Hangover from banks’ use of short-term funding refuses to go away
As the global economy recovers, banks’ dependence on short-term wholesale funding, and repo in particular, could rise to levels that pose a danger to the financial system, especially if asset bubbles begin to build again.
The US Federal Reserve recently drew attention to the issue, urging policymakers to ensure reducing the risks posed by short-term funding was their highest priority.
Deposits are the most stable form of bank funding, but with banks’ ratios of deposits to assets in long-term decline, they’ve turned to wholesale sources such as interbank, repo, swaps and commercial paper for short-term funding.
That decline in deposits is being exacerbated by an extended period of low interest rates, the result of monetary-easing policies around the world.
Reliance on short-term funding is not as great as it was before the financial crisis, but with pressures – regulatory and market – to use more secured funding and the interbank lending market frozen, repo is once again becoming a key source of short-term funding.
The European repo market in particular has rebounded, growing by almost 9% in the first eight months of the year to €6.1 trillion as banks switch from the ECB to the wholesale market for funding, according to International Capital Market Association figures. Significantly, the proportion of short-dated repos rose from 50.5% to more than 57%.
According to Federal Reserve data, the US repo market has fallen by around a third since its peak in early 2008 but is still a $4.6 trillion-a-day market even as US banks have reduced their reliance on secured and unsecured lending, filling the gap with deposits and equity.
The fear is that banks might still be vulnerable to swings in market funding of the type that saw wholesale funding liquidity evaporate in September 2008. Analysts famously said at the time that a growing number of banks were suffering the wholesale version of a bank run.
Wholesale funding is also implicated in the transmission of the financial crisis to the rest of the world via wholesale-dependent banks. This not only shut off the lending tap, but these banks suffered bigger losses than less-exposed lenders.
Prudential authorities in the US and Europe have been examining ways of regulating repurchase contracts since the financial crisis, in which many, including the Fed, say a run on repo acted as an “accelerant”.
They are particularly keen to reduce the pro-cyclicality of repo markets by limiting the build-up of excessive leverage in the financial system resulting from rehypothecation, in which collateral posted is re-used multiple times for other trades, creating collateral chains.
These chains increase the interconnectedness among financial institutions using repos. If collateral posted against default has been rehypothecated, it be could be tricky to recover, or even lost, if one of the firms in the chain goes bankrupt.
The US’s Financial Stability Board (FSB) believes minimum haircuts, regulation of cash collateral reinvestment, requirements on rehypothecation and the introduction of central counterparties are the answer. The European Commission is weighing proposals to ban rehypothecation without the express consent of an asset’s owner.
“In Europe, one crucial issue is that we’re actually seeing more sovereign banking system tie-up in places like Spain and in Italy in particular,” says Chris Clark, strategist at Icap. “It’s caused quite a considerable wobble in markets just recently.
“The Italian banking system is very much reliant on Italian government bonds to raise funds, but most international cash lenders are reluctant to lend to an Italian bank using Italian collateral, and those that do will do so only at a price.”
He adds: “Margins charged by central counterparties on Italian repo trades are now at a level where you have a somewhat bifurcated market where most banks will try to avoid putting any Italian repo trades through central clearers and go bilateral. So there’s a dual market with a significant premium for bilateral trades.”
Clark says potential risks were highlighted by an incident earlier this year where LCH.Clearnet, the main clearer for international funders of Italian banks, unsettled many members by warning that, in the event of a default on an Italian repo, it would not cover members’ losses in full, as is usual, but instead move to a system of “cash settlement” where a lender would receive only what collateral could be disposed of.
“At the time, this caused quite a lot of worry within the market and we saw fairly significant moves in the Italian repo spreads to other core eurozone repo markets,” he says.
The market and regulators agree on the important role secured funding fulfils. Hence the substantial financial set-piece regulation, including Basel III, EMIR and Dodd-Frank, which seek to reinforce and extend the use of collateralization as a way to hedge credit and liquidity risks.
However, there is also an ambivalence about moves to try to make it safer as they will likely make it more expensive to use collateral.
“There is concern with flighty capital and you can get a run on a bank just as much from the wholesale markets as from the retail deposit markets, although in fact the retail depositors are stickier in general,” says Barney Reynolds, partner at Shearman & Sterling.
“On the other hand, a bank that isn’t wholesale funded in part can’t easily be split into a good bank/bad bank. If it’s all, or mainly, retail funded, that side of the balance sheet can’t easily be split so the regulators are slightly in a quandary on this issue because there are some conflicting imperatives.”
He adds: “You can bail in wholesale debts more easily than retail, which are usually insured and have bail-in protection as well, so there’s more likely flexibility for regulators in a resolution context at least in using wholesale funding and it’s also more quickly scalable than retail.
“The dangers of repo markets and collateralized lending and borrowing are the focus of a lot of debate and proposed regulation by the FSB and Basel, looking at downward valuations, sudden requirements to post more collateral and resolution bodies.”
A banking source, who asked not to be named, puts it more bluntly: “If you’re relying on repo funding as a key element of your core business in your business plan, then you’re taking all the points that make repo risky and magnifying them.”