Covid-19 reveals systemic flaws – Brainard

Covid-19 had revealed systemic vulnerabilities in the financial system, Lael Brainard, a member of the Federal Reserve Board, said on March 1.

Speaking to the Institute of International Bankers, Brainard outlined possible reforms to money market funds and other sectors, and warned of potential risks during the recovery.

Brainard paid specific attention to money market funds, which suffered a wave of withdrawals as the pandemic gripped North America and Europe last March. She noted: “Over the worst two weeks in mid-March, net redemptions at publicly offered institutional prime MMFs amounted to 30% of assets.” These runs compelled the Fed to open emergency liquidity facilities for money market funds and corporate bond markets.

The Fed governor suggested reforms to money market funds, such as instituting swing pricing or a minimum balance at risk. The former would penalise early redemptions; the latter would limit the amount that could be withdrawn.

The New York Fed published a paper in January that found that fears of existing withdrawal penalties spurred institutional investors to pull investments out of money market funds. The Financial Stability Board is now considering reforms to the regulation of the non-bank sector at the global level.

Brainard also addressed the brief crisis in the Treasuries markets, caused by an unusually strong desire for cash. The Fed intervened to stabilise markets by purchasing $1.2 billion in Treasuries and $200 billion in mortgage-backed securities between March 12 and April 15.

Brainard said that one possible response would be to institute a permanent repo backstop facility. She also suggested the Fed could make an emergency repo facility for foreign central banks permanent. This credit line, the Foreign and International Monetary Authorities (Fima) Repo Facility, will continue operating until September 2021.

The Fed board member cited the resilience of banks and centralised clearing markets. Post-2008 reforms had served banks well, providing sufficient capital buffers to weather the pandemic, Brainard said.

Clouds on the horizon

Looking ahead, Brainard warned of ongoing concerns and potential hazards in financial markets. Although vaccination promised a brighter future, “a variety of risks related to the virus could result in a sudden change in investor risk sentiment”, she said.

Commercial real estate posed risks should demand fall as companies shift work away from offices. Some banks’ capital reserves could fall close to minimum levels, she said. Brainard cautioned that banks could face low yields, and realise losses on loans as credit forbearance ends. “Some sectors of commercial real estate loans and commercial and industrial loans are more vulnerable than before the crisis,” she said.

The Fed governor also noted that asset and stock prices were quite high, while interest rates remained very low, leading to a search for riskier assets. She also highlighted “the potential for stretched equity valuations and elevated volatility due to retail investor herd behavior facilitated by free online trading platforms”. This was likely a reference to the Gamestop bubble in late January and early February.