Jeremy C Stein: The fire-sales problem and securities financing
transactions
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the Workshop on "Fire Sales" as a Driver of Systemic Risk in Tri-Party Repo and
Other Secured Funding Markets, Federal Reserve Bank of New York, New York City,
4 October 2013.
* * *
I am grateful for helpful comments from Matt Eichner, Mike Gibson, Nellie Liang, Bill Nelson, and Mark Van
Der Weide. The thoughts that follow are my own, and are not necessarily shared by other members of the
Federal Open Market Committee.
Thank you. It's a pleasure to be here at this workshop. In an effort to provide some broad
framing for the sessions to follow, I thought I would try to do three things in my opening
remarks. First, I will briefly discuss the welfare economics of fire sales. That is, I will try to
make clear when a forced sale of an asset is not just an event that leads to prices being
driven below long-run fundamental values, but also one that involves a market failure, or
externality, of the sort that might justify a regulatory response. Second, I will argue that
securities financing transactions (SFTs) are a leading example of the kind of arrangement
that can give rise to such externalities, and hence are particularly deserving of policy
attention. And third, I will survey some of the recently enhanced tools in our regulatory
arsenal (e.g., capital, liquidity, and leverage requirements) and ask to what extent they are
suited to tackling the specific externalities associated with fire sales and SFTs.
To preview, a general theme is that 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. In this
regard, some of what I have to say will echo a recent speech by my Board colleague Daniel
Tarullo.1
The positive and normative economics of fire sales
In a recent survey paper, Andrei Shleifer and Robert Vishny write that: "...[A] fire sale is
essentially a forced sale of an asset at a dislocated price. The asset sale is forced in the
sense that the seller cannot pay creditors without selling assets....Assets sold in fire sales
can trade at prices far below value in best use, causing severe losses to sellers."2 Shleifer
and Vishny go on to discuss the roles of investor specialization and limited arbitrage as
factors that drive the magnitude of observed price discounts in fire sales, and there is, by
now, a large body of empirical research that supports the importance of these factors.
However, by itself, the existence of substantial price discounts in distressed sales speaks
only to the positive economics of fire sales, not the normative economics, and hence is not
sufficient to make a case for regulatory intervention. To see why, consider the following
example: An airline buys a 737, and finances the purchase largely with collateralized
borrowing. During an industry downturn, the airline finds itself in distress, and is forced to sell
the 737 to avoid defaulting on its debt. Other airlines also are not faring well at this time, and
are not interested in expanding their fleets. So the only two bidders for the 737 are a movie
star, who plans to reconfigure it for his personal use, and a private-equity firm, which plans to
lease out the plane temporarily and wait for the market to recover so the firm can resell it at a
profit. In the end, the private-equity firm winds up buying the plane at half its original price.
Two years later, it does indeed resell it, having earned a 60 percent return.
This is clearly a fire sale in the positive-economics sense, but is there a market failure here
that calls for regulation? Intuition suggests not. The airline arguably caused the fire sale by
using a lot of leverage in its purchase of the 737, but it also seems to bear most of the cost,
by being forced to liquidate at a large loss. The movie star and the private-equity firm are, if
anything, made better off by the appearance of a buying opportunity, and there are no other
innocent bystanders. So the airline's ex ante capital structure choice would seem to
internalize things properly; the fire sale here is just like any other bankruptcy cost that a firm
has to weigh in choosing the right mix of debt and equity.
For a fire sale to have the sort of welfare effects that create a role for regulation, the reduced
price in the fire sale has to hurt somebody other than the original party making the leverage
decision, and this adverse impact of price has to run through something like a collateral
constraint, whereby a lowered price actually reduces, rather than increases, the third party's
demand for the asset.3 So if hedge fund A buys an asset-backed security and finances it
largely with collateralized borrowing, A's fire selling of the security will create an externality in
the conventional sense only if the reduced price and impaired collateral value lower the
ability of hedge funds B and C to borrow against the same security, and therefore force them
to involuntarily liquidate their positions in it as well.4 The market failure in this case is not
simply the fact that this downward spiral causes a large price decline, it is that when hedge
fund A makes its initial leverage choice, it does not take into account the potential harm - in
the form of tightened financing constraints - that this may cause to hedge funds B and C.5
Another key point is that the fire-sales problem is not necessarily caused by a lack of
appropriate conservatism on the part of whoever lends to hedge fund A in this example
- let's call it dealer firm D. By lending on an overnight basis to A, and with an appropriate
haircut, D can virtually assure itself of being able to terminate its loan and get out whole by
forcing a sale of the underlying collateral. So D's interests may be very well-protected here.
But precisely in the pursuit of this protection, A and D have set up a financing arrangement
that serves them well, but that creates a negative spillover onto other market participants,
like B and C. It follows that even if policies aimed at curbing too-big-to-fail (TBTF) problems
are entirely successful in aligning D's interests with those of taxpayers, this is not sufficient to
deal with fire-sales externalities. They are a fundamentally different problem, and one that
arises even absent any individually systemic institutions or any TBTF issues.
3
An alternative mechanism that works similarly is when the third party is a regulated intermediary and
mark-to-market losses reduce its capital ratios, and again force it to involuntarily sell assets in the face of
falling prices.
4
The fundamental welfare economics at work here is developed in John Geanakoplos and Heracles M.
Polemarchakis (1986), "Existence, Regularity, and Constrained Suboptimality of Competitive Allocations
When the Asset Market Is Incomplete," in Walter P. Heller, Ross M. Starr, and David A. Starrett, eds.,
Essays in Honor of Kenneth Arrow: Vol 3., Uncertainty, Information, and Communication
(New York:
Cambridge University Press), pp. 65-95. A discussion of the connection of this work to specific aspects
of macroprudential regulation is in Samuel G. Hanson, Anil K. Kashyap, and Jeremy C. Stein (2011), "A
Macroprudential Approach to Financial Regulation (PDF) ," Journal of Economic Perspectives, vol. 25
(Winter), pp. 3-28.
5
This is the first-round externality. Adverse spillovers from a fire sale of this sort may also take the form of
a credit crunch that affects borrowers more generally. Such a credit crunch may arise as other financial
intermediaries (e.g., banks) withdraw capital from lending, so as to exploit the now-more-attractive
returns to buying up fire-sold assets. Ultimately, it is the risk of this credit contraction, and its implications
for economic activity more broadly, that may be the most compelling basis for regulatory intervention.
Fire-sale externalities in securities financing transactions
The preceding discussion makes clear why SFTs, such as those done via repurchase (repo)
agreements, are a natural object of concern for policymakers. This market is one where a
large number of borrowers finance the same securities on a short-term collateralized basis,
with very high leverage - often in the range of twenty-to-one, fifty-to-one, or even higher.
Hence, there is a strong potential for any one borrower's distress - and the associated
downward pressure on prices - to cause a tightening of collateral or regulatory constraints on
other borrowers.
I won't go into much detail about the institutional aspects of SFTs and the repo market.
Instead, I will just lay out two stylized examples of SFTs that I can then use to illustrate the
properties of various regulatory tools.
Example 1: Broker-dealer as principal
In this first example, a large broker-dealer firm borrows in the triparty repo market - from,
say, a money market fund - in order to finance its own holdings of a particular security.
Perhaps the broker-dealer is acting as a market-maker in the corporate bond market, and
uses repo borrowing to finance its ongoing inventory of investment-grade and high-yield
bonds. In this case, the asset on the dealer's balance sheet is the corporate bond, and the
liability is the repo borrowing from the money fund.
Example 2: Broker-dealer as SFT intermediary
In this second example, the ultimate demand to own the corporate bond comes not from the
dealer firm, but from one of its prime brokerage customers - say, a hedge fund. Moreover,
the hedge fund cannot borrow directly from the money market fund sector in the triparty repo
market, because the money funds are not sufficiently knowledgeable about the hedge fund to
be comfortable taking it on as a counterparty. So instead, the hedge fund borrows on a
collateralized basis from the dealer firm in the bilateral repo market, and the dealer then turns
around and, as before, uses the same collateral to borrow from a money fund in the triparty
market. In this case, the asset on the dealer's balance sheet is the repo loan it makes to the
hedge fund.
Clearly, there is the potential for fire-sale risk in both of these examples. One source of risk
would be an initial shock either to the expected value of the underlying collateral or to its
volatility that leads to an increase in required repo-market haircuts (e.g., the default
probability of the corporate bond goes up). Another source of risk would be concerns about
the creditworthiness of the broker-dealer firm that causes lenders in the triparty market to
step away from it.
In either case, if the associated externalities are deemed to create significant social costs,
the goal of regulatory policy should be to get private actors to internalize these costs. At an
abstract level, this means looking for a way to impose an appropriate Pigouvian (i.e.,
corrective) tax on the transactions.6 Of course, the tax must balance the social costs against
the benefits that accompany SFTs; these benefits include both "money-like" services from
the increased stock of near-riskless private assets, as well as enhanced liquidity in the
market for the underlying collateral - the corporate bond market, in my examples.7 So in the
absence of further work on calibrating costs and benefits, there is no presumption that the
optimal tax should be large, only that it may be non-zero, and that it may make sense for it to
differ across asset classes.
Can existing regulatory tools be used to tax SFTs efficiently?
With this last observation in mind, my next step is to run through a number of our existing
regulatory instruments, and in each case ask: to what extent can the instrument at hand be
used efficiently to impose a Pigouvian tax on an SFT, either one of the dealer-as-principal
type or one of the dealer-as-intermediary type? As will become clear, the answer can depend
crucially on both the structure of the transaction as well as the nature of the underlying
collateral involved. Also, I should emphasize that nothing in this exercise amounts to a
judgment on the overall desirability of any given regulatory tool. Obviously, even if risk-based
capital requirements are not particularly helpful in taxing SFTs, they can be very valuable for
other reasons. I am asking a different question: to what extent can the existing toolkit be
used - or be adapted - to deal with the specific problem of fire-sale externalities in SFTs?
1. Risk-based capital requirements
Current risk-based capital requirements are of little relevance for many types of SFTs. In my
Example 1, where the dealer firm holds a corporate bond as a principal and finances it with
repo borrowing, there would be a capital charge on the corporate bond, but this capital
charge is approximately independent of whether the corporate bond is financed with repo or
with some other, more stable, form of funding. So there is no tax on the incremental fire-sale
risk created by the more fragile funding structure.8
In Example 2, in which the dealer is an intermediary with a matched book of repo borrowing
and lending, there is, in principle, a capital requirement on its asset-side repo loan to the
hedge fund. However, the Basel III risk-based capital rules allow banks and bank holding
companies to use internal models to compute this capital charge for repo lending, and the
resulting numbers are typically very small - for all practical purposes, close to zero - for
overcollateralized lending transactions, with repo being the canonical example.
I'm not arguing that the very low risk-based charges on repo lending in Basel III are "wrong"
in any microprudential sense. After all, they are designed to solve a different problem - that
of ensuring bank solvency. And if a bank holding company's broker-dealer sub makes a repo
loan of short maturity that is sufficiently well-collateralized, it may be at minimal risk of
bearing any losses - precisely because it operates on the premise that it can dump the
collateral and get out of town before things get too ugly. The risk-averse lenders in the
triparty market - who, in turn, provide financing to the dealer - operate under the same
premise. As I noted earlier, these defensive reactions by providers of repo finance mean that
the costs of fire sales are likely to be felt elsewhere in the financial system.
2. Liquidity requirements
Liquidity requirements, such as those embodied in the Basel III Liquidity Coverage Ratio
(LCR), can impose a meaningful tax on certain SFTs in which the dealer acts as a principal.
If the dealer holds a corporate bond and finances it with repo borrowing of less than 30 days'
maturity, the LCR kicks in and requires the dealer to hold high-quality liquid assets (HQLA)
against the risk that it is unable to roll the repo over. In this particular case, there can be said
to be a direct form of regulatory attack on the fire-sales problem. However, this conclusion is
sensitive to the details of the example. If, instead of holding a corporate bond, the dealer
holds a Treasury security that is deemed to count as Level 1 HQLA, there is no impact of the
LCR.
Moreover, the LCR plays no role in mitigating fire-sales externalities in the important
matched-book case in which the dealer acts as an intermediary.9 If a dealer borrows on a
collateralized basis with repo and then turns around and lends the proceeds to a hedge fund
in a similar fashion, the LCR deems the dealer to have no net liquidity exposure - and hence
imposes no incremental liquidity requirement - so long as the lending side of the transaction
has a maturity of less than 30 days. The implicit logic is that as long as the dealer can
generate the necessary cash by not rolling over its loan to the hedge fund, it will always be
able to handle any outflows of funding that come from being unable to roll over its own
borrowing. This logic is not incorrect per se, but it is very micro-focused in nature, and does
not attend to fire-sales externalities. It worries about the ability of the dealer firm to survive a
liquidity stress event, but does not take into account that the dealer's survival may come at
the cost of forcing its hedge fund client to engage in fire sales.10
3. Leverage ratio
If a broker-dealer firm faces a binding leverage ratio, this constraint can act as a significant
tax on two types of SFTs that are largely untouched either by risk-based capital requirements
or by liquidity regulations. The first is when the dealer, acting as a principal, uses repo to
finance its holdings of Treasury securities or agency mortgage-backed securities, assets that
generally have only modest risk weights when held as trading positions. The second is when
the dealer acts as an intermediary and has a matched repo book. In both cases, the SFTs
blow up the firm's balance sheet and, hence, the denominator of the leverage ratio, even
while having little impact on risk-based capital or LCR calculations.
The crucial issue here, however, is whether the leverage ratio does, in fact, bind. A traditional
view among regulators has been that the leverage ratio should be calibrated so as to serve
as a meaningful "backstop" for risk-based capital requirements, but that under ordinary
circumstances it should not actually be the binding constraint on firms. For if it were to bind,
this would put us in a regime of completely un-risk-weighted capital requirements, where the
effective capital charge for holding short-term Treasury securities would be the same as that
for holding, say, risky corporate debt securities or loans.
Recently, U.S. regulators have issued a proposed rulemaking that seeks to raise the Basel III
supplementary leverage ratio requirement to 5 percent for the largest U.S. bank holding
companies, and to 6 percent for their affiliated depository institutions. While this increase
might be considered a parallel shift that preserves the backstop philosophy in light of the fact
that risk-based requirements have also gone up significantly, it does increase the likelihood
that the leverage ratio may bind for some of these firms at some times - particularly for those
firms with a broker-dealer-intensive business model in which the ratio of total assets to risk-
weighted assets tends to be higher. In this event, there would indeed be a significant tax on
SFTs undertaken in the affected firms. However, because it is unlikely that the leverage
constraint would bind symmetrically across all of the largest firms, my guess is that the effect
would be less to deter SFT activity in the aggregate than to cause it to migrate in such a way
as to be predominantly located in those firms that - because they have, say, a larger lending
business and, hence, more risk-weighted assets - have more headroom under the leverage
ratio constraint.
Other possible approaches
To summarize the discussion thus far, the mainstays of our existing regulatory toolkit -
riskbased capital, liquidity, and leverage requirements - have a variety of other virtues, but none
seem well-suited to lean in a comprehensive way against the specific fire-sale externalities
created by SFTs. The liquidity coverage ratio affects a subset of SFTs in which a dealer firm
acts as a principal to fund its own inventory of securities positions, but does not meaningfully
touch those in which it acts as an intermediary. By contrast, an aggressively calibrated
leverage ratio could potentially impose a significant tax on a wider range of SFTs, but the tax
would by its nature be blunt and highly asymmetric, falling entirely on those firms for whom
the leverage ratio constraint was more binding than the risk-based capital constraint. As
such, it would be more likely to induce regulatory arbitrage than to rein in overall SFT activity.
These observations raise the question of whether there are other tools that might be better
suited to dealing with SFT-related fire-sales externalities. I will touch briefly on three of these.
1. Capital surcharges
In his May speech, Governor Tarullo alluded to the possibility of liquidity-linked capital
surcharges that would effectively augment the existing regime of risk-based capital
requirements.11 Depending on how these surcharges are structured, they could act in part as
a tax on both the dealer-as-principal and dealer-as-intermediary types of SFTs.
Accomplishing the latter would require a capital surcharge based on something like the
aggregate size of the dealer's matched repo book; this comes quite close to the Pigouvian
notion of directly taxing this specific activity. As compared to relying on the leverage ratio to
implement the tax, this approach has the advantage that it is more likely to treat institutions
uniformly: the tax on SFTs would not be a function of the overall business model of a given
firm, but rather just the characteristics of its SFT book. This is because the surcharge is
embedded into the existing risk-based capital regime, which should in principle be the
constraint that binds for most firms.
There are a couple of important qualifications, however. First, going this route would involve
a significant conceptual departure from the notion of capital as a prudential requirement at
the firm level. As noted previously, a large matched repo book may entail relatively little
solvency or liquidity risk for the broker-dealer firm that intermediates this market. So, to the
extent that one imposes a capital surcharge on the broker-dealer, one would be doing so
with the express intention of creating a tax that is passed on to the downstream borrower
(i.e., to the hedge fund, in my example).
Second, and a direct corollary of the first, imposing the tax at the level of the intermediary
naturally raises the question of disintermediation. In other words, might the SFT market
respond to the tax by evolving so that large hedge funds are more readily able to borrow via
repo directly from money market funds and securities lenders, without having to go through
broker-dealers? I can't say that I have a good understanding of the institutional factors that
might facilitate or impede such an evolution. But if the market ultimately does evolve in this
way, it would be hard to argue that the underlying fire-sales problem has been addressed.
2. Modified liquidity regulation
A conceptually similar way to get at matched-book repo would be to modify liquidity
regulation so as to introduce an asymmetry between the assumed liquidity properties of repo
loans made by a broker-dealer, and its own repo borrowing. For example, in the context of
the Net Stable Funding Ratio (NSFR), one could assume that a dealer's repo loans to a
hedge fund roll off more slowly than do its own repo borrowings from the triparty market. This
assumption would create a net liquidity exposure for a matched repo book, and would
thereby force the dealer to hold some long-term debt or other stable funding against it.
Although the implementation is different, the end result is quite close to that obtained with the
capital-surcharge approach I just described: in one case, there is a broad stable funding
requirement for intermediaries against a matched repo book; in the other case, there is an
equity requirement. It follows that, whatever its other advantages, going the modified-NSFR
route does not eliminate concerns about disintermediation and regulatory arbitrage.
3. Universal margin requirements
These sorts of regulatory-arbitrage concerns have motivated some academics and
policymakers to think about a system of universal margin requirements for SFTs.12 In its
simplest form, the idea would be to impose a minimum haircut, or down payment
requirement, on any party - be it a hedge fund or a broker-dealer - that uses short-term
collateralized funding to finance its securities holdings. Because the requirement now lives at
the security level, rather than at the level of an intermediary in the SFT market, it cannot be
as easily evaded by, say, a hedge fund going outside the broker-dealer sector to obtain its
repo funding.13 This is the strong conceptual appeal of universal margin from the perspective
of a fire-sales framework.
In this regard, it is worth noting that the Financial Stability Board (FSB) has recently released
a proposal to establish minimum haircut requirements for certain SFTs.14 However, the FSB
proposal stops well short of being a universal margin requirement. Rather, the minimum
haircuts envisioned by the FSB would apply only to SFTs in which entities not subject to
capital and liquidity regulation (e.g., hedge funds) receive financing from entities that are
subject to regulation (i.e., banks and broker-dealers), and only to transactions in which the
collateral is something other than government or agency securities. In this sense, there is a
close relationship between the FSB minimum-haircut proposal and the specific variant of the
capital-surcharge idea that I mentioned a moment ago. Both have the potential to act as a
restraint on those SFTs that are intermediated by regulated broker-dealer firms, but both are
vulnerable to an evolution of the business away from this intermediated mode. The minimum
margin levels in the FSB proposal are also quite small, so it is unclear how much of an effect,
if any, they will have on market behavior. For example, the minimums for long-term corporate
bonds, securitized products, and equities are 2 percent, 4 percent, and 4 percent,
respectively.
Conclusions
Let me wrap up. My aim here has been to survey the landscape - to give a sense of the
possible tools that can be used to address the fire-sales problem in SFTs - without making
any particularly pointed recommendations. I would guess that a sensible path forward might
involve drawing on some mix of the latter set of instruments that I discussed: namely, capital
surcharges, modifications to the liquidity regulation framework, and universal margin
requirements. As we go down this path, conceptual purity may have to be sacrificed in some
places to deliver pragmatic and institutionally feasible results. It is unlikely that we will find
singular and completely satisfactory fixes.
With this observation in mind, I would be remiss if I did not remind you of another, highly
complementary area where reform is necessary: the money market fund sector. Money funds
are among the most significant repo lenders to broker-dealer firms, and an important source
of fire-sale risk comes from the fragility of the current money fund model. This fragility stems
in part from their capital structures - the fact that they issue stable-value demandable
liabilities with no capital buffer or other explicit loss-absorption capacity - which make them
highly vulnerable to runs by their depositors. I welcome the work of the Securities and
Exchange Commission on this front, particularly its focus on floating net asset values, and
look forward to concrete action. Another source of fragility arises from money funds investing
in repo loans collateralized by assets that they are unwilling or unable to hold if things go
bad. This feature creates an incentive for them to withdraw repo financing from
brokerdealers at the first sign of counterparty risk, even if the underlying collateral is in good shape.
I'm sure we will hear much more about this last set of issues over the remainder of the
conference today. I look forward to the discussions. Thank you.