Fed moves telegraph fears of prolonged liquidity crisis

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WASHINGTON — Taken together, the Federal Reserve’s aggressive actions over the last week to shore up liquidity as the coronavirus rocks the global economy are an unprecedented commitment from the nation’s central bank to ensure the smooth flow of credit.

The Fed has slashed interest rates to nearly zero, has established a number of credit facilities in order to lend to businesses and consumers, has encouraged banks to dip into their capital liquidity buffers and has pledged an unlimited amount of bond purchases — all to boost the economy and ultimately guarantee that businesses and banks have enough cash on hand.

But despite the Fed’s moves, there are concerns that a shortage of corporate debt and other types of liquidity could develop into a deeper crisis, especially if the COVID-19 pandemic shows no signs of abating.

“The Fed has the same challenges the grocery stores have with dealing with people who are buying toilet paper,” said Thomas Vartanian, the founder and executive director of the Financial Regulation & Technology Institute at George Mason University’s Law School. “Hysteria and lack of confidence is a psychological factor that changes dynamics, and it has [in] every financial crisis over the last 200 years.”

Stacks of 2017 50 subject uncut sheets of $1 dollar notes bearing the name of U.S. Treasury Secretary Steven Mnuchin sit in a machine at the U.S. Bureau of Engraving and Printing in Washington, D.C., U.S., on Wednesday, Nov. 15, 2017.

Fortunately, banks were armed with more capital and liquidity buffers after the 2008 crisis thanks to the Dodd-Frank Act, and experts largely agree that financial institutions are well equipped to handle periods of financial stress.

Yet other sectors lack the same protections, and a liquidity crisis at those businesses could result in a domino effect that would end up hurting banks all the same.

“Banks entered this crisis with strong levels of capital, thanks in large part to the restrictions Dodd-Frank put in place. Other corporations … enter this with often little cash on hand to weather a crisis and significant amounts of leverage,” said Aaron Klein, a fellow at the Brookings Institution. “So the banking industry is better poised to weather some of this storm than many of the large corporate players who weren't required to save money for a rainy day.”

Although banks may be prepared for a downturn, it is hard to know at what point economic stress would reach financial institutions, said Kathryn Judge, a professor at Columbia Law School.

“With things like the liquidity coverage ratio, [banks] have more liquidity on hand,” she said. “But things are moving so quickly and in such big ways that I think it's almost impossible to rule out the possibility of a lack of liquidity proving problematic for some set of institutions.”

Businesses have also been incentivized to pile on more debt because of the historically low interest rates since the financial crisis, which has led to record-high levels of corporate debt.

Much of that debt is held by nonbanks, which — unlike regulated financial institutions — are not held to capital and liquidity standards.

“What types of disruptions and whether they could occur not just in the real economy but also in banks is always hard to know,” Judge said.

If delinquencies were to rise as businesses struggle to make ends meet, banks would lose out on loan payments, which would threaten their business models.

“It affects banks because banks are the ultimate creditors,” Klein said. “If people default, banks and investors carry that risk.”

For that reason, the Fed has been hyperfocused on ensuring that liquidity within the system is plentiful so that banks could continue lending in a downturn. But the longer the economic fallout from the coronavirus lasts, the more unknowns there are, Vartanian said.

“As soon as some sort of distress impacts financial markets, what happens is the natural shrinkage of credit availability because everybody wants to have enough cash available to weather the storm,” he said. “And so the question becomes when that credit availability begins to be so severe that it causes constrictions in the marketplace.”

The severity of the coronavirus pandemic “is going to test the solvency of countless small and large businesses,” Klein said. But the key for the Fed is to be able to tell the difference between insolvency and illiquidity, he said.

“The epicenter here is business, not finance,” Klein said. “The Fed regulates financial institutions; it doesn't regulate Main Street. But if it's deciding which corporate entities need liquidity and which are insolvent, that puts the central bank in a very different role.”

Unlike the 2008 financial crisis that originated in the financial sector, the economic turmoil the world is currently experiencing originated completely outside the financial sector, and is directly harming areas of the economy like restaurants, travel and hospitality and the hourly workers who hold so many jobs in those sectors. Solving the liquidity crunch for Wall Street is only part of the solution, Klein said.

“If the cause differs, then the treatment should differ,” he said. “In this situation, you need to stabilize the economy to stabilize markets, not stabilizing markets to stabilize the economy.”

That is where the role of government stimulus could come in to provide much-needed relief to affected workers, which could serve those people better than liquidity injections from the Fed.

“Fiscal stimulus is ultimately going to have to play the bigger role than the Fed,” Judge said. The Fed cannot substitute for congressional action, and under a constitutional design, Congress holds the power of the purse.”

For Vartanian, a stimulus package combined with the Fed’s actions should help to shorten the duration of the crisis.

“The combination of what the Fed's doing and legislation that's enacted by Congress will probably provide the certainty and the confidence that the markets need to look at this as a short-term liquidity problem,” he said.

But he also warned that it could become a longer-term problem if the coronavirus crisis is protracted.

The Fed’s actions may have helped to get ahead of some of that by committing to essentially unlimited quantitative easing and doing “whatever necessary” to safeguard the nation’s financial system, Judge said.

“Part of what we need to know is not just that the Fed is using the tools that we all understand that they have in their back pocket, but they are going above and beyond that and saying we will use whatever tools we might need to create as circumstances continue to evolve,” she said.

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