The Financial Lessons of the Covid-19 Pandemic

The coronavirus crisis delivered a severe shock to the U.S. financial system. So how did it do? Did the reforms enacted after the 2008 financial crisis succeed in ensuring stability this time around?

The answer is mixed, which means there’s more work to do.

The core U.S. banking system has emerged in good shape. Thanks to regulatory changes, banks had more cash available to accommodate the increase in demand for credit and more high-quality capital to absorb losses. This helped maintain confidence that they would be able to keep performing essential functions such as providing credit and facilitating payments. Yet even here, there’s a caveat: The banks benefited greatly from the government’s multi-trillion-dollar efforts to support markets and the economy, so no one should conclude that they are bullet-proof. 

The rest of the financial system — specifically, the non-bank or “shadow banking” sector, which in the U.S. dwarfs the banking system — proved much more vulnerable. Sudden demands for cash prompted runs on some money-market mutual funds, crippled mortgage-focused real estate investment trusts and froze the markets for municipal and corporate bonds. Even the highest-quality assets weren’t exempt: In March, yields on U.S. Treasuries spiked as hedge funds and others sold the securities to raise cash. All this necessitated extraordinary interventions by the Federal Reserve to prevent a broader market meltdown.

Clearly, non-banks need to be more robust and resilient. I see four areas for improvement.

  • Set up a reliable, credible mechanism for meeting cash demands when crises hit. Only the Fed has the elastic balance sheet needed to achieve this. Ad-hoc interventions aren’t good enough: They tend to come too late and create moral hazard. One solution would be to set up a standing repo facility, which would lend cash against Treasuries and other government-backed securities. The liquidity should be expensive enough to be tapped only in times of stress, and the collateral requirements should be large enough to protect the Fed from losses in volatile markets. If made broadly available, the liquidity available from such a facility would become an attribute of the securities that the Fed would accept and this would lower the government’s borrowing costs. Moreover, the facility’s mere existence would reduce incentives to dash for cash in times of stress.
  • Address mutual funds’ vulnerability to runs. In particular, the SEC should tie mutual funds’ redemption standards to the liquidity of their underlying assets: If, say, it would take a few weeks to sell the assets in an orderly way, investors should have to wait that long to be able to redeem their mutual fund shares for cash. This would help prevent runs that arise when everyone tries to get out before the mutual funds’ liquidity buffers are exhausted. It also would help the mutual fund avoid a fire sale of assets. I don’t think this would be too onerous. A high-yield bond fund shouldn’t be anyone’s first source of liquidity. And such an SEC mandate would actually help fund managers, who are reluctant to impose such standards on their own for fear of losing business to the competition.
  • Fix or replace the Financial Stability Oversight Council. The FSOC is supposed to identify and address stability risks arising in the non-bank portion of the financial system, but has failed to do so. Ahead of the coronavirus crisis, for example, it had identified no firms or activities as systemically important. If that were the case, then why were extraordinary interventions necessary? The Biden Administration and Congress should give the FSOC the support, structure and authority it requires to do its job. That said, it might never be very effective. As part of the executive branch, it’s inherently subject to changes in presidential administrations, and thus can’t follow a consistent set of policies over time. Also, the members of the FSOC — including the SEC, the Fed and the Commodity Futures Trading Commission — have an interest in the council being weak, so it won’t be able to encroach on their turf and interfere with their prerogatives. If these flaws can’t be overcome, a different model to limit financial stability risks in the non-bank financial sector will be needed.
  • Attend to flaws in bank regulation. Capital and liquidity requirements are crucial, but they can also have unintended consequences in crises. Banks refuse to lend to non-banks, even against the collateral of Treasuries, because they don’t want to deplete their cash buffers. The Fed’s efforts to ease cash crunches by buying Treasuries and mortgage-backed securities boost bank reserves, causing the banks to bump up against regulatory leverage ratios. Risk-weighted capital requirements become tighter when markets are more volatile. To mitigate these problems, the Fed should make it easier for banks to use their liquidity buffers, make capital requirements more neutral to the business cycle and exempt bank reserves (which have no risk and are determined by the Fed’s own actions) from the leverage ratio calculations. This should be done in coordination with the Basel Committee on Banking Supervision, which is responsible for ensuring that standards globally are broadly consistent.

This isn’t all that needs to be accomplished, but it would make an excellent start.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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