Vice Chairman Stanley Fischer
At the “Financial Stability: Policy Analysis and Data Needs” 2015 Financial Stability Conference sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research, Washington, D.C.
December 3, 2015
Financial Stability and Shadow Banks: What We Don’t Know Could Hurt Us
A Closer Look at Shadow Banking
Still, our view of developments at nonbank firms that have traditionally relied on high leverage and short-term wholesale funding and were at the center of the financial crisis–the shadow banking sector–remains incomplete.6
One source of information about leverage at nonbanks is the Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS), which the Federal Reserve initiated after the crisis. The SCOOS provides information about the availability and terms of credit in securities financing and over-the-counter derivatives markets–for example, on credit granted by dealers to counterparties such as hedge funds or insurers to finance investments in securities like commercial mortgage-backed securities or corporate bonds. In recent years, the SCOOS has suggested relatively stable use of leverage across hedge funds and other counterparties–but this qualitative assessment provides only a high level, and very partial, view.7
An important risk factor during the mid-2000s was the growth in securitization and the creation of so-called high quality collateral. Currently, the volume of securitization is far below mid-2000s levels, with much of the decline reflecting the collapse in private residential mortgage-backed securities. Further, the low level of activity probably understates the improvement in risk, as pre-crisis securitization was highly reliant on short-term wholesale funding through vehicles such as asset-backed commercial paper programs to finance the highest-rated tranches.
More generally, wholesale short-term liabilities have declined across the board. For example, the gross volume of repos (repurchase agreements) fell from its peak of nearly $5 trillion in early 2008 to about $3 trillion by early 2009, while total assets of money market mutual funds contracted from approximately $3.75 trillion at the end of 2008 to about $2.5 trillion in recent years.8 The decline in the volume of repos is part of a more general pullback from risk among broker-dealers and their clients, and dealer balance sheets are much smaller, on balance, than pre-crisis.
Some, perhaps even the lion’s share, of the retreat in securitization, money market mutual fund shares, and repos is probably due to investors’ memory of the financial crisis. Institutions and individuals burned by runs and losses from fire sale conditions have, at least for the time being, adopted a more prudent stance. But structural changes have also played a role. The largest broker-dealers are now part of bank holding companies and are therefore subject to consolidated supervision by the Federal Reserve, which includes regular stress-testing and tighter capital and liquidity requirements. The new liquidity rules for large banks and the capital surcharge for systemically important banks discourage reliance on short-term wholesale funding. And the ability of banks to provide support to structured investment vehicles has been substantially curtailed through both restrictions on the accounting treatment of formerly off-balance-sheet exposures and more stringent capital requirements, including the supplementary leverage ratio applying to on-balance-sheet assets and off-balance-sheet exposures.
Indeed, some have asked whether the reduction in broker-dealer activities has gone too far, citing heightened concerns over a possible shortage of bond market liquidity as one example of potentially negative consequences. Most measures of market liquidity in Treasury and corporate bond markets have not shown signs of a deterioration in market functioning in recent years. There are certainly concerns that bond market liquidity may not be as robust as in the past, which could lead to sharper-than-anticipated price movements–of which the bond market events in mid-October 2014 are often cited as an example. However, a review of the evidence does not point clearly to a significant role for the reduction in broker-dealer balance sheets or regulatory changes as being responsible for any shifts in liquidity.9 Other structural factors, such as the long-term trends toward higher participation of high-frequency trading firms in Treasury markets and greater disclosure of corporate bond trades, have been important.
In my view, the reduction in leverage and maturity transformation associated with better regulations leaves the financial system much more resilient–even if such regulations have modestly affected market liquidity.