Photographer: Michael Nagle/Bloomberg

The Federal Reserve saved the corporate bond market after it froze last year. Now regulators want Wall Street to pay the price for that rescue, and the industry is already pushing back.

Government officials view the unprecedented steps taken in March 2020 -- the central bank pledged to buy corporate bonds, a promise that got the gears of credit turning again -- as a mandate to address long-standing concerns that bond liquidity disappears in bad times.

Meanwhile, the giants of finance think the Fed simply took a proportional response to a once-in-a-century pandemic, which doesn’t justify upending how the business runs in normal environments.

Those dueling narratives are circulating in Washington as Treasury Secretary Janet Yellen on Wednesday convenes her first meeting of the Financial Stability Oversight Council. Corporate bonds appear to be on the agenda.

There’s much at stake. Investors in many bond mutual funds could face surcharges meant to slow down the run for the exit in times of stress. Money managers could see profits pressured by higher compliance costs. But unforeseeable crises seem to be happening about every decade now, and generally Wall Street has succeeded in socializing the costs of being rescued while its profits remain privatized. If talks end up with no reform and there’s yet another crisis requiring a Fed bailout, taxpayers could be outraged.

Resiliency Lacking

“One of the biggest dangers is we take a near miss and take it as a sign that the system worked,” said Kathryn Judge, a Columbia University law professor and member of the Financial Stability Task Force sponsored by the Brookings Institution and University of Chicago Booth School of Business. “The system only worked because the Fed jumped in,” she said. “It is not a system that is as resilient as we want or need it to be.”

This is not a new debate, with talk intensifying following the 2008 financial crisis. Liquidity seemed basically fine, even as companies’ debt loads ballooned and banks pulled away from some market-making following new regulations. But there were signs of fragility, such as in 2011 during the European debt crisis and in 2015 as the Fed was signaling it was going to raise interest rates. The Securities and Exchange Commission put liquidity on the agenda for its inaugural Fixed Income Market Structure Committee meeting in 2018.

Read More: Why Corporate Bond Liquidity Might Not Be as Bad as You Fear

Then came Covid-19. When the direness of the situation dawned on investors, they began to sell just about everything to raise cash. Corporate debt wasn’t immune. Bond funds saw massive outflows, too, forcing their managers to slash holdings. Spreads on investment-grade and high-yield corporate bonds spiked to their highest premiums since the Great Recession. All that made it nearly impossible for companies to borrow -- right when they desperately needed to.

The Fed’s footprints remain all over the market. It owns $13.8 billion of bonds from dozens of companies including Amazon.com Inc. and Waste Management Inc. That’s not enormous given the size of the market, but the Fed did offer to purchase up to $750 billion of the debt, and that promise was enough to turn things around. This program has been shut, but officials have said little to diminish expectations that they would swoop in again during the next crisis.

An issuance boom following the rescue has swelled debt outstanding from non-financial U.S. corporations by more than $1 trillion to $11.1 trillion, according to central bank data.

On Wednesday, Yellen’s FSOC meeting includes an agenda item to discuss “open-end mutual fund performance during the Covid-19 crisis.” Fixed-income funds under that umbrella can hold a combination of Treasuries, agency bonds and corporate debt. Investors have come to expect they can withdraw their money at any time, with delays only at settlement times.

That’s usually no problem in normal times because fund managers keep cash on hand to pay redemptions. But in a stampede, that cash pile quickly gets depleted, presenting a liquidity test as the manager then has to dump holdings into a market that may not want them. And a year ago, the Treasury market was also locked up, intensifying the pain in corporate credit.

‘Fundamental Rethink’

“The open-end bond fund structure requires a fundamental rethink,” said Judge. “You are promising immediate liquidity against assets that aren’t that liquid” in stressful times.

That dynamic has prompted regulators such as Fed Governor Lael Brainard to ask if there should be a liquidity surcharge, or swing pricing, for investors trying to exit during a panic -- a nudge to get them to stand pat.

Open-end mutual funds already follow liquidity management guidelines put into place by the SEC several years ago that require them to hold a certain portion of assets in liquid securities to meet redemptions. The rules also allow U.S. funds to implement swing pricing if they want to do so, but this rarely -- if ever -- happens.

The regulatory conversation will be influenced by scholars such as Columbia University’s Judge and Nellie Liang, President Joe Biden’s nominee for a senior Treasury Department role that would let her powerfully influence markets regulation.

Read More: Biden Treasury Pick Quietly Starts Work to Rein In Wall Street

Expect a loud response from the finance industry. An often-repeated warning since the 2008 crisis is that rules passed in the aftermath constrained bond dealers’ ability to warehouse bonds, making them less able to contribute to market liquidity.

“If dealer capacity is too low, I would look to see if there are regulations that are restricting dealer capacity without commensurate gain in a safer financial system,” said Bill Nelson, the chief economist at the Bank Policy Institute, an advocacy group for large banks and a former senior member of the Fed staff. “The doom loop where the Fed creates regulations that then make markets less liquid which call for more Fed intervention -- maybe they should reconsider that.”

Moral Hazard

Liang, writing in an October report, showed an interest in tailoring regulations to create deeper markets, and expressed worry that the Fed’s rescue has raised expectations of permanent market support, “making reforms all the more critical to counter moral hazard incentives.”

She has also put on the table the sensitive question of whether access to the Fed’s discount window -- a liquidity backstop for banks -- should be expanded.

“There certainly is a case that the Fed discount window backstop for the financial system through the banks is no longer fit for purpose, with such a large part of financial intermediation not in the banking system,” she wrote. If it were to be expanded, “standards for access and use would need to be established.”

Regulators view the clock ticking down fast if they want to enact any changes. During a March 17 press conference, Fed Chairman Jerome Powell discussed problems he saw in the short-term funding markets as well as the broader “non-bank financial intermediation” -- the catch-all term to describe asset managers and other large investment institutions that have now taken on bank-like roles. “We don’t feel like we can let the moment pass,” Powell said.

Eric Pan, CEO of the Investment Company Institute, the mutual fund industry’s advocate in Washington, said in a recent speech that he welcomes smart regulation, but cautioned against reforms that go too far and hurt the debt capital markets.

“The stakes of getting this right are enormous,” he said.

— With assistance by Benjamin Bain, and Christopher Condon