Table of Contents
Acknowledgments xiii
Introduction xv
I Connectedness, Contagion, and Correlation: Definitions and a Review of the Economic Literature
1 The Concept of Connectedness 3
1.1 Asset Connectedness 3
1.2 Liability Connectedness 4
2 The Concept and History of Contagion 5
2.1 History of Contagion 6
2.2 Panicked Runs: Multiple Equilibria (Outcomes) 9
2.3 Information Economics 12
2.4 Measures of Systemic Risk 14
3 The Concept of Correlation 15
II Connectedness in the Crisis
4 Asset Connectedness: Lehman and AIG 19
4.1 Lehman Brothers' Collapse and Bankruptcy 19
4.2 Effects of the Lehman Collapse on Different Counterparties 24
4.2.1 Third-Party Creditors: Exposures and Expectations 25
4.2.2 Derivatives Counterparties: Exchange-Traded, CDS, and OTC Portfolios 30
4.2.3 Prime Brokerage Clients 47
4.2.4 Structured Securities Investors 48
4.2.5 Money Market Funds 50
5 Liability Connectedness: Money Market Funds and Tri-Party Repo Market 53
5.1 Money Market Funds and Liability Connectedness 54
5.2 Tri-Party Repo Market and Liability Connectedness 55
6 Dodd-Frank Act Policies to Address Connectedness 59
6.1 Central Clearing 59
6.2 Exposure Limitations 61
6.3 SIFI Designation 62
III Contagion
7 Contagion in the 2008 Crisis: The Run on the Nonbank Sector, "Shadow Banks" 67
7.1 Overview 67
7.2 Contagion after Lehman 71
7.2.1 Money Market Funds and Commercial Paper Markets 71
7.2.2 Interbank Lending and Repos 73
7.2.3 Investment Banks 74
7.3 Government Responses to the 2008 Contagion 75
8 History of Lender of Last Resort in the United States 79
8.1 First and Second National Banks 80
8.1.1 General Background and Powers 80
8.1.2 First Bank of the United States (1791-1811) 82
8.1.3 Second Bank of the United States (1816-1836) 84
8.2 Creation of the Federal Reserve System in 1913 and Its Authority as Lender of Last Resort to Nonbanks 88
9 Dodd-Frank Restrictions on the Lender-of-Last-Resort Power 93
9.1 Broad Program Requirement 94
9.2 Requirement of Approval by the Secretary of the Treasury 96
9.3 Loans Only to "Solvent" Institutions 101
9.4 Banks Cannot Use the Proceeds of Discount Window Loans to Make Loans to Their Nonbank Affiliates 104
9.5 New Collateral Policies Imposed on the Fed 105
9.6 Disclosure Requirements 106
10 Comparison of LLR Powers of Fed with Bank of England, European Central Bank, and Bank of Japan 109
10.1 Bank of England 109
10.1.1 Sterling Monetary Framework 110
10.1.2 Participation in the Sterling Monetary Framework and Acceptable Collateral 111
10.1.3 Discount Window Lending 112
10.1.4 Contingent Term Repo Facility Lending 113
10.1.5 Emergency Liquidity Assistance 114
10.1.6 ELA Assistance to Solvent Banks and Nonbanks 115
10.1.7 Lending at Treasury Direction 115
10.2 European Central Bank 116
10.2.1 Emergency Liquidity Assistance 116
10.2.2 ECB and European Commission Authority to Restrict NCB LLR 119
10.2.3 Liquidity via ECB Monetary Policy Operations 120
10.2.4 Long-Term Refinancing Operations 121
10.2.5 Purchasing Programs 122
10.3 Bank of Japan 122
10.3.1 Article 33 123
10.3.2 Article 38 124
10.3.3 Article 37 125
10.3.4 Article 44 126
10.4 Comparison of LLR Powers of the Four Central Banks 126
10.4.1 Independence 126
10.4.2 Ability to Lend to Nonbanks and Supervisory Authority 130
10.4.3 Regime Structure 130
10.4.4 Collateral 131
10.4.5 Requirement of Solvency 131
10.4.6 Treasury Approval or Direction 133
10.4.7 Need for a "Broad Program" 134
10.4.8 Disclosure Requirements 134
10.4.9 Using Discount Window Proceeds to Lend to Affiliates 135
11 Strengthening the LLR Powers of the Fed 137
12 Liability Insurance and Guarantees 145
12.1 Amount of Liabilities to Insure 148
12.2 Insurance Pricing 151
12.3 Ex ante Pricing 151
12.4 Option Pricing 154
12.5 Ex post Pricing 155
12.6 During a Crisis 157
12.7 International Challenges 157
13 Insuring Money Market Funds 161
Conclusion to Part III 165
IV Ex ante Policies to Avoid Contagion: Capital, Liquidity, Resolution, Money Market Mutual Fund Reform, and Limits on Short-Term Funding
14 Capital Requirements: Basel III Framework 169
14.1 Higher Basel III Capital Requirements 170
14.2 Surcharges for Globally Systemic ally Important US Banks 172
14.3 Risk-Weighted Assets Approach (RWA) 174
14.4 Leverage Ratio Approach 174
14.5 Tighter Definitions of Capital 176
14.6 Stress Tests 176
14.7 Calls for Even Higher Levels of Capital 177
14.8 Economic Impact of Capital Requirements 179
14.9 Role of Markets in Setting Capital Levels 180
15 Liquidity Requirements 183
15.1 Basel Liquidity Requirements 185
15.2 US Implementation of Basel Liquidity Requirements 186
16 Bank Resolution Procedures, Contingent Capital (CoCos), and Bail-Ins 189
16.1 Contingent Convertible Capital Instruments (CoCos) 190
16.1.1 Demand for CoCos 192
16.1.2 Conversion Triggers 192
16.2 Creditor Bail-ins by Regulators 194
16.2.1 Shortcomings of Bail-in outside Formal Resolution 196
16.2.2 Bailable Instruments and the Amount of Losses 197
16.2.3 Other Potential Obstacles to Bail-In 200
17 Dodd-Frank Orderly Liquidation for Nonbank SIFIs (Including Bank Holding Companies) 205
17.1 General Design of OLA and the SPOE Strategy 205
17.2 Total Loss Absorption Capacity (TLAC) to Assure Holding Company Recapitalization 208
17.3 Recapitalization of Operating Subsidiaries: Banks and Broker-Dealers 210
17.4 Derivatives Contracts 215
17.5 International Coordination Problems 216
18 Living Wills 219
19 Money Market Mutual Fund Reform 223
19.1 Enhanced Liquidity Requirements 224
19.2 The 2014 Reforms: Floating NAV, Redemption Fees, and Gates 225
19.3 Floating NAV 226
19.4 Liquidity Fees and Redemption Gates 227
19.5 Capital Requirement 229
19.6 Insurance 229
19.7 End of Public Institutional Prime MMFs? 230
20 Dependence of the Financial System on Short-Term Funding 231
20.1 Quantifying Short-Term Funding 231
20.1.1 Gross Funding 232
20.1.2 Net Funding 234
20.1.3 Importance of Short-Term Funding 235
20.2 Caps on Short-Term Funding 236
20.3 Indirect Limits on Short-Term Funding 237
21 Government Crowding Out of Private Issuance of Short-Term Debt 239
21.1 Crowding Out by the Treasury 239
21.2 Crowding Out by the Federal Reserve 241
21.2.1 General Overview of Fed's Tools of Monetary Policy 242
21.2.2 Interest on Excess Reserves and Reverse Repo Program 242
21.2.3 IOER and RRP Impact on Private Short-Term Debt Issuance 243
21.2.4 Size of the RRP Program 244
21.2.5 Potential Conflicts between Monetary Policy and Increasing the RRP Program to "Crowd Out" Private Short-Term Debt 245
21.2.6 Adverse Consequences of Partial and Full Crowding Out via RRP 247
V Public Capital Injections into Insolvent Financial Institutions
22 Capital Purchase Program and Other TARP Support Programs 251
22.1 Design of TARP 252
22.2 Expiration and Wind-Down of TARP 255
22.3 TARP Housing Programs Have Not Been Wound Down 261
23 Criticisms of Bailouts Generally 265
23.1 Taxpayer Loss 265
23.2 Bailouts May Not Work or Be Prolonged 267
23.3 Creation of Moral Hazard and Too-Big-to-Fail Competitive Advantage 268
23.4 Bailout Decisions May Be Political and Ad Hoc 270
23.5 Bailouts May Fail to Boost Lending Activities 271
24 Specific Criticisms of TARP 273
24.1 Too Favorable Terms for CPP Participants 273
24.2 Interference with Firm Operations 274
24.3 Lack of Enforcement of the CPP's Contractual Terms 275
24.4 Comparisons with Foreign Bailout Efforts in the 2008 Crisis 275
25 Standing Bailout Programs 279
25.1 Standing Bailout Programs in the European Union and Japan 279
25.1.1 Eurozone 279
25.1.2 Japan 281
25.2 Virtues of Standing Bailout Authority 284
26 Conclusion 287
Appendix 295
Notes 303
Index 405
