Credit crunch

The Urgent Agenda for Financial Reform

Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Unfortunately, as a consequence of the official actions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances.

Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on central banks, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.

With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Task Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-30 Report that provides detailed proposals for reforming the U.S. Treasury market.

In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In our view, full implementation of the agendas set out in the these reports would make the U.S. financial system far safer than it is today….

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Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

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A Primer on Securities Lending

Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.

Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post...

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