Broker-Dealer Potential for Problems Has Not Been Fully Addressed

August 13th, 2014
in econ_news

from the Boston Fed

In a speech in New York, Federal Reserve Bank of Boston President Eric Rosengren called for a comprehensive re-evaluation of the regulation of broker-dealers (intermediaries that effect transactions in securities), given the lessons of the financial crisis.

Follow up:

Quotes from the speech highlighted.

Broker-dealers played a dramatic role during the crisis. Given their dependence on unstable, short-term funding, broker-dealers can experience significant funding problems during times of financial stress and, unfortunately, that potential for problems has not been fully addressed since the crisis.

Before the crisis, broker-dealers’ reliance on collateralized borrowing in the form of repurchase agreements was assumed to insulate them from runs, perhaps because many viewed collateralized lending as providing little default risk. But as Rosengren notes, this proved to be wrong once the crisis hit:

Many of their creditors did not want to take possession of the collateral backing the repurchase agreements in the event of a default by a broker-dealer. As a result, there were widespread runs on broker-dealers, particularly those experiencing acute financial problems.

This was not, however, just a problem for broker-dealers. Because of broker-dealers’ crucial role as market-makers, liquidity in the credit markets that support economic activity was severely impaired.

Rosengren added that the largest domestic net suppliers of repurchase agreement financing are money market mutual funds.

During the financial crisis, deteriorating confidence in broker-dealers was compounded by the fact that investors were also fleeing money market mutual funds.

Given the lessons learned from the crisis, one might have expected less reliance by broker-dealers on repurchase agreements, and a significant increase in capital required of broker-dealers.

What is striking is the lack of change – while there has been some improvement in capital, the 2013 liability structure looks surprisingly similar to the structure that prevailed before the financial crisis.

Rosengren said that perhaps the most direct way to reduce runs related to unstable funding is to require financial organizations dependent on unstable funding, like broker-dealers, to hold significantly more capital than they would if they used stable sources of funding. He also suggested an increase in the capital required for any holding company with significant broker-dealer operations.

These and other potential policy remedies would have an impact on profitability, but given recent history, Rosengren believes that trade-off may be unavoidable and in the public interest from a financial stability perspective.

Given the widespread support provided to broker-dealers and the difficulties they encountered during the crisis, a comprehensive re-evaluation of broker-dealer regulation is overdue.

[click on image below to read the entire speech]


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