Connectedness and Contagion: Protecting the Financial System from Panics

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MIT Press, May 13, 2016 - Business & Economics - 416 pages
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An argument that contagion is the most significant risk facing the financial system and that Dodd¬Frank has reduced the government's ability to respond effectively.

The Dodd–Frank Act of 2010 was intended to reform financial policies in order to prevent another massive crisis such as the financial meltdown of 2008. Dodd–Frank is largely premised on the diagnosis that connectedness was the major problem in that crisis—that is, that financial institutions were overexposed to one another, resulting in a possible chain reaction of failures. In this book, Hal Scott argues that it is not connectedness but contagion that is the most significant element of systemic risk facing the financial system. Contagion is an indiscriminate run by short-term creditors of financial institutions that can render otherwise solvent institutions insolvent. It poses a serious risk because, as Scott explains, our financial system still depends on approximately $7.4 to $8.2 trillion of runnable and uninsured short-term liabilities, 60 percent of which are held by nonbanks.

Scott argues that efforts by the Federal Reserve, the FDIC, and the Treasury to stop the contagion that exploded after the bankruptcy of Lehman Brothers lessened the economic damage. And yet Congress, spurred by the public's aversion to bailouts, has dramatically weakened the power of the government to respond to contagion, including limitations on the Fed's powers as a lender of last resort. Offering uniquely detailed forensic analyses of the Lehman Brothers and AIG failures, and suggesting alternative regulatory approaches, Scott makes the case that we need to restore and strengthen our weapons for fighting contagion.

 

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Contents

1 The Concept of Connectedness
3
2 The Concept and History of Contagion
5
21 History of Contagion
6
Multiple Equilibria Outcomes
9
23 Information Economics
12
24 Measures of Systemic Risk
14
3 The Concept of Correlation
15
II Connectedness in the Crisis
17
145 Tighter Definitions of Capital
176
147 Calls for Even Higher Levels of Capital
177
148 Economic Impact of Capital Requirements
179
149 Role of Markets in Setting Capital Levels
180
15 Liquidity Requirements
183
151 Basel Liquidity Requirements
185
152 US Implementation of Basel Liquidity Requirements
186
16 Bank Resolution Procedures Contingent Capital
189

Lehman and AIG
19
42 Effects of the Lehman Collapse on Different Counterparties
24
Money Market Fundsand TriParty Repo Market
53
51 Money Market Funds and Liability Connectedness
54
52 TriParty Repo Market and Liability Connectedness
55
6 DoddFrank Act Policies to Address
59
62 Exposure Limitations
61
63 SIFI Designation
62
III Contagion
65
The Run on theNonbank Sector Shadow Banks
67
72 Contagion after Lehman
71
73 Government Responses to the 2008 Contagion
75
8 History of Lender of Last Resort in the
79
81 First and Second National Banks
80
82 Creation of the Federal Reserve System in 1913 and Its Authority as Lender of Last Resort to Nonbanks
88
9 DoddFrank Restrictions on the LenderofLast
93
91 Broad Program Requirement
94
92 Requirement of Approval by the Secretary of the Treasury
96
93 Loans Only to Solvent Institutions
101
94 Banks Cannot Use the Proceeds of Discount Window Loans to Make Loans to Their Nonbank Affiliates
104
95 New Collateral Policies Imposed on the Fed
105
96 Disclosure Requirements
106
10 Comparison of LLR Powers of Fed with Bank
109
102 European Central Bank
116
103 Bank of Japan
122
104 Comparison of LLR Powers of the Four Central Banks
126
11 Strengthening the LLR Powers of the Fed
137
12 Liability Insurance and Guarantees
145
121 Amount of Liabilities to Insure
148
122 Insurance Pricing
151
124 Option Pricing
154
125 Ex post Pricing 51
155
126 During a Crisis
157
13 Insuring Money Market Funds
161
Conclusion to Part III
165
Capital
167
Base1 III Framework
169
141 Higher Basel III Capital Requirements
170
142 Surcharges for Globally Systemically Important US Banks
172
143 RiskWeighted Assets Approach RWA
174
161 Contingent Convertible Capital Instruments CoCos
190
162 Creditor Bailins by Regulators
194
17 DoddFrank Orderly Liquidation for Nonbank
205
172 Total Loss Absorption Capacity TLAC to Assure Holding Company Recapitalization
208
Banks and BrokerDealers
210
174 Derivatives Contracts
215
175 International Coordination Problems
216
18 Living Wills
219
19 Money Market Mutual Fund Reform
223
191 Enhanced Liquidity Requirements
224
Floating NAV Redemption Fees and Gates
225
193 Floating NAV
226
194 Liquidity Fees and Redemption Gates
227
195 Capital Requirement
229
197 End of Public Institutional Prime MMFs?
230
20 Dependence of the Financial System on Short
231
202 Caps on ShortTerm Funding
236
203 Indirect Limits on ShortTerm Funding
237
21 Government Crowding Out of Private Issuance of
239
212 Crowding Out by the Federal Reserve
241
V Public Capital Injections into Insolvent Financial
249
22 Capital Purchase Program and Other TARP Support Programs
251
221 Design of TARP
252
222 Expiration and WindDown of TARP
255
223 TARP Housing Programs Have Not Been Wound Down
261
23 Criticisms of Bailouts Generally
265
232 Bailouts May Not Work or Be Prolonged
267
233 Creation of Moral Hazard and TooBigtoFail Competitive Advantage
268
234 Bailout Decisions May Be Political and Ad Hoc
270
235 Bailouts May Fail to Boost Lending Activities
271
24 Specific Criticisms of TARP
273
242 Interference with Firm Operations
274
243 Lack of Enforcement of the CPPs Contractual Terms
275
25 Standing Bailout Programs
279
252 Virtues of Standing Bailout Authority
284
26 Conclusion
287
Appendix
295
Notes
303
Index
405
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About the author (2016)

Hal S. Scott is Nomura Professor and Director of the Program on International Financial Systems (PIFS) at Harvard Law School. He is Director of the Committee on Capital Markets Regulation, a research organization.

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