The 2008 financial crisis caused a worldwide economic collapse. As noted in the 2008 G20 leaders’ Washington summit declaration, it was caused by market participants seeking higher yields without adequate appreciation of risks, failed due diligence, weak underwriting standards, unsound risk management, opaque products, and excess leverage. Policy-makers, and especially regulators and supervisors, failed to appreciate these risks and their systemic consequences – they hadn’t done their jobs.
Little more than a decade later, the world is beset by another massive shock. This shock, though, is catastrophically severe for economies and financial systems.
In response to the 2008 crisis, the G20 launched a massive international regulatory reform agenda. In April and October 2008, the Financial Stability Forum – the Financial Stability Board’s precursor – prepared recommendations to increase the resilience of markets and institutions. These recommendations became a focal point for the Washington, London and Pittsburgh G20 summits.
What followed was a string of successes in strengthening global banks, especially systemic banks. The FSB and the Basel Committee prescribed strong medicine, boosting the quantity and quality of capital and raising liquidity coverage. They reined in leverage, created robust resolution regimes, and upped total loss absorbing capacity. In the US, the Dodd-Frank Act buttressed and complemented these actions.
At the time, officials recognised and were deeply concerned that tightening bank regulation would cause activity to gravitate to lightly overseen non-bank finance – ‘shadow finance’.
Hence, the FSB launched annual exercises to quantify non-bank finance. It asked how non-banks should be overseen, given their wide range and differences from banks. The asset management industry launched ferocious lobbying to restrain officialdom.
In the end, an ‘activities-based’ approach was adopted, focused for example on the size, scope and amount of leverage and interconnectedness of asset managers.
The Treasury-led Financial Stability Oversight Council discusses the non-bank finance sector in its annual reports. The Federal Reserve’s financial stability reports also discuss the non-bank sector and implications for US financial stability, but despite pointing to budding risks, say little about what is to be done.
In the US, with banks in the purview of the Fed and other bank regulators, the Securities and Exchange Commission plays a prominent role in overseeing many forms of non-bank finance. The FSOC is charged with identifying risks to US financial stability and promoting market discipline.
In its early years, the FSOC pushed the SEC with some success to tighten criteria for money market mutual funds. It designated systemically significant financial market utilities and non-bank financial institutions such as AIG, Prudential and MetLife.
But in 2017, President Donald Trump ordered the FSOC to review its determination and designation processes. The FSOC backed off its effort to designate MetLife. Subsequently, the FSOC put forward procedures for activities-based determinations for non-banks. The proposed approach was viewed as sufficiently light-touch, opaque and protracted as to draw the opprobrium of former Fed Chairs Ben Bernanke and Janet Yellen, and former Treasury Secretaries Tim Geithner and Jack Lew.
The banking system has held up fairly well through the coronavirus crisis thanks to Basel 3 and associated measures.
But nonetheless, the Fed had to immediately pull out its 2008-09 playbook to avoid a global financial meltdown originating mainly in non-banks. It once again had to step in to backstop money market mutual funds, commercial paper, asset-backed securities, corporate bonds and municipal bonds, among others. Money market sponsors have stepped in to prevent breaking the buck. Hedge funds have engaged in fire sales. Mortgage-backed security markets have frozen, imperilling housing.
Despite the considerable chatter over the years about non-bank finance, it appears this sector is failing its 2020 stress test. Regulators have underestimated the risks posed by leverage in trading books and in non-banks as well as by interconnectedness. They have miscalculated the spillovers to financial stability and the US economy in particular. Just as in 2008, failures of regulatory oversight are abundant.
When the dust soon hopefully settles on immediate coronavirus firefighting, regulators need to quickly get to the bottom of how financial markets behaved. The FSB, as in 2008, should immediately investigate what happened, what went wrong and what fixes are needed.
In the US, the FSOC should launch such a study. Given the Council’s current light touch philosophy, a ‘shadow committee’ of financial experts, committed to fighting systemic risk and with experience in fighting the 2008 crisis, should undertake such an investigation.
Non-banks impact financial stability. It’s high time, rather than leaving it to the FSOC, that the Fed used its financial stability reports to go beyond analysis and offer policy recommendations on non-banks.
An essential outcome of the pandemic’s impact on the global financial system must be to seriously reduce the risks emanating from non-banks and leverage.
Mark Sobel is US Chairman of OMFIF.