Re-introducing regulations after the crisis is not going to be easy
Over the last couple of months, regulations designed to keep the financial system and the public save have been suspended left and right. Most banks have waived the covenants on existing or new loans to businesses, so they are not forced into technical default in the middle of this crisis. In the United States, the Fed eased the leverage ratio limits for large banks until the end of March 2021 to incentivise them to lend more to struggling businesses. And health care regulators around the world are relaxing their standards for the introduction of a Covid vaccine and the use of anti-viral drugs in Covid patients.
All these efforts to suspend regulations make sense in a crisis and are welcome additions to the toolbox to fight the current crisis. But we have to remember that these regulations were all put in place to protect investors and the public from the adverse consequences of reckless lending and untested medical products. Suspending them today theoretically introduces the possibility that these risks will build up in the system again.
Of course, today is not the time to worry about these long-term risks in lending markets and to public health. When your house is on fire you don’t worry about the water damage the firefighters cause.
But eventually – most likely in 2021 – regulators have to re-introduce these regulations again and banks will have to enforce loan covenants again. After all, the leveraged loan market has been on the radar screen as a likely trigger for the next financial crisis and the current crisis has led to a deterioration of the financial positions of many high-yield borrowers. But the companies that are breaching their loan covenants today are unlikely to back in good shape in a year’s time and large US banks that increase their leverage ratios won’t be able to unwind these loans quickly enough in 2021, which means we have to choose one of these four options to deal with the problem of higher financial leverage in the system:
Ignore the limitations that were in place before the crisis and just live with the higher leverage in the system, accepting the risk that we will see another major financial crisis in the lending market similar to the Savings & Loan crisis in the late 1980s.
Re-introduce the regulations and limits and deal with the defaults of individual companies that breach their covenants or can’t repay their debt. IF the economy has returned to a more normal state in 2021 this would be doable but certainly prolong the recession that we experience this year or even trigger a double-dip recession.
Extend the suspension of these regulations to give businesses more time to get their balance sheet in order. This would most likely create a whole lot of zombie companies that are theoretically insolvent but are kept artificially alive by banks and regulators. In the end, this would resemble the situation in Japan after the 1990 bubble burst when too many banks and other businesses were kept alive to preserve jobs. These zombie companies would essentially become a permanent drag on the economy and the stock market.
Review the suspended regulations and gradually re-introduce them one by one while suspending other rules forever, if they are deemed unnecessary. This way, the default risks to businesses can be kept at a minimum and only the businesses that cannot get out of their debt hole would go bankrupt.
You can guess, which option I prefer, but there is a political problem with that option. If we re-introduce only the regulations and limits that we think are useful, there is going to be a big political fight about the effectiveness of regulation. Free-marketers will advocate that the regulations have been an obstacle in the crisis and the fact that nothing bad has happened after we suspended the regulation shows that these regulations were unnecessary in the first place. Advocates of more regulation, on the other hand, would argue that excessive de-regulation in the past has led to financial crises and that it often takes years before a lack of regulation triggers instability in financial markets or the economy.
Of course, both sides would be correct to some extent. The problem with regulation is always to find the right balance between risk mitigation and stifling innovation and growth. Which is why I hope this topic will not become political. We have institutions like the Financial Stability Board or the Bank of England and the Federal Reserve that have entire teams of experts to assess the risks of suspending and re-introducing regulations. They should be in charge of the process and the process should not be subject to interference from industry interests and politicians. In the end, what I would like to see is that the public would follow expert advice on how to deal with the issue at hand.
And then I watch the news these days and see all the people who have no background in epidemiology or public health who think they know better how to deal with the Covid-19 pandemic and think to myself: Whatever…