This is the 2nd post on Fed Governor Jeremy Stein’s important speech at the Oct. 4th New York Fed workshop on fire sales and tri-party repo, “The Fire-Sales Problem and Securities Financing Transactions” In this post we focus on some of the regulatory controls Stein considered might be placed on tri-party repo.
In yesterday’s post, Fed Governor Stein looked at the existing regulatory levers placed on the banking system: risk-based capital, liquidity requirements and the leverage ratio. The conclusion was that these regulations were designed to solve different problems – not mitigate fire sale risk. That is not to say that these rules don’t impact the securities financing business – just ask any repo trader about LCR. But the regulations don’t address the externalities; those knock-on effects to other market participants who can be hurt through no effort of their own.
Stein said,
“…To summarize the discussion thus far, the mainstays of our existing regulatory toolkit–risk-based capital, liquidity, and leverage requirements–have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by SFTs. The liquidity coverage ratio affects a subset of SFTs in which a dealer firm acts as a principal to fund its own inventory of securities positions, but does not meaningfully touch those in which it acts as an intermediary. By contrast, an aggressively calibrated leverage ratio could potentially impose a significant tax on a wider range of SFTs, but the tax would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom the leverage ratio constraint was more binding than the risk-based capital constraint. As such, it would be more likely to induce regulatory arbitrage than to rein in overall SFT activity…”
So what might be up the Fed’s sleeve then? One might be capital surcharges. Stein said, “… Depending on how these surcharges are structured, they could act in part as a tax on both the dealer-as-principal and dealer-as-intermediary types of SFTs. Accomplishing the latter would require a capital surcharge based on something like the aggregate size of the dealer’s matched repo book..” and “… 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…”
Stein noted that this approach would be a departure from the way capital is typically used to make a firm safer. The cost of the incremental capital would be expected to be passed along from the broker/dealer to the downstream customer. “…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…”
Raising the cost of capital specifically on SFT books will increase friction in the market, raising costs. But we are left scratching our heads wondering exactly how this would somehow reduce fire sale risk. If the objective was to reduce the size of repo books (along with market liquidity), this will certainly do the trick. But will it change anyone’s behavior when the market is under extreme stress? Not sure about that. Also, as Stein noted, when you impose a tax on intermediaries, you get disintermediation – the trades simply go to where there is no tax.
Minimum haircuts: while the FSB recently suggested minimum haircuts on SFTs, it was limited to trades between banks and non-regulated actors and then only on non-government collateral. And the proposed haircuts were very low. (See our Sept 4th post “More on the FSB report on securities lending and repo”). Stein seems to prefer something universally applied to all trades. For minimum haircuts to prevent fire sales, they would have to be high enough to give comfort to the cash lender that they can wait for the market to revert to fair value. For some collateral, that process happens very quickly. For others – sub-prime mortgage securitization comes to mind – it can take a lot longer and the appropriate haircuts will be very high (think 50% IMHO). The result will be substantial penalties on risk paper and mean less liquidity in those markets. These rules would need to apply to all securities financing markets (including sec lending), not just tri-party trading. Post-crisis regulation has focused on how to get participants to put more skin in the game, lowering leverage and educing exposure to shocks. Mandatory high haircuts at the broker/dealers level will accomplish this as long as the higher haircuts are passed down to clients — and we think they would. We could see a market where these kinds of rules do dampen fire sale risk, but the devil is in the details.