Fed’s Quarles sees need for more reforms to short-term funding markets

Short-term funding markets seized up during the early days of the coronavirus pandemic, demonstrating that more reform is needed, the Federal Reserve’s chief banking overseer said Thursday.

Commercial paper and prime money funds, which provide companies short-term funding and serve as key elements in the financial system, froze in mid-March amid a wave of panic-selling as fears over the virus intensified.

While the Fed ultimately implemented a series of funding programs that helped ease the stress, the repeat of many of the same problems that occurred during the financial crisis in 2008 has sparked regulators to conduct a review of what further changes need to be made.

“One lesson is that several short-term funding markets proved fragile and needed support – the commercial paper market and prime and tax-exempt money market funds, as key examples,” Randal Quarles, the central bank’s vice chair for supervision, said in remarks to the Institute of International Finance. “The runs on prime money funds and commercial paper were particularly disappointing, since in many ways they resembled runs that we saw in these markets during the” financial crisis.

Quarles chronicled the events that led up to huge redemptions in money markets and corporate bond funds as cash became a priority. With those markets locked, companies borrowed heavily in commercial and industrial loans and used Fed liquidity facilities to keep the market machinery running. The Treasury market also saw significant disturbances as bid-ask spreads soared in what is generally the world’s deepest and most liquid funding market.

Quarles said the banking system, a source of stress during the last crisis, was actually “a source of strength” this time around.

However, he said the repeat of the some of the same issues that came up during the crisis 12 years ago, and the need for the Fed to go even beyond the programs it used then, serve as a call for additional reforms ahead of 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 considerable financial stress.”

The Financial Stability Board, which Quarles leads, has put together what he described as a “high-level steering group of central bankers, market regulators, and international organizations.” The panel’s job will be “to better understand the role that vulnerabilities stemming from nonbank financial institutions played in those events and to define a work program to address such vulnerabilities during 2021.”

Quarles said the events of March indicate that some of the previous reforms didn’t work, but added that he is optimistic based on the outcomes of how the various institutions responded.