Today, Federal Reserve Governor Jeremy C. Stein delivered a speech discussing the fire-sales problem associated with securities financing transactions (SFTs) and potential policy remedies, including a liquidity-linked capital surcharge, modifications to liquidity standards such as the Basel III net stable funding ratio (NSFR) and universal margin requirements for SFTs.
Existing Regulatory Tools: In his speech, Governor Stein argued that “the mainstays of our existing regulatory toolkit–risk-based capital, liquidity, and leverage requirements–have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by SFTs.”
New Regulatory Tools: Governor Stein went on to consider other tools that might be better suited to dealing with SFT-related fire-sales externalities. These other tools include:
1. Capital Surcharge: A liquidity-linked capital surcharge that “could act in part as a tax on both the dealer-as-principal and dealer-as-intermediary types of SFTs.” Governor Stein observed that imposing the tax at the level of the intermediary naturally raises the question of disintermediation.
2. Modified Liquidity Regulation: In this context, Governor Stein suggested the possibility of modifying the Basel III NSFR to require a dealer to assume that its repo loans to a hedge fund roll off more slowly than do its own repo borrowings from the triparty market. This assumption would create a net liquidity exposure for a matched repo book, and would thereby require the dealer to hold some long-term debt or other stable funding against it. Governor Stein observed that the modified-NSFR approach also would not eliminate concerns about disintermediation.
3. Universal Margin Requirements for SFTs: According to Governor Stein, in its simplest form, a universal margin requirement imposes a minimum haircut, or down payment requirement, on any party – be it an unregulated fund or a regulated broker-dealer – that uses short-term collateralized funding to finance its securities holdings. Since the requirement applies at the transaction level, rather than at the level of an intermediary in the SFT market, it would apply even if a fund goes outside the regulated sector to obtain its repo funding.
FSB’s Proposal for Minimum SFT Haircuts: In discussing universal margin requirements for SFTs, Governor Stein noted that the Financial Stability Board’s proposed framework for minimum haircuts on SFTs (discussed in an earlier blog post) “stops well short of being a universal margin requirement.” Specifically, Governor Stein stated that:
- The minimum haircuts envisioned by the FSB would apply only to SFTs in which entities not subject to capital and liquidity regulation (e.g., hedge funds) receive financing from entities that are subject to regulation (i.e., banks and broker-dealers), and only to transactions in which the collateral is something other than government or agency securities. According to Governor Stein, the scope of application of the FSB proposal leaves it “vulnerable to an evolution of the business away from this intermediated mode.”
- The minimum margin levels in the FSB proposal are relatively low so it is “unclear how much of an effect, if any, they will have on market behavior.” Governor Stein noted that, for example, the minimum haircuts for long-term corporate bonds, securitized products and equities are 2 percent, 4 percent and 4 percent, respectively.
A Mix of Regulatory Tools: Governor Stein concluded his speech by stating that a sensible path forward to address the fire-sales problem associated with SFTs might involve drawing on some mix of capital surcharges, modifications to the liquidity regulation framework and universal margin requirements. He noted that conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results.
Jeremy C. Stein, The Fire-Sales Problem and Securities Financing Transactions (Nov. 7, 2013) available here: http://www.federalreserve.gov/newsevents/speech/stein20131107a.pdf