[This story previously appeared in Securities Regulation Daily.]
By Jacquelyn Lumb
The president and CEO of the Federal Reserve Bank of Boston has called for a comprehensive reevaluation of broker-dealer regulations. Eric S. Rosengren, in a keynote address at a conference on the risks of wholesale funding sponsored by the Federal Reserve Banks of Boston and New York, noted that broker-dealers played a dramatic role in the 2008 financial crisis yet the SEC’s capital and liquidity requirements have not materially changed. Broker-dealers that are not part of bank holding companies remain under a similar regulatory environment as before the crisis, according to Rosengren, and he called for an increase in the capital required for any holding company with significant broker-dealer operations.
Financial crisis. Many of the most significant runs that occurred during the financial crisis involved financial institutions other than banks. Rosengren mentioned money market mutual funds in particular. The SEC adopted new liquidity requirements, but Rosengren said he would have preferred even more protections against runs on money market mutual funds. He said he is on record as questioning whether the withdrawal restrictions and fees the SEC adopted will help stabilize these funds in a crisis situation.
The most dramatic runs during the crisis affected security brokers and dealers. Rosengren noted that these broker-dealers fund their holdings in uninsured short-term credit markets, which makes them more susceptible to runs than financial institutions that finance their holdings through longer-term or insured borrowing. He said there have been significant reductions in some broker-dealers’ holdings of highly risky assets and some improvements in capital and liquidity positions, but their reliance on a wholesale funding models remains surprisingly unchanged.
Possible solutions. The potential funding problems have not been fully addressed since the crisis, and Rosengren discussed a number of possible responses. The most direct approach would be to require financial organizations that are dependent on unstable funding to hold significantly more capital, he advised. A larger share of long-term subordinated debt could be used to finance securities positions, he suggested.
Another option is to limit the amount of maturity transformation that can be done with repurchase agreements, which would require a limit on the extent to which short-term repurchase agreements could be used to finance long-term assets or high credit risk assets. Another option is to prohibit money market mutual funds from holding repurchase agreements secured by collateral that, by rule, they cannot purchase.
Rosengren suggested that additional remedies be explored, including a regulation that specifies the eligible collateral for a repurchase agreement and mandates a haircut, or a change in accounting treatment so that repurchase agreements with less liquid collateral could not be counted as cash and cash equivalent to the investor. His most controversial possibility was to open the Federal Reserve’s discount window to provide a liquidity facility for broker-dealers, based on the rationale that market-making is as important to the economy as lending.
Rosengren acknowledged that the discount window option was not likely, but said a significant reevaluation of the broker-dealer regulatory requirements is needed and that much higher solvency standards would reduce the risk of runs. Given the broad support provided to broker-dealers and the difficulties they experienced during the crisis, Rosengren said a comprehensive reevaluation of their regulation is long overdue.