In the wake of the global financial crisis, Yale SOM’s Andrew Metrick and former Treasury secretary Timothy Geithner founded the Yale Program on Financial Stability to create a repository of knowledge about government responses to the crisis, to inform the work of policymakers in the future. Starting in 2020, YPFS turned its attention to the response to the economic turmoil triggered by the COVID-19 pandemic.
On September 23, June Rhee, a senior editor at YPFS and director of Yale SOM’s Master of Management Studies in Systemic Risk, testified before a financial services subcommittee of the U.S. House of Representatives seeking to assess the Fed’s response to the pandemic, discussing her research on the lending programs created by the Fed during both crises and their implications for future responses. A few weeks later, she spoke with Yale Insights about her findings.
Q: What did the Fed do in response to the pandemic?
Early in the pandemic, there was a lot of worry that the wholesale funding markets were quickly coming under stress. For example, the commercial paper market, which provides corporations and financial institutions liquidity for day-to-day operations, was tightening.
If that market freezes up, daily functions at a lot of financial institutions and corporations would have to stop. That would have a large effect on the economy. It reached a point where the Fed was concerned, and they stepped in to ensure liquidity. They created programs for a number of similar wholesale funding markets.
The response very much mirrored what they had done during the global financial crisis.
Q: How effective was it?
After the Fed announced its programs, interest rates in wholesale funding markets dropped back to levels where they had been before the pandemic, even though the utilization of the programs was very small compared to what it was during the global financial crisis. Because the Fed launched six or seven facilities at basically the same time, it’s hard to tell what impact each one had individually. However, a lot of people think that simply by launching all these facilities early and quickly the Fed helped the market regain its confidence.
“Signaling is important in a financial crisis. The existence of a backstop helps wholesale markets to function normally even if the backstop isn’t used."
Signaling is important in a financial crisis. Many studies have looked closely at the “announcement effect.” The existence of a backstop helps wholesale markets to function normally even if the backstop isn’t used. Fortunately, with the COVID-19 pandemic we didn’t reach a state of financial crisis; it was more a period of financial distress.
Q: We were hit with a global pandemic that killed millions and shut down much of daily life. Why wasn’t there a financial crisis?
I think everyone was expecting a larger impact. And in some countries, it did become a financial crisis. The U.S. had the fiscal space and the resources to handle the stresses. The Fed’s lending facilities helped the wholesale markets. The broader government action helped buffer the wider economic impacts, including the Treasury getting money into the hands of individuals and families.
In addition, regulatory changes made in the U.S. and worldwide after the global financial crisis succeeded in making financial institutions safer. They had capital buffers built up to utilize during really bad times. And knowing that there was some confidence that we could get through it without a financial crisis.
Q: You describe one situation as financial distress and another as a crisis. How straightforward is it to make such distinctions?
There isn’t a switch that flips on letting us know for certain we’re in a financial crisis. It’s a judgment call.
If you look at narratives from the global financial crisis, the Treasury and the Fed spent a lot of time watching where the financial market was going before deciding to intervene. They were wary of political pushback. And, in general, the government and the central bank really believe the market will be able to bounce back without a lot of intervention.
The downside of waiting is if you let markets burn too long, it can reach a point that is irreparable. There’s no longer any way to intervene effectively. On the other hand, unnecessary intervention does distort the market, which has larger and longer repercussions than we necessarily appreciate. It’s hard to find that sweet spot of intervening at the right moment in the right way. So, for a lot of policymakers, especially in the U.S., they only intervene when it’s absolutely necessary.
Q: With the pandemic the response was quick. Why didn’t policymakers struggle to decide it was time to act this time?
With COVID, they were able to quickly reach consensus on action for a couple reasons. First, there were policymakers who had experience dealing with a financial crisis. With the global financial crisis, no one had firsthand experience of anything but financial contractions. The Great Depression was only a history lesson.
Second, because the financial distress was caused by a global health crisis, the danger was clear. Shutdowns were happening all over the world. Central bank policymakers and everyone else saw what was happening and understood its seriousness. And even though, from a financial perspective, it wasn’t as dire as the global financial crisis, it was easy to reach a consensus on action.
By contrast, the trigger for the global financial crisis came from inside the financial system, specifically the housing market. The causes and significance of what was happening was less apparent to the general public. They could keep going about their day-to-day lives. Even among most experts, initially, it wasn’t clear that instability could spread from market to market and country to country the way it did. So it was hard to gain consensus that yes, we are in a financial crisis and we need to act.
Q: When did the consensus emerge in the global financial crisis?
There was debate among the Treasury, the Fed, and the other regulatory agencies up until Lehman Brothers went into bankruptcy.
By then, the Fed had already found a buyer for Bear Stearns, the first of the investment banks to go down. But with that, the thinking was that they weren’t really intervening, they were just facilitating the actions of two private entities.
With Lehman, all the potential purchase partners fell through. Once that happened, the question became, are we going to bail out this big investment bank that we never really had a supervisory power over? And is it a viable institution that we could defend saving or is it just a troubled institution that has to go?
In the end, they let it fall. The repercussions were way larger than any of the policymakers expected. That became the moment where there was consensus that they needed to figure out how to save the financial system.
Q: What tools does the Fed have at its disposal in a financial crisis?
Section 13(3) of the Federal Reserve Act gives the Fed emergency lending powers in unusual and exigent circumstance. As long as the Fed believed loans were well secured, they could loan to any business or institution. I should note that has since changed. But, during the global financial crisis, it had been so long since those powers had been used that the Fed’s legal team had questions about exactly what was allowed.
Central banks in England, the EU, and Japan were jumping in to fund markets and make purchases directly. It was clear the Fed didn’t have the authority to do that, so they got creative. They built separate entities—funding facilities and lending facilities—that helped save wholesale funding markets.
As an example, money market mutual funds are not insured like bank deposits are, but they were seen as safe because the principal had always been protected by the parent financial institutions. It paid slightly more than a bank deposit, yet investors could still withdraw money at any time. Investors liked that liquidity.
As the global financial crisis was starting and instability was transmitting throughout the financial markets, money market mutual fund investors were getting nervous. Many moved their money out of money market funds and into even safer assets like U.S. Treasuries.
There was enough money being pulled out that the funds were having liquidity issues. They needed the parent financial institutions to step in, which meant that the parents were going to be liquidity strained also.
The Fed stepped in by providing a backstop which essentially ensured liquidity in that market. And, further, in collaboration with the FDIC, they guaranteed all investments in the money market mutual funds from before a certain date. It was an important example of the Fed stabilizing one market that could have cascaded problems into others if the action hadn’t been taken.
Also in collaboration with the FDIC, they launched guarantee programs for a number of financial institutions, including some that weren’t traditional banks, like AIG and investment banks. After the Troubled Asset Relief Program (TARP) was announced, the Treasury got involved and helped with injecting capital, restructuring, and rebuilding the financial institutions.
Q: How did the Fed resolve the questions about its legal authority?
With a lot of debate and by writing a lot of legal memos. They were interpreting the legal language even as they were implementing programs.
In some cases, there was an announcement of a program, then a delay of a month or so before it began operating. That time went to developing structures to ensure the Fed wasn’t overstepping its authority.
Eventually they decided that a slightly roundabout approach would satisfy the language in the legal authority. The Fed created special purpose vehicles that weren’t on the Fed’s balance sheet and lent them money. The special purpose vehicles would purchase the assets that the Fed wasn’t sure if they had authority to purchase directly.
Q: How significant was the delay?
In the middle of a crisis, a delay of a month might mean you don’t have a market to salvage anymore. There are anecdotes of Fed or Treasury officials checking with CEOs of financial institutions. The CEOs would say, “We don’t have an issue”—then a week later, they’re filing for bankruptcy. Money was draining out of the money market mutual funds so fast that even a day or two could have been decisive. In a financial crisis, if the investors are running, you have to be able to act quickly.
With the COVID pandemic, everything had already been designed and tested. The questions about their legal authority had been answered. There were people with experience in place to make sure the programs functioned properly. Relaunching the Fed’s emergency facilities was comparatively quick and easy.
Q: You mentioned that there’s a wariness of political pushback after the Fed intervenes in markets. Was there pushback after the global financial crisis?
There was a backlash against the Fed for getting extensively involved in the markets and helping individual institutions. Congress modified Section 13(3). The Fed’s response to the pandemic was the first test of the new rules. Fortunately, I don’t think the changes restricted the Fed in any way, but questions remain about whether under different circumstances the new rules might create challenges for the Fed.
The key changes were that the Fed is no longer able to help individual institutions. The Treasury must approve the Fed’s emergency plan. And finally, the Fed has to report the names of the financial institutions using any of the programs to Congress.
With COVID, the Fed wasn’t aiming to help individual institutions; they wanted to help out the markets broadly. The Treasury gave approval quickly. And the Congress won’t disclose the names of institutions using the emergency facilities for a year. If disclosure were done more quickly, there’s concern about exposing weaker actors to market reaction; after a year, that’s less of a concern.
If we were to face a financial crisis where the policy makers in various departments struggled to reach a consensus—if the Fed wanted to act and the Treasury said no—it’s an open question how significant that might be.
Q: Did the COVID pandemic provide a test of whether the Fed is ready for a financial crisis?
I think the real test is going to be when the next crisis happens years down the road and it’s triggered by something that no one expects, like an unregulated financial market.
Under those conditions, there are going to be a lot of different political forces saying, “Let it burn. Let the damaged institutions fail.” Then, even if the know-how and infrastructure to respond are there, getting approval from the Treasury Secretary will be a key hurdle.
And after the COVID facilities were launched, there was yet another political backlash. It was smaller, but it prevents the Treasury from backing some of the Fed’s programs in the future, specifically for the corporate and the municipal bond markets. It will mean there are new legal questions to answer, perhaps new structures needed, if the Fed wants to intervene in those markets again.
Hopefully, those will be resolved before the next crisis. In addition, there are even still technical questions about the Fed’s authority going back to the global financial crisis. And it’s important to get answers to as many outstanding questions as possible.