101 California Law Review, Vol. 101, pp. 1641-1703, 2013
56 Pages Posted: 6 Mar 2013 Last revised: 27 Aug 2016
Date Written: August 11, 2013
Regulatory reaction to the 2008-2009 financial crisis focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk, and that the destructive impact of the failures during the crisis of AIG, Lehman Brothers, and the Reserve Primary Fund could have been softened or eliminated were strong clearinghouses in place. Via the Dodd-Frank Wall Street Reform Act, Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could cut financial risk, reduce contagion, and halt a local financial problem before it becomes an economy-wide crisis.
But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008–2009 crisis. Although they are efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times. They generally do not reduce the core risk targeted — that the failure of a financial firm will cause other firms to fail — but rather transfer that risk of loss to others. The major reduction in risk among the inside-the-clearinghouse traders is largely achieved by pushing that risk elsewhere, often to a systemically dangerous spot. Financial contagion can thus side-step the clearinghouse fortress and bring down other core financial institutions. Worse, clearinghouses could not have readily handled the major stresses that afflicted the economy in 2008–2009, could well have transmitted and magnified them, and can only weakly affect the type of financial stress that Congress targeted with Dodd-Frank. When we add in the other weaknesses of the new clearinghouses — as too-big-to-fail institutions, as institutions whose members’ incentives to contain clearinghouse riskiness are weaker than the public’s, and as institutions that will not be easy to regulate — even the direction of clearinghouses’ impact on systemic risk is uncertain.
The stakes are high in correctly assessing the value of clearinghouses in containing systemic risk. Much like an overconfidence inspired by powerful military fortresses that an invading enemy can side-step, the reigning overconfidence in clearinghouses lulls regulators to be satisfied that they have done much to arrest problems of contagion and systemic risk by building up clearinghouses, when they have not.
Keywords: bankruptcy, financial crisis, contagion, bank run, qualified financial contracts, derivatives in bankruptcy, Dodd-Frank Act, systemic risk
JEL Classification: G20, G28, G32, G33, G38, K22
Suggested Citation: Suggested Citation