Since the mid-1980s, credit to the nonfinancial business sector in the United States has become more procyclical. This greater procyclicality has been associated with different macroeconomic outcomes. Output fluctuations that were muted during the Great Moderation gave way to the Great Recession. More uniform patterns, however, have characterized the early stages of business cycle recoveries, which have been slow, especially in terms of employment gains. What role does a higher reliance on credit by nonfinancial businesses play in these developments? How does leverage affect the behavior of output and other key macroeconomic variables, such as employment and investment, in different phases of the business cycle? Does higher leverage during an expansion lead to slower recoveries? Under what conditions can more reliance on credit be a buffer to small adverse shocks yet amplify tail events? Is monetary policy playing a role in the amplification of credit cycles, particularly when the zero-lower-bound problem necessitates that policymakers maintain low interest rates for a longer period of time than would otherwise be the case? On the other hand, are the adverse effects of high leverage potentially less damaging in an environment characterized by an extended period of low interest rates that reduces the cash-flow burden of debt-service payments?

This paper explores the financial stability implications of the transformed landscape of the financial system in which, relative to banks, nonbank lenders have been playing an increasingly important role in the supply of debt financing. For example, insurance companies, which used to focus on holding bonds, are now directly providing loans that previously were primarily supplied by banks. Moreover, the composition of bondholders has changed, with mutual funds and other less regulated entities having gained nontrivial market shares. How important are the distortions associated with the varying degrees of regulatory oversight that differentially limit risk-taking across alternative sources of credit?

If the expansion of nonbank lenders is partly due to enhanced regulation of banks after the Great Financial Crisis, have these post-crisis regulations hampered banks’ ability to supply sufficient liquidity during stress situations? How did banks perform in this regard in response to the pandemic? To what extent did nonbank entities help provide liquidity to the nonfinancial sector? Given that nonbank lenders often rely on bank loans as a (partial) source of funding for the loans they make, how did such indirect exposure affect financial stability risks during the pandemic, and what are the implications for financial stability going forward?

The nonfinancial business sector entered the COVID-19 crisis with an unprecedentedly high level of leverage. This degree of indebtedness had been partially fueled by a period of stability and very low interest rates. This paper uses detailed information from the FR Y-14Q borrower data to study how pre-crisis leverage affected firms’ ability to access credit during the crisis and the implications for real economic activity. It pays special attention to the disparate experiences across firms with and without access to public funding markets (for corporate bonds and equity), which tends to correspond with firm size. Did the banking sector provide sufficient liquidity in the aftermath of the pandemic shock, especially to (mostly small) firms without access to the corporate bond market that benefited from the Fed’s corporate bond facilities? To what extent did higher pre-pandemic leverage increase a firm’s chances of facing tighter lending standards and loan terms by banks after the pandemic shock, and did it depend on collateral and/or other loss mitigating measures? Was liquidity efficiently distributed across borrowers, especially small firms, to support a strong recovery? What was the impact, if any, of pre-pandemic leverage on how much firms benefited from the various policy responses by the government and the Fed? What is the likely effect of the additional borrowing during the crisis on firms’ future performance and the related path of the economic recovery? Over time, how much has leverage hampered firms’ adaptation to the pandemic shock (e.g., have the more highly levered or smaller firms experienced slower recoveries in employment and in making the necessary investment to adapt to the post-pandemic environment)?

A dozen years later, economists have yet to reach a consensus on the role of household leverage in the Great Recession. A highly influential strand of literature uses cross-sectional data to suggest that the household balance sheet effects transformed a mild contraction into the Great Recession. Researchers have exploited variation in debt levels across households and regions to estimate how leverage affected consumer spending. Similarly, many studies suggest that the “forced” deleveraging after the 2008 crisis contributed to the economic slowdown. At the same time, using aggregate time series, researchers find much weaker evidence. For example, in a 2018 paper, Ben Bernanke argues that the timing of the collapse is inconsistent with a central role for household balance sheets, and he concludes that “the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit.” This paper reviews the evidence and attempts to synthesize the cross-sectional and time series evidence in leverage changes before and after the crisis. In addition, the paper will discuss ongoing concerns and suggest potential policy responses going forward, especially in light of the recent changes in regulation and the Federal Reserve’s long-run monetary policy framework that suggests longer episodes of low-interest-rate periods.

The paper starts with the premise that COVID-19 has changed the geography of economic activity in the United States permanently. Firms have learned that workers do not need to go to offices to be productive and can meet with clients, attend conferences, and even install and troubleshoot equipment without traveling thousands of miles, staying in hotels, and eating in restaurants. Households have learned that they can get everything from clothing to appliances to groceries without going to malls or shopping centers. These changes mean that many commercial real estate (CRE) properties in the office, lodging, and retail sectors are no longer viable in their current configuration.

As a result of these fundamental changes, elevated levels of distress in the CRE debt market are expected to persist. This paper will focus on options for resolution. Importantly, forbearance policies that worked relatively well in prior crises and for temporary disruptions related to COVID-19 may not be successful this time around, as many properties need real rather than financial changes to again become viable. For those properties that need to be redeployed to alternative uses, policies that encourage the relatively rapid transition of distressed properties may dominate policies that favor forbearance.

The paper will empirically examine these issues by analyzing how financial distress has been resolved in the CRE sector over the past 20 years. In particular, the paper will examine the frequency of workout versus foreclosure outcomes, and changes in owner identity/type and use characteristics when foreclosure occurs. The fundamental empirical prediction is that foreclosure occurs more frequently with retail, office, and hotel property in the post-pandemic world than in the pre-pandemic world, with a greater propensity for asset purchase by owner types that redeploy or facilitate the redeployment of assets to alternative higher and better uses. Several related issues will be addressed, including the long-term resilience of office property to work-from-home effects.

The revised long-run monetary policy framework of the Federal Reserve explicitly acknowledges the challenges for monetary policy posed by a persistently low-interest-rate environment. What are the implications for financial instability risks from the zero-lower-bound problem extending the duration of periods of monetary policy easing? Should a buildup of financial instability risks provide an off-ramp for monetary policy pursuing the achievement of sustained 2 percent inflation before initiating a move away from the zero-lower-bound policy, especially given the perceived flatness of the Phillips Curve? For example, should monetary policy focus only on goods and services price inflation, or also on asset price inflation? If so, which sectors should be the primary focus, given that excesses often do not appear in all asset markets simultaneously? How concerned should we be with reaching-for-yield behavior in a low-for-long environment, especially when risk premiums become unusually small? Going forward, how can we best trade off the risks of an underperforming economy with the buildup of the risks from episodes of financial instability that also could result in an extended period of low real economic activity?

To the extent that high leverage is seen as problematic, what are potential policies that can limit the degree of leverage? On the regulatory policy front, higher bank capital requirements (such as through implementing a countercyclical capital buffer or time-varying stress test capital buffers) would constrain bank loan supply during booms and perhaps increase lending capacity at the onset of a crisis like the most recent one. However, the efficacy of such policies is now more uncertain because of the significant increase in nonbank financial institutions’ market shares. Constraining banks’ capacity to lend will lead nonbanks to intermediate more of the credit to nonfinancial firms and households. In this context, a shift from regulating institutions to regulating activities could represent a more comprehensive and effective regulatory approach to contain financial stability risks. A tightening of monetary policy, by “getting into all of the cracks,” would impact less regulated nonbank intermediaries as well as banks. Fiscal policy could also play a role in curtailing leverage, for example through increasing the cost of debt by limiting the tax deductibility of interest payments by borrowers. This panel will provide a discussion of potential contributions from regulatory, monetary, and fiscal policies to rein in the risks to the macroeconomy from financial instability episodes emanating from “excessive” leverage. What macroprudential tools have been shown to be effective? What tools would be particularly useful in the US context, especially given that the United States is perceived to have a market-based rather than a bank-based financial system?