Market Analysis

Wholesale Change?

The skinny on Fed proposals to crack down on short-term money markets.

It’s no secret our esteemed Fed governors are a busy bunch. Between debating the end of quantitative easing (QE), putting the final touches on the Volcker Rule, jawboning about the state of the economy and Janet Yellen’s Senate confirmation hearings, Bernanke and company have scarcely left the financial media’s front pages. Yet in all the hoopla, one development has stayed largely in the shadows: the Fed’s quest to increase its oversight of short-term funding markets. In recent days, Governor Daniel Tarullo has unveiled preliminary plans to raise capital requirements for banks relying on wholesale funding—an effort some describe as the last remaining step toward preventing another 2008. But as with many of the 2008-inspired regulatory changes, it ignores the real cause and, if regulators aren’t careful, could reduce liquidity in the financial system and weigh on money supply growth. This risk doesn’t outweigh the many positive fundamentals underpinning this bull markets, but it does bear watching.

Wholesale funding is the catch-all for the tools banks use to raise funds above and beyond customer deposits. The main vehicles are commercial paper and repurchase (aka repo) agreements—short-term contracts where one bank sells securities to another and agrees to repurchase them at a later date. Banks roll these over daily, entering new short-term financing agreements to repay maturing notes.

In 2008, a wholesale funding freeze was the straw that broke Lehman’s back. By September, after a year of exaggerated and in many cases unnecessary writedowns wiped trillions off balance sheets, banks were extremely hesitant to lend to each other. Capital was precious, and FAS 157 (mark-to-market accounting) made counterparty risk difficult to assess—no one knew when the next round of writedowns would come or who it could wipe out. After a $5.6 billion writedown led Lehman to a massive Q3 loss, the investment bank couldn’t get a dime. Its core business units were healthy enough, but counterparties expected further writedowns on the $60 billion mortgage portfolio, and they weren’t sure Lehman had sufficient liquid assets to cope. Creditors withdrew and the firm couldn’t get overnight funding to meet obligations, rendering it effectively bankrupt. Funding markets seized further, and financial panic ensued.

This is what the Fed wants to prevent. If banks that rely on wholesale funding have to maintain higher capital ratios, the logic goes, they’ll be less exposed to another run on short-term funding. And if repo transactions face a surcharge, there will be fewer of them, theoretically further reducing systemic risk. But well-intentioned as these proposals may be, they overlook two key facts.

One: Shadow financing markets wouldn’t have cratered in 2008 if FAS 157 hadn’t forced banks to take massive writedowns. Judging from the profits the Fed has reaped on its Maiden Lane portfolios (it isn’t and has never been subject to mark-to-market provisions a la FAS 157) and the anecdotal evidence of formerly “toxic” assets trading near face value, those writedowns weren’t necessary. Banks never intended to sell these securities—just hold them to maturity. Since the Fed adjusted the guidance on FAS 157’s application to illiquid assets, writedowns are no longer an issue.

Two: Lehman might have survived if it were able to borrow from the Fed’s discount window. Because Lehman was an investment bank, it couldn’t—the Fed couldn’t act as lender of last resort. This, too, has been addressed. The last remaining big investment banks either merged with retail banks or reorganized as bank holding companies in September 2008. They can borrow from the Fed now, if need be, to maintain overnight liquidity.

One might rationally think the Fed understands this, considering Chairman Ben Bernanke was instrumental in tweaking FAS 157 and the Fed was heavily involved in the investment banks’ mergers and re-orgs, and realize higher capital ratios and the like are largely redundant. But Fed policy contradicts itself a lot these days. Exhibit A is QE. This is Exhibit B. Recently, the Fed announced yet another new scheme, FARRP, aimed at increasing liquidity in wholesale funding markets. These new proposals would likely make liquidity problems worse, as they discourage wholesale funding. If you think that sounds innocuous, consider that commercial paper and other wholesale funding notes comprise the bulk of money market funds. Reducing the amount outstanding could whack retail money market funds—a key cash-equivalent for many investors. It would also whack broad money supply. Commercial paper and repo agreements are components of M4, the broadest measure of money. M4 has barely budged during this expansion, and shrinking commercial paper markets are a big reason why. If the market shrinks further, M4 could stagnate or even contract again. Plus, if short-term funding becomes more scarce, it probably becomes more expensive, which would shrink the rate spread and make lending less profitable—and less abundant. Slow loan growth, too, means slow money supply growth—the opposite of what the economy needs for faster growth.

For the moment, this is just a proposal, and it isn’t clear how, exactly, the rule would be applied. The Fed hasn’t defined what “reliant” on wholesale funding means—a key factor in gauging the rule’s potential impact. For example, if the Fed deems it appropriate to tie the added capital requirement to the absolute amount of commercial paper and repo agreements outstanding, bigger banks would likely be impacted. If the Fed instead ties it to the ratio of wholesale funding to deposits, it likely has a smaller scope and impact on money markets. But even if it’s applied more broadly, it’s tough to envision the rule change materially hamstringing Financials—many banks already exceed forthcoming Basel III requirements, and those with shortfalls don’t have far to go. Even with an extra layer of requirements, they can probably raise what they need by retaining earnings. They shouldn’t need to cut lending or issue new shares.

So while reining in wholesale funding is largely a solution in search of a problem, it likely shouldn’t disrupt this bull market or Financials stocks. Banks have weathered years of uncertainty over Dodd-Frank, and they can probably survive a little more as the Fed hammers this out. And the US economy has managed to grow for over four years despite the weakest US M4 money supply growth on record. Our economy is far more resilient than many give it credit for, and that underappreciated strength should keep driving this bull market.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.