FRB Governor Stein's Speech at FRB on "Fire Sales" in Securities Financing Markets (with Lofchie Comment)

In a speech at a workshop held by the New York Fed, Fed Governor Jeremy C. Stein delivered a speech discussing "fire sales" in securities financing transactions and laying out a case for further policy attention to the issue.

Governor Stein began by discussing the welfare economics of fire sales, explaining that a forced sale of an asset is not just an event that leads to prices being driven below long-run fundamental values, but one that involves market failure or externality of the sort that might elicit a regulatory response. Governor Stein stated that by itself, the existence of substantial price discounts in distressed sales does not speak to the normative economics of fire sales, and therefore is not sufficient to make a case for regulatory intervention.

He then discussed how securities financing transactions ("SFTs"), such as those done via repurchase agreements, are an object of concern for policymakers since they give way to fire sale externalities (e.g., market costs that may result from problems in these markets). Governor Stein laid out two stylized examples of SFTs which illustrate the properties of various regulatory tools: (i) where a broker-dealer acts as principal, and (ii) where a broker-dealer as an SFT intermediary. In either case, Governor Stein noted that if the associated externalities are deemed to create significant costs, the goal of the regulatory policy should be to get private actors to internalize these costs.

Finally, Governor Stein surveyed and assessed the effectiveness of recent regulatory tools, such as risk-based capital requirements, liquidity requirements, and leverage ratio. He concluded that while these tools have a variety of virtues, none seem well-suited to comprehensively lean against the specific fire sale externalities created by SFTs. He suggested possible alternative ways to deal with SFT-related fire-sale externalities, such as capital surcharges, modified liquidity regulation, and universal margin requirements.

Lofchie Comment: Governor Stein's suggestion that the government could (or should) play a material role in the making of credit decisions, including involvement in the mechanics of unwind decisions is problematic. Query: how should the government determine which unwind decisions affect third parties (and which do not).

See: Governor Stein's Speech.