As the end of the year approaches, the Federal Reserve is watching the Treasury repo market closely and pouring in liquidity, hoping interest rates don’t spike again as they did in September, briefly affecting monetary policy tools and raising questions about market liquidity. Although broader macroeconomic problems stemming from repo market uncertainty seem unlikely, some Wall Street banks and their advocates appear to be seizing on the market volatility as a pretext to attack post-crisis rules that they have long disliked. The Federal Reserve Board should resist these attacks and not weaken critical standards that have made the system safer.
In September, demand for overnight cash to fund Treasury positions at some financial firms exceeded the amount of cash being offered by the biggest banks and money-market funds, causing interest rates in the repo market to rise briefly to unanticipated levels. The Fed stepped in and the market calmed down. Some were quick to blame this turbulence on stronger post-crisis regulatory standards for the largest banks, which, as the argument went, stopped them from providing more cash to fund overnight Treasury repos. These critics cited various culprits, individually or in combination: liquidity regulations and supervision; capital standards, including stress-testing capital thresholds; and requirements for so-called living wills. Yet what has been missing from their claims is compelling evidence that any of those played a material role in the repo market volatility.
Recent events in the repo market do suggest that some things have changed and that participants in these markets, including the Fed, are still feeling their way through the consequences. These changes include an increased supply of Treasury debt that must be funded as the deficit has grown rapidly; less cash in the system as the Fed has wound down quantitative easing and shrunk its balance sheet; increased difficulty or reluctance by banks to access and utilize intraday or overnight loans provided by the Fed; and greater demand for repo funding of government securities by hedge funds and other leveraged investors.
Fed officials said recently that a possible contributing factor might be related to supervision of the largest banks’ liquidity management practices, including their internal liquidity stress tests. What this means is not entirely clear. It could refer to appropriately greater caution on the part of banks and their supervisors, which learned during the financial crisis that assuming a near-unlimited capacity to quickly turn assets into cash is not something they should rely on at all times, even when they have a lot of Treasury securities to use as collateral. As we saw in in 2008-2009, this can be especially difficult during a period of stress when solvency may be questioned and liquidity is needed the most.
That some bankers have seized on market volatility to advance a deregulatory agenda is no surprise. Stronger standards have been costly for the biggest Wall Street banks, which are now forced to absorb costs that make the system safer by reducing the likelihood of their demise. Weakening the post-crisis banking standards would be misguided because they have buttressed financial stability, contributed to strong performance of U.S. banks, including relative to foreign competitors, and supported an extended period of economic growth. If Wall Street’s efforts to roll them back are successful, it would weaken our financial system and make it more likely that the next economic downturn could turn into another full-blown financial crisis.
The core safety-enhancing measures for the largest banks include stronger capital and liquidity standards, more intensive and focused banking supervision, and derivatives markets reforms. They also include attempts to make these banks better able to be resolved should they fail — the so-called living wills — so they would not require a taxpayer bailout. Unfortunately, the feasibility of resolving a massive and complex bank when it’s failing remains a matter of hopeful speculation.
Because of the enormous challenges associated with resolving a giant bank, true confidence in avoiding crashes and taxpayer-supported bailouts must depend on efforts to reduce the probability of such a failure in the first place. That’s precisely what stronger liquidity and capital standards do, especially when supported by strong banking supervision. Given the damage the failure of a large bank could have on the economy and society, current requirements should be strengthened, not weakened, with the most obvious benefits coming from higher capital standards. And more should be done to better ensure that the collapse of a huge bank could be addressed without requiring a bailout.
In the current political climate, progress on such measures to enhance financial stability is unlikely, and indeed meaningful deregulation has already taken place. This makes it all the more important to avoid weakening the safeguards now in place. While the interaction of various factors influencing the repo market needs to be better understood, what is not in doubt is the overarching importance of ensuring Wall Street’s largest banks are financially strong and do not pose a threat to the economy. The 2008-2009 financial crisis exposed not only the danger of banks’ business practices and failure of their risk management but also the ineffectiveness of the precrisis banking regulatory and supervisory regimes. All of these contributed to an economic collapse that led to devastating outcomes for tens of millions of Americans.
Although this was well known only a few years ago, memories appear alarmingly short. It’s critical to remember the tremendous damage caused by the financial crisis before contemplating any further moves back in the direction of woefully inadequate regulations. Weakening effective standards that have made the largest banks and the economy safer would be a mistake, and nothing that has happened in the repo markets changes that.
This article was provided by Bloomberg News.
