02 March 2017
Connectedness and Contagion
Protecting the financial system from panics
Hal S Scott
2016, MIT Press, 416 pages,
Reviewer: William Allen, NIESR
Hal S. Scott is a professor at Harvard Law School who has taken a close interest in financial issues and evidently has a clear understanding of them. His book analyses the financial crisis and the ensuing regulatory actions, and is refreshing for its careful and clear presentation of the facts of the crisis, and its reliance on the facts as a foundation for its comments on the regulatory response. Scott’s main assertion is that the post-crisis concentration on connectedness in the financial system as a source of danger has been misconceived, and that contagion is a far greater menace. The facts that Scott presents are interesting and unexpected. Using the voluminous report of Anton Valukas, the Examiner in the bankruptcy of Lehman Brothers, as a main source, he shows that Lehmans’ failure alone would not have brought down any other financial institution. “In sum, third-party exposure to LBHI [Lehman Brothers Holdings Inc.] and its US debtor affiliates could not and did not have a systemically significant destabilizing effect.” (p 29).
Instead, Scott concludes that the crisis was propagated by contagion, “The spread of run-like behavior from one financial institution to an expanding number of other institutions, reducing the aggregate amount of funding available to the financial system.” (p 67). He accordingly concludes that regulatory actions to reduce connectedness, such as insistence on the use of central counterparties for clearing derivatives trades, are misplaced, and that the post-crisis restrictions on the power of the Federal Reserve to provide liquidity assistance in a crisis are positively dangerous.
In one instance, Scott overstates his case against the significance of connectedness a little. In discussing the run on money market mutual funds in September 2008, which led the funds to withdraw large amounts of deposits from foreign bank branches in the United States, he claims that the funds, “Provided no more than 3.0 per cent of funding as a percentage to any of the largest foreign or domestic banking groups as of June 30, 2013.” But the crisis occurred in 2008, not 2013; and, as Richhild Moessner and I have shown, as swap markets became paralysed during the crisis, liquidity shortages became currency specific. If you were short of dollars, then a surplus of euros didn’t necessarily help.
The debate about the powers of the Fed is part of a political debate about how much power elected politicians should entrust to appointed officials. Scott’s conclusion is pragmatic:
The losses from contagion and the impact on our economy and country would have been much worse but for heroic efforts by the Federal Reserve to expand its role as lender of last resort, by the FDIC [Federal Deposit Insurance Corporation] to expand the amount of its insurance, by the Treasury to temporarily guarantee the money market funds, and by the government under TARP to make capital injections in some major banks that were insolvent, or on the brink of insolvency. While the lesson of the crisis should have been that Congress must strengthen their powers, its actual response was to weaken them. (p 288).
Moessner and I reached a similar conclusion about the effects of the Fed’s actions in 2008 on the global economy.
The politicians who have constrained the powers of the Fed and other government agencies to act on their own initiative are responding to public opinion. Yet if the Fed’s powers had been constrained before the crisis occurred, then the consequences would have been vastly worse. Some principle of democratic control of monetary policy would have been asserted, but at horrific cost. Scott expresses his frustration that, “Those in and out of government privately agree with many of my conclusions, particularly the need for Congress to strengthen the lender of last resort and establish a stronger guarantee system, but will not speak out for fear of being accused of trying to bail out Wall Street.” (p 293). Democratic politics needs more thoughtful leaders, and fewer dedicated followers of fashion.
Scott’s book is well written and clearly argued. Anyone interested in financial regulation, or in the relations between central banks and legislatures, or in what actually happened during the financial crisis, would profit from reading it.
W. A. Allen and R, Moessner, ‘Central bank co-operation and international liquidity in the financial crisis of 2008-09’, BIS working paper no 310, June 2010, http://www.bis.org/publ/work310.htm