Not enough in the tank to dampen fire sales
08 October 2013 New York
Image: Shutterstock
Regulatory mechanisms “fall short” as a comprehensive, market-wide approach to fire sales that can result from securities financing transactions, according to Federal Reserve governor Jeremy Stein.
Stein was speaking at the Federal Reserve Bank of New York Workshop on Fire Sales as a Driver of Systemic Risk in Triparty Repo and other Secured Funding Markets in New York on 4 October.
He said that securities financing transactions are “a natural object of concern for policymakers” because the market sees a large number of borrowers finance the same securities on a short-term collateralised basis, with very high leverage—“often in the range of twenty-to-one, fifty-to-one, or even higher”.
“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.”
He suggested placing a tax on securities financing transactions because “the goal of regulatory policy should be to get private actors to internalise these costs”, adding: “At an abstract level, this means looking for a way to impose an appropriate Pigouvian (ie, corrective) tax on the transactions.”
“Of course, the tax must balance the social costs against the benefits that accompany securities financing transactions; these benefits include both ‘money-like’ services from the increased stock of near-riskless private assets, as well as enhanced liquidity in the market for the underlying collateral...”
“So in the absence of further work on calibrating costs and benefits, there is no presumption that the optimal tax should be large, only that it may be non-zero, and that it may make sense for it to differ across asset classes.”
In assessing whether the mainstays of the existing regulatory toolkit can act as the tax, Stein said that risk-based capital, liquidity, and leverage requirements “have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by securities financing transactions”.
“The liquidity coverage ratio affects a subset of securities financing transactions in which a dealer firm acts as a principal to fund its own inventory of securities positions, but does not meaningfully touch those in which it acts as an intermediary.”
“By contrast, an aggressively calibrated leverage ratio could potentially impose a significant tax on a wider range of securities financing transactions, but the tax would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom the leverage ratio constraint was more binding than the risk-based capital constraint. As such, it would be more likely to induce regulatory arbitrage than to rein in overall securities financing transaction activity.”
Other regulatory options are available in the event of a securities financing transaction-induced fire sale, but capital surcharges could create a tax that is passed on to the downstream borrower, leading to disintermediation.
Universal margin requirements, such as those proposed by Financial Stability Board in the form of minimum haircut requirements for certain securities financing transactions, have the potential to act as a restraint on transactions that are intermediated by regulated broker-dealer firms, but are vulnerable to the same evolution of the business—“away from this intermediated mode”—as capital surcharges, according to Stein.
Stein concluded: “I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments that I discussed: namely, capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements.”
“As we go down this path, conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find singular and completely satisfactory fixes.”
He added a note of caution over money market funds, saying that they are “among the most significant repo lenders to broker-dealer firms, and an important source of fire-sale risk comes from the fragility of the current money fund model”.
“I welcome the work of the Securities and Exchange Commission on this front, particularly its focus on floating net asset values, and look forward to concrete action.”
Stein was speaking at the Federal Reserve Bank of New York Workshop on Fire Sales as a Driver of Systemic Risk in Triparty Repo and other Secured Funding Markets in New York on 4 October.
He said that securities financing transactions are “a natural object of concern for policymakers” because the market sees a large number of borrowers finance the same securities on a short-term collateralised basis, with very high leverage—“often in the range of twenty-to-one, fifty-to-one, or even higher”.
“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.”
He suggested placing a tax on securities financing transactions because “the goal of regulatory policy should be to get private actors to internalise these costs”, adding: “At an abstract level, this means looking for a way to impose an appropriate Pigouvian (ie, corrective) tax on the transactions.”
“Of course, the tax must balance the social costs against the benefits that accompany securities financing transactions; these benefits include both ‘money-like’ services from the increased stock of near-riskless private assets, as well as enhanced liquidity in the market for the underlying collateral...”
“So in the absence of further work on calibrating costs and benefits, there is no presumption that the optimal tax should be large, only that it may be non-zero, and that it may make sense for it to differ across asset classes.”
In assessing whether the mainstays of the existing regulatory toolkit can act as the tax, Stein said that risk-based capital, liquidity, and leverage requirements “have a variety of other virtues, but none seem well-suited to lean in a comprehensive way against the specific fire-sale externalities created by securities financing transactions”.
“The liquidity coverage ratio affects a subset of securities financing transactions in which a dealer firm acts as a principal to fund its own inventory of securities positions, but does not meaningfully touch those in which it acts as an intermediary.”
“By contrast, an aggressively calibrated leverage ratio could potentially impose a significant tax on a wider range of securities financing transactions, but the tax would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom the leverage ratio constraint was more binding than the risk-based capital constraint. As such, it would be more likely to induce regulatory arbitrage than to rein in overall securities financing transaction activity.”
Other regulatory options are available in the event of a securities financing transaction-induced fire sale, but capital surcharges could create a tax that is passed on to the downstream borrower, leading to disintermediation.
Universal margin requirements, such as those proposed by Financial Stability Board in the form of minimum haircut requirements for certain securities financing transactions, have the potential to act as a restraint on transactions that are intermediated by regulated broker-dealer firms, but are vulnerable to the same evolution of the business—“away from this intermediated mode”—as capital surcharges, according to Stein.
Stein concluded: “I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments that I discussed: namely, capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements.”
“As we go down this path, conceptual purity may have to be sacrificed in some places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find singular and completely satisfactory fixes.”
He added a note of caution over money market funds, saying that they are “among the most significant repo lenders to broker-dealer firms, and an important source of fire-sale risk comes from the fragility of the current money fund model”.
“I welcome the work of the Securities and Exchange Commission on this front, particularly its focus on floating net asset values, and look forward to concrete action.”
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