Fed's Stein Offers Fixes to Fire Sales

WASHINGTON — Federal Reserve Board Gov. Jeremy Stein on Friday laid out potential regulatory remedies to help lessen the risks associated with fire sales.

The governor warned that the existing regulatory toolbox of risk-based capital, liquidity and leverage requirements did not go far enough and were not "well-suited to lean in a comprehensive way" against risk tied to fire sales created by securities financing transactions.

"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-deal will run into solvency or liquidity problems — they fall short as a comprehensive, marketwide approach to the fire-sale problems associated with SFTs," said Stein in a speech at a conference at the New York Fed.

The liquidity coverage ratio, for example, could affect a sliver of securities financing transactions in cases where the dealer firms acted as a principal and funded their own inventory of securities positions. But it would not "meaningfully touch" those SFTs which acted as an intermediary.

On the other hand, utilizing an "aggressively calibrated leverage ratio," which could impose a meaningful tax on a broader swath of SFTs would wind up being "blunt and highly asymmetric." It would also fall largely on firms whose "leverage ratios constraint were more binding than the risk-based capital constraint" making it more likely to cause regulatory arbitrage, he said.

Stein didn't offer any specific endorsements on an approach, but rather suggested a range of possible channels to address the issue, including the possibility of using a mix of tools.

"I would guess that a sensible path forward might involve drawing on some mix of the latter set of instruments … capital surcharges, modifications to the liquidity regulation framework, and universal margin requirements," said Stein.

Among Stein's suggestions was imposing a liquidity-linked capital surcharge — an idea first aired by Fed Gov. Daniel Tarullo in May — that could act as tax on both the dealer-as-principal and dealer-as intermediary types of SFTs.

Taking such an approach could likely treat institutions more uniformly given that it wouldn't be a function of the overall type of firm, but rather the characteristics of its SFT book. Even so, Stein noted such an approach would be a departure from regulators' current method of requiring a firm to hold the capital.

Stein also suggested another possibility that would require making adjustments to the liquidity rules. The adjusted concept would "introduce an asymmetry between the assumed liquidity properties of repo loans made by a broker-deal, and its own repo borrowing."

Doing so, Stein said, would still not eliminate concerns about regulatory arbitrage entirely. One possible way to correct for that would be to use a universal margin requirement.

The requirement would "impose a minimum haircut, or down payment, on any party — be it a hedge fund or a broker-dealer — that uses short-term collateralized funding to finance its securities holdings," he said.

Because the requirement is at security level, it would not be "easily evaded" by a hedge fund traveling outside the broker-dealer sector to get its repo funding.

The Financial Stability Board recently released a proposal to establish a minimum haircut requirement for certain SFTs, but Stein said it "stops well short of being a universal margin requirement" suggesting U.S. regulators may be inclined to go further in addressing such risks.