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Fed officials urge changes to still-risky U.S. funding markets

By Jonathan Spicer

NEW YORK (Reuters) - A serious re-evaluation of the still-risky short-term funding market is overdue, two top Federal Reserve officials said on Wednesday, with one urging a supervisory revamp and higher capital requirements for broker-dealers given the threat they still pose to the U.S. financial system.

Among the U.S. central bank's most influential voices on regulation, the officials issued their warning to bankers, supervisors and academics gathered at the New York Fed for a conference on risks that remain in wholesale funding markets six years after the financial crisis.

The Fed and other regulators have been pushing firms to bulk up their capital to avoid a repetition of the 2008 crisis, in which Lehman Brothers' failure highlighted how quickly broker-dealers can lose investors' confidence and access to cheap short-term funds.

It is "interesting" that so little has changed for broker-dealers given Lehman was one, Boston Fed President Eric Rosengren said. A "comprehensive re-evaluation of broker-dealer regulation is overdue."

New York Fed President William Dudley said changes must be made in part because it is now more difficult, in the post-financial crisis era, for the central bank to intervene in wholesale markets in the face of fire-sales or investor runs.

Some "important issues and vulnerabilities remain," Dudley said. "It is essential to make the system more stable."

The comments appeared to bolster the stance of Fed Chair Janet Yellen, with Rosengren offering a handful of approaches as regulators attempt to fill in the gaps left by the landmark 2010 Dodd-Frank financial regulation law. The law has been criticized for overlooking the so-called shadow banking industry, including funds and insurers, that reside outside of formal banking.

Rosengren floated several rule changes that would limit broker-dealers' reliance on short-term wholesale funding and reduce the risk of runs.

While the most direct way to solve this is with higher capital standards, he said, regulators could also limit the extent to which the firms could use short-term repurchase agreements to fund longer-term or higher-risk assets. Money market mutual funds could also be prohibited from holding repos secured by such assets, many of which they are not allowed to hold, he said.

Rosengren even floated the Fed as a permanent liquidity backstop for broker-dealers - though he acknowledged that such an outcome seemed "unlikely."

Such moves "would have an impact on the profitability of broker-dealers," he said. "But given recent history, that trade-off may be unavoidable and in the public interest from a financial stability perspective."

Last month the Securities and Exchange Commission, which regulates individual market participants, adopted moderately tougher rules for money market mutual funds, which are the biggest domestic players in wholesale markets.

Rosengren slammed the rules when they were proposed last year. But on Wednesday he softened that criticism, saying that while he would have preferred even more protection on runs on the funds, the new requirement for "prime" money funds to float their values "does represent a meaningful improvement."

He repeated that withdrawal restrictions available to the funds, known as "gates," remained a problem and said he hoped that element of the SEC's rules would fade in importance in the future.

The Fed officials did not comment on monetary policy or the economy.

(Reporting by Jonathan Spicer; Editing by Meredith Mazzilli)

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