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Hal S. Scott, Interconnectedness and Contagion (Comm. on Capital Mkt. Reg., Nov. 20, 2012).

Abstract: This 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). 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. Each potential solution is discussed in detail with an evaluation of its effectiveness in addressing financial contagion.