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 …

, 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 - a similar comment applies to the net stable funding ratio ( nsfr ), which requires regulated firms to fund illiquid exposures with some amount of long - term debt or other form of stable funding. like the lcr, the nsfr effectively treats matched - book repo as creating no net liquidity exposure, and hence imposes no requirement on it. even from a microprudential perspective, the lcr can be said to have a flaw in that it is blind to maturity mismatches within the 30 - day window. for example, if a dealer borrows on an overnight basis from a money fund, and then makes a 29 - day loan to a hedge fund, the lcr deems it to be fully matched, and to have no incremental liquidity