When the COVID-19 pandemic shuttered major economies in March 2020, it also wreaked havoc on financial markets. In the first few weeks of March, investment-grade corporate bonds lost roughly a fifth of their value, on par with the declines in equity and high-yield debt. (Haddad et al. 2020, Falato et al. forthcoming). Contrary to the usual flight to quality, in mid-March, Treasury yields began rising and only stabilised after the Federal Reserve initiated a massive purchase program. (Vissing-Jorgensen 2020). The distress in the Treasury market accentuated distress in other markets and liquidity challenges for firms. Nonbanks that service a huge swathe of home loans looked as though they may face their own collective liquidity crisis, causing ripple effects in mortgage origination and elsewhere. Crisis was averted only because of the quick and aggressive interventions by the Federal Reserve, Congress, and others.
That a shock the size of the pandemic would trigger distress in financial markets is far from surprising. What is surprising is how much of the distress arose in domains that could have been identified posing a potential threat to stability well before the pandemic hit. And yet, each remained largely unaddressed.
For example, the volume of investment-grade bonds outstanding more than doubled since the 2008 financial crisis, contributing to and enabled by a rapid growth in bond mutual funds. Studies had already shown that such funds exhibit a first-mover advantage, rendering them inherently fragile. Similarly, despite regulations that presumed Treasuries could always and easily be converted into cash, the Treasury market had already exhibited meaningful dysfunction in response to stressors far smaller than the pandemic. That the volume of Treasuries outstanding had more than doubled since 2008 while the capacity of banks to provide liquidity for Treasuries had stagnated was also readily apparent (Duffie 2018). The mortgage market too has evolved dramatically since 2008, with banks originating and servicing fewer loans, particularly to higher risk borrowers. That nonbanks were critical to mortgage origination and servicing and that they nonetheless remained thinly capitalised, heavily dependent on wholesale funding, and outside the domain of prudential regulators, was known.
That these vulnerabilities and others had not been addressed suggests structural shortcomings in the US financial regulatory regime. (Bolton et al. 2019). As these examples show, a core challenge is that finance is dynamic. Rules introduced to address known threats to stability cause activity to migrate elsewhere. Improvements in information technology and other innovations give rise to new actors and new modes of financial intermediation. (Carletti et al. 2020, Petralia et al. 2019). Yet the regulation of these evolving actors and activities often fails to adjust to new realities. The net result is de facto deregulation and these same problems and patterns, are present in Europe (Hudula 2020).
In a new report co-authored with colleagues on the Task Force on Financial Stability, co-sponsored by The Hutchins Center on Fiscal and Monetary Policy at Brookings and the Chicago Booth Initiative on Global Markets, we explore how the US financial regulatory regime is falling short (Hubbard et al. 2021). We also propose reforms to increase the likelihood that policymakers will identify and address threats to stability – before they harm the real economy.
The US regulatory structure is famously fragmented, with three bank regulators, two market regulators, and host of other financial regulators. The Dodd-Frank Act sought to mitigate this challenge by creating a new Financial Stability Oversight Council (FSOC), under the leadership of the Secretary of the Treasury. The other federal financial regulators and a few others, fifteen in total, are members of this FSOC. Rather than propose an overhaul to the system, we sought to improve it. We focused on ensuring regulators have the information and other competencies they need to tackle systemic threats and that they are incentivised to do so.
First, we recommend that Congress clarify that every FSOC member has an obligation to promote stability and resilience. To make sure that they have the personnel and resources they need to fulfil this mission, we propose that each FSOC member also have a new office of financial stability and resilience. To encourage regulators to consider the collateral consequences of their interventions, we would require that they undertake an impact analysis when adopting new rules, and that they also undertake a lookback five years later to see how well their predictions fared. Each FSOC member would also be required to prepare an addendum to the FSOC’s annual financial stability report, identifying what they see as potential threats to stability and explaining how they intend to respond to threats that they and others have identified within their domain.
It may well take time, and some trial and error, to realise the benefits of these layered and complementary reforms. Nonetheless, given the authority that FSOC members already possess, we see the process of ensuring FSOC members acquire the information, skills, and incentives to tackle threats to stability as key to building a more resilient system.
A second area of reform is FSOC leadership. The Treasury Secretary consistently takes the lead when crisis hits, but often has a plate full of other pressing matters during periods of stability. For this and other reasons, efforts to promote stability can languish when all seems well. To facilitate ongoing diligence and the horizon scanning needed to identify common vulnerabilities and interconnections, we propose a new Undersecretary for Financial Stability within the Treasury Department. In addition to being authorised to testify before Congress on behalf of the FSOC and facilitating coordination among FSOC members, the new Undersecretary and an expanded staff would have full control over the FSOC Annual Report. With other FSOC members now providing their own addenda and not having veto power over the text of the main report, FSOC leadership should have greater freedom to use the report to identify weaknesses, explain how the financial system is changing, and propose plans for addressing deficiencies.
These two sets of reforms are designed to be mutually supportive and to normalise an understanding that regulation and regulators to evolve alongside changes in the financial system. The reforms should lay the groundwork for more meaningful macroprudential activities-based regulation by harnessing that authority where it lies – with FSOC member agencies – and creating built-in mechanisms for holding regulators to account when they drag their feet and for seeking new authority from Congress when current tools prove insufficient. The enhanced transparency should also enable those outside of government to sound the alarm bells more readily when needed.
The third major area of reform addresses information and data gaps. These gaps continue to undermine the capacity of regulators to identify emerging threats and interconnections, and that can accentuate the tendency for market actors to run in the face of a shock. The Office of Financial Research – the other major regulatory innovation in the Dodd-Frank Act – was designed to identify such gaps, promote data standardisation and sharing, and to gather and analyse the data needed to recognise potential fragilities. For an array of reasons, it has thus far fallen short of these important aims. We propose strengthening the organisation, by having it morph from the OFR into the Comptroller for Data and Resilience and making it a full member of the FSOC. We suggest that other FSOC members should be required to consult with the CDR when undertaking any new data collection, and we propose other reforms that should enhance the CDR’s capacity to further the important aims laid out for it.
The full report provides a more complete account of the deficiencies of the current system and how these three changes, and other more modest reforms, could lay the groundwork for a more effective and accountable system for addressing threats to stability,
Bolton, P, S Cecchetti, J-P Danthine and X Vives (2019), “Sound at last? Assessing a decade of financial regulation: A new eBook,” VoxEU.org, 3 June.
Carletti, E, S Claessens, A Fatás and X Vives (2020), “The bank business model in the post-Covid-19 world,” VoxEU.org, 18 June.
Duffie, D (2018), “Post-Crisis Bank Regulations and Financial Market Liquidity.” Thirteenth Baffi Lecture, Banca d’Italia, Rome, Italy, 31 March.
Falato, A, I Goldstein and A Hortaçsu (forthcoming), “Financial Fragility in the COVID-19 Crisis: The Case of Investment Funds in Corporate Bond Markets”, Journal of Monetary Economics.
Haddad, V, A Moreira and T Muir (2020), “When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response”, NBER Working Paper 27168.
Petralia, K, T Philippon, T Rice and N Véron (2019) “Banking, FinTech, Big Tech: Emerging challenges for financial policymakers”, VoxEU.org, 24 September.
Hubbard, G, D Kohn, L Goodman, K Judge, A Kashyap, R Koijen, B Masters, S O’Connor and K Stein (2021), Task Force on Financial Stability, the Hutchins Center on Fiscal & Monetary Policy and the University of Chicago Booth School of Business Report.
Vissing-Jorgensen, A (2021) “The Treasury Market in Spring 2020 and the Response of the Federal Reserve,” University of California, Berkeley, 5 April.