Thoughts on The Squam Lake Report: Reengineering the Financial System to Better Withstand Extreme Volatility

The most important contributions of The Squam Lake Report are its analysis and recommendations not for eliminating the possibility of future crises, but for enabling the financial system to better withstand the bouts of volatility that are a natural outcome of market forces. In this regard, the Report's most promising proposal is its prescription that systemically important financial firms issue “contingent capital” that converts from debt to equity when a financial firm's solvency is at risk. But if contingent capital is a good idea, the author argues that the Squam Lake proposal should be complemented by three features not addressed by the report. First, systemically important financials must be required, not just encouraged, to issue contingent capital. Second, contingent capital should not count toward normal regulatory capital requirements but function as a supplemental cushion against the possibility of crisis. Third, financial institutions should be prohibited from holding contingent capital securities issued by other financials so that losses are channeled outside of the financial system. In addition, the actual conversion of contingent capital should not depend on regulators' declaration of a financial crisis, but should occur once critical capital thresholds are breached.