On Tuesday, Treasury Secretary Tim Geithner provided testimony before the House Financial Services Committee on Financial Reform on the topic of financial reform. He said, "The failure of Lehman Brothers in September 2008 was a key inflection point during the most critical phase of the recent financial crisis. Lehman's bankruptcy accelerated a classic "run" on our financial system -- a phenomenon not witnessed in this country since the 1930s. In the face of this run, the U.S. government, together with governments from around the world, had no choice but to intervene aggressively, on an unprecedented scale, to prevent an economic catastrophe."
Geithner continued, "In the run-up to the recent crisis, we witnessed a period of explosive growth in leverage and maturity transformation outside the perimeter of prudential banking regulation. This parallel, lightly regulated system has come to be known as the 'shadow banking system.' Large dealer firms like Lehman were a key part of this system -- but they were just one part. At its peak, the shadow banking system financed about $8 trillion in assets with short-term obligations, making it almost as large as the real banking system. The rapid growth of this system was fueled by light regulation and weak or nonexistent capital requirements. It was also driven by cheap funding from large institutional investors, such as money market mutual funds and securities lenders, which furnished a ready supply of short-term financing."
The Treasury head explained, "Like other dealer firms, Lehman Brothers relied heavily on a critical funding market called the repurchase agreement, or 'repo,' market. This market proved to be a major source of liquidity risk and instability in the crisis -- for Lehman as well as other firms. This portion of the shadow banking system merits particular attention. Repos are essentially loans that financial institutions use to finance securities inventories -- typically on an overnight basis.... One particularly large and important segment of the repo market is called 'tri-party' repo. In this $2 trillion market, repo lenders (usually money market mutual funds) extend loans overnight to dealers. During the trading day, credit is provided by big banks that act as repo 'clearing banks.' Through this process, individual dealer firms typically borrow hundreds of billions of dollars each day."
He said, "While tri-party repo has been effective in providing liquidity to securities markets during normal times, under stress conditions these arrangements proved to be a source of liquidity risk for important parts of the financial sector. During the recent crisis, there was significant uncertainty in the markets about whether money funds would maintain their investments and whether repo clearing banks might refuse to provide intraday credit.... These structural issues were exacerbated by tri-party lenders' concerns around collateral quality.... As a consequence of these issues, the tri-party repo market was a critical source of liquidity strain on dealer firms during the financial crisis."
Geithner added, "And money market mutual funds, which provide a large portion of tri-party repo funding, made these liquidity problems even more acute. Money funds were themselves shown to be sources of instability during market stress. In a chaotic and uncertain financial environment, savers who parked cash in money funds became concerned that those assets might not have been as safe as they had anticipated. These concerns intensified after Lehman's bankruptcy, when one large money fund 'broke the buck,' meaning that its net asset value fell below $1 per share. The money fund industry experienced a modern-day bank run in September 2008. This run accelerated dramatically following Lehman's collapse."
He also said, "Aggressive policy action was required to stabilize the money funds, including a temporary government guarantee of this $3 trillion industry. Although this program was successful and resulted in positive returns to taxpayers through guarantee fees, the money fund guarantee exposed taxpayers to substantial risks. Tri-party repo and money funds are prominent examples of market structures and practices that were not robust enough to withstand a major disruption."
Finally, Geithner said, "Regulators are taking action to address the unstable aspects of the repo and money fund industries. Under the auspices of the Federal Reserve, an industry-led task force has been working to develop enhancements to the policies, procedures and systems supporting the tri-party repo market. This initiative is designed to ensure that the structure of the tri-party repo market will not amplify systemic risk during future periods of market stress. And the SEC recently enacted new rules to strengthen liquidity and disclosure in the money fund industry. More work remains to be done in this area, and the President's Working Group on Financial Markets is preparing a report setting forth options to address systemic risk and to reduce the susceptibility of money funds to runs."
