Connectedness and contagion tied to institutional structures

 

There is a lot of talk about connectedness and contagion in markets, yet the institutional structures are often overlooked as major contributors to the cause or control of major market shock events that are associated with panics. Hal Scott in his book Connectedness and Contagion: Protecting the financial system from panics. As a lawyer Scott has a different perspective than most economists, but this is a useful book for any economist who is studying panics. The focus is on the policies and their impact on markets from the Great Financial Crisis. Some policies have been critical at mitigating any panic and contagion, but Scott also suggests that policy changes and structures can add to potential risks. 

We often find that markets are more connected than expected during a crisis. Whether third party creditors, derivative counterparties, prime brokerage, structured securities, or money market funds, there are a myriad of connections that lead to connectedness and higher correlations. The contagion during the GFC was significant across the banking system, money markets, and brokerage firms. There have been changes in the system, but we again found that significant connections existed during the Great Pandemic. Solve one problem and a new one will arise. 

All the panic problems are attempted to be solved through the lender of last resort, yet the idea of lending freely in a crisis is not as easy as waiving some magic monetary or fiscal wand. The rules and programs that need to be in place or are in place can be very complex. Unfortunately, Scott makes the case that some of the rules post-GFC have reduced the ability of the Fed and the government to serve as the lender of last resort, and rules can add significant complexity to the marketplace. There is not uniformity of rules across all central banks, so if there is a global contagion, it is not clear how different central banks will respond. 

Banking rules such as the Basel III framework are complex, yet other supposedly simple approaches will not solve the problem. The designation of globally systematically important banks, risk-weighted assets, leverage ratios, stress tests, liquidity requirements, living wills, contingent capital, or other attempts to solve contagion may lead to other problems which are not obvious. Money market funds like banking institutions have similar problem with trying to regulate away crises. However, rules are needed because bailouts are expensive and in a crisis mistakes will be made.

The watch words form this book - know your institutions and regulation before a crisis because once a panic comes it will be too late to try and understand the system.