As bank after bank trumpets its healthier balance sheet this earnings season, questions still linger about the safety of the $1.7 trillion overnight lending market, whose freezing in 2008 nearly collapsed the entire U.S. financial system.
The financial crisis colorfully demonstrated how the repo market, a crucial source of funding for global banks, is subject to panics during times of stress that can bring down firms (see: Lehman Brothers) or even threaten the whole structure.
While the repo market appears to be safer than before the crisis, thanks in part to less reliance on complex securities, it still poses a systemic risk four years after the end of the Great Recession.
“The risks of runs and contagion remain,” Daniel Tarullo, a member of the Federal Reserve Board of Governors, said in a speech in May. “I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place.”
These potential fixes include installing minimum margin requirements and a liquidation vehicle to be used in times of stress.
Cheap Overnight Funding
So what exactly is the repo market and why did it buckle so drastically during the ’08 crisis?
The most common form of this wholesale funding is the tri-party repo market, which allows banks to borrow money very cheaply on an extremely short-term basis -- typically just one day -- by pledging assets -- Treasurys, stocks, mortgage-backed debt -- as collateral.
Investors include money-market funds, which make up about 31% of the market, banks and securities lenders like insurers and pension funds.
“The crisis revealed that this funding is potentially quite fragile."
- Fed chief Ben Bernanke
These agreements use a third party, such as a custodian bank or clearing organization, to serve as a middle man, hence the name tri-party.
“A stable and well-functioning tri-party repo market is critical to the health and stability of the U.S. financial markets and the U.S. economy” because it creates liquidity, is interconnected with the rest of the system and serves as a “critical source of funding for systemically important broker-dealers,” the New York Fed says on its website.
Investors Fled Repo as Lehman Crumbled
But this crucial cog in the financial system ran into serious trouble in 2008 as banks played a game of hot potato with complex mortgage-backed securities. No one knew what these suddenly-toxic assets were worth, nor which banks were most exposed to them, fanning the flames of fire sales.
“When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran,” Fed chief Ben Bernanke said in a speech in May. “Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy.”
“The crisis revealed that this funding is potentially quite fragile,” Bernanke said.
The freezing of the repo market had real-life implications as banks like now-defunct Lehman Brothers and others had trouble meeting their daily funding needs through wholesale funding.
“Pre- and post-default fire sales can feed on each other” and lead to “contagion effects and liquidity hoarding,” Joseph Abate, short rates analyst at Barclays (BCS), wrote in a recent report.
Such a seizure of the repo market can extend the amount of time it takes to liquidate positions to as long as nine days for Treasurys and 30 days or longer for certain types of asset-backed securities, Abate said.
Is Repo Safer Now?
The lessons of the last crisis have fueled a number of changes to the repo market to make it less dangerous to the system as well as to counterparties.
For starters, the tri-party repo market is now smaller: about $1.73 trillion in collateral value as of June, according to the NY Fed, compared with a peak of around $2.5 trillion.
There’s also been less reliance on wholesale funding in general. As a percentage of total assets, wholesale funding dropped below 25% in the beginning of 2013, compared with a peak of about 40% at the end of 2008, according to Fed stats cited by Barclays.
Image provided by Barclays
Instead of fickle overnight financing, U.S. banks are leaning a bit more on less-flighty deposits.
However, non-U.S. banks, which have little to no access to bank deposits, are still relying on wholesale funding. According to Barclays, foreign bank wholesale funding recently stood at almost $1.5 trillion, down just slightly from $1.7 trillion in January 2008.
“Non-U.S. banks remain vulnerable to external funding shocks,” Abate said.
Image provided by Barclays
Still, the structure of the collateral being used in the repo market has gotten stronger, with banks pledging ultra-safe Treasurys 36.6% of the time in April 2013, compared with 26.8% during the crisis period of July ’08 to July ’09, according to Barclays.
Also, the market is less concentrated than it used to be, making it less exposed to a major bank failure.
Barclays said the top three dealers now make up about 30% of the total Treasury repo market, down from almost 50% in late 2010.
Image provided by Barclays
More Reform Needed
In an interview, Abate said on a scale of one to 10, with 10 being very safe, he would rate today’s repo market at an eight, up from a six during the crisis.
“Despite these improvements, there is more work to be done to reduce systemic risk in the repo market,” he said.
Tarullo, the Fed governor, said future regulation in this area should “force some internalization by market actors of the systemic costs of this intermediation.” In other words, ensure the industry picks up the bill, not taxpayers.
But Tarullo warned a single, comprehensive regulatory measure “may not be achievable in the near term” that mitigates the risk without squashing the repo market itself.
One potential move is for regulators to raise minimum capital and/or liquidity requirements at regulated banks
Barclays said the creation of a liquidation or resolution agent would help ease concerns about the repo market. Such an entity would act as an intermediary between the lender and borrower and in the event of a bank failure would provide cash directly to the lender, preventing the fire-sale conditions of 2008.
Tarullo also said regulators could enact a minimum margin requirement that would be aimed at containing the risks of runs and contagion. He called this the “most promising avenue” and “definitely worth pursuing.”
“More work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market,” Bernanke said.