Julia-Ambra Verlaine and Liz Hoffman
Today, the banks are not the cause of the economic crisis. But nor are they the solution. Changes to the nation’s financial system, put in place after the 2008 crash to prevent a repeat, have sapped banks’ tolerance for the kinds of risks that are necessary to bring about a recovery, according to regulators, experts and bank executives themselves.
Banks are far safer today, but the costs of those changes have become clear over the past month: sustained turbulence across Wall Street securities-trading, credit drying up for some of the country’s largest corporations and the Fed taking unprecedented action, in some cases sidestepping banks that have proven to be imperfect conduits for its rescue efforts.
“There is less risk-taking in the banking system” today, said Jean Boivin, head of the BlackRock Investment Institute, the think-tank arm of the world’s biggest asset manager. “As a result, the traditional channel of [the Fed] lending to banks and having them deploy it is not as powerful.”
The changes in regulations and market infrastructure that made banks safer than they were in 2008 also made them less effective at their basic job: moving money from those who have it to those who need it, which could be a drag on the nation’s financial recovery.
The Fed is charging into the gap, increasing its sway over the economy and putting Washington at the center of business like never before. At the end of March, the central bank said it would lend straight to struggling companies, bypassing banks.
A warning sign flashed back in September. Almost overnight, a crucial but often overlooked part of the financial system broke down—the market for Treasury repurchase agreements, or repo, where banks and asset managers borrow for short periods of time using government debt as collateral.
The going rates for repo spiked on Sept. 16, tripling in the course of an afternoon from 2% to about 6%. Suddenly a kind of borrowing that is usually so inexpensive and plentiful that nobody pays it much attention became scarce and expensive.
Historically when this happened, banks would seize the opportunity to earn money at higher rates and jump in. Prices would abate.
That didn’t happen. Scott Skyrm, a repo trader at Curvature Securities LLC, watched the next day as rates as high as 9.25% flashed on his screen. Traders with securities scrambled to find cash to exchange them for.
“The panic was a classic run on the bank,” said Mr. Skyrm. “Cash investors did not pull cash out of the market, but they made borrowing cash more expensive.”
Not until the Fed stepped in with hundreds of billions of dollars in repo funding did the market begin to stabilize. Rates abated within a week.
Bank executives and traders sounded the alarm. At a banking conference that month, JPMorgan Chase & Co.’s chief executive, James Dimon, said regulations requiring his bank and others to hold loads of cash-like assets would hamper the ability of banks to help keep markets functioning during tough times.
When coronavirus hit, stocks plummeted. Investors fled gold-plated bonds for the safety of cash, sparking a race for U.S. dollars. Money-market funds, which lend to businesses overnight, struggled to stay liquid.
This is when banks usually step into their role as the circulatory system of the markets, scooping up assets, matching buyers with sellers and making money in the process. Unwilling to give up cash, and with their trading limited, they couldn’t steady the safest and most liquid market in the world: the market for U.S. government debt.
Sharp swings in Treasury bond prices in March showed markets at their breaking point. The 30-year bond had its biggest weekly move since October 1987. The 10-year bounced between 0.335% and 1.25% inside of two weeks.
So the Fed stepped in where banks no longer could, buying Treasurys even faster than it did in 2009—some $720 billion over 10 days in late March and early April.
The Treasury market stabilized, but others broke down, and the Fed rolled out one Band-Aid after another. It cut interest rates to near zero, opened up its dollar reserves to central banks around the world and pledged to buy hundreds of billions of dollars in public and corporate debt. It intervened to prop up money-market funds, exchange-traded funds and short-term corporate IOUs.
Over the past six weeks the Fed’s portfolio of securities and other holdings has grown by more than $2 trillion, to $6.6 trillion. It is likely to get larger still.
The Fed is “now the commercial bank of last resort for the entire economy,” said Michael Feroli, JPMorgan’s chief economist.
In the 2000s, lighter regulations allowed banks to hold big positions in, say, corporate bonds or mortgages. They also had trading desks that wagered with the firm’s own cash. When markets lurched, banks had both the regulatory freedom and the financial incentive to keep trading.
It didn’t always end well—trading blowups nearly brought down firms including Morgan Stanley and Merrill Lynch—but it added to the overall ecosystem of buyers and sellers, which helped smooth out bumps.
The Dodd-Frank legislation of 2010 shuttered those proprietary trading desks and limited banks’ ability to take risks even as middlemen for clients. Today banks dart in and out of positions quickly so as not to trip risk limits or attract the attention of on-site Fed examiners.
Those same limitations are also clear in lending, banks’ most basic function and one that is sorely needed now. The U.S. government has earmarked hundreds of billions of dollars in emergency loans to businesses whose revenue has fallen off a cliff.
Normally, when the Fed wants to prop up the economy, it cuts interest rates, making money cheaper, and trusts banks will get that money out by making new loans.
Over the past decade, more and more lending has moved outside of banks. New regulations made certain types of loans—to low-rated borrowers—uneconomic for banks to own, in an effort to discourage a repeat of the borrowing binge that set off the mortgage crisis.
Private-equity firms and hedge funds stepped in, lending directly to companies and buying up consumer loans from a new crop of online lenders.
The result is that many American consumers and businesses get their credit not from their local bank—which the Fed can press into service to jump-start the economy—but from institutions that are outside the banking system entirely.
In leveraged loans, an especially risky type of debt, banks’ share fell from 25% in 2000 to 3% in 2018, according to FDIC data.
Nonbanks like auto makers and car dealerships wrote half of new car loans last year, according to Experian. In mortgages, nonbanks like Quicken Loans Inc. and loanDepot.com made 59% of home loans through the first nine months of 2019, according to Inside Mortgage Finance.
Many of those loans wind up being sold to banks, and many of those entities rely on banks for their own funding. But the last mile to many consumers and businesses runs through institutions that U.S. regulators have few ways to control.
The rollout of the $350 billion emergency-loan program for small businesses, passed as part of the $2 trillion coronavirus stimulus, has been rocky. Congress added $310 billion to the program, called the Paycheck Protection Program, on Thursday.
The government will pay off the loans for borrowers that use most of the money to keep employees on the payroll, making them fairly safe for the banks that extend them.
But banks have been concerned about lending too much, too fast, or to people who are too risky. They worry about foot-faulting the intake forms, violating arcane money-laundering rules, or having loans go bad at higher-than-expected rates—all of which could land them in trouble with regulators, according to bank executives and experts.
“Banks are not just opening up the fire hose full blast,” said Darrell Duffie, a finance professor at Stanford University. “The Fed’s money is getting out there, but it seeps through the system more slowly.”
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com and Liz Hoffman at email@example.com