Introduction

This book is concerned with the fundamental stability of our financial system upon which the viability of our economy, and ultimately our polity, rests. In the 2008 financial crisis we witnessed a severe plunge in real estate prices—the Case Shiller National Home Price Index stood at 184.62 in July 2006, but by September 2008 it had fallen to 161.95. It eventually fell as low as 134.03 in 2012.1 This decline in housing prices was unprecedented; before 2006, the index had never declined by more than five points over a three-year period.2 The Moody’s/RCA Commercial Property Price Index for US commercial real estate experienced a similar fall, peaking at 173 in the fourth quarter of 2007 and declining to 104 in the fourth quarter of 2009.3 These declines led to significant losses for financial institutions exposed to residential mortgages and commercial real estate. Five of the twenty largest US financial institutions either became insolvent—Washington Mutual, Lehman Brothers, and AIG (at least the holding company)—or were acquired with government assistance—Bear Stearns and Wachovia.4 The IMF estimated total losses to be $4.1 trillion.5 GDP growth fell from positive 5.12 percent in 2006 to negative 0.92 percent in 2008 and negative 0.11 percent in 2009, putting the US economy into recession.6

This book demonstrates that “contagion,” not “connectedness,” was the most potentially destructive feature of the 2008 financial crisis. Connectedness occurs when financial institutions are directly overexposed to one another and the failure of one institution would therefore directly bankrupt other institutions, resulting in a chain reaction of failures. Contagion is a different phenomenon. It is an indiscriminate run by short-term creditors of financial institutions that can render otherwise solvent institutions insolvent due to the fire sale of assets that are necessary to fund withdrawals and the resulting decline in asset prices triggered by such sales.

Contagion indeed remains the most virulent and important part of systemic risk still facing the financial system today. This is because, as set forth throughout this book, our financial system still depends on approximately $7.4 to $8.2 trillion of runnable and uninsured short-term liabilities—defined as liabilities with a maturity of less than one month, with about 60 percent of these liabilities held by nonbanks.

The losses and the impact on our economy and country in September 2008 would have been much worse but for the response of our government to halting the contagion that broke loose following the bankruptcy of Lehman Brothers. However, since then the Congress has dramatically weakened the Federal Reserve, FDIC, and Treasury’s ability to respond to contagion, leaving our financial system sharply exposed to another contagion.

The Federal Reserve was created in 1913 to stem such panics, which were rife in the nineteenth century and culminated in the panic of 1907, by acting as a lender of last resort. After the bank runs experienced in the Depression of 1933, Congress created the Federal Deposit Insurance Corporation (FDIC) to guarantee deposits. These two powers were used extensively during the 2008 crisis. The Fed supplied liquidity to the banking and nonbanking financial sector, the latter through its authority under Section 13(3) of the Federal Reserve Act. The FDIC expanded the scope and amount of deposit insurance. In addition, the US Treasury offered temporary guarantees to money market funds. And finally, TARP was enacted to infuse public capital into the banking system, beginning with the nine largest banks. In the aftermath of the crisis, the use of these powers has been called into question as contributing to moral hazard—giving institutions the incentive to take on risk—and as constituting undesirable public bailouts of insolvent institutions. In fact some members of Congress believe that public funds in any form should not be used to support the private sector, including financial institutions.

As a result of these concerns, the Fed’s and FDIC’s powers were pared back by the Dodd–Frank Act of 2010, and in the case of the Treasury’s temporary guarantee to money market funds, by TARP. The Fed’s powers to loan to nonbanks under 13(3) can now only be used with the approval of the Secretary of Treasury, the Fed can only loan to nonbanks under a broad program (not to one institution as it did in the case of AIG), and nonbanks must meet heightened collateral requirements. The Fed now ranks fourth to its central bank peers—the Bank of England, the European Central Bank, and the Bank of Japan—in its powers to act as lender of last resort. The FDIC and the Treasury cannot on their own, without prior congressional approval or new authority, expand guarantees. The authority to make public capital injections, even to address widespread insolvency that could seize up the banking system and real economy, has expired with the expiration of TARP.

The contraction of powers, which former Secretary Timothy Geithner calls barely adequate in his book Stress Test, puts us at severe risk in dealing with the next financial crisis. Secretary Geithner states: “We went into our crisis with a toolbox that wasn’t exactly empty, but also wasn’t remotely adequate for our complicated and sprawling modern financial system. … What should be in the toolbox? The vital tools are: an ability to extend the lender-of-last-resort authority to provide liquidity where it’s needed in the financial system; resolution authority … and, along with deposit insurance … broader emergency authority to guarantee other financial liabilities.”7

Or consider this quote from former Secretary of the Treasury Paulson:

Dodd–Frank falls short in other areas …. Congress has also removed some of the most creative and effective tools used to stave off collapse. In order to provide greater Congressional control, Dodd–Frank limits regulator discretion in times of crisis. In one respect, of course, that’s all to the good. Congress is responsible to our citizens, so it’s encouraging to see the focus on taxpayer protection. The bank rescues were a source of public outrage, so it is understandable that Congress would take steps to ensure that failing institutions not be propped up in their present form. But some of the powers that Congress limited or constrained, such as some Federal Reserve lending authorities or the FDIC guarantee authority, were rarely used, if ever. Emergency measures such as we used to stem the crisis should be employed only when we are facing the economic equivalent of war, and the president and two-thirds of the Fed and the FDIC make a financial emergency declaration to protect the American people. Why give up these tools and disarm when there is no assurance that policy makers will not need such flexibility again?8

In significant part, the Dodd–Frank Act is premised on the diagnosis that connectedness not contagion was the major problem in the crisis—this is reflected in the requirement for central clearing of over-the-counter derivatives (swaps), net exposure limits for banks, and the designation of systemically important banks and other financial institutions as systemically important financial institutions (SIFIs) and therefore subject to heightened supervision by the Federal Reserve. The recent Federal Reserve rule calibrating a capital “surcharge” for systemically important banks is also based on a connectedness analysis, which I show has no empirical relation to reducing the risk of contagion. But connectedness was not the major problem, contagion was. Some argue that the old powers to fight contagion are no longer necessary because we have put in place new regulations to prevent future contagion—namely enhanced capital requirements, new liquidity requirements, and new resolution procedures. I call this the two wings and prayer approach. Capital and liquidity requirements, the wings, are ex ante policies designed to prevent contagion, not to deal with it if it does occur. It would be foolhardy to believe we can completely avoid contagion by adopting such policies. Capital requirements only apply to banks and a few specific nonbanks (e.g., the three nonbank SIFIs, for which the requirements have not yet been determined), and could never be at a high enough level to assure short-term creditors that capital would not be seriously eroded by the fire sale of assets in a crisis. For example, according to Warren Buffet’s Financial Crisis Inquiry Commission testimony:

No capital requirements protect you against a real run. I mean, if virtually all of your liabilities are payable that day, you can’t run a financial institution and be prepared for that. And that’s why we’ve got the Fed and the FDIC. You could be the most soundly capitalized firm in town but if there were no FDIC and the Fed and you had a bank capitalized with 10% of capital and I had one with 5% of capital and I hired 50 people to go over and start standing right in front of your bank, you’re the guy that’s going to fall first. Then when they get through with you they’re going to come over to my bank too, that’s why we don’t do that sort of thing because you can’t contain the fire over on the other guy’s bank. You just can’t stand a run. So you need the Federal Reserve and the FDIC. And even with Northern Rock, the UK government had come and said we guarantee everything and they still had lines. When people are scared they’re scared. I mean, if you see its uninsured and you see a line at a bank where you’ve got your money, then get in line, get your money and put it under your mattress. That’s why we’ve got a Fed and FDIC. I think the FDIC and Social Security were the two most important things that came out of the ‘30s. I mean the system needed an FDIC.9

New liquidity rules, also only applicable to banks, seek to assure that banks have liquid assets to cover withdrawals in a run. But they are based on dubious assumptions about the withdrawal rates of different kinds of bank funding, and ultimately cannot avoid the need of a central bank to act as a lender of last resort. At best, this level of private liquidity can buy some breathing room for the central bank to determine what to do. At worst, they create a hoarding situation where the assurance of each institution of its own liquidity prevents each institution from supplying liquidity to others, thus worsening a weak institution’s options during a crisis.

New resolution authority under the Orderly Liquidation Authority in Dodd–Frank is the prayer. First, its use is not assured. It only comes into play if a financial institution on the brink of insolvency is designated by the Treasury, upon the recommendation of a super-majority of the boards of the Fed and FDIC, as a threat to the financial stability of the United States. Second, while procedures are being designed with the objective of making sure no short-term creditors of banks and other subsidiaries of financial institutions, like broker dealers, would lose money in an OLA procedure (as opposed to equity and longer term debt), these procedures may not prove effective or credible enough to stop runs on solvent institutions. Short-term creditors may still flee because they believe it is better to be safe than sorry.

Money market fund reforms are also inadequate to address contagion. As described throughout this book, runs on money market funds were a central feature of the 2008 crisis and were only stopped by the provision of temporary guarantees by the Treasury and indirect lender of last resort support by the Fed (lending to banks to purchase the assets of money market funds). Since 2008 the SEC has implemented new rules that require money market funds to hold more liquid assets, and prime institutional money market funds to have floating rather than fixed asset values. However, these reforms are unlikely to stop runs on such funds in the future, since investors could still fear further declines in the value of assets and the depletion of the most high-quality liquid assets to meet the withdrawals of investors that redeem first. Furthermore new SEC rules that give fund boards the authority to charge fees for withdrawals or suspend redemptions may only accelerate runs of investors fearful of the imposition of such limits.

This book takes the view that we need to restore and strengthen our weapons to fight contagion. Having strong anti-contagion weapons would indeed mean that a very large financial institution could be allowed to fail. This is because such a failure would not spark contagion, as the market would know that the necessary government authorities, including a strong lender of last resort and the provider of guarantees, exist to protect the solvent financial institutions. Having strong contagion fighting powers would therefore allow us to solve the too-big-to-fail problem and reduce moral hazard. At the same time a strong lender of last resort should not be one operating under an ill-defined framework. The legally permissible actions of the Fed should be bounded in a clear framework so that it is politically and legally accountable; such specification of actions that might be taken in a contagious panic could well forestall the panic in the first place.

However, this book recognizes that it is impossible for Congress to strengthen these weapons now—anyone proposing such measures would be attacked as trying to bail out Wall Street rather than congratulated for trying to improve the stability of our financial system. This book is meant as a measure to prepare the ground for a more rational and less populist discussion of these issues.

The book is organized as follows.

Part I gives an overview of the three components of systemic risk: (1) connectedness, (2) contagion, and (3) correlation. It is backed up by an appendix with a review of the economic literature on these components.

Part II examines in depth whether asset connectedness, specifically firms with credit exposure to Lehman, proved to be a problem after Lehman’s failure. It also considers whether asset connectedness would have been a problem if AIG had not been rescued. It then addresses liability connectedness, which is whether the failure of a major funder of the financial system could trigger the failure of others. It concludes by explaining that important parts of Dodd–Frank are focused on dealing with the systemic risk caused by connectedness. This includes a discussion of SIFI designation, particularly for asset management firms. The conclusion of part II is that connectedness is not the major contributor to systemic risk.

Part III begins with a general review of the problem of contagion, and how it manifested itself in the financial crisis, particularly in the nonbank sector. It then reviews the government response to contagion in the crisis. Part III also discusses potential solutions to contagion, beginning with a focus on the measures used in the crisis, lender of last resort and guarantees. This includes a comparison of the lender-of-last-resort powers of the major central banks. It also details the limitations imposed on the Fed’s lender-of-last-resort powers and the FDIC’s and Treasury’s authorities to guarantee liabilities. It then describes certain reforms to the Fed’s lender-of-last-resort authorities and the FDIC’s guarantees that could strengthen the financial system.

Part IV turns to the two wings and the prayer approaches to contagion—capital, liquidity, and resolution procedures. This part also sets forth the problems with the recent money market fund reforms. It concludes with an examination of an alternative approach to limiting contagion—by dramatically reducing the dependency of banks and nonbanks on the short-term funding (liabilities with one month or less in maturity) that exposes them to contagion.

Part V looks at TARP and other techniques of capital injection, and compares the US approach of eliminating TARP with the standing TARP policies of the eurozone and Japan, and the ironclad bailout policy of China.