In mid-March 2008, Bear Stearns took its place in history as the first of the major bailouts during the most recent financial crisis. The minutes of the March 14, 2008 meeting of the Federal Reserve’s Board of Governors rationalized the bailout by highlighting the “expected contagion that would result from the immediate failure of Bear Stearns.” A few weeks later, in an early April 2008 hearing on Bear Stearns, then–Fed chairman Ben Bernanke jettisoned the references to contagion and instead spoke of how “extremely complex and interconnected” the financial system was, spawning use of the phrase “too interconnected to fail.” That became the phrase du jour to describe the risk of allowing Bear Stearns and, later, other institutions to fail.

What should we make of the use of such technical and ever-changing terminology as the response to the crisis evolved? In Connectedness and Contagion, Hal Scott brings to light what is meant by phrases like “connectedness” and “contagion,” and applies these concepts to the context of the recent financial crisis as well as other historical financial crises.

Scott is a professor at Harvard Law School and director of the school’s Program on International Financial Systems. He is also the director of the Committee on Capital Markets Regulation, a bipartisan and nonprofit group whose objective is to enhance the competitiveness of U.S. capital markets and ensure the stability of the U.S. financial system via research and advocacy. Scott’s publications include the Foundation Press textbooks International Finance: Transactions, Policy, and Regulation (with Anna Gelpern, now in its 20th edition) and The Global Financial Crisis (a new paperback edition comes out this year). Earlier this year, the Trump administration considered him for the position of vice chairman for supervision at the Board of Governors of the Federal Reserve, an important position that was created as part of the post-crisis Dodd-Frank reforms.

As the Trump administration, along with the House Financial Services and Senate Banking Committees, begins to consider banking reform, some have argued that the Dodd-Frank Act went too far in retaining the tools for the Federal Reserve to intervene in large, weak institutions. Scott takes a different tack in Connectedness and Contagion, arguing that Dodd-Frank actually went too far in trimming back those powers.

Clarifying concepts / Scott wastes no time in providing a lucid set of definitions for “connectedness” (“concern that the failure of one bank will cause the failure of others”); “correlation” (“failure of multiple institutions due to a collapse in asset prices”); and “contagion” (“indiscriminate spread of run-like behavior throughout the financial system, including to healthy institutions”). He labels these the “three Cs of systemic risk.” These concepts were widely used during the financial crisis by the financial authorities and repeated by the media, but rarely defined. He then launches into a summary of the academic literature for the “three Cs.”

Scott lays out compelling examples from the crisis (particularly Lehman Brothers and AIG) to argue that the extent of interconnectedness was overstated and concludes that interconnectedness was not a major problem. He makes the further point that changes in the Dodd-Frank Act, such as imposition of central clearing, exposure limitations, and designation of Systemically Important Financial Institutions, were based on a false narrative: “Thus the Dodd-Frank Act has strong measures to combat connectedness despite the lack of evidence that this was a real problem in the crisis.”

He argues, rather than the ongoing focus on interconnectedness, that contagion was actually at work during the crisis in the money market fund and investment bank industry, as well as the commercial paper, interbank lending, and repo markets after the failure of Lehman. On money market funds, he states, “Clearly, investors were running as a result of general panic and not concern over a particular fund’s fundamentals.” As for the third C, correlation, Scott concludes, “Although correlation played an important role in the recent crisis, contagion is what transformed $100–200 billion in losses on subprime mortgage products into the destruction of roughly $8 trillion of equity market capitalization between October 2007 and October 2009.”

An open-ended power to lend / Scott dedi cates nearly a quarter of the book to the Fed in its role as lender of last resort (LLR), arguing that LLR is a very effective means to fight contagion. He builds his case for a strong LLR with plenary authority, arguing that it “is even more important than a strong and independent manager of monetary policy.” He tips his hand from the start, describing the Fed’s LLR measures during the financial crisis as “heroic and creative,” which follows up on the book’s up-front dedication: “To all those who so successfully fought the panic created by the financial crisis of 2008.”

He traces the history of LLR back to the days of Walter Bagehot and the nation’s early central banks, the First and Second Banks of the United States. Throughout this section, he rants against “populist” sentiment, a phrase he applies with derision, which is also a tactic Bernanke deployed in his memoir of the financial crisis. Scott targets those who question the efficacy of concentrating such broad-based lending powers in the hands of the government:

It is important to understand this history not only because it explains why it took so long to create the Fed but also because the populist objections to any kind of government bank are still with us today and indeed are the main factor why the Fed is now such a weak lender of last resort.

As you might expect, he is not pleased with the provisions in the Dodd-Frank Act that reduce the extent of plenary authority the Fed exercises as LLR. Among the provisions he dislikes:

  • no loans to single institutions
  • nonbank loans must be approved by the treasury secretary
  • no loans to insolvent institutions
  • no funding to nonbank affiliates
  • tougher collateral requirements
  • disclosure to the public and Congress

He claims that these provisions “have made our financial system much less stable” and argues for the elimination of most of the restrictions. In doing so, he ignores the whole line of argument—most articulately advanced by Anna Schwartz in her 1992 paper, “The Misuse of the Fed’s Discount Window”—that the Fed has abused its plenary authority by propping up weak (particularly large) institutions going back at least as far as the 1920s. This is in conflict with Bagehot’s dictum to only lend to “sound” institutions.

Scott rounds out this LLR discussion by laying out a side-by-side comparison of the powers of the Fed, Bank of England, European Central Bank, and Bank of Japan. He concludes that the United States “grants by far the weakest [LLR] powers to its central bank, particularly with respect to nonbanks.” He concludes that reversing some of the Dodd-Frank changes and granting further discretion to the Fed are the answers for stability.

Hooray for bailouts / The last major section of Connectedness and Contagion addresses bailouts, which Scott euphemistically calls “Public Capital Injections into Insolvent Financial Institutions.” He lays out what is probably the most full-throated defense of bailouts that has been published since the memoirs of Bernanke and Obama administration treasury secretary Timothy Geithner.

In the introduction to this section, he offers the oft-repeated argument in Chicken Little–style language that “bailouts are realistically the lesser of two evils, if economic collapse is the alternative.” As with most commenters who take such an approach, he engages in speculation and, I believe, wildly overstates the likelihood of economic collapse.

Rather than defend bailouts head-on, most of his discussion is spent raising up various criticisms of bailouts and then, in straw man fashion, debunking them. For example, he admits that the moral hazard concerns are the “strongest argument against government bailouts.” But he does not really address the fact that in a market economy failing institutions should be subject to the same elements of market discipline as any other institution and that banks are simply not as “special” as bailout defenders make them out to be. Additionally, Scott does not offer any evidence that “bridge banks” do not work. This is a major oversight because a bridge bank is an available method for resolving large, complex, “too big to fail” institution (TBTF) and any complete analysis of resolving these mega institutions would have addressed it. He only mentions bridge banks in reference to the Japanese system, but he does not address bridge banks and their use to ease a TBTF bank through a marketing process by temporary nationalization.

The depth and level of detail in the endnotes for Connectedness and Contagion (which take up a full 100 pages of the book) are truly impressive. The notes reveal a deep level of analysis of the studies, speeches, testimony, legislative provisions, and media materials for the range of topics under scrutiny in the book. I expect to refer to them many times in the future as I do my own research on LLR and bailout-related topics.

Connectedness and Contagion is thus a useful reference guide and the views presented on connectedness and contagion are well-supported. However, the arguments regarding the issues of LLR and bailouts are the same tired arguments we have heard over the past decade, about how we should trust the financial authorities like the Federal Reserve to “do the right thing” when it comes to propping up our largest financial institutions. If you buy into that policy approach, then Connectedness and Contagion should be on your reading list.