Responding to the Financial Crises: Lessons Learned Bank Structure Conference May 8, 2009 Anil K Kashyap University of Chicago Booth School of Business

Martin N. Baily Brookings Institution Andrew B. Bernard Dartmouth College John Y. Campbell Harvard University John H. Cochrane University of Chicago Douglas W. Diamond University of Chicago Darrell Duffie Stanford University Kenneth R. French Dartmouth College Anil K Kashyap University of Chicago Frederic S. Mishkin Columbia University Raghuram G. Rajan University of Chicago David S. Scharfstein Havard University Robert J. Shiller Yale University Matthew J. Slaughter Dartmouth College Hyun Song Shin Princeton University René M. Stulz Ohio State University

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

4 Primary Dealers’ Mean Leverage

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 5

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 6

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…. 7

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 8