The House of Representatives is working on a draft bill that would more closely regulate
large financial institutions in an effort to reduce the systemic risk that pushed the economy
deep into recession. The nearly 300-page bill deals with a number of tough issues,
including the role of the Federal Reserve in providing credit to non-banks (the “exigent
circumstances” clause of the Federal Reserve Act), and, most significantly, establishing
rules for the unwinding of a large, systemically important institution. The definition of
systemically important institution, however, is subject to a number of interpretations, some
of which are outlined in another amendment. But it is generally assumed that any bank or
financial institution with more than $10bn in assets would qualify.
While no doubt well intentioned, an amendment passed yesterday has significant
implications for secured funding markets. Proposed by Reps. Miller (D) and Moore (D),
it would effectively replace existing repo and secured funding with unsecured
borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a
large systemically important institution is put into receivership by the FDIC and there
are not enough assets to cover the cost of unwinding it to the government, all secured
claims would be automatically converted into unsecured loans with a haircut of up to
20%. This discount is meant to raise enough funds to offset any taxpayer losses. In the
language of the bill, it establishes a “polluter pays” structure for unwinding a financial
institution: the cost of a (hopefully) orderly unwind is fully absorbed by the firm’s
shareholders and unsecured creditors – not the taxpayer.
We believe the Miller and Moore amendment would have significant implications for
the repo market. It would likely make secured funding to large institutions much more
“flighty” – that it, much more volatile and prone to leave quickly. In any situation where
it appears that a large firm is about to fail, secured lenders will rapidly head for the exit and
terminate as many of their repo transactions as possible. No secured lender will want to be
left in a trade with a bank in receivership where the regulators have converted the
transaction into an unsecured loan at 80% of the original amount (net of the original
haircut). We believe the proposed legislation will also make secured lending far more pro-
cyclical – with lenders stepping away from a systemically important institution immediately
upon hearing anything that might raise the odds of a FDIC takeover.
In our opinion, the combination of flight-prone money and pro-cyclicality would ultimately
defeat the intent of this legislation, which is to reduce systemic risk. Instead, large
systemically important firms would become more vulnerable to liquidity runs – of the sort
seen last fall. In addition, the Miller and Moore amendment would raise funding costs for
large institutions, pushing them into the unsecured market and removing an important
source of liquidity to the repo market – at precisely when unsecured money is not available.
In a broader sense, the amendment calls into question the legal underpinnings of secured
funding. After all, if the repo and other secured funding contracts can be reversed (no pun
intended) when a systemically important institution is taken over by the FDIC, might there
be other situations in which repo trades would be demoted in a bankruptcy?
Obviously, it is too early to forecast the fate of this bill, much less those of the dozen or so
attendant amendments. However, like other regulatory efforts – from reforming tri-party
repo to recasting how money market funds operate – the Miller-Moore proposal exemplifies
the new shift toward heavier regulation in Washington. Striking a happy medium between
ensuring financial stability and overly aggressive regulation will prove very difficult next
year. As a result, 2010 could be a very bumpy year.
John Jansen again: I just want to be clear that I did not write this. It is from a research report by Barclays which a reader sent my way.