The Lessons of the Financial Crisis
Rene Stulz

René M. Stulz

In examining the world financial crisis, René M. Stulz and 14 other leading economists believe that the government should require banks and other financial institutions to withhold compensation for top executives that would be forfeited if their firms go bankrupt or receive extraordinary government assistance.

“We think that (this practice) will lead executives to take actions that will make bailouts less likely,” says Stulz, Everett D. Reese Chair of Banking and Monetary Economics and director of the Dice Center for Research in Financial Economics.

Re-examining the structure of executive compensation is one of eight urgent recommendations found in The Squam Lake Report (published by Princeton University Press), which offers a unified, coherent voice for fixing the troubled financial markets. The report’s release coincides with one of the largest overhauls of the financial system since the Great Depression.

Stulz, Fisher’s preeminent financial economist and risk management expert, is among the book’s authors. He and a handful of the world’s top economic minds formed the Squam Lake Working Group in late 2008 during the crisis. These academics hope to reach policymakers directly, and they appear to be listening. Ben S. Bernanke, chair of the Federal Reserve Board, gave the keynote speech at the book’s launch in June. Stulz and other Squam Lake members have testified in front of congressional committees and provided input to the executive branch.

The book’s authors offer eight recommendations, including creating a systemic regulator to oversee the health and stability of the overall financial system. They also want a resolution authority established for non-financial firms, which would encourage these firms to create their own rapid resolution plans—so-called “living wills” to help authorities anticipate and address difficulties that might arise in a resolution. In all their recommendations, Stulz and others hope government officials consider the implications of any regulation on both individual institutions and the financial system as a whole.

“I think we have taken many useful steps. However, at the same time, the Greek crisis has made it clear that we still have many of the problems that caused the subprime collapse to have such a dramatic impact,” says Stulz, who admits that the crisis has increased the occurrence of government bailout of large institutions viewed “too-big-to-fail.”

He says a major factor that led to the crisis was global imbalances in savings and investments.

“A number of countries save more than they invest—in some cases, because they keep their exchange rate too high, and we save less than we invest. These imbalances lead to large inflows into the United States,” Stulz says. “The huge capital inflows went into houses we found out we did not need. If we are going to have such large capital inflows, they should go into investments that lead to greater long-term growth rather than consumption or public deficits. Otherwise, we will have debt we can’t afford and unemployment we can’t live with.”

Stulz believes how much the financial system becomes more robust “will depend critically on how regulators choose to implement the new laws. We expect to be active in making sure that regulators take steps that make the financial system safer without making it less efficient.”

This watchdog role is much needed, as Stulz voices serious concern about complacency among firms even as the crisis continues to affect capital markets and economies worldwide.

“For some firms, it seems that the credit crisis occurred in a different century. It is critical for boards to keep pushing for changes in risk management that reflect what we’ve learned from the crisis,” he concludes.

“For some firms, it seems that the credit crisis occurred in a different century. It is critical for boards to keep pushing for changes in risk management that reflect what we’ve learned from the crisis.”

René M. Stulz

Everett D. Reese Chair of Banking and Monetary Economics

Director of the Dice Center for Research in Financial Economics

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