The most important systemic vulnerabilities that have not been subject to sufficient regulatory reforms are those created in short-term wholesale funding markets. In the recent financial crisis, severe repercussions were felt throughout the financial system as short-term wholesale lending against all but the very safest collateral froze up. Although short-term wholesale funding levels at major U.S. and foreign banking firms are lower than they were at the outset of the crisis, major global banks remain significant users. High levels of such funding increase the probability of severe funding problems at, and thus the failure of, major financial firms. They also complicate the orderly resolution of major financial firms in the event of failure.Indeed, precisely because an effective orderly resolution mechanism provides for continued funding of certain short-term creditors to staunch potentially calamitous runs, that type of funding will not be subject to the increased market discipline resulting from the creation of a credible resolution process. This fact only strengthens the case for measures to limit the potential of short-term wholesale funding to be an accelerant of systemic problems.

I'm not arguing that the very low risk-based charges on repo lending in Basel III are "wrong" in any microprudential sense. After all, they are designed to solve a different problem--that of ensuring bank solvency. And if a bank holding company's broker-dealer sub makes a repo loan of short maturity that is sufficiently well-collateralized, it may be at minimal risk of bearing any losses--precisely because it operates on the premise that it can dump the collateral and get out of town before things get too ugly. The risk-averse lenders in the triparty market--who, in turn, provide financing to the dealer--operate under the same premise. As I noted earlier, these defensive reactions by providers of repo finance mean that the costs of fire sales are likely to be felt elsewhere in the financial system.

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My aim here has been to survey the landscape--to give a sense of the possible tools that can be used to address the fire-sales problem in SFTs--without making any particularly pointed recommendations. I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments that I discussed: namely, capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements. As we go down this path, conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find singular and completely satisfactory fixes.

If industry is unable to play its role in achieving a holistic solution {to repo market reform}, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk.

The diversity of participants in the tri-party repo market has made it difficult to move forward quickly with a market solution that addresses the risk I have outlined. Industry leadership is absolutely critical to overcoming these challenges. If industry is unable to play its role in achieving a holistic solution, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk. While such an approach may indeed enhance the overall stability of this market, it could also lead to unintended consequences that include reducing the efficacy of the critical role played by this market in supporting the broader financial system.

In summary and conclusion, I would stress that MMMF reform is overdue. However, it is important that the reforms actually reduce the financial stability issues that remain under the current structure. Promising a fixed NAV with no capital while taking credit risk is not sustainable – especially in potential future crises where the response of the public sector will be substantially limited, compared to 2008. MMMF runs should not be allowed to once again impede the flow of stable funding within our financial system.

The SEC proposal to allow funds to impose liquidity fees and redemption gates should be dropped. This particular proposal is, in my view, worse than the status quo. It would only increase the risk of financial instability.

However, I strongly support requiring a floating NAV for all prime funds, both institutional and retail, which would treat these funds like other mutual funds. Investors who want a fixed NAV can keep their funds in government-only funds – and those should have the vast majority of their portfolios invested in cash and government securities.

Although the amounts of short-term wholesale funding have come down from their pre-crisis peaks, this structural vulnerability remains, particularly in funding channels that can be grouped under the heading of securities financing transactions (SFTs). The use of such funding surely has the potential to increase again during periods of rapid asset appreciation and ready access to leverage. While SFTs are an important and useful part of securities markets, without effective regulation they can create a large run risk, and thus can increase systemic problems that may develop in various asset and lending markets.

The risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. Capital charges are low because credit risk is low. The Liquidity Coverage Ratio (LCR), recently adopted by the Basel Committee and soon to be implemented in the United States through a proposed rulemaking, is an important step forward for financial regulation, since it will be the first broadly applicable quantitative liquidity requirement for banking firms. But it, too, has a principally microprudential focus, since it rests on the implicit premise that maturity-matched books at individual firms present relatively low risks.

While maturity mismatch by core intermediaries is a key financial stability risk in wholesale funding markets, it is not the only one. Even if an intermediary's book of securities' financing transactions is perfectly matched, a reduction in the intermediary's access to funding can force the firm to engage in asset fire sales or to abruptly withdraw credit from customers. The intermediary's customers are likely to be highly leveraged and maturity-transforming financial firms as well, and, therefore, may then have to engage in fire sales themselves. The direct and indirect contagion risks are high.

The dangers thus arise in the tail and apply to the entire financial market when normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A macroprudential regulatory measure should force some internalization by market actors of the systemic costs of this intermediation. As I have argued elsewhere, one or more such measures should be the highest priority in filling out reform agendas directed both at the largest institutions and at systemic risk more generally.25

One reason I place a high priority on initiatives to address the vulnerability created by short-term wholesale funding is that the development of these and other structural measures does not depend so heavily on identifying when credit growth or asset prices in one or more sectors of the economy have become unsustainable. Instead, an externality analysis can help identify the points of vulnerability and guide the fashioning of appropriate regulations. Indeed, what I described as structural policies may be better suited to containing certain kinds of risks than would policies requiring regular adjustment. Obviously, judgment will still be needed to determine the degree of constraint to be imposed on relevant activities of large banking organizations. But unlike real-time measures--where time will presumably be of the essence if those measures are to be effective--the adoption of structural constraints can proceed with the full opportunity for debate and public notice-and-comment that attends the rulemaking process.

Fed. Gov. Daniel K. Tarullo said in testimony July 11 that the difference in treatment for insurers may come on the liability side. With a bank, there can be a rapid liquidation but insurance is very different, Tarullo said. There is no way to accelerate funding, he noted, referencing life insurance company payouts.

“People aren’t going to die more quickly if an insurance company is in trouble,” Tarullo said last week to demonstrate the limits of life insurance liquidations.

“With that constraint, we are working as much as we can in tailoring risk-weighting for insurance products but are a little confined here,” he said, adding to lawmakers' fears that the Fed’s hands are indeed tied for special insurance treatment.

“I think this does impose some difficulty for our oversight,” Bernanke said today of the Collins Amendment.

A major source of unaddressed risk emanates from the large volume of short-term securities financing transactions (SFTs)--repos, reverse repos, securities borrowing and lending transactions, and margin loans--engaged in by broker-dealers, money market funds, hedge funds, and other shadow banks. Regulatory reform mostly passed over these transactions, I suspect, because SFTs appear safe from a microprudential perspective. But SFTs, particularly large matched books of SFTs, create sizable macroprudential risks, including large negative externalities from dealer defaults and from asset fire sales. The existing bank and broker-dealer regulatory regimes have not been designed to materially mitigate these systemic risks. The global regulatory community should focus significant amounts of energy, now, to attack this problem. The perfect solution may not yet be clear but possible options are evident: raising bank and broker-dealer capital or liquidity requirements on SFTs, or imposing minimum margin requirements on some or all SFTs.

[I]t is reasonable to ask whether systemic risks can in fact be reliably identified in advance... To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises

Stress-testing techniques can also be used in more-focused assessments of the banking sector's vulnerability to specific risks not captured in the main scenario, such as liquidity risk or interest rate risk. Like comprehensive stress tests, such focused exercises are an important element of our supervision of SIFIs. For example, supervisors are collecting detailed data on liquidity that help them compare firms' susceptibilities to various types of funding stresses and to evaluate firms' strategies for managing their liquidity. 

I think most of us would acknowledge, upon reflection, that a good bit has been done, or at least put in motion, to counteract the problems of too-big-to-fail and systemic risk more generally. At the same time, I believe that more is needed, particularly in addressing the risks posed by short-term wholesale funding markets. 

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As you can tell from my description, many of these reforms are still being refined or are still in the process of implementation. The rather deliberate pace--occasioned as it is by the rather complicated domestic and international decisionmaking processes--may be obscuring the significance of what will be far-reaching change in the regulation of financial firms and markets. Indeed, even without full implementation of all the new regulations, the Federal Reserve has already used its stress-test and capital-planning exercises to prompt a doubling in the last four years of the common equity capital of the nation's 18 largest bank holding companies, which hold more than 70 percent of the total assets of all U.S. bank holding companies. The weighted tier 1 common equity ratio, which compares high-quality capital to risk-weighted assets, of these 18 firms rose from 5.6 percent at the end of 2008 to 11.3 percent in the fourth quarter of 2012, reflecting an increase in tier 1 common equity from $393 billion to $792 billion during the same period.

At a conceptual level, the policy goal is fairly easy to state: a regulatory charge or other measure that applies more or less comprehensively to all uses of short-term wholesale funding, without regard to the form of the transactions or whether the borrower was a prudentially regulated institution. The aspiration to comprehensiveness is important for two reasons. First, the risks associated with short-term funding are as much or more macroprudential as they are firm-specific. From a microprudential perspective, SFTs are low risk, because the borrowing is short-dated, overcollateralized, marked-to-market daily, and subject to remargining requirements. The dangers arise in the tail and apply to the entire financial market when the normally safe, short-term lending contracts dramatically in the face of sudden and significant uncertainty about asset values and the condition of counterparties. A regulatory measure should force some internalization by market actors of the systemic costs of this intermediation.

Second, to the degree that regulatory measures apply only to some types of wholesale funding, or only to that used by prudentially regulated entities, there will be a growing risk of regulatory arbitrage. Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.

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[A]s a starting point, we would do well to consider measures that apply broadly. One option is to change minimum requirements for capital, liquidity, or both at all regulated firms so as to realize a macroprudential, as well as microprudential, purpose. In their current form, existing and planned liquidity requirements produced by the Basel Committee aim mostly to encourage maturity-matched books...

Similarly, existing bank and broker-dealer risk-based capital rules do not reflect fully the financial stability risks associated with SFTs. Accordingly, higher, generally applicable capital charge applied to SFTs might be a useful piece of a complementary set of macroprudential measures, though an indirect measure like a capital charge might have to be quite large to create adequate incentive to temper the use of short-term wholesale funding.

By definition, both liquidity and capital requirements would be limited to banking entities already within the perimeter of prudential regulation. The obvious questions are whether these firms at present occupy enough of the wholesale funding markets that standards applicable only to them would be reasonably effective in addressing systemic risk and, even if that question is answered affirmatively, whether the imposition of such standards would soon lead to significant arbitrage through increased participation by those outside the regulatory circle.

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As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain.

Today, although some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared, non-deposit short-term funding remains significant. In some instances it involves prudentially regulated firms, directly or indirectly. In others it does not. The key condition of the so-called "shadow banking system" that makes it of systemic concern is its susceptibility to destabilizing funding runs, something that is more likely when the recipients of the short-term funding are highly leveraged, engage in substantial maturity transformation, or both…

First, the regulatory and public transparency of shadow banking markets, especially securities financing transactions, should be increased. Second, additional measures should be taken to reduce the risk of runs on money market mutual funds. The Council recently proposed a set of serious reform options to address the structural vulnerabilities in money market mutual funds.

Third, we should continue to push the private sector to reduce the risks in the settlement process for tri-party repurchase agreements. Although an industry-led task force made some progress on these issues, the Federal Reserve concluded that important problems were not likely to be successfully addressed in this process and has been using supervisory authority over the past year to press for further and faster action by the clearing banks and the dealer affiliates of bank holding companies.

Let me be clear. We must deal with the fire sale issue in tri-party repo and the heightened run risk it creates. I believe there are three potential ways forward, all of which are superior to the status quo. First, tri-party repo transactions could be restricted to open market operations (OMO) eligible collateral… Thus, one could construct an effective lender of last resort backstop for an OMO-eligible- only tri-party repo system.

However, there are also some significant disadvantages to such an approach. The less liquid collateral could just migrate to be financed elsewhere, with associated run and fire sale risks… [T]his approach would do little to mitigate the risk of fire sales of a defaulted dealer’s collateral by its investors once a dealer is bankrupt.

The second option is to have a mechanism or process to facilitate the orderly liquidation of a defaulted dealer’s collateral. One could imagine a mechanism that was funded by tri-party repo market participants and potentially backstopped by the central bank…

Because no single market participant has a strong incentive to develop such a mechanism, however, sustained regulatory pressure may be required to reach such a solution. From the perspective of the tri-party repo borrowers and investors, the status quo undoubtedly is viewed as superior because neither group is forced to fully bear the externalities associated with their actions. Instead they anticipate that emergency liquidity would be made available in the event of a future systemic crisis.

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. For example, the use of tri-party repo could be restricted unless borrowers demonstrated that there was an adequate means of orderly collateral liquidation upon the failure of a major dealer.

In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

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Sixth, we could make structural changes to the financial system to make it more stable in terms of liquidity provision. For example, consider the three structural issues outlined earlier that amplified the crisis—tri-party repo, collateral requirements tied to credit ratings, and haircut spirals. In the case of tri-party repo, the amplifying dynamics could be reduced by enforcing standards that limited the scope of eligible collateral or required more conservative haircuts. Formal loss-sharing arrangements among tri-party repo borrowers, investors, and clearing banks might reduce or eliminate any advantage that might stem from running early. Eliminating the market’s reliance on intraday credit provided by clearing banks could eliminate the tension between the interests of clearing banks and investors when a dealer becomes troubled. In the case of collateral requirements, collateral haircuts could be required to be independent of ratings.

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.