If it were simpler to explain, address or even pronounce, interconnectedness might have been the primary target of financial system reformers.
After all, it was concern about exposures to counterparties, and to counterparties' counterparties, that accounted for most of the panic in the markets 18 months ago.
Interconnectedness "char-acterize[s] the operation of the modern financial system," said Randall Kroszner, a University of Chicago economics professor and former Federal Reserve Board governor. "We need to acknowledge that and make sure our regulatory system is effective in dealing with an interconnected system rather than a system that looks like it did 50 years ago."
But the ensuing policy debate has been bogged down instead in rancor over whether to limit the size of banks, where to house consumer protection enforcement and how to define proprietary trading. These are valid questions, perhaps, but they may not do much to get at what many in the industry see as the central problem exposed by the crisis.
"The political messaging has overtaken the substance," said Scott Talbott, senior vice president for government affairs at the Financial Services Roundtable, which represents executives of the largest financial institutions.
And if that is a predictable response from a group at odds with the recent political messaging — namely the momentum-gathering mantra that big banks are bad — consider the distinction between size issues and interconnectivity issues drawn by Dana Chasin, legislative and policy liaison at Americans for Financial Reform, an umbrella organization for more than 250 consumer, labor and community advocacy groups: "These are not just apples and oranges, the questions of size and interconnectedness. They're apples and elephants."
Chasin, whose coalition includes the AFL-CIO, AARP and the Consumer Federation of America, said he's been encouraged by recent efforts in Congress to at least raise the issue of interconnectedness. The regulatory reform bill proposed by Senate Banking Committee Chairman Chris Dodd calls for the creation of an Office of Financial Research, which would work under the Treasury Department to collect data and conduct analysis to monitor systemic issues and identify emerging risks, while legislation passed by the House lists interconnectedness among the primary factors that regulators should consider in determining whether a financial company is too big to fail.
The issue of interconnectedness "is playing a more important [policy] role than it was six to eight months ago," Chasin said.
But as a popular rallying cry it still gets trumped by size, because size is so much easier to measure and define.
And yet in the fall of 2008, the biggest disruptions to the regular functioning of the financial system were caused by the things that people could not measure, or could not define: Would the government explicitly support Fannie Mae and Freddie Mac to prevent more dominoes from falling in the housing market? Would fire sales for all kinds of exotic securities lead to writedowns that might render big banks insolvent? Would everyone on the hook for credit default swap settlements be able to make good on the contracts?
Peter Wallison, an American Enterprise Institute fellow, argues that aside from the commercial banking system — where interconnectedness is inherent in the payments system and deposits and the like — the issue is little more than a bogeyman. Even when the government decided to rescue American International Group, there was no proof that the insurance company was too interconnected for the rest of the system to be able to handle a failure, he said.
"I think what happened in the AIG case was that the Fed really panicked," he said. "It's very unlikely that a large financial institution would rely so much on any other single financial institution that the failure of one of them would cause the failure of the [other]. They're all very widely diversified."
But Mark Williams, a finance instructor at Boston University and a former bank examiner at the Fed, said the perils of having increased levels of interconnectivity without a commensurate regulatory response were on full display that fall, particularly when Lehman Brothers failed.
The problem "wasn't that we let this company get so interconnected," said Williams, author of "Uncontrolled Risk," a new book about the lessons of Lehman. "It was that the warning signs of interconnectedness and risky behavior were percolating for years, yet there wasn't the infrastructure to mandate higher capital standards, and leverage ratios were able to be increased. We allowed greater risk-taking with lower controls. That's where we failed."
Williams also said we've yet to fully confront other interconnectivity issues underscored by the crisis, including credit derivatives.
"Derivatives could be the best thing since the iPod, or they could be financial dynamite in the wrong hands," he said. Either way, "there should be more restrictions on the speculative nature of them."
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