A prescription is only as good as the diagnosis on which it is based. This is just as true in finance as it is in medicine. And, in Hal Scott\u27s assessment, the reforms adopted in the wake of the 2007-09 financial crisis ( Crisis ) are based on a fundamental misunderstanding of the reasons for that crisis. The future is accordingly bleak

Judge, Kathryn

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If It Ain\u27t Broke, Don\u27t Fix It

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Columbia Law School Scholarship Archive Faculty Scholarship Faculty Publications 2017 If It Ain't Broke, Don't Fix It Kathryn Judge Columbia Law School, kjudge@law.columbia.edu Follow this and additional works at: https://scholarship.law.columbia.edu/faculty_scholarship  Part of the Banking and Finance Law Commons Recommended Citation Kathryn Judge, If It Ain't Broke, Don't Fix It, 70 VAND. L. REV. EN BANC 265 (2017). Available at: https://scholarship.law.columbia.edu/faculty_scholarship/3224 This Article is brought to you for free and open access by the Faculty Publications at Scholarship Archive. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of Scholarship Archive. For more information, please contact scholarshiparchive@law.columbia.edu, rwitt@law.columbia.edu. If It Ain't Broke, Don't Fix ItKathryn Judge*A prescription is only as good as the diagnosis on which it isbased. This is just as true in finance as it is in medicine. And, in HalScott's assessment, the reforms adopted in the wake of the 2007-09financial crisis ("Crisis") are based on a fundamental misunderstandingof the reasons for that crisis. The future is accordingly bleak.In his thorough and thoughtful new book, CONNECTEDNESS ANDCONTAGION: PROTECTING THE FINANCIAL SYSTEM FROM PANICS (2016),Hal Scott argues that the reforms underway are based on the faultyassumption that interconnectedness was the primary problem givingrise to the Crisis. Scott refutes this view by providing the richestaccount to date of the myriad vectors through which the failure ofLehman Brothers may have contributed to weaknesses at otherfinancial institutions and the knock-on effects that would have beentriggered had AIG also been allowed to fail. Having convincinglyestablished that the actual losses arising from Lehman's failure wereinsufficient to explain the magnitude of the fallout that followed, Scottargues that the panic that ensued must instead be the product of"indiscriminate" runs, which he equates with contagion.' The answerfor contagion is a robust lender of last resort, ideally coupled with theoption of crisis-time guarantees. The Dodd-Frank Wall Street Reformand Consumer Protection Act (the "Dodd-Frank Act") moved the needlein the wrong direction on both fronts, while adopting an array of otherreforms that tackle the largely illusory connectedness problem. As aresult, we are less prepared to deal with the next crisis than we were todeal with the last one.The exquisitely detailed, institutionally sensitive treatment ofits subjects are what make this book an important contribution to thealready sizeable corpus of work on the Crisis. That this type oftreatment is required to establish some of the points that Scott seeks toconvey, however, also weakens some of his core claims. For example, incollecting information from the bankruptcy proceedings and numerous* Professor of Law, Columbia Law School.1. HAL S. SCOTT, CONNECTEDNESS AND CONTAGION: PROTECTING THE FINANCIAL SYSTEMFROM PANICS 67 (2014).265VAND. L. REV. EN BANCother sources that detail Lehman's actual exposures to other financialfirms and the hedging undertaken by those firms that reduced theireffective exposure to Lehman, Scott does succeed in showing that theactual exposures were generally modest.2 By systematically identifyingthe major markets in which Lehman was active and the financialramifications of its failure on those markets, Scott also provides insightinto the operations of the tri-party repo market, money market mutualfunds, and an array of other market structures that were central to theCrisis and yet remain beyond the comprehension of most. The very needto review such a wealth of material, however, also casts doubt on thenotion that anyone could have known as much as Scott knows today atthe time that Lehman failed. This is all the more true given the failureof the Federal Reserve and other financial policymakers to make ameaningful effort to better understand these dynamics prior toLehman's failure, despite the warning signs and authority that couldhave been used to that end.3More to the point, the runs that occurred throughout the Crisiswere not nearly as "indiscriminate" as Scott suggests. They werewidespread and included runs on institutions that we know, with thebenefit of hindsight, to have been relatively well capitalized. But therewas also remarkable and meaningful heterogeneity in the decisionsshort-term creditors made about what investments to exit and when.4When viewed in light of the distinct incentives of money claimants, asopposed to other types of investors, they may be as readily explained bya lack of meaningful information as by coordination problems orhysteria.5 This does not undermine his normative claims, but it leavesunexplored a more nuanced analysis of the relationship between whymoney claimants fled and how best to stop the bleeding when the nextcrisis hits. Paying too little heed to information, as known andknowable, in real-time during the Crisis also results in a failure toaddress other tools that might further the very crisis-management aimsthat Scott highlights as critical.62. See id. at 19-58.3. Kathryn Judge, The First Year: The Role of a Modern Lender of Last Resort, 116 COLUM.L. REV. 843 (2016).4. See, e.g., Daniel Covitz, Nellie Liang, & Gustavo A. Suarez, The Evolution of a FinancialCrisis: Collapse of the Asset-Backed Commercial Paper Market, 68 J. FIN. 815, 824 (2013); GaryGorton & Andrew Metrick, Securitized Banking and the Run on Repo, 104 J. FIN. ECON. 425, 434-36 (2012).5. See, e.g., Kathryn Judge, Information Gaps and Shadow Banking, 103 VA. L. REV. 411,461-66 (2017); Bengt Holmstrom, Understanding the Role ofDebt in the Financial System 3 (Bankfor Int'l Settlements Monetary and Econ. Dep't, Working Paper No. 479, 2015).6. See, e.g., MORGAN RICKS, THE MONEY PROBLEM: RETHINKING FINANCIAL REGULATION(2016); Judge, supra note 5; Ronald J. Gilson & Reinier Kraakman, Market Efficiency After the266 [Vol. 70:265IF IT AIN'T BROKE, DON'T FIX ITNone of these qualms detract from Scott's core insight. The mostimportant lesson in CONNECTEDNESS AND CONTAGION: PROTECTINGTHE FINANCIAL SYSTEM FROM PANICS rests on a platitude that is evenmore banal than a faulty diagnosis: if it ain't broke, don't fix it. As greatas the Great Recession was, it would have been far worse had financialpolicymakers failed to respond aggressively following the failure ofLehman Brothers. Legislators have stripped financial regulators of thevery tools that proved most effective in containing the Crisis and mayyet scale them back further. Scott sounds a much-needed alarm bell.We can only hope that he is heard.Financial Crisis: It's Still a Matter of Information Costs, 100 VA. L. REV. 313, 330 (2014); GaryGorton & Andrew Metrick, Regulating the Shadow Banking System (Working Paper, 2010).2017] 267

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If It Ain\u27t Broke, Don\u27t Fix It

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