While I favor assessment of the specific risks and costs associated with a particular form of nonbank intermediation, I also believe that the greatest risks to financial stability are the funding runs and asset fire sales associated with reliance on short-term wholesale funding, and thus I place particular emphasis on this factor. If there is one lesson to be drawn from the financial crisis, it is that the rapid withdrawal of funding by short-term credit providers can lead to systemic problems as consequential as those associated with classic runs on traditional banks

The financial turbulence of 2008 was largely defined by the dangers of runs--realized, incipient, and feared.... In the first instance, at least, this was a liquidity crisis. Its fast-moving dynamic was very different from that of the savings and loan crisis or the Latin American debt crisis of the 1980s. The phenomenon of runs instead recalled a more distant banking crisis--that of the 1930s.

Despite this defining characteristic of the last crisis, measures to regulate liquidity have by-and-large lagged other regulatory reforms, for at least two reasons. First, prior to the crisis there was very little use of quantitative liquidity regulation and thus little experience on which to draw... A second reason liquidity regulation has followed other reforms is that judicious liquidity regulation both complements, and is dependent upon, other important financial policies--notably capital regulation, resolution procedures, and lender-of-last-resort (LOLR) practice. Work on liquidity regulations has both built on reforms in these other areas and occasioned some consideration of the interaction among these various policies.

But while perhaps a bit drawn out, the work has proceeded. A final version of a Liquidity Coverage Ratio (LCR) was agreed internationally and has been adopted by regulation in the United States. The Basel Committee's recently announced final Net Stable Funding Ratio (NSFR) is another significant milestone in building out a program of liquidity regulation.

[W]e believe that more needs to be done to guard against short-term wholesale funding risks. While the total amount of short-term wholesale funding is lower today than immediately before the crisis, volumes are still large relative to the size of the financial system. Furthermore, some of the factors that account for the reduction in short-term wholesale funding volumes, such as the unusually flat yield curve environment and lingering risk aversion from the crisis, are likely to prove transitory.

Federal Reserve staff is currently working on three sets of initiatives to address residual short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. GSIBs. The second involves proposed modifications to the BCBS's net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants. The third is numerical floors for collateral haircuts in securities financing transactions (SFTs)--including repos and reverse repos, securities lending and borrowing, and securities margin lending.

Federal Reserve staff is currently working on three sets of initiatives to address residual short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. GSIBs. The second involves proposed modifications to the BCBS's net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants. The third is numerical floors for collateral haircuts in securities financing transactions (SFTs)--including repos and reverse repos, securities lending and borrowing, and securities margin lending.

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.

Short-term funding of longer-term assets is inherently unstable, especially in the presence of information and coordination problems.

Additional measures should be taken to address residual risks in the short-term wholesale funding markets. Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex organizations. Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis. To the extent that minimum margin requirements lead to more conservative margin levels during normal and exuberant times, they could help avoid potentially destabilizing procyclical margin increases in short-term wholesale funding markets during times of stress.

While the LCR and NSFR are important steps forward, they do not fully address the financial stability concerns associated with short-term wholesale funding. These standards tend to focus on the liquidity positions of firms taken in isolation, rather than on the financial system as a whole. They only apply to internationally active banks, and not directly to shadow banks, despite the fact that liquidity shocks within the shadow banking system played a major role in the crisis. Furthermore, the current versions of the LCR and NSFR do not address financial stability risks associated with so-called matched books of securities financing transactions.
Federal Reserve staff are actively considering additional measures that could address these and other residual risks in the short-term wholesale funding markets. Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex banking organizations. Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis. In designing such measures, we are carefully thinking through questions about the tradeoffs associated with tighter liquidity regulation that will be discussed at this conference.

Still, we have yet to address head-on the financial stability risks from securities financing transactions and other forms of short-term wholesale funding that lie at the heart of shadow banking. There are two fundamental goals that policy should be designed to achieve. The first is to address the specific financial stability risks posed by the use of large amounts of short-term wholesale funding by the largest, most complex banking organizations. The second is to respond to the more general macroprudential concerns raised by short-term collateralized borrowing arrangements throughout the financial system.

This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century.

The similarities between deposit runs and short-term wholesale funding runs have suggested to some that the policy responses should also be similar. Those taking this position argue for providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale funding, or both. Others, myself included, are wary of any such extension of the government safety net and would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding. Unlike deposit insurance, the savings of most U.S. households are generally not directly at risk in short-term wholesale funding arrangements. And, also unlike insured deposits, there is an argument in the short-term wholesale funding context that counterparties should be capable of providing some market discipline in at least some of the contexts in which such funding is provided.

Similarly, the LCR and, at least at this stage of its development, the Net Stable Funding Ratio (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. Thus, reverse repos and other SFT assets generally are treated as completely liquid instruments. Under the initial 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. Again, this may be a reasonable position from a microprudential perspective, geared toward more or less normal times. But here is where we need an explicitly macroprudential perspective that forces firms to internalize the tail-event financial stability risks associated with SFT matched books.

Among the first set of options, 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 additional capital requirement 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 capital requirement would then be added to the Tier 1 common equity requirement already mandated by the minimum capital, capital conservation buffer, and globally systemic bank surcharge standards. However, this component of the Tier 1 common equity requirement would be calculated by reference to the liability side, rather than the asset side, of the firm's balance sheet.

It does not seem far-fetched to think that, with time and sufficient economic incentive, the financial, technological, and regulatory barriers to the disintermediation of prudentially regulated dealers could be overcome. Indeed, there have already been reports of some hedge funds exploring the possibility of disintermediating dealers by lending cash against securities collateral to other market participants.


For this reason, there is a need to supplement prudential bank regulation with a third set of policy options in the form of regulatory tools that can be applied on a market-wide basis. That is, regulation would focus on particular kinds of transactions, rather than just the nature of the firm engaging in the transactions. To date, over-the-counter derivatives reform is the primary example of a post-crisis effort at market-wide regulation.5 Given that the 2007–2008 financial crisis was driven more by disruptions in the SFT markets than by disruptions in the over-the-counter derivative markets, comparable attention to SFT markets is surely needed. Over the past two years, the Financial Stability Board (FSB) has been evaluating proposals for a system of haircuts and margin requirements for SFTs. In its broadest form, 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. Like minimum margin requirements for derivatives, numerical floors for SFT haircuts would be intended to serve as a mechanism for limiting the build up of leverage at the security level, and could mitigate the risk of procyclical margin calls.

Governor Tarullo alluded to the possibility of liquidity-linked capital surcharges that would effectively augment the existing regime of risk-based capital requirements.12 Depending on how these surcharges are structured… {they might come} quite close to the Pigouvian notion of directly taxing this specific activity. As compared to relying on the leverage ratio to implement the tax, this approach has the advantage that it is more likely to treat institutions uniformly: the tax on SFTs would not be a function of the overall business model of a given firm, but rather just the characteristics of its SFT book. This is because the surcharge is embedded into the existing risk-based capital regime, which should in principle be the constraint that binds for most firms.
There are a couple of important qualifications, however. First, going this route would involve a significant conceptual departure from the notion of capital as a prudential requirement at the firm level. As noted previously, a large matched repo book may entail relatively little solvency or liquidity risk for the broker-dealer firm that intermediates this market. So, to the extent that one imposes a capital surcharge on the broker-dealer, one would be doing so with the express intention of creating a tax that is passed on to the downstream borrower (i.e., to the hedge fund, in my example).
Second, and a direct corollary of the first, imposing the tax at the level of the intermediary naturally raises the question of disintermediation. In other words, might the SFT market respond to the tax by evolving so that large hedge funds are more readily able to borrow via repo directly from money market funds and securities lenders, without having to go through broker-dealers? I can't say that I have a good understanding of the institutional factors that might facilitate or impede such an evolution. But if the market ultimately does evolve in this way, it would be hard to argue that the underlying fire-sales problem has been addressed.