Breakingviews - March’s market bailout demands regulatory payback

LONDON (Reuters Breakingviews) - After the panic comes the bailout. And after the bailout comes the reckoning. In 2008, governments rescued banks and then embarked on a decade-long overhaul to ensure they would never need to do so again. This year’s pandemic-induced meltdown in financial markets, which prompted similarly unprecedented interventions, has sparked a comparable backlash.

A trader is reflected in a board at the New York Stock Exchange showing the day's numbers as markets continue to react to the coronavirus disease (COVID-19) inside of the NYSE in New York, U.S., March 18, 2020.

The “dash for cash” that raged through global markets in March was different from the worldwide banking crisis that followed the collapse of Lehman Brothers almost 12 years earlier. The cause lay in a deadly pandemic which started outside the financial system. And it mainly threatened financial investors rather than bank depositors.

Bank reforms were partly responsible for the market ructions this time round. After 2008, regulators explicitly set out to shift risks, such as proprietary bets on property or commodities, from bank balance sheets to investment funds better suited to coping with asset gyrations. They succeeded. By the time Covid-19 struck, non-bank financial intermediaries like investment funds and insurance companies controlled almost half the world’s financial assets, up from 42% in 2008, according to the Financial Stability Board.

Yet while regulated lenders weathered the pandemic storm, the extreme selloff in equity and corporate bond markets exposed new vulnerabilities in the financial system. Even the largest global companies faced sharply higher borrowing costs and struggled to roll over short-term financing. U.S. Treasury bonds and gold, normally the ultimate safe havens in a panic, tumbled along with other assets.

Authorities had little choice but to step in. Central banks swooped in to buy government bonds, but also supported markets for commercial paper and corporate credit. In the following eight months the central banks of the “G7” largest developed economies expanded their balance sheets by $7 trillion, more than twice as much as in the period following Lehman’s collapse.

These interventions were, as the FSB noted last week, “speedy, sizeable and sweeping”. They were also effective: with the help of large-scale government spending, markets quickly rebounded. Yet the crisis still raises urgent questions for financial authorities. Malfunctioning markets impose extra costs on companies, consumers and governments. And if central banks make a habit of propping them up in a crisis, investors will be motivated to be more reckless in future.

That conundrum is at the heart of the FSB’s new “holistic review” of the market turmoil. The global body, set up after the 2008 crisis, said last week it intends to reform money-market funds and study the vulnerabilities of open-ended investment vehicles. It’s also looking at the impact of margin calls on derivatives, and the resilience of government bond markets.

The focus on money-market funds is overdue. It’s the second time in just over a decade that these vehicles, which now manage almost $7 trillion, have been bailed out. In 2008 the Fed stepped in after the Reserve Primary Fund “broke the buck” when its net asset value dipped below a dollar. This March, U.S. prime money-market funds, which invest in short-term corporate and other non-government paper, lost 11% of their assets. Without support, some funds would probably have restricted withdrawals or imposed fees on investors asking for their cash. Indeed, the prospect of such measures, ironically introduced to make money-market funds safer, may have fuelled the panic.

Yet focusing on specific parts of the world’s financial plumbing risks missing the broader lesson, which is that markets magnified the economic shock of Covid-19. For example, consider hedge funds which arbitrage price differences between U.S. Treasury bonds and futures contracts. In normal times this activity appears to improve the market. But in March, as investors sold Treasuries to raise cash, hedge funds joined the rush for the exit. “Arbitragers had gone from being a stabiliser of the market to being an amplifier of market stress,” Jon Cunliffe, deputy governor of the Bank of England, argued earlier this month.

These funds are links in a highly interconnected and constantly evolving financial chain. If regulators tighten up rules in one part, for example by making it harder for investors to quickly withdraw their cash, the risk is that new vehicles with fewer constraints will spring up.

That’s why some policymakers are once again debating whether central banks should make their backstops more permanent. They envisage monetary authorities acting as market-makers of last resort, providing direct support to investment funds in the same way that they have long been lenders to troubled banks.

This idea, previously debated during the 2008 crisis, raises some tricky questions. How would central banks protect themselves from losses on assets they bought? Which funds or institutions would be eligible for help? And, most importantly, how would central banks charge for the support they were providing?

After the 2008 crisis, the task facing regulators was fairly clear: banks needed more capital and bigger buffers of liquid assets. The March market panic and subsequent bailout demand a similar reckoning. This time, however, the necessary reforms are far less obvious.


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