Money fund industry nemesis Eric Rosengren, President of the Federal Reserve Bank of Boston, gave a speech last week at Bard College entitled, "Risk of Financial Runs – Implications for Financial Stability". He commented, "Today I would like to discuss the risk of financial runs.... I believe the actions taken around other, less traditional financial institutions have not moved nearly as markedly or at the same pace as the corrective actions taken for commercial banks. This is despite the fact that less traditional financial institutions were at the epicenter of the crisis. My comments today will focus on one area that has received less attention in the United States than elsewhere -- the need to ensure that large broker-dealers will not need to rely on a government safety net in the future."
Rosengren explains, "The financial runs that beset highly leveraged institutions, structures, and products were significant and unfortunate features of the financial crisis. While deposit insurance reduces the risk that depositors will flee en masse from commercial banks, the financial crisis highlighted that other types of financial institutions and structures were also highly susceptible to runs. `For example, money market mutual funds, which are not required to hold capital, experienced credit losses and significant investor flight (i.e., runs) during the crisis. Policymakers put in place temporary backstops -- insurance funded by the U.S. Treasury and a liquidity facility facilitated by the Federal Reserve -- to avoid further collateral damage. Since then, there has been much public discussion of regulatory actions that could significantly reduce the financial stability concerns around money market mutual funds -- which are regulated by the SEC -- but industry opposition has been vocal, and no significant actions have as yet been taken. Former SEC Chair Schapiro was right to pursue money market fund reform, and now that her successor is confirmed I am hopeful that the SEC will revisit this issue."
He tells us, "Structured investment vehicles (SIVs), which financed long-term, risky financial assets with short-term commercial paper, also encountered trouble during the crisis. Investors who were concerned about the valuation of the SIVs' long-term assets "ran" from the short-term commercial paper the SIVs issued to finance their assets, causing many SIVs to fail or be wound down. Additionally, broker-dealer firms -- which were assumed by most observers to present less risk of a run because their borrowing is often fully collateralized -- proved vulnerable and also played a prominent role during the crisis. `However, widespread questions about the appropriate valuation of collateral during the crisis made it apparent that collateral in and of itself was not sufficient to avoid runs."
Rosengren says, "Two prominent broker dealers failed at critical junctures during the crisis. The first major broker-dealer failure involved Bear Stearns. Arguably the most disruptive failure was Lehman Brothers. Emergency loans were provided to Bear Stearns, and in the wake of its assisted merger a variety of emergency credit facilities to backstop the industry were set up. Additional actions were taken, to forestall more widespread runs after the failure of Lehman Brothers. Despite the central role that broker-dealers played in exacerbating the crisis, too little has changed to avoid a repeat of the problem, I am sorry to say. In short, I firmly believe that a reexamination of the solvency risks of large broker-dealers is warranted."
He adds, "[B]roker-dealers experienced dramatic difficulties during the 2008 crisis, and the Federal Reserve needed to temporarily backstop broker-dealers with substantial lending. Given that recent history, the assumption that collateralized lenders like broker-dealers are not susceptible to runs has been proven wrong. At the same time, broker-dealer capital regulation by the SEC remains largely unchanged, despite the lessons of the financial crisis. Consequently, broker-dealers remain vulnerable to losing the confidence of funders and counterparties should the world economy again experience a significant financial crisis."
Rosengren continues, "Moreover, the current broker-dealer situation vis-a-vis capital poses the potential for significant moral hazard. Were a crisis to once again cause serious problems in liquidity and in securities-market functioning, it is quite possible that programs such as the PDCF and TSLF would need to be considered again (notwithstanding likely public opposition to what could be perceived as "bailouts"). If broker-dealers assume that they will once again have access to such government support should markets be disrupted, they will have little incentive to take the steps necessary to shield themselves from financing problems during a crisis and thus minimize their need for a government backstop."
He comments, "One of the fallouts of the financial crisis is that many of the large broker-dealer operations are now part of bank holding company structures. Goldman Sachs and Morgan Stanley became bank holding companies during the crisis. Bear Stearns was acquired by J.P. Morgan Chase, and Merrill Lynch was acquired by Bank of America. While these large broker-dealer operations are in bank holding companies, there are significant regulatory requirements and restrictions that apply, including capital thresholds and limitations on transactions between the FDIC-insured depository subsidiaries and the affiliated broker-dealer subsidiaries. `Despite these restrictions, however, broker-dealers can still pose a risk to the broader organization by leaning on the parent bank holding company for support and, accordingly, reducing the availability of funds at the parent company to support any FDIC-insured depositary."
Finally, Rosengren adds, "In summary and conclusion, I would just reiterate that broker-dealers did not perform well during the financial crisis. Many of the largest broker-dealers failed or were converted to or subsumed into bank holding companies. Despite these structural changes, significant government intervention was required to maintain market functioning and liquidity, in markets key to the stability of the U.S. financial system and the economy that relies on it. Unfortunately, despite this history of failure and substantial government support, little has changed in the solvency requirements of broker-dealers. The status quo represents an ongoing and significant financial stability risk. In my view, then, consideration should be given to whether broker-dealers should be required to hold significantly more capital than depository institutions, which have deposit insurance and pre-ordained access to the central bank's Discount Window."
