Last March, when the COVID-19 pandemic hit, financial markets around the world were plunged into crisis as investors and businesses everywhere attempted en masse to extract as much liquidity from their investment vehicles as possible.
This so-called “dash for cash” created a frenzy of margin calls that some investment firms did not have the liquidity to cover, causing a spike in corporate and government bond yields and forcing central banks to purchase massive amounts of bond debt in order to stabilize the global economy.
In a Reuters Newsmaker speech on Thursday, Andrew Hauser, executive director of the Bank of England, cautioned that unless banking practices are reformed to reflect today’s financial realities, the global banking system will continue to be vulnerable to similar shocks.
“Taken together, fully half of all financial assets are now held outside the banking system,” Hauser said, noting that more people than ever are pouring their savings into stock portfolios, pensions, money-market funds, and other non-bank, market-based investment.
“These trends aren’t new — and to the extent that they bring broader access to cheaper, faster, and more diverse financial services, they’re good news,” Hauser added. “But they do pose novel challenges to financial stability. In particular, as its usage grows, market-based finance seems increasingly prone to liquidity shocks.”
Market dysfunction cannot be ignored
The only reason the market didn’t implode during the onset of the COVID-19 pandemic was because of swift and appropriate action from large central banks. The major central banks that make up the G-10 added more than $8 trillion to their balance sheets, mostly by buying government bonds, Hauser explained. Unfortunately, even though the bond buy-up stabilized markets, the fact that they had to be stabilized demonstrates why such market dysfunctions need to be addressed by targeted regulatory reforms, he said.
“There is every reason to believe that absent further action, we will see more frequent periods of dysfunction in the very markets [that are] increasingly relied on by households and firms, if business model vulnerabilities persist and intermediation capacity remains strained,” Hauser warned. “The public authorities cannot afford to ignore such dysfunction if it reaches a scale that threatens financial stability.”
Market maker of last resort?
In order for financial markets to support the public’s increasing reliance upon them without jeopardizing the stability of the system, Hauser proposed several remedies that he thinks regulators should consider. The Financial Stability Board (FSB) is already working to make non-bank financial markets more resilient by strengthening market-wide infrastructures, he said, but cautioned that work still needs to be done to re-think the role of central banks in providing liquidity to financial markets when the going gets rough.
“A key part of the success of the [pandemic] asset purchase programs was that [central banks] took large quantities of risk off private-sector balance sheets, meeting the heightened demand by non-banks for cash and allowing intermediaries to return to providing finance to the real economy,” Hauser explained. However, this approach shifted a significant amount of private-sector risk into the public sector. And while this transfer of risk may have been justified to solve the unprecedented COVID-19 crisis, he noted, it is not a prudent prescription for future financial health.
“While [the central banks’ COVID-19 response] was fully justified by the unprecedented nature of the shock, the use of ad-hoc tools risks embedding inappropriate expectations about how central banks might behave in future cases of market dysfunction,” Hauser said. One approach worth considering is adopting something similar to the Bank of England’s role as “lender of last resort” to commercial banks in trouble, he explained. This could be looked at as a “market maker of last resort” role, he added, which would involve trading two-way securities when signs of market dysfunction arise.
Addressing future dysfunction
Considering that financial markets will likely play an increasingly important role in household and corporate finances going forward, Hauser outlined a number of ways in which central banks could revise their financial toolkit for dealing with instances of future market dysfunction.
For example, as central banks are inevitably called upon to provide insurance against liquidity shocks in future financial markets, banks need to clarify and refine their tools to enable more precision and resilience. “In some cases, banks may be able to use existing tools designed for monetary policy purposes, as they did in the COVID-19 crisis. But in others, those tools may prove poorly suited to the task, and new ways will be needed to achieve those ends,” he said.
Central banks should consider formalizing what has until now been a discretionary role in soothing financial markets, so that everyone will know what their response will be in advance, he said. Such an approach would not only take the guesswork out of the bank’s role, Hauser said, “it may also provide confidence that the system is backstopped against operational or other idiosyncratic market-wide events, such as systemic IT outages.”
Further, central banks also need to decide what marketable assets make the most sense to manage in the event of a systemic shock. Government bonds are an obvious choice, Hauser explained, but he also noted that banks bought a range of assets during the 2008-‘09 financial crisis and the dash-for-cash in March, including corporate bonds and short-term debt securities.
Once a set of revised tools is developed, rules would of course have to be established to ensure that public money isn’t exposed to too much private risk, or that irresponsible actors in the private market aren’t rewarded. Indeed, such reforms are necessary, Hauser insisted, because the pandemic crisis has exposed the systemic fragility of non-bank financial markets at a time when more people than ever are utilizing them.
“Many of the vulnerabilities in financial markets exposed last spring have been staring us in the face for some time,” Hauser said, adding that “they will only grow in importance in the years ahead, as households and firms come to rely ever more closely on such markets to care for their savings and fund investment.”