By Steven K. Beckner

(MNI) – Boston Federal Reserve Bank President Eric Rosengren warned
Friday that bank-sponsored money market funds and bank-affiliated
broker-dealers are vulnerable to short-term funding strains during times
of stress, and urged such activities be included in bank stress tests.

While financial institutions generally have increased their capital
and liquidity positions since the depths of the financial crisis in
2008, money market funds sponsored by banking organizations and
broker-dealer financing still present threats to financial stability
and, in turn, economic growth and demand “remedial action,” he said in
remarks prepared for delivery to a banking conference in Amsterdam.

Rosengren, who will return to the voting ranks of the Fed’s
policymaking Federal Open Market Committee next year, did not talk about
the U.S. economy or monetary policy.

Instead he focused on what he called “capital efficient” financial
structures — institutions that minimize their capital — which are
“susceptible to strains on short-term funding during times of financial
market stress or crisis.”

“One way to address these structures is to make them the focus of
stress tests that result in meaningful decisions about capital
adequacy,” he said.

Rosengren likened the risks to those which faced “structured
investment vehicles” or SIVs, off-balance sheet entities which bank
holding companies created prior to the financial crisis that borrowed
short-term to invest in mortgage-backed securities and other assets.
When asset prices fell, investors stopped buying the SIV paper,
resulting in a liquidity crunch and forcing banks to bring bad assets
back onto their balance sheets.

Now, he suggested the risky analogue is the prime money market fund
sponsored by a bank or other depository institution. More than half of
the $1.41 trillion in prime money market fund assets are held by
bank-sponsored funds. Yet they hold no capital.

“The problem is that a financial intermediary — which has no
capital, but takes credit risk, and provides under normal circumstances
immediately available funds at a fixed net asset value — may be
inviting trouble,” he said. “Such a fund can be susceptible if the
credit risk of the assets it invests in were to rise, causing investors
to become concerned about the fund’s ability to sell its assets, meet
redemption demands, and maintain a stable net asset value.”

After Lehman Brothers September 2008 collapse caused an exodus from
the Reserve Primary Fund with heavy investments in Lehman paper that
spread to other money market funds, the Fed set up a special lending
facility to help that industry. But Rosengren said “questions remain as
to whether support could or would be possible today, given changes
ushered in by the Dodd-Frank Act.”

And he said “our concerns should be amplified by the fact that many
prime funds are sponsored by depository institutions or their

He noted that bank-affiliated money market funds were heavily
invested in paper issued by Dexia, the troubled Franco-Belgian financial

When money market funds’ assets become impaired it is “quite
common” for them to obtain support from their bank sponsors, which
drains the banks’ capital, he said, noting that from 2007 to 2011
Moody’s found $9 billion in bank losses associated with money market

Rosengren welcomed reform proposals from the Securities and
Exchange Commission but said “at this time it is unclear what the final
proposal will be, or whether the SEC’s final proposal will be adopted.”

“In the absence of such reforms for all money market mutual funds,
an alternative for funds with depository institution or depository
institution affiliated sponsors would be to include likely money market
mutual fund support in the sponsor’s stress tests,” he said.

“(T)his is an admittedly partial approach, in the absence of more
comprehensive reforms that I hope will occur,” he said. “But this
approach would at least make more banking organizations more resilient
… but it would also make clearer to money market mutual fund investors
that banks had capital that could support funds during stressful
periods. It would thus make clear that money market mutual funds with
well capitalized sponsors are likely to be less risky than those that do
not have well capitalized sponsors.”

Rosengren’s other area of concern is broker-dealer financing. He
said the failure of Bear-Stearns and Lehman showed that “broker-dealers,
like traditional depository institutions, could be vulnerable to
stresses during times of crisis.”

“(B)ank holding companies with a relatively high concentration of
broker-dealer activity tend to hold more assets that are liquid and
invest in highly marketable securities that can be refinanced through
repurchase agreements – since broker-dealer operations cannot be funded
by insured deposits,” he said. “In short, you see greater use of
short-term, non-deposit funding sources at the bank holding companies
with high concentrations of broker-dealer activity.”

The Fed set up the “primary dealer facility” in 2008 amid the
difficulty in maintaining collateralized funding.

“One way to assess the increased market sensitivity of bank holding
companies might be to model in stress tests how a sudden shortage of
liquidity might impact broker-dealer operations, and determine the
capital implications,” he suggested.

“Potentially, broker-dealers could be structured in such a way that
liquidity facilities would not be necessary for broker-dealers during
times of financial stress,” he continued. “However, if a stress test
highlights the benefits to those firms of having additional capital or
more liquid assets, it should also take into account the costs

Rosengren said “an alternative would be to develop a framework
where, under certain conditions, liquidity facilities would be regularly
made available for broker-dealers during periods of high stress.”

“At a minimum, stress tests that focus on the behavior of
broker-dealers and their counterparties during times of stress should be
undertaken and their implications well understood,” he said.

** MNI **

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