Coronavirus is contagious. So is financial panic.
The spread of the novel coronavirus could cause a run on the financial system leading to a deep recession. Severe stock-market drops and increased demand for liquidity are warning signals. Bank equity capital has increased by $750 billion to $2.1 trillion since 2007, but a panic could still overwhelm well-capitalized banks. We need to restore the weapons to fight contagion that Congress took away during the last financial crisis. Strong pre-emptive action would greatly diminish the risk of a panic.
The previous systemic threat to the financial system was spurred by the failure of Lehman Brothers in 2008. That threat came from within the banking system in the form of bad housing loans. This time is different. Wall Street risk-taking isn’t to blame for the coronavirus.
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In 2008 the Fed supplied needed liquidity to the banking and nonbanking financial sector, the latter through its authority under Section 13(3) of the Federal Reserve Act. Meanwhile, the Federal Deposit Insurance Corp. expanded the limits of deposit insurance, among other things providing unlimited protection for transaction accounts. The Treasury Department offered guarantees to money-market funds.
Once the crisis abated, however, there was growing public concern about “moral hazard”—that government backstops and guarantees created incentives for risky behavior. In response, the Dodd-Frank Act of 2010 limited the Fed’s lender-of-last-resort powers for nonbanks, an increasingly important part of the financial system. Fed loans to nonbanks can now be made only with the approval of the Treasury secretary. They must be done through a broad program, unlike the one-off rescue of AIG, and must meet heightened collateral requirements. Loans to nonbanks must be disclosed to congressional leaders within seven days and to the public within one year. Loans to banks must be disclosed within two years. While disclosure is usually desirable, in this situation it creates the specter of future stigma that deters financial institutions from seeking even badly needed Fed funding. Even before the current crisis, banks’ use of the discount window had dropped to record lows.
Dodd-Frank also prevents the FDIC from expanding guarantees to bank depositors without congressional approval, as it did in the credit crisis. And the Treasury is now prohibited from guaranteeing money-market funds. These legislative changes make it difficult for the Fed and other regulators to deal effectively with a financial panic.
Government agencies have compounded the problem of their own weakness with regulations that make it harder for financial firms to lend to each other. The liquidity coverage ratio, the Fed liquidity stress tests, and the “living wills” process require the largest banks to meet stiff liquidity requirements that can result in liquidity hoarding.
Even before the coronavirus sent markets tumbling, the scarcity of liquidity was a big problem. The 9% spike of overnight repurchase agreement, or repo, rates last September caused the Fed to supply as much as $75 billion a day to the repo market. Although the demand for such support had fallen to about $26 billion by the end of February, it rose to $100 billion on March 4. The Fed responded Monday by raising the minimum support offered to $150 from $100 billion. While this change is welcome, it falls short.
Here’s what should be done immediately: First, the Fed should reactivate all the facilities it created in the crisis and any additional ones it believes necessary, so it is ready to be the strongest possible lender of last resort—to do whatever it takes, consistent with its present legal authority. This includes making U.S. dollars available to other major central banks through currency swaps. And the Treasury secretary should announce his approval of these efforts, consistent with the requirements of Section 13(3). Second, financial regulators should modify their rules and supervision to stimulate liquidity in the interbank and repo markets. Third, Congress should restore all the powers it took away from the Fed, FDIC and Treasury during the crisis. Fourth, international coordination through the Group of 20 must be accelerated. This is a global problem.
China, Europe and Japan already have many of these powers. Policy makers in the U.S. need them too. Bold action can prevent a panic before it starts. The public knows the situation is serious and wants the government to act.
Mr. Scott is an emeritus professor at Harvard Law School and the director of the Committee on Capital Markets Regulation.