Britain voting to exit the European Union will not only have a profound effect on currency markets, trade, and economic growth in the UK but it could also have serious implications for the global financial system.
According to Hal Scott, professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation, “the global spillover effects could be compounded by the fact that the Federal Reserve, the FDIC, and Treasury Department are highly limited in their ability to respond due to Dodd-Frank restrictions on their lending authority to non-banks and ability to guarantee debt.”
The Federal Reserve and other central banks around the world are charged with serving as a lender of last resort (LLR). When there is a panic, large financial institutions must borrow from these central banks or else they will fail. “The U.S. government would not be able to do much to prevent a liquidity crisis,” says Scott, “the European Central Bank and the Bank of England have far more authority to respond to a panic than the U.S. government.”
This vote exposes a major flaw in banking regulation, which focuses on the risk of interconnectedness among banks instead of contagion. The financial system may not be prepared to handle the potential fallout from Britain voting to exit the European Union.
This is because the Brexit could cause a run on the banks and other financial institutions. As this political upheaval instigates fear in investors, they may pull their money out of the short-term debt market. This could lead to fire-sales of assets and a liquidity crisis. “The potential from Brexit isn’t due to bad investments or moral hazard by banks or other financial institutions. We are talking about a classic panic,” Scott continues.
Scott details the systemic risk inherent in these kinds of panics in his book, Connectedness and Contagion (MIT Press, June 2016). He notes that “contagion” remains the most virulent and important part of systemic risk still facing the financial system today. While “connectedness” is the possibility that the failure of one institution would bankrupt other institutions directly overexposed to them, resulting in a chain reaction of failures, “contagion” is an indiscriminate run on financial institutions that can render them insolvent.
“If the U.S. can’t stabilize its financial system to prevent contagion things would become significantly worse across the globe,” Scott argues. “The mere possibility of such a contagion and the weakness of the U.S. to deal with it are highlighted by the Brexit. It should be a major concern of the world.”
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