A speech over the weekend by Federal Reserve Vice Chair Janet Yellen gave a concise status of the Fed’s thinking on shadow banking. We review the main elements and provide some supporting evidence for future regulatory actions.
The Yellen speech, Regulatory Landscapes: A U.S. Perspective, made at the International Monetary Conference in Shanghai China, makes clear that not only has the Fed not forgotten about shadow banking, it looks like it is the next great piece of unfinished business on the agenda. This ties into a number of other themes we have heard from the Fed over recent months. We quote the speech then provide our comments.
“We need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks.”
This is a pitch for trade repositories, and we think that the US Financial Stability Oversight Council (FSOC) will be taking up the Financial Stability Board’s (FSB) mandate for repositories in securities lending and repo in the near future. The FSOC’s 2013 annual report continues to show heavy duty spending on IT. The next problem is how to analyze the data once it is all collected. This is no trivial task and we think it will be some years before the matter gets sorted out. Even so, it looks like the Fed is serious about initiating the workstream (as is the US Treasury).
“We also need to take further steps to reduce the risk of runs on money market mutual funds.”
We refer back to our May 21, 2013 post, “How can institutional 2a-7 money market funds survive?” We think that more US 2a-7 money market fund reform is inevitable. Sadly, this will result in a game of whack-a-mole, where the risk that was in 2a-7 funds now shows up in separately managed accounts. This removes the risk that a money market fund sponsor might be liable for losses; any loss would clearly be the responsibility of the separately managed account holder. However, the systematic risk would still be evident along with further dollops of liquidity risk with longer dated term investments.
“In addition, we need to further ameliorate risks in the settlement process for triparty repo agreements, including through continued reductions in the amount of intraday credit provided by the clearing banks.”
The best material on the Fed’s thinking here is the early May 2013 paper by Begalle, Martin, McAndrews and McLaughlin on fire sale risk in the tri-party markets. This is a meaty, intellectually driven paper that will likely serve as the Fed’s backbone for tri-party risk reduction in the future. It brings up some tricky points though, and recommendations for liquidity risk reduction and post-default ideas that may not hold in practice. As our May 8 2013 review noted, “The authors suggest that an agreement between dealers to form a consortium to buy out government paper from the cash lenders (should there be a dealer default) could mitigate the risk of a fire sale…. This is despite the presumed crisis engulfing the market at the time and uncertainty about who ended up with enough illiquid paper to sink themselves. This might be ok if the funding problem has idiosyncratic roots, but we wonder about (what amounts to) mutualization when the risk zips past the tipping point and goes systemic.”
We are pleased to welcome Brian Begalle, a co-author of this fire sale report, as a speaker at the Finadium repo event in New York City on June 11, 2013.
“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…. 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.”
Just when things were getting predictable, it seems that there is still much more securities finance regulation to come. We look again to the Financial Stability Board to lead the charge on this.
Here’s our favorite line from the weekend’s Federal Reserve speechifying: Fed Chairman Ben Bernanke, speaking at Princeton’s graduation this past weekend, said “If your uniform isn’t dirty, you haven’t been in the game.” Good one.