Our structured and bespoke wholesale financing offers a wide range of financial products (senior debt and equity), including 12-month revolving loan contracts in the form of: wholesale financing can be organized quickly, but it is dangerous to rely on how banks rated during the global financial crisis when the wholesale finance market collapsed. The overuse of short-term wholesale funding – instead of retail deposits – and reverse repurchase agreements meant that banks were exposed to liquidity risk when liquidity was greatest. Emergency measures taken by the Federal Reserve with support from the Treasury Department have temporarily reduced the risk of adverse events related to vulnerabilities in the non-bank sector in the short term, but the remaining vulnerabilities require longer-term structural corrections. In addition, other cash management instruments similar to blue-chip institutional funds, such as foreign dollar-denominated funds and short-term mutual funds, do not directly benefit from the MMLF backstop. Between $400 billion and $1 trillion of the assets under management of these vehicles largely reflect major U.S. institutional funds, and strong buybacks can destabilize short-term financing markets, even in the presence of the MMLF. Lower asset prices due to fire sales could lead to losses to market value for other investors, including blue-chip U.S. funds. A pivotal moment in the subprime crisis occurred in 2007, when Northern Rock, a British bank that depended on wholesale markets for most of its financing, was no longer able to finance its lending activities and had to apply to the Bank of England for emergency financing. As mentioned in previous financial stability reports, the vulnerability of the financial system to funding risks has increased due to the resumption of growth of blue-chip MMFs in 2018 and 2019, as well as the increase in corporate debt held by long-term investment funds since 2008. These developments, which will be discussed in more detail later in this section, contributed to significant funding shortages in March. These tensions, in turn, prevented a number of employers from accessing credit markets at a time when credit needs were particularly acute; In response, the Federal Reserve has taken several steps, including establishing emergency credit facilities and providing regulatory relief to ensure the smooth functioning of various markets and support the flow of credit to households and businesses.
For more information, see the fields ”Federal Reserve Measures to Stabilize Short-Term Funding Markets During the COVID-19 Crisis” and ”Federal Reserve Measures and Facilities to Support Households, Businesses, and Communities During the COVID-19 Crisis.” Going forward, regulators, including the Federal Reserve, are considering reforms that will address structural vulnerabilities in the non-bank financial institutions sector that required emergency responses both during the 2007-2009 financial crisis and during the COVID-19 crisis. CLO emissions decreased by approximately 33% in September 2020 compared to the same period in 2019. These securities finance more than 50% of outstanding leveraged institutional loans – loans that have come under significant price pressure, as mentioned earlier. Unlike open-ended mutual funds, CLOs generally do not allow early redemptions or rely on funding that must be extended before the underlying assets mature. As a result, CLOs avoid the risk associated with a rapid reversal in investor sentiment. Overall, CLO fundamentals have improved in recent months, but they are still low compared to pre-pandemic levels, and some risks remain. For example, the increase in underlying credit degradations and defaults has led to an increase in the number of CLOs that have failed collateral tests in recent months. CLO managers who failed the over-collateralization tests usually tried to fix these flaws by selling risky collateral.
To the extent that CLO managers are unable to remedy impairments in junior CLO tranches, the resulting degradations of those tranches may force some CLO investors, including leveraged funds, to sell their stakes in clo. Such sales have the potential to put pressure on the prices of junior CLO tranches. Wholesale financing providers tend to be sensitive to changes in the credit risk profile of the institutions to which they make these funds available, as well as to the interest rate environment. For example, these providers closely monitor the financial situation of the institution and are likely to limit this financing if other investment opportunities offer more attractive interest rates. As a result, an institution may experience liquidity problems because wholesale funding is not available if needed. Scientific research suggests that the use of wholesale financing was one of the main determinants of banks` vulnerability during the 2007-2008 financial crisis. [2] While core deposits remain an important source of funding for liabilities, many insured custodians have struggled to attract core deposits and are increasingly seeking wholesale funding sources to meet funding and liability management needs. Demand for high-quality liquid assets (HQLA) in global financial markets suggests that wholesale money markets are still far from being repaired, even as global systemically important banks (G-SIBs) comply with the new Basel III capital and liquidity measures – such as the liquidity hedging ratio and the net stable funding ratio. First-class MMFs, particularly institutional funds, recorded cycles in March, with outflows reaching the same proportion of assets repaid during the MMF rush in 2008.
The strong buybacks of these funds were triggered in part by investor concerns about the possibility of liquidity fees and redemption doors. Blue-chip retail funds and tax-exempt funds have also suffered serious buybacks. As investors fled to safety, short-term funding markets were severely skewed. Action by the Federal Reserve was needed to slow repayments and restore the functioning of short-term funding markets (see box ”Federal Reserve Measures to Stabilize Short-Term Funding Markets During the COVID-19 Crisis”). .
