The Impact of Liquidity Regulation on Broker-Dealer Stability

Courtesy of Marco Macchiavelli and Luke Pettit

At the peak of the cycle in 2006, broker-dealers (dealers hereafter) were involved in originating, distributing and financing mortgage-related instruments, which exposed them to significant risks at the turn of the housing cycle in early 2007. To make things worse, they were financing a significant portion of these risky mortgage-related assets by rolling over overnight repurchase agreements (repos).  Dealers faced severe runs once funding conditions deteriorated, resulting in the demise of several of them, most famously Bear Stearns and Lehman Brothers.

In the aftermath of the financial crisis, the Basel Committee introduced the Liquidity Coverage Ratio (LCR) which requires banks to hold enough High Quality Liquid Assets (HQLA) that can be liquidated to meet a 30-day run. After the Basel Committee finalized the LCR rule, each constituent country was tasked with implementing its own versions of the rule, with the U.S. implementation ending up as one of the most stringent.

In our paper, we empirically document the financial stability effects of the LCR on the largest domestic and foreign dealers operating in the U.S. market.[1] For identification, we use a difference in difference approach, exploiting the fact that domestic dealers are subject to the more stringent U.S. implementation. We therefore compare the behavior of domestic dealers with that of foreign dealers around LCR announcement and compliance dates.

Using confidential data on dealers’ financing and inventories, together with detailed triparty repo transactions, we uncover three main effects of the LCR on dealers. First, the LCR induces dealers to increase the maturity of triparty repos backed by lower-quality collateral, while leaving the maturity structure of repos backed by high-quality collateral unchanged. Second, the LCR leads dealers to reduce their reliance on repos as a way to finance inventories of high-quality assets, resulting in more of these inventories counting towards HQLA – which improves the LCR.[2] Third, the LCR incentivizes dealers to cut back on trades that downgrade their own available collateral (from the client’s perspective a collateral upgrade); as a result, dealers engage in less liquidity enhancements for their clients.

Each of these changes appear to de-risk dealers’ operations to various degrees. The terming out of repos backed by lower-quality collateral improves stability. Since dealers finance a sizable portion of their lower-quality inventories on the repo market, access to longer-term repos backed by such collateral reduces rollover risk and possible fire-sale losses in a stress event. Moreover, dealers also borrow in the repo market to finance clients’ leverage. Therefore, dealers can pass some of these maturity extension benefits to their clients.

Next, the reduced reliance on repos to finance Treasury inventories improves dealers’ stability, but only indirectly. Reliance on overnight repos to fund Treasuries does not pose direct fire-sale risk in case these repos do not roll, as Treasuries are the most liquid assets and tend to appreciate during stress events. However, having more unencumbered Treasuries increases the size of dealers’ liquidity pools that can be monetized in case of a run. The importance of maintaining large liquidity pools is highlighted in several occasions in the Financial Crisis Inquiry Commission (FCIC) report, where regulators discuss how Lehman’s liquidity pools were not sufficient to withstand a run.[3]

Reliance on repos to finance inventories becomes a source of fire-sale risk only to the extent that repos do not roll while the underlying collateral becomes illiquid (or loses value). In this regard, we estimate that a significant reduction in the reliance on repos to finance riskier and less liquid collateral occurred right after the 2007-09 crisis, and before the LCR was even announced. In particular, domestic dealers significantly relied on repos to finance inventories of corporate debt pre-crisis: about 40% of their corporate debt inventories were financed with overnight repos. In the immediate aftermath of the crisis (before the LCR is even announced) the number drops from 40% to roughly 10%. This finding suggests an endogenous de-risking that occurred right after the crisis: cash lenders and dealers identified this pre-crisis practice as too risky and scaled it back autonomously. This finding also complements the observation that large dealers have been more reluctant to take inventory risk post-crisis (Bessembinder et al. (2018), Goldstein and Hotchkiss (2017), and Schultz (2017)).

The third estimated LCR effect—a reduction in trades that downgrade dealers’ own collateral—has uncertain financial stability implications during a stress scenario, but reduces the everyday liquidity enhancement services provided by dealers to their clients. The implementation of initial and variation margins for non-cleared derivatives has been gradually phased-in, with the last set of market participants having to comply by September 2020.[4] This may create significant demand for dealers to upgrade clients’ collateral for the purpose of posting margins; at the same time the LCR constrains the dealers’ ability to do so.

In addition to collateral transformation, dealers also offer maturity transformation services. The LCR penalizes excessive maturity transformation, namely the financing of more-than-30-day reverse repos through less-than-30-day repos. This penalty is negatively correlated with the collateral quality. Consistent with these incentives, we observe significant maturity transformation in excess of the 30-day threshold for high-quality collateral. For lower-quality collateral (corporate debt), foreign dealers subject to a less stringent LCR provide significant maturity transformation: they fund 47% of more-than-30-day reverse repos with overnight repos; on the other hand, this number is not significantly different from zero for domestic dealers.

The effects that we estimate, in addition to being consistent with both incentives and timelines of the LCR implementation, are unlikely to be driven by other post-crisis regulations. As discussed in more details in our paper, neither the Basel III leverage ratio, nor the Volcker rule, nor the U.S. stress tests are likely to generate our results.

There are also some liquidity risks that are not fully addressed by the LCR rule, but are nonetheless present in the data. Maturity transformation within 30 days, while not always penalized by the LCR, can still expose dealers to rollover risk; this risk is present to various degrees across collateral types. For instance, in the equity space, U.S. dealers finance almost all of their 2-to-30-day reverse repos with overnight repos. There is also some non-trivial degree of negative maturity transformation in the Treasury and agency space, which actually improves the LCR. However, it may expose dealers to the risk of collateral runs (Infante and Vardoulakis (2018)).[5]

To sum up, the LCR generally improves the financial stability of dealers, which are the intermediaries at the core of U.S. financial markets. However, we also find that improving their liquidity profile comes at the expense of the dealers providing less liquidity transformation to their clients. Finally, we also show that a significant reduction in fire-sale risk occurred autonomously right after the 2007-09 crisis, and before the announcements of Basel III regulations.

 

References

Bessembinder, Hendrik, Stacey Jacobsen, William Maxwell, and Kumar Venkataraman, “Capital commitment and illiquidity in corporate bonds,” The Journal of Finance, 2018.

Infante, Sebastian and Alexandros Vardoulakis, “Collateral runs,” working paper, 2018.

Goldstein, Michael and Edith Hotchkiss, “Providing liquidity in an illiquid market: Dealer behavior in US corporate bonds,” Journal of Financial Economics, 2019.

Schultz, Paul, “Inventory management by corporate bond dealers,” working paper, 2017.

 

[1] Domestic dealers are to the domestic broker-dealer subsidiaries of U.S. financial institutions (for instance, J.P. Morgan Securities LLC); the term foreign dealers refers to the domestic subsidiaries of foreign financial institutions (such as HSBC Securities (USA) Inc).

[2] Securities count towards HQLA only if unencumbered; by repoing out a security, it becomes encumbered since a third party now has a right on it.

[3] Chief among them is the remark that in June 2008, “regulators’ most recent stress test showed that Lehman would need $15 billion more than the $54 billion in its liquidity pool to survive a loss of all unsecured borrowings and varying amounts of secured borrowings.” See the report on pages 284, 328, and 363. The citation above is from page 328.

[4] See the ISDA-SIFMA July 2018 report on margins for non-cleared derivatives. As a reference, most interest rate swaps and credit default swaps were required to be cleared by Title VII of Dodd-Frank, which was implemented by the SEC and CFTC in 2012 (see the final rule).

[5] A collateral run can happen when the collateral reversed in overnight is pledged in a longer-term repo, and the overnight reverse repo does not roll. In this instance, the client is effectively pulling the collateral away from the dealer while it is still pledged to another party; as a result, the dealer has to find another way of sourcing that collateral. These runs also erode the dealer’s net financing.