Federal Reserve Bank of Boston President Eric Rosengren said brokerage regulation needs a “major re-examination” to prevent funding shortfalls during a crisis and that brokers should have higher capital requirements.
“Broker-dealers can experience significant funding problems during times of financial stress,” Rosengren said in remarks prepared for delivery to a Fed conference on wholesale funding risk in New York. “Unfortunately that potential for problems has not been fully addressed since the crisis.”
Firms that depend on unstable funding should be required to “hold significantly more capital” than if they relied on more stable sources, Rosengren said. Such requirements should apply to large independent brokers, foreign firms with U.S. holding companies and banks with “major” brokerages. Companies should use more long-term debt to finance positions because it “reduces the need for short-term and more ‘runnable’ funding,” he said.
Fed officials have warned the web of repurchase agreements, or repos, remains prone to unravel in a panic, leading to fire sales of assets that could spread losses across the financial system. The failure of Lehman Brothers Holdings Inc. in 2008 was due in part to its inability to renew short-term funding deals as the value of its collateral plunged.
Rosengren said the risk of runs could be cut by limiting how short-term repo agreements held by intermediaries can be used to finance long-term assets or high-credit-risk assets. While tighter regulation would reduce broker profits, history shows “that trade-off may be unavoidable and in the public interest from a financial stability perspective,” he said at the event organized by the Boston and New York reserve banks.
“Given the widespread support provided to broker-dealers and the difficulties they encountered during the crisis, a comprehensive re-evaluation of broker-dealer regulation is overdue,” Rosengren said. “What is striking is the lack of change. While there has been some improvement in capital, the 2013 liability structure looks surprisingly similar to the structure that prevailed before the financial crisis.”
The Boston Fed chief also brought up a possibility of allowing brokers to access central bank lending facilities in a crisis to keep markets functioning, while also calling such a move “complex and likely controversial” and also unlikely.
“The Federal Reserve’s discount window could theoretically provide a way of reducing liquidity risk, by providing a standing liquidity facility for broker-dealers,” he said. “The rationale for such a step would be rooted in the notion that market-making is as important as lending in today’s economy.”
Fed Chair Janet Yellen told lawmakers last month she wouldn’t rule out expanding discount-window access to brokers and other non-banks during a financial crisis. “It depends what the circumstances are,” Yellen said. “A broad-based scheme in a situation of systemic risk is a possibility but it is something that would have to be very serious to consider.”
The Securities and Exchange Commission is considering new funding rules for brokers as well as a limit on leverage similar to those used by the Fed and other bank regulators. SEC Chair Mary Jo White called in a February speech for increased broker oversight to boost their capital and stronger protections for customer assets.
Commissioner Kara M. Stein said in June the SEC needs to update its capital rules for large brokers such as those owned by Goldman Sachs Group Inc. and JPMorgan Chase & Co. to limit the impact of a firm’s failure on the financial system.
Rosengren, 57, has been a consistent supporter of Fed stimulus, though he doesn’t have a policy vote on the Federal Open Market Committee again until 2016. He joined the bank as an economist in 1985 and became president in 2007. The Boston Fed district includes Massachusetts, Maine, New Hampshire, Rhode Island, Vermont and almost all of Connecticut.
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