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Interconnectedness, Fragility and the Financial Crisis: “Too Big/Interconnected to Fail” and Moral Hazard Randall S. Kroszner Norman R. Bobins Professor of Economics The University of Chicago Booth School of Business Outline • Financial System and Growth • FragiliMes of the Financial System • “Too Big to Fail” as a subset of “ Too Interconnected to Fail” • Moral Hazard – Sources – Can we put the genie back in the boPle? • Importance of Making Markets More Robust to MiMgate Moral Hazard Financial System and Growth • Numerous studies, using both US and internaMonal data, strong suggest that deep financial market development is a driver of long-‐run economic growth – Is there a trade-‐off between higher average economic growth and higher volaMlity? FragiliMes of the Financial System • Why is the potenMal for instability greater for financial services than in non-‐financials? – Leverage: Financial insMtuMons typically have much higher leverage than non-‐financials – Liquidity: Financial insMtuMons generally have a larger “maturity mismatch,” funding longer-‐term assets with shorter-‐term liabiliMes Interconnectedness and the Crisis • Increasing layers of financial intermediaMon -‐-‐ greater interconnectedness – so informaMon about funders, counterparMes, and customers needed to judge soundness of an insMtuMon – Is this due to • More efficient allocaMon/dispersion of risk? • Regulatory arbitrage? • Thus, “ Too Big to Fail” is really a subset of “ Too Interconnected to Fail” Interlinkages, Liquidity and Leverage • With a marketwide liquidity shock, both asset and liability side of balance sheet face stress – Unplanned asset expansions hence unplanned increase in leverage • Inability to securiMze/sell so stay on balance sheet • Taking on “off balance sheet” assets on balance sheet – Funding “runs” • Deposit insurance largely prevented depositor runs • But inability to obtain even secured financing Funding and Counterparty Fragility • Fragmented structured leading to high reliance on short-‐term external funding – Legacy of Glass-‐Steagall; rise of MMMFs – Unprecedented freezing of even secured funding markets • Interconnectedness through counterparty and funding chains – Legal uncertainty about bankruptcy resoluMon and contract enforcement – In illiquid market, broken hedges can’t be repaired so exposure explodes Moral Hazard • Moral Hazard arises anyMme you think you can get away with taking a risk without having to pay the full consequences of the downside • The Moral Hazard (MH) problem thus is associated not just with potenMal for bail-‐outs – Any insurance contract – Any limited liability system • Highly levered firms have more incenMve to “shoot for the moon” so a high MH potenMal • Double-‐liability pre-‐FDIC and clawbacks Moral Hazard • Concerns about the potenMal for a “cascade” can lead policy makers to intervene • Crucial to make policy makers feel comfortable that an insMtuMon/market can fail without cascading through the intermediaMon chain – Otherwise market parMcipants will not find it credible Moral Hazard • How much is Moral Hazard (limited liability vs bailout potenMal) a driver of the fragiliMes of the crisis? – Bear Stearns? – Leverage and reliance on short-‐term funding? – “Cliff effects” in the tranches of mortgage-‐back securiMes? – UncertainMes in contract enforcement in stress? • So how Mghtly should policy-‐makers hands be Med? – Panic of 1907 MH and the Robustness of Markets • Crucial to understand fragiliMes of market infrastructure that can exacerbate interconnectedness and MH problems • Important to give policymakers and, hence, market parMcipants sufficient comfort that key insMtuMons can fail without causing the system to collapse – Understanding tools/limits of Fed policy • Making markets more robust to enhance that comfort (e.g., resoluMon regime, contract enforcement, central clearing of OTC derivaMves, etc.)
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