By Hal S. Scott
The Dodd–Frank Act of 2010 used to be meant to reform monetary guidelines with a purpose to hinder one other great situation akin to the monetary meltdown of 2008. Dodd–Frank is essentially premised at the analysis that connectedness used to be the most important challenge in that crisis—that is, that monetary associations have been overexposed to each other, leading to a potential chain response of disasters. during this booklet, Hal Scott argues that it's not connectedness yet contagion that's the most vital part of systemic danger dealing with the economy. Contagion is an indiscriminate run via momentary collectors of monetary associations which may render differently solvent associations bancrupt. It poses a significant danger simply because, as Scott explains, our economy nonetheless depends upon nearly $7.4 to $8.2 trillion of runnable and uninsured momentary liabilities, 60 percentage of that are held via nonbanks.
Scott argues that efforts via the Federal Reserve, the FDIC, and the Treasury to forestall the contagion that exploded after the financial ruin of Lehman Brothers lessened the industrial harm. And but Congress, spurred via the public's aversion to bailouts, has dramatically weakened the facility of the govt to reply to contagion, together with boundaries at the Fed's powers as a lender of final hotel. supplying uniquely certain forensic analyses of the Lehman Brothers and AIG mess ups, and suggesting substitute regulatory ways, Scott makes the case that we have to restoration and boost our guns for battling contagion.
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Additional info for Connectedness and Contagion: Protecting the Financial System from Panics
55 One potential weakness of this theory is that it may be challenging to construct empirical tests for the presence of multiple equilibria. However, Hortacsu et al. (2011)56 constructed a testable model in which companies face a negative feedback loop between their perceived financial health and demand for their products. In this model, financial distress can reduce the demand for a firm’s products by, for example, reducing the expected value of the company’s warranties. In the banking sector, a warranty corresponds to a bank’s promise to convert deposits to cash on demand.
The fall of housing prices in the period prior to the 2008–2009 financial crisis). Correlation can also refer to the herding instinct of asset managers that can result in market crashes and instability, or in irrational asset bubbles. In addition the academic literature discussing “indirect” connectedness is really discussing correlation. 3 Herding behavior involves the tendency of asset managers to move out of a particular security or asset class in a correlated manner. The concern is that if most large asset managers sell at the same time, the market for that security or asset class may collapse, putting stress on all holders of such assets.
26 Chapter 4 the time of the Lehman bankruptcy. This subsection therefore focuses on the magnitude and nature of third-party exposures to LBHI and its Chapter 11 affiliates and, to some degree, the recoveries that third parties expected or had reason to expect from the estate, concluding that the potential exposure of $150–250 billion was not destabilizing and that creditors could have reasonably expected to recover on a nonnegligible portion of their claims. The claims data from the Initial and Modified Third Amended Plans provide a clear picture of the magnitude and sources of potential thirdparty exposure to Lehman.
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