Is the interconnectedness or contagion theory a more accurate explanation for the 2008 financial crisis? At an AEI event on Friday, Hal Scott of Harvard University presented the findings of his recent paper, which argues that the financial crisis was caused by contagion stemming from perceived risk rather than the interconnectedness of large financial institutions. This contagion, said Scott, resulted in a breakdown of short-term funding networks that are crucial to the proper functioning of financial markets. Scott further characterized the Dodd-Frank Act as a costly measure that failed to address the contagion theory.
While panelists agreed that the contagion hypothesis was largely ignored in the wake of the financial crisis, they disagreed over whether financial legislation could address one theory without taking the other into account. Charles Calomiris of Columbia University emphasized the role information asymmetry played in exacerbating investor concerns over potential problems stemming from both interconnectedness and contagion.
On the issue of short-term funding, Douglas Diamond of the University of Chicago argued that existing regulation failed to meet the challenges of a potential liquidity crisis. While Scott said he considers expansion of insurance into the short-term markets a possible solution to these challenges, both David Skeel of the University of Pennsylvania and Diamond stressed the moral hazard costs of said expansion.
A new paper by Hal Scott of Harvard Law School — drawing on a close analysis of the Lehman Brothers and AIG cases — casts doubt on the validity of an idea that underlies the Dodd-Frank Act. The act is based on the notion that the failure of a large financial firm like Lehman could cause another systemic crisis because of the firm’s “interconnections” with other large firms. Accordingly, the act authorizes the Financial Stability Oversight Council to designate large banks and nonbank financial institutions as “systemically important” because of their interconnections with others, and subjects them to stringent new regulation by the Federal Reserve. The Fed, in turn, has proposed a regulation that would limit interconnections among these large financial firms. Scott, however, shows that interconnections were not responsible for the chaos that followed the Lehman bankruptcy.
Instead, Scott suggests that “contagion” — the tendency for runs to develop among firms that rely on short-term funding — is a better explanation for what happened in the 2008 financial crisis. The Dodd-Frank Act, he argues, would be more effective if it focused on preventing run-like behavior rather than imposing new and restrictive regulation on individual institutions. This conference will examine the Scott paper and its implications for the Dodd-Frank Act.
If you are unable to attend, we welcome you to watch the event live on this page. Full video will be posted within 24 hours.