Tarullo: short-term funding the next great unsolved challenge

It all comes down to liquidation risk. The Fed’s Daniel Tarullo spoke last week and called out short-term wholesale funding markets unfinished business. We take a look at his comments.

Federal Reserve Governor Daniel Tarullo spoke on May 3 at the Peterson Institute for International Economics. His speech, “Evaluating Progress in Regulatory Reforms to Promote Financial Stability,” reviewed progress to date then went into repo and other short-term funding markets at some length.

Here’s the summary of Tarullo’s view: “Relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infamous SIVs, have disappeared or substantially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (SFTs).” This means repo, securities lending and the like.

“The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is especially relevant in considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding.” I.e., let’s not forget that Lehman failed in large part because of a loss of repo funding. This could happen to another major bank if conditions were to sharply worsen.

Tarullo’s ideas for constraining monitoring the risk of SFTs include:

– Minimum requirements for capital, liquidity, or both.
– A higher capital charge for all SFT transactions.
– Minimum margining requirements for SFTs. “It is definitely worth pursuing.” Tarullo references the now well known Financial Stability Board Consultative Document on securities lending and repo from November 2012.

A few things here. What much of these policies amount to is a frictional tax on repo and securities lending. It seems not dissimilar from the Financial Transactions Tax, just with a different policy purpose. If the goal is a safer system, and what that safety really boils down is liquidation risk, then why not create a better liquidation procedure? Maybe the situation would have been much different for Lehman had there been some sort of liquidation facility, liquidity facility or Orderly Liquidation Authority that could have seen the bank through? The issue was how liquid the underlying paper was and could the financing trades be disentangled quickly — govies were unwound quickly, corporate liquidity was a problem.  This ties back to the Fed’s concern about anything other than government bonds and agencies as the collateral that backs repo. And what about the LCR? Doesn’t it address the same kind of liquidity crises?

The various comments and speeches on this issue seem to be going in circles. Our question is, do policy makers want these markets to exist for the benefits they provide to society? If so, then support SFTs with mechanisms that provide liquidity in a crisis. Recognize that collateral chains are not evil weapons of value destruction and actually facilitate collateralized credit creation. On balance, that is a good thing. Make it punishing to shareholders and management to use any facility but make it available none-the-less.

Tarullo also gets back to liquidity risk but does not discuss any liquidation or liquidity policy actions: “While there is decidedly a need for solid minimum requirements for both capital and liquidity, the relationship between the two also matters. Where a firm has little need of short-term funding to maintain its ongoing business, it is less susceptible to runs. Where, on the other hand, a firm is significantly dependent on such funding, it may need considerable common equity capital to convince market actors that it is indeed solvent. Similarly, the greater or lesser use of short-term funding helps define a firm’s relative contribution to the systemic risk latent in these markets.” Again we say, if these markets help the economy and hence society, which we think they do, then they are worth supporting.

Tarullo believes “that we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets, both in general and as they affect the too-big-to-fail problem. This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it.”