III. Contagion

Part III begins by describing how contagion principally manifested itself in the nonbank sector during the 2008 financial crisis. It next turns to how the government successfully responded to the problem through the Fed’s use of its lender-of-last-resort authority, the expansion of guarantees by the FDIC and the Treasury, and public capital injections under TARP. These powers were attacked after the crisis as undesirable bailouts and were either restricted or eliminated, leaving us vulnerable to future contagion. The book then looks in depth at two of these powers, lender of last resort and guarantees, concluding that they not only need to be restored but strengthened. Although the central bank’s lender-of-last-resort capability can play two roles: (1) lender to individual institutions during periods of market stress and (2) general liquidity provider (a market maker of last resort), this book focuses only on the first of these roles because the need for general liquidity is generally a volatility issue, not a contagion or systemic risk issue.