It has been strongly asserted by some regulators, including the Federal Deposit Insurance Corporation, that the Dodd-Frank Act now permits the safe resolution of any systemically important financial institution that becomes distressed. I disagree.
Failures among some of our largest financial institutions remain a significant potential danger to our economy. This risk is currently greatest in Europe.
Going forward, a large bank may indeed be allowed by its government to fail, but the resulting impact on other market participants could be quite damaging. This is especially so if more than one such institution fails around the same time.
The likelihood of big-bank failures will become lower after the scheduled increases in regulatory bank capital and liquidity mandated under the proposed “Basel III” international accord. Yet, to a significant degree, the fragilities I explain in How Big Banks Fail remain.
Given the continuing potential for large bank failures, additional measures should be taken to reduce this failure risk and to mitigate the contagion effects of a collapsing major bank or a large financial institution that operates outside of the regulated banking sector.
These measures should include the “hardening” of key market infrastructure, such as central transaction clearing utilities. Some regulations, for example those covering the safety of money market funds, should be further tightened.
The ongoing European sovereign debt crisis has replaced the “subprime crisis” as a fomenter of systemic financial risk. Other forms of financial crises could follow. These may include a global currency crisis, a U.S. or Japanese sovereign debt crisis, the breakdown of a financial market through a failure of information technology, or recurrent collapses of large real estate markets.
Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business. He is a Fellow of the American Academy of Arts and Sciences and past President of the American Finance Association, and serves on the board of directors of Moody’s Corporation and on the Financial Advisory Roundtable of the Federal Reserve Bank of New York.