Economic policy response functions will continue to ratchet up this week as concern spreads at least as quickly as the coronavirus itself. The entirety of Northern Italy may be quarantined, but capital markets in Milan are set to open on schedule on Monday morning.
Last week’s analysis focused on the four main policy tools available to help cushion the blow of expected large-scale downdrafts in the global economy. We focused on monetary policy, fiscal policy, trade policy, and health policy. With markets opening in Milan, attention now shifts to technical regulatory policy options that can help keep financial markets functioning smoothly.
The good news is that market professionals globally in the last 20 years have had much concrete experience in how to address extraordinary situations.
From the September 11 attacks that included the capital markets in New York to the Lehman Brothers collapse to the EuroArea bond crisis, capital market leadership has had two decades to design and implement contingency plans for disruptive events that render trading systems and the people that run them unable to perform basic functions for a period of time.
Market operations in Italy and beyond may be able to function owing in large part to the high level of automation in capital markets. But how those markets can function in the face of potentially high volatility and/or the possible absence of a large percentage of key personnel remains to be seen.
Therefore, this post assesses the key policy levers regulators have at their disposal to promote smooth market functioning in extraordinary situations.
Quick Recap – Last Week
Last week’s fiscal and monetary policy actions in key jurisdictions (US, EU, UK, Japan) are only the beginning of what will likely be a multi-faceted effort to support economic activity. The first round of policy actions were designed to address an immediate health policy situation as well as a limited term supply shock associated with disrupted supply chains.
If you want a sense of what a mobilizing government looks like globally, have a look at our COVID19 time series for the last few weeks:
Policymakers globally are taking action even more than they are talking.
Look closely at the scale. These are some of the highest readings we have seen for action on our platform to date. The aggregate actions include items that generate no significant media attention (e.g., meeting cancellations, travel restrictions) as well as high profile actions such as significant allocations of fiscal resources to meet healthcare and vaccine research needs both at home and abroad.
If the situation in Italy is a harbinger of things to come for the rest of the world, then policymakers will soon shift to tools best able to address the more serious demand shocks. Large drops in consumer demand are about more than just temporary shifts regarding discretionary purchases (travel, tourism, restaurant dining) as people shelter-in-place at home. Significant levels of illness require medium-term shifts in consumer spending as individuals divert resources to meeting health care needs.
Unlike the September 11 and Lehman crises, this coronavirus crisis moves slowly by market standards. This gives policymakers as well as businesses time to prepare in a manner that minimizes the adverse economic consequences of significant levels of illness for a period of weeks. Critical infrastructure and continuity plans are likely being actively considered, if not implemented.
But even if all companies (large and small) manage to implement crisis operations plans flawlessly, the reality is that revenues will certainly fall for companies globally the first quarter of 2020. The only exception will be sectors that are on the front line of fighting the crisis (e.g., healthcare, cleaning supplies, virtual conferencing, and platforms that facilitate distributed, remote work). Small and medium-sized companies may absorb the hardest hits since their monthly revenues are the most exposed to local discretionary consumer purchases.
The next moves policymakers make to minimize the disruption will be technical. Consequently, today we zoom in on the more subtle options central banks have when acting either as financial regulators or as payment system operators.
Main Financial Regulation Policy Options
Financial firms that invested in automated trading, reporting, and capital calculation technology will find the current situation far less challenging at the operational level than firms that may still be relying on key personnel that use paper.
We are about to find out how much financial firms have actually automated a broad range of functions.
Traditional regulatory requirements regarding trading halts in the face of high volatility and exemptive relief regarding routine regulatory reporting requirements can be expected to function normally. However, it should be noted that circuit breakers have a checkered history with respect to their ability to achieve their goal of decreasing market volatility.
At a technical level, publicly traded companies may soon seek exemptive relief, extensions, or other loosening of requirements when filing their 1Q2020 reports with securities regulators. Publicly traded companies will require guidance from securities and accounting regulators on how to treat losses associated with dramatic drops in revenue due to the coronavirus as well as how best to disclose the outcome of scenario analyses and related forward-looking statements about revenue and profit expectations for 2Q2020 and beyond.
Since the full scope of the impact of the virus on individual companies will not be known by the time these reports must be finalized in the second half of March 2020, securities and accounting regulators will have to act quickly to provide guidance that delivers a level playing field and some kind of minimum standard for investor disclosures.
The more serious regulatory requirements will likely be triggered in the medium-term, if significant adverse economic impacts materialize. Most countries wait for 90 days before requiring banks to declare a loan past-due. For borrowers, significant (if not life-threatening) illness in March that adversely impacted payment prospects would not appear until June. Any payments made between now and June would re-start the clock.
In other words, the scale of the virus crisis would have to be massive in order to trigger non-payment of loan obligations starting in June.
Banking regulators can make quiet but important adjustments in bank regulatory capital requirements in a proactive manner in order to provide banks with a counter-cyclical cushion to offset economic headwinds. Without getting into the mind-numbing technical detail of the Basel III capital requirements, at a high level here it is important to note that the easiest levers for regulators to pull would be to decrease dramatically two key regulatory ratios: the counter-cyclical buffer (CCyB) and the macroprudential buffer. Both these ratios are designed expressly to provide regulators with the opportunity to generate increased liquidity for banks when times are bad and to rein in underwriting activity when times are good.
More serious, longer-lasting, and controversial moves would involve relaxation of the leverage ratio, the net stable funding ratio and capital required to cover risks arising from bank trading books.
The last obvious set of tools is the most high profile one: liquidity assistance. Significant volatility in capital markets can trigger mandatory regulatory and internal risk management requirements to close out positions and call in collateral. Such situations tend to be transitory but intense. Central bank liquidity provision and/or asset purchases can alleviate the situation.
Such moves can and will make headlines, but they are best understood as “break-the-glass” measures to deal with a temporary situation. They do not necessarily signal adverse structural shifts in an economy in terms of impaired supply and demand functions. If economic or financial market conditions deteriorate sufficiently to require central bank liquidity assistance, the scale of the operation matters. Perspective matters. Federal Reserve liquidity assistance following the September 11 attacks and the Lehman/AIG failures provide handy benchmarks:
So as tension and volatility risk in capital markets, the charts above should provide helpful perspective in assessing the scale of the policy response from the central banking community.
A latent, under-appreciated risk exists as well: insufficient automation of trading processes. One reason why capital markets collapsed following the Lehman/AIG bankruptcies was because back office procedures even in 2008 derivatives markets were still operating based on paper confirmations. There was no way of knowing aggregate exposures across subsidiaries to the same counterparty and there was not way of knowing the amount of exposures without manual processes Following that crisis the financial industry has spent billions to create interoperable systems and Legal Entity Identifiers; regulators and FinTech firms have been rapidly implementing automated regulatory reporting.
Have they done enough? If a large number of traders and executives are incapacitated for a week or two due to illness, only the firms that have implemented appropriate levels of technology automation will be able to continue functioning smoothly. The rest will see their operational risk capital charges increase due to gaps in functionality.
The Bottom Line
Financial regulators and central banks have many levers to help cushion the impact of rapidly deteriorating economic conditions due to exogenous events. Some of those tools are designed to address short-term pressure points (like market volatility) without providing perspective on real economic trends.
The best case scenario is that the coronavirus generates only a transitory supply shock (1Q2020) and a transitory demand shock (visible in data that becomes available in 2Q2020). Financial institutions and policymakers must, however, prepare for less ideal scenarios in which supply shocks persist past 1Q or demand shocks accelerate in 2Q due to fear.
Hopefully, the situation will incentivize policymakers to operate in a far more cooperative manner than in 2008. The regulatory dynamic during 2008 was dominated in many respects by a refusal of regulatory policymakers to work with each other. It may sound idealistic, but perhaps the long lead-time and the shared risk in this situation will provide the foundation for a return to the kind of trust and cross-border regulatory cooperation that existed before 2008.
At the business level, the virus crisis is likely to accelerate the decades-old shift towards process automation. Key vulnerabilities associated with the loss of significant staff will likely create incentives for business leaders to shift rapidly towards remote-working platforms and process automation initiatives. The shift will have a material impact on the structure of the 21st century workforce, prioritizing advanced technological skills and the ability to interact with next-gen technology. but that is a story for another day.
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