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, Goldstein & Hortaçsu (forthcoming)). Contrary to the usual flight to quality, in mid-March, U.S. Treasury yields began rising and only stabilized 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 swath of home loans looked as though they might 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 as 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 had 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 had 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 capitalized, 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 U.S. 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.
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 U.S. financial regulatory regime is falling short. We also propose reforms to increase the likelihood that policy makers will identify and address threats to stability – before they harm the real economy.
The U.S. regulatory structure is famously fragmented, with three bank regulators, two market regulators, and a 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 additional experts, 15 in total, are members of the FSOC. Rather than propose an overhaul to the system, we sought to improve it. We focused on ensuring that regulators have the information and other competencies they need to tackle systemic threats – and the incentive 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 fulfill 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 realize 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 authorized 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 normalize an understanding that regulation and regulators should 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 more readily sound the alarm bells 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 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 standardization and sharing, and gather and analyze the data needed to recognize potential fragilities. For an array of reasons, it has thus far fallen short of these important aims. We propose strengthening the organization by having it morph from the OFR into the Comptroller for Data and Resilience and by 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, Patrick, Stephen Cecchetti, Jean-Pierre Danthine and Xavier Vives, “Sound at last? Assessing a decade of financial regulation: A new eBook,” VoxEU, 03 June 2019, https://voxeu.org/article/sound-last-assessing-decade-financial-regulation-new-ebook.
Carletti, Elena, Stijn Claessens, Antonio Fatás and Xavier Vives, “The bank business model in the post-Covid-19 world,” VoxEU, 18 June 2020, https://voxeu.org/article/bank-business-model-post-covid-19-world.
Duffie, Darrell. “Post-Crisis Bank Regulations and Financial Market Liquidity.” Thirteenth Baffi Lecture, Banca d’Italia, Rome, Italy, March 31, 2018. https://www.darrellduffie.com/uploads/policy/DuffieBaffiLecture2018.pdf.
Ellul, Andrew, Chotibhak Jotikasthira and Christian T. Lundblad, “Regulatory Pressure and Fire Sales in the Corporate Bond Market,” Journal of Financial Economics 101, no. 3 (2011), https://papers.ssrn.com/sol3/papers.
Falato, Antonio Itay Goldstein, and Ali Hortaçsu, Financial Fragility in the COVID-19 Crisis: The Case of Investment Funds in Corporate Bond Markets, Journal of Monetary Economics forthcoming, https://bfi.uchicago.edu/wp-content/uploads/BFI_WP_202098.pdf.
Goldstein, Itay, Hao Jiang and David T. Ng, “Investor Flows and Fragility in Corporate Bond Funds,” Journal of Financial Economics 126, no. 3 (2017): 592-613, https://www.sciencedirect.com/science/article/abs/pii/S0304405X17302325?via%3Dihub.
Haddad, Valentin, Alan Moreira and Tyler Muir, When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response, NBER Working Paper 27168, http://www.nber.org/papers/w27168.
Housing Finance Policy Center at Urban Institute, “Housing Finance at a Glance: A Monthly Chartbook,” Urban Institute, April 2021, https://www.urban.org/sites/default/files/publication/104157/housing-finance-at-a-glancea-monthly-chartbook-april-2021.pdf.
Hodula, Martin, Off the radar: The rise of shadow banking in Europe, 16 March 2020 https://voxeu.org/article/radar-rise-shadow-banking-europe.
Judge, Kathryn, “Information Gaps and Shadow Banking,” Virginia Law Review 103, no. 3 (2017): 411-482, https://www.virginialawreview.org/articles/information-gaps-and-shadow-banking/.
Kashyap, Anil K. and Caspar Siegert, “Financial Stability Considerations and Monetary Policy?” Federal Reserve Bank of Chicago, June 5, 2019, https://www.chicagofed.org/~/media/others/events/2019/monetary-policyconference/financial-stability-and-monetary-policy-kashyap-siegert-pdf.
Liang, Nellie and Pat Parkinson, “Enhancing liquidity of the U.S. Treasury market under stress,” The Brookings Institution, December 16, 2020, https://www.brookings.edu/research/enhancing-liquidity-of-the-u-s-treasurymarket-under-stress/.
Petralia, Kathryn, Thomas Philippon, Tara Rice, Nicolas Véron “Banking, FinTech, Big Tech: Emerging challenges for financial policymakers,” VoxEU, 24 September 2019, https://voxeu.org/article/banking-fintech-big-tech-emerging-challenges-financial-policymakers.
Task Force on Financial Stability, Report, June 2021, at https://www.brookings.edu/wp-content/uploads/2021/06/financial-stability_report.pdf.
Vissing-Jorgensen, Annette, “The Treasury Market in Spring 2020 and the Response of the Federal Reserve,” University of California, Berkeley, April 5, 2021, http://faculty.haas.berkeley.edu/vissing/vissing_jorgensen_bonds2020.pdf.
This post comes to us from Kathryn Judge, the Harvey J. Goldschmid Professor of Law at Columbia Law School, and Anil Kashyap, the Stevens Distinguished Service Professor of Economics and Finance at the University of Chicago’s Booth School of Business. A version of this post appeared on VoxEU, here.