Market Pulse
April 02, 2020

Building a Better Transmission Mechanism: Extending Credit to the Real Economy


Market Pulse

Building a Better Transmission Mechanism: Extending Credit to the Real Economy

Building a Better Transmission Mechanism: Extending Credit to the Real Economy

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April 02, 2020


The Federal Reserve announced on April 1 regulatory relief for banks in order to create a more efficient transmission mechanism to extend credit to the real economy. Regulatory forbearance for banks making loans to troubled businesses and relaxing capital rules to expand balance sheets are key features of the plan.

The Fed temporarily changed its supplementary leverage ratio (SLR) rule to ease strains in the Treasury market resulting from the coronavirus and increase banking organizations’ ability to provide credit to households and businesses. The significance is that this defines part of the mechanism by which moneys allocated from the CARES Act to support small and large business in the amount of $4.5Tr can be transmitted to the real economy.

It is critical to understand the policy reaction functions designed to support markets from the Fed, Treasury and Congress during times of crisis because it provides insight into which assets may perform best as the economy moves out of the crisis environment. We find it is helpful to think through this by using a framework that describes each phase of the policy reaction. They are:

  1. Liquidity: The Fed is well suited to address liquidity problems in the market by increasing repo operations, QE, FX swap lines and increasing credit facilities for commercial paper, money markets corporate bonds. We observed this already over the past few weeks.
  2. Stabilization: Once again the Fed is well suited to enact market stabilization measures by increasing the size and scope of the liquidity-support measures they put in place. We observed that the Fed expanded the scope of these liquidity facilities to include more assets that needed relief and increased the size to ‘whatever it takes’.
  3. Solvency: This is the phase we are at right now. Here is where the Fed and the Federal Government need to coordinate and they are doing so via the business assistance package in the CARES Act and enlisting help from the large banks to transmit this policy. The Fed can’t do this alone.
  4. Stimulus: The Fed can’t do this at all. This involves spending and investment programs that involves tax payer money and needs to be legislated through Congress and signed into law by the President.

Addressing Solvency for Business via the CARES Act

A feature of the CARES Act was designed to support small and large business by directing loans and buying assets in order to ensure that businesses did not come out of the crisis impaired due to lost economic activity from the coronavirus. The Treasury provided the Fed with $454Bn in capital of which the Fed then creates and lends to a special purpose vehicle (SPV). This SPV can purchase assets and make loans to businesses. A one-percent probability is assigned to a ten-percent loss, so the SPV can be levered 10:1 and create $4.5Tr in loan and purchase power.

However, the problem is that neither the Fed nor the Treasury is set up to evaluate credit and collateral for businesses. Take small businesses for example, many loans are collateralized by the home of the business owner or an asset like a life insurance policy.

Larger businesses may be an easier credit to assess but not always. One can see how cumbersome this can be for a government agency. This is where banks come into play. After all, making loans and assessing credit is their bread and butter.

Another problem arises though. Banks may not be willing to lend to companies that are distressed because if the loans become impaired then banks have to reserve more capital against it and this creates a capital problem for the banks.

This is where the Fed and the banks can work together and it is why regulatory relief for the banks is not just helpful, it’s essential. After all, the Fed is the regulator for the banks and can change regulations when and as needed. The goal is for the Fed to transmit credit to the real economy as quickly and efficiently as possible. This is what’s behind the temporary regulatory relief for the banks from the Fed.

Changing the Regulatory Environment

The Fed announced on April 1 a temporary relaxation of SLR rules for banks that will have the immediate effect of increasing capital for banks and allowing them to expand their balance sheets (i.e. increase leverage) as appropriate to continue to serve as financial intermediaries. Banks function as financial intermediaries as a matter of course, which is critical to the Fed’s policy support goal of transmitting credit to the real economy. But there is more to the story.

In addition to relaxing capital ratio rules via the SLR, the Fed, acting as a bank regulator, may not markdown banks for providing forbearance on loans made to businesses that become impaired due to the coronavirus as long as these businesses were in good order prior to the crisis.

The goal is to send a message to banks to keep credit flowing to the real economy so that these companies can rebound after the virus passes. The Fed will therefore lend or buy from banks rather than make loans directly to businesses. Thus regulatory forbearance for banks is an essential part of the process, not just the relaxation of capital rules and allowance to expand balance sheets.


The Fed and Congress are moving extremely quickly to address the stress in the economy and markets. What took quarters and years to achieve during the GFC is taking days and weeks to achieve today. The reason is that the metric of economic loss is clear to policy makers; jobs lost. The coronavirus crisis is impacting Main Street, small and large businesses alike. Unlike the GFC, there is no moral hazard issue or blame directed at bad actors. The crisis is ubiquitous and needs market support at every level.

However, there will be winners and losers in terms of which assets may recover fastest, and by more, and some slower -- or not at all. As asset managers we are assessing where policy support may be directed and which assets may benefit most as a result. Currently we find the best opportunities in the highest quality sectors of the market; assets that are investment grade. However, there are opportunities that will arise in places like consumer credit and asset backed securities as we believe policy needs to also support the consumer and ensure they do not lose access to credit once the virus passes.

Aside from economics, our main concern is for all the people directly affected by the virus. We sincerely hope everyone stays healthy and we believe we will all get through this together.




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Managing Director
Global Fixed Income Team

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