Dodd-Frank didn’t build stress testing for coronavirus

Anyone who experienced the 2008 financial crisis knew it was only a matter of time before there was another disruption that tested the system.

Still, it was difficult to imagine exactly when and how it would materialize.

Like the mortgage crisis, the coronavirus pandemic comes at a time when corporate profits were high, unemployment was low and growth was steady. But unlike the last crisis, the triggering event originated outside the financial system.

The recession accompanying this pandemic will further test the resilience of the financial sector, and the 2010 Dodd-Frank Act reforms along with it. Will this time be different? And if so, how?

Some lessons are already coming into focus.

The first, and perhaps most striking takeaway at the moment, is that there are vulnerabilities in some of the very same markets as 2008. It very much feels like déjà vu all over again, with short-term funding markets like repo and money market funds requiring Federal Reserve intervention.

Nonbanks like mortgage servicers are warning of liquidity shortages, and asset managers have received permission to fund redemptions in their mutual funds.

It is frankly difficult to view this state of affairs as anything other than an indictment of the Dodd-Frank created Financial Stability Oversight Council. That many of these markets and entities are back in the soup indicates that meaningful reforms took too long; came up short when they eventually happened; and were rolled back too quickly.

It is unclear how FSOC will evolve from here — former regulators are already saying that they have more work to do. But using it as a forum for regulators to get together and talk, with little meaningful action, simply will not get the job done.

In response to the turmoil in credit markets, the limitations on the Federal Reserve’s emergency lending authorities have also taken center stage. A number of the former regulators that presided over the last crisis have argued that those reforms would unduly constrain the central bank during a new panic. But by all indications that hasn’t been the case.

The Fed has reopened a number of the same facilities that were around in 2008 — an alphabet soup of acronyms like CPFF, MMLF and PDCF — to backstop commercial paper, money market funds and investment-grade corporate debt.

For evidence of how much flexibility section 13(3) of the Federal Reserve Act still provides, consider that Congress aims to run a multitrillion-dollar corporate, state and municipal lending facility through that single provision of law. That this section could support a new program nearly equal to the size of the Fed’s existing balance sheet suggests that these constraints are less a straitjacket than a loose, flowing robe.

The centrality of the stress-testing regime, what Professor Mehrsa Baradaran calls “regulation by hypothetical,” has become one of the most touted elements of macroprudential regulation. Yet the actual conditions created by the COVID-19 pandemic have quickly eclipsed some of the worst-case hypotheticals of supervisory stress tests, with warnings of potentially even worse things to come.

Stress testing deserves significant attention in this moment, followed by a reckoning with whether it is a useful predictive tool, or merely a time-intensive check-the-box exercise.

Stress testing is critical because it’s not only meant to be an intellectual exercise; it influences capital regulation — another area that will surely be tested again.

For some time, advocates and regulators have been calling for the Federal Reserve to implement its countercyclical capital buffer, an added layer of loss resiliency that banks are supposed to build up in the good times, and spend down in the bad times.

Instead, banks made sizeable shareholder distributions as several capital and leverage rules were “tailored” in recent years.

The clear shortcomings in the capital adequacy framework in 2008 led former Treasury Secretary Timothy Geithner to tell Congress that reforms should be about “capital, capital, capital.”

When post-crisis bank capital rules have threatened to constrain bank payouts or asset growth, however, the rules have yielded to forbearance, most recently for the leverage ratio.

Still, regulators have an insurance policy. The $2 trillion stimulus plan contains streamlined authority for the Federal Deposit Insurance Corp. to resurrect bank debt guarantee programs. Hopefully this isn’t a sign that regulators believe they will need to use this tool again.

There has been a persistent argument in recent years that banks don’t need as many rules and protections because the post-crisis reforms have enabled them to weather any storm. Now that an economic tsunami has arrived, how the system responds will raise important questions about a path forward.

Will the next steps be toward more sweeping and structural reforms that craft a financial system that can withstand the next COVID-19, whatever that happens to be? Or will there be a gradual return to business as usual, and an expectation of even bigger bailouts the next time around?

One thing that does seem clear: There is still a ways to go before the system is resilient enough to withstand the universe of possible risks, like climate change, that are still looming.