March 1, 2015
Dodd-Frank restrictions on the Federal Reserve’s powers to act as lender-of-last-resort, coupled with restrictions on federal guarantees for bank deposits and money-market funds, pose a threat to U.S. and global financial stability.
The heart of the 2008 crisis was a panic following the bankruptcy of Lehman Brothers. Due to its losses from this bankruptcy, the Reserve Primary Fund “broke the buck,” touching off a run on other money-market funds. Credit markets froze. The Fed stepped in and supplied liquidity to the banking and non-banking financial sector, the latter through its authority under Section 13(3) of the Federal Reserve Act. Meanwhile, the Federal Deposit Insurance Corporation expanded the limits of deposit insurance, and the Treasury Department offered guarantees to money-market funds.
Once the crisis abated, however, there was growing public concern about “moral hazard”—that government backstops and guarantees incentivized risky behavior in financial markets. The Dodd-Frank Act (July 2010) pulled back the Fed’s lender-of-last-resort powers for non-banks. They can now be exercised only with the approval of the Treasury secretary, and the Fed cannot lend to a single institution as it did with AIG . It must now only lend under a broad program, and must also meet heightened collateral requirements.
In addition, the FDIC cannot expand guarantees to bank depositors without congressional approval, and the Treasury can’t do the same to money-market funds without new legislative authority. These changes could make it difficult for the Fed and other regulatory bodies to act effectively in the next crisis.
Some claim there is nothing to worry about because of new regulations to prevent another crisis: enhanced capital requirements, new liquidity requirements and new resolution procedures. This approach calls to mind a strategy of two wings and a prayer.
Capital requirements, the first wing, only apply to deposit-taking banks and systemically important nonbank financial institutions (SIFIs), of which there are now only three—GE Capital, Prudential , and American Insurance Group. (Met Life is contesting its designation.) Regulators envision that regulatory capital for the most important U.S. banks will max out at 8% to 11.5% of risk-weighted assets. Neither this level of capital, nor any practical higher level, can assure that banks would not become insolvent in a panic after a fire sale of assets. Such fire sales were a critical feature of the 2008 crisis.
New liquidity rules, the second wing—assuring that banks have sufficient “liquid” assets such as U.S. Treasurys or foreign-government debt to cover withdrawals—are based on assumptions that these assets have low credit risk and assume certain rates of withdrawal of different types of funding. These assumptions may prove wrong in an unbridled panic. The Fed may still need to supply liquidity.
Dodd-Frank’s Orderly Liquidation Authority is the prayer. The FDIC steps in only if a financial institution on the brink of insolvency is designated by the Treasury secretary, in consultation with the president, as threatening financial stability. This determination is necessary even if the institution has previously been designated as systemically important for regulatory purposes. By the time that determination is made, and even afterward, other institutions may be attacked by runs causing their own insolvency.
To prevent runs on money-market funds, the Securities and Exchange Commission now requires institutional funds that do not exclusively invest in government securities use floating net-asset values, and not maintain a constant (if fictional) value of $1 per share. But floating net-asset values by themselves will not prevent investors from a run, since they may fear further price declines. Similarly, the powers the SEC granted to fund boards to penalize or restrict redemptions also may accelerate runs.
What stopped the runs on money-market funds in 2008 were Treasury guarantees. After the Troubled Asset Relief Program (October 2008), that solution is no longer readily available.
Some commentators believe that restrictions on the Fed’s lender-of-last-resort powers are not that important. After all, the Treasury secretary can approve using them and also approve the design of a broad program. Yes. But markets cannot know a Treasury secretary will act, and with such bailouts now in disrepute, runs are more likely in a future crisis.
The financial system is the plumbing without which an economy cannot function, and that system can be destroyed by the spreading contagion of a run. The weapons that regulators used to end the last crisis need to be restored and strengthened. Concerns about moral hazard should not bar the Fed from being the lender of last resort to solvent institutions (as best it can determine) that are panic victims, not undue risk takers.
The Fed was created in 1913 to be a lender of last resort against the background of the deep recession that followed the bank runs of 1907. Fed lending can be labeled a bailout. But history tells us this is a necessary feature, however undesirable in principle, of a stable financial system and economy.
This article originally appeared in the Wall Street Journal, and LPAF Policy Advisor Glenn Hubbard co-authored the piece with Hal Scott is professor of international financial systems at Harvard Law School.