This Report was Compiled for ICMA’s European Repo Council by Richard Comotto, Senior Visiting Fellow at the ICMA Centre at the University of Reading

H/T Alea

Executive summary

1.1 “Shadow banking” is an imprecise term that has attracted various definitions. The current working definition is “non-banks performing bank-like functions”, although the Financial Stability Board (FSB) has narrowed this down to “non-banks performing credit intermediation” (by which they mean the recycling of savings into loans).

1.2 In fact, shadow banking is an alternative term for market finance. It is market-based because it decomposes the process of credit intermediation into an articulated sequence or chain of discrete operations typically performed by separate specialist non-bank entities which interact across the wholesale financial market. Shadow banking also relies on active secondary markets in order to be able to price assets and relies on the wholesale financial market for funding. The wholesale financial market includes repo.

1.3 The shadow banking system provides credit both directly as well as indirectly through various processes of financial transformation (redistribution of risk): credit, maturity and liquidity transformation. Together with leverage, these are the risk factors on which the FSB is focusing.

1.4 Official concern about shadow banking stems from the fear that it poses greater systemic risk than traditional banking. A range of issues have been highlighted: the scale of shadow banking; regulatory gaps; regulatory arbitrage; agency problems in securitisation; the interconnectedness of shadow banks with each other, and the interconnectedness of the shadow and traditional banking systems; the complexity of the shadow banking system; the resulting lack of transparency; the mispricing of risk in wholesale market funding; and the tendency of collateralised financing to generate excessive leverage and to amplify pro-cyclicality.

1.5 While some shadow banking may be the product of regulatory gaps and arbitrage, it is widely recognised that much of this activity is driven by efficiency gains from specialisation and comparative advantage over traditional banks, and is therefore desirable.

1.6 Part of the concern about shadow banking is about the possible instability of the wholesale funding on which the shadow banking system is seen to rely. While wholesale liabilities such as repo are like the deposits issued by traditional banks, they are judged to be riskier for a number of reasons: the greater dependency of shadow banks on such funding; less regulation; lack of any official safety net; and the fickleness of such institutional cash balances.

1.7 The FSB has set up a number of “workstreams” to look at the key risk factors in credit intermediation by shadow banks, one of which is focused on repo and securities lending. The repo (and securities lending) workstream is considering the possible introduction of macro-prudential requirements such as minimum margin or haircuts to mitigate pro-cyclicality, and improving the infrastructure of the secured funding markets. This paper is intended to inform this work.

1.8 The possible introduction of minimum haircuts as a macro-prudential requirement to mitigate systemic risk and dampen pro-cyclicality was discussed in the paper on Haircuts and Initial Margins in the Repo Market published by the International Capital Market Association (ICMA) in February 2012. This noted that the suggestion that repo amplified pro-cyclicality was based on the concept of a haircut-asset valuation spiral. This idea has given rise to the broader claim that the market crisis of 2007-09 was essentially, if not entirely, a “run on repo” and that repo is an inherently unstable source of funding. It underpins the proposal for mandatory minimum haircuts. However the academic literature behind this idea, not least the influential paper by Gorton and Metrick, focuses narrowly on the use of structured securities as repo collateral, despite evidence that it was a relatively minor component in the US and even less important in Europe. The bulk of collateral did not in fact suffer rapid or severe increases in initial margins/haircuts. Estimates of the likely impact of such changes on the liquidity of the European repo market between 2007 and 2009, using available data on market size and composition, suggest that their systemic impact was relatively insignificant in terms of the deleveraging that took place over this period (by an order of magnitude smaller). Recent analysis of regulatory and industry data on repo funding provided to shadow banks in the US by money market mutual funds and securities lenders also makes this point.

1.9 Another regulatory concern about repo is the potential for excessive leverage. In theory, repo can allow infinite leverage. In practice, firms are not free to keep borrowing, even against the best collateral. All lenders, but especially money market lenders, are very sensitive to the accumulation of excessive levels of borrowing by counterparties. This is true even where repo is the borrowing vehicle. The idea that collateral makes lenders indifferent to counterparty credit risk is a gross misunderstanding of the nature of repo and other forms of secured funding. Because even the highest quality collateral is not risk-free, the primary credit risk to a repo buyer is on the repo seller, not on the collateral. The role of collateral is not to permit lending to new and riskier counterparties but to allow lending to existing counterparties to be conducted more efficiently, but within the normal credit risk management framework. This means that credit limits (in addition to market scrutiny) will constrain access to repo financing notwithstanding the fact of collateralisation.

1.10 It is also important to remember that the repo market serves not just shadow banks but also traditional banks, and that it has played a key role in maintaining access by the latter to funding during the crisis, particularly through the CCP (central clearing counterparty)-cleared segment of the repo market (the experience of Spanish banks is a noteworthy example).

1.11 Official concern about excessive leverage has led to calls for mandatory haircuts to act as a type of fractional reserve which would inject a decay factor into the repeated re-use of collateral (in addition to acting as a break on amplification of pro-cyclicality). A mandatory haircut is undesirable as it would distort the relative pricing of secured versus unsecured instruments. It would also be a very blunt tool, which would reduce liquidity across the entire market, to deal with what should be seen as a problem of risk management specific to individual institutions and which should be addressed directly through leverage limits and capital ratios.

1.12 The question has also been asked as to whether repo encumbers assets sold as collateral, to the disadvantage of unsecured creditors. In both borrowing against
pledged collateral and repo, the risk of encumbrance is debatable. Given that cash is received against a pledge and through a repo, the value of the borrower’s estate in insolvency has not necessarily been diminished. In the case of non-US repo, the status of the assets is clear. There has been a true sale of collateral and they must be ignored (temporarily) by unsecured creditors. This is the same situation as if the assets had been sold outright. The real problem with encumbrance would appear to be in the accounting treatment of collateralised borrowing. In the case of both borrowing against pledged collateral and repo, but for different reasons, the collateral remains on the balance sheet of the borrower/seller. However, it is unlikely that an unsecured creditor would be misled by this treatment. Pledges are registered and, when accounted for under a transparent regime such as IFRS (International Financial Reporting Standards), repo collateral is clearly identified. Moreover, because collateral remains on the balance sheet of the borrower/seller and the borrowed cash is added, the balance sheet expands, which means that the ratio of unsecured debt to unencumbered assets is unchanged by repo.

1.13 Encumbrance could arise where repo collateral is subject to an initial margin/haircut, as the assets represented by the initial margin/haircut are not compensated by cash. However, initial margins/haircuts are not universally applied nor are they of significant size, at least in the bulk of the repo market. And where initial margins/haircuts are deep, for example, in long-term repo and collateral swaps, the giving of the initial margin/haircut is typically compensated by a pledge-back of the initial margin/haircut by the buyer to the seller, which eliminates encumbrance.

1.14 The perceived problem of encumbrance should perhaps be considered from another angle. Initial margins/haircuts are intended to compensate the repo buyer for the loss he may experience when trying to liquidate collateral in the event of a default by the seller. To this extent, they are intended to translate the market value derived from quotations and historic transactions into a future liquidation value. But much, if not all, of the loss which is expected by a repo buyer when collateral is liquidated, and which is compensated by an initial margin/haircut, would also be experienced if the same assets were to be sold off outright in the cash market. This means that the share of the market value of an asset represented by an initial margin/haircut imposed in the repo market is largely illusory and would be of no real benefit to unsecured creditors in the event of a default, even if that asset had remained in the ownership of the seller, rather than being repoed out. In other words, there may be no real value in an initial margin/haircut to encumber. The real problem may be the going-concern valuation of assets on balance sheets rather than their value in the repo market.

1.14 Some accounting regimes do not indicate clearly which assets on the seller’s balance sheet are out on repo. Wider adoption of IFRS is therefore desirable.

1.15 Questions have been raised about the transparency of repo. These doubts seem to have arisen from Lehman’s Repo 105 and MF Global’s repo-to-maturity, which some commentators appear to have mistakenly assumed represent the standard method of accounting for repo. In fact, the standard accounting treatment is to retain the collateral on the balance sheet of the seller to reflect the fact that, because the seller commits to repurchase the collateral at a fixed repurchase price, he retains the risk and return on that collateral. Helpfully, because a cash asset and corresponding repayment liability are added to the seller’s balance sheet, this will expand to indicate increased leverage.

1.16 Another concern about the lack of transparency of repo arises from the impact such transactions have on the quality of the seller’s assets. But this is not an issue specific to repo. Rather, it is about general balance sheet transparency. If greater balance sheet transparency is deemed necessary, assets will need to be categorised in terms of credit and liquidity risk. It would be relatively straightforward to categorise holdings of assets in terms of credit risk by using credit ratings. In terms of liquidity risk, it would seem logical and most efficient to use the proposed regulatory liquidity ratio framework (Liquidity Coverage Ratio and Net Stable Funding Ratio) to classify assets.

1.17 In addition to concern over the transparency of repo on a firm’s balance sheet, there is also an issue about repo market transparency. However, there is a wide range of statistics already available, including the semi-annual ICMA survey of the European repo market. The problem is that the sources are disparate and inconsistent. In the US, systematic disclosure requirements on short-term funding arrangements are being introduced. Greater disclosure may be helpful for both regulators and the market. But the extent of disclosure needs to be carefully considered, so that the regulatory value of the information gathered justifies the cost of reporting.

1.18 In Europe, the idea of a repo trade repository has been mooted. This would be no small undertaking. The repo market has a similar transaction frequency to FX but each repo requires far more data to be captured. The repository would also have to be very flexible, as there is a wide range of repo contract variants and alternative legal constructions. A thorough cost-benefit analysis is merited.

1.19 While this paper is focused on repo, there are issues in the wider debate on “shadow banking” which warrant comment, including: the pejorative and vague nature of the term; the implication that traditional banks are more transparent and unsecured funding is perhaps safer; the danger of forgetting that much of what is called shadow banking is driven by efficiency gains from specialisation and comparative advantage over traditional banks; the risk of triggering a new wave of regulatory arbitrage; an uncritical acceptance of the regulation of traditional banks; a concern with network complexity in shadow banking but an acceptance of network instability in traditional banking; the discussion of issues such as over-leveraging in a macroeconomic vacuum, as though financial stability is possible without macroeconomic stability; the difficulty of deciding how much systemic risk should be factored into normal market pricing; and the danger of incoherent regulatory initiatives generating unintended consequences, ultimately on the financing of the real economy.