In March, as the COVID-19 pandemic came to a head in the United States, the Federal Reserve took action to shore up the financial sector in the face of an unprecedented economic crisis. The central bank slashed interest rates to zero and injected billions of dollars of liquidity into financial markets.
But while a 2008-style financial crash (thankfully) didn’t happen, the Fed’s support for hedge funds and other underregulated corners of the financial sector exposed shortcomings of the current regime of financial regulation. As reported by Jeanna Smialek and Deborah B. Solomon of The New York Times:
To head off a devastating downward spiral, the Federal Reserve came to Wall Street’s rescue for the second time in a dozen years. As investors sold a vast array of holdings and rushed to the comparative safety of cash, the Fed pledged to become a buyer of last resort to restore calm to critical markets.
That backstop bailed out many people and investment firms, including a class of hedge funds that had been caught on the wrong side of a trade with ample risks. The story of that trade — how it went wrong and how it was salvaged — offers a cautionary tale about important issues Congress did not address in the 2010 Dodd-Frank financial law and the Trump administration’s hands-off approach to regulation.
The article is an important look into the problems associated with oversight by authorities–such as Treasury Secretary Steven Mnuchin–with cozy ties to the financial sector, the relative weakness of the Financial Stability Oversight Council (FSOC), and how 2008 reforms made traditional banks safer but, in an example of the squeeze-the-balloon effect, “Tougher regulation in the formal banking sector has pushed risk-taking to the shadowy corners of Wall Street — areas that Dodd-Frank left largely untouched.”
There is one particular comment made by former Fed Chair Janet Yellen that highlights the importance of consistently enforced, rules-based financial regulation and the risks associated with ad hoc interventions by the Fed:
“It’s very dangerous to have a regime in which you know this can happen,” Janet L. Yellen, the former Federal Reserve chair, said in an interview. “The Fed did unbelievable things this time.”
Relying on the central bank to save the day is not a long-term solution, she said. There is no guarantee that the Fed and the Treasury Department, which must provide the money to support many of the central bank’s emergency programs, will be so aggressive in the future. [Emphasis added]
The risk of another crisis is created by inconsistent application of financial regulation across institutions. Until that problem is solved, we’re left relying on heroic intervention by the Fed.