The Federal Reserve continued its crusade to blame the Great Recession on everyone except banks with another set of speeches (and a conference) on the evils of "wholesale funding". The Federal Reserve Bank of Boston and the Federal Reserve Bank of New York hosted a "Workshop on the Risks of Wholesale Funding" yesterday, which featured academics but no market participants. NY Fed President & CEO William Dudley gave the "Welcoming Remarks at Workshop on the Risks of Wholesale Funding" while Boston Fed President Eric Rosengren gave the keynote, "Broker-Dealer Finance and Financial Stability." The conference Overview explains, "Wholesale funding refers to a firm's use of deposits and other liabilities from institutions such as pension funds, money market mutual funds and other financial intermediaries. When a firm relies on short-term wholesale funds to support long-term illiquid assets, it becomes vulnerable to runs by its wholesale creditors. This risk manifested itself during the recent financial crisis, when many firms experienced an outflow of wholesale funds following the failure of Lehman Brothers. The resulting need to dispose of illiquid assets led to "fire sales" and the transmission of shocks throughout the financial system. The purpose of this workshop is to promote a better understanding of the risks posed by wholesale funding, and to explore policy options for minimizing these risks." (Note: The Federal Register version of the SEC's Money Fund Reform has been published; see today's "Link of the Day" for details.)
Dudley comments, "As you all know, the financial system plays an essential role in modern economies, and liquidity is in turn critical to the functioning of the financial system. Because financial intermediation is critical to economic activity and intermediation is dependent on funding and liquidity, disruption to funding and liquidity can cause severe damage to the economy. The experience of recent years revealed serious flaws in the system.... The extensive use by financial firms of short-term wholesale funding was one critical factor in the crisis. Not only did this reliance on short-term funding 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."
He continues, "In the pre-crisis period, the growth of securitization was accompanied by an increasing reliance on short-term funds raised in wholesale markets to finance securities and activities essential to securitization. This ranged from the use of repo funding to finance inventories of securities held for market-making purposes to the issuance of asset-backed commercial paper by conduits created to acquire and hold securities. Both demand and supply factors drove the increased use of short-term wholesale finance. On the supply side, the growth of savings from corporations and institutional investors in need of deposit-like products in which to place their cash balances created a plentiful source of funds. These products were viewed as "safe" since, after all, the funds were only exposed for a short period of time, and in the case of repo, they were secured by collateral. On the demand side, setting aside any possible instabilities in this funding source, it was more profitable to use shorter-term funds to finance longer-term assets."
Dudley tells us, "In fact, the growing reliance on short-term wholesale funding to finance longer-term assets increased liquidity and maturity mismatch risk in the financial system.... Short-term funding of longer-term assets is inherently unstable, especially in the presence of information and coordination problems.... Of course, this insight is not a new one. Prior to the establishment of a lender of last resort and retail deposit insurance for banks -- which came with the quid pro quo of prudential regulation -- bank runs were a regular and disruptive feature of our financial system. These innovations solved the coordination problem and stabilized this source of funding."
He adds, "What was new prior to the crisis was the extent to which maturity transformation and financial intermediation had migrated outside of commercial banks. The growth of what we call the shadow banking system occurred largely without the types of safeguards -- robust prudential regulation, deposit insurance, lender of last resort -- that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the financial system. The systemic risk created by this gap in coverage was not well recognized by regulators or the private sector prior to the global financial crisis."
Dudley continues, "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. It began in the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits, and spread via auction-rate securities to the repo, money market and financial commercial paper markets that formed the core financing for market-based financial intermediation.... The inherent fragility of short-term wholesale funding was greatly aggravated by certain institutional shortcomings in these markets, particularly in the structure of the tri-party repo system and the U.S. money market mutual fund business."
He says, "Through the tri-party repo market, each day the two large clearing banks were providing a large amount of intraday credit to securities firms to facilitate the daily "unwind" of the prior day's transactions. In the run-up to the crisis, the daily "unwind" helped make tri-party repo look like a very liquid investment while still being an apparently highly durable source of funding. This masked the underlying risks and contributed to weak risk management practices. 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 explains, "The "breaking the buck" by the Reserve Fund following the Lehman bankruptcy 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. As with bank deposits prior to deposit insurance, 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. By being first in line, they could exit while the fund could still repay at par, leaving others to bear any losses. 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 states, "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.... [T]he lender of last resort liquidity provision was extended to directly backstop key wholesale funding markets and made available to certain nonbank firms. 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). When wholesale funding for non-residential mortgage securitizations evaporated, the Fed rolled out the Term Asset-Backed Lending Facility (TALF)."
Finally, Dudley comments, "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. The New York Fed, for example, has led a Federal Reserve effort to make the tri-party repo system more resilient to stress, while the SEC has taken steps to address risks associated with money market mutual funds. Nonetheless, some important issues and vulnerabilities remain. Moreover, because the Dodd-Frank Act raised the hurdle for the Federal Reserve to exercise its Section 13.3 emergency lending authority, extraordinary interventions will be more difficult to undertake, perhaps causing investors to be even more skittish in the future. This is why it is essential to make the system more stable."
The "Summary" of Rosengren's speech says, "In a speech in New York, Federal Reserve Bank of Boston President Eric Rosengren called for a comprehensive re-evaluation of the regulation of broker-dealers (intermediaries that effect transactions in securities), given the lessons of the financial crisis." "Broker-dealers played a dramatic role during the crisis," said Rosengren. Given their dependence on unstable, short-term funding, "broker-dealers can experience significant funding problems during times of financial stress and, unfortunately, that potential for problems has not been fully addressed since the crisis."
It explains, "Before the crisis, broker-dealers' reliance on collateralized borrowing in the form of repurchase agreements was assumed to insulate them from runs, perhaps because many viewed collateralized lending as providing little default risk. But as Rosengren notes, this proved to be wrong once the crisis hit.... Rosengren added that the largest domestic net suppliers of repurchase agreement financing are money market mutual funds." He says, "During the financial crisis, deteriorating confidence in broker-dealers was compounded by the fact that investors were also fleeing money market mutual funds."
The summary says, "Given the lessons learned from the crisis, one might have expected less reliance by broker-dealers on repurchase agreements, and a significant increase in capital required of broker-dealers. "What is striking is the lack of change -- while there has been some improvement in capital, the 2013 liability structure looks surprisingly similar to the structure that prevailed before the financial crisis," said Rosengren.
Finally, Rosengren's speech comments on money funds, "That experience led to regulatory reforms by the Securities and Exchange Commission, including new liquidity requirements for money market mutual funds and recently issued rules that, among other things, will result in the fluctuation of net asset values of shares for some of these funds. While I would have preferred even more protection against financial runs on money market mutual funds, this element of the recent rulemaking does represent a meaningful improvement. Still, I am certainly on record as questioning whether the imposition of withdrawal restrictions ("gates") and fees will help to stabilize money market mutual funds in crisis situations."
