The US economy has no brakes

The fall in disposable income of borrowers would lead to mass defaults while borrower leverages are that high.

In the absence of leverage tools, the US economy is constantly speeding up. Businesses and households are over-indebted due to the low interest rates in the last decade.

While leverages are high, a fall in disposable income of borrowers would lead to mass defaults.

Covering nonbanks under the Basel standards would not enable to fully control leveraging, though. Where no maturity transformation is required, both banks and nonbanks mediate securitization without owning securities.

Constraining leverage in security markets

Banks can theoretically produce infinite amount of loans out of deposits. Regulators constrain bank leveraging by requiring to reserve capital for each additional loan. Mitigating bank leverages also serve to mitigate the leveraging of households and businesses. Thus, excessive credit risk surging is deterred.

Constraining leveraging is more difficult in the financial systems with improved security markets. While securities are the alternative source of funding, financial agencies other than banks can also become major actors in the financial system. They initiate securitization between lenders and borrowers. As banks provide long-term credits out of short-term deposits, nonbanks transform maturity by producing long-term securities out of short-term securities. You can read how nonbanks produce assets and become a systemic risk source here.

After 2008, Basel standards built new capital and liquidity buffers for banks. Non-banks are mainly not subject to these standards as long as they are not designated as systemically important financial institution (SIFI). As you can read here, the Financial Stability Oversight Committee (FSOC) of the US lifted all three SIFI designations as of October 2017. As expected, the nonbank sector has grown over the averages of the banking sector.

Covering nonbanks under the Basel standards does not fully control leveraging, though. Where no maturity transformation is required, both banks and nonbanks mediate securitization without possessing any security. For example, financial agencies do not purchase any mortgage while producing them. Hence, they can initiate the production of unlimited amount mortgages without reserving additional capital. In terms of mortgages, many countries constrained borrowers' leverage via the loan-to-value rule which limits the debt amount with respect to the house value. In the US, no financial authority has been authorized to set an lev ratio. Consequently, the US financial regulations do not adequately address security markets.

In the absence of leverage tools, the US economy is constantly speeding up. Businesses and households are over-indebted due to the low interest rates in the last decade. Therefore, the COVID-19 distress caused drastic fluctuations in the financial markets. The Fed blocked a liquidity crisis by providing massive funding for all types of markets and borrowers.

A solvency crisis follows the liquidity crisis with a lag. The COVID-19 led to a dramatic contraction in the output and a skyrocketing unemployment. While leverages are high, a fall in disposable income of borrowers would lead to mass defaults. Banks would further squeeze credits to protect their equities against delinquencies. The credit contraction would further pulls expenditure and output down.