In a speech today in New York, Boston Federal Reserve President Eric Rosengren called on regulators to re-examine their scrutiny of broker-dealers, recalling lessons from the financial crisis of 2008.
"Broker-dealers played a dramatic role during the crisis," Rosengren said in his prepared remarks before the conference on the risks of wholesale funding. 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, Rosengren said, "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 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.
Recalling the financial crisis of 2008, Rosengren reminded his audience that the collapse of Lehman Bros. was not an isolated incident, but rather one in a string of crises for broker-dealers.
"Bear Stearns had failed earlier that year, Merrill Lynch experienced significant funding difficulties and was eventually acquired, and Goldman Sachs and Morgan Stanley opted to become bank holding companies," he said. "Foreign broker-dealers did not fare much better: several large foreign broker-dealers operating in the United States experienced very substantial losses that required a significant rebuilding of capital."
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."
