Today, Federal Reserve Governor Daniel K. Tarullo delivered a speech discussing the potential financial stability concerns raised by short-term wholesale funding in the form of securities financing transactions (SFTs), which include repo and reverse repo, securities lending and borrowing, and securities margin lending transactions. Governor Tarullo also discussed possible regulatory measures to address these concerns, including (1) regulatory capital surcharge calculated by reference to a firm’s reliance on SFTs and other forms of short-term wholesale funding (2) modifications to capital and liquidity standards such as standardized banking book risk weights, trading book capital charges and Basel III net stable funding ratio (NSFR) and (3) universal margin requirements for SFTs.
Financial stability risks: Governor Tarullo discussed two types of financial stability risks associated with short-term wholesale funding in the form of SFTs. According to Governor Tarullo, a broker-dealer typically uses SFTs to finance either securities inventory or a back-to-back SFT loan to another financial firm (SFT matched book).
Governor Tarullo stated that there are financial stability risks associated with a dealer’s use of short-term SFT funding to finance its inventory because if a broker-dealer loses access to financing and is forced to sell securities at a depressed price, fire sale externalities may result because other market participants may be less able to borrow against the same securities. And if the broker-dealer fails due to runs by short-term SFT lenders, post-default fire sales by its creditors or contagious runs on other financial intermediaries may ensue.
As for financial stability risks associated with SFT matched books, Governor Tarullo stated that even if the outflows and inflows associated with a dealer’s SFT positions are perfectly maturity-matched, reputational considerations may inhibit a dealer from reducing the amount of SFT credit that it provides to its customers, exposing the dealer to considerable liquidity stress. If the dealer does reduce the amount of credit that it provides to its customers, those customers may be forced to engage in asset fire sales of their own. Where the customers are highly leveraged, maturity-transforming entities that lack access to a liquidity provider of last resort, this may pose a significant risk of contagion.
Existing Regulatory Tools: In his speech, Governor Tarullo argued that while “[p]ost-crisis financial regulatory reform has taken some steps to address the financial stability risks associated with a dealer’s use of short-term SFT funding to finance inventory,” the “current regulatory framework does not impose any meaningful regulatory charge on the financial stability risks associated with SFT matched books.” Specifically Governor Tarullo noted that:
- The Basel III risk-based capital rules generally require banking organizations to hold relatively little capital against SFT assets, which are assumed to pose little microprudential risk.
- Although leverage requirements have the potential to impose higher charges on SFT assets, they are unlikely to bind evenly across firms and, as a result, the leverage ratio may simply cause SFT assets and liabilities to migrate to those firms with stronger leverage ratios.
- The Basel III liquidity coverage ratio (LCR) and, at least at this stage of its development, the 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. Under the current 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.
Policy Options to Address Financial Stability Risks Posed by Short-Term Wholesale Funding: Governor Tarullo stated that there are three kinds of policy options that can be considered, individually or together, in responding to the financial stability risks posed by firms with large amounts of short-term wholesale funding – whether loaned, borrowed, or both.
- Option 1: Impose a regulatory capital surcharge calculated by reference to a firm’s reliance on SFTs and other forms of short-term wholesale funding, whether the firm uses that funding to finance inventory or an SFT matched book.
- Option 2: Directly increase the relatively low charges under current and pending regulatory standards imposed on SFT matched books.
- Option 3: Introduce a system of numerical floors for SFT haircuts that can be applied on a market-wide basis regardless of the type of firm engaging in the SFTs.
Option 1: With respect to policy option 1, Governor Tarullo stated that the idea that seems most promising is to tie capital and liquidity standards together by requiring higher levels of capital for large firms that substantially rely on short-term wholesale funding.
- The short-term wholesale funding capital surcharge would be calculated by reference to a definition of short-term wholesale funding, such as total liabilities minus regulatory capital, insured deposits and obligations with a remaining maturity of greater than a specified term.
- There might be a kind of weighting system to take account of the specific risk characteristics of different forms of funding.
- The short-term wholesale funding capital surcharge would be added to the common equity capital requirements already mandated by the Basel III minimum capital, capital conservation buffer and G-SIB surcharge standards.
- In a departure from the existing capital framework, the short-term wholesale funding capital surcharge would be calculated by reference to the liability side, rather than the asset side, of the firm’s balance sheet.
- Governor Tarullo noted that the short-term wholesale funding capital surcharge would be consistent with, although distinct from, the long-term debt requirement that the Federal Reserve will be proposing to enhance the orderly resolution of large firms.
Option 2: Governor Tarullo stated that policy option 2 would be to address head-on the macroprudential concerns arising from large matched books of SFTs. It would either involve increasing capital charges applicable to SFTs or modifying liquidity standards so as to require firms with large amounts of SFTs to hold larger liquidity buffers or to maintain more stable funding structures.
- Governor Tarullo stated that it is not clear how much appetite there may be internationally for revisiting agreements that have been completed, such as the LCR and the Basel III capital standards.
- However, with the NSFR still under discussion, and with the Basel Committee in the process of reconsidering the standardized banking book risk weights and capital charges associated with trading book assets, Governor Tarullo believes there are opportunities to pursue these options.
- This echoes a November 2013 speech delivered by Federal Reserve Governor Jeremy C. Stein (discussed in this blog post), in which he 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 tri-party 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.
Option 3: Governor Tarullo observed that options 1 and 2, which involve imposing requirements on regulated financial intermediaries, do not address the risk of disintermediation. According, he believes options 1 and 2 should be supplemented by regulatory tools that can be applied on a market-wide basis.
- Minimum Haircut Floors for SFTs: Governor Tarullo discussed introducing a system of numerical floors for SFT haircuts would require any entity that wants to borrow against any security to post a minimum amount of excess margin that would vary depending on the asset class of the collateral.
- FSB’s Proposal for Minimum SFT Haircuts: Governor Tarullo noted that the Financial Stability Board’s proposed framework for minimum haircuts on SFTs (discussed in an earlier blog post) “has some significant limitations.” First, with respect to counterparty scope, the FSB’s proposal would apply only to SFTs in which regulated entities provide financing to unregulated entities; the proposal would not cover SFTs between a regulated lender and a regulated borrower, between an unregulated lender and a regulated borrower, or between an unregulated lender and an unregulated borrower. Second, the proposal would apply only to lending against collateral other than sovereign obligations. Finally, Governor Tarullo believes the FSB’s proposed numerical floors are set at relatively low levels, i.e., significantly below the haircuts that currently prevail in the tri-party repo market.
- Alternative to FSB’s Proposal: Governor Tarullo stated that an alternative to the FSB’s proposal would be to apply a system of minimum haircuts for SFTs regardless of the identity of the parties to the transaction. Such an approach would at least partially offset the incentive that will otherwise exist to move more securities financing activity away from regulated intermediaries. Regarding calibration, Governor Tarullo presented three approaches for setting the minimum haircuts above the backstop levels contemplated in the current FSB proposal: (1) base the minimum haircuts on current repo market haircuts; (2) set haircuts for a given asset class based on asset price volatility or haircut levels observed during times of stress or long-term periods that include times of stress; or (3) set haircuts at levels that are commensurate with the amount of capital a banking organization would need to hold against the security if it held the security in inventory.
- Alternative Transactional Structures: Governor Tarullo also noted that while universal margin requirements for SFTs address disintermediation concerns, such requirements might be circumvented through the use of alternative transactional structures. If margin requirements for cash SFT transactions are significantly higher than margin requirements for creating the same economic exposures using synthetic SFT transactions, a framework of minimum margins for SFTs could push market participants to rely more heavily on derivatives that are the functional equivalent of cash SFTs. Moreover, market participants might attempt to arbitrage margin floors through arrangements whereby the lender effectively lends the SFT borrower the minimum excess margin amount. Governor Tarullo believes these issues will need to be addressed as options for minimum margins are further developed.
Materials: Daniel K. Tarullo, Shadow Banking and Systemic Risk Regulation (Nov. 22, 2013) available here: http://www.federalreserve.gov/newsevents/speech/tarullo20131122a.pdf