For release on delivery
9:05 a.m. EST
March 1, 2021
Some Preliminary Financial Stability Lessons from the COVID-19 Shock
Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at the
2021 Annual Washington Conference
Institute of International Bankers
(via webcast)
March 1, 2021
It has now been one year since the devastating effects of the first wave of the COVID-19
pandemic hit our shores, a year marked by heartbreak and hardship.1 We look forward to a
brighter time ahead, when vaccinations are widespread, the recovery is broad based and
inclusive, and the economy fully springs back to life. But we should not miss the opportunity to
distill lessons from the COVID shock and institute reforms so our system is more resilient and
better able to withstand a variety of possible shocks in the future, including those emanating
from outside the financial system.
The Dash for Cash
Investor sentiment shifted dramatically in the early days of March 2020 with the
realization that COVID would disrupt the entire global economy. Short-term funding markets
became severely stressed as market participants reacted to the advent of this low-probability
catastrophic event. The abrupt repositioning and repricing of portfolios led to a dash for cash, as
even relatively safe Treasury holdings were liquidated, volatility spiked, and spreads in Treasury
and offshore dollar funding markets widened sharply. Forceful and timely action by the Federal
Reserve and other financial authorities was vital to stabilize markets and restore orderly market
functioning.
Although some parts of the financial system that had undergone significant reform in the
wake of the Global Financial Crisis remained resilient, the COVID stress test highlighted
significant financial vulnerabilities that suggest an agenda for further financial reform. I will
briefly comment on these areas of vulnerability as well as areas where earlier reforms led to
greater resilience.
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Short-Term Funding Market Vulnerabilities
The COVID shock brought to the fore important vulnerabilities in the systemically
important short-term funding markets that had previously surfaced in the Global Financial Crisis.
Signs of acute stress were readily apparent in intermediaries and vehicles with structural funding
risk, particularly in prime money market funds (MMFs). Indeed, it appears these vulnerabilities
had increased, as assets held in prime MMFs doubled in the three years preceding last March.
When the COVID shock hit, investors rapidly moved toward cash and the safest, most liquid
financial instruments available to them. Over the worst two weeks in mid-March, net
redemptions at publicly offered institutional prime MMFs amounted to 30 percent of assets.
This rush of outflows as a share of assets was faster than in the run in 2008, and it appears some
features of the money funds may have contributed to the severity of the run.2
The run in March forced MMFs to rapidly reduce their commercial paper holdings, which
worsened stress in short-term funding markets. Funding costs for borrowers shot up, and the
availability of short-term credit at maturities beyond overnight plunged. These markets provide
the short-term credit many businesses need to keep operating and meet payrolls. So when short-
term funding markets shut down, it can imperil many businesses, too.
For the second time in 12 years, a run on MMFs triggered the need for policy
intervention to mitigate the effect on financial conditions and the wider economy. To head off
the risk of widespread business failures and layoffs, the Federal Reserve took a number of
actions, including announcing the Commercial Paper Funding Facility on March 17 and the
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Money Market Mutual Fund Liquidity Facility on March 18, 2020. Following the announcement
of these facilities, prime MMF redemptions slowed almost immediately, and other measures of
stress in short-term funding markets began to ease.
The March 2020 turmoil highlights the need for reforms to reduce the risk of runs on
prime money market funds that create stresses in short-term funding markets. The President's
Working Group on Financial Markets has outlined several potential reforms to address this risk,
and the Securities and Exchange Commission recently requested comment on these options.3 If
properly calibrated, capital buffers or reforms that address the first-mover advantage to investors
that redeem early, such as swing pricing or a minimum balance at risk, could significantly reduce
the run risk associated with money funds. Currently, when some investors redeem early,
remaining investors bear the costs of the early redemptions. In contrast, with swing pricing,
when a fund's redemptions rise above a certain level, the investors who are redeeming receive a
lower price for their shares, reducing their incentive to run.4 Similarly, a minimum balance at
risk, which would be available for redemption only with a time delay, could provide some
protection to investors who do not run by sharing the costs of early redemptions with those who
do. Capital buffers can provide dedicated resources within or alongside a fund to absorb losses
and reduce the incentive for investors to exit the fund early.
To be sure, domestic money market funds are not the only vulnerable cash-management
investment vehicles active in U.S. short-term funding markets. For example, offshore prime
money funds, ultrashort bond funds, and other short-term investment funds also experienced
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stress and heavy redemptions last March. The runs on offshore MMFs that hold dollar-
denominated assets like commercial paper underscore the importance of working with
international counterparts to increase the resilience of short-term funding markets. We are
supporting the work of the Financial Stability Board to assess options for mitigating the
vulnerabilities of MMFs globally and report on them later this year.
The COVID shock also highlighted the structural vulnerabilities associated with the
funding risk of other investment vehicles that offer daily liquidity while investing in less-liquid
assets, such as corporate bonds, bank loans, and municipal debt. Funds that invest primarily in
corporate bonds saw record outflows in March 2020. These open-end funds held about one-sixth
of all outstanding U.S. corporate bonds prior to the crisis. Bond mutual funds, including those
specializing in corporate and municipal bonds, had an unprecedented $250 billion in outflows
last March, far larger than their outflows at any time during the 2007-09 financial crisis. The
associated forced sales of fund assets contributed to a sharp deterioration in fixed-income market
liquidity that necessitated additional emergency interventions by the Federal Reserve. In
assessing possible reforms to address this run risk, swing pricing could be helpful, because it
reduces the first-mover advantage for running from a fund by imposing a cost when redemptions
are high. Swing pricing has been used for more than a decade in European mutual funds, where
it has been shown to slow redemptions in stress events.5 In the United States, mutual funds have
not adopted swing pricing, in part because of technical obstacles.
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Treasury Market Functioning
The COVID shock also revealed vulnerabilities in the market for U.S. Treasury
securities. The U.S. Treasury market is one of the most important and liquid securities markets
in the world, and many companies and investors treat Treasury securities as risk-free assets and
expect to be able to sell them quickly to raise money to meet any need for liquidity. Trading
conditions deteriorated rapidly in the second week of March as a wide range of investors sought
to raise cash by liquidating the Treasury securities they held. Measures of trading costs widened
as daily trading volumes for both on- and off-the-run securities surged. Indicative bid-ask
spreads widened by as much as 30-fold for off-the-run securities. Market depth for the on-the-
run 10-year Treasury security dropped to about 10 percent of its previous level, and daily
volumes spiked to more than $1.2 trillion at one point, roughly four standard deviations above
the 2019 average daily trading volume. Stresses were also evident in a breakdown of the usually
tight link between Treasury cash and futures prices, with the Treasury cash-futures basis-the
difference between prices of Treasury futures contracts and prices of Treasury cash securities
eligible for delivery into those futures contracts-widening notably.
Selling pressures were widespread, reflecting sales by foreign official institutions,
rebalancing by asset managers, a rapid unwinding of levered positions, and precautionary
liquidity raising. Available data suggest that foreign institutions liquidated about $400 billion in
Treasury securities in March, with more than half from official institutions and the remainder
from private foreign investors, at a time when offshore dollar funding markets also experienced
acute stress. Domestic mutual funds sold about $200 billion during the first quarter, selling their
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less-liquid Treasury securities in order to raise cash to meet investor redemptions. Hedge funds
reduced long cash Treasury positions by an estimated $35 billion.6
Dealers play a central role in the Treasury market by buying and selling securities and
providing financing to investors. Their capacity or willingness to intermediate these flows was
strained amid the elevated uncertainty and intense and widespread selling pressure in mid-
March. Operational adjustments associated with the rapid move to remote work may also have
inhibited intermediation.
The acute stresses in the Treasury market necessitated emergency intervention by the
Federal Reserve at an unprecedented scale. The Federal Open Market Committee authorized
purchases of Treasury securities and agency mortgage-backed securities (MBS) "in the amounts
needed" to support smooth market functioning of these markets.7 Between March 12 and
April 15, the Federal Reserve increased its holdings of Treasury securities by about $1.2 trillion
and agency MBS by about $200 billion. The Federal Reserve provided overnight and term
repurchase agreement (repo) operations to address disruptions in Treasury financing markets.
These actions rapidly restored market functioning, and a variety of indicators had returned to
pre-COVID levels by the summer.8
While the scale and speed of flows associated with the COVID shock are likely pretty far
out in the tail of the probability distribution, the crisis highlighted vulnerabilities in the critically
important Treasury market that warrant careful analysis. A number of possible reforms have
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been suggested to strengthen the resilience of the Treasury market. For instance, further
improvements in data collection and availability have been recommended to enhance
transparency related to market participants, such as broker-dealers and hedge funds. Some have
suggested that the Federal Reserve could provide standing facilities to backstop repos in stress
conditions, possibly creating a domestic standing facility or converting the temporary Foreign
and International Monetary Authorities (FIMA) Repo Facility to a standing facility.9 Other
possible avenues to explore include the potential for wider access to platforms that promote
forms of "all to all" trading less dependent on dealers and, relatedly, greater use of central
clearing in Treasury cash markets.10 These measures involve complex tradeoffs and merit
thoughtful analysis in advancing the important goal of ensuring Treasury market resilience.
Offshore Dollar Funding Markets
The global dash for cash also led to severe stress in offshore dollar funding markets,
where foreign exchange swap basis spreads increased sharply to levels last seen in the Global
Financial Crisis. Foreign banking organizations serve as key conduits of dollar funding for
foreign governments, central banks, businesses, nonbank financial institutions, and households.11
9
See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Announces Establishment of a
Temporary FIMA Repo Facility to Help Support the Smooth Functioning of Financial Markets," press release,
March 31, https://www.federalreserve.gov/newsevents/pressreleases/monetary20200331a.htm; and Board of
Governors of the Federal Reserve System (2019), "Minutes of the Federal Open Market Committee: January 29-30,
2019," https://www.federalreserve.gov/monetarypolicy/fomcminutes20190130.htm.
10
See Treasury Market Practices Group (2019), Best Practice Guidance on Clearing and Settlement (New York:
TMPG, July), https://www.newyorkfed.org/TMPG/best_practices.html; Darrell Duffie (2020), "Still the World's
Safe Haven? Redesigning the U.S. Treasury Market after the COVID-19 Crisis," Hutchins Center Working Paper
#62 (Washington: Brookings Institute, May),
https://www.brookings.edu/wpcontent/uploads/2020/05/WP62_Duffie_updated.pdf; and U.S. Securities and Exchange Commission (2020), "SEC
Proposes to Extend Regulations ATS and SCI to Treasuries and Other Government Securities Markets," press
release, September 28, https://www.sec.gov/news/press-release/2020-227.
11
For a discussion of the importance of liquidity regulation for these operations, see Lael Brainard (2019),
"Statement on Proposals to Modify Enhanced Prudential Standards for Foreign Banks and to Modify Resolution
Plan Requirements for Domestic and Foreign Banks," April 8,
https://www.federalreserve.gov/newsevents/pressreleases/3B1F641BEB4A485B994EBC38165F0F3B.htm#aboutM
enu.
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They hold $14 trillion in dollar-denominated claims-about half of the total global dollar claims
of banks. The Federal Reserve and several other central banks responded swiftly to distress in
the offshore dollar funding markets by announcing the expansion and enhancement of dollar
liquidity swap lines on March 15, followed on March 19 by the reopening of temporary swap
lines with the nine central banks that had temporary agreements during the Global Financial
Crisis. On March 30, the Federal Reserve introduced a new temporary FIMA Repo Facility to
support the liquidity of Treasury securities held by foreign monetary authorities, an important
innovation. Following these interventions, foreign exchange swap basis spreads started moving
down almost immediately and within a few weeks reached their levels before the COVID shock.
Central Clearing
The reforms put in place pursuant to the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act) in response to the previous crisis appear to have supported the
resilience of the financial system as it absorbed the COVID shock. Importantly, regulators
instituted global reforms to encourage and, in some cases, mandate central clearing after
observing the loss of confidence in key banking intermediaries during the Global Financial Crisis
associated with the opaque web of bilateral derivatives contracts. As a result, during the COVID
turmoil, the greatly expanded scope of central clearing, with the attendant reduction in
counterparty and settlement risks, supported the orderly functioning of critical securities and
derivatives markets amid sharply increased trading volumes and spiking volatility. Moreover,
several central clearing platforms (CCPs) successfully handled problems that emerged at a few
smaller market participants, without noticeable spillovers to other markets and institutions.
However, as part of the risk controls that are inherent in central clearing, the COVID
market turmoil generated exceptionally large flows of cash through CCPs from market
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participants with mark-to-market losses to those participants with corresponding gains.
Furthermore, during the March COVID turmoil, a number of CCPs collected significantly higher
financial resources from their members to protect against increased risk as captured by their risk
models. These demands for liquidity were met adequately, and the markets operated efficiently
and effectively, although the sudden spikes in CCP requirements may have stressed the liquidity
positions of some trading firms. And while CCPs performed well during this period of stress,
forceful public emergency interventions and the strong capitalization of banks likely mitigated
the risks of large clearing member defaults.
The COVID-19 shock presents an important opportunity to reflect on lessons learned
about central clearing by the public and private sectors. CCPs could consider the effects of the
market dysfunction on their liquidity risk-management plans, including their assumptions
regarding the ability to raise cash from noncash assets or securities. In addition to reassessing
their liquidity planning, CCPs could also assess the tradeoffs between their own risk-
management decisions and broader financial stability concerns, particularly in light of how CCPs
may have contributed to deleveraging by some market participants in March by the magnitude of
the increases in financial resources they collected when trading and volatility spiked. CCPs
could assess their margin models, consider improvements to reduce pro-cyclicality, and consider
increased transparency to help clearing members anticipate margin calls during periods of
volatility. The holistic review by the Financial Stability Board, in which we participate, could
provide important insights into these issues.12
Bank Capital and Liquidity
The resilience of the banking sector in response to the COVID shock underscores the
importance of guarding against erosion of the strong capital and liquidity buffers and risk-
management, resolution, and stress-testing programs put in place pursuant to the Dodd-Frank
Act. Banks entered the pandemic with strong capital and liquidity buffers, especially those
banks whose size and complexity are systemically important. Strong capital and liquidity buffers
allowed the banking system to accommodate the unprecedented demand for short-term credit
from many businesses that sought to bridge the pandemic-related shortfalls in revenues. Banks'
capital positions initially declined because of this new lending and strong provisioning for loan
losses but have since risen above their pre-pandemic levels, reflecting better-than-expected loan
performance and a reduction in credit provision as well as caps on dividends and restrictions on
share repurchases in the past several quarters.
Strong capital and liquidity positions will remain important, as banks still face significant
challenges-including an environment of higher-than-normal uncertainty. For instance, some
sectors of commercial real estate loans and commercial and industrial loans are more vulnerable
than before the crisis. Similarly, net interest margins could remain in the lower part of their
historical ranges for some time. Although losses and delinquency rates on bank loans are
currently low, performance could deteriorate as borrowers exit forbearance, with particularly
hard-hit businesses and households facing arrears on rent and mortgage payments.13 Recent
developments have been encouraging, but downside risks remain, which could delay recovery
and lead to higher losses.
Bank resilience benefited from the emergency interventions that calmed short-term
funding markets and from the range of emergency facilities that helped support credit flows to
businesses and households. While the results of our latest stress test released in December 2020
show that the largest banks are sufficiently capitalized to withstand a renewed downturn in
coming years, the projected losses take some large banks close to their regulatory minimums.14
According to past experience, banks that approach their regulatory capital minimums are much
less likely to meet the needs of creditworthy borrowers. It is important for banks to remain
strongly capitalized in order to guard against a tightening of credit conditions that could impair
the recovery.
Cyclical Vulnerabilities
Structural vulnerabilities such as those discussed earlier could interact with cyclical
vulnerabilities in the financial system, potentially magnifying the associated risks. Valuations
are elevated in a number of asset classes relative to historical norms. After plunging as the
pandemic unfolded last spring, broad stock price indexes rebounded to levels well above pre-
pandemic levels. Some observers also point to the potential for stretched equity valuations and
elevated volatility due to retail investor herd behavior facilitated by free online trading platforms.
Risk appetite in credit markets is also elevated, with high-quality investment-grade (IG)
corporate debt trading at slightly negative real yields and issuance of leveraged loans returning to
2019 levels. While financial markets are inherently forward-looking, taking into account the
prospects of widespread vaccinations and substantial fiscal support, a variety of risks related to
the virus could result in a sudden change in investor risk sentiment. This could, for instance,
trigger outflows from corporate bond mutual funds and other managed funds with an investor
base that is sensitive to fund performance. Commercial real estate prices are susceptible to
declines if the pace of distressed transactions picks up or if the pandemic leads to permanent
changes in patterns of use-for instance, a decline in demand for office space due to higher rates
of remote work or for retail space due to a permanent shift toward online shopping.
Debt loads at large nonfinancial firms were high coming into the pandemic and remain
so. Measures of leverage at large firms remain near the historical highs reached at the beginning
of 2020, with the aggregate book value of debt exceeding 35 percent of assets in the third
quarter. A large portion of IG debt is currently at the lowest IG rating, making this debt
vulnerable to downgrades. Such downgrades may bring insurers, mutual funds, and other
regulated institutional investors closer to internal or statutory thresholds on their holdings of non-
IG securities, potentially forcing these institutions to shed assets.
Over a longer horizon, changes in the economic environment associated with low
equilibrium interest rates, persistently below-target trend inflation, and low sensitivity of
inflation to resource utilization could be expected to contribute to a low-for-long interest rate
environment and reach-for-yield behavior. In these kinds of environments, it is valuable to
deploy macroprudential tools, such as the countercyclical capital buffer, to mitigate potential
increases in financial imbalances.
The Path Ahead
The COVID shock subjected the financial system to an acute stress that necessitated
emergency interventions on a massive scale by financial authorities around the world. The
COVID turmoil underscores the importance of ensuring the financial system is resilient to a wide
range of shocks, including those emanating from outside the financial system. Regulators and
international standard-setting bodies have an opportunity to draw important lessons from the
COVID shock about where fragilities remain, such as in prime MMFs and other vehicles with
structural funding risk. A number of common-sense reforms are needed to address the
unresolved structural vulnerabilities in nonbank financial intermediation and short-term funding
markets.