False 'interconnectivity' theories give us poisonous Dodd-Frank

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Article Highlights

  • The theory that the failure of one major financial institution will drag down others is not implausible

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  • Common shock—not Lehman’s failure—caused the financial crisis

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  • False “interconnectedness” theory of the financial crisis serves as foundation for the Dodd-Frank Act

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It should be no surprise that when MF Global failed, the market reaction was a virtual yawn. We have been told so often that the failure of a large nonbank financial institution will cause a systemic breakdown that some otherwise sensible people have come to believe it.

The underlying idea—that financial institutions are "interconnected" and the failure of one will drag down others - is not implausible. But like so much else that underlies the Dodd-Frank Act, it was accepted as true—and acted upon—without much evidence, or even much thought.

"What we learned from Lehman's collapse is that, even in the midst of a serious common shock, the failure of a large interconnected financial firm—what anyone would call a SIFI—will not cause the failure of others and thus is not too big to fail."—Peter Wallison

It is certainly true that chaos followed Lehman's bankruptcy, but in that chaos only one financial institution—the Reserve Fund, a money market mutual fund that held Lehman commercial paper - actually suffered debilitating losses as a result of Lehman's failure. Other financial institutions were in trouble, to be sure, and some of them needed assistance or rescue, but in each case their weakness and possible insolvency was not caused by their interconnections with Lehman.

Wachovia, Washington Mutual, AIG, and Merrill Lynch - and indeed every one of the other firms that received assistance or rescue—were victims of the mortgage meltdown, the sudden collapse in 2007 of an unprecedented 10-year housing bubble. That collapse, exacerbated by mark-to-market accounting, wiped almost $2 trillion in value off the balance sheets of financial institutions around the world, making them look unstable, illiquid and possibly insolvent. Losses, if any, caused by Lehman's failure were simply not a factor.

The sudden decline in the value of a widely held financial asset - as happened in late 2007 and early 2008 - is known to scholars as a "common shock." By definition, a large number of financial firms are involved, and investors are anxious and wary. The rescue of Bear Stearns in March 2008 created substantial moral hazard, seeming to establish a U.S. government policy that all large financial institutions would be rescued. But when Lehman was allowed to fail, market participants were stunned; they did not know which of their counterparties were still creditworthy; they began to hoard cash; banks would not lend to other banks. This is what we know as the financial crisis.

It was thus a common shock - and not losses from Lehman's failure—that caused the financial crisis. The remarkable thing is that, even at a time when its counterparties were weakened by the effects of a common shock, Lehman's collapse itself did not cause any of them to fail.

This fact has profound implications. The entire edifice of the Dodd-Frank Act was built on the interconnections idea. For example, a council of regulators called the Financial Stability Oversight Council, was given authority in the act to designate certain nonbank financial firms as "systemically important financial institutions" (SIFIs), and subject them to special stringent regulation by the Fed. The underlying idea is that the failure of one of these institutions will drag down others, causing systemic instability.

Similarly, the act's "orderly resolution" provisions, which give the FDIC authority to take over and resolve failing nonbank firms, makes no sense if these firms can go into bankruptcy without systemic knock-on effects. What we learned from Lehman's collapse is that, even in the midst of a serious common shock, the failure of a large interconnected financial firm - what anyone would call a SIFI—will not cause the failure of others and thus is not too big to fail.

Sometimes it is argued that the TARP funds distributed to the largest financial institutions saved them from insolvency after Lehman. But these funds were not made available until six weeks after Lehman's demise, and were repaid by the largest recipients—with the Fed's approval - about eight months later. If the funds were really needed to cover losses coming from Lehman, they could not have been repaid without leaving large holes in the balance sheets of the institutions that initially received them. At the most, what the TARP funds did—aided by the stress tests later run by banking regulators - was restore market confidence in the basic stability of these institutions.

The guarantees of loans by the FDIC were to the same effect. They restored market confidence but didn't make insolvent firms solvent.

Returning now to the case of MF Global, we can see why the market was not materially moved by the failure of this $41 billion firm. Lehman was twelve times larger, and a major player in the ever-mysterious credit default swap market, yet its failure did not inflict serious losses on its counterparties. If it hadn't been for the common shock of the mortgage meltdown and the moral hazard caused by the ill-advised rescue of Bear, Lehman's failure would have been a bankruptcy of historic size but not the purported cause of a financial crisis.

Yet great oaks from little acorns grow, and from the mistaken "interconnections" theory has grown the poison oak of Dodd-Frank.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI

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