We have some more thoughts on Fed Governor Tarullo’s speech.

Fed Governor Tarullo’ November 22 speech “Shadow Banking and Systemic Risk Regulation” at the Americans for Financial Reform and Economic Policy Institute Conference in Washington, D.C. had a lot of meat in it. In many ways it was an extension of Fed Governor Jeremy Stein’s October 4, 2013 speech at the Fed’s workshop on Fire-Sales and Tri-Party. We posted about that speech on October 7th “Fed Governor Stein’s speech on tri-party repo and fire sales: a primer on why the Fed cares so much” and again on October 8th’ “Fed Governor Stein has some ideas on how to mitigate fire sale risk”. In that speech Stein talked about specific capital charges applicable to securities financing transactions as well as minimum haircuts. In Governor Tarullo’s speech, he mentioned both of those as ways to mitigate short term funding risk. Tarullo also added a specific regulatory charge as an option to keep a lid on securities financing.

But lets back up for a second. Why do repo traders fund short, exposing themselves to constant rollover risk? Of course an upward sloping yield curve is one major reason. Lend cash long, borrow it short has been a tried and true moneymaker over the years. (As an aside, a small tweek to the Volcker Rule could remove this prop trading aspect of repo trading. The reduction to market liquidity would be huge. Unfortunately that arguement did not hold water on the cash prop trading side.)

But there is more to it. Repo desks fund positions that have a vey short time horizon. Cash desks, prime brokerage clients, or repo desk clients (like hedge funds) often have no idea how long they will be keeping a position on. Cash providers also need to keep things short, especially 2a7 funds. The logical response is to fund short. But as the regulators have said over and over, this creates susceptibility to a funding shock. If a bank’s sources of cash evaporates (an example would be money market funds withdrawing cash lent via tri-party repo) the bank will need to close out the asset side of their repo businesses. The result might mean outright selling inventory positions. Or it could mean closing out client financing positions – which then could cause those clients to have to sell. This can fuel fire sales with prices clearing at levels below economic value and the externalities that Governor Stein’s speech laid out.

One idea that Governor Tarullo outlined was a regulatory charge that would be calculated based on the liability side of a repo dealer’s balance sheet, presumably with higher charges for books with a greater reliance on short dated borrowings. This would push dealers to fund long. But it would not change the nature of their repo book assets or clients demands for flexible funding. This creates it’s own set of mismatches and risks. In a crisis where prices fall, financing books shrink, and the markets are flooded with liquidity — but liabilities remain outstanding – the result will be a very expensive mismatch. Over-funded repo books have, in a sense, a negative convexity problem. Can this cripple banks in the way that getting caught on the wrong side of lend cash long / borrow short? That remains to be seen. There are ways to hedge this risk – for example with OIS  – but the mismatch issue may not be trivial.

Tarullo did note that the mandatory haircuts proposed in the FSB paper were pretty low. He said, “…the FSB’s proposed numerical floors are set at relatively low levels–levels that are, for example, significantly below the haircuts that currently prevail in the tri-party repo market…” We have written that the mandatory levels were lower than typical tri-party levels and, as such, would never bind the market. Our most recent post on this was “The FSB announces the 2nd phase of their study on securities financing; this time its all about haircuts” (November 6, 2013).

There is an extra dimension to the minimum haircut issue that we think should be raised: haircut variability. The Fed and academics have written a lot about their concern that tri-party haircuts don’t change as quickly as they should. This means markets are either on or off…and when they are off, the result looks just like a bank run. Bilateral markets did not suffer in the same way. Those haircuts adjust up (and down) quickly, in response to changing market risks.

So maybe one solution is to create a mechanism where regulators can easily change minimum haircuts across the markets. The very risk of haircuts moving around – similar to the frequently changing margins on futures contracts – may modify behavior. Leveraged players will need to keep more capital aside if they think the chances of haircuts going up are real. And isn’t making sure cash borrowers can support their margin requirements the key to avoiding defaults? It seems to work in the futures markets. Hey, even MF Global might still be in business if they had realized that repo IM could just jump and knew to hold enough cash to pay the higher margins that LCH could impose on their repo trades. It also limits the size of financing books since the stand-by margin can’t be used as IM for a different trade. The simplest way to do this is within a repo CCP. Just a thought.

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