A decade after the worst financial crisis in our lifetimes and the subsequent tightening of financial regulation, the risks to financial stability are rising. The reason: financial regulations are being relaxed at the same time as the Federal Reserve is cutting interest rates to offset risks from heightened trade tensions. This is not a good combination at this point in the business cycle. It greatly increases the risk that the next recession, whenever it occurs, will be severe because it will be amplified by elevated financial imbalances.
Like the Fed, I have been assessing overall risks to financial stability in the U.S. as “moderate”. The banking system has more capital. The shadow banking system as we knew it has been reined in. These more stable financial intermediaries are a critical counterweight to high financial vulnerabilities elsewhere. Among the vulnerabilities: compensation for credit risk in corporate bonds and loans is slim, and commercial real estate capitalization rates (rental income-to-price) are at historically low levels. Corporate debt ratios are at a record high and increases in debt are concentrated in the lower-quality firms. In addition, some mutual funds are promising daily liquidity while holding less liquid leveraged loans and corporate bonds, a risky mismatch.
Recent moves to ease regulations suggest financial stability risks are at an inflection point. Incentives to leverage will continue to rise as interest rates remain low amid a global search for yield. Vulnerabilities that have been “moderate” could escalate quickly to “elevated”, as they did in the lead up to the 2007 – 2008 crisis.
Given current conditions, regulators should be ensuring the strength of the financial sector to withstand future risks, not weaken it, but that is not what is happening in the U.S. Recent moves to ease regulations suggest financial stability risks are at an inflection point. Incentives to leverage will continue to rise as interest rates remain low amid a global search for yield. Vulnerabilities that have been “moderate” could escalate quickly to “elevated”, as they did in the lead up to the 2007 – 2008 crisis.
To be sure, a number of recent actions by regulators have usefully simplified and improved the efficiency of financial regulations, such as relaxing some regulations on and supervision of banking firms with assets of less than $250 billion. But other actions are significantly increasing the risks that the financial sector won’t be sufficiently resilient to support the economy once a downturn takes hold.
First, a pullback by the Financial Stability Oversight Council (FSOC), the committee established by the Dodd-Frank Act in 2010 to identify risks and respond to emerging threats to financial stability, could lead to a return of significant vulnerabilities in the shadow banking system. The FSOC has the authority and responsibility to designate nonbank financial firms as systemically important if their distress could lead to significant problems for the broader financial system and economy. While the designation process needed improvements, the FSOC has changed the rules in ways that make it unlikely that it will ever designate a nonbank financial firm as systemically important. But vulnerabilities with systemic consequences, such as excess leverage and funding mismatches, can arise at financial firms regardless of their charter, which is why AIG, GECC, and other nonbank financial firms received government assistance during the crisis. By effectively foreclosing use of this tool, FSOC removes incentives for these firms to self-limit activities that contribute to systemic risk in order to avoid designation. It makes it more likely that vulnerabilities will build outside of regulated firms, and make systemic problems more difficult to measure, assess, and prevent.
FSOC says that instead of looking at individual firms, it will emphasize an activities-based approach and rely on primary regulators, such as the Securities Exchange Commission (SEC) and state insurance regulators, to reduce financial stability risks. But it is not clear that FSOC or regulators have the authorities to reduce activities-based systemic risks. What can they do to reduce rising financial stability risks posed by loans originated by banks or private funds that are leveraged subsequently through complex securitizations and then used as collateral for borrowing in short-term funding markets? The actions of FSOC to limit designation without a strong viable alternative tool makes the entire financial system more fragile, with higher risks of credit disruptions and market dysfunction when asset prices fall and many firms with common holdings are forced to deleverage.
At the same time, there are persistent efforts in Congress to repeal important reforms to money market mutual funds (MMFs.) If successful, these efforts would contribute to a buildup of shadow banking risks. The SEC implemented these reforms in 2016 to fix the significant fragility of prime MMFs which became apparent after the Primary Reserve Fund “broke the buck” as a result of losses on Lehman Brothers’ paper that it held. That episode demonstrated the costly dynamic of a run: investors in many MMFs rushed to redeem their shares before others to avoid any principal losses, disrupting the flow of credit to America’s largest corporations and prompting a government rescue. Proposed repeal of the reforms would allow institutional prime and tax-exempt MMFs that hold non-Treasury securities to once again promise to redeem at $1 per share, obscuring underlying risks. This would encourage a return to a shadow financial system highly reliant on short-term funding, and set up an all-too-familiar dynamic, risking a severe disruption to credit markets from investor runs.
In the banking sector, post-crisis reforms have aimed to both strengthen banks to prevent bailouts and to ensure banks will have enough capital to absorb losses after the economy turns down and still provide credit to support the economy. Based on the experience with new rules, regulators have been improving the reforms by tailoring and simplifying regulations and supervision. But some recent proposed changes likely will lead the most systemically important firms to reduce their capital buffers today, despite no signs that capital is constraining lending to households and businesses. That means that banks will be in a weaker position to lend when it will be especially needed in a future recession.
The stress tests that the Fed administers support the objective to assure banks can continue to provide credit in a downturn. When times are good, for instance, the stress test scenarios assume a bigger increase in unemployment than they do when the economy is weak and unemployment is already elevated (see Kohn and Liang). It turns out, however, that the net loss estimates (losses minus revenues-to-risk-weighted assets (RWA) from the stress tests for the most systemically important banks are not as countercyclical as the scenarios. The estimated stress test net losses were lower in 2019 than in 2018, and lower in any year since 2014. Instead, the requirement that banks include shareholder payouts (dividends plus share buybacks) has been more important to preventing stress test capital requirements from declining since 2014.
The Fed has recently suggested a change that would end the inclusion of dividends expected to be paid in the first four quarters of the stress test scenario, in addition to ending the inclusion of share buybacks. Removing expected dividends on its own would lead to a reduction in the capital required by the stress tests of about 0.5 percentage point of RWA next year.
The Fed could offset this reduction in capital, such as by increasing the countercyclical capital buffer (a new Basel III capital requirement that could be increased when systemic risks are rising and released when systemic risks abate), but this change would remove an important incentive to keep dividends in check. Higher dividends as a share of total shareholder payouts means the banking system would retain less capital when expected losses start to rise: Banks will want to keep paying dividends because cuts are usually viewed as a negative signal and result in larger stock price declines than would cuts in share repurchases.
In 2008, dividends were almost 60 percent of shareholder payouts, and banks maintained them, paying out ¾ of a percent of RWA even as expected losses were starting to mount. In contrast, with total shareholder payouts reaching 1.8 percent of RWA in 2018, the share paid in dividends was 30 percent, which is a better outlook for retaining capital. (While new Basel III rules require banks to cut dividends if capital falls below the regulatory minimum and buffers, the pre-funding feature in the stress tests gives financial institutions an incentive to conserve capital before losses are booked for the purposes of calculating capital ratios.)
On top of these potential regulatory changes is a message being conveyed to supervisors to scale back scrutiny of banks’ underwriting standards. Supervisors generally do not have authority to penalize poor underwriting standards when the risks they pose are off-loaded from the bank – through securitization, for instance — even if poor underwriting poses risks to the overall economy. But supervisors’ authority to require strong underwriting standards even for loans banks keep on the balance sheet has been called into question. In a review conducted at the request of Congress, the Government Accountability Office said that the supervisory guidance for leveraged loans amounted to a rule, which meant that it could not be enforced without a rule-making and was subject to Congressional review.
In summary, financial stability risks are rising. Financial regulations are being relaxed, even though we should expect financial vulnerabilities to rise and become more complex as monetary policy is loosening to cushion the economy from uncertainty from heightened trade tensions. A guiding principle for financial reforms from the G-20 that emerged in the immediate aftermath of the financial crisis was to offset the procyclical effects of financial regulations in order to reduce the significant amplification of economic downturns by the financial system. This principle is even more relevant now when monetary policy has less room to cut rates to support the economy. But recent actions are doing the opposite of what the G-20 called for. As a consequence, an adverse shock will be amplified more by financial intermediaries that become less resilient as financial regulations are relaxed, resulting in greater losses in employment and wealth in the next recession.