On May 20, the Wall Street Journal published an eye-opening piece, “The Day Coronavirus Nearly Broke the Financial Markets” with the subtitle “The March 16 stock crash was part of a broader liquidity crisis that threatened the viability of America’s companies and municipalities.” You may remember that Monday as the day the Dow Jones Industrial Average plunged nearly 13%, the second biggest one-day fall in history. “Few realized how close it came to going over the edge entirely,” says the Journal. I certainly didn’t and I highly recommend reading the whole article.
That day’s rout had threatened money market funds, a scary prospect indeed, since investors count on those funds to provide a steady $1.00 share price and near-instant redeemability. Institutional holders of money market funds were bailing out, requiring fund managers to dump bond holdings to raise cash. But there were almost no buyers. Panic spilled over into municipal bond markets, which ground to a halt for a week or so.
Books will be written, and likely are being written at this moment, about the week of March 15. I merely want to follow up on a couple of paragraphs in the Journal article because they show vividly how government regulations sometimes produce results that, even from the point of view of the regulators, are disastrous. (Ludwig von Mises, where are you?)
I refer here to the increased capital requirements that were imposed on banks following the 2008-2009 financial debacle. When a new bank is formed, investors provide capital to get things started. As the bank grows, it makes loans that are recorded as assets and accepts deposits that are liabilities. The amount by which assets exceed liabilities is the bank’s capital, and that amount varies from day to day. If liabilities should ever exceed assets, the bank’s capital would be wiped out and it would be insolvent. (This is the essence of banking; today’s big banks are a lot more complicated than this summary suggests.). New rules increased the amount of capital that banks were required to hold relative to liabilities.
The Fed had met in an emergency session the day before, a Sunday and the Ides of March to boot, and had announced it would slash interest rates and buy up to $700 billion in bonds. It is not clear whether that announcement saved the markets or spooked them. What is clear is that a particular side effect of a particular regulation made things worse.
There were no buyers for the assets that money market fund managers and others wanted to sell. Why? The assets in question were not junk; they were seemingly sound loans made to businesses and local governments. One institutional trader, Vikram Rao, called senior executives at several big banks to ask them why.
It seems that a bunch of complex securities called interest-rate swap contracts had swung sharply in favor of banks who were parties to them. The banks’ counterparties had locked in super-low interest rates on future debt sales but when rates fell even further, they suddenly owed additional collateral. That collateral was immediately booked as a nice profit for the banks. Good for the banks, right?
Wrong. The new assets caused some banks to bump up against their capital limits. The increased post-2008 limits were intended to strengthen banks and lessen the likelihood of future bailouts. A good example of wise regulators forcing gun-slinging bank managers to cool down? It might have seemed that way, but when the rules make it impossible for a bank to make sound and reasonable acquisitions of new assets because they are up against their capital limits, things can go badly awry. Especially when those acquisitions might have staved off panic in the financial markets.
That’s what happened on March 16. Mr. Rao got the same answer from all his banker contacts as to why they couldn’t buy any of the sound securities that mutual funds and others were panic-selling: there was “no room to buy bonds … and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis.”
Again, this is only one aspect of a complex series of events that unfolded during those March days, but it does show rather vividly how well-intentioned regulation can go awry.
You and I, paragons of financial prudence, keep six months’ living expenses in cash, right? But you know what, not everybody does. Politicians force us to send our children to school, force us to buy health insurance, force us to pay into the rotten Ponzi scheme called Social Security, force us to build our home deck railings with openings between verticals not exceeding four inches. If all that is OK, why shouldn’t our nanny government force us all to maintain a cash reserve? Now suppose we were never allowed to touch that reserve even in a sudden crisis? What kind of crazy reserve would that be?
Preposterous, but that’s how unbending capital requirements worked out in the banking system on March 16. Yet when the story of that week is written, Elizabeth Warren and her ilk will slant it as just another market failure calling for more and stricter regulations. As Mises taught, those regulations will trigger still more unforeseen problems and the cycle will continue unto full socialism in banking.
Unless the tide is turned, we must oppose all bank regulation. Punish fraud and theft but otherwise, laissez nous faire! Put the onus on bank managers to exercise prudence with regard to capital backing and other practices like reserve levels or purchase of deposit insurance. Let them earn reputations for sound banking that we small fry can rely on. To be sure, today’s managers don’t want that onus, quite comfortable as they are behind regulators’ skirts. But it’s the only way out of the spiral toward full socialization of banking.