20 March 2020
Coronavirus infects the financial sector thanks to three deep mistakes made after the subprime crisis.
The financial impact of the coronavirus may seem disproportionate. Since the start of the year, around twenty trillion dollars have been wiped out in the global equity and bond markets. Taking into account the huge help coming from governments around the world, it is difficult to imagine a scenario in which the private sector would lose such a large sum of money during the limited time (three months, a year, two years?) necessary to get rid of the virus. In fact, these losses implicitly assume a deep financial crisis which would have a longer and deeper impact on the economic situation than the initial health crisis. Financial markets fear a scenario where credit markets would freeze, leading to large-scale bankruptcies and a deep and lasting recession. While a bubble in a dark corner of the US financial market (i.e. the origination of subprime mortgages) led more than 10 years ago to a global financial crisis, the emergence of this deadly virus could again have catastrophic consequences for the world economy.
Maybe everything will normalize quickly, thanks to vigorous health actions to stop the viral infection and to some wise public decisions to support the economy and limit bankruptcies. But the panic in the financial markets over the past few weeks dramatically highlights three fundamental mistakes made by the global regulatory community after the subprime crisis.
The first was an excessive focus on the assets hold by financial institutions in order to reduce liquidity crisis. The idea was that if an institution has enough liquid assets, it will not be threatened by a loss of “market access” (loss of deposits, redemptions of shares for open-ended mutual funds, etc.). Thus, banks were forced to hold a cushion of government bonds and mutual funds were expected to test their liquidity position. But, as the situation in recent weeks illustrates, market liquidity can evaporate even for the least risky assets (US Treasury bonds) and the idea that holding liquid assets is a perfect protection against a liquidity crisis is wrong. The only perfect protection is on the liability side of the balance sheet: regulated institutions must have a funding structure that protects them from runs. Liabilities should be structured such that creditors are very unlikely to withdraw their money when the markets freeze. Obviously, we are far from this ideal situation in the open-ended mutual funds sector: the redemption rules are rather lax and many of these funds can suffer runs. Investors know this. Fear of these possible runs has played a role in the recent collapse of various markets.
The second key error is to have fostered such unfair competition between banks and the various investment funds. Believed to be responsible for the 2008-2009 crisis, banks were punished and constrained by tough new regulations, while various investment funds were able to thrive and fuel the disturbing growth of the “private assets” market. This lack of a level playing field has led to a dangerous situation where there is little transparency about the risks coming from unlisted “private assets”. This opacity, and as already mentioned the inaccurate redemption rules used by many investment funds, can cause panics in financial markets. Many illiquid assets would find a much better place on the balance sheet of well-capitalized banks than in opaque investment funds!
Last but not least, the reforms decided after the subprime crisis have left a dangerous vacuum: the lack of enough solid “investors of last resort” with a long-term focus. When the corporate sector suffers a big shock, as it is the case with the coronavirus, it is crucial to have investors able to absorb the losses and to provide new capital to injured companies. But nothing has been done to promote these long-term investors and, worst, some regulations have encouraged a pro-cyclical behavior. As we have already mentioned, investors in open-ended mutual funds are encouraged to run when the markets freeze. More importantly, the new bail-in rules for banks mean that investors would be crazy to bring new capital to a weakened bank as they could be expropriated over the weekend a few months later with little justification. In troubled times, the true value of the assets hold by a bank are almost impossible to evaluate, and the regulators have a huge amount of discretion over the life and deaths of banks. No wonder bank stocks are the first to suffer in the event of an unexpected economic shock. If we are to avoid systemic financial crisis, the presence of credible “last resort investors” with a long-term horizon is crucial. In difficult times, governments should help these people take risks, not discourage them! It is obvious that taxpayers must be protected from the mistakes of the banks, but the current pro-cyclical bail-in rules must be, and can be, radically improved to better respect shareholders’ rights.
Hopefully we can quickly defeat the coronavirus, the economy will experience a V-shaped recovery supported by easy money and huge budget spending, and the financial markets will experience an impressive recovery. But even in this optimistic scenario, the important lessons of the past few weeks should not be forgotten. In an interview with the French newspaper Le Monde in September 2018, Larry Fink, CEO of BlackRock, said: “In 42 years on the financial markets, I have experienced many crises. They are rarely the same. However, the system does not have a great ability to look forward, but rather in the rear view mirror. In my experience, governments and regulators solve the problems that cause a crisis, and often the solutions found carry the seeds of the next crisis. ” Here we are. Obviously, the short term priority is to find cures rather than vaccines. Central banks are again playing the 2008 playbook and inject a massive amount of liquidity. But it will be also necessary to rebuild a financial sector with stronger immunity. This obviously is a complex question with many dimensions. But three key broad principles offer a good starting point. There should be a level playing field between banks and investment funds, all financial institutions must really be run-free, and we need more private or public “investors of last resort” with a long-term horizon and with the right incentives to provide capital in an economic downturn.