Fed’s Dudley Calls for Wholesale Funding Market ‘Reform’

Federal Reserve Bank of New York President William C. Dudley said “reform” of the money-market fund industry and the market for tri-party repurchase agreements is essential because they threaten financial stability.

“The sheer size of banking functions undertaken outside commercial banking entities -- even now, after the crisis -- suggests that this issue must not be ignored,” Dudley said today in the text of remarks for a speech in New York. “I don’t think we should be comfortable with a situation in which extensive maturity transformation continues to take place without the appropriate safeguards against runs and fire sales.”

More than four years after the collapse of Lehman Brothers Holdings Inc., U.S. regulators are still grappling with how to reduce the risks from the loosely-regulated so-called shadow banking system and lower the likelihood that taxpayers will need to bail out too-big-to-fail banks in a crisis.

Regulators need to “consider whether our current architecture is satisfactory,” said Dudley, who spoke at the New York Bankers Association’s annual meeting and economic forum. If supervisors deem it unacceptable, they could either “curtail the extent of short-term wholesale finance in the system,” or “expand the range of financial intermediation activity that is directly backstopped by the central bank’s lender of last resort function,” he said.

Social Value

These options and “the issue of the social value created by market-based financial intermediation” will “require further study and analysis,” Dudley said. “Regardless of where we come out on these questions, we must make the basic structure of the wholesale funding market as sound as possible” and “push ahead with tri-party and money fund reform.”

Five months after beating back a regulatory plan by then-Chairman Mary Schapiro of the U.S. Securities and Exchange Commission, fund companies acknowledge they face longer odds in blocking a similar proposal expected to reach SEC commissioners before the end of March. The agency is being pressed to reconsider changes by the Financial Stability Oversight Council, or FSOC, a risk-monitoring panel that includes the heads of the Fed and Treasury Department.

Dudley has repeatedly voiced support for money-market reforms.

“A glaring vulnerability exists with money-market mutual funds,” Dudley wrote in an Aug. 15 Bloomberg View column. “Money funds should have capital buffers and modest limits on investor withdrawals. Such reforms are necessary to protect the economy from financial instability in the future.”

Best Option

Dudley said today that the best option proposed by the FSOC is the one implementing a capital buffer in conjunction with a restriction on redemptions that would require investors who withdraw to hold a “small balance” for a “short period” to absorb losses.

Regulators have worked to impose tighter restrictions on money funds since the September 2008 collapse of the $62.5 billion Reserve Primary Fund. Its failure, caused by losses on debt issued by Lehman, triggered a wider run on prime funds that helped freeze global credit markets.

Three of the five largest U.S. money-market fund managers, signaling they can’t stop a second attempt by regulators to overhaul rules for the $2.7 trillion industry, are fighting instead to limit the scope of any changes.

Fidelity Investments, Vanguard Group Inc. and Charles Schwab Corp. are urging regulators to exempt retail-oriented funds and focus on those that cater to institutional clients and buy corporate debt, a category that absorbed the bulk of an investor run in 2008.

‘Institutional Flaws’

“We have not come close to fixing all the institutional flaws in our wholesale funding markets,” Dudley said. “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.”

The Fed has been seeking to strengthen the market for tri-party repurchase agreements, which approached collapse in 2008 as Lehman went bankrupt. The central bank intensified its effort after a private-sector Tri-Party Repo Infrastructure Reform Task Force that it sponsored disbanded. The task force issued a final report in February 2012 that said more time and effort were needed to reach its goal of “practical elimination” of the extension of intraday credit to dealers from the industry’s two clearing banks.

Primary Dealers

Repos are transactions used by the Fed’s primary dealers for short-term funding. They typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to lenders, which typically are money-market mutual funds.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry’s clearing banks.

Dudley said regulators must “deal with the fire sale issue in tri-party repo and the heightened run risk it creates.” He proposed three ways of doings so: restricting transactions to open-market operations eligible collateral, creating a mechanism to “facilitate the orderly liquidation of a defaulted dealer’s collateral,” or having regulators limit the use of tri-party repo “on the grounds that it is still an unstable source of funds.”

Dudley didn’t comment on the outlook for the economy or monetary policy.

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