Model is a framework that captures this interrelationship by incorporating both. It equates all firm capital to the amount necessary to cover all firm risks.

“The diverse activities of line managers, the treasurer, the risk manager and others should be coordinated so that, through their joint efforts, the company achieves a maximal reduction of risk at minimum cost.”

The Insurative Model shows us that a firm’s decisions on insurance and risk retention can be just as important as its debt-equity mix. Whereas risk managers have traditionally turned to the insurance market to transfer risk to third parties and treasurers have turned to the capital markets to do the same, the convergence of the capital and insurance markets is producing risk-management tools that incorporate features of both. It’s therefore become necessary to integrate risk management at all levels. When this is accomplished, CFOs have at least three tools for optimizing their capital structure: debt, equity and insurance.

Risk Mapping

Risk mapping, or cataloging and quantifying the risks faced by a company, is more art than science. Risk mapping is not a one-time effort. It should be a dynamic, ongoing process. The steps in risk mapping are:

  1. Measurement: Establish parameters to quantify the impact of any risk.
  2. Classification: Organize a top-down framework for cataloging risk.
  3. Identification: Develop a bottom-up list of specific risks facing the firm.
  4. Assessment: Evaluate the significance of each identified risk.
  5. Analysis: Model the collective impact of risks on the firm.

Risk-Management Tools

With the convergence of the businesses of banks, insurers and reinsurers, companies in all of these fields now can be thought of as risk consolidators. Banks help companies raise debt and equity capital and also help corporations trade interest rate risk, commodity risk and foreign exchange risk in the capital markets. The insurance industry helps companies transfer risks from the firm to a (re)insurer. But banks and the insurance industry have learned from each other and borrowed techniques to develop more efficient solutions. These new solutions integrate risk management to several different degrees:

  1. Integration within markets, with a given capital structure: These techniques combine risks within either the insurance or the capital markets and can be executed by the risk manager alone. They include basket options, double-trigger options, and aggregate insurance policies.
  2. Integration across markets, with a given capital structure: These techniques integrate the insurance and capital markets and require cooperation between the risk manager and the treasurer. They include multi-line, multi-year products (MMPs) and multi-trigger products (MTPs).
  3. Integration across markets, with changing capital structures: These techniques apply to insurance and capital markets risks, separately or integrated, and generally involve the CFO and other managers. They include finite risk reinsurance, run-off solutions and contingent capital.
  4. Integration across markets, with changing market structures: These techniques require changes in the structure of the insurance and capital markets to make them viable. They include insurance-linked securities (ILS), insurance derivatives, credit derivatives and weather derivatives.

MMPs and MTPs

Multi-line, multi-year products bundle several (generally two) risks together. In the financial markets, such bundles are called baskets. The hedger is covered if combined losses from both risks are greater than a specified amount. The dealer prices the product based on the correlation of the two risks and hedges its exposure to both risks in the capital markets. In the insurance area, MMPs combine various risks - like property and casualty - and fix the loss retained by the policyholder, irrespective of which risk was the source of the losses, with the remainder up to an aggregate limit passed on to the insurer.

“Capital management and risk management are two sides of the same coin. Conventional finance theory treats them separately.”

MMPs can cover traditional insurance risks like fire, financial risks like interest rate fluctuation, and the previously uninsurable, like political and business risks. They finance risk more effectively because they diversify a portfolio of risks spread over time. Policyholders benefit from efficiency gains, stabilization of risk costs, administrative efficiency and flexibility.

“As the distinction blurs between corporate finance, risk management and insurance, corporations have the opportunity to achieve a higher level of capital efficiency by drawing on new ideas that bridge these disciplines.”

In multi-trigger products, payments are made on one risk only if triggered by an event on another risk. For example, an oil company might consider an MTP in which catastrophe coverage is provided only if oil prices fall below a certain trigger level. MTPs provide protection from disaster scenarios and present substantial price advantages. But companies of questionable financial strength run a high risk if they use MTPs to save premiums.

“The chief executive officer (CEO) is responsible for a firm’s success in the marketplace and may therefore be deemed its ultimate risk officer.”

The ultimate integrated product is right at the bottom line: enterprise earnings protection. A number of products are already in the works to indemnify a company for deviations in earnings from projected levels. Such a product would hedge all known and unknown risks in a single basket, with the probable exception of losses due to a market downturn.

Finite Re

Finite risk reinsurance combines risk transfer and risk financing. The reinsurer assumes a limited risk for a multi-year term. Profits that accrue over that period are shared with the company as compensation for the limitation on the risk coverage. For clients, finite re can smooth financial results and help optimize balance-sheet structure. There are many types of finite re contracts available, including loss portfolio transfer (LPT), adverse development cover (ADC), and spread loss treaty (SLT).

“The time has come to begin thinking about capital structure more broadly, not as debt and equity, but as debt, equity and insurance.”

Changes in tax legislation and accounting principles have increased the demand for blended covers, which combine finite and traditional reinsurance elements. Blended covers allow disparate risk types to be included in a single multi-year package, while frequently occurring, easily predicable minor losses remain in the retention. These predictable risks can be covered with a multi-year finite solution.

CC and ILSs

Contingent capital (CC) first gained popularity in the insurance industry. A CC instrument is an option to raise a limited amount of equity or debt upon the occurrence of an agreed-upon event. The sources of this capital are mostly banks, reinsurers and the capital markets. CC enables a company to retain the risk of low-probability, high severity events without dragging down return on investment by raising the capital to cover such risks in advance.

“Earnings protection takes the integrated concept to the furthest extent possible - where all risks, both known and unknown, traditionally insurable and not, are hedged in a basket program.”

Insurance-linked securities (ILSs) include over-the-counter swaps, exchange traded and over-the-counter options, and private placement bonds. These securities provide a new source of competitively priced insurance coverage and create a new investment opportunity for institutions outside of the insurance industry. The annual U.S. ILS market could reach $10 billion within the next 10 years.

“Adopt integrated risk management and your company or job (if not necessarily your soul) will be saved (or at least vastly improved).”

Most ILSs to date have been catastrophe, or cat bonds whose coupon and interest payments depend on the performance of a pool or index of natural catastrophe risk, rather than actual losses. For issuers, ILSs offer attractive pricing, additional reinsurance capacity, credit enhancement and greater leverage. For investors, the securities offer attractive returns and an opportunity to add diversification to their overall portfolios.

The Future

There are many trends in the financial world acting as catalysts for the growth of integrated risk management. Shareholders are concerned about the efficient use of their funds, public officials are looking after the interests of consumers, shareholders and policyholders, and ratings agencies and other financial intermediaries are taking a much closer look at the risk-management abilities of managers. Advances in analytical models that measure risk and the standardization of risk management practices are also accelerating the development of IRM.

“Sitting on the sidelines as new markets evolve means missing opportunities. History teaches us that significant economic profits go to market innovators.”

But there are still barriers that must be overcome, especially the bureaucratic inertia that makes it difficult to cross traditional functional lines. In addition, the high transaction costs, complexity of the products and uncertainty about regulatory and accounting treatment are all negative factors.

The U.S. has taken the lead in alternative risk transfer (ART) solutions and the prospects there are bright due to the increasing importance of the capital markets and the integration of risk management tasks within corporations. In Europe, development in the U.K. is relatively advanced, while the market remains in its infancy on the continent. But the European regulatory, tax and accounting environments are favorable to innovation, and the region should see strong growth for ART solutions in the medium term. The development of ART solutions is just beginning in Asia and Latin America.

The CRO

An important step in the growth of integrated risk management is the creation of the chief risk officer role within a number of firms, mostly in the finance industry. The CRO manages the identification and measurement of all risks faced by his or her company, as well as the efficient use of risk capital. Ideally, the CRO should be senior management, reporting directly to the CEO. He or she should have no direct business or revenue responsibility, acting instead like an auditor or an accountant.

The CRO will become the champion for IRM as a framework from which to rationally assess and measure the relationship between the risks that a company faces and the capital resources it has at its disposal.

About the Author

Prakash A. Shimpi is Managing Principal (U.S.) for Swiss Re New Markets. Swiss Re is a leading reinsurance firm with a global reputation for innovative financial techniques and management. Prior to joining Swiss Re in 1995, Shimpi was managing director of the Global Insurance Corporate Finance Division of Chase Manhattan Bank.

Read summary...
Integrating Corporate Risk Management

Book Integrating Corporate Risk Management

Thomson Texere,
 


12 November 2025

The Evolution of Technical Analysis

Recommendation

Finance professor Andrew W. Lo and research specialist Jasmina Hasanhodzic present a history of finance and of the development of business and stock markets. Their informative research connects the commerce of ancient times to modern practices, theories and analytical methods. BooksInShort recommends this sweeping and engaging history to professionals curious about how business evolved and to students majoring in economics, finance, history or related disciplines.

Take-Aways

  • Technical analysis uses patterns in past market data to predict future prices.
  • The practice dates back to the ancient civilizations of Babylon, Greece and Rome.
  • Rapid population growth, the expansion of trade, the abacus and paper money contributed to the development of China’s merchant class.
  • The stock ticker, telegraph and telephone transformed business on Wall Street in late 19th-century America.
  • Charles Dow and his successors introduced scientific methods such as “data gathering, hypothesis testing and mathematical rigor” to technical analysis.
  • Dow’s theory attempted to explain how human psychology affects market prices.
  • “Relative strength” measures a stock’s performance compared with others in its industry.
  • A market cycle lasts approximately 10 years, according to the “market cycle theory.”
  • Computers help, but people are still better at some aspects of technical analysis.
  • Proponents of the efficient markets hypothesis reject technical analysis, but recent studies in behavioral finance support it.

Summary

How Technical Analysis Works

Technical analysis seeks patterns like cycles or waves in past market data to forecast prices. This kind of study originated long before computers permitted the development of today’s math-intensive, analytical theories. Technical analysis and quantitative analysis both attempt to predict the future based on the past, but quantitative analysis depends on a rigorously mathematical approach, while technical analysis applies human judgment and interpretation to data. “One is statistical, the other is intuitive.” The investment industry more commonly uses quantitative analysis, while technical analysis prevails in commodities and currency trading.

Ancient Arithmetic

Ancient civilizations left many examples of their technical analyses, including “Babylonian price records, Greek market sentiment assessments and Roman seasonality patterns.” These early societies followed market prices and sought to gauge how supply and demand shifts would affect prices and profits. They also applied insights gleaned from astrology and weather observations.

“It should come as no surprise that in ancient times technical forecasting methods were inextricably linked with and...arose from trading and speculation.”

Early Babylonian commercial innovations included using a system of weights and measures, as well as formalizing deals with contracts written on clay tablets. The Babylonians invented limited partnerships, in which one partner raised capital and another traveled for business. Babylonians accumulated great stores of wealth. Traders often acted as brokers, buying and selling merchandise they did not produce.

“Nowhere was the focus on getting rich so pronounced as in ancient Babylon, an early hotbed of commercial innovation.”

In ancient Mesopotamia, the word “street” implied the market. The Babylonian language had words to connote merchant stalls, prices and marketplaces. Assyrian documents record price fluctuations and suggest that increases in demand led to increases in prices. For almost four centuries, the Babylonians kept journals of weather readings and the prices of various commodities. These diaries quoted prices as the amount that one “shekel of silver” (the basic unit of money) could buy. They documented the value of Babylon’s six staples: “barley, dates, mustard, cardamom, sesame and wool.” Modern technical analysis also monitors a small number of well-chosen stocks over a long period of time. Babylonians charted their markets and sought to forecast future prices based on existing prices. If a price forecast was unfavorable, they took action to control the future supply and demand. For example, they might shut down the market briefly or bring scarce commodities into play.

“The union of banking and trade...naturally led to speculation, which became so pronounced that it...prompted Aristotle to write about chrematistichè, or the art of getting rich.”

The market-based economy arose in ancient Greece. Farmers focused on particular crops and produced them for export. As the economy grew, demand for such specific services from farmers, craftsmen and merchants increased. People no longer produced all their own food but instead bought what they wanted from specialized growers.

Coinage, Banks, Fairs and Markets

Coins appeared around 650 BC. The first banks were religious institutions, which accepted deposits and lent money out for interest. As banks became private institutions, instead, the banking profession emerged. Ancient Rome’s commercial environment featured “market-oriented agricultural production,” an increased demand for luxuries, the regular issue of Roman coinage, and national and international free trade. Romans built permanent market halls and opened specific marketplaces for cattle, vegetables, wine and general provisions.

“A passion for making money was considered a deep character flaw that evinced poor control over one’s emotions and an amoral willingness to exploit others for one’s own profit.”

Even in those early times, people held negative opinions about traders and businesspeople. Cultures from China to Greece saw merchants and traders as greedy, dishonest and unreliable; society considered the desire to make money a character flaw.

Technical analysis went global starting in the fifth century. Price charts became widespread in Europe. Chinese manuals advised merchants to learn how to predict changes in the price and availability of goods based on cycles. With the rise of exchanges, the merchant class matured. Public contempt for traders subsided; people began to tolerate and even respect them.

“The societal embrace of trading did not materialize in medieval and renaissance Asia to the same extent, despite its technological superiority.

In medieval Europe, the clergy decreed that townspeople must hold their markets on weekdays in the streets or squares instead of in churchyards after Sunday services. Markets served local inhabitants, while fairs catered to traveling traders. Fairs dealt in wholesale goods rather than in retail products, lasted several days and took place either once or twice a year. These gatherings were central to European commerce for centuries, but advances in transportation and communications during the Industrial Revolution led to their decline and eventual replacement by year-round produce markets.

Evolving Western Business Practices

During the Renaissance, Europeans discovered the New World and the route to the Far East. This exploration opened European markets to overseas clients and created commercial and political rivalries among nations. In medieval Italy, merchants wrote bills of exchange as proxies for cash. Banks encouraged saving and investment, increased the supply of capital available to merchants, handled deposits, lent money and allowed depositors to withdraw cash with prior notice.

“For example, the Chinese invented the printing press and used it to print money at least three centuries before Europeans.”

Business methods became more systematic as commercial practices grew more complex. The adoption of Arabic numerals in the 12th century simplified calculation. New business manuals told merchants about the locations of markets and fairs, including their array of traded commodities, local customs and transport options. They also described weights, measures, currencies, exchange rates, business techniques and accounting methods.

“The merchant class [instituted] lay education in the Middle Ages, putting an end to solely monastic education and the use of Latin in business and private life.”

In the Middle Ages, the Catholic Church taught that making money was wrong. The doctrine of the “just price” stated that it was dishonest to sell an item for more than it was worth. The usury doctrine maintained that charging interest on loans was a mortal sin. Traders circumvented church rules by buying bills of exchange for less than their face value or intercepting goods in transit and reselling them at higher prices.

“The adoption of Arabic numbers in the 12th century was a big step forward because they tremendously simplified calculation.”

Over time, the church changed its attitudes toward making money. It recognized that the laws of supply and demand governed prices and that charging interest was acceptable within limits. As a result, the definition of usury changed from “interest charged for loans” to “excessive” interest on loans. The Protestant Reformation in the 16th century reduced the authority of the church and established a moral system based on thrift, hard work and honor, particularly keeping promises. Social attitudes toward trading further softened, and investing became socially acceptable.

Analysis in Historic Asia

“Medieval and renaissance Asia” did not embrace trading to the same extent as Europe did. Asian governments were more oppressive than European regimes, so merchants had to overcome restrictive regulations and policies. The origins of Chinese markets date from the “Commentaries” of the ancient Book of Changes, also known as the I Ching. Between the eighth and the 13th centuries, China’s merchant class emerged. Rapid population growth, trade and technical innovations – such as the abacus and paper money – spurred China’s economy.

“Banks...encouraged individuals to save and invest [and] increased the supply of capital available to merchants...fueling economic growth.”

Technical analysis arose in Japan as the country’s rice exchanges emerged, shaped by national political unification in the late 16th and early 17th centuries.

Charles Dow

By the mid-19th century, “financial speculation” gained acceptance as one of the four accepted principles of wealth production, along with “work, capital and trade.” In late 19th-century America, the stock ticker, telegraph and telephone transformed business on Wall Street. Charles Dow, the father of modern technical analysis, began publishing the Dow Jones Industrial Average, which was the “average price of the 11 most active stocks on the New York Stock Exchange.” Dow and his successors introduced scientific methods such as “data gathering, hypothesis testing and mathematical rigor” to technical analysis. Yet these developments did not change public skepticism and mistrust in regard to technical analysis.

“Chinese merchants operated on the belief that the market was not a mysterious force beyond control but one that could be understood, mastered and manipulated.”

Dow’s theories sought to explain how human psychology affected market prices. He described his concept of the “trend” as patterns in “successive highs and lows.” According to Dow, the market is in a “bull period as long as the average of one high point exceeds that of previous high points. It is a bear period when the low point becomes lower than the previous low points.” Other methods for reading and interpreting the market include:

  • “Relative strength” – This is a comparison of how one stock performs in relation to shares of other companies in the same industry.
  • “Market cycles” – A market cycle lasts approximately 10 years: five to six years of boom followed by a bust or depression of roughly the same duration.
  • “Wave principle” – The stock market follows a cyclical pattern. Each cycle has eight waves: five waves in one direction, followed by three waves in the opposite direction.
“Breakthroughs in communications made time shrink, transforming the way business was conducted on Wall Street and solidifying an ethos of impartial, numerical representation of financial reality.”

Critics disparaged technical analysis because it is based on pattern recognition, not statistical analysis. Before computers, analysts used data patterns to detect supply and demand imbalances. Each pattern told a story based on market psychology and crowd action and reaction. But after the stock market crash in 1929, statistics provided investors with greater objectivity in financial dealings. Investors could use trading volume – the number of shares involved in stock sales or purchases – as a measure of supply and demand for shares.

New Developments

The financial world is vastly more complex today than ever before, but technical analysis remains meaningful because it is “so robust and so deeply relevant to how markets operate.” Technical analysts have adapted their methods to deal with these developments:

  • “Small investors” – The bull market in the 1950s and 1960s created prosperity that attracted individual investors and day traders.
  • “Institutional trading” – Small investors in bull markets led to a growing number of mutual funds specializing in the US stock markets and in international investments.
  • “Negotiated commissions” – The SEC mandated a transition from fixed commissions to graduated commissions in 1971.
  • “Market integration” – The US dropped the gold standard, also in 1971, requiring investors always to consider the strength of the dollar. Foreign currency derivatives allowed investors to hedge movements in the dollar’s value.
  • “Decimalization” – The exchanges now quote stock prices in decimals instead of in fractions of a point. That construct reduces the spread between the bid and ask prices of shares: the bid/ask spreads, advance/decline lines and high/low statistics. A stock can “go up one cent and make a 12-month high.”
  • “Electronic markets” – Electronic exchanges now match buyers and sellers without a market maker or specialist. Electronic markets enable “streamlined procedures, fast execution, reduced commissions and after-hours trading.”
  • “Computers” – Computerized “automatic ranking and filtering” of securities enables immediate communication of financial data. Technical analysis still requires great expertise, because the market is too complicated to represent with only equations and statistics. People are still better than computers at classification and image recognition.

Technical Analysis and the Efficient Markets Hypothesis

The efficient markets hypothesis (EMH) states that no one can predict market price changes in a “properly functioning market.” It is based on the idea that – given an ideal competitive market with many self-interested participants – current stock-market activity reflects all relevant factors that determine value. It omits no information that indicates useful patterns or trends in market data. Proponents of the EMH do not believe it is possible to find “exploitable patterns in historical market prices,” and thus dimiss the foundation of technical analysis. Yet technical analysis is more in tune with behavioral finance, which calls for the use of “social, cognitive and emotional factors to explain and predict market activity.” More recent studies have provided “new theoretical underpinnings...and empirical validation” for technical analysis.

About the Authors

Andrew W. Lo is a professor of finance at the MIT Sloan School of Management and the chairman of the AlphaSimplex Group, where electrical engineer and computer scientist Jasmina Hasanhodzic is a researcher.

Read summary...
The Evolution of Technical Analysis

Book The Evolution of Technical Analysis

Financial Prediction from Babylonian Tablets to Bloomberg Terminals

Bloomberg Press,
 


12 November 2025

The Squam Lake Report

Recommendation

This slim volume is named after the isolated New England resort where 15 renowned economists, academics and policy makers met in the fall of 2008 to devise solutions to the “World Financial Crisis.” That they convened amid fast-paced, seismic economic events adds to the star-chamber aspects of their collaboration. Still, these éminences grises – all nonpartisan, without commercial sponsorship or political axes to grind – developed their ideas by sharing their expertise. Their recommendations cover reforms in banking, financial products, regulation, compensation, pensions and hedge funds – all the named villains of the last crisis. Why did they issue these ideas? So they could educate political and fiscal leaders – if they would only listen – about possible laws that could help avert or lessen the likelihood and impact of future meltdowns. BooksInShort recommends this sound advice to students of and participants in the global economy.

Take-Aways

  • In 2008, 15 economists met at Squam Lake, New Hampshire, to hash out global economic problems in the wake of the “World Financial Crisis.”
  • Their nine recommendations for new laws addressing the issues, conflicts of interest and banking catastrophes that unfolded during the crisis include:
  • Institute a “systemic regulator for financial markets” using central banks as overseers.
  • Establish “a new information infrastructure for financial markets” to shed light on the “shadow banking system” of hedge funds, derivatives and the like.
  • Regulate “retirement savings”. Govern financial executives’ compensation.
  • Regulate “hybrid securities” and create faster, better crisis “resolution options.”
  • Establish clearinghouses and exchanges to monitor and control credit default swaps.
  • Build up bank “capital requirements” to mitigate runs by requiring liquidity and institutional “living wills.” Make brokers separate client funds from institutional funds.
  • New reforms should place failure’s onus on financial institutions, not on taxpayers.
  • If the Squam Lake proposals had been in effect before the World Financial Crisis, Bear Stearns, Lehman Brothers and AIG may have had completely different histories.

Summary

Squam Lake

Amid the raging economic storm of autumn 2008, 15 top economists assembled at tranquil Squam Lake, New Hampshire, to construct a series of recommendations. Their objective? To educate and assist politicians and policy makers on financial system reform. The 15 gurus especially wanted to mitigate the negative, “unintended consequences” that well-intentioned legislation often introduces.

“We have aspired to help guide the evolving reform of capital markets – their structure, function and regulation.”

Despite the rapid pace of events that fall, the economists focused on long-term issues and their solutions. They analyzed and concurred on nine major areas: banking regulation, financial transparency, pension reform, capital requirements, executive compensation, bank capitalization, moral hazard, and the “shadow banking system” of hedge funds, credit default swaps, brokerages and investment banks. They collaborated on reports, outlining their reasoning and conclusions on each topic. To insert their findings into “policy conversations in real time,” they subsequently conferred with members of the US Congress, the Federal Reserve, the European Central Bank, the Bank of England, the Banque de France and other global, high-level government institutions.

“Though informed by the lessons of the Crisis, our proposals are guided by long-standing economic principles.”

Two precepts underlie the Squam Lake recommendations: First, the experts want legislators to consider the impact of reform on financial markets as a whole, not just on single companies. Second, any new rules should put “the costs of failure” squarely on financial firms, not taxpayers. Eliminating “too big to fail” thinking would lead to more sensible risk taking among the firms. Events in the fall of 2008 – the US government takeover of Fannie Mae and Freddie Mac; Lehman’s demise; the AIG, ING and UBS bailouts – all figured in the global credit shortage. “Fascinating market pathologies” seized up liquidity for banks, plus hedge funds, arbitrageurs and other shadow banking world operators. The crisis bared four drawbacks to the financial system:

  1. “Conflicts of interest” – The “highly uncertain future payoffs” inherent in financial transactions mean that traders will assume more risk when they’re paid handsomely on good trades, but not made to suffer on bad ones. Shareholders face a similar conflict, or “agency problem,” with a firm’s managers, who may take undue risk when their compensation isn’t sufficiently tied up in shares. Investors discourage troubled banks from raising new capital because they fear the dilution of their shares, resulting in “debt overhang.” Conflicts pit financial investors against society’s best interests: Healthy financial institutions spur growth and jobs, but failing banks can cause economic breakdowns, so governments rescue them. These “privatized gains and socialized losses” mean shareholders come out whole at the expense of taxpayers. Too-big-to-fail thinking adds risk to the system and chips away at the freedom of capitalist societies.
  2. “Bankruptcy and resolution procedures” – In the US, bankruptcy rules allow companies to continue operating while their financial side undergoes repair. But that doesn’t work for banks, all of whose operations are financial. Plus, because of banks’ short-term funding, lenders who beat a hasty retreat at the first signs of trouble will bring down firms quickly. Even insured depositors may “run” on their banks, preferring to withdraw their cash now than wait for a government bureaucracy to pay them. Troubled banks have to conduct “fire sales” of their assets that can drive prices down precipitously, endangering other banks. Intricate connections among financial institutions create domino-like scenarios when one is failing. Institutional knowledge disappears when a bank does, and the loss of a lender can threaten its commercial clients.
  3. “Bank runs” – Financial entities underwent “a modern version of bank runs” during the World Financial Crisis. Investment banks that fund themselves overnight with commercial paper, repurchase agreements and other collateralized borrowings saw many of their traditional counterparties head for the exits. Due to market uncertainty, lenders wanted more collateral and turned away from even secured transactions. Hedge funds that settle trades through investment banks’ prime brokerage units pulled their collateral and business from any firm they considered doubtful. Bear Stearns saw $5 billion in cash vanish when a major client withdrew its business; within a week – after churning through $18 billion in liquidity – Bear failed, a victim of a “destructive and self-fulfilling” run.
  4. “The inadequacy of the regulatory structure” – Financial regulation, declining for years, did not keep pace with financial innovation. New products and structures can improve the economy, but can also undermine markets if not properly monitored. Creativity often arises from legal limits. Piecemeal regulations centered on single banks are inadequate for proactively monitoring complex, interrelated fiscal markets.
“We believe our recommendations will help prevent or mitigate future crises even though we do not fully understand all the causes of the last one.”

Each of the following policy proposals, had they been in place before 2008, might have lessened or even prevented many of the World Financial Crisis’s worst results.

“A Systemic Regulator for Financial Markets”

Current regulatory schemes that focus strictly on individual banks’ safety and soundness overlook the interrelationships among firms and markets, and the changes wrought by financial innovation. Look no further than the shadow banking system, which transacts freely under no current legislative control. Instead, “one regulatory organization in each country should be responsible for overseeing” its fiscal system’s “health and stability.” This systemic regulator should be divorced from consumer protection, which can be inherently short sighted and political. A central bank should take this role: It is the hub of economic activity, it interacts with market participants, it is typically apolitical and it has the monetary heft to intervene in crises.

“A New Information Infrastructure for Financial Markets”

Lack of good information dogged the administrators working to save AIG and other firms. Making financial entities supply data about derivatives would highlight related exposures among counterparties; information on “bonds, mortgages and asset-backed securities” would reveal the extent of “fire-sale risk” in case of forced liquidation. Governments need an information infrastructure that can collect, analyze, report on and react to indicators of emerging crises.

“Regulation of Retirement Savings”

More US corporations offer “defined contribution pension plans,” where employees choose how to invest their nest eggs. While such plans give workers control over their investments, protection from employer bankruptcies and job-change portability, they also place a huge burden on people to understand investing. Governments have a stake in citizens’ investment choices, since people’s earnings can relieve pressures on entitlement programs. A “simple, standardized disclosure label” on products offered for retirement accounts, similar to those on food, should note an investment’s fees and risk profile, but not its past returns, which can be misleading. Workers who do not expressly opt out should, by default, have 5% of their salaries automatically invested in their firms’ retirement plans, in diversified investments with limits on their stakes in employer shares.

“Reforming Capital Requirements”

Economies still depend on banks moving money from savers to borrowers, so banks need capital requirements that better reflect their relative risk profile. Big banks with broad networks should hold more capital than small local banks. Similarly, self-financed banks with riskier short-term debt should hold more reserves than banks relying on dependable customer deposits. The less liquid a bank’s assets are, the higher its capital charges should be. Regulators will have to mitigate the potentially negative aspects of increased capital requirements, such as banks becoming less price-competitive, driving consumers to smaller or even overseas financial institutions.

“Regulation of Executive Compensation in Financial Services”

Although high executive pay draws lots of press, regulators should not legislate bankers’ compensation. Markets can best dictate remuneration. Real financial skill is discernable and powerfully profitable, while failure is brutally expensive. An investment banker can turn an idea into a disaster or can succeed and promptly decamp to a rival firm. Still, the salary in “systemically important financial institutions” is fair game for regulation, especially if that can mitigate bankers’ incentives to take incautious risks. Firms should withhold a significant, fixed-dollar part of senior executives’ annual pay for several years. If the employee quits or is fired, or if the firm dissolves or accepts government aid, the “holdback” is lost. Such holdbacks also can give firms a capital cushion during crises.

Regulate “Hybrid Securities”

To avoid taxpayer bailouts, financial entities should issue long-term hybrid securities – before rocky times – that begin as bonds but turn into equity under specific conditions. The systemic regulator would trigger this change by declaring a crisis. The conversion would result in an immediate infusion of capital in troubled markets. Thus, the onus of maintaining a bank’s solvency stays with its shareholders, not the public. Policy makers and bank executives should collaborate on the details of such securities.

“Improving Resolution Options”

Complex international firms that needed government intervention during the financial crisis presented supervisory bodies with many challenges. Regulators could not claim proper “legal authority” to sell or restructure private firms that were subject to myriad regulatory systems; nor could they understand all the networks and connections among a firm’s subsidiaries and external counterparties. Systemically crucial financial institutions should file quarterly “living wills,” road maps for unwinding or reorganizing in a crisis. Such “rapid resolution plans” would supply up-to-date details on legal structure, shareholders, contingent liabilities, contracts, major assets and the like. Banks with inordinately complex operations should maintain more capital. Global regulators now should begin negotiating a “unified cross-country resolution process.”

“Credit Default Swaps, Clearinghouses and Exchanges”

Economic downturns can send systemic tsunamis across the $25-trillion credit default swap (CDS) market. Clearinghouses acting as buffers between parties to a CDS could help a failure’s systemic impact. Counterparties would not be directly exposed to each other, but to the clearinghouse, which would net outstanding amounts, reducing overall exposures. The clearinghouse – which should clear other derivative products as well – must hold enough capital and maintain effective controls on its operations by legislative fiat. Institutions should trade recurring derivatives on an exchange or within a reporting system.

“Brokers, Dealers and Runs”

Brokers can, to a certain extent, commingle client assets from their clearing and prime brokerage units with their own proprietary assets for short-term funding. Therefore, when panic ensues, hedge funds and other clients create runs as they withdraw their collateral. Mandating greater segregation of funds would cut the likelihood of runs. “Liquidity requirements” on broker-dealers and banks would disregard client assets as a stable source of financing.

If Only...

Had these proposals been in effect prior to the World Financial Crisis, Bear Stearns could have relied on its hybrid securities and compensation holdback for capital, and its living will could have given regulators vital data at a critical time. A systemic regulator would have seen Fannie’s and Freddie’s risks and forced them to raise more capital. Lehman’s regular reporting of its positions and its derivatives clearing would have lessened its risk to the system; its bankruptcy would have been more orderly. And AIG could have used every Squam Lake recommendation.

About the Author

The Squam Lake Group is a non-partisan, non-affiliated group of academics who offer guidance on the reform of financial regulation. Dartmouth Professor Kenneth R. French coordinated 15 contributors, including former, current and future American Finance Association presidents; an ex-Federal Reserve governor; a former IMF chief economist and several former Clinton and Bush Council of Economic Advisers members. They are: Kenneth R. French, Martin N. Baily, John Y. Campbell, John H. Cochrane, Douglas W. Diamond, Darrell Duffie, Anil K. Kashyap, Frederic S. Mishkin, Raghuram G. Rajan, David S. Scharfstein, Robert J. Shiller, Hyun Song Shin, Matthew J. Slaughter, Jeremy C. Stein and René M. Stulz.

Read summary...
The Squam Lake Report

Report The Squam Lake Report

Fixing the Financial System

Princeton UP,
 



All Articles
Load More