Hailey Lee | CNBC
Short-term funding markets have settled in the early days of the coronavirus pandemic, indicating that further reforms are needed, the Federal Reserve's chief overseer said Thursday.
Commercial paper and prime money funds, which finance companies in the short term and serve as key elements of the financial system, froze in mid-March amid a wave of panic selling as fears about the virus increased.
While the Fed ultimately put in place a number of funding programs to ease the stress, the repetition of many of the same issues that emerged during the 2008 financial crisis has led regulators to scrutinize the further changes.
"One lesson is that several short-term funding markets were proving fragile and in need of support – the commercial paper market and prime and tax-exempt money market funds as key examples," Randal Quarles, vice chairman of the central bank for supervision, said in a note to the Institute of International Finance. "The high quality cash and commercial paper runs were particularly disappointing as they were in many ways similar to the runs we saw in these markets during the financial crisis.
Quarles recorded the events that led to huge redemptions in money markets and corporate bonds as cash became a priority. With these markets locked, companies borrowed heavily for commercial and industrial loans and used the Fed's liquidity facilities to keep the market machinery going. The treasury market also experienced significant disruption as bid-ask spreads increased in what is generally the deepest and most liquid finance market in the world.
Quarles said the banking system, a source of stress during the last crisis, is indeed "a source of strength" this time around.
However, he said that the repetition of some of the same issues that arose during the crisis 12 years ago and the need for the Fed to go beyond the programs it was using then serve as a call for further reforms before the next crisis.
"The shortening of maturities in the commercial paper market was similarly reminiscent of the financial crisis," Quarles said. "It appears that these short-term funding markets remain an unstable source of funding in times of significant financial stress."
The Financial Stability Board, which Quarles chairs, has established what he calls the "high-level steering group of central bankers, market regulators and international organizations". The task of the panel will be to "better understand the role played by the vulnerabilities of non-bank financial institutions in these events and to define a work program to address these vulnerabilities in 2021".
Quarles said the March events suggested some of the previous reforms did not work, but added that he was optimistic about the results of the various institutions' response.