The Simple Fix for the Repo Market
Banks that own broker-dealers need to hold more capital to withstand runs and other shocks, said Eric Rosengren, the head of the Federal Reserve Bank of Boston said Wednesday.
Federal Reserve Board Chair Janet Yellen on Wednesday offered few clues when regulators would move ahead with issuing a proposal to address risks tied to short-term wholesale funding.
Federal Reserve Board Gov. Daniel Tarullo said Friday that he was still concerned about ongoing risks from banks' potential overreliance on short-term wholesale funding, but suggested one possible remedy: higher capital requirements.
The Federal Reserve Board is due in 2014 to unveil an initial plan to clamp down on risks tied to financial institutions' reliance on short-term wholesale funding.
The most recent financial crisis exposed significant problems with the repurchase agreement market. Unfortunately, policymakers are now gravitating toward a roundabout solution when there is a better, simpler alternative.
Repurchase agreements (repos) allow broker-dealers to access funding by selling securities that they agree to buy back, typically the following day. The securities serve as loan collateral for the investors who act as lenders. During the financial crisis, broker-dealers' access to the repo market dried up because investors were wary of taking the high-risk securities that served as collateral.
To improve the stability of the market, policymakers such as Federal Reserve Bank of Boston president Eric Rosengren have proposed raising capital requirements for companies that own broker-dealers. In theory, holding more capital would make broker-dealers less likely to fall into financial distress. They would therefore be able to maintain access to funding in the repo market.
There are two big problems with this proposal. First, raising capital requirements would drive up the cost of the services offered by broker-dealers and could make U.S. intermediaries less competitive internationally. Moreover, it is unclear how regulators would determine the appropriate level of capital required.
An alternative solution exists that would be both less costly and easier to implement. Broker-dealers should be required to provide collateral that any lender would be willing to take, such as Treasury securities. Treasury securities were not widely held on the books of broker-dealers during the crisis because of lax regulations about acceptable forms of collateral. Reversing these regulations would be an effective and direct means of addressing the problem at hand.
The current issues in the 100-year-old repo market stem from subtle changes in bankruptcy code. During the early part of the repo market's evolution, broker-dealers almost always used Treasury securities as collateral. But in the financial crisis of the early 1980s, a number of broker-dealers failed. The repo market then collapsed because bankruptcy laws at the time permitted general creditors to seize the securities held as collateral. Former Fed chairman Paul Volcker proposed that repos be exempt from bankruptcy proceedings in order to prevent similar market collapses in the future. At Volcker's suggestion, only certain types of collateral were exempt: certificates of deposit, bankers' acceptances and Treasuries.
Congress made this law in 1984. If this system had still been in place during the recent financial crisis, the repo market would have been much less likely to freeze up.
The real trouble began in 2005, when the law was amended to expand the kinds of collateral exempt from bankruptcy proceedings. From that time forward, mortgage loans, mortgage-backed securities and agency-backed securities were exempt as well. These risky instruments generally had higher yields, so they became broker-dealers' collateral of choice in the run-up to the financial crisis. When the housing crisis hit, lenders were unwilling to accept mortgages in any form as collateral because of their long-lived maturities and escalating credit risk.
But if regulators require broker-dealers to use Treasury securities as collateral, investors would be willing to continue to lend throughout a crisis. Treasuries of all maturities are highly liquid, so investors like money-market funds will know that they can sell them without price concessions.
Rather than use higher capital requirements as an indirect solution to instability in the repo markets, it is far better to address the problem head-on. Low-quality credit securities were at the center of the last financial crisis. Returning to traditional money market securities is the surest way to prevent a reoccurrence.
Scott Hein is the Robert C. Brown Chair in finance and Drew Winters is the Raymond and Lucille Pickering Chair in finance, both at Texas Tech University. Both Hein and Winters are co-executive editors, along with colleague Dr. Jeffrey Mercer, of the Journal of Financial Research.