Connectedness and Contagion
Protecting the Financial System from Panics
440 pp., 6 x 9 in, 8 figures, 22 tables
- Published: November 1, 2022
- Published: May 13, 2016
- Published: May 13, 2016
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.
Anyone with good sense should want to consider Hal Scott's thoughtful analysis of our policy response to the last financial crisis. Agree or disagree, Scott's views deserve careful consideration in the debates over financial stability that are sure to come.
Lawrence H. Summers, Charles W. Eliot University Professor and President Emeritus, Harvard University
Scott has written the definitive work on how contagion in the financial sector spread and amplified an initial shock to housing into the global financial crisis, at great economic cost, and how it was only contained by the liquidity supplying efforts of the Federal Reserve and other authorities. He raises serious and legitimate questions about whether constraints on the Fed's lending authority in Dodd–Frank will leave us short of the tools necessary to stop the next financial panic, and he warns persuasively against any further limits on the Fed's ability to act as lender of last resort to banks and nonbanks alike.
Donald Kohn, Senior Fellow, The Brookings Institution
Abolishing taxpayer bailouts of fundamentally bust institutions is essential if finance is to be a worthwhile, legitimate part of a market economy. Hal Scott rightly argues that this will not dispose of the need for central bank liquidity insurance given problems of contagion and panic during crises. He worries that, by tying the hands of the Federal Reserve behind its back, US legislators got this wrong, exposing the American people and the wider world to unnecessary risk. Whether or not he is correct matters hugely. Read this book to make up your own mind.
Paul Tucker, Chair, Systemic Risk Council, and Fellow, Harvard Kennedy School