The Fed’s Tarullo signals another tax on short-term funding

The Federal Reserve’s Daniel Tarullo, in testimony today before the US Senate’s Committee on Banking, Housing, and Urban Affairs on Dodd-Frank implementation, had some tough words for banks that rely heavily on short-term funding. While there is much to discuss throughout, we highlight just the parts of his speech most relevant to the funding markets.

Short-term wholesale funding
We believe that more needs to be done to guard against short-term wholesale funding risks. While the total amount of short-term wholesale funding is lower today than immediately before the crisis, volumes are still large relative to the size of the financial system. Furthermore, some of the factors that account for the reduction in short-term wholesale funding volumes, such as the unusually flat yield curve environment and lingering risk aversion from the crisis, are likely to prove transitory.

Federal Reserve staff is currently working on three sets of initiatives to address residual short-term wholesale funding risks. As discussed above, the first is a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. GSIBs. The second involves proposed modifications to the BCBS’s net stable funding ratio (NSFR) standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants. The third is numerical floors for collateral haircuts in securities financing transactions (SFTs)–including repos and reverse repos, securities lending and borrowing, and securities margin lending.

Modifications to the NSFR could be designed to help address the types of concerns described in my previous testimony regarding SFT matched book activity. In the classic fact pattern, a matched book dealer uses SFTs to borrow on a short-term basis from a cash investor, such as a money market mutual fund, to finance a short-term SFT loan to a client, such as a leveraged investment fund. The regulatory requirements on SFT matched books are generally low despite the fact that matched books can pose significant microprudential and macroprudential risks. Neither the BCBS LCR nor the NSFR originally finalized by the Basel Committee would have imposed a material charge on matched book activity.

In January, the BCBS proposed a revised NSFR that would require banks to hold a material amount of stable funding against short-term SFT loans, as well as other short-term credit extensions, to nonbank financial entities. By requiring banks that make short-term loans to hold stable funding, such a charge would help limit the liquidity risk that a dealer would face if it experiences a run on its SFT liabilities but is unable to liquidate corresponding SFT assets. In addition, by making it more expensive for the dealer to provide short-term credit, the charge could help lean against excessive short-term borrowing by the dealer’s clients.

Turning to numerical floors for SFT haircuts, the appeal of this policy measure is that it would help address the risk that post-crisis reforms targeted at banking organizations will drive systemically risky activity toward places in the financial system where prudential standards do not apply. In its universal form, a system of numerical haircut floors for SFTs would require any entity that wants to borrow against a security to post a minimum amount of excess margin to its lender that would vary depending on the asset class of the collateral. Like minimum margin requirements for derivatives, numerical floors for SFT haircuts would serve as a mechanism for limiting the build-up of leverage at the transaction level and could mitigate the risk of procyclical margin calls.

Last August, the FSB issued a consultative document that represented an initial step toward the development of a framework of numerical floors. However, the FSB’s proposal contained some significant limitations, including that its scope was limited to transactions in which a bank or broker-dealer extends credit to an unregulated entity and that the calibration of the numerical floor levels was relatively low. Since then, the FSB has been actively considering whether to strengthen the proposal along both of these dimensions.

The full speech is available here.

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