Regulators scrambled to strengthen the banking system after the 2008 financial crisis. That made banks safer but their actions pushed the risk of rising defaults into the shadows. While the banks — designated as systemically important — repaired and tidied up their balance sheets, asset managers, hedge funds and others stepped into the gap, providing credit to the non-financial economy. Investor money flowed in, searching for yield.
Now those shadow banks — lenders that are not regulated like banks — are causing worries about systemic risk as the impact of coronavirus spreads. An index tracking US Business Development Companies, listed lenders to small businesses, has halved since February. Many Real Estate Investment Trusts, which have relied on the short-term money markets to boost dividend payouts, are also being pummeled. Money market mutual funds invested in corporate debt have been hit by disruptive mass redemptions. Junk bond exchange traded funds have traded at often large discounts to their underlying assets.
The regulations that shifted risk on to these groups were right. Bank balance sheets are the main means of payment in a modern credit-based monetary system; ensuring banks remain solvent and liquid at times of crisis is vital. As Ben Bernanke said in 2008: “If you do not have a banking system, you do not have an economy.” Policymakers feared cash would stop coming out of ATMs after that crisis; such worries are mercifully absent today.
Investors in bond exchange traded funds, for example, ought to be prepared to lose their capital. Shares in these funds are not money and there is no public obligation to ensure they keep their value. It is better that investors and shadow banks carry these risks rather than society as a whole.
There are still systemic risks from the shadow banks but they are different. The worry now is that the flow of credit to the non-financial economy stops. Businesses need liquidity to remain functional through the shutdown. Ensuring they have this credit is vital to making the recession as shallow and shortlived as possible.
The Federal Reserve was therefore right on Monday to launch unlimited bond purchases and a facility to lend directly to companies. As well as joining the European Central Bank and the Bank of England in buying corporate bonds in the secondary market, the Fed will allow investment-grade companies to access bridge financing for up to four years, bypassing banks and shadow banks alike.
Passage of a well-designed stimulus package by the US Congress would also help to cut risk. The sell-off in commercial real estate, for example, and concerns about those that lend to the sector partly reflects the fact that retailers with no income cannot make rent payments. It is the right decision to bail out companies laid low by the coronavirus pandemic. This is the root problem: once pressure on corporate America is alleviated, so the pressure on the financial system abates. Other knock-on problems are trickier. Many dollar borrowers are beyond the direct reach of the Fed and Congress. It is in US interests to help emerging markets too, both through swap lines and IMF grants.
This is as yet only the first leg of what could become a full-blown credit crisis. More businesses will fail and employees will lose jobs. Borrowers will default on consumer loans, auto loans and mortgages. Eventually some of this will find its way back to the banks. But even if shadow banks suffer in the short term, we are in a better place today because regulators forced greater protections on the banking system.
Source: Economy - ft.com
