CLS Blue Sky Blog

Coronavirus, Systemic Risk, and Lessons from 2008

The greatest single-day decline in the stock market this century, widespread fear and uncertainty, shuttered schools, an end to large gatherings everywhere from NBA games to the South by Southwest festival – these are just a few of the signs that the United States and the rest of the world will face some very tough economic times in the months and years ahead. The prospect of another crisis, and the increasing probability of another worldwide recession, have many looking back to 2008. A brief comparison of the two crises brings the lessons of the past into focus, in addition to highlighting the new challenges this time around.

Let’s start with some basics: This is not 2008. The 2008 crisis emanated from within the financial system. It arose because of excessive risk taking and leverage within that system. It was exacerbated by the complexities of the financial system, the complex institutions and instruments that constitute it, and the fragmentation of the regulators charged with overseeing it. When the housing bubble burst and AAA-rated mortgage-backed securities (MBS) were downgraded, no one could readily trace those losses through the system. This was just one of the many information gaps that increased the size of the crisis and slowed the government’s efforts to contain it. Without credible information, short-term creditors were more inclined to panic, other investors were more hesitant to deploy the capital they still had, and policy makers had a hard time identifying the holes that most needed filling.

Banks cannot be blamed for starting the current crisis, nor can financial regulators be expected to contain it.  It is, at bottom, a public health crisis, and  the top priority must be to contain the spread of Covid-19. Yet the pandemic will inevitably trigger widespread economic problems, and while congressionally authorized fiscal support will be the most important tool for minimizing them, the health of the financial system will also come into play. If the reforms of the last decade work, the financial system should be able to absorb this shock and continue to provide the support that the real economy will so desperately need to recover.  But if runs, losses, and uncertainty take over – and sadly, this seems more likely at this stage – the financial system could magnify, rather than soften, the economic impact of Covid-19.

Given the centrality of the financial system to the capacity of the U.S. economy to weather the tough times ahead, now is a critical time to assess what lessons the last crisis might hold for today. Here are three. More are sure to follow.

(1) Capital, capital, capital. One of the biggest lessons from the last crisis is that capital matters a lot and banks had far too little of it. Bank capital, at core, is an equity cushion that can absorb losses no matter the source. A well-capitalized bank can absorb losses that arise from known risks, but it also serves as a hedge against uncertainty.  The more capital a bank has, the greater its ability to withstand adverse developments without failing. The question is whether banks are adequately capitalized to deal with the multi-faceted challenges they face.

The good news is that in the decade following the crisis, all banks dramatically increased their capital cushions. U.S. banks did a particularly impressive job in this regard. U.S. banks are far better capitalized than they were going into the last crisis, and they also have a lot more room to absorb losses than their European counterparts. The bad news is that the trend has reversed in recent years, at least for the largest banks. As reflected in this figure from the Federal Reserve Bank of Kansas City, those banks have slightly less capacity to absorb losses today than they had a couple of years ago. The other bit of unfortunate news is that the Federal Reserve Board of Governors chose not to use its authority to require banks to build up countercyclical capital buffers despite a record-breaking period of expansion. When the Board last voted on the matter, in March 2019, Governor Lael Brainard cast the sole vote to impose such a buffer. As she explained in a speech two months later, “Because interest rates likely will do less than in past cycles, regulatory buffers will need to do more. As a consequence, now is a bad time to be weakening the core resilience of our largest banking institutions…. Instead, we should be … making good use of the countercyclical tool that we have.” Her colleagues may be wishing they had paid greater heed to her warning.

(2) Information matters. Unknowns and uncertainty can make the situation worse. Credible information can improve things. These lessons were learned the hard way during the 2008 crisis. From the early runs on asset-backed commercial paper to the fallout that followed the failure of Lehman Brothers, the evidence shows that when counterparties and other creditors lacked reliable information, they tended to pull back in unison, exacerbating the market dysfunction. Lack of credible information also compromised the efficacy of the government’s response. The crisis had been underway for more than a year by the time Lehman Brothers failed; more aggressive and better targeted interventions during that year may well have reduced the magnitude of the crisis that followed. At the same time, the widespread bailouts and massive government support that followed the collapse of Lehman Brothers – actions that remain contested and reviled – were necessitated in part because the government lacked good information about precisely who needed support and in what amounts. By contrast, the positive market response to the first round of stress tests demonstrated that a supply of credible information – which is less costly to taxpayers than credit or liquidity injections – can also be a very powerful way for the government to restore market functioning and bolster the health of the financial system.  In short, information gaps can make a bad situation worse; credible information can help reduce panic, promote healthy market functioning, and enable the government to better tailor its actions to the challenges it is facing.

Applying these lessons to the current situation sheds light on some creative ways that regulators might be able to mitigate the damage that has yet to come. For example, the Federal Reserve System employs a host of top-notch research economists in addition to having a wealth of data at its fingertips. Are these resources being redeployed to answer the myriad questions now arising about the potential economic impact of Covid-19 and efforts to quell its spread?  Are the Board of Governors and the dozen regional banks working together to identify and address the most pressing open issues? What about the two new bodies created by the Dodd-Frank Act to help address systemic risk – the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR)? Is the U.S. Treasury Secretary ready to use his role as the chair of the FSOC to facilitate information sharing and coordination among the 15 members and the bodies they represent? Is the OFR ramping up its capacity to provide the FSOC and its members much needed information about the systemic threats we face? For example, the OFR has the authority to bring in industry experts and academics for periods of up to two years, and to request “funds, facilities, staff, and other support services” from other agencies.  What type of emergency working groups might it form to shed light on the various vectors through which Covid-19 and containment efforts could exacerbate systemic dysfunction?

Recognizing the importance of credible information also sheds light on ways that the government can help address some of the problems arising outside financial markets. Once fear becomes the default position, information gaps and uncertainty can exacerbate inclinations to withdraw. Understanding how information gaps may contribute to prolonged disengagement, and the type of information and modes of engagement that could help restore trust and promote activity when the time comes, could be critical to efforts to emerge from the abyss.  That time is not yet upon us, but that is precisely why the government should use this opportunity to prepare for when it does come.The last thing to note is that information may help reduce the amount of fiscal support needed and could also help ensure that support is deployed where it is needed most, but the value of good information only accentuates the pressure on Congress to act. Regulators, financial or otherwise, cannot be expected to produce credible information about how bad things might get and why without some assurance that the government will try to mitigate the harms they reveal. No regulator wants to cause the crisis that it is seeking to contain. Congress still holds the power of the purse, and it is up to Congress to signal its preparedness to act and to dictate the terms of any support it will provide.

(3) Don’t forget about liquidity. Short-term debt functions differently than other investments. It is the byproduct of a special type of deal. The holder is not looking for a long-term investment, nor is he making any deeply informed decision about the risk-adjusted return that an instrument will yield. He is providing short-term funding because he wants a safe place to park his money. He wants to know it is safe and that he can transform it into cash, at face value, whenever he needs to do. This is why liquidity so often disappears during periods of systemic distress. In the face of adverse developments or new uncertainty, running is often the rational choice. Just as it did in 2007 and throughout the last crisis, the Federal Reserve is quickly ramping up its support for short-term markets.  This can help stabilize these markets and prevent dysfunction in them from having spillover effects elsewhere in the system.

Because the devil always lies in the details, it’s also worth noting that the Fed may have had additional reasons for the particular interventions it undertook last week. Those interventions not only injected additional liquidity into the system, they also were designed to stabilize the market for U.S. Treasuries. The importance of U.S. Treasuries and the markets in which they trade to today’s financial system is hard to overstate. The reasons can be traced back to the last crisis. Because a lack of liquidity is what brought Bear Stearns, Lehman, and AIG to their knees, post-crisis reforms required banking organizations to increase their liquid holdings.  The idea was that if banks are required to hold sufficient “high-quality liquid assets” to meet their short-term cash-flow needs, this should buy regulators some time to come up with a plan before such an organization is brought to the brink of failure.  Among the most important HQLA now lining bank balance sheets are U.S. Treasuries. In other words, for the post-crisis regime to work as intended, the market for U.S. Treasuries must enable banks to sell these instruments quickly and en masse if needed. In a helpful discussion of these rules and other post-crisis changes, BNY Mellon concluded, “All in all, the picture that emerges of the US Treasury market in mid-2019 is one of an asset that has never been so central to global investors.”  The Fed has a lot of reasons to want to ensure these markets keep working, even if they have to intervene to make that happen.

This post comes to us from Kathryn Judge, the Harvey J. Goldschmid Professor of Law at Columbia University Law School.

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