More Tools Needed to Stop Asset Fire Sales, Fed's Stein Says

WASHINGTON — Federal Reserve Board Gov. Jeremy Stein warned Thursday that the current scope of regulatory tools will be insufficient to ward off the risks associated with asset fire sales.

"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-dealer will run into solvency or liquidity problems — they fall short as a comprehensive, marketwide approach to the fire-sales problem associated with SFTs [securities financing transactions]," said Stein, in a speech at joint conference hosted by the Federal Reserve Bank of Chicago and the International Monetary Fund.

Only a month earlier Stein made the case that the current set of tools available to regulators — risk-based capital, liquidity, and leverage requirements — failed to go far enough in lessening the risks tied to fire sales created by securities financing transactions. Instead, he suggested that a mix of instruments could be used by policymakers to address the issue.

Fed officials, including Gov. Daniel Tarullo, who heads bank supervision at the central bank, have repeatedly issued warnings that regulators must go further in addressing this aspect of the shadow banking system in order to minimize the risks caused by fire sales.

"Relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs," said Tarullo in a speech in May.

While some improvement has been made since the crisis, he said "significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions."

U.S. regulators have said they plan to issue a proposal by the end of the year to address potential reforms to short-term whole sale funding.

Both Stein and Tarullo have suggested, among other things, a possible capital surcharge, changes to the liquidity rule, and universal margin requirements.

In theory, a liquidity-linked capital surcharge, an idea first aired by Tarullo in May, would serve as a tax on both the dealer-as-principal and dealer-as intermediary types of SFTs. Doing so, would allow policymakers to address the issue through the characteristics of a firm's SFT book, rather than as the type firm it is.

Another possibility would include changes to the recently proposed liquidity rules. Policymakers, Stein suggested, could "introduce an asymmetry between the assumed liquidity properties of repo loans made by a broker-dealer, and its own repo borrowing."

Lastly, in order to help eliminate concerns about regulatory arbitrage, regulators could install a universal margin requirement. They could accomplish that by imposing "a minimum haircut, or downpayment, on any party — be it a hedge fund or a broker-dealer — that uses short-term collateralized funding to finance its securities holdings."