Several regulatory reforms stemming from the lessons of the 2008/9 Financial Crisis are still quite incomplete. That is particularly true about some instruments and activities of the so-called shadow banking sector. We saw that clearly in the severe liquidity problems in US Treasuries in March 2020. Usually, regulatory shortcomings become visible when stressful situations or crises emerge.
Author: Vítor Constâncio
Published: 1 March 2022
Several regulatory reforms stemming from the lessons of the 2008/9 Financial Crisis are still quite incomplete. That is particularly true about some instruments and activities of the so-called shadow banking sector. We saw that clearly in the severe liquidity problems in US Treasuries in March 2020. Usually, regulatory shortcomings become visible when stressful situations or crises emerge. Due to inflation, higher bond yields, FED tightening, and now the Russian invasion of Ukraine, the present negative market conditions may develop into a larger crash. This time, the famous “FED put” may not be readily available as the focus will be on fighting inflation and not easing. Naturally, nothing will reach the pandemic panic level of 2020. Even so, problems with Money Market Funds (MMFs), Central Clearing Counterparties (CCPs) or the repo market may emerge. MMFs are vulnerable institutions (“banks without capital”, some say) that had to be bailed out more than once by the FED. CCPs are not sufficiently robust to withstand potential defaults by some participants, and their regulatory resolution regime is still embryonic and insufficient.
I will focus, however, on repos, even though they may not suffer, this time, the pressures they had in previous crises. Still, the US experiences of the role of collateralised short-term debt in the “Panic of 1907”, or the “run on repo” (Gary Gorton (2010)) that started the 2008 crisis, or the repo market spike that forced to FED to make interventions in the trillions of dollars should constitute enough examples of the risks behind the instrument. The use of repos exploded in the 2000s after the SEC allowed Asset-Backed Securities (ABS) to be repoed (2003) and the bankruptcy law changed (2005) to consider all sorts of repos as being excepted from bankruptcy workouts, enhancing their safety. Similar developments occurred in Europe (Perotti, 2010,2013).[1] In the US “.. the desire for wider collateral for repos was to be a crucial driver of the crisis… Repo markets funded the Housing Bubble”.[2]
Naturally, repo activity contributes positively to creating market liquidity and helps the circulation of collateral in a system more and more collateralised and subject to regulatory requirements involving collateral that repo activity helps to fulfil. In good times, market institutions love them and complain that there should be more. Nevertheless, like in other domains, there may be too much a good thing, and the macroprudential side of the repo role in the financial system must also be considered.
The main risk associated with repos is that they are very short-term transactions, mainly overnight, open to renewals, that in times of stress may disappear. In the alternative, margin calls increase sharply, haircuts go up, and the repo rates go sky-high to convince lenders to provide cash against the securities. As the repos are used to fund longer maturity assets, a lack of liquidity in the repo market transmits to the securities markets with possible fire sales. The repos transform an initial drop in the prices of the used securities into a general liquidity squeeze.
After the 2008 crisis, regulators disregarded the academic proposals to reform the repo market. They hoped that the spontaneous restrain after that shock and the concentration of transactions in higher-quality securities would stabilise the market. Then, March 2020 happened with Treasuries liquidity problems requiring an intervention by the FED up to 1.5 tr dollars in the repo market and the commitment to unlimited purchases of Treasuries. A milder spike of repo rates occurred in September 2019, also leading to sizable FED interventions in repos. In March 2020, an important part of the Treasuries sell-off came from hedge funds’ practice of the basis trade (see OFR Series (2020)[3]. The basis trade is a near arbitrage between the spot and futures market of Treasuries that involves repo. When the repo rate goes high, the basis trade consists in selling Treasuries in the spot market, doing repo lending with the cash and buying Treasuries in the futures market. Here we see operating the mechanism that goes from sudden illiquidity in the repo market to the sell-off of the underlying securities, Treasuries in this case, thus creating liquidity problems in the usually most liquid market in the world.
A second problem with repos is that they allow the building up overall leverage of the financial system that may crumble in sudden periods of stress, aggravating the situation. It is very tempting for firms and institutions with good securities portfolios to repo them and get cheaper money to buy longer maturity assets with higher returns and increase their leverage. History illustrates well the spontaneous tendency for finance to increase leverage and maturity transformation without considering the potential social costs of an overall excess of credit and debt and the subsequent crashes.
Another issue with repos is that initial haircuts are generally too low, and in stressful situations, they go suddenly too high, making them quite procyclical. However, the FSB induced regulations about initial haircuts are insufficient as they do not apply to transactions with Treasuries, which are the overwhelming majority, and exclude transactions involving regulated institutions.
What amplifies the risks associated with repos is the practice of re-use and re-hypothecation of the securities for additional transactions. Considering all types of securities financing transactions, of which repos are the sizable majority, Manmohan Singh (2011)[4] estimated that in 2010 the ratio between pledged securities and the existing stock of those securities was 3. In 2020, Infante et al (2020)[5] for US Treasuries alone found a multiplier of 7. The whole repo market is still obscure in many aspects, and there are no statistics on the size of re-use of securities. Rehypothecation, i.e. re-use of clients´ securities is limited to 140% of their account in the US and subject to clients´ authorisation in Europe for UCITS funds only. Re-use of all other paper used in repos is re-usable without limits. While in office at the ECB I pushed for an FSB subgroup to examine these practices and make recommendations for harmonisation of regulation across jurisdictions and limitations of re-use practices. However, the subsequent Report (2017)[6] concluded with a simple recommendation for information gathering about both practices that, so far, has produced no results.
A markets crash that may possibly happen this time, with significant but not dramatic drops in securities prices, may not trigger sufficient turmoil in the repo market to the point of making operational its sizable liquidity stress transmission and amplification to other markets. In any case, past examples, and particularly the one in 2020, should be sufficient to justify some new regulations in this market.
The risks that it involves should be mitigated by: (a) limiting the use of very short-term repos (overnight) as funding instruments for longer maturities; (b) returning to a narrower scope of safe harbour protection e.g. “The exemptions from normal bankruptcy rules should be limited to United States Treasuries”[7] ; (c) restricting the practice of re-use of securities, and (d) amending the regulation of minimum haircuts and margins.
Let me expand on the last of these. Margins and haircuts are a key determinant of the build-up of leverage in the non-bank financial system and are strongly interlinked with the procyclicality of that leverage. Floors on margins and haircuts help to limit the build-up of leverage in a benign market environment and reduce the size of any “shock effect” of a sudden increase of margins and haircuts. Already in the ECB’s response to the European Commission’s consultation on the review of the European Market Infrastructure Regulation (EMIR), it was suggested “that macroprudential intervention tools be included in Level 1 of EMIR” and noted “two policy instruments that potentially could reduce or limit leverage through derivatives and SFTs (that consist mostly of repos) and the pro-cyclicality of margins and haircuts: (a) permanent minimum requirements, and (b) time-varying minimum requirements or buffers”.[8]
It is necessary to acknowledge that the heavier regulation on banks increases the incentives for risky leverage to build up outside the banking sector. Non-banks and market-based financing expanded enormously, also helped by repos, and their role in financing the economy continues to grow. “This diversification of finance sources has many positive aspects. However, it enhances regulators’ responsibility to ensure that it does not lead to the build-up of systemic risk”.[9]
[1] Perotti, Enrico (2010) “Systemic liquidity and bankruptcy exceptions” CEPR Policy Insight n. 52 and Perotti (2013) “ The roots of shadow banking” CEPR P:I: n. 69
[2] Bayoumi, T. (2017) “Unfinished Business: The unexplored causes of the Financial Crisis and the lessons yet to be learned”, Yale University Press.
[3] Office of Financial Research Brief Series (2020) “Basis Trades and Treasury Market Illiquidity” By Daniel Barth and Jay Kahn
[4] Singh, Manmohan. 2011. “Velocity of Pledged Collateral: Analysis and Implications.” IMF Working Papers 11-256.
[5] Infante,S, Press,C, and Zack Saravay (2020) “Understanding Collateral Re-use in the US Financial System” American Economic Review, May, vol. 110: 482–486
[6] FSB Report (2017) “ Re-hypothecation and collateral re-use: Potential financial stability issues, market evolution and regulatory approaches
[7] Edward R. Morrison, Mark J. Roe & Christopher S. Sontchi (2014) “ Rolling Back the Repo Safe Harbors”, Columbia Law at: https://scholarship.law.columbia.edu/faculty_scholarship/1083
[8] See “ECB response to the European Commission’s consultation on the review of the European Market Infrastructure Regulation (EMIR)”, September 2015.
[9] See Vitor Constâncio (2016) “Margins and haircuts as a macroprudential tool” ECB speech.
