With Professor Hal S. Scott, Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School, Author of Connectedness and Contagion: Protecting the Financial System from Panics
The impact of the financial crisis of 2008 ran deep. Everyone from the man on the street to the Federal Reserve felt the tremors to some degree. As a result, the US government instituted a series of regulations designed to prevent a replay of those events. But will they actually do the job?
Professor Hal Scott, the Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School, is doubtful. In his book, Connectedness and Contagion: Protecting the Financial System from Panics, he explains his thesis.
Back in 2008, while the financial world was falling apart one banking and financial institution at a time, the Federal Reserve came to the rescue, like a caped crusader with a huge safety net. They guaranteed market funds after the failure of Lehman Brothers, lent money to those banks on the point of failure, and increased insurance limits on ordinary demand deposits, in essence, acting as the lender of last resort.
The contagion that Professor Scott refers to in his title is the irrational panic that causes everyone to want nothing more in such critical times than to withdraw their money and stuff it in a safe deposit box or under the mattress, all of which has a huge impact and can exacerbate an already shaky situation.
The collapse of the housing market got all the credit for the crash, when, actually, it was so much more complex, states Professor Scott. The decline in housing prices “evolved into something quite different where you had runs on money market funds that weren’t holding anything, where companies like Xerox couldn’t issue commercial paper.” And it quickly became a panic about everything. During a financially vulnerable period, it’s obvious that depositors and investors are not privy to the same information as those on the inside of these financial institutions, so, mostly heeding the advice of their peers, the public becomes infected with distrust and fear allowing a “head to the hills” mentality to take over.
We just experienced a global version of this contagious fever with Brexit. The doomsday prophets were all over the media, and even though we haven’t seen it all play out yet, the sky did not fall on Europe’s head.
After the financial crisis of 2008, the US government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act which imposed regulations on financial institutions designed to prevent another such outbreak. In his book, Professor Scott tells why he thinks the issue was incorrectly addressed. Dodd-Frank, he says, requires banks to shore up their capital in order to weather another financial crisis, but if panic takes over again and depositors demand their money, no amount of capital would be sufficient. In addition, many of the measures that successfully warded off disaster in 2008— lender of last resort, deposit insurance, guarantees by the Treasury in the money market funds, and TARP—have now been restricted or eliminated.
Should another crisis occur, political or economical, Professor Scott says, “we would not be in a really good position to fight it.” Congress and the public, to a degree, have become so averse to the idea of bailouts that it’s caused a weakening of the government’s ability to avert another financial crisis.
Just as the medical community develops and implements vaccines to prevent outbreaks of major diseases, Scott argues for protective regulations to thwart the contagion that could infect our financial system should we face another 2008-like crisis. Connectedness and Contagion: Protecting the Financial System from Panics is a vital read on that topic.
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Steve Pomeranz: Professor 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’s also Director of the Committee on Capital Markets Regulation, which is a non-profit organization dedicated to enhancing the competitiveness of US capital markets and ensuring the stability of the US financial system. It’s in this light that I’ve asked him to join me today. He is the author of a number of books, and the one that we want to discuss today is Connectedness and Contagion: Protecting the Financial System from Panics. Welcome to the program, Professor Scott.
Professor Hal Scott: Thanks for having me on.
Steve Pomeranz: This topic is important because there have been many changes to the financial system and regulations since 2008. Let’s visit that time. During the ’08 crisis, much was happening that was of an historic nature, and the government acted quickly to restore confidence in the US financial system. What led up to the crisis, and what did the Treasury actually do?
Professor Hal Scott: Well, the Treasury itself guaranteed the money market funds, which was a very important measure, because we saw a run on those funds following the failure of Lehman. I think, more importantly, or just as importantly, at least, the Fed lent to both banks and non-banks. The FDIC increased insurance limits, in fact, to infinity on ordinary demand deposits. There was no threat that payments would be disrupted as a result of the crisis.
Steve Pomeranz: The government was acting as lender of last resort. Can you describe that and give us a little history on being the lender of last resort?
Professor Hal Scott: Yeah. That’s sort of a major theme of my book. In a financial panic, what happens is that people just try to get their money out of wherever it is, in a bank or even a non-bank that they can withdraw the money from, because they’re kind of worried about the future. That happened a number of times in our history and a very severe crisis took place in 1907 as a result of this, which actually resulted in the creation of the Fed in 1913. The idea is if you have a solvent financial institution that’s just experiencing difficulty because of an irrational panic, we had one in the Depression, as you recall, it’s not completely irrational. It’s just there were fundamental things underneath, that the Fed comes forward and lends to the financial institutions in difficulty because you and me, and all the institutions are withdrawing our money.
Steve Pomeranz: Well, you know, there used to be a saying that when you see a line around the block at your bank, join it. Right?
Professor Hal Scott: Yeah.
Steve Pomeranz: The idea is not to ever get the financial system to that point. My understanding was that the cause of the crash, simplistically, obviously, stating, was that the value of those mortgage-backed securities—which turned out to be so poorly constructed and really worth much less than they thought—burned a hole through the bank’s balance sheets, effectively shutting down lending and ruining the collateral against which many loans were based. Is that accurate? Or is that kind of myth?
Professor Hal Scott: No. I think that was kind of the thing that set everything in motion. It really was the decline in housing prices that made all those vehicles untenable. That evolved into something quite different where you had runs on money market funds that weren’t holding anything, where companies like Xerox couldn’t issue commercial paper. There was a fundamental problem, as you pointed out, but it quickly became kind of a panic about everything. That’s what a contagion is, when you’ve got this irrational run on the financial system. That became a much more serious problem in some ways to our economy than even the collapse in housing prices.
Steve Pomeranz: The irony is that it’s not necessarily whether an institution itself is solvent because there will be institutions that are poorly managed or that are directly affected by some negative economic event, but this contagion can spread across banks or any financial company that have absolutely no securities, none of the affected securities and no balance sheet that’s affected at all. What causes this contagion? Why is everything being sold? Why is the baby being thrown out with the bathwater, as they say?
Professor Hal Scott: Well, people just get nervous. We kind of dodged a bullet a couple weeks ago with Brexit. I’m not sure we completely dodged it yet. You remember, sort of, after the vote, people were speculating, “What’s going to happen in the future? Is Europe falling apart? Is Britain going down the tubes?” That kind of sort of concern can quickly turn into a total overreaction, where everybody says, “Better safe than sorry. I’m getting my money out and I’m not loaning anymore.” It’s very hard, Steve, to say what creates that panic. An economist once wrote a famous article saying sun spots can create a panic. You never know. You never know.
Steve Pomeranz: Well, depositors and investors don’t have the same information as institutions have which hold their money, so you state in your book that individuals use the actions of their peers as a cost effective way to judge what’s really going on. Can you explain that a little bit?
Professor Hal Scott: Well, by the way, this is, I would say, what we’re talking about, and our audience is largely composed of individuals. The real problem is not so much you and me, it’s other institutions, banks not loaning to banks, nobody in the bond market buying commercial paper, and so forth. It’s that kind of activity at a very wholesale level, not you and I, but companies who just sort of say, “I’m not giving anybody my money anymore.” Once that happens, your whole economy can freeze up.
Steve Pomeranz: My guest is Professor Hal Scott. He’s the Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School. He’s written a book, Connectedness and Contagion: Protecting the Financial System from Panics.
The institutions that are effective also have a bias against seeing the world as it is. You mentioned in your book that Allen Schwartz, the former CEO of Bear Stearns, was denying any rumors of the deterioration of the bank’s financial condition right up to the last minute. Either he knew and he wasn’t saying, or he actually didn’t know. Really, all the other players don’t have the information, especially if the CEO doesn’t have it.
Professor Hal Scott: Well, no, they don’t. Even, as you point out, maybe Phelps didn’t even know, you know? Your balance sheet or Lehman’s balance sheet in that period was highly dependent on the valuation of its assets. Those evaluations really depended on, well, what did the market think? It’s commercial, a lending portfolio, it was very hard to know. As soon as the market said, “I don’t know, it could be disastrous,” then everyone started withdrawing their money from Lehman, and that’s what really precipitated its bankruptcy.
Steve Pomeranz: Since the 2008 crisis, the government has asked and demanded that banks shore up their capital to make sure that they have enough capital to weather the next financial crisis. You’re stating that you don’t think that the capital issue is the most important issue because it doesn’t address the contagion issue. Why is that?
Professor Hal Scott: Well, your capital highly depends on the value of your assets, so what happens when people start withdrawing money, you’ve got to sell those assets to get cash to give them the money they want. We call that a fire sale. You’ve got to sell them, you have no choice. Well, that, in turn, means that everybody holding those assets loses value. What happens in this situation is you run through your capital very, very quickly. No sensible amount of capital …we increase capital requirements—and I’m giving you a rough estimate—maybe double them from 8 percent of assets to 15 percent for the largest banks as a result of a crisis, 15 percent… you run through that very, very quickly in a contagious panic. So no sensible amount of capital—if we really want to have any lending in our economy—would ever be enough to protect yourself against a run.
Steve Pomeranz: It’s being said that—you had mentioned Brexit before and looking at the Euro—that if interest rates continue to stay negative there and more and more countries and banks continue to offer interest rates negative, that depositors will pull their money out because it’ll be a lot cheaper to keep your money in a vault somewhere than it would be to keep it on deposit at an institution where you actually have to pay for them to hold it. That could cause a run on the banks in Europe. Is that a viable risk right now?
Professor Hal Scott: I think it’s a definite risk, and I think we don’t see yet, as far as I know, and with very few exceptions, banks really charging their customers to hold money there for the very reason you just stated. Now, if I kept my money in a safe, and, again, not you and I, but if we’re talking about large institutions which have millions and millions of dollars in account with banks, keeping your money in a safe could be expensive, too, Steve. Really, it’s the question of they can charge you a little to keep your money, but there’s going to come a point where there are going to be competitive alternatives. They can’t charge so much that you really would be better off renting out a safe some place.
Steve Pomeranz: We’re talking about, in America, we talk about banks that are too big to fail. You don’t believe that Dodd Frank legislation has really done enough or addressed necessarily the right issue because it’s addressed the capital issue and also the government’s ability to act in times of stress, which I think I read from your book that you feel is-
Professor Hal Scott: It’s wrongly addressed that issue.
Steve Pomeranz: Yeah, go ahead. Give us an idea of what’s wrong with Dodd Frank in that area.
Professor Hal Scott: Well, I’m for higher bank capital; I’m very much in favor of that. We’ve also introduced a better way to resolve large institutions, which should decrease the problem of too big to fail. The main problem, Steve, in the aftermath of 2008 was all the things that we did successfully—lender of last resort, deposit insurance, guarantees by the Treasury in the money market funds, and indeed TARP—all that has been, until this day, is demonized as bailing out Wall Street. For that reason, all of those weapons that we use to fight successfully the crisis in 2008 have been now restricted or eliminated.
If we had another crisis here, we would not be in a really good position to fight it. I think that should be changed. It’s nice to talk about bailing out Wall Street and say anybody who ever lends money to the banks is corrupt, et cetera, et cetera, but what did Brexit have to do with bad bank behavior? That was a political issue in Europe. Or, if there were a major terrorist event, that could set in motion contagion. We need to be able to deal with it if it occurs, and, unfortunately, right now, we’re not.
Steve Pomeranz: Professor Hal Scott, Nomura Professor and Director of the Program of International Finance Systems. The book is, Connectedness and Contagion: Protecting the Financial System from Panics. I will tell you I read it, and it’s a book that states the facts without bias and without rhetoric as well. If you’re interested in this topic, I recommend this book. Professor Scott, thank you so much for joining me.
Professor Hal Scott: My pleasure. Thank you.