Fed Governor Stein's speech on tri-party repo and fire sales: a primer on why the Fed cares so much

Fed Governor Jeremy Stein gave a fascinating speech at Friday’s FRB NY conference on Tri-party rep and fire sales. Entitled “The Fire-Sales Problem and Securities Financing Transactions”, it goes a long way toward revealing how the Fed is thinking about the issue and why they are not afraid to restructure tri-party repo (and with it probably the rest of the repo market).

We are going to divide this into two posts. The first will be on why Governor Stein is focused on fire sales (and its connection to securities financing trades) as well as the existing regulatory levers – risk-based capital, liquidity requirements, and leverage ratios – impact (or lack thereof) on fire sales.

The concern with fire sales – defined as “…a forced sale of an asset at a dislocated price…. assets sold in fire sales can trade at prices far below value in vest use, causing severe losses to sellers..” — is not driven by a desire to regulate broker/dealers. Dealers financing books can take care of themselves and have a variety of tools at their disposal to manage their risk. Ironically those risk management techniques – haircuts and margining in particular – may trigger the kind of risk the Fed wants to dampen as repo dealers (and cash lenders alike) liquidate the moment a counterparty defaults, sending securities cascading into the market.

Stein said,“…by itself, the existence of substantial price discounts in distressed sales…is not sufficient to make a case for regulatory intervention…” Rather, it’s the externalities that create all the issues. How will the lower prices that are the result of a fire sale in turn impact other markets and participants who may not have signed up for additional risk that comes when too much leverage creates system fragility? So the question is how to change the system in such a way to “…balance the social costs against the benefits that accompany SFTs; these benefits include both “money-like” services from the increased stock of near-riskless private assets, as well as enhanced liquidity in the market for the underlying collateral…”

Stein examined the “existing toolkit” and how they can be used or adapted to address fire sale risk. Those regulatory levers are risk-based capital, liquidity requirements, and the leverage ratio.

Risk-based capital is not a constraint in the repo world. (Aside:  see our August 7th post “Soberlook post on capital ratios and repo did they get it all right?”).

“…the Basel III risk-based capital rules allow banks and bank holding companies to use internal models to compute this capital charge for repo lending, and the resulting numbers are very small – for all practical purposes, close to zero – for overcollateralized lending transactions, with repo being the canonical example…

Stein isn’t saying this is bad policy; just that it isn’t there to address fire sales.

“…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…

Liquidity requirements (LCR): it depends on the specific circumstances. Stein gave an example of a dealer financing a corporate bond for less than 30 days. This would trigger the need to hold HLQA against it. Using the HLQA to generate liquidity will mean one less reason to ignite a fire sale. If the asset were a UST, there would be no need to hold HLQA (since the UST already is one). But for dealers running matched books, Stein said that LCR does not act as a constraint.

“…If a dealer borrows on a collateralized basis with repo and then turns around and lends the proceeds to a hedge fund in a similar fashion, the LCR deems the dealer to have no net liquidity exposure–and hence imposes no incremental liquidity requirement–so long as the lending side of the transaction has a maturity of less than 30 days….”

LCR protects banks from liquidity shocks, but does not mean those same shocks don’t impact other participants negatively – potentially triggering fire sales.

Addressing the leverage ratio, Stein said there was

“..A traditional view among regulators has been that the leverage ratio should be calibrated so as to serve as a meaningful “backstop” for risk-based capital requirements, but that under ordinary circumstances it should not actually be the binding constraint on firms. For if it were to bind, this would put us in a regime of completely un-risk-weighted capital requirements, where the effective capital charge for holding short-term Treasury securities would be the same as that for holding, say, risky corporate debt securities or loans…

But with the proposed increases to leverage ratios, the question is whether these ratios will, in fact, “bind” the banks. Securities financing is balance sheet intensive and “…it does increase the likelihood that the leverage ratio may bind for some of these firms at some times–particularly for those firms with a broker-dealer-intensive business model in which the ratio of total assets to risk-weighted assets tends to be higher…” and “…cause it to migrate in such a way as to be predominantly located in those firms that–because they have, say, a larger lending business and, hence, more risk-weighted assets–have more headroom under the leverage ratio constraint…”

That is a really interesting observation. How will regulatory change force evolution in business models? Will a bank like Wells Fargo, who has not traditionally been broker/dealer focused, seize the opportunity to bulk up on repo? The problem with this notion is that repo does not and should not exist in a vacuum. It needs the capabilities that come with being a major broker/dealer to make it work. Just think about a bank that has a big repo book but doesn’t have much market share in the trading of the underlying instruments. That’s a really bad idea, especially with less liquid collateral. And on the flip-side, can banks like, for example, Goldman Sachs, serve their clients without a major repo business in place? Not likely.

Tomorrow we will look at some of the possible responses from the regulators and how we think the market will react.

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