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.”
Transform Risks
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.
Monthly Purchases
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 1.86% at 10:00 a.m. in New York trading, an increase from a 2013 low of 1.62% on May 2. The Standard and Poor’s 500 stock index has increased 14.4% this year compared with a 14.0% gain for the KBW Bank Index, which includes 24 large financial institutions such as Bank of America Corp. The S&P 500 rose 0.3% to 1,631.30.
The Federal Open Market Committee has considered whether bond purchases aimed at fueling economic growth and reducing 7.5% unemployment will distort asset prices and disrupt markets. The buying has pushed up the Fed’s balance sheet to $3.32 trillion.
“Asset purchases were seen by some as having a potential to contribute to imbalances in financial markets and asset prices, which could undermine financial stability over time,” according to minutes of the March 19-20 FOMC meeting.
Deflating Bubbles
Policy makers are also debating what tools to use in deflating asset price bubbles. Fed Governor Jeremy Stein in February said he saw circumstances “where it might make sense to enlist monetary policy” to curb excessive risk-taking because interest rates influence corners of the financial system unreachable through bank regulation.
Minneapolis Fed president Narayana Kocherlakota said in April that Fed efforts to ensure stable prices and reduce unemployment will probably warrant a long period of low interest rates that will inflate asset prices.
“Even in the presence of effective supervision and regulation, these phenomena could pose residual macroeconomic risks,” he said.
