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    On October 20, 2020, US Federal Reserve Board (FRB) Vice Chair for Supervision Randy Quarles signaled that regulatory reforms may be needed to address vulnerabilities to the financial system from the nonbank sector. In remarks delivered at the Securities Industry and Financial Markets Association’s (SIFMA) annual meeting, Quarles provided the FRB’s initial assessment of how the COVID-19 shock impacted the financial system and identified several vulnerabilities arising from nonbank financial intermediation. He emphasized how nonbank financing arrangements amplified the shock and contributed to the turmoil in financial markets. While he stopped short of offering any policy proposals in his remarks, Quarles, who currently chairs the Financial Stability Board (FSB), stated that the FSB will identify potential areas for policy reform in a forthcoming report to the G20 that will a provide a diagnosis of the shock to financial stability from the COVID-19 pandemic. Quarles’s remarks add to a growing number of initial assessments by federal regulators that have found that nonbank activities and business models amplified the COVID-19 economic shock. Together, these assessments are laying a factual foundation for federal regulators, and even possibly Congress, to consider reforms to improve the resiliency of the nonbank sector. Accordingly, nonbank financial institutions should be alert that substantial regulatory reforms maybe on the horizon. It is possible that efforts to enact such reforms could occur as early as next year regardless of the outcome of the election.

    Quarles began his remarks by noting that nonbank financial intermediation has grown significantly since the 2008 financial crisis. Nonbanks have a wider range of business models (which now include fintechs, as well as mortgage lenders, insurers, and pension funds); support a broader range of products (including private debt markets, repo markets, and collateralized loan obligations); and play a greater role in financial markets (including through high-frequency trading). He also noted that since the US dollar is still the currency of choice in global finance, the growth globally of dollar-denominated market-based financing by nonbank institutions has made international financial markets more interconnected.

    Quarles identified the World Health Organization’s (WHO) designation of COVID-19 as a global pandemic, and the announcements of lockdowns in several countries, on March 11, 2020, as the triggering events for the financial market turmoil that month. He then discussed how the crisis unfolded and was magnified by both the inability of broker-dealers to provide liquidity and investor runs on money market funds.

    Quarles outlined how the WHO designation was followed by sharp increases in the demand for cash, which sent repo rates soaring and dramatically widened bid-ask spreads on securities as liquidity evaporated in the market. He noted that broker-dealers were unable to provide the liquidity that market participants sought due to both internal and regulatory risk limits. As a result, market participants resorted to drawing down lines of credit with banks, which Quarles indicated limited banks’ ability to lend during the crisis. The lack of liquidity also pushed down securities prices, triggering larger-than-expected margin calls, which put further downwards pressure on prices as market participants scrambled to sell securities to raise the needed funds. Quarles also suggested that this lack of liquidity in the market may have undermined the ability of the market to self-correct as potential buyers were unable to find securities to purchase.

    Money market funds were singled out by Quarles as an example of how nonbank financial institutions amplified the turmoil in financial markets to such a degree that the Federal Reserve ultimately had to intervene. As occurred in 2008, money market funds experienced runs, but, Quarles noted, the runs in March 2020 were actually larger than those in 2008. Even though the Securities and Exchange Commission (SEC) had implemented reforms to prevent runs on money markets in the wake of the 2008 financial crisis, money market fund runs still occurred as investors sought to avoid potential redemption fees or suspensions on redemptions. According to Quarles, these runs once again placed further selling pressure on commercial paper, further magnifying the initial COVID-19 shock.

    Although the FRB was able to respond quickly to support deteriorating financial markets, Quarles pointed out that it had to implement not only traditional lender-of-last resort support for banks but also facilities to support nonbanks, including broker-dealers and money market funds.  And the support provided by the FRB during this crisis was greater than that it provided during the 2008 financial crisis.

    Quarles stated clearly that he believes that “we have work to do” to address the vulnerabilities revealed by the COVID-19 shock. He said that last year he had established a FSB working group to assess risks in the nonbank financial sector. Looking ahead, Quarles stated that the FSB will provide a “holistic review of the COVID [e]vent” to the G20 Summit in November in a report that will also identify potential areas for policy reform. In addition, Quarles said that the FSB will be mapping out the entire financial system (including the nonbank financial sector), seeking to identify “nodes and channels of risk transmission in the system” to help policymakers understand how risk is magnified and absorbed. Quarles stated that understanding the vulnerabilities to financial stability from the banking sector is insufficient and that “[w]e must also understand vulnerabilities in the nonbank sector and how shocks are transmitted to or from the nonbank sector.” He specifically identified money market funds and other open-ended funds invested in less liquid assets as areas requiring further attention to improve the resilience of the US financial system.

    Quarles’s remarks are the latest in a series of actions by federal financial regulators to bring attention to the need for regulatory reform in the nonbank sector. Most recently, on October 5, 2020, the SEC released a staff report titled “U.S. Credit Market Interconnectedness and the Effects of the COVID-19 Economic Shock.” In its report, the SEC provided an assessment of the vulnerabilities presented by the nonbank sector that largely paralleled Quarles’s assessment. It also focused on the lack of market making by broker-dealers and the runs on money market funds. It further identified repo lending, nonbank mortgage companies/mortgage REITS, and mortgage servicers as magnifying the COVID-19 shock. Although the SEC’s report did not make any recommendations for regulatory reforms, the implication from its narrative is that further reform of the nonbank sector is needed.

    This past July, the Financial Stability Oversight Council (FSOC) also weighed in on nonbank regulation by initiating a review of secondary mortgage activities. While that review is likely to focus on the systemic risks posed by Fannie Mae and Freddie Mac, other nonbank mortgage activities are likely be incorporated, especially in light of the problems highlighted by Quarles and the SEC. Indeed, the FSOC’s new operating procedures that adopted an “activities-based approach,” replacing its former “entity-based approach,” have created a review process more conducive for the FSOC to compel financial regulators and Congress to adopt new regulations for an entire activity, instead of having the FSOC simply designating the largest nonbank financial institutions for heightened prudential regulations by the Federal Reserve. Given the diversity and variety of nonbank financial institutions, federal regulators are likely to view an activities-based approach as a more effective route. Along these lines, it is possible that next year the SEC (or other federal regulators) could re-examine money market fund regulation, or, depending on the outcome of the election, Congress could enact prudential standards for certain nonbank financial institutions, such a mortgage lenders and mortgage servicers. Finally, it is important to note that each of these actions by the FRB, the SEC, and the FSOC have been undertaken by Republican appointees and during the Trump Administration, which has been cautious about overregulating financial markets. Many thought leaders on the Democratic side have long sought additional regulation of the nonbank sector. Accordingly, there appears to be an emerging bipartisan consensus on the need to address systemic risks presented by the nonbank sector.

    Authors: Andrew Olmem