Bernanke Sees Important Risks in Wholesale Funding

Federal Reserve Chairman Ben S. Bernanke said risks persist in wholesale funding markets used frequently by Wall Street brokers to finance securities trading.

“Important risks remain in the short-term wholesale funding markets,” Bernanke said today in a speech at a Chicago Fed banking conference. “One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower.”

Bernanke outlined how the Fed has overhauled risk monitoring since a collapse in mortgage finance triggered a crisis in 2008 that led to the worst recession since the Great Depression. The Fed is stress-testing the largest banks and has set up teams and developed models to look for risks across both financial markets and institutions, switching to a more industry-wide approach from one that looked at banks individually.

“More work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market,” Bernanke said. He said the “possibility of a run” on money-market funds remains.

The financial crisis revealed that the market for repurchase agreement funding -- where a securities dealer uses collateral for short-term loans with an agreement to reverse the transaction later -- was “quite fragile,” Bernanke said.

‘Worried Lenders’

“As questions emerged about the nature and value of collateral” during the crisis, “worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely,” the Fed chairman said. “Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation.”

Bernanke said researchers at the U.S. Treasury Department and the Fed are attempting to construct data sets on triparty and bilateral repo transactions to improve monitoring. The Fed is also looking at ways dealers may be funding less-liquid assets or transforming risks “from forms that are more easily measured to forms that are more opaque.”

The Fed chief has elevated market and institutional surveillance to an equal footing with macroeconomic research and forecasting, establishing the Office of Financial Stability Policy and Research headed by PhD economist Nellie Liang.

Part of Liang’s mission is to look beyond the banking system to risks that may arise in areas such as real-estate investment trusts or bond finance for high-risk companies.

Stability Monitoring

“Financial-stability monitoring is distinct from supervision because of its focus on the risks for the whole financial system, in both regulated and non-regulated institutions and markets,” Liang and two other Fed economists said in a research paper published by the central bank last month.

Tracking risk is essential for the Fed as it pushes down long-term bond yields through monthly purchases of $85 billion in Treasuries and mortgage-backed securities.

The Treasury 10-year note yielded 1.90 percent at 12:22 p.m. in New York, an increase from a 2013 low of 1.62 percent on May 2. The Standard and Poor’s 500 Index was little changed at 1,625.97. The S&P 500 is up 14 percent this year, about the same as the gain in the KBW Bank Index, which includes 24 large financial institutions such as Bank of America Corp.

Asset Prices

The Federal Open Market Committee has considered whether bond purchases aimed at fueling economic growth and reducing 7.5 percent unemployment will distort asset prices and disrupt markets. The buying has pushed up the Fed’s balance sheet to $3.32 trillion.

Bernanke said Fed officials are looking at the pricing and structure of financial securities to identify risks and asset price bubbles.

“It would be hubristic to believe that we could always identify such deviations,” he said in response to a question.

More important is spotting “the vulnerabilities that could transform what might be a relatively modest misvaluation or move in asset prices into a much broader crisis,” he said.

To that end, the Fed is watching to see if holders of assets are highly leveraged or lack liquidity, or how such assets might transmit stress throughout the system if they moved sharply lower, he said.

The Fed chairman called the perception among investors that the largest banks are still too big to fail “a very big issue.”

“We will not have completed the goals of financial regulatory reform unless we adequately address this issue,” he said in a question-and-answer period.

Capital Agreements

Jaret Seiberg, a Washington policy analyst for Guggenheim Securities LLC, said Bernanke’s remarks reinforce his view that regulators will go beyond current capital agreements and impose additional requirements on the biggest banks.

“We continue to believe the regulators will use a combination of a more restrictive leverage limit, a capital surcharge based on reliance on short-term debt, and a long-term debt requirement,” Seiburg said in a note to clients.

If safeguards under the U.S. Dodd-Frank Act and the international accord known as Basel III won’t eliminate the perception that the largest banks will be bailed out, Bernanke said he would argue that the largest banks “have to have more and better quality capital.” Higher capital requirements could also give banks an incentive to reduce their size, complexity and interconnectedness, he said.

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