IV. Ex ante Policies to Avoid Contagion: Capital, Liquidity, Resolution, Money Market Mutual Fund Reform, and Limits on Short-Term Funding

Following the crisis, three strategies have been deployed to make the financial system safer from systemic risk: (1) capital requirements designed to enable banks to incur losses without failing; (2) “private” bank liquidity requirements designed to ensure that banks have sufficient high-quality assets that can be sold or pledged as collateral to meet sudden withdrawals, allowing institutions to survive without public liquidity support; and (3) resolution procedures that impose losses on the debt and equity holders of financial holding companies without impacting the short-term creditors of their banks or other operating subsidiaries like broker-dealers. Some claim these policies alone or in combination will sufficiently insulate the financial system from contagion ex ante so as to obviate the need for a strong LLR and guarantee system. As developed below, I disagree and have called this the two wings and a prayer approach, the resolution being the prayer. While special policies, as we have already discussed, have been developed to avoid runs on money market funds, these policies will not achieve this objective. The problem with these policies is that they are so internally flawed that they are unlikely to achieve their own defined objectives, and even if they did, could not work well enough to stop contagion. Furthermore liquidity provision in the United States has suffered as a result of Dodd–Frank: public provision of liquidity has been limited by the restrictions on the Fed, while private provision of liquidity has also been limited through the combination of the new leverage ratio requirements, the liquidity coverage ratio and the Volcker rule.

That said, this part will look at another approach to stopping contagion, one that has been subject to much discussion but is not close to being adopted—at least in any direct form—to sharply reduce the amount of short-term funding in the financial system as a whole. Indeed the best that any or all of these policies can do is to reduce the probability of contagion ex ante. Given the destructive nature of contagion, however, we will still need ex post responses, lender of last resort, and guarantees.