William C Dudley: Risks of wholesale funding
Welcoming remarks by Mr William C Dudley, President and Chief Executive Officer of the
Federal Reserve Bank of New York, at the workshop on the "Risks of Wholesale Funding",
New York City, 13 August 2014.
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Michael Fleming, Jamie McAndrews, Susan McLaughlin and Joseph Tracy contributed to preparing these
remarks.
It is a pleasure to welcome you to the New York Fed today to discuss the important issue of
wholesale funding.
As you all know, the financial system plays an essential role in modern economies, and
liquidity is in turn critical to the functioning of the financial system. Because financial
intermediation is critical to economic activity and intermediation is dependent on funding and
liquidity, disruption to funding and liquidity can cause severe damage to the economy. The
experience of recent years revealed serious flaws in the system. Risk was mispriced and
there was a build-up of excesses before the crisis. Structural weaknesses in the financial
system then amplified the effect of the sharp decline in U.S. house prices, and the result was
a widespread financial crisis and a deep recession both here and abroad.
The extensive use by financial firms of short-term wholesale funding was one critical factor in
the crisis. Not only did this reliance on short-term funding create the potential for a firm to fail
in an extraordinarily rapid manner when faced with a loss of market confidence, but it also
served as a channel through which the effects of those failures were widely propagated
throughout the broader financial system.
I will focus my brief remarks on describing the structural vulnerabilities associated with
shortterm wholesale funding, laying the groundwork for our discussions at today's workshop.
As always, my remarks reflect my own views and not necessarily those of the Federal
Reserve System.
As this audience knows, in the two decades leading up to the financial crisis, the global
financial system underwent a rapid transformation. During this period, there was a shift from
bank-based financial intermediation to capital markets-based financial intermediation, and an
increase in the scale and complexity of securitization activities.
In the pre-crisis period, the growth of securitization was accompanied by an increasing
reliance on short-term funds raised in wholesale markets to finance securities and activities
essential to securitization. This ranged from the use of repo funding to finance inventories of
securities held for market-making purposes to the issuance of asset-backed commercial
paper by conduits created to acquire and hold securities.
Both demand and supply factors drove the increased use of short-term wholesale finance.
On the supply side, the growth of savings from corporations and institutional investors in
need of deposit-like products in which to place their cash balances created a plentiful source
of funds. These products were viewed as "safe" since, after all, the funds were only exposed
for a short period of time, and in the case of repo, they were secured by collateral. On the
demand side, setting aside any possible instabilities in this funding source, it was more
profitable to use shorter-term funds to finance longer-term assets.
In fact, the growing reliance on short-term wholesale funding to finance longer-term assets
increased liquidity and maturity mismatch risk in the financial system. This was particularly
dangerous because many of the assets being financed were structured-credit products,
some of which were opaque, difficult to value and illiquid. In periods of market stress, these
features increase the run risk by funding providers.
Short-term funding of longer-term assets is inherently unstable, especially in the presence of
information and coordination problems. It can be rational for a funding provider to supply
funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the
firm's continued ability to roll over its funding from other sources. But, if the use of short-term
funding becomes sufficiently widespread, the firm's roll-over risk increases. In this situation,
there is a strong incentive for each lender to "run" early if there is any uncertainty that could
undermine the borrower's ability to continue to roll over its funding from other sources. This is
the case even if the provider of funds believes that the borrower would remain solvent as
long as it retained access to funding on normal terms. The cost of running when it turns out
to be unnecessary is small relative to the cost of not running when it turns out to be prudent.
Of course, this insight is not a new one. Prior to the establishment of a lender of last resort
and retail deposit insurance for banks - which came with the quid pro quo of prudential
regulation - bank runs were a regular and disruptive feature of our financial system. These
innovations solved the coordination problem and stabilized this source of funding.
What was new prior to the crisis was the extent to which maturity transformation and financial
intermediation had migrated outside of commercial banks. The growth of what we call the
shadow banking system occurred largely without the types of safeguards - robust prudential
regulation, deposit insurance, lender of last resort - that have safeguarded the commercial
banking system from the types of widespread panics and runs that are capable of
destabilizing the financial system. The systemic risk created by this gap in coverage was not
well recognized by regulators or the private sector prior to the global financial crisis. Market
participants had little incentive to internalize the negative externality of the run-risk created by
their collective choice of finance, and they made erroneous assumptions about the liquidity of
asset markets and the capacity and willingness of banks to distribute central bank liquidity to
the wider financial system during periods of stress.
Because the boom years resulted in strong earnings, low price volatility and few credit
losses, firms were able to operate at extreme levels of leverage. When housing prices
started to decline, the vulnerabilities of this type of business model soon became apparent.
Heavy reliance on short-term wholesale funding exposed the system to a series of
intertwined downward spirals in asset and funding markets. This spread in waves. It began in
the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits,
and spread via auction-rate securities to the repo, money market and financial commercial
paper markets that formed the core financing for market-based financial intermediation.
Initial declines in asset prices especially for mortgage related assets forced leveraged
holders with maturity mismatches to sell assets. This increased price volatility and further
reduced the value of the assets that collateralized other firms' borrowings. Higher volatility
led banks and secured lenders to raise margins, while concern about counterparty risk and
their own funding needs made banks reluctant to on-lend liquidity.
The resulting higher margins on repo and increased collateral calls due to credit ratings
downgrades reduced the quantity of assets that could be financed in repo markets and
elsewhere, prompting further asset sales. As wholesale investors started to exit, this set in
motion a bad dynamic - a fire sale of assets that cut into earnings and capital. This
increased the incentives of investors to run and for banks to hoard liquidity against the risk
that they could themselves face a run. This downward spiral of fire sales and funding runs
was a key feature of the financial crisis.
The inherent fragility of short-term wholesale funding was greatly aggravated by certain
institutional shortcomings in these markets, particularly in the structure of the tri-party repo
system and the U.S. money market mutual fund business.
Through the tri-party repo market, each day the two large clearing banks were providing a
large amount of intraday credit to securities firms to facilitate the daily "unwind" of the prior
day's transactions. In the run-up to the crisis, the daily "unwind" helped make tri-party repo
look like a very liquid investment while still being an apparently highly durable source of
funding. This masked the underlying risks and contributed to weak risk management
practices.
As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party
repo market became increasingly concerned about the liquidity and credit risks that they
faced. The clearing banks became uncomfortable with their large intraday exposures to their
clients - broker-dealers, thrifts and others. If the risk that a client might fail became too high,
a clearing bank could decide not to unwind that client's trades in the morning, leaving its
investors with the collateral. Most of these investors lacked the operational or financial
capacity to take possession of collateral and liquidate it in a gradual manner to recoup their
investment; they had a strong incentive to run at the first sign of trouble to avoid getting stuck
with the dealer's collateral. Alternatively, if a client were to fail suddenly after the mornings
unwind, then the clearing bank would be stuck with huge loans to these counterparties that
could have put their own viability at risk, backed by securities that were not necessarily high
quality and liquid.
The "breaking the buck" by the Reserve Fund following the Lehman bankruptcy also made it
clear that the monies provided to the money market mutual funds by their own investors were
also inherently unstable. This made such funds, in turn, an unreliable source of finance in
repo, commercial paper and other markets. Investors in a fixed net asset value (NAV) money
market fund could take their money out on a daily basis at par value, with no redemption
penalty. This could occur even if the money market fund did not have sufficient cash or liquid
assets that it could easily sell to meet all potential redemptions. As with bank deposits prior
to deposit insurance, this created an incentive for investors to be the first to get out whenever
there was any uncertainty over the underlying value of the assets in the fund. By being first in
line, they could exit while the fund could still repay at par, leaving others to bear any losses.
The longer the investor waited, the greater the risk that the fund would be forced into the fire
sale of assets to meet redemptions and end up breaking the buck.
As the crisis unfolded, the Federal Reserve, the U.S. Treasury and others took a series of
actions to contain the spiral of funding runs and asset fire sales. First, the traditional lender of
last resort function was strengthened through the introduction of the Term Auction Facility
(TAF) and foreign exchange swaps with foreign central banks.
Then, as the crisis intensified, the lender of last resort liquidity provision was extended to
directly backstop key wholesale funding markets and made available to certain nonbank
firms. The Federal Reserve created a direct backstop to the tri-party repo system through the
Primary Dealer Credit Facility (PDCF). When the Reserve Fund broke the buck after the
failure of Lehman Brothers, precipitating a run on money market mutual funds, the Treasury
guaranteed money market fund assets and the Fed introduced the Asset-Backed
Commercial Paper Money Market Fund Liquidation Facility (AMLF). The Fed also
backstopped the commercial paper market (formerly funded in large part by money market
mutual funds) by introducing the Commercial Paper Funding Facility (CPFF). When
wholesale funding for non-residential mortgage securitizations evaporated, the Fed rolled out
the Term Asset-Backed Lending Facility (TALF).
These actions ultimately stabilized funding markets and crowded back in private funds. But,
they were an emergency response, not a sustainable long-term solution. After all, because
most of the special Fed liquidity facilities were authorized under Section 13.3 of the Federal
Reserve Act, they were required to be temporary in nature and to end when times were no
longer "unusual and exigent."
Much has been done over the past few years to mitigate the structural flaws that make
wholesale funding a point of weakness in the global financial system. The New York Fed, for
example, has led a Federal Reserve effort to make the tri-party repo system more resilient to
stress, while the SEC has taken steps to address risks associated with money market mutual
funds. Nonetheless, some important issues and vulnerabilities remain. Moreover, because
the Dodd-Frank Act raised the hurdle for the Federal Reserve to exercise its Section 13.3
emergency lending authority, extraordinary interventions will be more difficult to undertake,
perhaps causing investors to be even more skittish in the future. This is why it is essential to
make the system more stable. To that end, I look forward to hearing the insights and
suggestions that come out of today's workshop.
Thank you for your attention.