squamlakeworkinggroup

1. Responding to the Financial Crises: Lessons Learned Bank Structure ConferenceMay 8, 2009Anil K KashyapUniversity of Chicago Booth School of Business

2. www.squamlakeworkinggroup.org Martin N. Baily Brookings InstitutionAndrew B. Bernard Dartmouth CollegeJohn Y. Campbell Harvard UniversityJohn H. Cochrane University of ChicagoDouglas W. Diamond University of ChicagoDarrell Duffie Stanford UniversityKenneth R. French Dartmouth CollegeAnil K Kashyap University of ChicagoFrederic S. Mishkin Columbia UniversityRaghuram G. Rajan University of ChicagoDavid S. Scharfstein Havard UniversityRobert J. Shiller Yale UniversityMatthew J. Slaughter Dartmouth College Hyun Song Shin Princeton UniversityRené M. Stulz Ohio State University

3. Lessons from the financial crisis Outline • Deleveraging and pro-cyclicality • Resolution of large institutions • Political economy

4. Primary Dealers’ Mean Leverage

5. Lessons from deleveraging • Basel II sorely deficient – cannot regulate firm by firm • Scope for monitoring will be expanded • Track anyone large who contributes to fire-sales • Capital levels • Market levels bind during the crisis, not during the boom • Need to make sure that institutions are forced to recapitalize • Contingent equity

6. Costs from inadequate resolution options • (Need to realize short-term debt is the market’s discipline device – instability is unavoidable) • Counter-party linkages have expanded the safety net much farther than anticipated • Yet the financial system remains fragile • Moral hazard for the foreseeable future is large • Cost to taxpayers is huge • Goal must be a way to unwind a large player • Mandatory dissolution plans • Need to stabilize expectations about which parts of the capital structure are protected

7. Political economy: the great unknown • Beggar they neighbor ad hoc rescues very costly • Still no good cross-border coordination mechanism • What is going to happen to the foreign subsidiaries of after the failure of a major institution based in a small country? • Demonization of finance industry • Directly undercuts private sector willingness to help recapitalize • No ability to enact narrow legislation • State controlled banks tempting to use for industrial policy….

8. The end game(that we know from past crises) • Banks will need to be recapitalized • Some banks will be liquidated • Losses will need to be allocated • Some bad assets moved out, good parts of the banks restarted • Will the political system permit this to happen promptly or will the crisis stretch on? • Lack of political will is the biggest risk to prolonging the crisis