Perhaps the most direct way to reduce runs related to unstable funding is to require financial organizations dependent on unstable funding to hold significantly more capital than they would if they used stable sources of funding…  To reduce run risk, a larger share of long-term subordinated debt could also be utilized to finance securities positions. Long-term financing reduces the need for short-term and more “runnable” funding. While some broker-dealers have utilized long-term financing to reduce run risks, paradoxically, other broker-dealers have been reducing their use of more stable sources of financing.

Another way to minimize run risks would be to limit the amount of maturity transformation that can be done with repurchase agreements specifically. This would call for limiting the extent to which short-term repurchase agreements held by regulated financial intermediaries could be used to finance long-term assets or high-credit-risk assets. Alternatively, institutional investors such as money market mutual funds could, with new regulation, be prohibited from holding repurchase agreements secured by collateral that they, by rule, could not purchase.

Other remedies are possible and should be explored … One would be regulation that specifies eligible collateral for a repurchase agreement and that mandates the “haircut.” Another approach could be focused on accounting treatment – for example, perhaps repurchase agreements collateralized with less-liquid collateral should not count as a “cash and cash equivalent” to the investor.

…

Allow me to mention one other possibility – a complex and likely controversial one, to be sure. In my view, the Federal Reserve’s Discount Window could theoretically provide a way of reducing liquidity risk, by providing a standing liquidity facility for broker-dealers like the primary dealer facility that was established during the financial crisis. The rationale for such a step would be rooted in the notion that market-making is as important as lending in today’s economy.

However, I realize that such an outcome seems unlikely. And at any rate a number of other steps I have mentioned – such as a significant re-evaluation of broker-dealer regulatory requirements and, particularly, much-higher solvency standards that would reduce the risk of runs – would seem to be prerequisites for such a path.

...

In sum, given the widespread support provided to broker-dealers and the difficulties they encountered during the crisis, a comprehensive re-evaluation of broker-dealer regulation is
overdue.

During the crisis, this market became less stable. As the financial condition of some of the major securities dealers worsened, the clearing banks became more reluctant to return the cash that the triparty repo investors had invested the prior evening. The clearing banks were worried that if a dealer were to fail, they could be stuck with a large obligation. The nervousness of the clearing banks, in turn, spilled back to the investors. If there is some chance that I might not get my cash back and instead be stuck with the collateral, do I really want to make the loan in the first place? The Primary Dealer Credit Facility essentially broke this dynamic by putting the Federal Reserve in the position of lender of last resort in the triparty repo system.

Attempts to organize a consortium of private firms to purchase or recapitalize Lehman were unsuccessful. With respect to public-sector solutions, we determined that either facilitating a sale of Lehman or maintaining the company as a free-standing entity would have required a very sizable injection of public funds--much larger than in the case of Bear Stearns--and would have involved the assumption by taxpayers of billions of dollars of expected losses. Even if assuming these costs could be justified on public policy grounds, neither the Treasury nor the Federal Reserve had the authority to commit public money in that way; in particular, the Federal Reserve's loans must be sufficiently secured to provide reasonable assurance that the loan will be fully repaid. Such collateral was not available in this case. Recognizing that Lehman's potential failure posed risks to market functioning, the Federal Reserve sought to cushion the effects by implementing a number of measures, including substantially broadening the collateral accepted by the Fed's Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF) to ensure that the remaining primary dealers would have uninterrupted access to funding.

The PDCF and the TSLF were created under the Federal Reserve's emergency lending powers, with the term of the PDCF set for a period of at least six months, through mid-September. The Federal Reserve is strongly committed to supporting the stability and improved functioning of the financial system. We are currently monitoring developments in financial markets closely and considering several options, including extending the duration of our facilities for primary dealers beyond year-end, should the current unusual and exigent circumstances continue to prevail in dealer funding markets.

The Committee on Banking, Housing and Urban Affairs…raised serious concerns about certain actions you have taken.  Specifically, it was noted that Congress has neither granted the Federal Reserve the authority to permanently open the discount window to investment banks with primary dealer status, nor authorized the SEC’s Consolidated Supervised Entities (“CSE”) program through which it regulates investment bank holding companies that own depository institutions.

 
Given the limited authority of the Fed and the SEC to regulate investment banks with primary dealer status, and Congress’s ultimate responsibility for formulating financial regulatory policy, we ask that no action regarding implementation of the MOU be taken before we can determine that it is in the best interests of our nation’s economy and the well being of its citizens.  While we recognize that oversight of investment banks with primary dealer status is temporarily necessary for the proper implementation of the PDCF, it is Congress’s role to determine if and how any alterations to our financial regulatory system should be undertaken.

(Co-signed by Sen. Shelby)

Broadly speaking, we believe that primary dealers are strengthening liquidity and capital positions to better protect themselves against extreme events. We also believe their management has learned some valuable lessons from the events of the recent financial turmoil that should translate into better risk management. We continue to monitor the effect of the PDCF and are studying a range of options going forward.

So how are these facilities supposed to work? What’s the theory? The notion is that the auction facilities should be the main means by which the Fed provides liquidity support to depository institutions and primary dealers. The PCF and PDCF are standby facilities designed to provide reassurance to market participants that sound depository institutions and primary dealers have access to backstop sources of liquidity. But the actual amount of funds advanced through these facilities is likely to be limited in most circumstances.

The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort. This helps to reassure the two triparty repo clearing banks and the triparty repo investors that the primary dealers will be able to obtain funding. This bolsters confidence in the triparty repo system and reduces the risk of the type of funding run that led to Bear Stearns’ illiquidity crisis.

The auction facilities have several advantages relative to the backstop facilities. First, they are dynamic—the results shift from auction to auction. The information obtained through the auction process facilities price discovery and helps policymakers assess market conditions and sentiment. Second, the auctions appear to have less stigma than the backstop facilities. Stigma is the word used to describe the unwillingness to use a liquidity facility because of fears that such use could send an adverse signal about the health and viability of the borrower.

For the auction facilities, stigma is very low for several reasons. First, many participants participate in the auctions. This provides cover against the potential for an adverse signal from participation. Second, the auctions are conducted for settlement on a forward basis. For example, in the TAF auction, the bidding takes place on Monday and settlement on Thursday. This time lag makes it clear that participants are not bidding because they need immediate funds and are having serious liquidity problems.

So how have the facilities performed in practice? As designed, most of the dollars have been disbursed via the auction facilities, the FX swaps, and the single-tranche OMOs, rather than via the backstop facilities.