Bernanke: The systemic risk is repos and derivatives

Bernanke

Repos and derivatives were the source of the system risk in the financial markets in 2008, Federal Reserve Chairman Ben Bernanke told economists at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyoming, August 22.

From Bernanke’s speech:

The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns’s borrowings were largely secured–that is, its lenders held collateral to ensure repayment even if the company itself failed.

However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.

Although not an extraordinarily large company by many metrics, Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives.

One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty. With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants. …

This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the “hardware” and the “software” components. The Federal Reserve, in collaboration with the private sector and other regulators, is intensively engaged in such efforts. For example, since September 2005, the Federal Reserve Bank of New York has been leading a joint public-private initiative to improve arrangements for clearing and settling trades in credit default swaps and other OTC derivatives. …

The Federal Reserve and other authorities also are focusing on enhancing the resilience of the markets for triparty repurchase agreements (repos). In the triparty repo market, primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term, risk-averse investors. We are encouraging firms to improve their management of liquidity risk and to reduce over time their reliance on triparty repos for overnight financing of less-liquid forms of collateral.

In the longer term, we need to ensure that there are robust contingency plans for managing, in an orderly manner, the default of a major participant. We should also explore possible means of reducing this market’s dependence on large amounts of intraday credit from the banks that facilitate the settlement of triparty repos. The attainment of these objectives might be facilitated by the introduction of a central counterparty but may also be achievable under the current framework for clearing and settlement.