Myron Scholes Global Markets Forum
November 18, 2008
A Faculty Panel on "What the Effects Will Be and What Should be Done"
John Cochrane, Myron S. Scholes Professor of Finance
Steven Kaplan, Neubauer Family Professor of Entrepreneurship and Finance
Raghuram Rajan, Eric J. Gleacher Distinguished Service Professor of Finance
Three faculty members wrapped up the Myron Scholes Forum credit crisis series by assessing the outlook and discussing what should be done next. “The key issue,” said Steven Kaplan, “is what are the loans worth?” He used a stylized bank balance sheet to show the audience what happened to banks’ debt and equity as the value of loan assets fell, and showed that the right policy approach depended on just how much a bank’s balance sheet had been affected. The treasury’s first approach - using taxpayer money to buy bad loans as a way to shore up the asset side of banks’ balance sheets - would only have made sense if the assets had not fallen very much, Kaplan said. However, because asset values had fallen sharply enough to wipe out a lot of banks’ equity, the treasury’s second crack at a Troubled Asset Relief Program made more sense. Recapitalizing them and reviving interbank lending by guaranteeing short-term debt was a more effective way to keep them solvent.
Although Kaplan thought the capital injections helped, he did not think they were enough and worried that the problem would get worse before it got better. One problem was that the economy had continued to deteriorate badly in the fourth quarter of 2008, which would further hammer banks’ asset values and make more of them insolvent.
John Cochrane, who studies capital markets, evaluated the system’s capacity for meeting the demand for new loans. The supply of risky debt had fallen, he said, but it was important to be clear about how much of this reflected risk aversion and how much stemmed from perceptions that the probability of default had risen (i.e., risk had gone up). He also argued that it was important to distinguish between banks - important intermediaries, but not the only financial institutions in the system - and the ultimate suppliers of capital, who could find ways to supply loans if the perceived risks and rewards were worth it. The core problem was not that banks had cut back lending; it was that the entire market for securitized mortgage markets had “fallen apart,” Cochrane said.
Key issues going forward, according to Cochrane, included the extent to which nonbank intermediaries would step in to supply loans that were demanded and whether individuals would eventually be willing to supply this capital to borrowers - such as home buyers - with less intermediation by the banks.
Looking at the future of financial regulation, Raghuram Rajan argued that “problems can emerge from anywhere in the system and can spill over.” Although many used to believe that it was possible to regulate one part of the system while giving others more leeway, according to Rajan, policy makers and regulators need to realize that “liquidity ties everything together…. In that sense, illiquidity is contagious. At least you need to know what’s going on in the rest of the system, if not actually regulating it.”
Rajan argued that, time after time, crises have shown that managers do not always have control over risks, and that risk management systems tend to be ignored after a long rise in asset prices, making them ineffective when they are most needed. Regulators need to expect failures, therefore, and plan better for dealing with them without leading to contagion or putting taxpayers’ money at risk every time. “There should be much more emphasis on anticipating the fact that banks will get into trouble periodically,” Rajan said.
He was skeptical about dealing with the problem through higher capital regulations, since this would likely lead banks to compensate for higher capital costs by seeking riskier assets. Rajan did not think that varying the capital requirements in good times and bad times would help much. Instead, he described a plan he had previously put forth, with fellow Chicago Booth professor Anil Kashyap and Jeremy Stein of Harvard University, to require banks to buy well-designed insurance for contingencies that were likely to cause systemic trouble.
All three panelists, Kaplan, Cochrane, and Rajan, agreed that such nonfinancial companies as General Motors should not be bailed out. Although taxpayers’ money was needed to prevent the current crisis from getting worse, they said, that money was necessary because aspects of the financial system make contagion a real risk. The same forces do not apply to industrial firms. They also worried about poor regulation and regulatory uncertainty emerging from the crisis. Cochrane added that rising public debt and resulting inflation was a big risk. “There are ways,” he said, “to make this much, much worse.”
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John H. Cochrane, Myron S. Scholes Professor of Finance, recent finance publications include the book Asset Pricing and articles on dynamics in stock and bond markets, the volatility of exchange rates, the term structure of interest rates, the returns to venture capital, liquidity premiums in stock prices, the relation between stock prices and business cycles, and option pricing when investors can’t perfectly hedge. His monetary economics publications include articles on the effects of monetary policy and the fiscal theory of the price level. He has also written articles on macroeconomics, health insurance, and other topics.
Cochrane is a research associate of the National Bureau of Economic Research and past director of its asset pricing program, a fellow of the Econometric Society, and an adjunct scholar of the CATO institute. He has been an editor of the Journal of Political Economy and associate editor of several journals including the Journal of Monetary Economics, Journal of Business, and Journal of Economic Dynamics and Control. Recent awards include the TIAA-CREF Institute Paul A. Samuelson Award for his book Asset Pricing, the Chookaszian Endowed Risk Management Prize, and the Faculty Excellence Award for MBA teaching.
Cochrane earned a bachelor’s degree in physics at MIT and earned a PhD in economics at the University of California at Berkeley. He was at the Economics Department of the University of Chicago before joining Chicago Booth in 1994 and visited UCLA Anderson School of Management from 2000 to 2001.
Steven Kaplan, Neubauer Family Professor of Entrepreneurship and Finance, conducts research on issues in private equity and entrepreneurial finance, corporate governance, mergers and acquisitions, and corporate finance. He has published papers in a number of academic and business journals. He has testified to the U.S. Senate Finance Committee and the U.S. House Financial Services Committee about his research. Kaplan is a research associate at the National Bureau of Economic Research and an associate editor of the Journal of Finance and the Journal of Financial Economics.
Kaplan teaches advanced MBA and executive courses in entrepreneurial finance and private equity, corporate financial management, corporate governance, and wealth management. He has been one of the top-rated teachers at Chicago Booth in BusinessWeek's biannual surveys since 1992. BusinessWeek named him one of the top 12 business school teachers in the country.
Kaplan serves on the board of directors of Accretive Health, Columbia Acorn Funds, and Morningstar. He also serves as a director of the Illinois Venture Capital Association and the University of Chicago Laboratory Schools, and as the academic dean of the Kauffman Fellows Program, an educational and mentoring program for new venture capitalists. He has been a member of the faculty since 1988.
He received his AB, summa cum laude, in applied mathematics and economics from Harvard College and earned a PhD in business economics from Harvard University.
Raghuram G. Rajan is Eric J. Gleacher Distinguished Service Professor of Finance at Chicago Booth. From 2003 to 2006, Rajan was Economic Counselor and Director of Research at the International Monetary Fund. His research is broadly on the role of institutions, especially financial institutions, in fostering economic development. In 2003, Rajan was awarded the inaugural Fischer Black Prize by the American Finance Association for contributions to finance by an economist under 40. Rajan is an electrical engineering graduate from the Indian Institute of Technology in Delhi. He earned his MBA from the Indian Institute of Management, Ahmedabad, and his PhD from MIT.
This event is part of the Initiative on Global Markets and is generously sponsored by Myron Scholes.
The Initiative also receives financial support from the Chicago Mercantile Exchange (CME) Trust and our corporate partners: AQR Capital Management, Barclays Bank PLC, John Deere, and Northern Trust Corporation.