Mar 1, 2021

Pat Parkinson on the 2020 Treasury Market Meltdown and How to Avoid a Potential Sequel

Implementing a standing repo facility and tweaking the supplemental leverage ratio are just a couple of solutions that can help prevent Treasury market stress in the future.
David Beckworth Senior Research Fellow , Pat Parkinson

Hosted by David Beckworth of the Mercatus Center, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Pat Parkinson is a senior fellow at the Bank Policy Institute and a 30-year veteran of the Federal Reserve system, where he served as director of the Division of Banking Supervision and Regulation. During that time, he was also a member of the Basel Committee on Banking and advised Alan Greenspan, Ben Bernanke, and Tim Geithner on financial market issues. Pat joins Macro Musings to discuss the treasury market meltdown in March 2020, as well as what we can do moving forward to avoid this issue from happening again. Specifically, David and Pat outline the implementation of a standing repo facility, changes to the supplemental leverage ratio, expanded central clearing, and increased data collection as possible solutions to this problem.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Pat, welcome to the show.

Pat Parkinson: Thank you. Glad to be here.

Beckworth: Glad to have you on. Now, you have a great paper you've co-written with Nellie Liang at Brookings, and I'm excited to get into it, but before we do, I'd love to hear about your career. You've had quite the run there at the Federal Reserve system, worked with some prominent leaders of the Federal Reserve, so maybe share with us how you got into it, and then some of your, maybe highlights from that time there.

Parkinson: Sure. Well, I joined the Fed way back in 1980 during the Volcker era, and started out actually in the international division. I think a turning point for me really was in early 1988 I was named chief of the capital markets section in the research division, and around that time, we were still working to sort through the implications, the policy implications, of the 1987 stock market crash. And that got me involved, number one, substantively, in issues around the capital markets, mainly regulatory issues, and then also, because a lot of that work was conducted by the president's working group on financial markets, which was comprised of the chairman of the Fed, the Secretary of the Treasury, and the chairman of the CFTC and SEC, I get involved in that set of issues, and in fact, was sort of the principal staff person supporting the chairman's participation, first Chairman Greenspan and then Chairman Bernanke from, say, 1990 all the way to 2008.

Parkinson: And so during that period, I didn't, other than early in my career, have much to do at all with monetary policy. I had episodic involvement in banking regulation, but had a lot of involvement in other issues, like, for example, I think I was the board's derivatives expert for many, many years, and also spent a lot of time on clearing and settlement of securities and derivatives, where I, I think, led the work of the G10 committee on payment and settlement systems for quite a few years, and in fact was the co-chair of the first central bank securities regulator task force that developed the standards for security settlement systems and derivatives clearinghouses, and that was something I did through much of my career.

Parkinson: I should bring Tim Geithner into the story, I guess. I think I knew him a little it when he was at Treasury back in the Rubin treasury days. But he became president of the New York Fed, I'm guessing around 2003, that might not be exactly right, and one of the issues he really decided to tackle was OTC derivatives, and I was very glad about that because I was one of a small number of staff members who were pushing for a long time to strengthen the closing and settlement infrastructure for the OTC derivatives market, but without much success. And I think the key thing that was lacking was some powerful figure to put the full energies and force of the Federal Reserve behind that, and Tim provided that. So I worked with him very closely in those years, say 2003 to 2007.

Parkinson: Then along comes the financial crisis, and again, I interacted with him a good bit on that. I think probably my most important involvement was in developing some of the emergency liquidity facilities at that time, and the New York Fed and Tim really played a leading rode in all that, I think, in some sense, the Board staff and even the governors were in a supporting role, I think one of the best judgments that Ben Bernanke showed was to say, "Gee, Tim really is good at this stuff and the New York Fed has lots of expertise, I'm going to let them take the lead and be supportive on these things, and not let egos and org charts get in the way."

Parkinson: And that really led to, then, knowing Tim from both the derivatives wars and the financial crisis, when he became Secretary of the Treasury in 2009, he asked me to come join him to work on regulatory reform. And I only lasted about six months, I must say, the Treasury Department and the political aspects were not to my liking, but we did get out this white paper on what should be the policy response to the great financial crisis, global financial crisis. And finished the white paper, which in some sense was the first draft, although high level, crude draft of what became the Dodd-Frank legislation.

Parkinson: And then, when I came back, I was prevailed upon by Bernanke and Dan Tarullo to take on leading the division of banking supervision and regulation. And that, in some sense, I say that was punishment for my sins, because it was for the first time in my ... I'd been a deputy director of research, I was a manager of this and that, but I never had to spend a whole lot of my time on management, and as director of the division of banking supervision and regulation, I had to spend a lot of time on management, and can't say that was to my liking, but I managed to tough it out for two years. And that sort of led to me ending up at Promontory as a banking consultant, which I think in some sense I was miscast, because I constantly had to tell them I was director of banking and supervision, but I dealt with a number of what I considered the most important targeted issues in supervision and regulation. When, for example, you wanted me to go on a pitch for an engagement on anti-money laundering, the truth of the matter was I knew not one thing about anti-money laundering.

Beckworth: Very interesting. So you've got a very storied career there, 31 years, worked with Greenspan, Bernanke, Geithner. And it was interesting, you mentioned Geithner took the lead on the 13(3) facilities back in 2008, is that what I heard you say? So ...

Parkinson: That's my perception. I’m sure others would tell it differently, but I think the New York Fed really did play a lead role on most of it. For better or for worse, the so-called Maiden Lane vehicles, the use of 13(3) authority to facilitate the orderly resolution of Bear Stearns and AIG.

Beckworth: Yeah. So maybe we can look at the facilities they did this time around, last year, as kind of his legacy. His legacy is these creative uses of 13(3), the different facilities for primary dealers, money market funds, all those facilities that we use. Of course, there was some additional new ones we did this past year, but I hadn't thought about Geithner, one of his legacies being the 13(3) facilities that we now tend to employ whenever there's this crisis.

Beckworth: Well, let's move to your paper, it's a really great read. It's with Nellie Liang, as I mentioned earlier, and the title is *Enhancing Liquidity of the US Treasury Market Under Stress.* So back in March 2020, the Treasury market really was breaking down, it was dysfunctional, and maybe walk us through, what actually happened and what was going on, why did the market have this problem, and then we'll get into the proposed solutions that you've outlined in the paper

The March 2020 Treasury Market Breakdown

Parkinson: Sure. I mean, fundamentally I think it was a matter of supply and demand. There were just extraordinary unprecedented demands turned treasuries into cash, and they came from many quarters. I think many people point to hedge funds, the unwinding of cash futures arbitrage trades where they had long positions in cash securities, and basically were forced by increasing margin requirements and probably increased perceptions of the risk of that trade to liquidate large amounts of treasuries, you had mutual funds, bond funds in particular, that held treasuries for liquidity, and they mainly hold corporate bonds, but the corporate bonds aren't terribly liquid, so when you need liquidity, what do you do? You sell the liquid assets that you have, and those are treasuries. And I think some are tempted to say this was all a problem with the non-bank financial institution sector or the shadow banking sector.

Parkinson: And certainly there were problems there, and there are issues to be addressed. Nellie and I didn't focus on those on our paper, but I believe we noted that was not because we didn't think that limiting potential demands from that quarter wasn't an important policy issue, it was simply that was getting so much attention elsewhere, that we instead focused our attention on the supply side. And there, I think clearly those remain over the counter markets, by and large. Not traded on exchanges, they're traded over the counter, they're dealer markets. You have a relatively small number of large dealers that are the primary sources of liquidity in the market, and for different reasons, they simply ... While they did provide a good bit of the liquidity, they were overwhelmed, they just didn't have the capacity to meet all those demands. And I think there's an ongoing debate that probably will never be fully resolved, how much of that was regulation constraining dealers from meeting demand, versus simply dealers having a limited risk appetite.

Parkinson: I think undoubtedly there's some of both. I think it’s crazy to think, given the scale of the sales, that seven to 10 large primary dealers were going to buy all of those treasury securities. But I think nonetheless there were aspects of the post-GFC regulatory regime that further limited their capacity to do so, as people say it limited the availability of balance sheet. Now, we could have a long discussion of which regs and what role did they play. I think the one that everybody points to is the so-called supplemental leverage ratio, leverage ratios were put in place, actually we always had a leveraged ratio in the United States, but additional leverage ratios were put in place after the GFC. But they were intended to be backstop to the risk space ratios, it was not intended that those in most cases be the binding constraint, and therefore the key influence, on the way banks allocated their resources.

Parkinson: But unfortunately, and there was an interesting debate back in 2014, before the board finalized the supplemental leverage ratio, they debated whether to include reserve balances at the Fed in the denominator of that ratio, and I think in the end they decided to do so, but that was based on a view that, while that might, at that time, be constraining the ability of banks and making the leverage ratio being close to being binding, that as the Fed normalized its balance sheet, as it sold securities as it has bought as part of QE, the constraint would no longer be binding, so we shouldn't worry about the fact that reserve balance was low, they were going to be coming down, not to worry.

Parkinson: As I say, it was a reasonable response at the time by the staff, but unfortunately, it didn't work out that way. And indeed, I think the perverse thing about the leverage ratios is that when you include reserves and also treasuries, I think, in the denominator of the leverage ratio, it's going to tend to become binding at the worst possible time, during a crisis, when the central banks, not just the Fed, but other central banks respond to chaos in markets by flooding the system with reserves. Governments, at least in this instance and also in 2008, are borrowing a lot of money, and so those treasuries are ending up on the balance sheets of the banks. So that makes a constraint that used to be in the background now become the binding constraint. And the reason that's important is that the leverage ratio sort of punishes low-risk, low-return activities. It treats all bank activities as if they're equally risky. So that means that they have a disincentive to engage in those low-risk activities, like providing treasury repo financing, or market-making in the treasury markets. And obviously that's not something you want them to be pulling back from in the midst of a market crisis.

I think the perverse thing about the leverage ratios is that when you include reserves and also treasuries, I think, in the denominator of the leverage ratio, it's going to tend to become binding at the worst possible time, during a crisis, when the central banks, not just the Fed, but other central banks respond to chaos in markets by flooding the system with reserves.

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Beckworth: That was a question I had after reading your article, and I've seen some other pieces on the supplemental leverage ratio. But the question I had is why did they propose this in the first place? In terms of the reserves being a part of the denominator, the assets you include, given that they're so safe. And you just answered my question, it was written in a time where the expectation was the Fed would shrink its balance sheet and reserves would not be a problem. And so it seems striking to me that once the Fed officially adopted this floor operating system or the ample reserve system, they should've gone back and revisited this rule. Because with the ample reserve system, this will always be an issue, like you said, during a crisis.

Parkinson: Yeah. I think the further things are there was a, like on the Basel Committee, they said it was important that the leverage ratio be a simple ratio, and if you started removing some assets from the denominator, that would be a slippery slope. That inevitably, if you told the banks they could remove the reserves, oh, they'd probably next want to remove treasuries, and then they have lots of other ideas about things.

Beckworth: Right, right. And then you get back to the original problem you had.

Parkinson: That's fair enough. And also, I think, between the agencies, the leverage ratio has almost always been something ... In politics, you talk about wedge issues. Well, the leverage ratio is a wedge issue. The FDIC, not only Sheila Bair, but lots of people at the FDIC think that the leverage ratio was the single most important banking regulatory reform post-crisis. I don't think you'll find anybody at the Fed that believes that, they wouldn't have it anywhere near the top of their list of the most important changes. But it's sort of an inter-agency political issue for that reason. And then now, for reasons I don't fully understand, the progressives regard an erosion of the leverage ratio as the worst possible thing that could be done. I don't agree with that, but I think anybody making policy has to take that perspective into consideration.

In politics, you talk about wedge issues. Well, the leverage ratio is a wedge issue...Lots of people at the FDIC think that the leverage ratio was the single most important banking regulatory reform post-crisis. I don't think you'll find anybody at the Fed that believes that, they wouldn't have it anywhere near the top of their list of the most important changes. But it's sort of an inter-agency political issue for that reason. And then now, for reasons I don't fully understand, the progressives regard an erosion of the leverage ratio as the worst possible thing that could be done. I don't agree with that, but I think anybody making policy has to take that perspective into consideration.

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Beckworth: Yeah. Well, let me go back for just a minute and just, again, talk about what happened in March. You provided a nice overview of it. But from an outsider's perspective watching it, it seemed surreal. I mean, the US treasury market, the mothership of financial markets was imploding, was not functioning. Now, I've learned since then, I've seen some of Ken Garbade's work, if I'm saying his name correctly, from the New York Fed. And he highlights, this has happened before. So World War II, the Fed had to step in, the treasury market almost collapsed, 1958, and then there's the Middle East concerns. And then 1970s, when the US troops were going into Cambodia, there were Treasury market problems. So it's not the first time this has happened, but maybe the first time in recent memory, definitely in my lifetime it's happened, and it just seemed shocking.

Beckworth: Now, in February we saw people rush out of equities, corporate bonds, into the safe assets. But then comes March 9, they're racing out of treasuries into cash, which is just, it was, again, very jarring, very shocking. And I'm going to read just an excerpt from a financial times article, what it was like for treasury market participants during this time. This is an article by Colby Smith and Robin Wigglesworth, just the enormity of it and what it looked like from their perspective. So I'm going to read here just a few paragraphs.

Beckworth: It starts with, "The wild price swings in March meant many investors struggled to offload even modest Treasury positions at sensible prices. Suddenly, brokers' screens were going intermittently blank and showing no pricing information for what is considered the world's risk-free rate. Deirdre Dunn, global co-head of rates at Citi, says it was the most dysfunctional Treasury market she has seen in her career, surpassing even the global financial crisis of 2008. Layer on top of that the practical complications of many traders working from home and the emotional stress of a pandemic, and things were getting chaotic. 'The intensity of everything at that time was remarkable,' she says."

Beckworth: And they go on, it's a pretty interesting article. But it's just striking that you never would have imagined the mothership of financial markets ... Now, I want to kind of step back, and I think this is pretty clear from your paper, but this is a plumbing issue, right? This isn't an issue of government solvency. I've heard a few people say that. But this is clearly a plumbing issue, and that's what your paper's about, how to fix the plumbing.

Parkinson: Yes. I mean, this didn't happen because suddenly people thought the United States wouldn't be able to pay back its debts, it's that people were really, this dash for cash, as I think Fed vice chairman Quarles has called it, was unprecedented in the sense that in previous crises, there would be a flight to quality. What did that mean? You sold risky assets and you bought treasuries.

Parkinson: Well, in this new world, I think, at some point, once people became to question their ability to instantaneously turn treasuries into cash, then that accelerated the movement out of ... it became a run on treasuries, and that was the problem. And some of this is the point of our paper, is that there are, even though people regarded treasuries as the most liquid markets in the world, and they probably were, actually the underlying market structure is pretty rickety. It's still an over the counter market, dominated by a few dealers, where clearing, which is central clearing, which is a feature of most other financial markets, sometimes, often mandated, clearing only a small share of treasury trades are in fact cleared. And where they're traded is over the counter, there are some inter-dealer trading systems, and some dealer to client trading systems, but those are not as transparent and don't provide the liquidity that other markets do.

Beckworth: So you're speaking now to the structural problems. Before we get into that, I want to flesh that out a little bit more. I want to read a quote from your paper that was excellent. Again, for me, the observer on the outside, this was shocking. But you have this quote in this paper, I love it, it's a great line that you say, "Although the evaporation liquidity, especially in US Treasury markets, came as a shock to both market participants and policymakers, in retrospect it was unsurprising.”

Beckworth: You've touched on some of them, and we're going to dig a little bit deeper here, but we shouldn't have been surprised if we had really lifted the hood on the engine, really got down and dirty, got some grease on our elbows, and really pulled apart the inner workings of the Treasury market, we would see there's some real structural problems. You have three, I believe, in your paper, maybe there's more, but I'm going to start with the first one. And you just mentioned the expansion of the size of the market, that the growth itself is something that's really accelerated lately and puts a strain on the market, so talk about that.

The Size and Changes of the Market as a Structural Problem

Parkinson: Well, I mean obviously the Treasury market's been growing enormously, and the outlook is certainly for further enormous growth. And one of the things the two political parties seem to agree on is at least when it comes to issuing debt to fund things, they're in favor of [it]. They're not very worried about debt levels. I'm conservative in the old sense. I remember the good old days in the '90s when both parties were committed to fiscal discipline and worried about the growth of the debt. Now it doesn't appear that anybody really is worried about that, and they only bring it up as a talking point in opposition to stuff the other guys want to do. So certainly, look at CBO estimates or whatever you want, we've got a lot more treasury debt on the way, and absent some of the reforms I think we discuss in our paper, I don't see any real growth in market-making capacity to meet the demands that may arise when the debt markets get that large.

We've got a lot more treasury debt on the way, and absent some of the reforms I think we discuss in our paper, I don't see any real growth in market-making capacity to meet the demands that may arise when the debt markets get that large.

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Beckworth: So the growth of the debt markets is a problem, given the flawed plumbing of the treasury market. So if we fix the plumbing issues, then this is less of an issue. Let me bring up a perspective on that-

Parkinson: Yeah, I think it's plumbing and it's the central bank tools issue.

Beckworth: Okay, central bank tool issue. Yeah, and some of the proposals you have will address this. Let me bring up, I had a previous guest on the show named Carolyn Sissoko, and she makes this observation that the money market in the US has evolved dramatically over the past few decades from an unsecured, overnight, like the federal funds market, to repo-based, it's largely repo-based finance. And she makes this point that the repo financing includes a lot of long-term treasury securities as collateral, and what happens as a result of this, whenever there's any kind of pressure, like what we saw in March, there's a collateral effect that kicks in as well, there's a dynamic that makes it unstable. Where with overnight funding markets unsecured through inter-bank lending, the Fed could easily step in and address that, but now the Fed has to actually respond to pressures in the Treasury market as well, because the money market itself has changed. Any thoughts on that?

Parkinson: Yeah, well, one of my first things I did at the Fed was writing a long paper with a lot of data about the scale of international inter-bank markets, and this was in 1982 or whatever, before even Basel I. And they were truly enormous, you remember the recycling of the petrodollars, just the enormous depth, almost unlimited depth of the inter-bank markets, the LIBOR markets, for example. And you're right, all of that has changed. I think, for one thing, it was the introduction of capital requirements making banks attentive to how much balance sheet they were using. Banks used to intermediate in those inter-bank markets for tiny spreads, and that was blowing up their balance sheets. And once you had a meaningful capital requirement, I think first the primary capital ratio that was introduced, God only knows, in the early '80s, it began to constrain that.

Parkinson: And then, as you noted, also, I think, over time, there was a shift to the extent that financial institutions were only willing to do so on a collateralized basis. So the importance of the repo and other securities financing markets. And then finally, the fact that you were mentioning, the Fed's ability to stabilize the inter-bank market, well, the players in the inter-bank market were banks, and those banks had access to the discount window, although there is this problem with stigma and their willingness to use it. But in the case of the repo markets, most of those participants are broker-dealer entities that may have sort of indirect access, subject to a bunch of frictions, through their affiliated banks, or if they're non-bank affiliated, they have no access whatsoever.

Beckworth: Yeah, so I guess the bigger point I think she's making is that the money market itself has fundamentally changed, and the proposals that we were going to discuss today, for example, is a fix given that change, as opposed to maybe that change itself should be questioned. Like, should we rely as heavily on repos that have longer-term treasury securities whose price can be affected by sudden swings in the market, or by interest rate changes that affect the price, unless there are collateral ... Now, I know that's a bigger challenge.

Parkinson: Well, I would say the issue there is the way in repo you try to mitigate the risk of longer-term ... You can use a wide variety of collateral, and the way you address the risk that there might be a collateral shortfall is through haircuts on the collateral, and the more price volatility there is in the asset, at least in principle, the higher the haircut you charge for the greater protection.

Parkinson: Their point is, I think, that when you talk to people who are secured lenders, one of the key things is how liquid the market for those assets are, how quickly you could liquidate them if there were default by your counterparty. I remember being told years ago, and I think it's right, think about corporate bonds versus equities. Well, equities, there's much greater price volatility than a corporate bond, but a lot of people would tell you they'd much rather take equities than corporate bonds as collateral at the right haircuts, because the equity markets are liquid, and the corporate bond markets are basically almost by appointment. So I think the question it raises is, if we're going to continue to rely so heavily on secured financing transactions, do we need to impose margin requirements on those?

I think the question it raises is, if we're going to continue to rely so heavily on secured financing transactions, do we need to impose margin requirements on those?

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Parkinson: It's interesting that, as far as I know, I'm not a lawyer, but my recollection is that the Fed's margin authority, which comes from the Securities Exchange Act of 1934 gives it no authority over Treasury collateral. I think it has, it definitely has, obviously has the famous 50% margin authority on equity, it has authority over corporate bonds and other things that it probably hasn't exercised, I think those are left as good faith margins. But it has no authority over treasuries, and I think that's something that probably should be questioned. As I understand it, that was because at the time, the US government again was thinking about issuing lots of debt, and the idea of applying margins to people that want to borrow, to buy those securities, understandably led to concerns that maybe the cost of the debt would be higher. And maybe that was the right trade-off, to not give the margin authority when our debt was so small. But given the staggering levels it's reached, I think that's another issue that Nellie and I, I think touched on, but we didn't take a position on in the paper.

Beckworth: Okay, so just to summarize the structural issues so we can move on to the proposed reforms, one, just the credit is increasingly provided through the bond market, and the public debt has grown significantly, so we're relying a lot on that form of financing. Also, you mentioned that the capacity for broker-dealers to handle this large amount of bond financing is getting smaller. You actually had a interesting statistic that the share of treasury holdings by these broker-dealers was 10% of the total in 2008, and it shrunk to 3% by 2019. So their balance sheet capacity was shrinking in part due to some of these regulations coming out of the great financial crisis.

Beckworth: But then the other flip side of that is that if the broker-dealers aren't holding these treasuries on their balance sheet, a decreasing share of them, then other entities must be. And you mentioned these other entities are ones that have to often quickly sell the treasuries, so it's a double whammy there, and sets us up for the very problems we saw in March. And I guess the question is, can we expect to see a March again? I mean, the pandemic was kind of a true tail event. Should we have planned for a tail event before we got to this point?

Parkinson: Well, I think the question really is, obviously in some sense, what happened in the tail was that the Fed came in and bought a lot of treasury securities, and probably given the magnitude, how far out we're in the tail in March 2020, maybe that's not a troubling thing. I think some people are actually more troubled by the Fed's intervention in September of 2019, where we weren't anywhere near that far in the tail. And it's an issue, or to say the least, reasonable people differ. But the question is, how much moral hazard did these Fed interventions create?

Parkinson: And I think a reasonable position is, number one, if it's done through repos rather than outright purchasing securities, that's not so bad, because the price risk stays with the party that's holding the security. But once you get into actual purchase of the treasuries, you want that to occur only in the five sigma event, and it seems like it's happening in the one and a half sigma event, and probably that's not good for systemic risk and the health of the financial system. You'd like to introduce some reforms that would not necessitate such frequent interventions by the Fed, interventions in a form that carries more rather than less adverse consequences.

I think a reasonable position is, number one, if it's done through repos rather than outright purchasing securities, that's not so bad, because the price risk stays with the party that's holding the security. But once you get into actual purchase of the treasuries, you want that to occur only in the five sigma event, and it seems like it's happening in the one and a half sigma event, and probably that's not good for systemic risk and the health of the financial system.

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Beckworth: I wonder too, not just the size of the intervention that was needed during March, but the timing. It was so quick, right? Where you think of like the QE programs in previous time, 2008-2009, they had time to go out and buy up securities. I mean, 2008 was a little bit different, markets were crashing then too, but they had more time to operate. This was such a quick and sudden rush for cash. It wasn't over multiple weeks and months, it had to be addressed quickly. And so really, the challenge here, if we're going to have a solution that doesn't require the Federal Reserve sitting in as having a system robust enough to handle the volume so quickly. Okay, well, let's talk about your solutions, then, that will get us there, because we've been kind of beating around the bush here, I want to jump into them. So you have four suggestions. First one is a standing repo facility, so tell us about that.

A Standing Repo Facility as a Solution

Parkinson: Okay. Well, a standing repo facility, I think in the paper we argue in some sense, the discount window was no longer fit for purpose in a financial system, and so much of the credit needs of the economy are being met through the bond markets rather than through bank loans. We want to make sure that the people that are actually making markets and providing liquidity to the Treasury market don't have to worry about their funding needs? And the other thing about a standing facility, there's some difficult issues that I won't deny about who gets access to that facility and how to price that facility. But abstracting away from all difficulties, the notion is that it would be an automatic stabilizer, that when, say, repo rates jumped up, that the Fed would stand ready to make repo loans at a spread to what was the normal market rate, and when it got above that threshold, they would just automatically be providing the funding that was needed, and therefore capping what happens to the repo rate.

And the other thing about a standing facility, there's some difficult issues that I won't deny about who gets access to that facility and how to price that facility. But abstracting away from all difficulties, the notion is that it would be an automatic stabilizer, that when, say, repo rates jumped up, that the Fed would stand ready to make repo loans at a spread to what was the normal market rate, and when it got above that threshold, they would just automatically be providing the funding that was needed, and therefore capping what happens to the repo rate.

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Parkinson: And of course, repo rates and repo markets are central to the functioning of the Treasury markets, as, oh, if you're a market-maker or anybody contemplating purchasing a treasury and doing so on credit, well, you're not going to purchase a security unless you're certain you have access to the credit, and ultimately the only entity that has unlimited capacity to meet demands for credit is the Fed.

Beckworth: So the concern here is it might create moral hazard. But if you look around, like at the ECB, they have a huge counterparty list compared to what the Fed… the Fed has a short list of primary dealers. Like the ECB, other central banks, they use standing repo facilities, and they have a large list of counterparties. I guess in my mind, and you talked about maybe limiting it to treasury securities or agencies, but why not allow other assets, as long as it's properly priced and there are haircuts included, and make it accessible to more counterparties, not just the primary dealers or broker-dealer crowd?

Parkinson: Right. Well, I think we suggested it be extended to all broker dealers who were able or willing to meet certain prudential standards [inaudible] the Fed, not just primary dealers. I don't understand why we limit access to things to the primary dealers, you'll have to ask the New York Fed to get an answer to that question. But what you're saying is what I think is probably ... It's interesting. We, I think, expected that our proposal to open it up to this wide range of broker-dealers subject to Fed supervision, that most of the opposition would be from people screaming, "Well, that's too much moral hazard." In fact, we're getting much more of the other point of view that you just expressed. "Well, it's Treasury collateral, what's the risk to the Fed that ... Why don't we open it up to everybody and anybody?"

Parkinson: And I think there, the answer I would give is that if you did that, there'd be a lot more leverage in the financial system. I mean, people would be willing to take the treasury cash futures basis trade. If I didn't have to worry about my ability to roll over my repo financing of the cash treasury position, that would be eliminating one important limit on my appetite for taking on that trade, and more generally, I think these relative value trades in which treasuries are the safe leg and something more risky is the other leg, you'd probably be giving a lot more energy to the so-called carry trade.

Parkinson: But a perspective that I've heard since Nellie and I wrote the paper, which I think is one that I want to think a lot more about, maybe a better answer, is you don't need to impose a full panoply of prudential regulations on folks that have access to a standing repo facility, you just have to make sure that when they take those funds that extend credit to others, or use the credit, take their own positions, that there's not excessive leverage, and the way you limit the excessive leverage would be through a margin regime, so it comes back to the issue we were discussing earlier. If you empower the Fed, or the SEC or whomever, to limit the amount you could borrow against treasury securities, wouldn't that address your issues about leverage in the system?

A better answer is you don't need to impose a full panoply of prudential regulations on folks that have access to a standing repo facility, you just have to make sure that when they take those funds that extend credit to others, or use the credit, take their own positions, that there's not excessive leverage, and the way you limit the excessive leverage would be through a margin regime, so it comes back to the issue we were discussing earlier.

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Parkinson: Now, again, it'll be a tricky business of figuring out what the right haircuts or what margin requirements would be for treasury securities, but that seems like a small problem in regulatory policy compared to some of the others we're discussing. So I'm warming to the idea that it should be broader, and that the essential regulatory measure needed to avoid the creation of that facility greatly increasing leverage and systemic risk in the financial system is authority and effective use of that authority to set margins on not only, obviously would be margins set on the loans that the Fed makes to their entities that access the facility, but then on the other side, limits on the leverage that those entities apply to their clients.

Beckworth: Yeah. So this seems like a very promising idea, and I know it's been discussed before. We've had David Andolfatto and Jane Ihrig on, well, David Andolfatto was on. But they proposed a standing repo facility some time ago, I know the Board was discussing it, or the FOMC was discussing it. Do you have any sense of where this idea stands at the Fed, or policymakers, any interest or appetite for it?

Parkinson: I don't know, I wish I could tell you they're about to embrace it. I sense there still is discomfort. The other thing, Nellie and I are trying to increase the supply of liquidity to the Treasury markets, I think most of the earlier discussion of a standing repo facility, that may have been a secondary aim, I don't know, but the primary aim was to cap the repo rate.

Beckworth: Yeah. And I think some of the early proposals also were dealing with how to get reserves off bank balance sheets, too, where yours is more the treasury market. And I want to be clear to listeners, as you read this paper, this standing repo facility here that Pat's talking about is just one of several, and you and Nellie want to see all of them together, not any one by themselves. Because as you just mentioned, by itself there might be some moral hazard issues, so you'd want some other, something else to address that. Alright, so that's our standing repo facility, first one. Let's move on to your second suggestion. And that is expanded central clearing, and you draw on Darrell Duffie's proposal, so walk us through that.

The Expanded Central Clearing Solution

Parkinson: Right. We draw on Darrell's study. Even Darrell just said it should be studied, I don't think it’s forward-leaning, any more forward-leaning than we were. Well, maybe first a bit of background information. We have central clearing of treasuries in the United States. We've had it since 1989, through the Fixed Income Clearing Corporation, which is a sub of the Depositary Trust and Clearing Corporation, which is basically the primary provider of clearing and settlement facilities to the equity and bond markets. But actually, today only a very small share of total trades and treasuries are cleared through FICC, I'll call it, the Fixed Income Clearing Corporation.

Parkinson: And in fact, that share has declined in recent years. It was never a huge share, because the clearing of trades was always limited to the so-called inter-dealer market, and back in the day, at least, I think the dealer to client market was 50% of the total treasury market, and none of that had been cleared. I think that's one of the big nuts to crack is how to get clearing to the dealer-client market. With regard to inter-dealer clearing, the amount of clearing as a share of trades greatly declined, because the inter-dealer market, that's now a misnomer. It used to be that the participants on those trading platforms were limited to dealers, and the dealers are banks and broker-dealers who remembers the Fixed Income Clearing Corporation, and as a matter of practice, if they traded one another it was submitted to FICC for clearing.

Parkinson: But as the so-called principal trading firms came to account for a huge share of the activity in the inter-dealer markets, they are not FICC members, so their trades are not cleared. So you're down to where, you'd have to look at one of the papers by the Treasury Market Practices Group, but I think somewhere, only 10 or 20% of total treasury trades are cleared through that CCP.

Beckworth: So would there be opposition to this? I mean, I can imagine, maybe someone loses business if all the clearing's done through the FICC. I mean, besides that, what would be the reason not to go down this path?

Parkinson: Well, I think there are some ... In the case of inter-dealer, I don't get it. I mean, you could say maybe the principal trading firms won't participate as actively if you required their trades to be cleared, but I'm pretty sure they participate very actively in the equity markets, in the derivative markets, exchange traded derivatives markets, yet all of that's cleared. So if CME and OCC and NSCC have figured out how to get them into clearing, I think where there's a will there's a way.

Parkinson: On the dealer to client stuff, which I actually think is the most important area to get into clearing, so that ... Two things. One, so if a dealer, say, is providing, he's buying a security from an asset manager, and then selling that in the inter-dealer market, today, well, the one trade with the other dealer may get cleared, but the other one doesn't. So there's no netting benefit, it takes up a bunch of his balance sheet. You'd like to get those asset managers at other buy side firms into clearing.

Parkinson: There, I think historically the impediments have been, currently, the way clearing works in the US and most other parts of the world is that when you participate in a clearing system, at least directly, it comes with responsibilities for loss-sharing, it comes with the mutualization of losses and liquidity pressures in the event that another participant in that clearing system fails. And in the case of buy side firms, in some cases their regulatory system prohibits them from participating in such loss-sharing, in others they simply ask themselves, "Well, do I really want to be on the hook to contribute to covering the losses from [inaudible] one of these gargantuan dealers were the major participants?" And they say no.

Parkinson: So I think you need to figure out a way around that. There is a product that FICC has developed called sponsored clearing, which is playing a pretty big role in the overnight treasury repo market currently. But basically, you get a member of FICC, usually a custodian bank, currently, to sponsor these buy side firms. What does that mean? Two things. It means that they take on the responsibilities to, if someone else defaults, to contribute to covering losses and liquidity pressures on behalf of that buy side client, and then secondly, from the point of view of the FICC, if the buy side client or a hedge fund were to default, they provide a guarantee that they'll make up for any losses that FICC might incur as a result of one of these sponsored members failing.

Parkinson: And that has been pretty successful in the dealer to client space. I had some concern that it might be concentrating a lot of activity in the custodian banks, but actually just, maybe yesterday or earlier this week, the New York Fed released a paper that said, at least in the case of overnight repo market for treasuries, in fact, sponsored clearing has decreased concentration. That seems counterintuitive to me, but maybe that's because probably the biggest custodians are Bank of New York and State Street, and they were not among the largest dealers. They're not primary dealers. So it may be that their greater share is coming at the expense of some even larger participants, and that's why measures of concentration are decreasing.

Parkinson: But I think there are a bunch of issues around client clearing, is sponsored clearing the path forward? If it isn't, what is, and if it is, how do you address certain concerns about concentration and access, et cetera? But again, I think those are questions that, again, if there's a will there's a way. We can sort through those issues. And I don't have any sympathy for the inter-dealer markets, either. I just wouldn't put up with that.

Beckworth: So with the previous proposal, standing repo facility, I think it's pretty clear how that would address the problem. You would reduce the fear, the desire to liquidate your treasuries quickly because you know there's a standing repo facility there, might open up some balance sheet space. How does central clearing address the problems we had in March 2020?

Parkinson: I'd say three things. One, because it does affect netting of purchases and sales, it means that it takes up little or no balance sheet space for the existing dealers, so it increases their capacity to intermediate. I also think, particularly, second thing's, if central clearing led the way to all to all or peer to peer trading systems, I think that, number one, smaller dealers would be better able to compete with the larger dealers, so it would become less concentrated and they might allocate more capital to supplement the capital they're currently allocating. And indeed, in some sense you obviate dealer intermediation. If one mutual fund can sell a treasury security to a pension fund, with the intermediation being done with FICC and no need for them to be transacting with a dealer, then obviously that doesn't require a dealer balance. The rub would be, typically those have to be cleared, and typically you've got a clearing firm intermediating between them and FICC, and it'll take up some of its balance sheet.

Beckworth: Okay. So you increase balance sheet capacity in a major way if you have more central clearing.

Parkinson: Yes.

Beckworth: Okay. And that was a big deal in March 2020. Okay, so we have the standing repo facility, we have the increased use of central clearing, and your third proposal is some changes to bank holding company regulations. You've touched on them already, but deals, I think, primarily with the supplemental leverage ratio, but you have a few others that you suggest. But again, walk us through the supplemental leverage ratio and why it can make a big difference in any future crisis like March 2020.

The Future Importance of the Supplemental Leverage Ratio

Parkinson: Well, I think two things. One, it's intended to be a backstop measure. I think we discussed this earlier. But what happens in a crisis is the Fed floods the system with reserves, the Treasury tends to be issuing a lot of debt, which leads to treasuries piling up on the balance sheets of dealer banks. So for both those reasons, the denominator of the leverage ratio balloons, and the leverage ratio, not the risk base ratio has become the binding constraint. And because the risk base ratios treat basically all assets as equally risky, including reserves held at the Fed, that discourages banks from engaging in low risk activities like providing repo financing or acting as a market-maker in the treasury markets. So you're discouraging them from doing what you need them to do at the very moment when you most need them to do it.

And because the risk base ratios treat basically all assets as equally risky, including reserves held at the Fed, that discourages banks from engaging in low risk activities like providing repo financing or acting as a market-maker in the treasury markets. So you're discouraging them from doing what you need them to do at the very moment when you most need them to do it.

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Beckworth: Another way of saying that is the supplemental leverage ratio, when it has reserves included in the denominator, is procyclical. It's a procyclical regulation during crisis, it makes things worse, which is not the intention. The other point, though, you brought out earlier was just the fact that the rule was designed with the intention of the stock of reserves declining over time. And just since this crisis started, you bring this out in the paper, we started out about 1.7 trillion early last year, and now we're up past three trillion, 3.1 trillion last I checked, in reserves. So this is going to be-

Parkinson: The wise heads think it's going to north of five trillion, I understand.

Beckworth: Yeah, so this is going to be not just a cyclical issue but a structural, long-term one, something that has to be addressed, I imagine. And again, if the context of designing this rule was the vision of shrinking the Fed's balance sheet, and now for the foreseeable future it's going to be large and larger, it seems like this rule needs a revisit on a permanent basis, not necessarily the temporary one we've received.

Parkinson: Right. Well, they're going to need to revisit, because the temporary exclusion of reserves and treasuries from the denominator of the supplemental leverage ratio at the holding company level, which was done by the Fed, that temporary exclusion expires at the end of March. So they have less than a month to figure this out, and probably shouldn't have people on pins and needles as the date approaches, so they actually have less time. And there are various ways you could address this issue. One would be to make particularly exclusion of reserves permanent. I think other people think another way would simply to be to recalibrate, particularly the so-called enhanced supplemental leverage ratio, to lower the required ratio and again, make it be unlikely to be a binding constraint even when reserves are growing. In any event.

The temporary exclusion of reserves and treasuries from the denominator of the supplemental leverage ratio at the holding company level, which was done by the Fed, that temporary exclusion expires at the end of March. So they have less than a month to figure this out, and probably shouldn't have people on pins and needles as the date approaches, so they actually have less time.

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Parkinson: One thing about that, I think, you mentioned the procyclical element. One of the remarkable things is that the Bank of England turned out to be prescient in this regard, in that, I won't get the timing right, but several years ago, they departed from what then was the Basel agreement and decided to exclude balances held at the Bank of England from the leverage ratio, and to avoid the charge that they were watering down the international standards, they then recalibrated the minimum required. The minimum requirement internationally is three, they recalibrated, I think it was to three and a quarter, and the logic was, if you looked at least at the UK banking system as a whole, reserves included 3%, reserves excluded three and a quarter required about the same amount of capital in aggregate in the banking system.

Parkinson: And then the Basel system subsequently defended that as a temporary ... I think even the Bank of England regarded that as a temporary measure, but it's been temporary for a long time. The Basel committee said yes, you could do that as a temporary measure in a jurisdiction. But you had to do this adjustment of the minimum upward. Now, the problem, some would point out, with adjusting the minimum upward and only excluding reserves is that that means that now, the leverage ratio is friendlier to holding reserves, but still unfriendly to doing anything with those reserves, including lending in the repo market. So in any event, it's a complex regulatory issue that you're going to hear a lot more about in the next month or so.

Beckworth: And just to be clear, and not to make this sound very dire, if they don't do anything, then in March, there's going to be a sudden increase of a binding constraint on bank balance sheets, which could have a contractionary effect to the economy. Presumably that won't happen, we'll have some changes before then, but if they don't, this is a real deal. Because again, we have reserves north of three trillion and they're continuing to grow, so this will be a very consequential decision, and I don't hear a lot about it. I mean, you've brought it up, I've seen maybe one financial reporter talk about it, but I don't think it's getting much discussion.

Parkinson: Well, it gets a lot of discussion behind the scenes.

Beckworth: Okay. Oh, I guess I'm not running in the right circles there, Pat, I need to run in your circles more.

Parkinson: Yeah.

Beckworth: Okay. One question I had on this section, so you suggested, you and Nellie suggested that in making this permanent change, you remove reserves from the denominator, totally agree, makes a lot of sense, but leave treasuries. And I understand your reasoning, the reasoning is that they still are subject to interest rate risk. We were just talking about that earlier in the show. But let me just play devil's advocate here. Your proposal is a package, right, so you're going to have a standing repo facility as well as making this change to the supplemental leverage ratio. So if you have a standing repo facility, is there really any interest rate risk to the Treasury? Because you can always run to the standing repo facility, convert it into cash if you had to, at a fixed rate. Would that minimize your concern or not?

Parkinson: So you're saying with a standing repo facility, they could always hold the treasury security to maturity. But I'm not sure we want a system in which, again, historically at least, the way you would view an emergency liquidity facility, whether it's the discount window or the standing repo facility, this is supposed to be short-term usage to get you through a crisis, it's not a facility  people would want to use, and just keep rolling over those repos for, say, 30 years so that you could convince yourself there was no risks. I don't think regulators or central banks are likely to look at it that way.

Historically at least, the way you would view an emergency liquidity facility, whether it's the discount window or the standing repo facility, this is supposed to be short-term usage to get you through a crisis, it's not a facility  people would want to use, and just keep rolling over those repos for, say, 30 years so that you could convince yourself there was no risks. I don't think regulators or central banks are likely to look at it that way.

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Parkinson: One of the main reasons that you have a leverage ratio, when people look at risk-based approaches and see deficiencies, in them, one of the deficiencies they see is that under the RWA approach, the risk weight attached to a government security is zero, and that's actually true whether it's the United States, or whether it's, not to pick on those poor folks, but, say, Greece. So there's a real problem, I think, with excluding ... I don't think we're ever going to get an international agreement where we're going to exclude government securities from the leverage ratio.

Beckworth: Okay. So your last reform, so just to recap, we have standing repo facility, increased central clearing, and then tweaking the supplemental leverage ratio to exclude reserves from the denominator of it. Your last proposed reform is increased data collection. So what do you want to see done there?

Increasing Data Collection as a Solution

Parkinson: Two things. I think there's a question of what's collected by the regulators, and then the question of what's publicly disseminated. Let's first tackle what's collected. That is one area where they've made some progress over the last few years, in particular the self-regulator for the securities industry, FINRA, has begun collecting data on transactions and treasuries between FINRA members, basically, between broker-dealers. And they have that data, and that data is what's being used in all these studies you're seeing emerging by Fed economists and Office of Financial Research economists on the Treasury.

Parkinson: I think where that has sort of fallen short is I don't think it includes repos, there is a separate data collection where they're getting lots of information about cleared repos from the Fixed Income Clearing Corporation, but I don't think even with the broker-dealers it's comprehensive, and then importantly, a bit of inter-agency politics, banks are not subject to the FINRA reporting requirement, and I think the Fed promised several years ago that they'd figure out some way to get bank transactions into the database, but that hasn't happened with great alacrity, shall we say. And I don't think it covers repos, at least bilateral repos. So I think there's still some limits to the collection of transactions information on treasury transactions.

Parkinson: Then there's the issues of public disclosure, and I think those are twofold. Maybe, go back. On collecting data, I think, too, whereas we collect data on broker-dealers, we collect data on banks, we don't collect data on other major participants in the Treasury markets, whether those are hedge funds or principal trading firms or what have you. And it would be nice to know, who are the big participants in the market? And I think probably more data should be collected on that. But the bigger problems, I think, are the lack of public transparency.

Whereas we collect data on broker-dealers, we collect data on banks, we don't collect data on other major participants in the Treasury markets, whether those are hedge funds or principal trading firms or what have you. And it would be nice to know, who are the big participants in the market? And I think probably more data should be collected on that. But the bigger problems, I think, are the lack of public transparency.

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Parkinson: The SEC, interestingly, going back to speeches by Mary Jo White, whenever that is, five, six years ago, emphasized the need that not only regulators collect data, but they make the data public, I would say both to inform public debate on questions like the ones we've been discussing, or simply to hold the regulators accountable for what's going on in those markets. But aside from the SEC, I don't think there's a great belief in the benefits of public transparency, which is odd, given that we have public transparency in most other markets, and we are talking about the treasury market, which you think we would think is as important as any. It may, again, reflect this view that treasury securities are risk-free, going back, although this we forget about Salomon Brothers, that markets can't be manipulated, et cetera. But I think it's past time to start making that data public.

Parkinson: And the other thing I would say is, I'm always astounded with banks or bank holding companies. You could go to the internet to find most of the regulatory reports, at least the quarterly, major reports, of every bank and bank holding company. The SEC publishes nothing whatsoever on ... And I've been complaining about this since at least the year 2000, when I was at the Fed, that they don't publish anything about the balance sheets of broker-dealers, and I don't understand that. What's so different about broker-dealers that people could know everything about what a bank's portfolio is and what its liability structure is, and nothing about broker-dealers. So I think that should change. So I think there's some more way to go in terms of transparency to regulators, and then a long way to go in terms of public transparency in the treasury markets.

Beckworth: So this could be done possibly through the Office of Financial Research as well as the SEC, those would be the two agencies that would get that information out?

Parkinson: Well, in terms of broker-dealer balance sheets, I don't know. Maybe the SEC has promised that they won't make it public. I don't know why they'd make such a promise, but they're the ones that could make it public, I think. And in terms of the other data, again, it's being collected by FINRA. I'm pretty sure if the SEC and the Fed said that they thought that FINRA should make that data public, they'd make it public.

Beckworth: So FINRA has it already, okay.

Parkinson: Yeah.

Beckworth: Alright, well, with that, our time is up. Our guest today has been Pat Parkinson, Pat, thank you so much for coming on the show to discuss your reforms for the treasury market.

Parkinson: I enjoyed it.

Photo by Chip Somodevilla via Getty Images

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