Remarks on Broker-Dealer Capital by the President of the Federal Reserve Bank of Boston

In his speech at the New York Conference on the Risks of Wholesale Funding, President of the Federal Reserve Bank of Boston Eric S. Rosengren stated that there should be a “comprehensive re-evaluation” of the capital regulation of broker-dealers (i.e., intermediaries that effect transactions in securities), given the lessons of the financial crisis. In other words, the capital regulations imposed on broker-dealers should be raised materially. According to Mr. Rosengren, the market’s perception that broker-dealers were not financially sound because they did not hold enough capital resulted in a reduction in liquidity in the credit markets that support economic activity during the financial crisis; thus, economic activity was severely impaired. Accordingly, Mr. Rosengren suggested, there should be an increase in capital requirements for any bank holding company with significant broker-dealer operations.

Lofchie Comment: Mr. Rosengren states that an increase in capital requirements would result in a reduction of the profitability of broker-dealers (or bank holding companies). He does not make explicit the consequences from that. Any reduction in profitability (meaning any increase in expenses) will inevitably reduce the level of activity and increase the cost that others (such as market participants) must pay to justify the expense of the activity. If Mr. Rosengren’s concern is that broker-dealers are not reliable providers of liquidity to the credit markets, then it is hard to see how increasing their capital requirements improves liquidity in those markets. Rather, his proposal should result in a material reduction of liquidity in the credit markets, which (in theory) should result in a material increase in corporate borrowing costs.

Mr. Rosengren’s proposal would seem less damaging to the market if banks were able to step in and provide the liquidity that his proposal would force broker-dealers to reduce. However, banks are prevented generally by statute or banking regulations from engaging in many broker-dealer activities. Furthermore, if the Dodd-Frank “push-out” rule goes into effect as scheduled, then swaps activities will be pushed out of banks into broker-dealer or other non-bank entities, increasing the importance of these institutions as providers of liquidity to the credit markets. In short, a Congressional policy that forces credit activities out of banks, combined with a regulatory policy that disfavors the provision of credit activities by non-banks, does not seem a good fit. The end result has to be a reduction in liquidity in the credit markets provided by regulated financial institutions, which may be compensated somewhat by an increase in credit market participation by unregulated institutions (or “shadow banks”), which the regulators also seem to disfavor.

A further irony of Mr. Rosengren’s approach of effectively disfavoring broker-dealers and the capital markets, as compared to banks, can be seen in the mortgage market. Using deposits to make mortgage loans (or borrowing short term and lending long term) has long been recognized to produce a mismatch. What made this mismatch workable is that banks were able to sell their mortgage loans to the capital markets through securitizations. But if banking regulators adopt regulations that reduce the liquidity of the capital markets, including securitizations, isn’t one effect to make it far more difficult for banks to sell their loans, which will exacerbate the funding mismatch at banks?

Higher capital charges advocated by Mr. Rosengren are already coming into effect, which will have the (negative) consequence of reducing liquidity in the credit markets. Recent reports demonstrate that broker-dealers are beginning to withdraw significant amounts of money from the lending markets as a result of the more punitive capital regulations imposed by the bank regulators (who have authority over the capital held by the holding companies that own the broker-dealers).

See: President and CEO of the Federal Reserve Bank of Boston Eric S. Rosengren’s Remarks on Broker-Dealer Finance and Financial Stability.
Related news: New York Fed. President Dudley Discusses Short-Term Wholesale Funding Issues (August 13, 2014).