Protecting Financial Stability: Lessons from the Coronavirus Pandemic

Howell E. Jackson is the James S. Reid, Jr., Professor of Law at Harvard Law School and Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law. This post is based on their recent paper.

The coronavirus pandemic has produced a public health debacle of the first-order. But, the virus has also propagated the kind of exogenous shock that can precipitate—and to a certain degree has precipitated—a systemic event for our financial system. This still unfolding systemic shock comes a little more than a decade after the last financial crisis. In a recently posted essay, Protecting Financial Stability: Lessons from the Coronavirus Pandemic, we contrast the current pandemic with the last financial crisis and then examine the steps that financial authorities have taken to safeguard financial stability against the effects of COVID-19. Our essay also explores the extent to which financial regulation might be reformed and supplemented in the future to address the emerging lessons of the pandemic crisis.

The last financial crisis is most vividly remembered as a top-down crisis starting with the failure of a series of major financial firms in 2008, culminating in a capital market meltdown in September following the bankruptcy of Lehman Brothers. The coronavirus pandemic, as yet, has not precipitated any similar financial failures, although capital markets did react dramatically in March of this year as the pathology of the virus and its potential implications on global economic activity started to come into focus. This new information produced an exogenous shock, prompting in many quarters a rush to cash and the evaporation of liquidity for many asset classes. The Federal Reserve Board, along with other central banks and financial regulators, responded promptly, drawing self-consciously on the emergency toolkit developed in the last financial crisis, as well as a number of counter-cyclical levers made available as part of regulatory reforms adopted in response to that last crisis. This intervention to stabilize capital markets (and financial firms) appears to have been successful, at least so far.

The pandemic of 2020 also differs from the last financial crisis in the scope and target of government responses. Whereas the initial interventions in 2008 were focused on providing public support to financial firms, the interventions of 2020 have been primarily designed to supply aid to households, businesses, health care providers, and state and local governments, all of whom have suffered and continue to suffer massive economic losses as a result of the pandemic. In contrast to 2008, when unanticipated financial losses were largely the product of poor loan-underwriting practices and excessively optimistic assumptions about housing prices, financial losses in the pandemic are the byproduct of conscious efforts to reduce economic activity in order to stem the spread of the virus. The perceived urgency—perhaps coupled with the absence of fault, either on the part of individuals or firms—has led Congress to adopt the $2.2 trillion CARES Act and several other pieces of major legislation authorizing far-reaching support efforts and even relaxing some of the Dodd-Frank Act restrictions imposed on the Treasury and other federal agencies to constrain emergency support of the financial system.

While the past few months have witnessed a consensus around a Draghi-esque “whatever it takes” approach to the current crisis, financial regulators face future risks as they attempt to mitigate systemic financial consequences of the pandemic. To begin with, the line between appropriate counter-cyclical adjustments of regulatory requirements and inappropriate forbearance with respect to weakened financial institutions is never clear, especially when the extent of economic losses from the pandemic remain uncertain. If the current recession is prolonged more than is currently anticipated, financial firms, even large ones, may eventually fail or require government assistance; at that point, critics may charge that federal authorities were excessively accommodating in the early stages of the crisis. Similar problems could arise with respect the Fed’s emergency lending vehicles, which, by design, are supposed to be limited to solvent borrowers with adequate collateral. No doubt, Fed personnel have structured these programs to comply with legal standards, but solvency and collateral values are dependent on estimations and risk tolerances that may prove to have been overly optimistic in retrospect.

Another distinctive and unprecedented feature of the U.S. coronavirus response has been the array of novel collaborations put in place to address the economic consequences of the crisis. Most notably, from the perspective of financial regulation, has been the extent to which the Treasury Department and Federal Reserve Board have joined together in new facilities designed to provide support for the real economy, typically with the Treasury assuming first-loss positions and sometimes requiring additional risk exposures from participating private financial institutions, but invariably with a large amount of additional funding coming from the Fed itself. While one cannot help but admire the creativity of these new instruments, complexity and novelty pose a number of potential concerns. Among other things, questions may well arise—and in some circles are already arising—as to whether these new instruments are properly designed to get aid to the appropriate parties, in many instances small businesses and individual payrolls. In addition, the close collaboration of the Fed and the Treasury Department could raise questions about Fed independence down the road, especially if some of the lending vehicles cause credit losses for the Fed’s balance sheet. Again, this risk will be amplified if the economic costs of the pandemic prove to be greater than originally anticipated.

As the third quarter of 2020 begins, the implications of the coronavirus pandemic for the financial system remains an open question. Conceivably, and hopefully, future observers will regard the Fed interventions of the Spring as prescient and successful, ameliorating immediate capital market reactions to COVID-19 and stabilizing the economy until Congress could put fiscal measures in place. On the other hand, it remains possible that the pandemic will linger longer than anticipated and economic losses will continue to mount throughout the second half of 2020 and beyond, producing losses that threaten even major financial firms. Even if economic recovery starts sooner, there remains something of an open question as to the impact of losses already incurred, especially as loan forbearance and rent holidays expire and individual and business bankruptcies accumulate.

Because we do not yet know how the pandemic will play out for the financial system, predictions about future reforms are difficult to make with confidence. But we offer a few tentative thoughts in our essay. For one thing, we think it unlikely that many of the kinds of reforms undertaken in response to the last financial crisis will be adopted in the aftermath of the pandemic. While it may have made sense to try to improve underwriting standards of home mortgages and tweak risk weighting for securitized assets after 2008, pandemic risks do not seem to be susceptible to narrowly focused adjustments. Conceivably, policy analysts may be able to devise mechanisms, like catastrophe bonds, to create more loss-absorption capabilities for pandemics and other low-probability but high-impact events. Additionally, there may be an appetite to promote greater resiliency throughout our financial system, not just requiring higher capital-adequacy ratios for regulated entities but also emergency savings programs for individuals and lower leverage levels for commercial firms, and perhaps giving greater fiscal flexibility to the federal government to continue acting as the insurer of last resort in crises of this sort. It may also be the case that some of the lessons of regulating systemic risk in the financial system might be exported to the public health field in the form of “macromedical” regulation, akin to the macroprudential regulation that financial supervisors have implemented since 2008.

The complete paper is available for download here.

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