On Tuesday, Sandra Krieger, an Executive Vice President at the Federal Reserve Bank of New York, gave a speech entitled, "Reducing the Systemic Risk in Shadow Maturity Transformation," which discussed ABCP, repo, and money market funds extensively. She said, "My objective today is to talk about the systemic risk that can be created by financial intermediaries that do not have direct and explicit access to official liquidity -- the so-called shadow banks -- and how these risks might be reduced. My focus is on maturity transformation activities -- that is, the use of short-term funding to finance longer term, risky assets. These activities exploded during the credit bubble. And they popped along with the bubble, killing or nearly killing the sponsoring institutions with the toxic (and nontoxic) assets therein." (See her slides here.)
Krieger explained, "[T]his talk is about the reforms that have occurred or need to occur to reduce the degree of systemic risk associated with shadow maturity transformation. Much regulatory reform is focused on making the link between banks and these activities more explicit and more properly supported by liquidity and capital. Other reforms are focused on reducing reliance on traditional banks, by having the shadow banking entities themselves provide for the necessary credit and liquidity backstops or by forcing shadow bank investors to bear the ex ante economic cost of their activities. This topic is one of many systemic risk issues of importance to the Federal Reserve."
She commented, "Today's more opaque and complex system of banks and shadow banks can nonetheless be distilled down to a basic element of financial intermediation: the transformation of long-term risky assets into very short-term liabilities. It is this maturity transformation that renders financial intermediaries intrinsically fragile since, by definition, an intermediary engaging in maturity transformation cannot honor a sudden request for full withdrawals."
Krieger continued, "The degree of maturity transformation undertaken in the shadow of our financial system was dramatically exposed in each of the darkest moments of the recent financial crisis. I am going to discuss shadow maturity transformation and reforms in three market segments: ABCP, tri-party repo and money market mutual funds. The collapse of the ABCP market drove pressure on the U.S. dollar LIBOR interest rate in August 2007. The withdrawal of tri-party repo funding from Bear Stearns in March 2008 was a large contributor to that firm's collapse and triggered significant knock-on effects in the market for the underlying collateral and in markets more broadly. Pressure on money market mutual funds in September 2008 exacerbated the problems created by the failure of Lehman Brothers, which itself was driven in part by issues that firm faced in tri-party repo funding."
She added, "The Federal Reserve created seven emergency liquidity facilities to deal with the unwind of shadow credit transformation: the term auction credit facility, foreign exchange swaps with foreign central banks (not new but used in an expanded manner), a primary dealer credit facility (PDCF), a term securities lending facility (TSLF), an asset backed commercial paper money market mutual fund liquidity facility (AMLF), a commercial paper funding facility (CPFF) and a money market investor funding facility (MMIFF). While successful in achieving their unique goals, these facilities were merely a bridge to more normal markets, buying time for well-needed structural reform."
Krieger said about "Money market mutual funds," "Money funds exist in the parallel banking system and the value proposition for investors derives from the elements that we have been discussing: investors earn returns that benefit from a maturity mismatch between the investor funding and the investments from which the return is generated -- and investors can withdraw on demand and with almost immediate execution. Money funds have little ability to absorb losses and, as with other parallel banking activities, have no official liquidity or credit support, although the Federal Reserve and Treasury stepped in during the financial crisis, using emergency powers.... This fragility of MMMFs can quickly spread to other financial firms and the broader economy given the size of the money fund industry and its prominence in short-term financing markets."
She explained, "The fragility of money funds, and potential broader consequences was front and center in September 2008 when Lehman failed; all of what I just said occurred: the confidence shock, and then rapid changes in money fund risk profiles and investor risk appetite moving in opposite directions. In this environment, the Prime Reserve Fund [sic], a well-established money market fund that had exposure to Lehman CP, 'broke the buck.' Money market fund investors at other funds voted with their feet regarding their discomfort with the lack of guaranteed credit and liquidity support for these activities, withdrawing large amounts from funds that invested in instruments that did not have full and direct government support or clearly sufficient parent support. Fund managers reacted by selling assets and investing at only the shortest of maturities, thereby exacerbating the funding difficulties for other instruments such as commercial paper."
Krieger later said, "The goal of MMMF reform is to reduce the fragility of these institutions and their susceptibility to runs, the rapid flight of investors, which can destabilize the broader financial system. To date, the Securities and Exchange Commission (SEC) has approved amendments to the rules applicable to MMMFs that focus on reducing risk on the asset side of funds' balance sheets.... The President's Working Group (PWG) has proposed a range of reform options for consideration by the Financial Stability Oversight Council. In general, these were intended to address the fact that MMMFs have a number of characteristics -- including a stable NAV, redemption upon demand, and extremely risk-averse investors -- which interact to make these entities vulnerable to runs. Several of these proposals entail the creation of liquidity and capital buffers. The former provide additional near-cash assets to deal with redemptions, while the latter enhances the loss absorption capacity available to deal with a credit event. Broadly speaking, two kinds of buffers can be set up: ex ante and ex post."
Finally, she commented, "In summary, regulators have certainly made some significant improvements to the structure of the MMMF industry which may reduce the likelihood of runs and improve its resiliency. However, until more significant reforms are undertaken, a clear systemic vulnerability remains. It is important to note that there may well be no single measure that adequately addresses this issue, and some combination of measures may ultimately be the most appropriate course."
