It’s been more than seven years since Paul Tucker warned of financial stability risks from outside the banking system. And it’s been more than a year since Don Kohn similarly spoke at Jackson Hole about unfinished business in financial stability policy and regulation, especially in nonbank finance, referring to the Task Force Report he co-chaired. Despite Tucker’s warnings, Kohn’s and others’ calls for urgent action, and the wake-up call from the ‘dash for cash’ following the pandemic shock, however, little has been done to address vulnerabilities in nonbank financial firms and in critical financial markets, which intermediate half or more of credit supplied, and whose resilience is critical for financial stability.

Author: Dr Richard Berner

Published: 6 October 2022

“Where should we be looking now for financial stability risks given this experience? The obvious answer is: any large-scale development in the financial system where high leverage meets maturity mismatch meets exuberant credit supply, particularly if the credit is collateralized by illiquid property. Although that sounds obvious, it actually leads to a big point: because regulatory arbitrage is endemic, and because the banking system is being re-regulated to a significant degree, future risks to stability are quite likely to come from outside of the banking system. The financial system is a shape shifter. That means that the key threats are going to emanate from firms or funds or structures that are not under the jurisdiction of banking supervisors or central banks. So other financial regulators – particularly securities regulators – are going to need the mandate and the culture and the knowhow to tackle stability issues. If those conditions aren’t met, we’re in trouble. I am not convinced they are met yet.”

Paul Tucker, Interview on Money and Banking.com, March 5, 2015

“Twice in this still-young century central banks have had to take steps, unprecedented in size and scope, to limit the economic fallout from financial instability. While we can’t expect a financial system to withstand an overnight shut down of the global economy like we experienced in March 2020 without support from central banks and fiscal authorities, the financial market turmoil at that time highlighted vulnerabilities that were visible well beforehand. The system is stronger than it was going into the Global Financial Crisis (GFC), but much remains to be done, especially in nonbank finance.”

Donald Kohn, Building a more stable financial system: Unfinished business, Federal Reserve Bank of Kansas City symposium, August 27, 2021

Introduction

It’s been more than seven years since Paul Tucker warned of financial stability risks from outside the banking system.[1] And it’s been more than a year since Don Kohn similarly spoke at Jackson Hole about unfinished business in financial stability policy and regulation, especially in nonbank finance, referring to the Task Force Report he co-chaired.[2] Despite Tucker’s warnings, Kohn’s and others’ calls for urgent action, and the wake-up call from the ‘dash for cash’ following the pandemic shock, however, little has been done to address vulnerabilities in nonbank financial firms and in critical financial markets, which intermediate half or more of credit supplied, and whose resilience is critical for financial stability.[3]

That’s dangerous because shocks that expose those vulnerabilities continue to emerge, including the ongoing conflict in Ukraine, an energy crisis in Europe and a global food crisis, central banks’ delayed and now-aggressive response to inflation, deflating asset prices, slower economic growth, and growing sources of climate, cyber and other risks. Indeed, the consequent evidence of rising and elevated volatility in bond markets and in economies signals increasing danger that may persist for some time.[4][5] For example, the recent turmoil in the U.K. gilt market is in my view symptomatic of the vulnerabilities that these and other shocks are exposing.

It’s also dangerous because failure to build financial system resilience would not just be a financial and an economic problem. It likely would be a political one. The failings of the past two decades already threaten the credibility and legitimacy of the institutions charged with ensuring monetary and financial stability. Many people were dissatisfied after the Great Financial Crisis that those responsible for it weren’t held to account. Surging inflation poses new challenges to the credibility of central banks. It’s thus hardly surprising that trust in government, according to a Pew Research survey, has fallen to near historic lows.  The world can ill afford another financial crisis while such challenges confront us and our government. Promoting further financial system resilience could help restore trust and should be an urgent priority. Legitimate, and thus resilient, institutions are needed to do the job.

In what follows I will discuss two aspects of financial stability, governance needed to achieve it, identify financial-system vulnerabilities, recognize looming shocks, assess their potential adverse consequences, and delineate recommendations to make the financial system more resilient.

New York Skyline by Lukas Kloeppel

Photo by Lukas Kloeppel from Pexels

Two Aspects of Financial Stability

Financial stability is about resilience. Whether the financial system has enough shock-absorbing capacity – such as capital buffers for banks – so it can still function in “wartime” is critical.

But financial-system resilience isn’t just about shock absorbers; it’s also about appropriate incentives to limit excessive risk taking across the financial system.  Often overlooked, guard rails such as market discipline, or transparent pricing of risk, are needed to increase the cost of, and constrain, risk-taking that can create financial vulnerabilities. For example: Living wills and resolution authority for large, complex financial institutions are good ideas but are untested. Yet a credible resolution authority is absolutely essential for assuring that central banks won’t lend to insolvent firms.  “Skin in the game” in compensation schemes and for CCPs are needed but they are insufficiently strong. Yet they are critical to align incentives of market participants with regulatory goals. The list is endless.

Both are essential for financial stability, even more so today than before the Great Financial Crisis. Ensuring resilience across the modern financial system is a dynamic exercise because the system is constantly changing and innovating; in Paul Tucker’s words “it is a shape-shifter.” Yet the rulebook of financial regulation is static and based on regulating entities. Such a setup encourages regulatory arbitrage – the migration of financial activity from heavily-regulated entities to those less regulated – that has been partly responsible for the growth of public and private capital markets – and for the migration of risks to them. Vibrant capital markets are unambiguously a good thing, but we’ve often mistaken vibrancy in peacetime for resilience. To ensure vibrancy in stress, shock absorbers and guardrails in nonbank finance and critical markets are essential. So too are appropriate rules of engagement, or governance.

Governance

Good governance matters; effective organizations start with it. Having defined a mission or purpose, they must spell out objectives, what decisions must be made, who will make and be accountable for them and how they will be communicated. Agreement on decision rights and other key elements of governance determine organization structure to achieve them. Public policy and regulatory institutions are no exception.

But there’s a failure to articulate objectives for financial stability policy and insufficient accountability for it. While U.S. laws recognized the need to have it, they failed to provide sufficient governance to achieve it. Our fragmented U.S. regulatory structure, lack of financial stability mandates for many of our financial regulators, and insufficient coordination among them meant that in the runup to the Great Financial crisis and in its aftermath, important information fell between the cracks, and accountability for supervisory failures was diluted. The interconnectedness of markets and institutions means that oversight and supervision must look horizontally across instruments, markets, institutions, and regions, rather than in vertical silos, and underscores the urgency for action. I suggest one proposal to strengthen governance at the end of this article.

Vulnerabilities

Equally, the events of the past few years have exposed financial system vulnerabilities that need urgent attention. Some arose from the long period of low rates and reaching for yield that has promoted a significant increase in corporate leverage and both incentives and wherewithal to bolt on more risk. But the most important venues for these and others are in nonbank finance and critical – or “systemically-relevant” – markets, including in market and funding liquidity, runnable liabilities, leverage, and maturity and liquidity mismatches, creating run and fire sale vulnerabilities.

In particular, financial markets and institutions that transact in them are more than ever vulnerable to liquidity shocks. Massive issuance of sovereign and private debt has increased the demands on the balance sheets of broker-dealers, while these traditional providers of liquidity appear to be less able and willing to provide it.[6] Open-ended bond funds that mismatch maturity and liquidity account for growing shares of fixed-income demand. Market structure has changed; the growth of principal trading firms and regulatory arbitrage have shifted liquidity supply away from banks and appears more likely to evaporate under stress.[7] Securities financing transactions involve “runnables” like repo with no proper liquidity backstop. And leverage combined with procyclical vulnerabilities in “market-based finance” – part of which is shadow banking — amplify shocks, partly through the interplay among leverage, funding and market liquidity.[8]

Indeed, unlike the GFC, in which solvency was the primary market and policy concern, the “dash for cash” resulting from the pandemic shock underscored fragilities in the functioning of funding and securities markets. The evidence: Spikes in secured, short-term funding rates rather than declines as in the GFC; runs on money-market and bond mutual funds; surging offshore dollar liquidity demands and sales of Treasury securities, especially from foreign official holders that widened FX swap basis and Treasury bid-ask spreads and the Treasury cash-futures basis; declines in market depth, and procyclical jumps in margins/haircuts at CCPs.[9]

In that moment, the Fed’s response and that of other central banks was appropriate, with backstops to facilitate market functioning and programs to limit the adverse consequences on asset prices and the supply of credit. But it created the unhealthy expectation that they will always be there to limit the effects of shocks on asset prices.[10] Worse, those responses masked the real vulnerabilities in markets that will surely threaten instability again.

We can do better, by making systemically-relevant markets more resilient and by strengthening the governance and effectiveness of liquidity provision by the authorities. Those will reduce the put to central banks, increase overall financial-system resilience, align incentives among market participants, limit regulatory arbitrage and improve market functioning.

The advent of crypto assets and decentralized finance adds urgency to completing the task of developing and implementing a framework for financial regulation that is based on activities as well as entities. We need to move away from who you are to what you do. This is a big global strategic issue for financial authorities today, and not just in crypto.

And the urgency to build resilience is even higher because other shocks that can expose such vulnerabilities are either coming or have already arrived. Among them: Inflation is globally rampant, and central banks are now moving to bring it down. The war in Ukraine could further jeopardize supplies of energy, food, and critical materials, and potentially involve cyber or even nuclear warfare.

Recommendations

Many of the ingredients to build resilience in nonbank financial intermediation and systemically-relevant markets are in plain sight. The Brookings Task Force Report recommends many actions with which I strongly agree: 1) Permanently remove deposits at Federal Reserve Banks and holdings of Treasury securities from the denominator of the Supplementary Leverage Ratio;[11] 2) implement central clearing of Treasuries and Treasury repo;[12] 3) implement swing pricing (and other changes) where appropriate for money market mutual and open-ended funds 4) standardize insurance company stress testing; and 5) improve global cooperation and information exchange.

As important as these are, however, none is a panacea for market resilience. For example, central clearing of Treasuries and repo will likely improve the capacity of traditional liquidity providers to intermediate in Treasury markets. But it also mutualizes counterparty risk and transforms it into liquidity risk, so in stress periods, the call on the Fed to provide system-wide liquidity to assure Treasury market functioning will still be there.

Here are five recommendations that I believe are even more consequential. Some are included in the Brookings and other reports. Taken together, they offer a better chance of addressing the looming threats to market and financial system stability.

  1. Improving governance and accountability for financial stability regulators

In the United States, the Federal Reserve’s supervisory responsibilities, expanded in the Dodd Frank Act, include financial stability, but the mandate for other U.S. financial regulators is less clear.[13] Nor does the Financial Stability Oversight Council have the authority needed to carry out its responsibility “to respond to emerging threats to the stability of the United States financial system.”[14] The Brookings Report of the Task Force on Financial Stability usefully suggested that each regulator have a clearly-defined financial stability mandate and that the Council and the Office of Financial Research be given new powers. I agree with those. For example, as I already noted, a framework for financial regulation that is based on activities as well as entities is needed, but Dodd-Frank doesn’t adequately provide it.[15] Without specific authority to take action, FSOC and the OFR will be challenged to contribute to financial-system resilience.

I am not suggesting a rigid approach; far from it. The Covid shock illustrated the need for flexibility to respond to emerging threats. And as Tim Geithner reminded us, the authorities do need to hone their skills and tools to deal with financial crises.[16] Strong governance is needed for those tools as well. In his speech of January 2021, Andrew Hauser provides important recommendations for improving the governance around central banks’ responses to liquidity shocks.[17]

But as with building resilience, regulators cannot – and should not – legitimately do that on their own. I agree with Paul Tucker that to ensure the legitimacy of regulatory action, elected representatives should decide on the degree of resilience in the financial system, and empower unelected technocrats – our regulators – to achieve it through regulation and enforcement.[18] Here I don’t have all the answers, but one aspect of that is to decide which assets and markets in which they trade are systemically-relevant or important, and to legitimize them as worth protecting.[19] There are other dimensions, but it’s time for a bipartisan effort to decide on resilience and legitimize appropriate authority to build it.

  1. Improve disclosure and reporting at nonbanks and for important markets such as uncleared bilateral repo

Data and information are the lifeblood of finance, and many of our financial institutions are required to disclose information related to their risks, safety and soundness. But fit-for-purpose data needed to assess threats to financial stability aren’t a priority, and a fragmented regulatory structure results in data that are fragmented, not comparable and duplicative.

Progress on data collection from private funds, money funds, cleared repo, and secondary transactions in Treasuries following the financial crisis and Treasury market dysfunction is laudable but insufficient to inform judgements about financial stability. The pushback against more disclosure from private firms and funds and on climate-related risks illustrates only some of the hurdles to disclosure.

The Office of Financial Research has the authority to collect data from any U.S. financial firm on behalf of the Council—that’s a valuable asset when looking for vulnerabilities across the financial system. Successful collaborative efforts between agencies and OFR – for example, with the Fed to collect data on cleared bilateral repo to construct SOFR – suggest that accelerated progress is there for the taking. Exploiting it doesn’t require new authority; it’s there.

  1. Crafting and implementing a haircut regime for repo and SFTs including minimum floors

Securities financing transactions (SFTs), including repo and securities lending, are vulnerable to funding and liquidity shocks that can contribute to runs and procyclical asset fire sales as SFT or CCP haircuts or derivatives margins increase.

We can address such vulnerabilities with tools aimed at the activities in which they occur: Setting minimum floors on haircuts could reduce procyclicality by limiting leverage, and maturity, credit, and liquidity transformation available through SFT activity.

  • It addresses the vulnerability directly rather than its symptoms;
  • A big enough static floor might constrain maturity transformation and procyclicality;
  • Floors on haircuts can act as both shock absorbers and guardrails – increasing the cost of excessive risk taking;
  • Adding a proactive variable countercyclical floor could further increase stability.

To be sure, designing and implementing haircut floors will be challenging. Market practices are diverse, so a system of minimum haircut floors is likely to be complex. The FSB proposal for minimum haircuts on noncentrally-cleared transactions thus includes 10 different minimum haircut floors.[20] [21]

  1. Broadening the Standing Repo Facility

The Fed’s standing Repo Facility was established under Federal Reserve authority and existing law as a tool to “support the effective implementation of monetary policy and smooth market functioning,” especially in an ample-reserves operating regime. Consequently, the take-up of the SRF by market participants has been limited, as of August 5, 2022, to the set of 25 primary dealers and Standing Repo Facility Counterparties – thirteen banks or U.S. branches of foreign banks.[22]

The SRF would be more likely to succeed if the range of counterparties involved was broader still. There is a range of market participants – other broker-dealers, hedge funds, and other leveraged investors without access to the facility, and they appear to account for a growing share of repo activity. [23] Broader access could reduce overall liquidity strains.[24]  Of course, broader access would require legislation and increased supervision of SRF counterparties, and incentives to mitigate their risk, such as appropriate rates and collateral haircuts.[25]

The goal of smooth market functioning has become more critical now that the Fed is shrinking its balance sheet. Although that process is highly predictable, together with aggressive rate increases, it may already be amplifying current bond-market volatility and changes in market prices as an increasing share of Treasury debt is absorbed by the markets. For a template, the Fed might well look to the Bank of England’s new Short Term Repo facility (STR) that will aim at providing sufficient liquidity so that short-term market interest rates remain close to Bank Rate during the unwind of its Asset Purchase Facility.[26]

Recently, rapid increases in UK gilt rates, accelerated by prospective fiscal expansion, triggered procyclical and disorderly margin calls and the forced unwinding of gilt holdings by UK defined- benefit pensions that used leverage to engage in Liability-Driven Investing (LDI). To restore market functioning, the Bank of England engaged in temporary purchases of gilts. It’s not clear that STR would have alleviated the strain. While the focus has been on the effects on gilt market volatility, that is a symptom that illustrates the fragility of systemically-relevant markets The underlying cause was that pension funds had levered up and become illiquid in a search for yield and duration; in doing so, they created vulnerabilities like those of banks and dealers. Rapidly rising gilt yields exposed those vulnerabilities, forcing sales.

  1. Improving liquidity, stress testing, recovery, resolution, and reducing misaligned incentives at CCPs

In stress periods, initial and variation margin at CCPs surge procyclically, liquidity evaporates and CCPs’ actions to push the cost of these developments onto clearing members can lead to fire sales as market participants dash for cash. The misalignment between CCPs’, clearing members’ and regulators’ incentives should be addressed not just to level the playing field but to reduce such liquidity demands.[27] While CCPs can maintain deposit accounts at the Fed, regulators should consider, with appropriate oversight and supervision, giving designated CCPs access to a standing liquidity facility, perhaps the SRF. The interconnectedness of CCPs – partly due to the extreme overlap in clearing membership – means that resilience must be considered across CCPs and borders, not piecemeal.

The Brookings Task Force appropriately recommends reducing the procyclical variation in margining with more through-the-cycle methodologies. In addition, FSOC members, especially the CFTC and SEC, but also the Fed, should work to increase the resilience of CCPs, including enhanced firm and supervisory stress testing, skin in the game and appropriate default management and access to liquidity, and to clarify transparency and self-insurance for CCPs and rigorous protocols for recovery and resolution. [28] The need for credible recovery and resolution protocols, which has been in discussion for at least five years, is especially urgent in view of the SEC’s proposal for central clearing of Treasuries and repo noted above. Before turning that proposal into reality, it would be good to know that the CCPs involved are resilient.[29]

Conclusion

This list of recommendations isn’t exhaustive, although it is extensive. But its variety and length – and those of others – reflect the fact that ensuring financial resilience is about looking at the system as a whole. There is still unfinished business in financial stability, and regulators need to keep at it to assure financial system resilience.

*I am grateful to David Aikman and Paul Tucker for helpful conversations and comments.

[1] Indeed, he continues to warn of them, see “Macroprudential policy as part of a broader financial stability regime – does it exist what should it be?” Macroprudential Matters, September 13, 2021.

[2] See also his “The US needs urgently to raise its macropru game,” Macroprudential Matters, October 15, 2021.

[3] Such warnings aren’t new; see also Regulatory Restructuring: Balancing the Independence of the Federal Reserve In Monetary Policy With Systemic Risk Regulation, Hearing Before The Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services U.S. House of Representatives, July 9, 2009.

[4] Isabel Schnabel, Monetary policy and the Great Volatility, Jackson Hole, August 27, 2022.

[5] Officials, such as those on the Financial policy Committee in the U.K., clearly recognize these vulnerabilities: “In the event of further shocks, impaired liquidity conditions could be amplified by the vulnerabilities in the system of market-based finance previously identified by the FPC.” Financial Stability Report, July, 2022, p 5.

[6] According to the Bank of America, banks’ share of Treasury market-making has shrunk dramatically over the past 15 years: Before 2008, primary dealer volumes were equivalent to about 15% of the value of Treasuries outstanding; now that is just 2.5%. “The root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding, in part because leverage requirements that were introduced as part of the post-global financial crisis bank regulatory regime have discouraged bank-affiliated dealers from allocating capital to relatively low-risk activities like market-making.” See Group of Thirty, U.S. Treasury Markets: Steps Toward Increased Resilience, July 1, 2021, and U.S. Treasury Markets: Steps Toward Increased Resilience Status Update 2022.

[7] See Joint Staff Report: The U.S. Treasury Market on October 15, 2014, July 13, 2015.

[8] Markus Brunnermeier and Lasse Pedersen, “Market Liquidity and Funding Liquidity,” The Review of Financial Studies, December, 2008; Tobias Adrian and Hyun Song Shin, “Liquidity and Leverage,” Journal of Financial Intermediation 19, no. 3 (July 2010): 418-37.

[9] See, for example, SEC U.S. Credit Markets Interconnectedness and the Effects of the COVID-19 Economic Shock; Financial Stability Board, Holistic Review of March Market Turmoil (PDF) (Basel: Financial Stability Board, November 17, 2020), Daniel Barth, R. Jay Kahn Hedge Funds and the Treasury Cash-Futures Disconnect, 1 April 2021, Annette Vissing-Jorgensen, The Treasury Market in Spring 2020 and the Response of the Federal Reserve, NBER August 2021, Lael Brainard, Some Preliminary Financial Stability Lessons from the COVID-19 Shock, March 1, 2021, Lorie Logan, Liquidity Shocks: Lessons Learned from the Global Financial Crisis and the Pandemic, August 8, 2021.

[10] “…the use of ad hoc tools [while justified in the event of the Covid shock] risks embedding inappropriate expectations about how central banks might behave in future cases of market dysfunction.” Andrew Hauser, From Lender of Last Resort to Market Maker of Last Resort via the dash for cash: why central banks need new tools for dealing with market dysfunction,” Thomson Reuters Newsmaker, London, January 7, 2021.

[11] Any action in this regard should be accompanied by a releveling of the leverage ratio, akin to the Bank of England’s adjustment in 2016. See Minouche Shaik, Remarks on a paper by Darrell Duffie and Arvind Krishnamurthy at Jackson Hole, August, 2016.

[12] On September 14, 2022, the Securities and Exchange Commission proposed rule changes aimed at facilitating additional clearing of U.S. Treasury securities transactions and enhancing risk management practices for CCPs in the U.S. Treasury market.

[13] See Federal Reserve, 2021 Annual Report, Financial Stability.

[14] The Council only has two binding authorities: To designate nonbank financial companies for heightened prudential oversight by the Federal Reserve, and to designate financial market utilities (e.g. CCPs) for heightened prudential supervision by the Fed in collaboration with the SEC and CFTC.

[15] And, illustrating the governance challenge, the Council itself effectively neutered the designation authority, see “Lowering the bar on financial regulation is fraught with risk,” American Banker, June 27, 2019.

[16] See Timothy Geithner, “Are We Safer? The Case for Strengthening the Bagehot Arsenal?, Per Jacobsson Lecture, October 8, 2016.

[17] For example, governance about central banks’ asset purchases should be geared to their stated purpose; in the pandemic shock, that was to restore core market functioning, as it did by the late spring of 2020. Instead, “central banks were ‘buyers of last resort’ more than ‘market makers of last resort’.” Hauser, op. cit.

[18] Paul W. Tucker, Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, Princeton University Press, 2018.

[19] See also Paul W. Tucker, Is the Financial System Sufficiently Resilient? A Research Programme and Policy Agenda,” 17th BIS Annual Conference, Jun 22, 2018.

[20] FSB, Transforming Shadow Banking into Resilient, Market-based Finance Regulatory framework for haircuts on non-centrally cleared securities financing transactions, 2020.

[21] For further discussion, see Vítor Constâncio, Unfinished regulatory reforms and the repo market, Macroprudential Matters, March 1, 2022.

[22] Many of the thirteen banks are part of the firm or holding company of which primary dealers are also a subsidiary.

[23] See Program on International Financial Systems, Expanding Access to the Standing Repo Facility for U.S. Treasuries, August, 2022.

[24] See G30 report, op. cit. and Kohn, op. cit.

[25] See Brookings Task Force on Financial Stability, op. cit.

[26] See Short Term Repo Facility – Provisional Market Notice 4 August 2022 and Short Term Repo – Market Notice 1 September 2022.

[27] On July 27, 2022, the CFTC proposed Governance Requirements for Derivatives Clearing Organizations aimed at reducing those misaligned incentives.

[28] See A Path Forward for CCP Resilience, Recovery, and Resolution for twenty recommendations to enhance CCPs’ resilience, recovery and resolution.

[29] See FSB Discussion Paper: “Financial resources to support CCP resolution and the treatment of CCP equity in

resolution”, 15 November 2018, and Systemic Risk Council, CCP Resolution, March 18, 2019.