Plunging stock markets, bond yields, and oil prices are creating a perfect storm of adverse conditions sure to impose severe damage on the real economy. Nervous markets are particularly focused on corporate credit markets.

Borrowing by non-financial companies has reached historic highs as companies have gorged on cheap credit and easy borrowing terms to goose shareholder returns. The prospect of widespread defaults in the debt-laden corporate sector is the weakest link in our fragile global economy, which is even more highly leveraged than the one which imploded during the 2008 financial crisis.

Will the banking system hold up? Optimists point to the significantly higher levels of capital that exist today in the banking system as compared to 2008. Yet, the fact that capital is twice as high as it was during those go-go years does not mean it is high enough. Under current rules, banks are still allowed to borrow 94 cents for every dollar of their funding. Even if bank capital is sufficient to keep the system afloat, will the biggest banks have the balance sheet capacity to continue lending? Indeed, to address the needs of the real economy, they will need to expand their balance sheets to take up the slack as corporate bond markets seize up.

Simply keeping the banking system solvent will not be sufficient to meet the economy’s needs, particularly if the banks retrench on credit, withholding loans to all but the most creditworthy, as they did during the financial crisis.

Bank-centric bailouts don’t work

In recent years, the Fed has been repeatedly urged to raise bank capital requirements through something called a Countercyclical Capital Buffer (CCyB). The CCyB is designed to increase capital levels toward the end of an economic cycle. This helps constrain debt-driven asset bubbles and also gives banks excess capital to release in a downturn so that they can expand credit when the economy needs it the most. But the Fed has repeatedly refused to invoke the buffer, while allowing banks, on average, to deplete their capital levels through shareholder payouts that exceed their earnings.

View photos WASHINGTON, DC - MARCH 03: Federal Reserve Chair Jerome H. Powell announces a half percentage point interest rate cut during a speech on March 3, 2020 in Washington, DC. (Photo by Mark Makela/Getty Images) More

Last week, with astonishing timing, the Fed finalized new capital rules which would weaken bank capital further, including a change which would reduce Tier 1 capital — one of three key capital metrics — by $100 billion. As a rule of thumb, $1 of Tier 1 capital supports roughly $16 of borrowing. Thus, if banks decide to distribute this $100 billion to shareholders, they could reduce their lending capacity by $1.6 trillion. Notably, as part of this rulemaking, the Fed will no longer require banks to have sufficient capital to expand lending during economic stress, one of the reasons why big banks’ capital minimums dropped.

The Fed could still reverse course, invoke the CCyB and apply it to this year’s round of stress testing. This would keep banks from distributing that excess capital. Yet, economic turmoil is already upon us. Such measures will help, but will be too little, too late. The Fed could, of course once again, pump bailout money into banks, hoping it will flow through to the real economy. This was the approach we used in 2008.

But while some banks did a better job supporting lending than others, for the most part, bailout funds did not support the real economy. They primarily propped up the irresponsible financial behemoths who caused the crisis and who were teetering on the edge of insolvency. Indeed, the banks were paying their executives big bonuses by the end of 2009, even as the rest of the economy struggled in the depths of severe recession. It took nearly 10 years for the so-called recovery to trickle down to middle- and low-income working families. Bank-centric bailouts don’t work.