Delivered at the 2021 Annual Washington Conference, Institute of International Bankers (via webcast), and published in a two-part series.
Part 2: Offshore dollar funding markets; Central clearing; Bank capital and liquidity; Cyclical vulnerabilities; The path ahead.
By Governor Lael Brainard
Offshore dollar funding markets
The global dash for cash also led to severe stress in offshore dollar funding markets, where foreign exchange swap basis spreads increased sharply to levels last seen in the Global Financial Crisis. Foreign banking organizations serve as key conduits of dollar funding for foreign governments, central banks, businesses, nonbank financial institutions, and households. They hold $14 trillion in dollar-denominated claims—about half of the total global dollar claims of banks. The Federal Reserve and several other central banks responded swiftly to distress in the offshore dollar funding markets by announcing the expansion and enhancement of dollar liquidity swap lines on March 15, followed on March 19 by the reopening of temporary swap lines with the nine central banks that had temporary agreements during the Global Financial Crisis.
On March 30, the Federal Reserve introduced a new temporary FIMA Repo Facility to support the liquidity of Treasury securities held by foreign monetary authorities, an important innovation. Following these interventions, foreign exchange swap basis spreads started moving down almost immediately and within a few weeks reached their levels before the COVID shock.
The reforms put in place pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in response to the previous crisis appear to have supported the resilience of the financial system as it absorbed the COVID shock.
Importantly, regulators instituted global reforms to encourage and, in some cases, mandate central clearing after observing the loss of confidence in key banking intermediaries during the Global Financial Crisis associated with the opaque web of bilateral derivatives contracts. As a result, during the COVID turmoil, the greatly expanded scope of central clearing, with the attendant reduction in counterparty and settlement risks, supported the orderly functioning of critical securities and derivatives markets amid sharply increased trading volumes and spiking volatility. Moreover, several central clearing platforms (CCPs) successfully handled problems that emerged at a few smaller market participants, without noticeable spillovers to other markets and institutions.
However, as part of the risk controls that are inherent in central clearing, the COVID market turmoil generated exceptionally large flows of cash through CCPs from market participants with mark-to-market losses to those participants with corresponding gains.
Furthermore, during the March COVID turmoil, a number of CCPs collected significantly higher financial resources from their members to protect against increased risk as captured by their risk models. These demands for liquidity were met adequately, and the markets operated efficiently and effectively, although the sudden spikes in CCP requirements may have stressed the liquidity positions of some trading firms. And while CCPs performed well during this period of stress, forceful public emergency interventions and the strong capitalization of banks likely mitigated the risks of large clearing member defaults.
The COVID-19 shock presents an important opportunity to reflect on lessons learned about central clearing by the public and private sectors. CCPs could consider the effects of the market dysfunction on their liquidity risk-management plans, including their assumptions regarding the ability to raise cash from noncash assets or securities.
In addition to reassessing their liquidity planning, CCPs could also assess the tradeoffs between their own risk-management decisions and broader financial stability concerns, particularly in light of how CCPs may have contributed to deleveraging by some market participants in March by the magnitude of the increases in financial resources they collected when trading and volatility spiked. CCPs could assess their margin models, consider improvements to reduce pro-cyclicality, and consider increased transparency to help clearing members anticipate margin calls during periods of volatility. The holistic review by the Financial Stability Board, in which we participate, could provide important insights into these issues.
Bank capital and liquidity
The resilience of the banking sector in response to the COVID shock underscores the importance of guarding against erosion of the strong capital and liquidity buffers and risk-management, resolution, and stress-testing programs put in place pursuant to the Dodd-Frank Act. Banks entered the pandemic with strong capital and liquidity buffers, especially those banks whose size and complexity are systemically important. Strong capital and liquidity buffers allowed the banking system to accommodate the unprecedented demand for short-term credit from many businesses that sought to bridge the pandemic-related shortfalls in revenues.
Banks’ capital positions initially declined because of this new lending and strong provisioning for loan losses but have since risen above their pre-pandemic levels, reflecting better-than-expected loan performance and a reduction in credit provision as well as caps on dividends and restrictions on share repurchases in the past several quarters.
Strong capital and liquidity positions will remain important, as banks still face significant challenges—including an environment of higher-than-normal uncertainty. For instance, some sectors of commercial real estate loans and commercial and industrial loans are more vulnerable than before the crisis. Similarly, net interest margins could remain in the lower part of their historical ranges for some time. Although losses and delinquency rates on bank loans are currently low, performance could deteriorate as borrowers exit forbearance, with particularly hard-hit businesses and households facing arrears on rent and mortgage payments.13 Recent developments have been encouraging, but downside risks remain, which could delay recovery and lead to higher losses.
Bank resilience benefited from the emergency interventions that calmed short-term funding markets and from the range of emergency facilities that helped support credit flows to businesses and households. While the results of our latest stress test released in December 2020 show that the largest banks are sufficiently capitalized to withstand a renewed downturn in coming years, the projected losses take some large banks close to their regulatory minimums.14 According to past experience, banks that approach their regulatory capital minimums are much less likely to meet the needs of creditworthy borrowers. It is important for banks to remain strongly capitalized in order to guard against a tightening of credit conditions that could impair the recovery.
Structural vulnerabilities such as those discussed earlier could interact with cyclical vulnerabilities in the financial system, potentially magnifying the associated risks. Valuations are elevated in a number of asset classes relative to historical norms. After plunging as the pandemic unfolded last spring, broad stock price indexes rebounded to levels well above pre-pandemic levels. Some observers also point to the potential for stretched equity valuations and elevated volatility due to retail investor herd behavior facilitated by free online trading platforms. Risk appetite in credit markets is also elevated, with high-quality investment-grade (IG) corporate debt trading at slightly negative real yields and issuance of leveraged loans returning to 2019 levels.
While financial markets are inherently forward-looking, taking into account the prospects of widespread vaccinations and substantial fiscal support, a variety of risks related to the virus could result in a sudden change in investor risk sentiment. This could, for instance, trigger outflows from corporate bond mutual funds and other managed funds with an investor base that is sensitive to fund performance. Commercial real estate prices are susceptible to declines if the pace of distressed transactions picks up or if the pandemic leads to permanent changes in patterns of use—for instance, a decline in demand for office space due to higher rates of remote work or for retail space due to a permanent shift toward online shopping.
Debt loads at large nonfinancial firms were high coming into the pandemic and remain so. Measures of leverage at large firms remain near the historical highs reached at the beginning of 2020, with the aggregate book value of debt exceeding 35 percent of assets in the third quarter. A large portion of IG debt is currently at the lowest IG rating, making this debt vulnerable to downgrades. Such downgrades may bring insurers, mutual funds, and other regulated institutional investors closer to internal or statutory thresholds on their holdings of non-IG securities, potentially forcing these institutions to shed assets.
Over a longer horizon, changes in the economic environment associated with low equilibrium interest rates, persistently below-target trend inflation, and low sensitivity of inflation to resource utilization could be expected to contribute to a low-for-long interest rate environment and reach-for-yield behavior. In these kinds of environments, it is valuable to deploy macroprudential tools, such as the countercyclical capital buffer, to mitigate potential increases in financial imbalances.
The path ahead
The COVID shock subjected the financial system to an acute stress that necessitated emergency interventions on a massive scale by financial authorities around the world. The COVID turmoil underscores the importance of ensuring the financial system is resilient to a wide range of shocks, including those emanating from outside the financial system. Regulators and international standard-setting bodies have an opportunity to draw important lessons from the COVID shock about where fragilities remain, such as in prime MMFs and other vehicles with structural funding risk. A number of common-sense reforms are needed to address the unresolved structural vulnerabilities in nonbank financial intermediation and short-term funding markets.
Related: Part 1