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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.
Registration and Lunch
Peter J. Wallison, AEI
Hal Scott, Harvard Law School and Director of the Committee on Capital Markets Regulation
Scott Alvarez, Federal Reserve Board
Charles Calomiris, Columbia University and AEI
Douglas Diamond, University of Chicago
David Skeel, University of Pennsylvania
Peter J. Wallison, AEI
For more information, please contact Emily Rapp at Emily.Rapp@aei.org, 202.419.5212.
For media inquiries, please contact MediaServices@aei.org, 202.862.5829.
Scott Alvarez is general counsel of the legal division at the Board of Governors of the Federal Reserve System, and has been since 2004. Previously, he served as associate general counsel and assistant general counsel, senior attorney, and staff attorney on the Federal Reserve Board. As general counsel, Alvarez serves as the chief legal officer for the Federal Reserve Board. He is responsible for advising the board regarding the Federal Reserve Act, Bank Holding Company Act, Gramm-Leach-Bliley Act, Dodd-Frank Act, Change in Bank Control Act, and related statutes and regulations governing domestic and international banking issues. He worked closely with the board and congressional staff on the development of positions and drafting of the Dodd-Frank Act; Gramm-Leach-Bliley Act; Federal Deposit Insurance Corporation Improvement Act; Financial Institutions Reform, Recovery, and Enforcement Act of 1989; Riegle-Neal Interstate Banking Act; and various regulatory burden-relief bills.
Charles Calomiris is the Henry Kaufman Professor of Financial Institutions at Columbia Business School. He is also a research associate at the National Bureau of Economic Research. His research spans several areas, from banking and corporate finance to financial history and monetary economics. Calomiris also served on the 2000 International Financial Institution Advisory Commission. Known as the Meltzer Commission, this congressionally mandated group recommends specific reforms of the International Monetary Fund, World Bank, regional development banks, and the World Trade Organization to the US government.
Douglas Diamond is the Merton H. Miller Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. He specializes in the study of financial intermediaries, financial crises, and liquidity. He is a research associate of the National Bureau of Economic Research and visiting scholar at the Federal Reserve Bank of Richmond. Diamond is a fellow of the Econometric Society, the American Academy of Arts and Sciences, and the American Finance Association. He was awarded the 2012 Morgan Stanley-American Finance Association Award for Excellence in Finance for career achievements and leadership in financial economics research.
Hal Scott is the Nomura Professor and director of the Program on International Financial Systems at Harvard Law School, where he has taught since 1975. He teaches courses on capital markets regulation, international finance, and securities regulation. In 1974–75, before joining Harvard, he clerked for Justice Byron White. The Program on International Financial Systems, founded in 1986, engages in a variety of research projects including examining capital adequacy rules for financial institutions. The program also organizes the annual invitation-only US-Japan, US-Europe, and US-China Symposia on Building the Financial System of the 21st Century, attended by financial system leaders in the concerned countries. Professor Scott's books include the law school textbook “International Finance: Transactions, Policy and Regulation” (19th Edition, Foundation Press, 2012) and “The Global Financial Crisis” (Foundation Press, 2009). Scott is the director of the Committee on Capital Markets Regulation, which, in May 2009, released a comprehensive report titled, “The Global Financial Crisis: A Plan for Regulatory Reform.” He is also cochair of the Council on Global Financial Regulation, an independent director of Lazard Ltd.; a member of the Bretton Woods Committee; a past president of the International Academy of Consumer and Commercial Law; and a past governor of the American Stock Exchange (2002–05).
David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School. He is the author of “The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences” (Wiley, 2011), “Icarus in the Boardroom: The Fundamental Flaws in Corporate America and Where They Came From” (Oxford University Press, 2005), “Debt’s Dominion: A History of Bankruptcy Law in America” (Princeton University Press, 2001), and numerous articles on bankruptcy, corporate law, financial regulation, Christianity and law, and other topics. Skeel has also written commentaries for The New York Times, The Wall Street Journal, Books & Culture, The Weekly Standard, and other publications.
Peter J. Wallison, a codirector of AEI's program on financial policy studies, researches banking, insurance, and securities regulation. As general counsel of the US Department of the Treasury, he had a significant role in the development of the Reagan administration's proposals for the deregulation of the financial services industry. He also served as White House counsel to President Ronald Reagan and is the author of “Ronald Reagan: The Power of Conviction and the Success of His Presidency” (Westview Press, 2002). His other books include “Competitive Equity: A Better Way to Organize Mutual Funds” (2007), “Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks” (2004), “The GAAP Gap: Corporate Disclosure in the Internet Age” (2000), and “Optional Federal Chartering and Regulation of Insurance Companies” (2000). He also writes for AEI's Financial Services Outlook series.