Monday, January 6, 2014

Fed Attention Turns to Wholesale Financing Activities

A New Focus on the Risks Associated with Repos, Reverse repos, Securities Lending, and Securities Margin Lending

In a November 22, 2013 address before the Americans for Financial Reform and Economic Policy Institute Conference, Federal Reserve Board Governor Daniel K. Tarullo outlined a potential regulatory initiative to limit short-term wholesale funding risks. As we mentioned in our November 6, 2013 post regarding Fed President William C. Dudley's concerns about tri-party repo, the Fed remains worried about the systemic risk posed by disturbances in the short-term wholesale funding market as a whole. Tarullo's speech, however, goes further than Dudely's.  Tarullo did not merely iterate the Fed's worries about the vulnerabilities created by the short term wholesale funding market, but actually outlined a regulatory framework by which the Fed may limit the systematic risks posed by short-term funding activities.

Short-term wholesale funding activities like repo, reverse repo, securities lending, and securities margin lending are all aspects of what has been called "shadow banking." According to Tarullo, prior to the financial crisis, these activities were part and parcel of an explosion in the creation of assets that were thought to be "cash equivalents," but were in fact far riskier in times of financial stress. This misperception made short-term wholesale funding activities more widely employed, and as the financial crisis unfolded, had the effect of transmitting the liquidity and market stresses of the financial crisis more broadly.

In some cases, the perception of claims on shadow banks as cash equivalents was based on explicit or implicit promises by regulated institutions to provide liquidity and credit support to such entities. In other cases, the perception came about because market participants viewed the instruments held on the balance sheets of shadow banking entities--notably highly rated, asset-backed securities--as liquid and safe. While reliance on private mechanisms to create seemingly riskless assets was sustainable in relatively calm years, the stress that marked the onset of the financial crisis reminded investors that claims on the shadow banking system could pose far more risk than deposits insured by the Federal Deposit Insurance Corporation (FDIC). Once reminded of their potential exposure, investors engaged in broad-based and sometimes disorderly flight from the shadow banking system.

Despite efforts over the past few years to address the financial stability risks associated with a dealer's use of short-term funding to finance inventory, Tarullo believes the regulations already on the books do not go far enough to address the potential macro prudential risks posed by runs in the short-term financing market and the resulting distressed “fire sales” and market price volatility.  According to Mr. Tarullo, current capital and liquidity regulations are inadequate for several reasons.

First, he believes that the the current regulatory framework does not impose any meaningful regulatory charge on the financial stability risks associated with matched book short-term funding transactions.   In Tarullo's opinion, risk-based capital rules under Basel III assign short-term financing activities capital requirements that are too low relative to the risks actually involved.

The Basel III risk-based capital rules require banking organizations to hold relatively little capital against SFT assets, which are assumed to pose little microprudential risk. Because leverage requirements do not take into account the fact that SFTs are collateralized transactions, leverage requirements have the potential to impose higher charges on SFT assets. But leverage requirements have traditionally been calibrated at non-binding levels and, to the extent they do bind in the future, are unlikely to bind evenly across firms. As a result, the leverage ratio may simply cause SFT assets and liabilities to migrate to those firms with stronger leverage ratios.   low capital requirements to SFT assets, in light of the fact that they are short-term, over-collateralized, backed by liquid securities, subject to daily mark-to-market and re-margining requirements and exempt from an automatic stay in bankruptcy.

Second, the Leverage Coverage Ratio is not calibrated well enough to meaningfully address short-term financing liabilities.

For example, the liquidity coverage ratio requires firms to hold a buffer of high-quality liquid assets when they use SFT liabilities that mature in less than 30 days to fund many types of securities. New risk-based capital rules have substantially increased the amount of capital that dealers are required to hold against assets in the trading book. But these reforms are limited: The LCR does not require firms to hold any liquidity buffer against SFT liabilities that mature in more than 30 days or that are backed by very liquid assets. There continues to be a need for standardized capital requirements for market risk to back up model-derived risk weights.
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Similarly, the LCR and, at least at this stage of its development, the Net Stable Funding Ratio (NSFR), both assume that a firm with a perfectly matched book is in a stable position. The LCR assumes a bank can call in reverse repos and other SFT assets that mature in less than 30 days or reuse the collateral that secures those assets for purposes of its own borrowing. Thus, reverse repos and other SFT assets generally are treated as completely liquid instruments. Under the initial version of the NSFR, firms would not need to hold any stable funding against reverse repos, securities borrowing receivables, or other loans to financial entities that mature in less than one year. Again, this may be a reasonable position from a microprudential perspective, geared toward more or less normal times. But here is where we need an explicitly macroprudential perspective that forces firms to internalize the tail-event financial stability risks associated with SFT matched books.

These "tail risks" are his key concern, and he outlined several concrete steps that the Fed is considering to address them, including those held in matched books.  Tarullo outlined two possible policy options to address the financial stability risks associated with firms that use large amounts of short-term funding.

First, he proposes a liabilities based capital surcharge calculated by reference to a firm’s reliance on short-term funding. Under this approach, short-term funding may be defined as total liabilities less regulatory capital, insured deposits, and other long-term obligations. Then, a firm’s funding sources could be risk weighted based on their measures of their relative stability.  The Tier 1 common equity capital surcharge would then be applied based on its level of reliance on short-term funding.  Tarullo did not indicate at what level of reliance a surcharge would be imposed, however.

Second, he proposes to address head-on the macroprudential concerns arising from large matched books of securities financing transactions by further increases in the capital and liquidity requirements applicable to short-term funding transaction matched books. This could include increasing the capital charges applicable to short-term funding transactions and requiring larger liquidity buffers for firms with large amounts of short-term funding activities.  Such a change may throw a spanner in the works of the already internationally vetted LCR, and could require a reworking of the Net Stable Funding Ratio to include this type of approach.

Because these proposals involve changes to the existing capital and liquidity frameworks for banking organizations they would apply only to regulated firms.  However,  Mr. Tarullo emphasized that the Fed intends to pursue regulatory reforms targeted at all participants in the short-term wholesale funding market, not just banks, to avoid incentivizing regulatory arbitrage by shadow banks.  Focusing on the type of transaction rather than the entity engaging in the transaction will serve to employ these regulations on a market wide basis rather than on specific types of market participants.  According to Tarulllo, “completion of this task will require a more comprehensive set of measures, at least some of which must cover financial actors not subject to prudential regulatory oversight." Mr. Tarullo gave no indication of the timing of these proposed regulations or where they may lie in the Fed's procedural pipeline.  But, the speech indicates that the proposal may be forthcoming any day now.