Stein Sees Market Risk in Securities Financing Transactions

Federal Reserve Governor Jeremy Stein said the market for securities financing transactions poses a risk to the financial system that may require further regulatory steps to contain.

“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,” Stein said today at a speech at the Federal Reserve Bank of New York. “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.”

Stein did not discuss the outlook for monetary policy or the economy in his prepared remarks. His speech focused on securities financing transactions, which include repurchase agreements, reverse repos, securities lending and borrowing, and securities margin lending.

The Fed is working to improve its regulation of financial institutions and markets following the 2007-2009 financial crisis that led to the collapse of Lehman Brothers Holdings Inc. and Bear Stearns Cos. The unemployment rate climbed as high as 10 percent in the wake of the crisis and has yet to recover to its levels of 2007.

Regulatory Changes

Stein said the Fed’s current regulatory changes “have a variety of virtues, but none seem well-suited to lean in a comprehensive way against the specific” risks created by securities financing transactions.

Federal Reserve Bank of New York President William C. Dudley said “significant vulnerabilities” remain in the market for tri-party repurchase agreements despite increased oversight. In a tri-party arrangement, a third party acts as the agent for the transaction and holds the security as collateral.

“Significant work remains to be done,” Dudley said in opening remarks at the conference today. “Current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales, whether by the dealer itself, or by the dealer’s creditors following a default.”

Dudley said he “would urge industry participants to begin work on this issue without further delay” and warned that failure to fix this problem would prompt increased regulation.

‘Holistic Solution’

“If industry is unable to play its role in achieving a holistic solution, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk,” Dudley said.

“While such an approach may indeed enhance the overall stability of this market, it could also lead to unintended consequences that include reducing the efficacy of the critical role played by this market in supporting the broader financial system,” the New York Fed chief said.

Fed Governor Daniel Tarullo said in a Sept. 20 speech that setting policies to contain the risks of short-term funding markets should be the “highest priority” for policy makers.

Stein today said that “some mix” of new regulatory tools, such as “capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements” may be called for to address the markets’ risks.

“I would be remiss if I did not remind you of another, highly complementary area where reform is necessary: the money market fund sector,” he said.

Stein, 52, a former Harvard University professor, has focused on the intersection of monetary policy, financial markets and regulation since joining the Fed’s board in May 2012.

To contact the reporters on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net; Caroline Salas Gage in New York at csalas1@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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