If there’s one thing investors have learned in recent days, it’s that there’s no way to guess what America will do next. With its on-again, off-again tariffs, the US administration has demonstrated a rare and reckless willingness to shock markets.
Amid such radical uncertainty, a financial crisis isn’t out of the question. Policymakers need to be prepared for the worst.
Such crises follow a familiar pattern, whether the cause is a housing bust, a global pandemic or, in the current case, the premeditated actions of the world’s biggest economy. The catalyst is debt, which investors use to buy many times more assets than they otherwise could. When prices fall sharply, lenders demand more cash collateral or pull out entirely, forcing asset sales that send prices down further in a vicious cycle. If the assets aren’t worth enough to pay all the debt, lenders suffer losses. If those losses threaten the financial system and the broader economy, governments must step in with taxpayer-funded bailouts.
Ideally, financial companies should have ample resources to absorb losses and prevent contagion. They don’t. In one of the world’s most important markets, US Treasuries, hedge funds are so leveraged that spikes in volatility can quickly send them to the exits. Systemically important banks lack the equity capital needed to survive worst-case scenarios on their own. The main public backstop — the US government — is itself troublingly stretched, with vast budget deficits rapidly expanding a sovereign-debt burden that is already the largest since the last world war.
These fundamental vulnerabilities can’t be remedied quickly. Regulators are contending with administration demands that they cut as many as 1 in 5 employees. There’s scant political appetite to raise capital or collateral requirements, which in any case shouldn’t be done under duress. Demanding more right away, with the prospect of a crisis looming, could make things worse.
What, then, can financial authorities do? They should have three priorities: Identify the weakest links, keep markets functioning as smoothly as possible, and provide solvent firms with ample access to cash, so they won’t dump assets or fail unnecessarily.
Regulators have a lot more information than they did when the 2008 financial crisis caught them off guard. Detailed transaction data allows them to piece together firms’ positions and identify dangerous concentrations of leverage. Surveys of market participants can help understand how a stress scenario would play out. A study of the 2021 implosion of Archegos Capital Management, for example, demonstrated that regulators could’ve seen risks building and thus taken preemptive action.
In markets, the goal should be to ensure that financing disruptions don’t distort prices. In the Treasury market, for instance, the Federal Reserve’s standing repo facility guarantees that certain banks and dealers can always borrow cash against government bonds. But it doesn’t apply to hedge funds, which for all their fragility play a crucial role in aligning the prices of Treasuries and their derivatives. The Fed should thus stand ready to take on their role if they withdraw. This would be a far better solution than the loosening of bank capital requirements that Treasury Secretary Scott Bessent has suggested.
Finally, financial institutions abroad hold dollar-denominated assets funded by borrowing in dollars. To prevent that funding from evaporating in a crisis, the Fed has established currency swap lines that empower counterparts such as the European Central Bank and the Bank of England to lend the US currency. Although activating the swap lines might prove politically fraught, officials should stress that it’s in America’s best interests, preventing fire sales that would harm US firms as well.
It’s unfortunate that policymakers need to contemplate a self-inflicted crisis of this kind. But the possibility must be taken seriously. Regulators everywhere should do what they can to be ready.
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