Existing Regulation Insufficient to Thwart Risk Created By Securities Lending

Federal Reserve Governor Jeremy Stein said current regulatory mechanisms fall short as a comprehensive, market-wide approach to the risk impact of fire sales created by securities financing transactions.

Delivering a speech at Federal Reserve Bank of New York workshop last Friday, Stein said a forced sale of an asset is an event that involves a market failure, or externality, of the sort that might justify a regulatory response. Second, he argued that securities financing transactions (SFTs) are a leading example of the kind of arrangement that can give rise to such externalities, and hence are particularly deserving of policy attention.

He noted that assets sold in fire sales can trade at prices far below value in best use, causing severe losses to sellers. “For a fire sale to have the sort of welfare effects that create a role for regulation, the reduced price in the fire sale has to hurt somebody other than the original party making the leverage decision, and this adverse impact of price has to run through something like a collateral constraint, whereby a lowered price actually reduces, rather than increases, the third party’s demand for the asset,” said Stein.

“So if hedge fund A buys an asset-backed security and finances it largely with collateralized borrowing, A’s fire selling of the security will create an externality in the conventional sense only if the reduced price and impaired collateral value lower the ability of hedge funds B and C to borrow against the same security, and therefore force them to involuntarily liquidate their positions in it as well.”

Stein used the fire sale argument to highlight why SFTs, such as those done via repurchase (repo) agreements, are a natural object of concern for policymakers. “This market is one where a large number of borrowers finance the same securities on a short-term collateralized basis, with very high leverage–often in the range of twenty-to-one, fifty-to-one, or even higher,” he said. “Hence, there is a strong potential for any one borrower’s distress–and the associated downward pressure on prices–to cause a tightening of collateral or regulatory constraints on other borrowers.”

Clearly, said Stein, there is the potential for fire-sale risk in the instance of the broker-dealer as principal and broker-dealer as SFT intermediary. One source of risk would be an initial shock either to the expected value of the underlying collateral or to its volatility that leads to an increase in required repo-market haircuts (e.g., the default probability of the corporate bond goes up).

Stein pointed out the inability of the existing regulations to deal with the specific problem of fire-sale externalities in SFTs:

1. Risk-based capital requirements. “Current risk-based capital requirements are of little relevance for many types of SFTs. After all, they are designed to solve a different problem—that of ensuring bank solvency. The risk-averse lenders in the triparty market—who, in turn, provide financing to the dealer—operate under the same premise. As I noted earlier, these defensive reactions by providers of repo finance mean that the costs of fire sales are likely to be felt elsewhere in the financial system,” he said.
2. Liquidity requirements. “Liquidity requirements, such as those embodied in the Basel III Liquidity Coverage Ratio (LCR), can impose a meaningful tax on certain SFTs in which the dealer acts as a principal,” he said. “However, this conclusion is sensitive to the details of the example. If, instead of holding a corporate bond, the dealer holds a Treasury security that is deemed to count as Level 1 HQLA, there is no impact of the LCR. Moreover, the LCR plays no role in mitigating fire-sales externalities in the important matched-book case in which the dealer acts as an intermediary. If a dealer borrows on a collateralized basis with repo and then turns around and lends the proceeds to a hedge fund in a similar fashion, the LCR deems the dealer to have no net liquidity exposure—and hence imposes no incremental liquidity requirement—so long as the lending side of the transaction has a maturity of less than 30 days.”
3. Leverage ratio. “If a broker-dealer firm faces a binding leverage ratio, this constraint can act as a significant tax on two types of SFTs that are largely untouched either by risk-based capital requirements or by liquidity regulations,” he said. “However, because it is unlikely that the leverage constraint would bind symmetrically across all of the largest firms, my guess is that the effect would be less to deter SFT activity in the aggregate than to cause it to migrate in such a way as to be predominantly located in those firms that—because they have, say, a larger lending business and, hence, more risk-weighted assets—have more headroom under the leverage ratio constraint.”

Stein said a general theme is that while many of these tools are likely to be helpful in fortifying individual regulated institutions—in reducing the probability that, say, a given bank or broker-dealer will run into solvency or liquidity problems—they fall short as a comprehensive, market-wide approach to the fire-sales problem associated with SFTs.

He said none of the above regulation seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by SFTs and suggested leveraging the following tools:

1. Capital surcharges. “As compared to relying on the leverage ratio to implement the tax, this approach has the advantage that it is more likely to treat institutions uniformly: the tax on SFTs would not be a function of the overall business model of a given firm, but rather just the characteristics of its SFT book. This is because the surcharge is embedded into the existing risk-based capital regime, which should in principle be the constraint that binds for most firms.”
2. Modified liquidity regulation. “A conceptually similar way to get at matched-book repo would be to modify liquidity regulation so as to introduce an asymmetry between the assumed liquidity properties of repo loans made by a broker-dealer, and its own repo borrowing. For example, in the context of the Net Stable Funding Ratio (NSFR), one could assume that a dealer’s repo loans to a hedge fund roll off more slowly than do its own repo borrowings from the triparty market. This assumption would create a net liquidity exposure for a matched repo book, and would thereby force the dealer to hold some long-term debt or other stable funding against it.”
3. Universal margin requirements.
”The idea would be to impose a minimum haircut, or down payment requirement, on any party—be it a hedge fund or a broker-dealer—that uses short-term collateralized funding to finance its securities holdings. Because the requirement now lives at the security level, rather than at the level of an intermediary in the SFT market, it cannot be as easily evaded by, say, a hedge fund going outside the broker-dealer sector to obtain its repo funding. This is the strong conceptual appeal of universal margin from the perspective of a fire-sales framework. In this regard, it is worth noting that the Financial Stability Board (FSB) has recently released a proposal to establish minimum haircut requirements for certain SFTs. However, the FSB proposal stops well short of being a universal margin requirement.”

Stein said a “sensible path forward” might involve drawing a mixture of these. “It is unlikely that we will find singular and completely satisfactory fixes,” he concluded.