WASHINGTON — A financial market meltdown in March highlighted weaknesses that still pose a threat to global financial stability, indicating the need for reform, a global body that monitors financial risks said on Monday.
“The March turmoil underscores the need to strengthen the resilience” among firms that are not formally banks but serve as important market go-betweens, the Financial Stability Board said in a report. The group, which includes officials from the United States, noted that “the financial system remains vulnerable to another liquidity strain, as the underlying structures and mechanisms that gave rise to the turmoil are still in place.”
In March, rapid trading in Treasury bonds evaporated as panic over the coronavirus pandemic gripped global markets, imperiling the core of the financial system. The new report may be the most comprehensive analysis yet of what exactly happened.
Randal K. Quarles, president of the F.S.B. and the Federal Reserve’s vice chair for supervision, noted in a letter accompanying the report that the March disruptions raised questions about the role played by investors who use a lot of leverage and about the willingness and capacity of key banks to keep trading flowing smoothly in troubled times.
The report noted that fragile spots had arisen from recent trends, including a growing mountain of corporate debt, heavy global reliance on dollar-denominated debt, and the increasingly critical role of nonbank financial players in keeping markets chugging along. When the broad shock of the pandemic hit, there was a scramble for cash, and vulnerabilities were exposed.
Investors in mutual funds and other types of investments rushed to cash out and foreign holders sold bonds in search of dollars. And while banks themselves were resilient, they seemed unwilling to serve as go-betweens in a wildly uncertain backdrop. Many types of securities became hard to trade, and as market plumbing seized up, big investors abroad and hedge funds began to dump bond holdings.
“Market dysfunction was exacerbated by the substantial sales of U.S. Treasuries by some leveraged nonbank investors and foreign holders,” the report said. “This combination of large asset sales, together with the limited capacity or willingness of dealers to intermediate in some markets, became self-reinforcing.”
That Treasury market turmoil was especially bad news. The market for U.S. government debt is considered among the deepest and most liquid in the world, and it forms the backbone of much of the broader financial system.
The Fed swooped in to help. It first offered enormous infusions of short-term funding. When that didn’t work, it began to buy huge quantities of government-backed debt and rolled out a series of emergency lending programs, which helped to relieve pressure on everything from short-term corporate debt to embattled money market funds, where ordinary investors park savings for slightly higher returns than traditional bank accounts offer. It went to previously untested lengths to keep dollars flowing globally.
Markets have calmed since March and April with the help of that support, but regulators have spent the months since trying to piece together exactly what happened. The picture the F.S.B. report paints is consistent with the narrative that has been emerging. The financial system could not handle a huge rush to cash, causing money market funds to face large redemptions, foreign Treasury selling, and the unwinding of a common and highly leveraged hedge fund trade.
Constraints on the banks that might have acted as go-betweens — partly a side effect of the same postcrisis regulations that have made the banks themselves safer — exacerbated the situation.
The question now is how much longer government supports will be necessary, and whether a crisis is likely to bite again.
“Persistent economic uncertainty and still elevated financial stability risks call for continued vigilance,” Mr. Quarles noted in his letter, pointing to still-mounting corporate debt and the possibility of bond downgrades that could force some institutional investors to sell holdings.
The F.S.B. report highlighted areas for future review rather than concrete suggestions for change. Topics deserving further attention included the role of leveraged investors in core government bond markets, and the structures of the funding markets that back up corporate and U.S. bond holdings.
The release accompanying the report also noted that the “effectiveness of the policy response to Covid-19 critically depends on measures taken remaining in place as long as necessary.”
In the United States, a political fight is brewing over whether to extend some emergency lending facilities, which require buy-in from the partisan Treasury Department. There are concerns that Secretary Steven Mnuchin will allow some of the programs enacted earlier this year to sunset.
The Federal Reserve appears likely to continue buying bonds, both to soothe markets and stimulate the economy, for some time. It has also signaled that it favors keeping market supports in place until they are no longer needed.
“When this crisis is behind us, we will put these emergency tools away,” Jerome H. Powell, the Fed chair, regularly says.