“Despite this considerable progress, we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs. It is true that some of the clearly risky forms of wholesale funding that existed before the crisis, such as the infamous SIVs, have disappeared or substantially contracted. But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions (SFTs). Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securities market. But, in the absence of sensible regulation, they are also potentially associated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls, and fire sales. Indeed, some have argued that this dynamic is exacerbated by a “maturity rat race,” in which each creditor acts to shorten the maturity of its lending so as to facilitate quick and easy flight, and in which creditors pay relatively little attention to the recovery value of the underlying assets. With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way. The regularization and refinement of rigorous stress testing may be the single most important supervisory improvement to strengthen the resilience of large institutions. The creation of orderly liquidation authority and the process of resolution planning advance prospects for increasing market discipline. But questions remain as to whether all this is enough to contain the problem. The enduring potential fragility of a financial system substantially dependent on short-term wholesale funding is especially relevant in considering the impact of severe stress or failure at the very large institutions with very large amounts of such funding.”
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