Editor’s note: It’s a scandal that Bernanke and Geithner handed reform of tri-party repo to the bankers instead of to Congress and Dodd-Frank and the reform has not been done.
The most vulnerable banks during this U.S. debt-ceiling crisis must surely be JP Morgan Chase and Bank of New York Mellon.
That’s because they’re the clearing banks for the tri-party repurchase market, which was the biggest threat to the financial markets in 2008 and which -unbelievably – is nearly as dangerous today as it was then, according to the Financial Stability Oversight Council, created by the Dodd-Frank Act to oversee the financial markets.
When U.S. Treasury Department officials held an unusual group meeting Friday in New York to discuss the debt-ceiling crisis with the Federal Reserve’s 20 primary dealers, who are obligated to participate in Treasury auctions, it’s a good bet one topic on everyone’s mind was how to protect the tri-party repo market, and its clearing banks, from turmoil.
In RepoWatch’s view, we’re in this fix today because the Federal Reserve and the U.S. Treasury Department decided after the 2008 financial crisis to let a special task force of bankers handle the tri-party repairs instead of Congress, and the bankers can’t agree on what to do.
Why did regulators keep this important reform out of The Dodd-Frank Act and turn it over to the bankers instead? Here’s a guess: Regulators were afraid Congress might screw up the vital market where the Federal Reserve conducts its monetary policy.
So today, three years after the financial crisis, key tri-party reforms have not been implemented.
The Financial Stability Oversight Council expressed its concern, and its exasperation, in its 2011 annual report to Congress released July 26:
A notable exception to the smooth operation of payment, clearing, and settlement systems through the (2008) financial crisis was the tri-party repo market. The weaknesses in the settlement infrastructure in this market and the attendant flaws in the risk management practices of borrowers, lenders, and the two clearing banks significantly amplified market instability. These weaknesses, if they are not addressed, will continue to have the potential to exacerbate volatility in the overall financial system during times of stress.
Why haven’t the bankers made the fixes? From the Financial Stability Oversight Council report:
The Task Force recently acknowledged that it will need time beyond 2012 to achieve these objectives. In addition to technological and infrastructure challenges, the Task Force’s composition, which spans a diverse array of market participants with varied economic interests, likely has affected its timetable.
Isn’t that another way of saying they can’t agree on what to do?
Don’t you wish you knew which bankers are dragging their feet? Unfortunately, we may never know because the deliberations are secret among bankers rather than open in Congress.
The solution to the delay, the Financial Stability Oversight Council said, is to put regulators in charge.
Given the vital importance and size of tri-party repo financing and the broad array of financial institutions active in this market, the regulatory community should exert its supervisory authority over the industry’s reform efforts to ensure that the Tri-Party Repo Infrastructure Reform Task Force meets its commitments as promptly as possible.
Whether that will ever happen is anyone’s guess. Meanwhile, RepoWatch e-mailed JP Morgan and Bank of New York Friday to find out what steps they’re taking to protect themselves and tri-party from problems during the debt-ceiling debate. Bank of New York spokesman Kevin Heine sent this reply:
We are monitoring the ongoing discussions in Washington and assessing the potential impact on our clients. While we hope for a compromise solution to the debt ceiling issue, we are preparing for various scenarios as part of our contingency planning process. We have the operational and systems capabilities to account for market events and accommodate client needs.
If JP Morgan replies, I will add its comment to this post.
For those of you who are not familiar with the tri-party issues, here’s some background:
Repowatch estimates that the tri-party repurchase market represents about one-fourth of U.S. repo transactions, including all of those conducted by the Federal Reserve to implement monetary policy and many conducted by money market funds. Twenty of the world’s largest repo dealers, the so-called primary dealers who are authorized to repo with the Fed, are all heavy participants. See a list of them below.
While many repo transactions are bilateral, negotiated privately between two parties, in the tri-party market JP Morgan and Bank of New York sit in the middle of each deal, performing such services as settling transactions and valuing and managing collateral.
The mechanics of the tri-party transactions require the two banks to extend hundreds of billions of dollars of credit to the repo borrowers during each day. In 2008 that exposed JP Morgan and Bank of New York to potentially huge losses when tri-party borrowers like Bear Stearns and Lehman Brothers spiraled toward insolvency.
In 2009, the New York Fed formed a task force of the large bank companies, mortgage giant Fannie Mae and the New York Fed to study ways to reduce the potential for systemic risk in tri-party repo. The task force issued 16 recommendations in May 2010. Among the recommendations was one they said was the most important, eliminating the intraday credit* by October 2011.
On July 6 the task force issued a progress report saying it will not meet that deadline. The original plan, to improve existing proceedures, turned out to be inadequate, and a “substantial” rebuilding of the system will be needed, the task force reported. The progress report said the task force is “exploring approaches” to solving the intraday credit risk.
Isn’t that another way of saying it hasn’t figured out what to do?
Now the Financial Stability Oversight Council tells us the task force has also failed to implement other important corrections.
Here’s more from the annual report:
Council members have identified three components of the market infrastructure that require strengthening: (1) mortgage servicing, (2) derivatives, and (3) tri-party repo. Of the three, the weaknesses in the tri-party repo market are most likely to amplify current risks.
Industry initiatives are underway to address shortcomings in the tri-party repo market infrastructure by reducing the market’s reliance on intraday credit provision by the clearing banks, but these efforts are unlikely to address all the structural weaknesses in the market, including dealer liquidity risk management, lender collateral management, and the market’s resilience to investor runs and a potential dealer failure.
During the crisis, the lack of transparency and the pervasive belief that the clearing bank would always unwind a dealer’s repos caused market participants to inaccurately assess the credit and liquidity risks inherent in their exposures, which contributed to the industry’s fragility.
The fragility of market and funding liquidity and the constraints on the type of collateral certain investors (particularly money market funds) are prepared to take heighten the risk of contagion from the tri-party repo market.
Many tri-party repo lenders, given their regulatory structure and investor base, still have a strong incentive to withdraw funding from a borrower at the first sign of distress, which can accelerate dealers’ funding difficulties.
For example, while money market fund reform can help insulate these funds from runs by their investors, money market funds still have the incentive to pull away from a troubled dealer in the tri-party repo market because, in many cases, money market funds cannot take possession of the collateral in the event of a dealer default.
Other important classes of lenders, such as asset custodians administering securities lending programs, can also face significant liquidity demands from their clients under certain circumstances, which may make them unwilling or unable to hold pledged collateral.
Regulators should ensure that the various participants in the tri-party repo market are implementing and sustaining the necessary improvements in their management of collateral to alleviate the risk of cash investor runs in this market.
Another risk to the tri-party repo market is the possibility of a dealer default. A dealer default would likely result in the sudden liquidation of a large amount of collateral by its counterparties, creating fire sale conditions in the underlying asset markets that could set damaging spirals in motion.
The Tri-Party Repo Infrastructure Reform Task Force has called for tri-party repo lenders to develop plans and arrangements for liquidating collateral in the event of a default, but supervisory action is needed to ensure that such plans are developed and maintained.
The Dodd-Frank Act includes reforms intended to help ensure that the risks posed by institutions such as the large dealers in the tri-party repo market are managed prudently and subject to adequate oversight.
Among other actions, when the Federal Reserve and FDIC finalize the new rules, most of the largest dealers in this market will be required to submit detailed resolution plans that will provide regulators with the tools and authority necessary to resolve a failed institution in a way that limits broader systemic impact and taxpayer cost.
Additional actions by the regulatory community may be necessary to promote confidence that liquidation of collateral from a major dealer will proceed in an orderly manner.
* For a more detailed discussion of the intraday credit, see Doubt cast on key tri-party reform.
The Federal Reserve’s primary dealers:
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
MF Global Inc.
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.