Connectedness and Contagion: Protecting the Financial System by Hal S. Scott

By Hal S. Scott

The Dodd--Frank Act of 2010 used to be meant to reform monetary guidelines so that it will hinder one other mammoth situation resembling the monetary meltdown of 2008. Dodd--Frank is essentially premised at the prognosis that connectedness was once the foremost challenge in that difficulty -- that's, that monetary associations have been overexposed to each other, leading to a potential chain response of disasters. during this ebook, Hal Scott argues that it isn't connectedness yet contagion that's the most vital portion of systemic probability dealing with the economy. Contagion is an indiscriminate run by way of momentary collectors of economic associations which could render in a different way solvent associations bancrupt. It poses a major threat simply because, as Scott explains, our economic system nonetheless will depend on nearly $7.4 to $8.2 trillion of runnable and uninsured non permanent liabilities, 60 percentage of that are held by means of nonbanks.

Scott argues that efforts by means of the Federal Reserve, the FDIC, and the Treasury to prevent the contagion that exploded after the financial ruin of Lehman Brothers lessened the industrial harm. And but Congress, spurred by way of the public's aversion to bailouts, has dramatically weakened the facility of the govt to reply to contagion, together with obstacles at the Fed's powers as a lender of final hotel. supplying uniquely distinct forensic analyses of the Lehman Brothers and AIG disasters, and suggesting replacement regulatory ways, Scott makes the case that we have to restoration and boost our guns for battling contagion.

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Example text

As discussed above, third-party creditor exposure to LBHI and its affiliated debtors was on the order of only $150 billion to $250 billion, spread across a variety of parties. By contrast, it was thought that the $360 billion in CDS losses would be borne by a concentrated group of systemically important financial institutions (“SIFIs”) assumed to be net sellers of Lehman CDS. Thus, as the Lehman CDS auction approached, these large institutions suffered double-digit percentage declines in their stock prices.

Another way to assess the exposure of creditors is based on the expectation of creditor recoveries as reflected in the Lehman bond prices. 1 illustrates that even at their lowest point, prices of LBHI bonds and, by extension, LBHI senior unsecured claims were always well above zero in the aftermath of LBHI’s filing. Parties holding claims guaranteed by LBHI had even more reason for optimism. 4 billion in 201197—in substantial amounts. 99 First, because Lehman had a large exchange-traded derivatives portfolio—futures Asset Connectedness 31 and options—its failure could have conceivably imperiled the clearinghouses and clearing firms with which it dealt.

88 Such claims suggest a substantial level of exposure, but the instruments did not in fact pose systemic risk because of their broad retail investor base and small denominations. Two other types of third-party claims bear mention, although the estate greatly reduced the estimated amounts of both. 94 In sum, third-party exposure to LBHI and its US debtor affiliates could not and did not have a systemically significant destabilizing effect. This conclusion does not depend on estimates of the value of the Lehman estate.

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