The writer is former Chair of the FDIC and former Assistant Secretary of the US Treasury for Financial Institutions.
There are many important issues requiring President Joe Biden’s attention. I regret to say that 12 years after the Great Financial Crisis (GFC), financial instability remains one of them. This instability was laid bare by the market disruptions of last March when once again, the Federal Reserve felt compelled to inject a massive amount of liquidity to calm tumultuous financial markets.
And once again, these bailouts rewarded and reinforced irresponsible risk-taking and unstable business models, instead of letting market discipline impose its will.
This is not to say that some level of Fed intervention wasn’t warranted. But most of the disruptions occurred in segments of the financial system that were known to be fragile — and had been identified by financial experts and regulators as sources of past instability. These include money market funds, corporate bond ETFs, and hedge funds speculating in U.S. Treasury markets. Notably, these are entities outside of the regulated banking sector which, because of reforms enacted pursuant to the 2010 Dodd-Frank financial reform law, have remained stable.
However, those Dodd-Frank reforms tightened controls over regulated banks when demand for credit was growing, particularly among government and corporate borrowers eager to take advantage of ultra-low interest rates. Nonbank intermediaries stepped in to fill the void, becoming an increasingly important source of credit.
Bond funds supported rising corporate debt issuance. Hedge funds supplemented regulated dealers in providing additional liquidity to US Treasury markets. Money market funds, which were bailed out during the GFC, survived to remain significant suppliers of short-term credit for both corporate and government borrowers.
Notably, not all nonbank credit providers were sources of instability in March. Money market funds that only invested in federally backed securities performed well. But so-called “prime funds,” invested in more volatile corporate debt suffered substantial outflows by institutional investors, required liquidity support from the Fed.
Corporate bond mutual funds, which execute redemptions at end-of-day prices, were relatively stable. But ETFs, which trade continuously throughout the day, were a source of stress and stabilized only when the Fed made the extraordinary commitment to purchase junk debt ETFs.
Hedge funds using highly leveraged strategies to profit from pricing differences between US Treasury securities and derivatives contracts contributed to extreme volatility in those markets when they were forced to sell their securities to cover margin. This led to the anomaly in the market for Treasury securities. Although normally traditional safe havens in times of stress, they fell in price, requiring massive Fed purchases to stabilize the market.
How to handle shadow banks
Instability among nonbank financial intermediaries, so-called “shadow banks,” almost always arises from the same problems that plague traditional banks: high levels of leverage, nontransparent risk exposures, and promises of immediate liquidity to customers (all while holding their money in long-term, illiquid assets).
Unless we want to tolerate a financial system reliant on Fed bailouts to function, we need to start providing some level of prudential oversight over entities that exhibit these vulnerabilities — or let them fail.
This would require coordinated action among bank regulators and market regulators like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). They are members of the Financial Stability Oversight Council (FSOC), empowered by Dodd-Frank to address systemic activities over both regulated banks and non-banks. .
Some measures to address shadow bank instability do not seem complicated. For instance, why not impose higher margin requirements on U.S. Treasury and derivatives trading to reduce volatility? Similarly, if money market funds want to create expectations among investors of liquidity and the protection of principal, why not require that they only invest in liquid assets where principal is actually protected (i.e. US government-backed securities), or that they hold capital against this implicit guarantee (as does a bank?)
The curious case of corporate bonds
In the case of corporate bond ETFs, market discipline would be a better solution than prudential supervision since they remain a fairly small part of the corporate bond market.
Their instability comes from the fact that they are traded continuously and can be sold quickly, while the bonds that underpin their shares take longer to sell. The resulting “gaps” in prices create endless opportunities for gaming, which in turn, leads to accelerating downward pressure on prices.
Advocates of corporate bond ETFs argue they increase transparency as their liquid nature provides a more accurate measure of the worth of underlying assets. If this is true, then surely Fed ETF purchases interfere with that signaling. We should let investors decide whether perceived benefits of increased transparency outweigh ETFs’ volatile nature. Fed bailouts simply perpetuate and reward their precarious business model. Investor interest in corporate debt ETFs has actually increased since March, drawing business away from more stable mutual funds.
Limiting future government interventions
The rationale behind the Fed’s “do what it takes” backstop of corporate debt markets, including its purchases of corporate bond ETFs, was to avoid bankruptcies caused by the inability of companies to access credit.
This is a good rationale, but one that does not support intervention in secondary markets where the benefits primarily accrue to bond investors. A limited-life facility to support newly issued debt of investment grade companies would have better served that purpose. And instead of buying bonds (as contemplated by the Fed’s primary corporate credit facility, which it never used), a better approach would have been to use temporary debt guarantees as we did during the Great Financial Crisis.
At the request of the Federal Reserve and the Treasury Department in late 2008, the FDIC launched a temporary program that guaranteed newly issued debt for financial institutions unable to refinance expiring debt because of frozen credit markets. We capped debt issuance under the program, charged a significant premium, and ended it after 9 months. Importantly, unlike Fed actions, the program did not add to money supply and because of the caps, it did not incentivize excessive borrowing.
Government interventions in financial markets may sometimes be necessary, but they have well-known negative side effects. They reward bad behavior and perpetuate instability. They provide clear benefits to Wall Street, with little demonstrated benefits to Main Street.
They should be avoided at all costs — and narrowly tailored when used. Financial regulators like to pride themselves on being apolitical, but by tolerating bailouts instead of embracing stronger regulation and market discipline, they will be complicit in perpetuating the populist resentment birthed by the bailouts of 2008 and 2009.
I applaud President Biden’s desire to unify the country. To do so, a first order of business should be to stop endless Wall Street bailouts. That, more than anything, will convince people on the left and right that our system works for all.
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