Renewing his call for reform of the wholesale funding markets, New York Federal Reserve Bank President William Dudley warned Friday that ignoring continuing "vulnerabilities" in the tri-party repo and money market mutual fund markets would risk further instability.
Dudley said a number of steps have been taken to lessen the risk of "runs" and "fire sales" in these markets, much more needs to be done.
He offered a number of options for correcting flaws in both the tri-party repo market and money market funds, but suggested even those reforms might not be enough to ward off future crises in remarks prepared for the New York Bankers Association.
A fresh look at the entire "architecture" of the U.S. financial system, with an eye to bolstering it against banks and non-banks' heavy reliance on short-term wholesale funding, is needed, according to Dudley. One of his options, requiring legislation and increased regulation, would be to expand the Fed's role in "backstopping" financial intermediation.
Dudley, who is vice chairman of the Federal Reserve's policymaking Federal Open Market Committee, did not talk about monetary policy two days after the FOMC left in place an aggressively stimulative credit stance.
Prior to the financial crisis, interbank lending had become less prominent as a source of funding on Wall Street, as financial institutions became increasingly reliant on borrowing in the so-called tri-party repo market, in which a clearing bank is involved in facilitating settlement between a lending firm and a borrowing firm. Firms also issued large amounts of asset-backed commercial paper, much of it bought by money market mutual funds, to finance mortgage backed securities in particular.
As the housing bubble burst more than five years ago, firms that had borrowed short-term in these markets, found themselves unable to roll over their loans as worried creditor "ran" from the markets, leading to rampant liquidity and dumping of assets in "fire sales."
The Fed responded with a host of emergency facilities, including the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), the Asset-Backed Commercial Paper Money Market Fund Liquidation Facility (AMLF), the Commercial Paper Funding Facility (CPFF) and the Term Asset-Backed Lending Facility (TALF).
But those facilities "were an emergency response, not a sustainable, long-term solution," said Dudley, who said the fundamental problem is that "short-term funding of longer-term assets is inherently unstable."
In the tri-party repo market, he recalled, clearing banks which had provided intraday credit to securities firms to facilitate their daily "unwind" of the prior day's transactions, "became uncomfortable with their large intraday exposures to their tri-party securities firm customers." Repo investors in turn became unnerved, not wanting to get stick with the dealer's collateral.
Meanwhile, investors in money market funds became distrustful of the commercial paper in which the funds were investing and pulled their money out.
Since the crisis, Dudley said "a number of steps have been taken that reduce the vulnerability of the system to funding runs in short-term wholesale markets."
He cited increased capital and liquidity requirements for large complex financial institutions under the Dodd-Frank legislation, higher risk-weighted capital standards under the Basel 3 international banking accord and the New York Fed's own efforts to "make the tri-party repo system more resilient to stress."
The New York Fed has pressed the two large clearing banks to make changes to their settlement processes that "will diminish their own intraday exposure and enable the market to operate with much less reliance on intraday credit," said Dudley, adding that intraday credit extensions by clearing banks have declined from 100% before November 2012 to about 80% and are due to fall to 10% by the end of next year.
Dudley also noted that the Securities Exchange Commission tightened the liquidity requirements and concentration limit rules for 2a-7 money market mutual funds and increased the fund manager disclosure requirements.
But he said the SEC rules, while they "make money funds somewhat less risky, ... do little to reduce investors' incentives to run at the first sign of trouble."
More broadly, Dudley said, "Worthwhile as the steps taken thus far are, we have not come close to fixing all the institutional flaws in our wholesale funding markets. The tri-party repo system and the money fund industry that plays a crucial role financing collateral through it are both still exposed to runs."
"In fact, in each of these areas, one could argue that the risks have increased compared to prior to the crisis," he said, "because the Dodd-Frank Act raised the hurdle for the Federal Reserve to exercise its Section 13.3 emergency lending authority and because Congress has explicitly precluded the U.S. Treasury from guaranteeing money market mutual fund assets in the future."
"With extraordinary interventions ruled out or made much more difficult, this may cause investors to be even more skittish in the future," he added.
And so Dudley said additional measures are "essential to make the system more stable."
He said "there is still considerable work to do" in reforming tri-party repos.
"In particular, the risk that investors will run at the first sign of trouble persists," he said. "That is because the costs of running are very low relative to the potential costs of staying put. The potential costs of staying are elevated in part because investors often don't have the capacity to take possession of the collateral or liquidate the collateral in an orderly way should a large dealer fail."
Dudley emphasized, "We must deal with the fire sale issue in tri-party repo and the heightened run risk it creates."
One approach would be to restrict tri-party repo transactions to collateral eligible for open market operations, but Dudley said that would have "some significant disadvantages."
Another option would be the creation of "a mechanism or process to facilitate the orderly liquidation of a defaulted dealer's collateral," but he said it would take "sustained regulatory pressure" to get participants to set up such a facility.
"Third, if borrowers and investors did not embrace an orderly collateral liquidation mechanism, supervisory oversight could be brought to bear to limit the use of tri-party repo funding on the grounds that it is still an unstable source of funds," Dudley suggested.
The New York Fed chief also said curbing incentives for money market funds investors to run "is essential for financial stability."
He said his favored approach is not to move to a floating net asset value for money market fund shares, but to retain a stable ($1 per share) NAV, while adding a new NAV buffer and a minimum balance requirement. The minimum balance would be at risk for 30 days following withdrawals.
"If the fund subsequently 'broke the buck' during this period by suffering losses greater than the size of its NAV buffer, the minimum balance would be first in line to absorb these losses, he explained.
After presenting these recommendations, Dudley addressed a "larger question."
"Reforming the tri-party repo system and the money market mutual fund industry is essential and would make the financial system significantly more stable," he said. "But even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop."
"We need to consider whether our current architecture is satisfactory," he said, suggesting two broad paths.
"The first option would be to take steps to curtail the extent of short-term wholesale finance in the system," he said, with regulators taking steps to "directly limit the use of short-term wholesale funding to finance longer-term assets" and taking "actions that reduced the amount of maturity transformation associated with securitization markets."
Dudley's second alternative would be to "expand the range of financial intermediation activity that is directly backstopped by the central bank's lender of last resort function."
The Fed's original primary function was to act as "lender of last resort" by providing needed credit to banks through its discount window -- a function it continues to perform, but Dudley said the time may have come to expand it beyond banks.
"We have banking activity -- maturity transformation -- taking place today outside commercial banks," he said. "If we believe these activities provide essential credit intermediation services to the real economy that could not be easily replaced by other forms of intermediation, then the same logic that leads us to backstop commercial banking with a lender of last resort might lead us to backstop the banking activity taking place in the markets in a similar way."
"However, any expansion of access to a lender of last resort would require legislation and it would be essential to have the right quid pro quo - the commensurate expansion in the scope of prudential oversight," Dudley said.
He acknowledged that this would involve some "thorny issues. For example, who would have access and on what terms and conditions? How would foreign-owned broker-dealers be treated? Would an insurance-type payment be appropriate for firms that enjoyed lender of last resort access but did not have insured deposits? How would the Fed's role, as the lender of last resort, be coordinated with the oversight responsibilities of the primary regulators?"
Whatever the complications, Dudley stressed that "the sheer size of banking functions undertaken outside commercial banking entities ... suggests that this issue must not be ignored."
"I don't think we should be comfortable with a situation in which extensive maturity transformation continues to take place without the appropriate safeguards against runs and fire sales," he continued. "Pretending the problem does not exist, or dealing with it only ex post through emergency facilities cannot be consistent with our financial stability objectives."
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