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.
“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 that the “possibility of a run” on money-market funds remains.
Bernanke said 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.”
“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 and the Fed are attempting to construct data sets on triparty and bilateral repo transactions to help better monitor activity. 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.
“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.