Nellie Liang, the Treasury's undersecretary for domestic finance, said regulators are "quite far along" in looking closely at liquidity risk management at banks but also need to pivot to address potentially systemic vulnerabilities of nonbank financial intermediaries including highly leveraged hedge funds.
Liang said Thursday at the annual meeting of the International Swaps and Derivatives Association that among the lessons to be learned from the recent bank failures is the impact of social media in igniting bank runs.
"Going forward, banks and regulators will review how liquidity risk and interest rate risk management and regulation may need to adjust given the effects of changes in technology and social media on deposits — their sensitivity to interest rates and their sensitivity to stress," she said.
While regulators are focused on liquidity risk at midsize banks, Liang said risks also have surfaced among a variety of nonbank financial intermediaries — including mutual funds, money market funds and hedge funds.
She said there is a "liquidity mismatch" in the structures of open-end bond mutual funds and prime money market funds which provide credit, but also have "well known vulnerabilities," and give advantages to "early movers."
Bond and open-end mutual fund investors are able to redeem shares daily even though the underlying bonds and loans cannot be sold as quickly.
"This mismatch can have systemic consequences because of highly correlated portfolios and investor behavior, which can lead to dysfunction in periods of stress," Liang said, citing the global "dash for cash crisis" in March 2020 that caused disruptions in sovereign bond markets.
"Excessive leverage can make it more difficult for financial intermediaries to manage systemwide shocks to demand or supply of safe assets, amplifying the effects of such shocks," Liang said. "More recently, in the days immediately following the bank failures, substantial margin calls from clearinghouses to highly leveraged hedge funds appears to have added to Treasury market volatility."
The Financial Stability Oversight Council staff has been working to monitor and identify potential emerging financial stability risks posed by highly leveraged hedge funds, she said. Their work has focused primarily on "common, broad practices and activities," instead of on individual institutions, she said. Regulators are assessing certain practices in bilateral repo transactions and the need for a broader data collection, she said.
In January, the Office of Financial Research proposed launching a permanent data collection, beyond a recent pilot, on the $2 trillion repo market that would allow regulators to monitor and identify emerging market vulnerabilities.
The Treasury also is working to make the $24 trillion market for U.S. Treasuries more resilient including potentially releasing some secondary market transaction-level data, she said. The Financial Industry Regulatory Authority began publishing daily aggregate volume data in the cash secondary market earlier this year, up from weekly data that it began releasing in 2020.
"We will proceed carefully and likely will start with on-the-run nominal coupons, with end-of-day dissemination and trade sizes capped to ensure the market continues to provide the ability to move significant positions," Liang said. "Regulators also are considering whether changes to the way Treasury securities are traded and cleared could make these markets more robust."
Treasury also plans to develop a regular buyback program for Treasury securities to bolster market liquidity, she said. Early next year, Treasury expects to begin a program to offer to buy securities in a more predictable manner, starting with amounts of between $5 billion to $10 billion monthly.
"The program is not intended to meaningfully change the overall maturity profile of marketable debt outstanding and it will not be used to mitigate episodes of acute market stress," Liang said.
