March 2020 Crisis – view from Fed

In a recent speech, Federal Reserve Board (FRB) Governor Lael Brainard highlighted vulnerabilities in the financial system that came to light from the Covid-19 shock. The speech was summarizing key points from a report published by the Financial Stability Board (FSB) in Nov 2020 on the impact of the pandemic on the financial system. The speech and the FSB report shine light on the depth of the market turmoil last year and also point to the fact that it would have been much worse if the central banks had not intervened. Unlike the 2006-2008 financial crisis, the stress this time was not in the big banks but outside the banking system and in the Non-Bank Financial Intermediaries (NBFI) as the Fed labels financial institutions that do not have a full banking license and/or are not supervised by a national or international banking regulatory agency. The areas of financial sector that came into the spotlight last year due to the pandemic were;

• Vulnerability of Money Market and Bond Funds – when the the G-20 nations went into lockdown in March 2020, investors rushed to liquidate assets and the two weeks in March 2020 saw money market funds (MMF) having net redemptions of 30% and outflows faster and larger than what was seen in 2008. Similarly, bond mutual funds had $250 billion in outflows last March which was far higher than the outflows during the 2007–09 financial crisis. To stop the outflow, FRB announced a Commercial Paper Funding Facility in March 17 and a MMF Liquidity Facility on March 18 which stopped the outflow. To reduce future risk of run on these funds in the next crisis, proposals presented by President’s Working Group in Dec 2020 have recommended introducing swing pricing or a minimum balance at risk for MMF funds and SEC is now asking for comments on them.
• Weakness in the Treasury Market – Trading conditions for US Treasuries (UST) dramatically worsened in the second week of March 2020 as investors sought to raise cash by liquidating the Treasury securities. As a result, daily volumes for UST rose to more than $1.2 trillion at one point which to put into context was four standard deviations above the 2019 average daily trading volume. The liquidation was driven by foreign institutions who liquidated about $400 billion in March alone; followed by domestic mutual funds which sold about $200 billion during the first quarter and then by hedge funds who reduced UST by $25 billion in same quarter. As a result bid-ask spreads for UST widened by as much as 30 times for off-the-run securities signaling the dash towards cash. To alleviate the crisis, between March 12 and April 15, the Federal Reserve Bank (FRB) increased its holdings of Treasury securities by about $1.2 trillion. The FRB also addressed the crisis by allowing banks to absorb excess UST into their balance sheets without any capital constraints by excluding UST and deposits held by banks at FRB from the Supplementary Leverage Ratio (SLR) and this exemption expires at end of this month. All of these and recent tremors in the UST market as concerns of inflation and growth have pushed yield higher indicate that further reforms in UST market are inevitable. One of the proposals in the FSB report is to encourage central clearing of treasuries however that creates it’s own concerns as noted in next point.
• Impact of IM’s charged by CCP’s – the market volatility in March last year caused Central Clearing Platforms (CCP’s) to collect significantly higher amounts of initial margin (IM) from their members (banks and broker dealers) based on their internal risk models. While members were able to pass on margin to the CCP’s these margin calls were larger than what was anticipated and drained liquidity from the system. Proposal’s in future are for CCP’s to assess liquidity risk management plans and to assess impact on systemic risk by demanding cash from members and also to assess models for pro-cyclicality. CCP’s reforms are being actively considered by the FSB report in their Nov 2020 report.

Proposals to address the above NBFI areas are actively being considered by the FSB and being coordinated by international regulators and so expect this area to see a lot of activity similar to what happened with the big banks after the financial crisis.