The Office of Financial Research (OFR) at the U.S. Department of the Treasury released its "2013 Annual Report, which "identifies threats to financial stability and tools to monitor them." The report contains a number of mentions of money market funds, asset managers and short-term funding markets. It says, "The Office and the Council continue to highlight financial stability risks related to securities financing transactions in repos (repurchase agreements) and other short-term funding markets. These markets are still exposed to the risk of runs and fire sales. Vulnerabilities remain in money market funds and similar sources of cash in these markets. In our report, Asset Management and Financial Stability, we drew attention to a related risk -- a rapid unwinding in response to market shocks of the reinvestment of cash collateral in securities lending transactions. Financial entities that engage in leveraged carry trades (borrowing short-term to invest in long-term assets) are particularly vulnerable."
The report continues, "Gaps still remain in the U.S. and global macroprudential toolkits. `For example, although regulators have begun to address vulnerabilities leading to the risk of runs on repo and money market funds, we believe that better tools are needed. Also, as noted in a recent OFR working paper, stress testing of large bank holding companies in the United States -- a valuable exercise used to determine regulatory capital and liquidity planning at these institutions -- could be improved by incorporating funding risks, potential spillovers, and feedback effects."
The OFR tells us, "The Office's framework for monitoring focuses on vulnerabilities in the financial system rather than shocks to it. Vulnerabilities are determinants of instability; shocks expose them. Examples of vulnerabilities include the potential for runs in money market funds that promise a fixed net asset value; lax loan underwriting standards; a rapid buildup of credit; insufficient bank capital or liquidity buffers to absorb losses or withdrawals; and excessive maturity transformation promoted by a period of low interest rates. Vulnerabilities may arise through market failures, incentives that lead to excessive risk-taking."
The latest Annual Report discusses, "Wholesale Funding Market Run Risk and Fire Sales," saying, "In past reports, the Office and the Council have each highlighted financial stability risks related to repo markets. Regulators and market participants have made progress in reducing vulnerabilities in the repo markets to runs and asset fire sales. Concentration has declined, collateral quality has improved, the volume of intraday credit has decreased, and some repo maturities have extended. Potential ways to mitigate remaining risks in repo markets include the creation of an orderly liquidation facility, limitations on collateral types, an extension of repo maturities, and minimum collateral haircuts. These changes would enhance the macroprudential toolkit, although their extension to transactions between unregulated entities and harmonization with non-U.S. markets would need to be addressed."
It continues, "Secured funding markets are still exposed to potential repo runs, which could amplify and transmit risk systemwide. Run risk stems from three current weaknesses. First, broker-dealers and others who obtain financing in the repo market are vulnerable to runs by counterparties. The Securities and Exchange Commission has proposed requiring prime money market funds to adopt floating share prices or impose liquidity fees or restrictions on withdrawals that could help reduce the likelihood of runs, but this system has yet to be tested (see FSOC, 2012b, and SEC, 2013a). Figure 5 illustrates the vulnerability of prime money market funds to counterparty failure. The most vulnerable funds would break the buck -- fall below the $1 per share net asset value by more than half a cent -- if any one of 30 or more counterparties defaulted; the less vulnerable funds would break the buck if any one of 10 to 19 counterparties defaulted. Figure 6 illustrates the connections of the largest money market funds to the institutional issuers whose securities they hold. In addition, forced asset (fire) sales are a risk if cash providers (such as money market funds) withdraw cash and collateral providers (typically broker-dealers) are unable to finance their positions. Finally, contagion risk could aggravate and extend such asset sales if the inability to unwind illiquid assets adds pressure on other securities and market participants."
Finally, the report adds, "Progress in addressing these risks for financial institutions has been mixed. The total and repo liabilities of shadow banking entities have declined significantly since the financial crisis (see Figure 7). However, mortgage real estate investment trusts (REITs) -- leveraged investment vehicles that borrow shorter-term funds in the repo market and invest in longer-term agency mortgage-backed securities (MBS) -- have not followed this trend." Watch for more excerpts in the coming days, or see the full report here.
