The American Enterprise Institute (AEI) hosted a conference Feb. 8 titled “Is Dodd-Frank Chasing a Ghost?” that was based on a lengthy paper by Hal Scott, Nomura Professor and director of the Program on International Financial Systems at Harvard Law School. The paper suggests that the Dodd-Frank Act mistakenly focused on interconnections among financial institutions as the main contributing factor to the 2008 financial crisis, when it should have focused instead on so-called “contagion” effects. If one accepts this distinction and the notion that it is significant, then, Scott argues, important policy conclusions flow from it.
Although Scott made the usual disclaimer that his views are his own, the fact that AEI’s Peter Wallison enjoys considerable access to the media and policymakers, and that Scott himself has a bully pulpit as director of the Committee on Capital Markets Regulation, suggests that some sort of policy initiative is in the offing. The purpose of this article is to place a marker that will alert readers as to the likely nature of these proposals, so that they can determine how they might respond whenever the agenda is presented to the market, to the financial regulators and perhaps to Congress.
In his extended, if not protracted, introductory remarks, Wallison stated that Scott’s paper “argues that the systemic event we know as a financial crisis was not caused by interconnections but instead by a phenomenon called ‘contagion.’” He then allowed that it might seem that “the difference between interconnections and contagion is an unnecessary and largely academic distinction.” Mark me down in that column.
The best advice for readers would be to glide past that issue and to concentrate on the recommendations Scott offers, then decide how much merit those recommendations would have when they are presented in the form of a proposal. In other words, regardless of whether Scott is right that the nice distinction he proposes between interconnections and contagion is valid, what are the implications of the policy ideas he will advance?
Wallison suggested that if Scott’s analysis is correct, the policy response should be to reduce the amount of regulation of the financial industry, rather than to impose “stringent regulation” of the largest financial institutions, as the Dodd-Frank Act purports to do. After a lengthy discussion of the events that led to the failure of Lehman Brothers and the bailout of AIG in 2008, Scott faulted Dodd-Frank for taking away the tools the authorities used to bail out and prop up large financial institutions in 2008.
Then he faulted the enhanced capital requirements that were adopted by the Basel Committee as unnecessary, “because banks really have their own self-interest in protecting themselves from excessive counterparty exposure.” That was the regulatory philosophy espoused by Federal Reserve Chairman Alan Greenspan in the years leading up to the 2008 episode, and one would think it would be discredited now. Assuming that a course of conduct is in the self-interest of banks does not mean they will actually follow it, particularly if they assume that they since they are “too big to fail,” they will be rescued by the government through the exercise of what is now know as the “Bernanke put.”
Scott asserted that the liquidity measures adopted by Basel are poorly conceived, and that the job of providing liquidity should fall, ultimately, with the Fed. One might have thought that the duty to provide funding for any enterprise would lie with the owners and managers of that enterprise, but this ethic seems to be lost in the world of too big to fail.
Scott’s other major idea is to extend to money market mutual funds some sort of deposit insurance-style protection in order to remove this source of pressure, from the threat of runs, on the ability of too big to fail banks to fund themselves in the short term.
Among the four prominent panelists who commented on Scott’s paper, Douglas Diamond, a finance professor at the University of Chicago, proclaimed, in a takeoff of a Friedman maxim regarding inflation, “Private financial crises are everywhere and always due to problems of short-term debt (and the reasons why short-term debt is needed).” As a member of the Squam Lake Group, Diamond supports the recommendation that a 3 percent capital standard be maintained in order to bolster liquidity and discourage runs.
Charles Calomiris, a professor at Columbia University, wrote a paper with Dick Herring of Wharton, blaming the failure to replace lost capital in a timely manner, as well as regulatory forbearance and the reliance of too big to fail banks on short-term funding, for transforming the housing bust into a systemwide financial crisis in 2008. However, Calomiris agreed with Scott that the ability of the Fed to act as lender of last resort “should not be obviated,” because this could constrain banks from creating liquidity.
Diamond also credited the short-term debt market for serving as a signal of trouble in the financial markets that may have prevented greater losses.
Scott Alvarez, general counsel of the Federal Reserve Board, chose to paraphrase President Franklin Delano Roosevelt, asserting that “fear itself” is one of the things, but not the only thing, we have to fear. He took issue with Wallison’s aversion to higher capital requirements and strict regulation, arguing that these measures help make the financial system more resilient. He criticized both of Scott’s proposals, on the grounds that open-ended provision of last-resort loans by the Fed would compromise its independence and that extension of deposit insurance to money market funds would entail considerable moral hazard.
Finally, David Skeel, a professor at the University of Pennsylvania Law School, faulted the authorities for sending conflicted signals to markets in 2008 by failing to bail out Lehman after the market assumed they would, then turning around and bailing out Bear Stearns. As an expert in bankruptcy law, he argued that with some needed modifications, the bankruptcy process would provide a better result than resolution by the FDIC.
Regarding Scott’s proposals, Skeel disagreed with Scott’s view that Dodd-Frank removes the bailout tools the authorities used in 2008, because the restrictions are “easily evadable,” and he stated he does not share Scott’s comfort with bailouts, but rather sees them as “more harmful than helpful.” He also disagrees with the idea that insurance should be extended to the short-term debt of systemic institutions, because this would only enhance their too big to fail status and cause money market funds to expand.
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