We have been picking our way through the nearly 200 page Financial Stability Oversight Council (FSOC) 2013 Annual Report. One thing that caught our eye was Chapter 7 “Potential Emerging Threats” and in particular Section 7.1, “Fire Sale and Risk Run Vulnerabilities”.
The FSOC continues to focus on broker-dealer financing. It hits all their hot buttons:
- funding long-term securities with short-term obligations, enabling vulnerable maturity transformation (read: shadow banking)
- facilitating funding to potentially illiquid securities via tri-party creating susceptibility to fire sales
- exposing the market to the risk of sudden shocks transmitted via pullbacks by money funds and other cash lenders who may have their own liquidity problems
”…intermediation chain allows participants to allocate funds to long-term investments while offering liquid investment products to investors. However, the intermediation conducted along this chain makes each step potentially vulnerable to runs and fire sales. If cash investors doubt the solvency or liquidity characteristics of their collateral or counterparty, they might rapidly unwind their investments. This in turn leaves broker-dealers who are funded through tri-party repo vulnerable to sudden collapses in sources of funding..”.
Taking aim at money market funds and repo,
“…Money market funds (MMFs) are among the largest cash investors in the tri-party repo market…The share of MMF assets allocated to repo and the share of broker-dealer repo funded by MMFs have been steadily increasing since experiencing a sharp decline during the financial crisis. As of the end of 2012, MMFs allocate over 20 percent of their investments to repos and fund nearly 25 percent of total broker-dealer repos. Because MMFs are susceptible to runs, their relative importance in the repo market creates a source of vulnerabilities for the broker dealer sector…”
Looking at the fire sale risk,
“…In the tri-party repo market, a fire sale can occur if a broker-dealer under stress immediately needs to sell assets that it can no longer finance. Such pre-default fire sales are a risk because broker-dealers perform maturity and liquidity transformation. As such, broker-dealers that obtain funding in the triparty repo market could be solvent but illiquid. The value of the securities they hold might exceed the face value of the repo if the securities are sold in a well-functioning market. If, however, the market for these securities becomes temporarily illiquid, the securities’ price might drop to a point at which—if a broker-dealer cannot provide additional collateral to make up for the shortfall in the required coverage—the securities are worth less than the face value of the repo they collateralize. This dynamic makes a run by repo creditors potentially self-reinforcing…”
“..The risk of fire sales is heightened when collateral is less liquid. In particular, firms that have a large fraction of their repo transactions collateralized by illiquid securities tend to be more vulnerable. Lenders’ incentives to sell collateral quickly in case of dealer distress rather than to liquidate over a longer time horizon or hedge those positions also increase the risk of fire sales…”
And addressing the specific issues of broker-dealers and the lack of lender of last resort (LOLR) facilities,
“…The fire sale risk in the tri-party repo market generates vulnerabilities for the securities broker-dealer sector. Although commercial banks benefit from access to the discount window and deposit insurance, broker-dealers do not have such backstop sources of funding…”
But the good news has been the greater use of term funding, probably driven by LCR.
“…However, compared to activity before the crisis, broker-dealers have modestly reduced their reliance on overnight tri-party repo funding, instead relying on longer-term repo funding sources. Furthermore, large broker dealers have reduced their reliance on MMFs for funding less liquid assets via repo. In addition, the largest broker-dealers are now part of bank holding companies (BHCs), and are thus subject to comprehensive prudential oversight at the holding company level. Despite these mitigating factors, the absence of direct and pre-specified sources of public liquidity and credit backstops makes broker-dealers, as compared to banks, more exposed to vulnerabilities in their funding sources…”
The FSOC describes a world that has done little to remove the vulnerabilities exposed in the financial crisis. They still see funding risk around the corner. But which problems can they fix and what are those solutions? The first stop may be money market funds. US regulators recent failure to come up with a viable solution is not the end of the debate. We suspect, like others, that the fixed price economic fiction of $1 a share will fall away for all but the shortest highest quality funds. But it may be a case of “careful what you wish for”. Institutional investors in MMFs will vote with their feet and the resulting dislocations may not be pretty.
How will the FSOC use their bully pulpit (and regulatory oversight) to reduce funding shock vulnerabilities? On top of the continued push to clean up tri-party unwind/rewind window, regulators have suggested mandated minimum haircuts, FRB backstopped liquidation facilities, and other ideas that could help prevent (or at least mitigate) exposure – but at a cost. It will be interesting to see what emerges.
A link to the Annual Report is here.