The COVID-19 crisis exposed what financial reformers missed

After the U.S. financial system came to the brink of collapse in 2008, Congress and regulators spent years on renovations designed to prevent that from ever happening again. More than six months into a global pandemic that has delivered another monumental shock, it’s worth asking: Were the reforms successful and sufficient?

The answer depends on what part of the financial system you’re looking at. Traditional banks have fared pretty well. The rest, not so much.

Regulators did a lot to make the core banking system more resilient. They increased requirements for loss-absorbing capital, and for the liquid assets needed to meet obligations in a crisis. They established stress tests designed to ensure that banks can survive a severe economic or financial shock. These changes neither throttled credit nor choked the economy, as opponents warned they would do. Rather, the costs were shared broadly — among shareholders (in the form of lower profits), bank executives (lower pay), borrowers (slightly higher interest rates) and savers (slightly lower deposit rates). Meanwhile, the U.S. experienced the longest economic expansion in its history.

Now we’re reaping the benefits, as the banking system sustains lending amid an extraordinary economic shock. Rather than amplifying distress, as it did during the 2008 crisis, it has absorbed and cushioned the shock. It has kept performing the crucial functions of intermediating between savers and borrowers, and of helping businesses manage financial risks.

Yet outside the banking system — in the realm of specialized lenders, hedge funds and money market mutual funds — reforms have proven inadequate. That’s why the Federal Reserve had to go to extraordinary lengths to intervene in financial markets, in order to support such nonbank institutions. It pledged trillions of dollars to, among other things, help highly leveraged investors unwind large bets on U.S. Treasuries and mortgage-backed securities, ensure money market funds had enough cash, and support corporate and municipal securities markets so companies and state and local governments could continue to raise funds.

So what went wrong? The experience has exposed a number of flaws and omissions.

First, there’s the ineffectiveness of the Financial Stability Oversight Council, established by the Dodd-Frank Act to address systemic risks outside the core banking system. It has abandoned its power to designate nonbank institutions as “systemically important” and subject them to special oversight by the Fed. All four major nonbanks that were once designated — AIG, GE Capital, MetLife and Prudential Financial — have since been removed from the list. It has also failed to rein in risks posed by activities, such as money-market funds offering deposit-like services, mutual funds investing in illiquid high-yield bonds while allowing investors to withdraw their money on a day’s notice, and the widespread use of overnight “repo” credit to fund highly leveraged investments in Treasuries and mortgage-backed securities.

The FSOC’s poor performance stems from a flawed design. It’s headed by a political appointee, the Treasury secretary, which makes it subject to the whims of the executive branch and leaves it with little incentive to take the long view beyond the next political cycle. The committee’s members — who include the heads of all the federal financial regulatory agencies — apparently prefer that it remain weak, lest it encroach on their areas of specialization. It’s as if they had all signed a mutual nonaggression pact: You leave me alone and I will reciprocate.

Second, some of the most powerful regulators, including the Securities and Exchange Commission and the Commodity Futures Trading Commission, have no strong, explicit mandate to ensure financial stability. This makes it difficult for them to evaluate and address systemic risk. Consider those mutual funds, which promise overnight redemptions even though they invest in assets that can become hard to sell during times of economic distress. This gives investors an incentive to pull out at the first sign of trouble, while there’s still enough cash on hand — putting other, slower-to-react investors at a disadvantage. Yet the SEC doesn’t have rules to help slow such runs, such as limiting how quickly investors can redeem shares for cash.

What to do? First, give all the agencies that oversee financial markets a stability mandate and the powers to carry it out. Second, evaluate and restructure the FSOC, providing the governance needed to effectively supervise the nonbank sector. Meanwhile, officials should act to make the markets for Treasuries and mortgage-backed securities more resilient to the kinds of shocks they experienced back in March and April. One option is for the Fed to provide a standing repo facility, to ensure that leveraged investors can always refinance their positions, rather than being forced to sell at the worst possible moment. By making Treasury securities more attractive to own, such a facility might have the added advantage of reducing the government’s cost of borrowing.

Financial regulators have made a lot of progress since the 2008 crisis. But the coronavirus crisis has demonstrated that there’s still a lot to do in the nonbank part of the financial system.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.