Did either interconnectedness or contagion cause the financial crisis

Harvard professor Hal Scott and the Committee on Capital Markets Regulation issued a discussion paper in which they looked at the role played by interconnectedness and contagion in the financial crisis.

They found that contagion was the primary cause of the financial crisis and they offered seven solutions to address the problem.

The study engages in a detailed analysis of interconnectedness (i.e., the linkage between financial institutions) in the context of the failure of Lehman Brothers in October 2008 and concludes that interconnectedness was not a major cause of the recent financial crisis. 

The study continues with a discussion of financial contagion (i.e., run-like behavior that spreads from the perceived failure of a financial institution to other financial institutions) and an analysis of possible solutions to contagion. 

The study highlights that a distinguishing feature of contagion is its ability to spread indiscriminately among firms in the financial sector and notes that contagious runs can occur even if there are no direct linkages to the original institution (i.e., even in the absence of interconnectedness).

This finding is in direct contrast to the finding of the Financial Crisis Inquiry Commission (FCIC).  FCIC found that all financial institutions shared a common interconnectedness and source of contagion.

Specifically, due to a lack of transparency, no financial institution (or investor) could determine if any other financial institution was solvent or not.

Without the ability to determine if a financial institution is solvent, banks with deposits to lend or investors with money to invest refused to lend to banks looking to borrow.  The result was the interbank lending market and unsecured bank debt market froze.

The study comes to the conclusion that contagion was the primary cause of the financial crisis and that short-term funding in particular is the primary source of systemic instability. 

In the context of these conclusions, the study engages in a comprehensive and detailed analysis of the possible solutions to financial contagion. The solutions include: (i) capital requirements, (ii) liquidity requirements, (iii) resolution procedures, (iv) money market mutual fund reform, (v) lender of last resort, (vi) liability insurance and guarantees, and (vii) public bailouts. ....

Please note that requiring the financial institutions to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is not included in the list of possible solutions.

If the financial institutions had been required to provide ultra transparency, then the issues of interconnectedness and contagion would have been moot.

With ultra transparency, each market participant can independently assess the risk of each financial institution and adjust their exposure to what they can afford to lose given this risk.  Included in the market participants who would adjust their exposure are a bank's competitors and investors.

References to transparency showed up 9 times in the study including the following

One example widely discussed during the financial crisis is the Swedish banking bailout in the early 1990s. 

The Swedish bailout adopted a typical “good bank-bad bank” approach and was not noteworthy in terms of techniques. 

However, the Congressional Oversight Panel has noted two aspects of the Swedish bailout: maximum transparency and independence. 

The Swedish government created an entity separate from its existing financial regulators to oversee the bailout efforts and granted it both political and financial independence. The bailout authority then required the banks in trouble to open their books and conducted audits to assess their potential capital needs. 

Gee, ultra transparency!