Still-fragile buy side uneasy as threat to repo from regulation mounts
Buy-side involvement in repo markets has yet to recover from lows plumbed following the financial crisis, despite increasing disintermediation of banks resulting from regulatory pressures and the search for yield.
Commercial banks have been increasingly forced to turn to repo to meet their short-term funding requirements, because of the collapse in interbank lending and low deposit rates, providing buy-side opportunities.
However, analysts say that if banks are forced to deleverage to comply with a new leverage ratio rule, this market could be substantially undermined – the cost of holding assets would simply become prohibitive.
Higher capital requirements and deleveraging have already resulted in big US banks’ corporate bond inventories slumping from a high of $235 billion in 2007 to $54 billion.
Estimates put at $180 billion the additional loss-absorbing capital that big banks in Europe, Japan and the US would have to hold to cover borrowings in the repo market under the leverage rules proposed by regulators this summer. That might wipe up to $2 trillion from the $13 trillion global repo market.
Concern is mounting that, together with higher capital requirements under Basle III, minimum haircuts and re-hypothecation limits in the US, and the financial transaction tax and central clearing in Europe, repo will become more costly or no longer economically viable given its low margins.
Pension funds, asset managers, insurers, money market funds, corporates and municipal authorities, as well as banks, could all see an important source of investment returns severely crimped.
According to the National Association of Pension Funds (NAPF), UK pension schemes’ repo market participation has yet to recover to pre-financial crisis levels because of the perceived risks and increased regulatory burden.
"Post financial crisis a large number of pension schemes actually stopped stock-lending and repo activity because it was deemed to be too risky given the small incremental return they were receiving. Some pension schemes have since come back into the repo and stock-lending market but I don't believe that all the participants involved pre-crisis are back in,'' says Helen Roberts, investment policy leader at NAPF. "Basle III and other proposed regulatory changes such as the financial transaction tax may well mean that repo and stock lending become unviable.
"Predictions that stock lending and repo will not exist going forward is clearly a concern because these activities oil the wheels of investing. The cost of investing may well increase as a result – clearly this would not be welcomed.
"The incremental return that pension schemes have enjoyed from stock lending and repo may also come to an end. Historically, pension funds have added 10 basis points or so to their investment returns over a typical year from this activity.''
But the squeeze on repo might also be creating fresh opportunities by speeding up the process of disintermediation, with more participants looking to conduct repo trades bilaterally.
More than 50% of European repo trades are directly negotiated already, according to the findings of the International Capital Markets Association’s (Icma) latest European repo market survey. However, the bulk of these transactions are based on established relationships that make central counterparty clearing appear an unwarranted added cost – for now.
In a recent post on his website, former repo trader and author Scott Skyrm argues that repo business will evolve between end users like money funds and end sellers such as hedge funds substituting large banks – forced to relinquish their intermediary role by the sheer cost – with CCPs.
The European repo market recovered further this year to €6.1 trillion, according to Icma, but is still below its 2007 peak of €6.8 trillion; US repo has fallen by around a third since its peak in early 2008 but Federal Reserve figures show it remains a $4.6 trillion a day market.
The US’s beefed-up leverage proposal takes no account of the riskiness of assets, applying the same flat 3% ratio approved by the Basle Committee to all institutions, with banks deemed systemically important by Basle subject to an additional tier 1 capital leverage buffer of at least 2%. Bank operating companies would be subject to 3% add-on, bringing their leverage ratio to 6%.
Critics say this could create a system that penalizes banks holding a higher proportion of low-risk assets – treasuries or cash, for example – requiring them to deleverage, while incentivizing investment in riskier assets promising a higher return.
US banks are lobbying hard for exemptions for cash and treasuries, arguing that their inclusion in measures aimed at preventing future financial crises is inherently contradictory.
The leverage ratio effectively caps the assets of the US’s eight systemically important – too big to fail – banks at around 20 times their capital. It also enlarges the calculation of assets to include many off-balance-sheet exposures such as undrawn lines of credit as well as non-rehypothecated securities and repo-to-maturity sales, with implications for repo and market liquidity.
In order to comply, the eight will have to slim down their assets, which include $1.1 trillion in repo liabilities alone, according to one big global investment bank. The Federal Deposit Insurance Corporation itself acknowledged at the time that these banks together were $63 billion short of the back-up capital they would need to protect against unforeseen losses.
The global investment bank says that for at least five of the eight there’s a stark choice to be made: raise new capital or slash their assets by a combined $600 billion. Three of the five have repo liabilities larger than the amount of assets they would need to divest to comply with the leverage ratio.
Mike O'Brien, head of global trading at Eaton Vance, a US fund manager, notes that the firm’s mutual funds have so far been insulated from the impact of higher repo costs on banks from regulation and monitoring requirements. “We are able to execute the repo trades that we need to get done although the pull-back in repo is something that a lot of people both at banks and other buy-side firms are talking about. I just haven’t experienced it,’’ he says.
O’Brien says the firm has resumed cash management trades in repo after pulling back significantly in the financial crisis, but is much stricter about the quality of the assets it will borrow to lend dollars, with US treasuries being the collateral of choice: “The regulations on repo for the mutual funds we run in the US haven’t changed significantly over the past couple of years, whereas the banks’ treatment of repos under various regulations has changed. So the banks are going to have to build the cost of doing these repos into the repo rate.’’
O’Brien concludes: “If the regulations build in enough cost there is a point at which it doesn’t make sense for me to do repo any more. We haven’t reached that point yet, but I certainly have a concern that we may in the future.”