United States: CFTC Interviews Harvard Law Professor On "Connectedness And Contagion"

Last Updated: September 25 2017
Article by Robert Zwirb

Most Read Contributor in United States, September 2017

In a "CFTC Talks" podcast interview conducted by CFTC Chief Market Intelligence Officer Andrew Busch, Harvard Law Professor Dr. Hal Scott – author of Connectedness and Contagion and The Global Financial Crisis, and Director of the Program International and President and Director of the Committee on Capital Market Regulation – discusses the 2008 financial crisis and where he sees financial market regulation heading in the U.S.

In the podcast, Dr. Scott gives his assessment of the current health of the U.S. financial structure as one that is both "underly" and "overly" healthy. According to Dr. Scott, this state of affairs is largely in reaction to the last financial crisis and the desire of regulators to prevent the reoccurrence of another one. As Dr. Scott explains:

"I think we're overdoing it with capital liquidity requirements. Kind of a reaction obviously to the crisis that I think we're trying to prevent something at a level of prevention that is so unlikely to occur. And on the other hand, we're going to pay and are paying a stiff price in current economic activity to prevent something at levels of prevention that are excessive."

While Dr. Scott believes that the capital and liquidity requirements are overdone, and that the problems can be solved by the regulators, he expresses doubts as to their willingness to readjust.

"And by the way, the capital and liquidity requirements that the system has is really not kind of dictated by Dodd-Frank. It's more sort of regulatory policy, it's the Basel Committee. So there's lot of discretion for the Feds here to change those rules. I don't think they'll be changed wholesale, but I do think there will be significant tweaks."

Finally, Dr. Scott discusses the example of the insurer AIG, whose use of credit default swaps and near collapse in 2008 is widely cited as justification for Dodd-Frank. Dr. Scott argues that, contrary to popular perception, a default by AIG would not have bankrupted any of its counterparties.

Commentary / Bob Zwirb

Perhaps the most important part of this interview is where Dr. Scott questions the assumptions underlying the enactment of Dodd-Frank in the aftermath of the financial crisis of 2008.  Recall that the conventional wisdom at the time blamed the lack of regulation of the over-the-counter swaps market before 2009, and insurance giant AIG's buildup of "excessive risk" for the crisis. In particular, former CFTC Chair Gary Gensler argued that financial institutions had become "too interconnected to fail" and that "[t]his interconnectedness [wa]s a direct result of the unregulated over-the-counter derivatives market where financial institutions are contractually obligated to each other through trillions of dollars of derivatives contracts."  Gary Gensler, Clearinghouses Are the Answer:  Complex derivatives should be regulated like commodity futures., Wall St. J. (Apr. 21, 2010).  

In addition to Dr. Scott, some had challenged the validity of these assumptions.  See, e.g., Craig Pirrong, "It's a Wonderful Life, AIG Edition," Streetwise Professor (March 28, 2009) (arguing that AIG was a "symptom, not primary cause," of the financial crisis; that AIG might have been the "particular channel through which the financial flood traveled," but the "underlying causes of the flood lie elsewhere"). But Dr. Scott goes further and takes aim directly at the notion held by regulators that a default by AIG could have easily led to a cascade of defaults resulting in a wider financial collapse.  As Dr. Scott explains:

I think there were assumptions in the market which I think – or maybe I should say of policy makers, not so much in the market, that there was this high degree of interconnectedness problem, so that if AIG went down Goldman was going to go down, or if Lehman went down, you know, counterparties to Lehman, on derivatives particularly, were going to go down . . . You know, my research shows that wasn't the case, hard to really find any major counterparty of Lehman that was affected on the derivative brought from the failure of Lehman.  There just isn't any.  And if you go to AIG . . . the data is that the exposure on capital of their major counterparties when you take into effect collateral, netting, and hedging, was not going to bankrupt any of their counterparties.

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