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July 25, 2012

Another reason we need strong Volcker Rule

Big trading operations at large bank holding companies have embedded a large and largely uncontrolled source run risk and leverage into the banking system.  Evidence from the financial crisis has made that painfully clear.           

During the crisis there was a run on repo borrowing, which is a key source of finance for large dealers.  To prevent the run from crushing the trading operations at the large banks and investment banks, and forcing the fire sale of assets, the Federal Reserve stepped in to replace the vanishing repo lenders. 

The Primary Dealer Credit Facility (PDCF) provided overnight repo financing to primary dealers.  The Term Securities Lending Facility (TSLF) provided 28-day swaps of tri-party-eligible collateral for Treasury securities.  (Those Treasury securities then could be used as collateral for repo borrowing).  In addition, the Federal Reserve made significant repo loans to banks.

The sums required to end the run on trader financing are staggering.  At the peak, in September 2008, outstanding loans from the PDCF, TSLF and Fed repo amounted to more than $460 billion. (See Figure below).

The Volcker Rule, properly implemented, can reduce these risks to the banking system.  By effectively reducing proprietary trading it will reduce the use of highly unstable repo finance, reduce the leverage that comes with trading finance, and limit the potential spillover effects of forced assets sales.



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