Eric Rosengren, president and CEO of the Federal Reserve Bank of Boston, spoke in Lima, Peru, yesterday about "Short Term Wholesale Funding Risks." He argues that greater disclosure of repurchase agreements could help mitigate the type of run risks that occurred during the financial crisis. States Rosengren, "In terms of preparing better for possible stress conditions, supervisors have made significant progress with organizations focused on traditional deposit-taking and lending activities. However, there is more work to be done with financial organizations -- firms that engage in bank-like activities outside the conventional banking system -- that have less traditional business models, especially in their sources of funding. Particular concern has been raised by Federal Reserve officials on the reliance by some financial institutions on short-term wholesale funding."
He says, "Short-term wholesale funding has been particularly important for firms with large broker-dealer activities. Given their role in making markets, broker-dealers hold an inventory of securities. These securities holdings frequently are financed by collateralized borrowing commonly called repurchase agreements or "repos." A repo, in this context, would involve a broker-dealer (the cash borrower) selling a security (the collateral) to an investor (the cash provider) with an agreement to repurchase the security at a later time. Prior to the recent financial crisis, many had assumed that repurchase agreements would be stable during stressful conditions because they are collateralized with a margin to cushion possible fluctuations in the price of the underlying collateral. Unfortunately, a lesson learned from the financial crisis was that this important form of short-term wholesale funding was actually not nearly as stable as many had expected."
Regarding the financial crisis, he explained, "The assets of broker-dealers grew quite dramatically during the period leading up to the financial crisis, as did broker-dealers' use of repurchase agreements to finance those assets.... Between 2000 and 2007, both broker-dealer assets and the use of repurchase agreements increased by over 150 percent. While broker-dealer assets increased rapidly over the seven-year period, the decline in the wake of the Lehman Brothers failure was precipitous. What is clear is that the events of 2008 present ample reason to have concerns about short-term wholesale funding."
Rosengren tells us, "The problems caused by reduced financing extend well beyond broker-dealers. Faced with funding problems, many broker-dealers sold securities under duress at fire-sale prices -- causing collateral problems for other buyers and sellers of securities. During the crisis, the largest U.S broker-dealers (i.e., those affiliated with investment banks) either became bank holding companies or were acquired by bank holding companies. Additionally, many of the other largest broker-dealers are owned by foreign bank holding companies, and soon will be required to form intermediate bank holding companies. Only a few remaining large broker-dealers are not part of either a domestic or foreign bank holding company. During the financial crisis, many nonbank affiliates of bank holding companies and nonbank financial institutions had significant liquidity problems."
And along came Dodd-Frank. "While lending facilities made available to broker-dealers significantly mitigated problems with broker-dealer financing flows that were contributing to the crisis, such funding authority is now subject to additional limitations. In particular, the Dodd-Frank Act now requires that Federal Reserve facilities or lending programs have broad-based eligibility and be designed to provide liquidity to the financial system (not assist just one individual firm). The Dodd-Frank Act also prohibits the use of such facilities by firms that are insolvent and requires that such facilities be approved by Treasury. In addition, the Dodd-Frank legislation encourages supervisory actions that would prevent the need for future 13(3) lending facilities to be established at all. That is, nonbank affiliates of bank holding companies and financial firms that are not banks should have the capacity to fund themselves through stressful situations without the expectation of resorting to Federal Reserve emergency powers.... Overall, the legislation that was designed to protect banks pre-crisis, and the further limitations imposed by the Dodd-Frank Act, pose significant impediments to future funding of broker-dealers by the Federal Reserve or their affiliated bank should they experience a run."
Consequently, preventative actions are required, he said. "These impediments make it imperative that preventive measures be taken to ensure that in future crises, broker-dealers' financing mechanisms are robust enough to endure potential financial stress. And clearly there should not be an expectation that such runs could necessarily be addressed through the bank holding company structure. Specifically, Federal Reserve Governor Daniel Tarullo and Chair Janet Yellen have suggested regulatory measures such as additional capital charges for banks that house significant short-term wholesale funding operations. While these additional regulatory measures are important, to date there has not been a significant focus on public and more timely disclosure of broker-dealers' financing activities. Disclosure has the potential to provide better information on the degree of reliance on repurchase agreements -- particularly repurchase agreements involving collateral not guaranteed by the federal government -- to the institutions' stakeholders interested in the extent of its risk-taking, such as holders of its long-term debt."
On repo disclosure, he continued, "Let me recognize that disclosure is not a standalone cure-all. It has the potential to be an important supplement to other important actions, like capital requirements. In particular, given the emphasis on run risks at broker-dealers, it would be useful to have far more detailed publicly available data on repurchase agreements used to finance broker-dealers and related affiliates. However, for more transparency to be beneficial, the right information needs to be disclosed. Information -- such as repo collateral composition (for example, U.S. Treasury, private collateralized mortgage obligations), haircuts, the counterparty, and maturity structure -- reported in a timely manner, would provide investors an opportunity to observe changes in financing patterns, and might prevent management from taking risks that its investors may deem excessive. Had such information been available prior to the crisis, the reliance on short-term funding based on both government and nongovernment collateral (the latter meaning collateral not guaranteed by the federal government) would have been apparent and might have resulted in greater market discipline than we saw leading up to the crisis."
He concludes, "The clear intent of the myriad regulations on bank holding companies and banks is to protect the banks and prevent bank support for affiliated nonbank subsidiaries (like broker-dealers) in the bank's holding company at the expense of the bank. This highlights the need for additional actions to limit the likelihood of future problems or crises that could require government interventions. As noted previously, a significant capital charge on short-term wholesale funding would certainly help. In addition, much greater disclosure on "runnable" liabilities would utilize the power of markets to help curb unhealthy levels of reliance on such funding. More detailed reporting requirements should include more disclosures on both the collateral composition and maturity structure of repurchase agreements."
In other news, Wells Fargo released its latest "Overview, Strategy, and Outlook, monthly Portfolio Management Commentary." David Sylvester, Head of Money Funds for Wells Capital Management, touches on a variety of issues, such as foreign taxation and Basel III's Liquidity Coverage Ratio. On foreign taxation, he wrote, "In the unveiling of his 2015 budget, Irish Finance Minister Michael Noonan announced an end to the infamous Double Irish tax structure, citing damage to the country's reputation from criticism about its policies from other governments. The announced change will not allow an Irish entity to claim tax residency in another country. As such, the Irish corporate tax rate of 12.5% would be applied to earnings generated through the Irish parent entity." He added, recent measures "make it more likely that companies seeking to pursue inversions will face significant pressure on their credit ratings. Most significantly, we could see higher debt levels and weakened credit metrics for those companies that pursue inversions."
On LCR he stated, "We wrote last month how banking regulations like the Basel III liquidity coverage ratio (LCR) will affect the issuance of short-term securities by financial institutions as they move toward compliance with these regulations. The LCR requires banks to hold an amount of high-quality, liquid assets to cover expected net cash outflows over the following one-month period under a stressed scenario. As a result, financial institutions have an incentive to minimize their issuance of short-term securities maturing in one month or less when the LCR test is conducted, which, for non-U.S. banks, occurs only at the period-end."
