Federal Reserve Bank of New York President & CEO William Dudley spoke Friday on "Fixing Wholesale Funding to Build a More Stable Financial System." He commented, "One critical factor [of the recent financial crisis] was the extensive use of short-term wholesale funding in the years leading up to the crisis. Not only did this aspect of our financial system create the potential for a firm to fail in an extraordinarily rapid manner when faced with a loss of market confidence, but it also served as a channel through which the effects of those failures were widely propagated throughout the broader financial system. Although much has been done over the past few years to mitigate the structural flaws that make wholesale funding a point of weakness in the global financial system, some important issues and vulnerabilities remain. I will focus my remarks today on some of those vulnerabilities -- including the areas of tri-party repo and money market mutual funds markets -- and discuss what could be done to make wholesale funding markets more stable."
He explained, "Short-term funding of longer-term assets is inherently unstable particularly in the presence of information and coordination problems. It can be rational for a provider of funds to supply funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the firm's continued ability to roll over its funding from other sources. But if the use of short-term funding becomes sufficiently widespread, the firm's roll-over risk increases. In this situation, there is a strong incentive for each lender to "run" if there is any uncertainty that could undermine the borrower's ability to continue to roll over its funding from other sources. This is the case even if the provider of funds believes that the borrower would remain solvent as long as it retained access to funding on normal terms."
Dudley continued, "Heavy reliance on short-term wholesale funding exposed the system to a series of intertwined downward spirals in asset and funding markets. This spread in waves, beginning in the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits, and spreading via auction-rate securities, to the repo, money market and financial commercial paper markets that formed the core financing for market-based financial intermediation."
He said, "The fragility of short-term wholesale funding was greatly aggravated by certain critical institutional shortcomings in these markets, particularly in the structure of the tri-party repo system and the U.S. money market mutual fund business.... As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party repo market became increasingly concerned about the liquidity and credit risks that they faced."
Dudley explained, "The crisis also made it clear that the monies provided to the money market mutual funds by their own investors were also inherently unstable. This made such funds, in turn, an unreliable source of finance in repo, commercial paper and other markets. Investors in a fixed net asset value (NAV) money market fund could take their money out on a daily basis at par value, with no redemption penalty. This could occur even if the money market fund did not have sufficient cash or liquid assets that it could easily sell to meet all potential redemptions. This created an incentive for investors to be the first to get out whenever there was any uncertainty over the underlying value of the assets in the fund.... The longer the investor waited, the greater the risk that the fund would be forced into the fire sale of assets to meet redemptions and end up "breaking the buck.""
He added, "As the crisis unfolded, the Federal Reserve, the U.S. Treasury and others took a series of actions to contain the spiral of funding runs and asset fire sales.... The Federal Reserve created a direct backstop to the tri-party repo system through the Primary Dealer Credit Facility (PDCF). When the Reserve Fund broke the buck after the failure of Lehman Brothers, precipitating a run on money market mutual funds, the Treasury guaranteed money market fund assets and the Fed introduced the Asset-Backed Commercial Paper Money Market Fund Liquidation Facility (AMLF). The Fed also backstopped the commercial paper market (formerly funded in large part by money market mutual funds) by introducing the Commercial Paper Funding Facility (CPFF)."
Dudley continued, "Worthwhile as the steps taken thus far are, we have not come close to fixing all the institutional flaws in our wholesale funding markets. The tri-party repo system and the money fund industry that plays a crucial role financing collateral through it are both still exposed to runs. In fact, in each of these areas, one could argue that the risks have increased compared to prior to the crisis. That is because the Dodd-Frank Act raised the hurdle for the Federal Reserve to exercise its Section 13.3 emergency lending authority and because Congress has explicitly precluded the U.S. Treasury from guaranteeing money market mutual fund assets in the future. With extraordinary interventions ruled out or made much more difficult, this may cause investors to be even more skittish in the future. This is why it is essential to make the system more stable."
He told us, "Turning first to the issue of tri-party repo reform, there is still considerable work to do. In particular, the risk that investors will run at the first sign of trouble persists. That is because the costs of running are very low relative to the potential costs of staying put. The potential costs of staying are elevated in part because investors often don't have the capacity to take possession of the collateral or liquidate the collateral in an orderly way should a large dealer fail. Both aspects result in run risk, fire sale risk and potential financial instability."
Dudley then said, "Turning next to the issue of money market mutual funds, further reform to directly address the incentive for investors to run is essential for financial stability. In November, the Financial Stability Oversight Council (FSOC) put out for comment three alternative paths forward: 1. Moving to a floating net asset value (NAV). 2. Retaining a stable NAV, but adding a new NAV buffer and a minimum balance requirement. The minimum balance would be at risk for 30 days following withdrawals. If the fund subsequently "broke the buck" during this period by suffering losses greater than the size of its NAV buffer, the minimum balance would be first in line to absorb these losses. 3. A larger NAV buffer than in the second alternative, but without a minimum balance at risk buffer."
He continued, "I have stated my views on money fund reform before. Although any of these proposals -- depending on the fine print of course -- would likely be an improvement over the status quo, the first and third proposals don't fully eliminate the incentives to run. In the case of a floating rate NAV, fund managers faced with large redemption requests typically sell their most liquid assets first, leaving the remaining investors with a riskier, less-liquid portfolio and a greater risk of loss. Similarly, with a stable NAV and a capital buffer, unless the capital buffer were very large, there would still be an incentive to run because the buffer might not prove large enough to shield the investor from loss."
He added, "Because the second option is the only one that actually creates a disincentive to run, as I stated before the FSOC proposal, I view it as the best one for financial stability purposes. The requirement that investors who withdraw funds must maintain a small balance for a short period to absorb near-term losses would deter investors from pulling out at the first glimpse of trouble and make the system safer. The modest withdrawal restrictions, which create a "minimum balance at risk," might be set at 5 cents on the dollar, based on the high-water mark of recent holdings, with more favorable treatment for small retail investors. A minimum balance at risk of loss would also increase market discipline. Corporations and other sophisticated investors would have an incentive to monitor risk-taking more carefully, rather than rely on their ability to get out ahead of small retail investors when trouble materializes."
Finally, Dudley concluded, "Reforming the tri-party repo system and the money market mutual fund industry is essential and would make the financial system significantly more stable. But even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop."
