Mary Fricker, founder of RepoWatch.org, said the repurchase market is a key reason for the ferocity of the financial crisis. She shares her tips and resources for covering the topic in this coverage guide.

  Covering the Repo Market and Shadow Banking

• An introduction: The repurchase market, shadow banking
• Resources for coverage
• Story ideas for diving in
• Tips for localizing

Commentary

After five years of angst, it’s clear that Congress, regulators, and bankers will not set up a framework to prevent the kinds of runs that devastated financial markets in 2007 and 2008.

They will not solve the conflict between growth and stability that is inherent in 21st Century banking.

Instead, they’re going for growth, without putting a new structure in place to prevent the next bubble, bust, and recession.

They’re betting they can do now what they have not been able to do for 30 years – spot trouble as it’s brewing in shadow banking and head off a financial crisis.

This means the financial future will look a lot like the past. More runs on shadow banks, though not imminent, will be inevitable. In these panics, financiers will look to the Federal Reserve for protection. And Americans will desperately need sophisticated business reporters  who claw daily into shadow banking. That means repurchase agreements, securities lending, securitization, derivatives, rehypothecation, and the companies that use these tools.

Treasury Secretary Timothy Geithner confirmed that leaders have selected this future in a January 17 interview with Wall Street Journal economics editor David Wessel:

We’re in a much better position to withstand pretty severe stress going forward. But all systems are vulnerable to crisis – inherently vulnerable. And no one could ever tell you with any credibility that our system today, or any financial system, is invulnerable to a future shock of the magnitude of what we experienced in ’08. …

But we’ve protected and preserved the absolutely essential ability of the central banks to provide funding on a broad scale to, again, reduce the risk that liquidity crises turn into systemic financial crises, and that’s very powerful.

(Editor’s note: “Liquidity crises” are runs on banks.)

This future is perilous, the president of the New York Fed said two weeks later. William C. Dudley told a bankers’ association in New York that serious dangers in the financial markets are still unresolved and that the Dodd-Frank Act has made it harder for the U.S. central bank to intervene. He asked:

How comfortable should we be with a system in which critical financial activities continue to be financed with short-term wholesale funding without the safeguards necessary to reduce the risk of runs and the fire sales of assets that can threaten the stability of the entire financial system?

(Editor’s note: “Short-term wholesale funding” is repo and other borrowing in the shadow banking system.)

Dudley also said there’s little agreement on how to fix these problems and it’s possible we’ve made them worse.

Worthwhile as the steps taken thus far are, we have not come close to fixing all the institutional flaws in our wholesale funding markets. … one could argue that the risks have increased compared to prior to the crisis.

Regulation of shadow banking is starting to look more and more like regulation of traditional banking 100 to 150 years ago, when it took decades of runs on banks, bank failures and economic agony before  Congress in 1933 finally approved FDIC insurance paid for by the banks, limits on bank size, and other safeguards.   This framework fostered 50 years of stability before it began to unravel.

Recent reports

Occasionally an economic study or business press report reminds us of how far we are from fixing the dangerous currents that flow under the surface of today’s credit markets.

Here are three, from economists, regulators, and …. China:

(1)  In “Shadow Banking: Economics and Policy” published Dec. 4 by the International Monetary Fund, four economists describe the main functions of shadow banking, tell about its problems, and argue that we need to fix them, even though we can’t agree on what to do.

Authors of the study include two of the leading international shadow banking experts, Zoltan Pozsar and Manmohan Singh, along with lead writer Stijn Claessens and Lev Ratnovski.

They note that experts have many, but “polar,” views on how fix shadow banking, and they review these ideas. Congress and federal regulators have embraced none of them, hoping instead that by setting new rules for various pieces of the financial markets they can head off broader dangers while letting shadow banking recover to fulfill its potential as a powerful engine of the world economy.

Meanwhile, “urgent” solutions are still needed, to stabilize broker-dealer banks, money market funds, and tri-party repo, the authors say. Also needed are better data collection and regulation, a bigger supply of safe assets for investors, and a better understanding of the interaction of shadow banks and central banks like the Federal Reserve.

With these improvements, shadow banking may be smaller but still useful, the authors claim. Without them, central banks and taxpayers may face even bigger bailouts in the future.

From the study:

… a multifaceted policy response to systemic risks arising from shadow banking is necessary. Such responses, if effective, may make the shadow banking system smaller in size but able to perform its useful economic functions in safer ways. Since not all components of the response are yet clear, more policy-oriented research is needed….

Unless the systemic risks in shadow banking are addressed, these contingent liabilities will remain in place, with perhaps larger actual costs in future crises. 

(2)  Nine days later, on Dec. 13, the Financial Times published “Fed begins stress tests on bank liquidity.” Reporter Shahien Nasiripour writes he learned from sources that the Fed has begun testing some of the largest U.S. and foreign bank companies to see if they’ll be able to get their hands on enough cash to stay solvent during a 30-day panic.

This could be good news, except for the following from Nasiripour:

The tests are intended to guide bank supervisors and the results will not be made public. There is no pass-or-fail level that banks must reach, but if a bank’s liquidity is called into question, Fed examiners could use the results to push them to adjust their funding or increase their stock of easy-to-sell assets.

In other words, regulators are going to let some of the most complex companies in the world continue to hide vital financial information, even though the crisis in 2007 and 2008 proved repeatedly that a company’s opaque financials are a key reason lenders and investors spook and run (for example, see  here,  here and here).

Liquidity

Nasiripour said the new liquidity stress tests follow a June meeting in New York where the Financial Advisory Roundtable, a group of international bankers and economists who advise the New York Fed, urged the Fed to test banks’ resilience to runs. 

(Editor’s note: See below for a list of the members of the Financial Advisory Roundtable.)

From the minutes of the meeting:

Members highlighted the importance of stress testing banks’ liquidity and access to funding during adverse periods. It was noted that the recent U.S. supervisory stress tests … focuses on capital adequacy, rather than liquidity. Members noted that bank access to funding can deteriorate rapidly, even for well-capitalized institutions, and that uncertainty and feedback loops make it difficult to model liquidity risk and liquidity stress events.

Here’s what that means:

Last year the Federal Reserve began annual “stress tests” of the major bank holding companies, by setting out a variety of crises and checking to see how each company would fare in each circumstance. These tests focused on whether the company had enough of its owners’ money, called capital, to be able to keep operating through these crises.

But in June the Financial Advisory Roundtable was asking the Fed to check something else. Its members wanted to know what would happen if a bank company’s lenders suddenly panicked and demanded their money back, or if a bank company’s trading partners suddenly demanded their securities back, as happened in 2007 and 2008. Would the bank company have enough securities and cash, or safe securities it could quickly sell for cash, to meet those demands?

That’s called having liquidity. According to bank regulators, “Liquidity is a financial institution’s capacity to meet its cash and collateral obligations at a reasonable cost.”

Companies with capital but not enough liquidity can quickly be bled dry by panicked shadow banking lenders who run, as we saw for example at Continental Illinois in 1984, American Savings in 1988, Orange County in 1994, Asia in 1997, Long-Term Capital Management and Russia in 1998, financial institutions throughout Wall Street, Fleet Street and Europe in 2008, MF Global in 2011 and right on down to Italy’s third-largest bank,  Monte dei Paschi di Siena, in 2013.

The members of the Financial Advisory Roundtable disagreed on secrecy, according to the minutes of the June meeting.

Members expressed a range of views about the costs and benefits of greater disclosure of  stress testing models and results. It was noted that the disclosure of stress testing results could trigger a bank run or loss of confidence unless accompanied by a plan to stabilize firms facing financial distress. It was also suggested that supervisors should be transparent up-front about what type of information is to be made publicly available at the conclusion of the tests. Members also suggested that disclosing a large amount of information about failed firms could be beneficial.

Spilled ink

European and U.S. regulators have spilled a lot of ink over liquidity. Here are some examples:

     – February 2008: European regulators in Basel, Switzerland, publish 13 pages on how banks should manage liquidity. 
     – September 2008: Basel regulators update with a 35-page report. 
     – March 2010: U.S. bank regulators spend 10,000 words laying out what they consider “sound practices for managing funding and liquidity risk.” 
     – December 2010: Basel regulators propose two important rules to address liquidity issues, the Liquidity Coverage Ratio, which would start Jan. 1, 2015, and the Net Stable Funding Ratio, which would begin Jan. 1, 2018..
     – December 2011: U.S. regulators issue their own  proposed liquidity standards and specifically embrace Basel regulators’ Liquidity Coverage Ratio and Net Stable Funding Ratio.  (These proposed U.S. standards are still pending.)
     – June 2012: UK regulators loosen their liquidity requirements in order to not impede “the ability of banks to support lending to the real economy.” 
     – January 2013: Basel regulators soften implementation of their Liquidity Coverage Ratio, saying they’ll certify a broader range of assets as being liquid, albeit with restrictions, and start the phase-in on time but delay full implementation until 2019.  They say the Net Stable Funding Ratio is still set to start in 2018, but some experts said changes in the Liquidity Coverage Ratio will inevitably force changes in the Net Stable Funding Ratio.

When he introduced the Basel changes January 27, Bank of England Governor Mervyn King said:

Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.

From the Basel report:

The (Basel) Committee (on Banking Supervision) remains firmly of the view that the Liquidity Coverage Ratio is an essential component of the set of reforms introduced by Basel III and, when implemented, will help deliver a more robust and resilient banking system.

However, the Committee has also been mindful of the implications of the standard for financial markets, credit extension and economic growth, and of introducing the Liquidity Coverage Ratio at a time of ongoing strains in some banking systems. It has therefore decided to provide for a phased introduction of the Liquidity Coverage Ratio, in a manner similar to that of the Basel III capital adequacy requirements.

Much of the business press presented these Basel changes as a serious blow to reform of the financial markets. Analyses by Financial Times reporters and by the finance lawyer who blogs at Economics of Contempt concluded that the changes weaken the Liquidity Coverage Ratio somewhat but leave important provisions intact.  RepoWatch thinks liquidity is nice, but 30 days is not enough to stop a systemic run. Let’s face it: In the U.S., only the Federal Reserve and the U.S. Treasury have that much liquidity.

(3) Then came The Financial Times’ latest updates (see here and here) on shadow banking in China, with their implications for unprotected global financial markets.

From the January 27 story by reporter Simon Rabinovitch:

Western rating agencies have warned that a rapid rise in off-balance-sheet banking activity is a threat to China’s financial stability. But Chinese regulators have countered by saying the risks are manageable. With the country’s financial system long dominated by state-run banks, they also view shadow lending as a byproduct of their attempts to unleash more market forces in the allocation of capital in China.

“… their attempts to unleash more market forces in the allocation of capital ….”  It appears that China, like the U.S., is going for growth over stability.

____

The Financial Advisory Roundtable

Here’s how the New York Fed describes the Financial Advisory Roundtable:

A group of distinguished economists, risk management professionals and other experts in the financial markets meet twice a year with the president of the New York Fed to discuss financial stability issues and present their views on financial policy.

Current members are:

Bankers
Amherst Securities Group, Laurie Goodman
Goldman Sachs, Charles Himmelberg
JPMorgan Chase, Terry Belton
State Street Corporation, Andrew Kuritzkes
UBS, Darryll Hendricks
Economists
Columbia University, Tano Santos
Duke University, Katherine Shipper
Harvard Business School, David Scharfstein
MIT, Andrew Lo
New York University, Stephen Ryan
Princeton University, Markus Brunnermeier
Princeton University, Hyun Shin
Stanford University, Darrell Duffie
University of Florida, Mark Flannery
Yale University, John Geanakoplos
Yale University, Gary Gorton

It felt like “The Gunfight at the O.K. Corral.”

First to appear was departing Treasury Secretary Timothy Geithner, who told Wall Street Journal economics editor David Wessel in a wide-ranging exit interview January 17 that the financial markets are much safer now and the Federal Reserve can handle those rare crises that inevitably arise.  

Two weeks later the head of the New York Fed, who replaced Geithner in that job in 2009, came out with guns blazing and a very different view.

On February 1, William C. Dudley, president of the Federal Reserve Bank of New York, gave bankers – and all Americans – a stunningly frank talk about the still-present dangers of 21st Century banking, dangers that turned a real estate crisis into a full-blown financial panic in 2007 and 2008 and have not been fixed.

Speaking at the New York Bankers Association’s 2013 Annual Meeting & Economic Forum at the Waldorf Astoria in New York, Dudley zeroed in on financial institutions that borrow short term, as on the repurchase market, and use that money to lend long term, as for home loans. He said this process increases the availability of credit, which is good, but it also increases the possibility of runs, which is a disaster.

Talking with the authority of the regulator who knows the most about these markets because his staff has to trade there, Dudley told the giants of the industry (here’s a list of association members)  that reform is imperative, especially now that the Dodd-Frank Act makes it harder for the Federal Reserve to ride to their rescue. He also revealed there’s little agreement on what to do.

Following are his prepared remarks, with occasional editor’s notes by RepoWatch:

Thank you for having me here to speak today. As you all know from daily experience, the financial system plays an essential role in modern economies. Because financial intermediation is critical to economic activity (this is when financial institutions take money from lenders and give it to borrowers), disruption to it can cause severe damage to the economy. The experience of recent years revealed serious flaws in the system. Risk was mispriced (loans were too cheap) and there was a build-up of excesses before the crisis. Structural weaknesses in the financial system then amplified the effect of the bursting of the bubble in U.S. house prices, and the result was a widespread financial crisis.

One critical factor was the extensive use of short-term wholesale funding in the years leading up to the crisis (this was money that banks and other firms borrowed from lenders other than depositors, often just for overnight). Not only did this aspect of our financial system create the potential for a firm to fail in an extraordinarily rapid manner when faced with a loss of market confidence, but it also served as a channel through which the effects of those failures were widely propagated throughout the broader financial system.

Although much has been done over the past few years to mitigate the structural flaws that make wholesale funding a point of weakness in the global financial system, some important issues and vulnerabilities remain. I will focus my remarks today on some of those vulnerabilities—including the areas of tri-party repo and money market mutual funds markets—and discuss what could be done to make wholesale funding markets more stable.(1)

I will also consider the larger issue of the appropriate role of wholesale funding in the financial system (hooray).  How comfortable should we be with a system in which critical financial activities continue to be financed with short-term wholesale funding without the safeguards necessary to reduce the risk of runs and the fire sales of assets that can threaten the stability of the entire financial system?

As always, my remarks reflect my own views and not necessarily those of the Federal Reserve System.

Wholesale funding as a structural vulnerability

As this audience knows, in the two decades before the financial crisis, the global financial system underwent rapid transformation. During this period, there was a shift from bank-based financial intermediation to capital markets-based financial intermediation,(2) and an increase in the scale and complexity of securitization activities.

In the pre-crisis period the growth of securitization was accompanied by a growing reliance on short-term funds raised in wholesale markets to finance securities and activities essential to securitization. This ranged from the use of repo(3) funding to finance inventories of securities held for market-making(4) purposes to the issuance of asset-backed commercial paper by conduits(5) created to acquire and hold securities. (Economists now call this shadow banking.)

The increased use of short-term wholesale finance was driven both by demand and supply factors. On the demand side, it was more profitable to use shorter-term funds to finance longer-term assets. On the supply side, such funding was plentiful because it was viewed as safe and because of the growing institutionalization of savings with corporations and institutional investors in need of deposit-like products in which to place their cash balances. After all, the funds were only exposed for a short period of time, and in the case of repo, secured by collateral.

The growing reliance on short-term wholesale funding to finance longer-term assets increased liquidity (this is the ability to get cash fast) and maturity mismatch risk (this is the risk of borrowing short and lending long). This was particularly dangerous because many of the assets being financed were structured-credit products (these are securities backed by loans, pools of loans and derivatives), some of which were opaque, difficult to value and illiquid.

Short-term funding of longer-term assets is inherently unstable particularly in the presence of information and coordination problems. It can be rational for a provider of funds to supply funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the firm’s (the borrower’s) continued ability to roll over its funding from other sources. But if the use of short-term funding becomes sufficiently widespread, the firm’s roll-over risk increases. In this situation, there is a strong incentive for each lender to “run” if there is any uncertainty that could undermine the borrower’s ability to continue to roll over its funding from other sources. This is the case even if the provider of funds believes that the borrower would remain solvent as long as it retained access to funding on normal terms.

Of course, this insight is not a new one. Prior to the establishment of a lender of last resort (the Federal Reserve) and retail deposit insurance (the FDIC) for banks—which came with the quid pro quo of prudential regulation (regulation to protect  deposits and promote financial stability) —bank runs were a regular and disruptive feature of our financial system. These innovations solved the coordination problem and stabilized this source of funding.

What was new prior to the crisis was the extent to which maturity transformation and financial intermediation began to take place outside of commercial banks. This activity occurred largely without the types of safeguards—robust prudential regulation, deposit insurance, lender of last resort—that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the entire financial system. The risk created by this gap in coverage was not well recognized by regulators or the private sector. Market participants had little incentive to internalize the negative externality of run-risk created by their collective choice of finance and made erroneous assumptions about the liquidity of asset markets and the capacity and willingness of banks to distribute central bank liquidity to the wider financial system during periods of stress.

Because the boom years resulted in strong earnings, low price volatility and few credit losses, firms were able to operate at extreme levels of leverage. When the housing bubble started to deflate, the vulnerabilities of this type of business model soon became apparent.

Heavy reliance on short-term wholesale funding exposed the system to a series of intertwined downward spirals in asset and funding markets. This spread in waves, beginning in the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits, and spreading via auction-rate securities, to the repo, money market and financial commercial paper markets that formed the core financing for market-based financial intermediation.

Initial declines in asset prices forced leveraged holders with maturity mismatches to sell assets. This increased price volatility and reduced the value of the assets that collateralized other firms’ borrowings. Higher volatility led banks and secured lenders to raise margins, while concern about counterparty risk and their own funding needs made banks reluctant to on-lend liquidity.

Higher margins on repo and increased collateral calls due to credit ratings downgrades reduced the quantity of assets that could be financed in repo markets and elsewhere, prompting further asset sales.(6) As wholesale investors started to exit, this set in motion a bad dynamic—a fire sale of assets that cut into earnings and capital. This just increased the incentives of investors to run and for banks to hoard liquidity against the risk that they could themselves face a run. This downward spiral of fire sales and funding runs was a key feature of the financial crisis (boldface by RepoWatch).

Specific institutional weaknesses

The fragility of short-term wholesale funding was greatly aggravated by certain critical institutional shortcomings in these markets, particularly in the structure of the tri-party repo system and the U.S. money market mutual fund business.

Through the tri-party repo market, the two large clearing banks (Bank of New York Mellon and JP Morgan Chase) were providing a large amount of intraday credit to securities firms each day to facilitate the daily “unwind” of the prior day’s transactions.(7) (The leading securities firms were Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley and Merrill Lynch.) In the run-up to the crisis, the daily “unwind” practice helped make tri-party repo look like a very liquid investment while still being an apparently highly durable source of funding. This masked the underlying risks and contributed to weak risk management practices.

As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party repo market became increasingly concerned about the liquidity and credit risks that they faced. The clearing banks became uncomfortable with their large intraday exposures to their tri-party securities firm customers. After all, if a securities firm were to fail suddenly, the clearing banks could be stuck with huge loans to these counterparties, secured by securities that were not necessarily high quality and liquid. Thus, as the condition of the most troubled securities firms deteriorated, there was a risk that one morning a clearing bank might decide not to unwind a firm’s tri-party transactions in order to avoid a large intraday exposure.

This risk faced by the clearing banks, in turn, unnerved the tri-party repo investors (many were money market mutual funds). After all, if the unwind did not occur, they would be stuck with the collateral securing their loans from the night before. Most of these investors were not prepared to take possession of and liquidate such collateral, and had no interest in doing so. The incentives for these investors were to run at the first sign of trouble to avoid getting stuck with the dealer’s collateral.

This incentive to run was reinforced by the fact that if the investors were stuck with the collateral, they would have strong incentives to sell it quickly in order to generate the liquidity needed to meet redemption calls or to keep their portfolios in line with regulatory guidelines. Such “fire sales” of assets could result in losses and could be extremely destabilizing to markets.

The crisis also made it clear that the monies provided to the money market mutual funds by their own investors were also inherently unstable. This made such funds, in turn, an unreliable source of finance in repo, commercial paper and other markets. Investors in a fixed net asset value (NAV) money market fund could take their money out on a daily basis at par value, with no redemption penalty. This could occur even if the money market fund did not have sufficient cash or liquid assets that it could easily sell to meet all potential redemptions. This created an incentive for investors to be the first to get out whenever there was any uncertainty over the underlying value of the assets in the fund. By being first in line, they could exit while the fund could still repay at par, leaving others to bear any losses. The longer the investor waited, the greater the risk that the fund would be forced into the fire sale of assets to meet redemptions and end up “breaking the buck.”

As the crisis unfolded, the Federal Reserve, the U.S. Treasury and others took a series of actions to contain the spiral of funding runs and asset fire sales. First, the traditional lender of last resort function was strengthened through the introduction of the Term Auction Facility (TAF) and foreign exchange swaps with foreign central banks.

Then, as the crisis intensified, lender of last resort liquidity provision was extended to directly backstop key wholesale funding markets and opened to certain nonbank firms. The Federal Reserve created a direct backstop to the tri-party repo system through the Primary Dealer Credit Facility (PDCF). When the Reserve Fund broke the buck after the failure of Lehman Brothers, precipitating a run on money market mutual funds, the Treasury guaranteed money market fund assets and the Fed introduced the Asset-Backed Commercial Paper Money Market Fund Liquidation Facility (AMLF). The Fed also backstopped the commercial paper market (formerly funded in large part by money market mutual funds) by introducing the Commercial Paper Funding Facility (CPFF). When wholesale funding for non-residential mortgage securitizations evaporated, the Fed rolled out the Term Asset-Backed Lending Facility (TALF).

These actions ultimately stabilized funding markets and crowded back in private funds. But, they were an emergency response, not a sustainable, long-term solution. After all, because most of the special Fed liquidity facilities were authorized under Section 13.3 of the Federal Reserve Act they were required to be temporary in nature and end when times were no longer “unusual and exigent.”

Status of reforms

Since the crisis, a number of steps have been taken that reduce the vulnerability of the system to funding runs in short-term wholesale markets. Capital and liquidity requirements for large complex financial institutions have been raised sharply, the largest broker-dealers have become part of bank holding companies subject to additional regulation, and risk-weights on assets have been adjusted to better capture risks and to reduce the scope for regulatory capital arbitrage by banks.

Higher capital levels for bank holding companies reduce the incentive for providers of funds to run from these firms at the first sign of trouble. Higher liquidity buffers(8) also help so that banks do not have to sell illiquid assets at the first signs of funding difficulties. This reduces the fire sale risk: that the sale of illiquid assets will depress asset values, potentially turning a solvent firm into an insolvent one.

Meanwhile, the New York Fed has led a Federal Reserve effort to make the tri-party repo system more resilient to stress. In particular, the Fed has pressed the two large clearing banks to make changes to their settlement processes that will diminish their own intraday exposure and enable the market to operate with much less reliance on intraday credit.(9) These efforts are starting to bear fruit: the share of trading activity that requires intraday credit extensions by clearing banks has declined from 100 percent before November 2012 to approximately 80 percent currently, and is expected to fall to 10 percent by the end of next year.(10)  (Chart)

Reducing the market’s dependency on intraday credit will make the market more resilient to future stress events, by forcing all participants to consider the credit and liquidity risks they are exposed to. Meanwhile, in 2010, the Securities Exchange Commission (SEC) tightened the liquidity requirements and concentration limit rules for 2a-7 money market mutual funds (which means these funds use repos more than ever) and increased the fund manager disclosure requirements. These changes, which were intended as a first step, make money funds somewhat less risky. But, they do little to reduce investors’ incentives to run at the first sign of trouble.

Worthwhile as the steps taken thus far are, we have not come close to fixing all the institutional flaws in our wholesale funding markets. The tri-party repo system and the money fund industry that plays a crucial role financing collateral through it are both still exposed to runs. In fact, in each of these areas, one could argue that the risks have increased compared to prior to the crisis (boldface by RepoWatch). That is because the Dodd-Frank Act raised the hurdle for the Federal Reserve to exercise its Section 13.3 emergency lending authority and because Congress has explicitly precluded the U.S. Treasury from guaranteeing money market mutual fund assets in the future. With extraordinary interventions ruled out or made much more difficult, this may cause investors to be even more skittish in the future. This is why it is essential to make the system more stable.

Turning first to the issue of tri-party repo reform, there is still considerable work to do. In particular, the risk that investors will run at the first sign of trouble persists. That is because the costs of running are very low relative to the potential costs of staying put. The potential costs of staying are elevated in part because investors often don’t have the capacity to take possession of the collateral or liquidate the collateral in an orderly way should a large dealer fail. Both aspects result in run risk, fire sale risk and potential financial instability.

Let me be clear. We must deal with the fire sale issue in tri-party repo and the heightened run risk it creates. I believe there are three potential ways forward, all of which are superior to the status quo. First, tri-party repo transactions could be restricted to open market operations (OMO) eligible collateral.(11) Such collateral would likely remain quite liquid during a time of crisis.(12) In addition, such collateral could, in a crisis, potentially be passed directly by a broker-dealer to the discount window under Section 13.13 authority, or, because of beneficial treatment under Section 23A of the Federal Reserve Act, be financed by a banking affiliate that would then itself borrow at the discount window. Thus, one could construct an effective lender of last resort backstop for an OMO-eligible- only tri-party repo system.

However, there are also some significant disadvantages to such an approach. The less liquid collateral could just migrate to be financed elsewhere, with associated run and fire sale risks. Also, given that housing finance reform could cause the agency debt and agency mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac to be replaced by something different that was not OMO eligible under the Federal Reserve Act, the share of assets that are OMO eligible could diminish over time. Finally, this approach would do little to mitigate the risk of fire sales of a defaulted dealer’s collateral by its investors once a dealer is bankrupt.

The second option is to have a mechanism or process to facilitate the orderly liquidation of a defaulted dealer’s collateral. One could imagine a mechanism that was funded by tri-party repo market participants and potentially backstopped by the central bank. This would have the advantage of dealing with the entire tri-party repo market and not artificially favoring one type of collateral over another. It would also push against the underpricing of liquidity and credit risk during good times by forcing market participants to pay for the costs of a liquidation facility up front.

Because no single market participant has a strong incentive to develop such a mechanism, however, sustained regulatory pressure may be required to reach such a solution. From the perspective of the tri-party repo borrowers and investors, the status quo undoubtedly is viewed as superior because neither group is forced to fully bear the externalities associated with their actions. Instead they anticipate that emergency liquidity would be made available in the event of a future systemic crisis.

Third, if borrowers and investors did not embrace an orderly collateral liquidation mechanism, supervisory oversight could be brought to bear to limit the use of tri-party repo funding on the grounds that it is still an unstable source of funds. For example, the use of tri-party repo could be restricted unless borrowers demonstrated that there was an adequate means of orderly collateral liquidation upon the failure of a major dealer.

Turning next to the issue of money market mutual funds, further reform to directly address the incentive for investors to run is essential for financial stability.

In November, the Financial Stability Oversight Council (FSOC) put out for comment three alternative paths forward:(13)

1. Moving to a floating net asset value (NAV).
2. Retaining a stable NAV, but adding a new NAV buffer and a minimum balance requirement. The minimum balance would be at risk for 30 days following withdrawals. If the fund subsequently “broke the buck” during this period by suffering losses greater than the size of its NAV buffer, the minimum balance would be first in line to absorb these losses.
3. A larger NAV buffer than in the second alternative, but without a minimum balance at risk buffer.

I have stated my views on money fund reform before.(14) Although any of these proposals—depending on the fine print of course—would likely be an improvement over the status quo, the first and third proposals don’t fully eliminate the incentives to run. In the case of a floating rate NAV, fund managers faced with large redemption requests typically sell their most liquid assets first, leaving the remaining investors with a riskier, less-liquid portfolio and a greater risk of loss. Similarly, with a stable NAV and a capital buffer, unless the capital buffer were very large, there would still be an incentive to run because the buffer might not prove large enough to shield the investor from loss.

Because the second option is the only one that actually creates a disincentive to run, as I stated before the FSOC proposal, I view it as the best one for financial stability purposes. The requirement that investors who withdraw funds must maintain a small balance for a short period to absorb near-term losses would deter investors from pulling out at the first glimpse of trouble and make the system safer. The modest withdrawal restrictions, which create a “minimum balance at risk,” might be set at 5 cents on the dollar, based on the high-water mark of recent holdings, with more favorable treatment for small retail investors.(15)

A minimum balance at risk of loss would also increase market discipline. Corporations and other sophisticated investors would have an incentive to monitor risk-taking more carefully, rather than rely on their ability to get out ahead of small retail investors when trouble materializes.

The larger question

Reforming the tri-party repo system and the money market mutual fund industry is essential and would make the financial system significantly more stable. But even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop.(16)

The financial crisis clearly demonstrated that we can no longer assume that in periods of stress banks will be willing to access lender of last resort loans and on-lend to the nonbank financial sector at sufficient scale to stabilize the system of market-based financial intermediation, as happened in earlier periods such as the commercial paper crisis in the mid-1970s.

The financing needs outside the commercial banks may be too large relative to the capacity of the banking system, banks may be reluctant to lend to competitors, be concerned about their own liquidity and funding needs, or simply be deterred by elevated counterparty risk.

We need to consider whether our current architecture is satisfactory. If we were to decide that the existing state of affairs is not acceptable in financial stability terms, there are two broad paths we could follow.

The first option would be to take steps to curtail the extent of short-term wholesale finance in the system. In principle, regulators across a broader set of institutions and markets could take steps to directly limit the use of short-term wholesale funding to finance longer-term assets, and take actions that reduced the amount of maturity transformation associated with securitization markets. In other words, regulators could require that a greater proportion of market-based finance be funded by longer-term debt. Alternatively, additional legislation or regulatory changes could be implemented to reduce the volume of wholesale-funded, capital markets activities.

It is also true that some of the measures under debate in the area of limiting the scope of activity or the scale of certain financial institutions, three of which were explored by my colleague Federal Reserve Governor Dan Tarullo in a recent speech, would likely have the effect of reducing the use of short-term wholesale funding relative to the current status quo.(17) For example, if regulators were to cap the size of a bank’s overall liabilities relative to gross domestic product (GDP) not only would this have the effect of capping the size of individual firms, but it also would likely limit the use of short-term wholesale funding by the largest institutions.

The other path would be to expand the range of financial intermediation activity that is directly backstopped by the central bank’s lender of last resort function. This expanded range could be defined either in terms of access by the types of firms that are systemically important in market-based finance, or by types of activity or assets.

It is worth pausing here to review in a little more detail the two key functions performed by a lender of last resort. The first function is to provide a precautionary backstop: to reduce the risk of a financial panic beginning in the first place by ensuring that collateral can always be financed.(18) The first function is important because it makes it less likely that investors will back away from firms because they think others perceive an elevated risk of insolvency, even if they themselves do not share this view. Thus, a lender of last resort facility can reduce the risk of financial instability due to coordination problems even if the lender of last resort is not utilized.(19) In contrast, an emergency facility is unlikely to be as effective. There will be uncertainty around whether it will be deployed, whether it will arrive in time, and how broad it will be.

The second function of a lender of last resort is to prevent the fire sale of assets by firms facing a sudden loss of funding from spreading contagion across the system and disrupting the provision of credit to the economy. This is particularly important during a financial panic, when the demand for liquidity increases sharply. Only the central bank has the ability to meet this increased demand under any potential circumstances.

We have banking activity—maturity transformation—taking place today outside commercial banks. If we believe these activities provide essential credit intermediation services to the real economy that could not be easily replaced by other forms of intermediation, then the same logic that leads us to backstop commercial banking with a lender of last resort might lead us to backstop the banking activity taking place in the markets in a similar way.

However, any expansion of access to a lender of last resort would require legislation and it would be essential to have the right quid pro quo—the commensurate expansion in the scope of prudential oversight. Substantial prudential regulation of entities—such as broker-dealers(20) —that might gain access to an expanded lender of last resort would be required to mitigate moral hazard problems. For example, firms might take less care in managing liquidity and capital if they know they have a lender of last resort backstop and be subject to less counterparty and creditor discipline. In addition, the fact that an institution has access to a lender of last resort facility has value to the institution, even if that institution never taps the facility. Thus, without a corresponding imposition of offsetting obligations and costs, the granting of access would create a significant competitive advantage.

Extension of discount window-type access to a set of nonbank institutions would therefore have to go hand-in-hand with prudential regulation of these institutions. Many thorny issues would have to be resolved. For example, who would have access and on what terms and conditions? How would foreign-owned broker-dealers be treated? Would an insurance-type payment be appropriate for firms that enjoyed lender of last resort access but did not have insured deposits? How would the Fed’s role, as the lender of last resort, be coordinated with the oversight responsibilities of the primary regulators?

Conclusion

Which path to go down—limit wholesale funding or backstop it more broadly—would depend in large part on the social value of the capital markets-based activities presently being financed in unstable short-term wholesale markets and the utility of short-term wholesale funding for lenders.

Of course, the choice might not be as black and white as this. Some activities undertaken by securities firms or other nonbank entities presumably are much more socially useful than others. In this case, legislators might deem that certain classes of securities firms should be granted access to a lender of last resort facility, but restricted in the scope of their permitted activities to those that do clearly create social value.

The sheer size of banking functions undertaken outside commercial banking entities—even now, after the crisis—suggests that this issue must not be ignored. I don’t think we should be comfortable with a situation in which extensive maturity transformation continues to take place without the appropriate safeguards against runs and fire sales. (boldface by RepoWatch) Pretending the problem does not exist, or dealing with it only ex post through emergency facilities cannot be consistent with our financial stability objectives.

The issue of the social value created by market-based financial intermediation and appropriate scope and terms associated with a lender of last resort function are complex ones that require further study and analysis. However, regardless of where we come out on these questions, we must make the basic structure of the wholesale funding market as sound as possible. Thus, we must push ahead with tri-party and money fund reform.

Thank you for your attention. I would be happy to take a few questions.

(1) I note that the set of issues relating to wholesale funding are closely related to the challenge of ending ”too big to fail” I discussed in a November 15, 2012, speech (see http://www.newyorkfed.org/newsevents/speeches/2012/dud121115.html). The more stable the sources of funding, the more resilient each firm would be, and the less the failure of any one firm would disrupt the provision of credit to the economy.

(2) Banking groups retained a prominent role in credit supply via nonbank affiliates outside the commercial bank.

(3) A repo is a sale of securities coupled with an agreement to repurchase the securities at a specified price on a later date.

(4) Market makers are institutions such as securities brokers and dealers that buy and sell securities on behalf of customers. Market making accommodates the asynchronous arrival of sellers and buyers, thus providing liquidity to financial markets.

(5) Conduits are bankruptcy-remote, special purpose vehicles that fund pools of securities in short-term funding markets. The securities might consist of loans, mortgages, receivables and securitized products such as asset-backed securities (ABS). The securities in asset-backed commercial paper (ABCP) conduits serve as collateral for the issuance of asset-backed commercial paper, while repo conduits fund in the repo market. Most conduits are so-called single-seller conduits that only serve individual banks or finance companies. Multi-seller conduits provide funding for asset pools of multiple institutions. Conduits are backed by credit lines from commercial banks, which allow the conduits to have a credit rating. Asset-backed commercial paper conduits are also defined in “Shadow Banking: A Review of the Literature.” Federal Reserve Bank of New York Staff Reports, no. 580, (October) 2011. http://www.newyorkfed.org/research/staff_reports/sr580.pdf.

(6) The problem was particularly acute for those firms with large securities trading and over-the-counter derivative businesses operated outside of depository institutions. In the United States, even those securities firms that were part of bank holding companies were vulnerable because Section 23A restrictions in the Federal Reserve Act that govern transactions between the bank and the nonbank affiliates as part of a bank holding company complex sharply limited what assets the securities firm could pass through to the bank and on to the Fed’s discount window facility.

(7) In the unwind, cash was transmitted back from securities firms to wholesale investors each morning, to hopefully be reinvested and returned back to the securities firms by the end of the day to finance their inventories of securities.

(8) The new global liquidity standards adopted by the Basel Committee provide a global minimum standard  (recently modified).

(9) At the end of 2011, the New York Fed disbanded a private-sector taskforce that had generated some good ideas but was running into trouble on implementation, and adopted a supervisory approach to pushing forward further reform.

(10) These estimates are based on data from the clearing banks with analysis by New York Fed Staff. See chart atwww.newyorkfed.org/banking/riskreduction_020113.gif

(11) OMO eligible is collateral that the Fed can purchase or repo in its open market operations.

(12) In addition, because the Federal Reserve is authorized to intervene in the Treasury, agency debt, and agency MBS markets, it could act to stabilize these markets during times of stress. This would make it easier to liquidate such collateral without unduly depressing prices.

(13) Financial Stability Oversight Council. 2012. “Proposed Recommendations Regarding Money Market Mutual Fund Reform.” (November).
http://www.treasury.gov/initiatives/fsoc/Documents/Proposed%20Recommendations%20Regarding%
20Money%20Market%20Mutual%20Fund%20Reform%20-%20November%2013,%202012.pdf

(14) See William C. Dudley. 2012. “For Stability’s Sake, Reform Money Funds.” http://www.bloomberg.com/news/2012-08-14/for-stability-s-sake-reform-money-funds.html.

(15) For a more detailed discussion, see “The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market”. http://www.newyorkfed.org/research/staff_reports/sr564.pdf

(16) Although the largest stand-alone securities firms adopted bank holding company status during the crisis, their non-depository institution arms do not have access to the discount window backstop because Section 23A of the Federal Reserve Act restricts the ability of the holding company to transfer assets from the non-depository institution to the commercial bank affiliate that has access to the discount window.

(17) See Daniel K. Tarullo. 2012. “Industry Structure and Systemic Risk Regulation.” December 4. http://www.federalreserve.gov/newsevents/speech/tarullo20121204a.htm. In this speech, he explores three policy proposals: (1) breaking up large financial institutions by reinstating Glass-Steagall restrictions or by imposing other prohibitions on affiliations of commercial banks with certain business lines; (2) placing a cap on the nondeposit liabilities of financial institutions; and (3) requiring financial institutions above a specified size to hold minimum amounts of long-term debt available for conversion to equity to avoid or facilitate an orderly resolution of a troubled firm

(18) A lender of last resort finances with an appropriate haircut.

(19) This was demonstrated recently by the European Central Bank’s Outright Monetary Transactions program

(20) Several of the largest broker-dealers adopted bank holding company status in recent years, but Section 23A rules restrict the capacity of their banking subsidiaries to channel liquidity to their broker-dealer operations.

This post is a transcript of  an 11-minute talk RepoWatch editor Mary Fricker gave to college journalism professors, students and others at the 11th Annual Convergence and Society Conference, Advancing Business Journalism and Convergence, at the University of South Carolina School of Journalism and Mass Communications September 28, 2012. Click here for accompanying handouts “In plain English,” “Resources,” and “Story ideas.”

Sometime on the weekend of September 19, 2008, I got one of the shocks of my life, when I heard on the car radio that Treasury Secretary Paulson was asking Congress for $700 billion to keep the financial markets from collapsing after the downturn in real estate.

$700 billion.

Maybe I was in a better position than some to understand what this told us about how big our problem must be, because I’d been a reporter during the last major financial crisis 20 years earlier.

I’d like to take you back to 1986, when I was a newspaper reporter in Northern California and shareholders of a tiny savings and loan (which was supposed to be making home loans) started coming into the newsroom with stories that the CEO and others working at the thrift were throwing money around, making crazy loans, and basically looting the place. Even the mob showed up at the loan window.

Following those tips, we spent four years digging through what became the nation’s S&L crisis.

What a great story.

In the end, regulators had to close 1,043 savings and loans, which was one-third of the industry. It was a stunning financial collapse. Almost every town in America was affected.

Yet in the end it only cost taxpayers $150 billion, which in 2008 dollars would have been $247 billion.

Paulson was asking for almost three times that much.

That day it really hit me, how badly I had failed my readers.

Oh, sure, I’d written housing bubble stories and I’d warned about derivatives and conflicts of interest at credit rating agencies. Who hadn’t? But I’d never written that the financial markets could collapse … because I didn’t know it. It was my job to know it. But I didn’t.

We’d had plenty of real estate bubbles before. I’d reported on at least three in my years as a reporter. They caused recessions, but they didn’t cause financial markets to collapse.

And besides, weren’t those home loans being pooled and packaged into securities that were sold to investors? And if investors lost money, who cares? Don’t investors make and lose money in the financial markets all the time?

Something didn’t add up. There had to be something I didn’t know.

It turned out that I didn’t know it because I hadn’t asked this obvious question: Where’s the money coming from to fuel the housing bubble and make all these home loans?

I hadn’t followed the money, as we are all taught to do.

The answer turned out to be: Shadow banking, which by 2008 had grown to provide about half the credit in this country for houses, cars, college educations, businesses, and much more. Yet I knew very little about it.

Shadow banking is banking that happens on Wall Street instead of in a bank. In my 10 minutes today, I don’t have time to explain much about how shadow banking works. You have a handout today that does that, and honestly it’s not hard to understand.

Also in the handout is a list of the kinds of companies that do shadow banking, including mortgage companies like Countrywide, all the investment banks like Bear Stears and Lehman Brothers, large corporations like GE, insurance companies like AIG, large money market funds, in fact, all big financial institutions including traditional banks.

But about shadow banking, I do want to just briefly say that it has five basic steps. Remember that traditional banking essentially has two steps: A bank makes loans with money it got from depositors. Well, shadow banking has five steps, and you already know some of them.

Step one: A company like Countrywide or a bank makes a loan. We know that step.

Step two: That company sells the loan to a different firm, which is often offshore. This second firm pools the loans and makes securities backed by the loans. We already know about the pooling and the securities, right? But we don’t know much about these odd securitizing firms, which often don’t have employees and may be owned by charities.

Step three: Then this securitizing firm sells some of the securities to investors. We knew that. But it also sells securities to giant financial institutions. We didn’t really know that part. And it keeps many of the securities itself to use as collateral to get overnight loans for itself from those same giant financial institutions. We didn’t really know about that part either.

Step four: The giant financial institutions, which now own some of these securities or have made loans secured by them, try to protect themselves from losing money on these securities by buying derivatives called credit default swaps. You probably know about this step because our reporters have done a great job of covering it.

(And, by the way, we’ve done a great job of covering derivatives in this crisis because years ago – and I remember this – some reporters did the terribly difficult early reporting to help us understand them, which is what we need to do now for shadow banking.)

Step five: These same giant financial institutions, which now own these securities or have made loans secured by them, also use them as collateral to get overnight loans for themselves, from each other.

With this new money, these new overnight loans, the steps begin again. The giant financial institutions recycle the new money down to step one, to make more loans, to use the loans to make more securities, to use the securities as collateral, to get more overnight loans, and so on.

This repeating cycle of five steps is shadow banking. (My web site, by the way, is mostly about step five. And just to prove there’s nothing new under the sun, a key reason for the largest collapse during the S&L crisis, American Savings, was … step five.)

What makes shadow banking so dangerous? It’s the same thing that makes traditional banking dangerous, it’s banks and other financial institutions borrowing money for short periods, like from depositors, and then turning around and lending it for long periods, like for a mortgage.

It’s borrowing short and lending long.

But shadow bankers don’t get their money from depositors like traditional bankers do, so they don’t have the safety net of FDIC insurance. Shadow bankers get their money by borrowing it on Wall Street from money market funds, pension plans, insurance companies, university endowments, municipalities, other big banks – from anybody with big pools of money to lend.

In fact, the purpose of shadow banking is to get those big pools of money down to the people who need to borrow it, to buy a house or car, for example.

These lenders, these big pools of money, are like depositors at traditional banks in that they can demand their money back at any time because they usually lend for very brief periods, like overnight.

If they lose faith in the securities they’ve taken as collateral, like they lost faith in mortgage securities in 2007 and 2008, they can panic and demand their money back.

That’s like in the years before FDIC insurance, when depositors panicked and ran on their neighborhood bank, lining up outside the door to get their money out, and quickly made their bank insolvent because it didn’t have the money any more, it had lent it long on things like home loans.

That’s really what happened in 2007 and 2008. We had the 21st Century version of a run on many shadow banks by shadow lenders, and it quickly threatened to bankrupt nearly all of our largest financial institutions.

Here’s what Bernanke said:

“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression …Out of maybe the 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.”

Since these shadow bankers, these giant financial institutions, made many kinds of loans, not just mortgages, the flow of all credit was quickly grinding to a halt.

That, the broad freezing of credit, was what almost turned a real estate bubble into a collapse of the financial markets and sent Paulson to Congress begging for $700 billion … on top of the more than a trillion dollars the Fed was pouring into the financial markets.

It worries me deeply that shadow banking is nearly as vulnerable today as it was in 2008. Little has been done to fix it. I’m afraid that might be our fault, at least in part, because we journalists haven’t covered it very much. We’ve focused on mortgages and CDOs and derivatives and Fannie Mae  and Freddie Mac and Glass-Steagall, and those are very important. I’m proud of the work we did in those areas. But we can fix mortgages and CDOs and derivatives and Fannie and Freddie and Glass-Steagall until we’re blue in the face, and we’ll still be vulnerable to runs on shadow banking … which is quiet now, but it won’t stay that way because it’s so profitable for shadow bankers.

When I’ve asked reporters why they don’t write more about shadow banking, they often say it’s hard to explain and readers aren’t interested.

Here’s where convergence and multimedia can save the day. My handout has some examples of this. We business reporters, who have such tough things to write about, can be the most enthusiastic embracers of graphics and video and audio and anything else the new media can give us to help us make shadow banking easy to understand and interesting. This conference has so much to offer us.

One last thing to keep in mind, as you try to make shadow banking relevant to your audience: Shadow banking is done with our money. Our money, in money market funds, pension plans, insurance companies, university endowments and so on, gets loaned to banks and other financial institutions, who in turn lend it back to us to buy houses and cars, get student loans, and anything else we need to borrow money for.

This is not esoteric stuff.

This is everyday life.

As noted in the introduction to this series, over the past two decades financial intermediation has evolved from a traditional, bank-centered system to one where nonbanks play an increasing role. For my contribution to the series, I document how the sources of bank holding companies’ (BHC) income have evolved. I find that the largest BHCs have changed the most; they’ve shifted their mix of income toward providing new financial services and are earning an increasing share of income outside of their commercial bank subsidiaries. In this post, I summarize my study’s key findings.

RepoWatch editor’s note: Though not strictly about repos and shadow banking, this article describes the companies that do most of both.) When market observers talk about a “bank,” they are generally not referring to a single legal entity. Instead, large domestic banking organizations are almost always organized according to a bank holding company (BHC) structure, in which a U.S. parent holding company controls up to several thousand separate subsidiaries. This hierarchy of controlled entities generally includes domestic commercial banks primarily focused on lending and deposit-taking as well as a range of nonbanking and foreign firms engaged in a diverse set of business activities, such as securities dealing and underwriting, insurance, real estate, private equity, leasing and trust services, asset management, and so on. In this post, we present some results of our article and contribution to the special EPR banking volume, “A Structural View of U.S. Bank Holding Companies,” which uses public regulatory data to document trends and stylized facts about the size, organizational complexity, and scope of large U.S. BHCs.

Consistent with the recommendation of the Council last year, the Federal Reserve has now taken a more direct supervisory approach to pursuing the necessary changes to the tri-party repo market. Similarly, the SEC continues to work through policy options for much needed reform of money market funds. Section 3 of this report sets out the Council’s 2012 recommendations in these and other areas.

“The Role of Bank Credit Enhancements in Securitization” by Benjamin H. Mandel, Donald Morgan, and Chenyang Wei, New York Fed, July 18:

The securitization markets for consumer and business asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), which supply a substantial share of credit to consumers and small businesses, came to a near-complete halt in the fall of 2008, as investors responded to a drastic decline in funding liquidity by curtailing their participation in these markets. In response, the Federal Reserve introduced the TALF program, which extended term loans collateralized by securities to buyers of certain high-quality ABS and CMBS, as part of a broad array of emergency liquidity measures intended to avert lasting harm to the economy. This article describes the TALF program and operations in detail, explains how the terms and conditions of the TALF were intended to restore market liquidity while limiting the risk of loss to the public, and assesses the efficacy of the program. The authors find that, while it is hard to isolate the effect of the TALF, the facility is likely to have made a significant contribution to restoring liquidity in 2009 and 2010.

The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.

The IIF strongly supports the increased international focus on addressing risks from the non-bank financial system and in particular those activities that contribute to non-bank financial intermediation or “shadow banking”. We welcome in particular the work of the Financial Stability Board and European Commission on greater international coordination and consistency of policy across jurisdictions, and we are keen to contribute to this work.

Shadow banking may help drive the day-to-day financial system, but it is a concept looking for a hard-and-fast definition.

Despite coming under intense scrutiny following the financial crisis, there have been disparate characterizations of what the shadow banking sector truly entails — with size estimates ranging from $10 to $60 trillion. At the same time, major regulatory efforts have either been enacted or are in the works to help reduce the size of this important sector, with no agreed-upon way to measure their effectiveness.

The purpose of the Deloitte Shadow Banking Index is to define and quantify the sector over time, including its components. This ongoing effort is designed to more closely measure size, importance, effect of market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.

RepoWatch recommends the following news reports. Items are arranged chronologically, with the most recent coming first.

“Fed Said to Press BNY Mellon to Speed Repo Market Change” by Bradley Keoun, Bloomberg News, September 25:

The Federal Reserve, seeking to cut risks in the financial system, is pushing Bank of New York Mellon Corp. (BK) to speed changes in a $1.8 trillion bond-lending market that helped fuel the 2008 crisis.

BNY Mellon, which handles about 80 percent of loans in the so-called triparty repo market, will complete computer upgrades and projects aimed at bolstering the system by 2014, two years earlier than planned, according to a document on its website. The bank had pledged in February to finish the tasks by 2016, prompting the Fed to criticize industry-led reforms as too slow.

Since then, the Fed has used its supervisory powers to get quicker results, said three people with knowledge of the matter, who requested anonymity because the talks are confidential. JPMorgan Chase & Co. (JPM), which clears the rest of triparty repo trades, previously agreed to complete reforms before 2014. The upgrades would make the market less prone to the panics that destroyed Bear Stearns Cos. in 2008 and triggered a $148 billion Fed bailout program to keep other brokerages from collapsing.

“The Fed continues to view repo as an outstanding risk,” said Josh Galper, a former Merrill Lynch & Co. executive who’s now managing principal of Finadium LLC, a securities-lending consultant in Concord, Massachusetts. “So they have made it clear that they want the process to move faster.”

“BNP Paribus: How to save European securitisation” by Lucy McNulty, International Finance Law Review, September 25:

The first Prime European Collateralized Securities labeled securitisation is expected imminently.

The PCS Initiative was launched by the Association for Financial Markets in Europe and the European Financial Services Roundtable in June.

It aims to revive the region’s depressed securitisation market by developing a label for high-quality securitisations.

“Do government SIFI liquidation programs make bank or CCP counterparties safer?” by Josh Galper, Securities Finance Monitor, September 17:

Recently the question has come up about which are less risky in today’s financial environment: bilateral counterparties or central counterparty clearing houses (CCPs). Both have their own pros and cons, and it is well known (to the industry, if not to regulators) that CCPs do not minimize or eliminate risk, they just spread it around differently. We are finding that there is a piece missing to the question, which is, “what is the risk now that banks and CCPs may be deemed Significant Financial Counterparties (SIFIs) and have implicit or explicit government guarantees?”

“ECB to Set Up Repo Database as EU Moves to Rein in Shadow Banks” by Rebecca Christie and Jim Brunsden, Bloomberg News, September 17:

The European Central Bank plans to boost oversight of trading in repurchase agreements by setting up a transactions database amid a push by regulators to rein in so-called shadow banking, a European Union document shows.

“Highlights of Bank of England comments on collateral and collateral transformations” by Josh Galper, Securities Finance Monitor, September 14:

The Bank of England released their quarterly bulletin yesterday with some interesting survey comments on collateral management and collateral transformation. …

“Contacts reported that financial market participants were managing the increased need for collateral in a number of ways. These include (i) managing collateral more efficiently; (ii) using so-called ‘collateral transformation services’; and (iii) loosening collateral criteria.”

“Conduit to Fund Guggenheim Repo Deals” by Asset-Backed Alert, September 14:

The former Liberty Hampshire has set up a commercial-paper conduit with some unusual twists.   The operation, which has gone by Guggenheim Treasury Services since early 2011, launched the vehicle Sept. 10 under the name Ridgefield Funding.

It has since placed more than $600 million of short-term paper in the hands of investors, with the goal of increasing its outstandings to $3 billion in the months ahead.   Bank of America and RBC Capital are serving as primary dealers for the securities, which carry P-1/A-1+ ratings from Moody’s and S&P.

Rather than financing clients’ receivables in the conventional sense, Ridgefield is part of a breed of conduits whose proceeds fund repurchase agreements written against the holdings of a counterparty — in this case, corporate bonds owned by BNP Paribas.

In a repurchase agreement, a counterparty sells securities to an investor with a promise to buy them back at a pre-set price. Ridgefield adds a step to that process, using payments on the repo contracts to compensate its noteholders.

But that’s not the vehicle’s most novel feature. Ridgefield is set up to offer what Guggenheim called “serialized commercial paper,” starting with a series called Ridgefield Funding, Series A1, that is backed only by BNP’s repo agreements. The next step would be to add counterparties in the months ahead, with each underpinning a discrete batch of notes.

Because the counterparties won’t be commingled, investors can choose which exposures they want to take on. Another benefit that Guggenheim is pitching to market players: The repo collateral would be bankruptcy remote, and would become accessible to noteholders immediately in the event of a counterparty insolvency. Like many other repo conduits, Ridgefield doesn’t make use of liquidity facilities.

Ridgefield is run by a Guggenheim Treasury team in New York that operates four other conduits with some $20 billion of commercial paper outstanding. Guggenheim Treasury is a unit of the $160 billion Guggenheim Partners of Chicago.

“U.S. financial risk council could use more sunlight – GAO” by Sarah N. Lynch, Reuters, September 13:

The new U.S. financial risk council should publicly share more details about its closed-door meetings on emerging risks to markets, a congressional watchdog report has found.

The Government Accountability Office said the Financial Stability Oversight Council, a group made up of the top U.S. regulators, fails to provide insight, even on information that is not market-sensitive.

The GAO’s report raises similar concerns about the Treasury’s Office of Financial Research, another new office created by the 2010 Dodd-Frank Wall Street reform law to analyze data about market threats.

“JPM Reviews Prime Money Fund Holdings: Uneventful is Good in August” by Crane Data, September 13:

J.P. Morgan Securities released its latest monthly “Update on prime money fund holdings for August 2012″ yesterday, which showed increases in money fund assets, increases in European-affiliated holdings, and increases in average maturities. The latest “U.S. Fixed Income Strategy” research from Alex Roever, Teresa Ho and Chong Sin says, “Prime money market fund assets under management rose by $16 billion (1.1%) in August, a month that was mostly uneventful for the money markets except for the anticipation leading up to the eventually cancelled SEC vote to release money fund reform proposals. …

“Total net bank exposures in prime money market funds increased by $17 billion according to our estimates, driven by increases in unsecured commercial paper/certificates of deposit and repo and offset by decreases in time deposits. Overall asset-backed commercial paper exposures sponsored by banks remained flat month-over-month. In general, funds favored switching out of overnight time deposits (unsecured) to overnight repo (secured) for liquidity …”

Roever, et. al., also write, “Prime money market fund allocations to overnight repo increased to about $200 billion in August, up about $25 billion month over-month and now represents over 70% of total repo holdings in prime money market fund portfolios. Overnight repo holdings remain elevated even as regulatory pressures are forcing broker/dealers to term out their funding liabilities. Basel III’s Liquidity Coverage Ratio in particular would force broker/dealers to hold government securities or cash for expected cash outflows over a 30-day horizon. The bulk of repo funding which is overnight to inside a week would fall under the Liquidity Coverage Ratio, making it costly for broker/dealers to fund shorter than 30 days. We expect such supply pressures on repo over the next several months to lead funds to enter into more term repo trades and seek other sources of overnight liquidity.”

“ESRB Aims for EU Shadow Banking Proposals in Early 2013″ by Jim Brunsden and Rebecca Christie, Bloomberg News, September 12:

The European Systemic Risk Board, a group of central bankers and other regulators charged with monitoring market threats, aims to recommend shadow banking oversight changes in early 2013, European Union documents show.

The ESRB wants to mitigate systemic risk associated with shadow banking, according to the papers prepared in advance of a Sept. 14-15 meeting of officials in Cyprus. The panel intends to make policy recommendations on ways regulators can manage the overall health of the financial system and prevent firms from collapsing and triggering contagion.

“Enhanced transparency of certain shadow banking activities is needed to further monitor the sector, for example in the areas of securities lending and repos and other shadow banking entities,” the documents said, referring to repurchase agreements and other financial products.

“Collateral, collateral transformation and CCPs: a close look at the crazy numbers” by J. Cooper, Securities Financial Monitor, September 12:

… Collateral transformation trades are a shell game in who holds risky collateral, and the regulators already know it. The risk of the central counterparty clearing house (CCP)-ineligible collateral now shifts to the dealer doing the trade, who then recycles the paper in bilateral or tri-party repo. The UK regulators, in particular, are already cautious about banks loading up on less credit worthy collateral. …

One part of the analysis we have not seen much attention paid to is collateral turnover. High quality paper is re-pledged in the market. Economist Manmohan Singh wrote that collateral velocity is like the velocity of money; clocking in at somewhere between 2 and 2.5. When you dead-end collateral in a CCP, it can no longer be re-pledged. When a collateral squeeze comes, it will be felt in this multiplier.

“Big Banks Hide Risk Transforming Collateral for Traders” by Bradley Keoun, Bloomberg News, September 11:

JPMorgan Chase & Co. and Bank of America Corp. are helping clients find an extra $2.6 trillion to back derivatives trades amid signs that a shortage of quality collateral will erode efforts to safeguard the financial system.

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Securities Finance Monitor reviewed the Bloomberg article in “Bloomberg article on collateral transformation: more questions than answers.“

“Does Draghi ease collateral shortfall?” by Will Duff Gordon, Data Explorers, September 11:

What does the European Central Bank’s easing of eligible collateral for the Long Term Refinancing Operation mean for the securities finance market? It might mean that there is enough collateral to go round – a huge statement to make regarding the central issue of our times.

“Basel Group Faces ‘Now or Never’ Chance on Bank-Liquidity Rule” by Jim Brunsden, Bloomberg News, September 11:

Global financial regulators begin three days of talks today that may pave the way for a deal on liquidity rules that lenders and the European Central Bank warn could stifle the economic recovery.

The Basel Committee on Banking Supervision will attempt to overcome divisions within its ranks as it races to meet a self- imposed January deadline for reviewing the liquidity coverage ratio, or LCR, three people familiar with the discussions have said. ECB President Mario Draghi has warned the measure risks choking off bank lending, while some other regulators, including in the U.S., say that diluting the LCR risks rendering the standard meaningless, according to the people.

“It’s now or never for the LCR,” Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics Inc., said in an e-mail. “If Basel can’t cobble together an agreement on it that is more than papered-over differences, the U.S. and U.K. will implement their own rules, the EU will stand down and the global liquidity framework may well dissolve.”

The 212 largest global banks would have had a collective shortfall of 1.76 trillion euros ($2.2 trillion) as of June 2011 in the assets needed to meet the LCR, according to figures published by the Basel group based on a draft version of the standard. …

The LCR, which would force banks to hold enough easy- to-sell assets to survive a 30-day credit squeeze, was drawn up by the Basel committee as part of a package of measures in response to the 2008 financial crisis. It is scheduled to become binding as of Jan. 1, 2015.

“Are Chinese banks hiding ‘The mother of all debt bombs’?” by Minxin Pei, The Diplomat, September 10:

Financial collapses may have different immediate triggers, but they all originate from the same cause: an explosion of credit. This iron law of financial calamity should make us very worried about the consequences of easy credit in China in recent years. From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China’s GDP in 2011. About two-thirds of these loans were made in 2009 and 2010, as part of Beijing’s stimulus package. Unlike deficit-financed stimulus packages in the West, China’s colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing.

… the potential risk for a financial tsunami is greatest in China’s shadow banking system. Because of very low-yield for savings by Chinese banks (since deposit rates are regulated) and competition among banks for deposits and new fee-generating businesses, a complex, unregulated shadow banking system has emerged and grown significantly in China in the last few years. 

Typically, the shadow banking system pushes something called “wealth management products,” which are short-term financial products yielding a much higher rate than bank deposits for investors….

The shadow banking system has another function: channeling funds to borrowers or activities explicitly banned by government regulation. …

Disturbingly, none of these huge risks are reflected in the financial statements of Chinese banks.

“China re-launches ABS programme for first time since crisis” by Lu Jianxin and Pete Sweeney, Reuters, September 8:

China has re-launched a programme to develop asset-backed securities interrupted by the global financial crisis as the government tries to shore up its banking system.

China Development Bank sold 10.166 billion yuan of credit-backed securities on Friday, marking China’s first sale of such instruments since the global financial crisis caused such products to fall into disrepute.

The asset-backed securities in question are backed by 49 performing corporate loans with a weighted average annual rate of 6.27 percent….

“Regulators choose this time to re-launch the ABS programme primarily to bolster the banking system,” said Liu Junyu, a senior money market analyst at China Merchants Bank in Shenzhen. …

By the expansion, regulators appear to also want to use ABS to help boost corporate fund-raising directly via the market, so as to reduce reliance on bank loans, as well as to give firms an additional channel to raise money through reviving some static assets, they said.

“Don’t Make Banks Too Small to Succeed” by Phillip Swagel, Bloomberg News Opinion, September 5:

Calls by former Citigroup Inc. Chief Executive Officer Sanford Weill and others to break up the big banks reflect lingering public fear and anger toward financial institutions that seem too big to fail.

These calls, however, ignore the unintended consequences of making our global banks too small to succeed: Much of the business will migrate to non-U.S. banks and the less-regulated shadow banking sector. …

Shadow banks are almost three times the size of the formal banking sector, and they are less transparent and less regulated, even with heightened attention from the newly created Financial Stability Oversight Council. Lending through shadow banking channels such as securitization or repurchase agreements might not be covered by a taxpayer guarantee, but failures in these parts of the financial system during the crisis brought about government intervention all the same. …

(Phillip Swagel, a professor at the University of Maryland’s School of Public Policy, was assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.)

“Barclays Abate Says Tri-​Party Repo Grows Strongly, But Will Shrink” by Crane Data, September 5:

A recent “Market Strategy” research piece from Barclays comments on the “Dealer repo activity.” Strategist Joseph Abate writes, “Overall, dealer activity in the repo market has held fairly steady in the past year. But dealer activity in the bilateral market is declining. … Dealers are active participants in the tri-party and bilateral repo markets. They use the tri-party market mainly to finance themselves and the bilateral repo market for trading specific collateral. Cash borrowings in the bilateral repo market have been falling since last summer. Bilateral repo now accounts for less than 35% of all dealer repo outstanding. Meanwhile, dealer tri-​party repo volumes are increasing. We estimate that money funds provide about 40% of the $1.5 trillion in tri-party repo. …

He continues, “We believe that pending regulatory changes will likely shrink the size of the tri-party repo market. However, while some of these financing trades might migrate to the bilateral market, we suspect that dealers are more likely to shrink as their ability to maintain a $600 billion repo market funding gap declines.” …

“A smaller tri-party market — particularly given the increase in its participation in the past year — may create some congestion for money funds looking for safe investments among sparse government supply. But, there could be some relief if bilateral repo (currently at $1 trillion in outstandings) picks up the slack. However, this requires that some traditional tri-party lenders such as money funds sacrifice some of the efficiency from the tri-party market for access to more collateral in the bilateral market.”

“Bank regulators warm to liquidity rethink” by Brooke Masters, Financial Times, September 2:

Global regulators are coalescing around plans to soften the impact of planned bank liquidity buffers by allowing institutions to count a wider variety of assets towards the requirements and changing the calculations in key ways to somewhat reduce the overall amount.

The Basel Committee on Banking Supervision, which sets the worldwide standards, has been promising for more than a year to take a second look at the “liquidity coverage ratio”, which is due to take effect in 2015 and requires banks to hold a stock of easy-to-sell assets against a 30-day market crisis.

The liquidity coverage ratio is a groundbreaking attempt to prevent runs like the one that brought down Lehman Brothers in 2008. But industry groups say the current version, which limits the buffer to cash, sovereigns and top quality corporate bonds, will hamper lending and some central bankers fear it will hinder efforts to stimulate the economy.

A Basel working group recently narrowed possible revisions to half a dozen serious proposals that will be considered at a meeting next week. Not all will pass and negotiations are expected to continue into the next meeting in December….

People familiar with the discussions say the industry has had little success persuading anyone beyond the European Central Bank to accept asset-backed securities, despite extensive lobbying.

“Russian Banks More Than Doubled Repo Borrowing In Second Quarter” by Artyom Danielyan and Stepan Kravchenko, Bloomberg News, August 31:

Russian lenders more than doubled the average amount borrowed via repurchase agreements with the central bank to 908.6 billion rubles ($28.1 billion) in the second quarter from 382.8 billion rubles in the previous three months, according to a report published on Bank Rossii’s website today.

“Search for yield boosts esoteric ABS” by Tracy Alloway, Financial Times, August 30:

Yields from US Treasuries and top-rated corporate bonds may be trading near record lows, but investors still want returns. Bankers have been willing to oblige. By slicing and dicing a host of unusual assets from racehorse semen to timeshare loans, they have been stepping up their marketing of income-producing investments to sell to investors.

So-called esoteric asset-backed securities have been in the market for years. But in recent months demand for yield has helped push this market towards recovery. While issuance has dropped from pre-crisis levels of as much as $45bn, esoteric deals are one of the few ABS markets where sales are increasing.

They are typically backed by cash flows from assets such as timeshare loans and shipping container leases but can stretch to more exotic items such as music and film rights and even pizza franchises and pharmaceutical patents. That differs from the home equity, credit card and auto loans that secure more familiar and traditional ABS.

“U.S. Money Fund Exposure and European Banks: Shift to Japan Continues” by Martin Hansen, Kevin D’Albert, and Robert Grossman, Fitch Ratings, August 29:

… While money market fund allocations to European banks increased moderately since end-June, the proportion of secured exposure in the form of repurchase agreements (repos) also continued to climb (see chart, Repos Continue to Rise). As of end-July, repos represent about 36% of money market fund allocations to European banks. It is important to note that the quality of repo collateral can vary, as illustrated in Fitch’s report, “Repos: A Deep Dive in the Collateral Pool” (August 2012).

“Foreclosure-rental bonds come to market without ratings” by Adam Tempkin and Charles Williams, Reuters, August 24:

The first so-called real estate owned (REO)-to-rental securitizations in the United States may go ahead without credit ratings, as agencies ponder how to assign grades to the new and potentially risky products.

In the planned deals, real estate and private equity investors would buy up blocks of foreclosed properties and rent them out to borrowers who have been displaced due to their unpaid mortgages. The rental payment streams – and possibly the proceeds from an eventual sale of the properties – would provide payments to bond investors.

“Costs rise for legacy ABS” by Anil Mayre, Reuters, August 24:

The weaker financial position of banks providing various roles in securitisation structures within the current regulatory framework has had a monetary impact on terms for issuers, which are not just counting the number of notches of downgrades.

Liquidity facilities designed to be a support mechanism and cover shortfalls were employed in a number of pre-crisis deals. And while they only accounted for a small percentage of portfolio sizes (typically single digits) and pay down over time, their costs continue to rise for both providers and recipients. The problem is a painful combination of capital charges and downgrades.

“Structured Repos Signal Market Appetite, Liquidity Risks” by Fitch Ratings, August 23:

Investor appetite for legacy, distressed structured finance securities continues to drive their acceptability as repo collateral. Fitch’s analysis of repo collateral trends, which covers the most recent Form N-MFP reporting period of end-May 2012, reveals that lower quality securities still predominate the collateral pools backing structured finance repos, with Countrywide, Bear Stearns, Lehman, and Washington Mutual ranking among the ten largest issuers of structured finance repo collateral. In terms of overall volumes, Federal Reserve Bank of New York (FRBNY) data indicates that roughly $75 billion of structured finance securities were financed through tri-party repos as of July 2012. Funding these less liquid, more volatile securities through short-term, wholesale borrowing poses potential liquidity risks to both repo market participants and the broader structured finance market….

For both investors and financial institutions, the persistent low-yield environment has likely played a pivotal role in stimulating appetite for these riskier securities. … However, funding these less liquid, low-quality securities through repo markets poses broader risks within the financial system.

“ABS Sales Fall In Europe On Central Bank Funding, S&P Says” by Tom Freke, Bloomberg News, August 22:

Sales of asset-backed bonds are falling in Europe as issuers take advantage of cheap central bank funding, according to Standard & Poor’s. …

Banks sold 44 billion euros ($55 billion) of bonds backed by mortgages, auto loans and credit-card payments in the first seven months of the year, about 10 percent lower than for the same period of 2011, S&P said, citing data from JPMorgan Chase & Co. Almost 50 percent of the notes sold were backed by prime U.K. home loans.

Volumes of ABS plunged about 80 percent in the five years since the financial crisis started, after previously fueling economic growth by allowing lenders to refinance the cheap credit they extended.

“J.P. Morgan sees first HKD triparty repo transaction” by Securities Lending Times, August 22:

J.P. Morgan Worldwide Securities Services has executed Hong Kong’s first HKD triparty repo transaction between Bank of China and Barclays.

The bank and the Hong Kong Monetary Authority collaborated on a repo financing collateral management programme to facilitate repo financing transactions between members of Hong Kong’s Central Moneymarkets Unit (CMU) and international financial institutions. The programme launched in June….

The trade “leveraged the cross-currency, cross-border and global capabilities of the repo financing programme and J.P. Morgan platforms by mobilising US Treasuries against HKD liquidity,” said J.P. Morgan in a statement.

Kirit Bhatia, head of technical sales for Asia (excluding Japan) at J.P. Morgan Worldwide Securities Services, said: “This is an exciting milestone for Hong Kong as it points to the new opportunities for local and global firms seeking to participate more deeply in the region’s rapidly developing capital markets. We look forward to playing a key role in the market’s ongoing development.”

“Are Giant Banks Indispensable? No, Says Big Business” by Maria Aspan, American Banker, August 21:

Big banks love their biggest customers, but the feeling isn’t always mutual.

That has become evident as the nation’s largest banks try to fend off a fresh wave of criticism that their size and marriage of investment and commercial banking pose a grave risk to the financial system….

JPMorgan Chase (JPM) Chief Executive Jamie Dimon has argued that big corporate customers rely heavily on the sophisticated financial services only megabanks can provide, including big loans, global cash management and deal advice….

Nobody interviewed for this article advocated breaking up big banks, but corporate officials carefully expressed frustrations with the side effects of the megabanks’ heft. The growing concentration of banking industry assets since the financial crisis has made dealing with the largest banks inevitable for many companies — and often requires buying a bundle of services to get the best deals on credit.

“Years of Scandal” by Christopher Matthews, Time, August 15:

America has been afflicted with one financial scandal after another over the past generation – culminating in the 2008 financial panic, the effects of which we are still suffering under. It has widely been assumed that each of these scandals have had disparate causes, but in their new paper (William) Bratton and (Adam) Levitin argue that three of the most notorious scandals of the past generation — Michael Milken’s junk-bond-related securities fraud in the 1980s, the Enron scandal of the early 2000s, and the subprime mortgage meltdown of 2007-08 — are all linked by their use of an esoteric accounting mechanism called a “special purpose entity,” or SPE.

“‘The new form of corporate alter ego’: SPEs, encore” by Joseph Cotterill, Financial Times Alphaville, August 14:

We qualify ‘new’. This paper is a full 30-year history of the special-purpose entity in banking, from Mike Milken to the Abacus CDO, via Bistro — up to the denouement of FAS 167.

Penned by William Bratton and Credit Slips blogger Adam Levitin, it also points out that corporate law continues to lag the accountancy profession in understanding the implications of SPEs. That weakness is important when the original purpose of many SPEs — for banks to replace equity with contracts as a means of controlling assets taken off-balance sheet, in order to gain relief from regulatory capital — is as relevant as ever.

“DTCC’s Avox Launches Legal Entity ID Portal” by Tom Steinert-Threlkeld, Securities Technology Monitor, August 9:

Avox has launched a Web portal that gives access to legal names, parent company names and other background data on 459,000 participants in financial market transactions.

When and where available, the data will include the Interim Compliant Identifiers mandated by the Commodities Futures Trading Commission.

“European unsecured bank debt issues fall” by Mary Watkins, Financial Times, August 8:

The proportion of senior unsecured debt issued by banks in Europe this year has fallen below 50 per cent of new issuance for the first time in five years, underlining how problems in the eurozone and new regulations are driving banks to tie up more of their assets to access funding.

“All eyes on asset encumbrance in Europe” by Izabella Kaminska, Financial Times, August 8:

Fitch has published an in depth analysis of encumbrance on EU bank balance sheets on Wednesday — a key talking point given the market’s current focus on such senior debt, such as covered bonds, repos and central bank funding.

The results are interesting because, by and large, they show there aren’t any real trends at all. …

Nevertheless, it’s still the case that the global trading banks that appear to “suffer” from over exposure, do so due to their repo operations. Levels vary from bank-to-bank depending on the weight of trading business relative to commercial banking and the extent of re-hypothecation (the practice of reusing assets).

“Corporate Cash Chasing Low-Risk Yield” by James Willhite, CFO Journal, August 7:

Corporate cash investments in asset-backed securities continued their upward march in July, settling at their highest level in four years as a component of cash balances.

“Banks’ Liquidity Hinges on Risky Assets” by Vincent Ryan, CFO.com, August 6:

By funding short-term cash needs with structured-finance securities, banks are creating significant liquidity risks for themselves and some of their markets, says Fitch Ratings.

Repos, or repurchase agreements, are a key source of short-term financing for Wall Street banks and other financial institutions, and they are under scrutiny once again for being fraught with risk.

A Fitch Ratings report last week found a significant weak point in repo markets, a part of the “shadow banking” system that finances trillions of dollars in banks’ trading activities.

The repo market is “an important utility in the financial system and promotes liquidity,” says Martin Hansen, senior director of macro credit research at Fitch Ratings. The problem with the repo market currently, though, is the quality of the collateral Wall Street banks and other financial institutions are using to borrow this short-term cash, says Fitch.

“The danger of repo” by Felix Salmon, Reuters, August 6:

Remember how there’s a very good chance that Treasury’s new floating-rate notes are going to be linked to some kind of repo benchmark? Well, here’s another reason that’s a bad idea: the repo market is shrinking fast, at least in Europe — and if it can shrink in Europe, it can do so in the US, as well.

What’s more, we want the repo market to shrink. … Repos … epitomize the paradoxical and ultimately destructive desire on the part of people with money to lend out money but to take no credit risk while doing so. …

And in times of crisis, a reliance on repo markets makes all banks incredibly fragile, and vastly increases the risk to taxpayers should a bank fail.

“Key repo contracts market falls 14%” by Mary Watkins, Financial Times, August 5:

The market for a key funding instrument for banks has shrunk in Europe, highlighting how reliant financial insitutions in the region have become on European Central Bank support.

The market for European repurchase, or repo, transactions contracted by an estimated 14.2 per cent year-on-year in the six months to June 30, based on constant samples over the period.

The total value of outstanding repo contracts – in which banks pledge their securities as collateral for short-term loans from money market funds or other investors – stood at €5.647tn in June, according to the latest bi-annual snapshot of the market by the European Repo Council of the International Capital Market Assocation (ICMA).

“EFSF repo request bolsters peripheral rally” by John Geddie, International Finance Review, August 4:

The European Financial Stability Facility’s request for bank loan facilities, and specifically a repurchase facility, bolstered buying in peripheral Europe on Friday.

Bank sources said they had received a request on Friday morning for a repo facility from the EFSF, following earlier requests for uncommitted unsecured and committed secured loans over recent weeks.

“The repo facility is a signal that the EFSF wants to be fully ready for any proposed secondary market intervention,” said Sphia Salim, European rates strategist at Bank of America Merrill Lynch.

“Congress Considers Health of Tri-Party Repo Market” by C-Span, August 2:

Senators Jack Reed & Mike Crapo say it’s crucial to clarify which government regulatory agency has sole oversight authority of the tri-party repo market. The Chairman and Ranking Member of the Senate Banking Subcommittee on Securities, Insurance & Investment convened a hearing Thursday on the potential risks repos pose to the broader U.S. financial system.

In testimony, Matthew Eichner, the Federal Reserve’s Research and Statistics Division Deputy Director listed a few agencies but couldn’t name the lead oversight agency which concerned lawmakers. Eichner stressed that while the market has improved its risk management since the 2008 financial crisis, he believes vulnerabilities remain and need to be addressed. Representatives from two clearing banks, BNY Mellon and Morgan Stanley, and an investors’ group also testified.

(RepoWatch editor’s note: See the related August 3 Wall Street Journal story “Fed sees risk in a big repo market” by reporter Andrew Ackerman who calls the tri-party repo market “an obscure but enormous corner of the financial system.” RepoWatch believes U.S. business reporters and editors need to ask themselves why they allow an “enormous corner” of the financial system to be “obscure.”)

The Federal Reserve and the repurchase market are intimate partners in the financial system that delivers credit throughout the U.S. economy.

For almost 100 years, they have relied on each other to help reach their goals of a strong economy and profitable banking.

From “Instruments of the Money Market” by the Federal Reserve Bank of Richmond in 1993:

In addition to its use as a short-term market for investing and lending funds, the repo market is the primary medium through which the Federal Reserve Bank of New York’s Domestic Trading Desk (the Desk) conducts open market operations on behalf of the Federal Reserve System.

Although the Fed has recently stopped doing repo transactions and is using a strategy known as “quantitative easing” instead, it has made clear that the repurchase market continues to be a key arrow in its monetary policy quiver.

The interdependence of the Fed and the repurchase market is an awkward entanglement for a central bank that wears several hats, including: It executes monetary policy, it regulates the country’s biggest financial institutions, and it is the lender of last resort to the financial markets.

In these roles, the Fed is supposed to trade on the repo market to keep the U.S. economy strong, discipline its repo trading partners when their activities might endanger the financial markets, and flood its repo trading partners with cash and securities if they get into financial trouble so acute it threatens the economy.

Juggling these roles, the Fed has emerged as a timid repo reformer, even as other bankers, regulators and analysts have called for substantial changes to the repurchase market, which was revealed in 2008 to be one of the weakest links in the chain that delivers credit from Wall Street to Main Street. 

From “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University, March 23, 2012:

… we note that the current financial legislation proposals are completely silent on how to reform the repo market …. We believe this omission is a mistake in light of the systemic nature of the repo market and its structural weaknesses. … Unless this systemic liquidity risk of repo market is resolved, the risk of a run on the repo market will remain.

The relationship between the Fed, other central banks, and the repurchase market has been building for decades.

Over time the Fed has chosen repos as one of its main tools for carrying out monetary policy: In general, it tries to slow an economy that is overheating by getting repo loans from selected securities dealers and making interest rates go up.  Or it tries to revive an economy that is faltering by giving repo loans to those same securities dealers and making interest rates go down. Or it does both,  as needed.

In 2006 the Federal Reserve reported that it got an average of $565 billion in repo loans from the dealers each month and gave an average of $177 billion.

In 2007 the Federal Reserve reported that it got an average of $723 billion in repo loans from the dealers each month and gave an average of $216 billion.

In 2011, the Federal Reserve did not do any repos with securities dealers, because it was using quantitative easing instead. (It did, however, get an average of $1.5 trillion in repo loans from foreign central banks and other international government groups. In part, this was possibly European organizations investing their cash at the Federal Reserve during times of turmoil at home.)

For repo transactions to flow readily into the economy, the Federal Reserve needs securities dealers who are thriving in a vibrant repurchase market. The Fed’s selected dealers do about 90 percent of all U.S. repo borrowing and 88 percent of the lending, according to a report by four New York Fed analysts.

At times the Fed has taken dramatic steps to keep the repo process hearty, as it did when a run on the giant Long-Term Capital Management hedge fund roiled the markets in 1998; after the terrorist attacks of 9/11; and during the financial crisis of 2008. Some experts expect such interventions to continue, because so much is at stake.

Economies throughout the world depend on the Fed being able to operate efficiently and effectively.

As then-Federal Reserve Chairman Alan Greenspan said in a June 14, 2000, speech, referring to 1998 when Russia defaulted on its debt and the Fed had to intervene to protect the credit markets from the near-collapse of Long Term Capital Management:

There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. 

The U.S. Treasury also relies on a vital repo market, in at least two ways. Repos help finance the national debt, because Wall Street’s appetite for Treasuries depends in part on well-functioning  repurchase financing, and since 2006 the U.S. Treasury has been making repo loans with its excess cash, as part of its investment program.

(Editor’s note: See below for a chronology of key steps in the Fed’s entanglement with the repurchase market. Also see below for excerpts from Martin Mayer’s 2001 book, “The Fed,” that explore the relationship between the Fed and the financial markets.)

Paul Volcker valued repo

Thirty years ago Paul Volcker, then chairman of the Federal Reserve Board, understood the critical role repos play in the financial markets and in Fed and Treasury operations: In 1982 he urged Senator Bob Dole to protect repos. From a Volcker letter to Dole:

Repos are used by a wide range of entities in addition to government securities dealers, including states, municipalities and other public bodies, financial institutions, and pension funds, to employ funds on a secure basis through temporary acquisitions of various kinds of securities, including U.S. government and agency securities, bankers’ acceptances and CDs.

In adition, repos are a very important tool used in Federal Reserve open market operations and in financing the national debt. Therefore, because of this widespread use in very large amounts, it is important that the repo market be protected from unnecessary disruption.

Ironically, a law that Volcker proposed in response to the 2008 financial crisis has stimulated a new debate on whether repos are dangerous and should be limited. 

The Volcker Rule says deposit-taking banks can’t trade or speculate on their own behalf.  But the rule exempts repos, securities lending, and transactions involving U.S. government and agency instruments, like Treasuries and Freddie Mac or Fannie Mae mortgage securities.

Occupy the SEC objected to the repo exemption in a December 15, 2011, statement:

Paul Volcker had a simple idea: get the government out of the hedge fund business. From his simple idea was born a simple proposal: ban proprietary trading and investments in hedge funds at government-backstopped banks. Congress agreed, to a point, and passed the “Volcker Rule” as section 619 of the Dodd-Frank Act.

The draft of the Volcker Rule, which grew from a three-page proposal to a 300+ page behemoth, was released by the regulatory agencies this October. The draft rule grants a number of exemptions from the proprietary trading restrictions. One of our major concerns is the blanket exemption for repurchase agreements (“repos”). The exemption isn’t mentioned in the statute, and for reasons discussed below it seems to defy the intent of the rule. In our eyes, the presence of such an overbroad exemption is profoundly disappointing. Whose interests are the regulators serving?

One could reply that they’re serving the interests of Paul Volcker and the Federal Reserve.

Repos make a good tool for central bankers for several reasons, according to a 1999 report by the Bank for International Settlements in Basel, Switzerland, which was founded in 1930 to help central banks worldwide and to be their banker.  From the report:

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations.

By both giving and receiving cash and securities, repos give central banks some precision over the flow of each, according to the report. Repos are considered low risk, because they’re collateralized. Repos can be precisely structured to meet the central bank’s goals, because terms like amount, maturity, and interest rate are flexible. And repos reach a market that has been broad and deep for decades. 

According to the Richmond Fed in 1993:  

As a result of the continued growth in the types and volume of arrangements, the repurchase market has become by most accounts one of the largest and most liquid financial markets in the world.

The 1999 report by the Bank for International Settlements noted, though, that repo markets can contribute to systemic risk. Foreshadowing the future, it said:

Shocks originating in securities markets can be transmitted through repo markets and give rise to systemic risk. Large price shocks in securities markets can result in an under-collateralisation of exposures in the repo market. The need to meet margin calls to cover such exposures may lead to financial distress at an institution using repos as a source of financing. Failure in securities settlement systems is another securities market shock that may be transmitted through the repo market.

Finally, leveraging through repo markets can contribute to systemic risk by allowing market participants to take bigger positions in markets. Excessive leverage resulting from inadequate risk management and inadequate counterparty discipline can also add to systemic risk by increasing the probability of failure of a large institution.

Fed tiptoes around reform

Although these warnings came true in 2008, the Fed has tiptoed around repo reform. For example:

-In 2009 the Fed handed reform of the vital tri-party repo market, where the Fed conducts its repurchase transactions, to a committee of Wall Street bankers and dealers, possibly to benefit from their expertise, insure their cooperation, and keep the market flowing through any changes.  The result: Earlier this year the committee adjourned without installing the reforms the Fed wanted, and four years after the crisis tri-party repo is still of deep concern to the Fed and other top regulators.  The Fed has told participants to draw up plans that show how they will operate more safely, and use tri-party repo less, in the future.  It will review the plans this fall.

-In 2010 the Obama Administration proposed to levy a “Financial Crisis Responsibility Fee” on some of the debt of financial firms with at least $50 billion in assets, to repay taxpayers for “the extraordinary assistance they provided to Wall Street.” Within two weeks the administration said it would exempt repo debt because some bankers and economists had warned that the fee could hurt the important repurchase market and impair Federal Reserve operations. (Not yet approved, the proposed fee with the repo exemption is included in the Obama Administration’s fiscal 2013 budget. Meanwhile, FDIC-insured banks have had to pay a fee on repos since the FDIC began charging one in 2011.)

-Some economists have made concrete proposals for ways to make the repurchase market more secure. But the Fed, which has the power to implement these suggestions, has done little – even though this period, when the Fed is not using repos, would seem to be a convenient time to make changes.

The close relationship between the Fed and the repurchase market also entangles the Fed in conflicts of interest and conundrums. Some examples:

-In its final days last October, securities dealer MF Global appealed to the Fed for help in responding to a run, as worried clients and trading partners clamored to get their money back. But the Fed was one of the trading partners doing the clamoring, to protect deals it had outstanding with MF Global. 

(RepoWatch editor’s note: This run could not have surprised MF Global or the Fed, as MF Global’s CEO Jon Corzine was deeply involved in the 1994-1998 rise and fall of Long-Term Capital Management and saw the runs that nearly destroyed it, and the Fed engineered the deal that rescued the fund.)

-Both MF Global and Lehman Brothers complained that JP Morgan Chase, acting as their tri-party repo clearing bank, held onto cash or securities they desperately needed in their final days. At MF Global, Corzine tried to fix the problem by picking up the phone and calling William Dudley, president of the Federal Reserve Bank of New York, to complain. But Dudley’s first concern would not have been for MF Global. It would have been for preserving the integrity of JP Morgan and tri-party repo.

- At times, repos, derivatives and government securities get special treatment under the bankruptcy code. For example, a repo lender holding a U.S. government-guaranteed security as collateral can immediately sell that security if the borrower files bankruptcy, without having to share it with other creditors. Critics claim this special treatment encourages repo lenders to make loans to risky borrowers they might not otherwise lend to, and the critics want the provision repealed. But efforts to undo it have met resistance in part from those who fear such a change would make repos less popular and interfere with the Fed’s ability to implement monetary policy.

The Fed and moral hazard

Some observers believe the Fed’s dramatic intervention in the financial markets from 2007 to 2010 succeeded in preventing another Great Depression. The Fed has said that one of its key goals was to keep the repurchase market operable, with emergency programs like the Primary Dealer Credit Facility and the Term Securities Lending Facility, both in effect from March 2008 to February 2010. But critics claim these crisis actions by the Fed also encouraged risk taking, by once again proving to repo bankers that the Fed will ride to their rescue:

From “Wall Street aristocracy got $1.2 trillion in secret loans” by Bradley Keoun and Phil Kuntz, Bloomberg News, August 22, 2011:

The Fed’s liquidity lifelines may increase the chances that banks engage in excessive risk-taking with borrowed money, (Harvard economics professor Kenneth) Rogoff said. Such a phenomenon, known as moral hazard, occurs if banks assume the Fed will be there when they need it, he said.

From “Will the Central Bank Bail-Outs Ever End?” by L. Randall Wray, EconoMonitor, February 23, 2012:

My worry is this: the “too big to fail” (or as my colleague Bill Black calls them “systemically dangerous”) institutions have learned that no matter what they do, they will be saved and their top management will never be punished.

From Greenspan’s June 14, 2000, speech:

Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

Three Federal Reserve economists reviewing the Primary Dealer Credit Facility agreed that the Fed’s actions to save the repo market could create moral hazard. But they saw a silver lining. From “The Federal Reserve’s Primary Dealer Credit Facility” by Tobias Adrian, Christopher R. Burke, and James J. McAndrews, Federal Reserve Bank of New York, August 2009:

To be sure, concerns have been raised that access to this type of backstop funding source could discourage dealers from managing their funding positions carefully. Yet the risk of such perverse incentives is offset by the protections the PDCF affords more prudent firms against the market stresses created by their highly leveraged counterparts.

The solution to the moral hazard problem is better regulation, the three economists said.

To the extent that backstop lending facilities like the PDCF might create conditions conducive to moral hazard, it is important to have regulation in place that helps enforce the prudent management of funding positions.

Absent repo reform, this means Americans must rely on the Fed to rein in its repo dealers, something the Fed in the past has not been able to do.

Further reading

RepoWatch recommends the following reports on the Federal Reserve:
-”The Federal Reserve System – Purposes and Functions“ by the Board of Governors, Federal Reserve System, June 2005.
-”The Fed” by Martin Mayer, Free Press, 2001. This books shows that the dangers exposed by the financial crisis were well known in advance. (See excerpts below.)
-”In Fed We Trust” by David Wessel, Three Rivers Press, 2010. This book describes the Fed’s role in responding to the financial crisis.
-”At the Fed,” the last chapter in Roger Lowenstein’s book about the fall of Long-Term Capital Management, “When Genius Failed,” 2001.                                                -The Fed’s Annual Reports describe the Fed’s operations. In the “Statistical Tables” section are data for each year going back to 1918.
-The Fed’s Open Market Operations reports are prepared by the Markets Group of the Federal Open Market Committee, Federal Reserve Bank of New York.

Some milestones

Following are some milestones in the Federal Reserve’s century-long affair with repos:

1917: The Federal Reserve begins using repos to provide temporary funds to member banks.  This will continue for a few years and then be discontinued until 1975.

1920s: The Fed begins using repos to extend credit to securities dealers.

1940s: The Fed stops using repos entirely.

1949: The Fed resumes intermittent use of repos for monetary policy.

1950: J.P. Morgan develops the overnight repurchase  agreement. In its overnight repurchase agreements, Morgan gets repo loans from its large depositors, thus replacing deposits with loans. This is (1) a way for Morgan to pay its large depositors interest, at a time when the law forbids banks to pay interest on deposits, and (2) it’s a way for Morgan to reduce deposits, thereby reducing the reserves that it has to keep with the Fed.

1951: Congress enacts the Treasury-Federal Reserve Accord, which establishes the independence of the Fed and its control of monetary policy and brings repos back into favor.

1953: Canada’s central bank begins using repos as an instrument of monetary policy. 

1969: Short-term interest rates reach new heights, and that spurs investor interest in making more repo loans.

1974: Rising rates and ballooning U.S. debt fuel the repo market. From “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University, March 23-24, 2012:

During the period of high inflation in the 1970s and early 1980s, rising short-term interest rates made repos a highly attractive short-term investment to holders of large amounts of idle cash. Increasing numbers of corporations, local and state governments, and at the encouragement of securities dealers, even school districts and other small creditors started depositing their idle cash in “repo banks” to earn interest rather than depositing money in commercial banks that did not pay interest on demand deposits.

Furthermore, the U.S.Treasury started borrowing heavily after 1974, eventually changing the status of the U.S. from a creditor to a debtor nation and increasing the volume of marketable Treasury debt significantly. This led to a parallel growth in government securities dealers’ positions and financing, and the repo market grew by leaps and bounds.

The flow of credit through the financial markets becomes increasingly dependent on U.S. Treasuries, because they make safe repo collateral.

1975: The Fed resumes repo transactions with member banks.

1982: The failure of a securities dealer active in the repo market causes panic. From a New York Fed report:

The prospect of a chain of failures was particularly worrisome: “There are hundreds of [repo] transactions out there that look safe until one participant goes under.” … Faced with an impending crisis, the Federal Reserve Bank of New York reminded market participants that it stood ready to act as a “lender of last resort” to assist the commercial banks in meeting “unusual credit demands related to market problems.”

The panic forces the industry, prodded by the New York Fed, to make important improvements in its repo contracts, and that increases the popularity of the market. 

1983: From “Retail Repurchase Agreements: Overcoming Insecurity within the Securities Laws” by Gabrielle Sigel, 1983:

Since 1969 bank issues of wholesale repos have blossomed, sustaining a 24 percent average annual growth rate. This growth is attributed to the higher interest rates of the past 15 years, the continued prohibition against interest payments on corporate demand deposits, and technological advancements which facilitate cost-efficient, short-term transfers of commercial paper.

1984: Federal Reserve officials and securities dealers get Congress to pass a law that exempts repos from a repo borrower’s bankruptcy if they are collateralized by Treasuries, securities issued by federal agencies like Fannie Mae, bank certificates of deposit and bankers’ acceptances. In other words, repo lenders who hold these types of collateral will be repaid before other creditors when a repo borrower files bankruptcy. This law increases the popularity of repos with lenders. Volcker wrote his 1982 letter, mentioned above, to support this legislation.  

1985: The Federal Reserve encourages the development of today’s tri-party repo market, which has become popular as an efficient way to repo, with a clearing bank handling the mechanics of the transactions for borrowers and lenders.

1986: Commercial banks increasingly embrace the repurchase market. From “The Behavior of the Bank Repurchase Agreement Market: 1981-1983” in the Journal of Applied Business Research, Winter 1986-1987, by George W. Kutner:

The repurchase agreement (repo) market is one of the most important markets to the banking industry. It acts as a major source of short-term funds for banks as well as a vehicle for managing their liability positions and obtaining liquidity. Use of this market has increased. Outstanding repos of all commercial banks has grown approimately 20 percent annually since 1969 with over $50 billion of commercial bank repos outstanding today.

1991: One-fourth of overnight borrowings by large traditional banks is done on the repurchase market, according to the Federal Reserve Bank of Richmond.

1993: The Federal Reserve Bank of Richmond publishes a book about money market instruments and says repo, which it pictures as a busy and thriving area of finance,  is one of the most important instruments of the money markets.

The same report tracks the growth in U.S. repo volume for the Fed’s securities dealers from $65 million in 1981 to $629 million in 1992. (RepoWatch editor’s note: These dealers’ repo volume will peak in 2008 at $4.6 trillion. Today it stands at $2.64 trillion.)

1997: Japan and the UK begin using repos as an instrument of monetary policy

1998: Tri-party repo begins offering a new service called GCF (General Collateral Finance) Repo, which adds another element of efficiency because it accepts any kind of qualified security as collateral, including Fannie Mae- and Freddie Mac-guaranteed mortgage securities, rather than requiring a certain security.

1998: This is the year of the Russian debt default and the collapse of the giant Long Term Capital Management hedge fund. The repurchase market plays a key role in the turmoil. The Federal Reserve arranges for a consortium of banks to rescue the fund.

1998-1999: The Federal Reserve formalizes its policy of not using its authority to restrict mortgage lending by companies it regulates. Fannie, Freddie and others nearly double their  issuance of mortgage-related securities. 

1999: The European Monetary Union is founded, with repos as a fundamental instrument of monetary policy. 

1999: The Federal Reserve begins using tri-party arrangements for its repos.

1999: The Bank for International Settlements publishes an in-depth look at central-bank use of repos, “Implications of repo markets for central banks.” The largely supportive study nevertheless identifies important risks.

1999: The Gramm-Leach-Bliley Financial Services Modernization Act makes the Federal Reserve the primary regulator for U.S. bank holding companies, which under this law can engage in a variety of financial businesses. Subsidiaries and affiliates of these holding companies conduct most U.S. repo transactions. 

2000-2001: The Federal Reserve dramatically drops short-term interest rates after the dot.com and telecom busts in 2000, thereby spurring more repo borrowing. After the terrorist attacks of 9/11/2001, it takes historic steps to keep the stricken repurchase market alive.  

November 26, 2001: Fannie Mae introduces its Benchmark Repo Facility, to stimulate the repo market for its mortgage securities by lending them overnight. The low rates and surge of collateral are boosts for the repo market and the Fed’s securities dealers.

2005: Congress passes a law that exempts repos collateralized with mortgage-related securities from a repo borrower’s bankruptcy. This extends the scope of the bankruptcy exemption that Congress granted to repos in 1984, with support from Paul Volcker. It gooses both the repo market and the housing market, by making lenders eager to make repo loans collateralized with mortgage-backed securities. Mortgage-backed securities join U.S. Treasuries as some of the most valued collateral for repo loans.

2007-2010: The housing bubble bursts. The Federal Reserve, the FDIC and the U.S. Treasury temporarily put a safety net in place for shadow banks, to halt multiple runs. They insure money market fund deposits, and they pour money into the financial markets through two dozen emergency programs, including the Primary Dealer Credit Facility and the Term Securities Lending Facility which specifically target the repurchase market.  They say they will do whatever it takes to keep credit flowing. Fed Chairman Ben Bernanke and Timothy Geithner, then president of the Federal Reserve Bank of New York, say their biggest fear is for tri-party repo.

2012:  Financial firms borrow $2.6 trillion on the U.S. repo market every day.  Roughly two-thirds of the loans are collateralized by U.S. Treasuries and one-third by mortgage securities insured by agencies like Fannie Mae and Freddie Mac. Congressional efforts to reduce U.S. debt and eliminate Fannie and Freddie would shrink the supply of safe collateral for repos, and that would have implications for the flow of credit in the U.S. and the Fed’s conduct of monetary policy.

From “The Fed” by Martin Mayer

In 2001, seven years before the 2008 panic, financial writer Martin Mayer took a critical look at “the inside story of how the world’s most powerful financial institution drives the markets” in his book “The Fed.” Following are some insightful passages:

To say that central banks must now seek their objectives through the market rather than through the banks masks the essential change. Securitization, derivatives, worldwide markets, and the vastly increased liquidity of once non-marketable assets … have made the idea of the ‘quantity’ of money a historical curiosity, like belief in a flat Earth. Credit may be amorphous, but credit risk is specific, and leverage – the fraction of the money at risk that the lender or investor or speculator must repay to his creditors – continues to rise. Henry Kaufman worries that securitization and derivatives will act as rubber bands allowing the sytem to keep stretching as the central bank pulls at it; an equal worry is that the chaos theoreticians may be right, and that a system where receipts and payments are tightly bound together may shatter beyond easy repair if a minor event far away – the Indonesian butterfly’s wings feared by the chaos maven – leads with awesome inevitability to systemic disaster.

As the Asian crisis of 1997 demonstrated, much of this risk remains with the banks.

*****

It was while the European central banks were in retreat that the Federal Reserve in fall 1999 sought and gained new powers and new responsibilities, winning a war with the Office of the Comptroller of the Currency that had been fought in the battlefields of Congress for more than 60 years.

*****

What central banks do for a living is, they prevent systemic failure. … Among the oddities of the 1990s has been the rise of a school of thought holding that there is no systemic risk in finance – that the markets will rebalance quickly if only governments will permit the foxes of economic growth to eat the lame ducks of unwisely sunk costs.

*****

The lesson from (the failure of Franklin National Bank in New York in 1974) was that in the modern world the big losers from a bank failure were likely to be the borrowers. One way or another, the creditors get taken care of, but the builder who has arranged a loan from the failed bank finds that no other bank will pick it up….

*****

In the United States, the deposit insurer is now the lender of last resort to the banks, and the central bank is the lender of last resort to the markets. …

Politically and economically, this is an enormously important phenomenon. Both the fixed-income markets and the stock markets have come to rely to an unprecedented degree on a safety net from the Federal Reserve.

*****

In 1981-1982, as a member of the finance committee of Ronald Reagan’s National Commission on Housing, I became one of the authors of the plan by which housing could be financed with real estate mortgage investment conduits, permitting pension funds and mutual funds to get in and out of housing investments, and permitting Wall Street houses to slice and dice mortgage paper that carried an implicit government guarantee. The bankers created innumerable “tranches” that could be sold separately to risk-averse investors and risk-seeking speculators, hedged to reduce the dangers of changes in interest rates, or rolled over in repurchase agreements to multiply both risks and rewards. It is by no means clear that the future will regard this system of home finance as a good idea.

*****

The health of the economy in the 1990s, and Chairman Alan Greenspan’s ability to change Fed policies at the margin to match the incremental changes in the economy, have masked the great truth that conceptually – looking ahead as central banks are supposed to look ahead – we no longer understand what we are doing.

*****

In the end, then, seeking risk reduction, the Fed and the Bank for International Settlements recommended an emphasis on bilateral netting between participants in the markets rather than multilateral netting through the clearinghouses. … It felt safer, because the raw numbers of monies passing through the clearinghouse were lower, but in real life two-party netting and the reduction of flows through the clearinghouse would eventually become a threat to the system.

*****

In 1994, mathematically inclined analysts were selling large foundations and hedge funds on the proposition that their computers could promise a return on investment in different “tranches” of collateralized mortgage obligations whether the market for such instruments went up or down. …

The mathematicians and strategists had not expected the Fed to raise rates in February 1994. Some large houses with heavy CMO portfolios took immense losses.

*****

How to regulate and supervise such “Large Complex Banking Organizations” is one of the great practical questions of our time.

*****

The belief here is that the reason why the Federal Reserve Bank of New York engineered the rescue of the Long Term Capital Management hedge fund in September 1998 was fear that the collapse of the fund would have exposed to public view the sloppy performance of the world’s great financial institutions – and the careless, trusting supervision that had permitted this overconfident crowd of Ph.D. economists, mathematicians, and gamblers to carry positions in excess of $100 billion, and derivative contracts with nominal values over $1 trillion on a capital base of less than $2 billion. …

Only a few days before the New York Fed felt it had to intervene to save (John Meriwether, chairman of Long-Term Capital Management) from losing his hedge fund, Alan Greenspan had testified to the House Banking Committee that “hedge funds were strongly regulated by those who lend the money. …”

*****

(Ed Furash, a bank consultant) likes to contrast the examinations done by the different federal agencies. “The Fed as a regulator,” he said, “adores ambiguity. The Office of the Comptroller of the Currency will say, seeing a bank that is buying collateralized mortgage obligations then putting them out for repurchase and using the cash to buy more collateralized mortgage obligations, ‘The level at which you are doing dollar rolls into CMOs is not justified by your capital.’ The Fed will say, ‘You should look and see whether your dollar rolls are compatible with safety and soundness.’

“Some bankers love it because they get more wiggle room. Others say, ‘Furash, will you tell me what the hell these guys really want.’”

And then, of course, there are the others that just don’t care. William Isaac noted that it is “very tough to do – to go into a major bank before it has obvious problems and say, you guys are making a lot of real estate loans and we are really worried about it and we think you ought to slow down. I’ve seen it, I was in Security Pacific on behalf of that board of directors, looking at what happened and why. The Comptroller of the Currency actually was calling the thing at Security Pacific five or six years before it happened, before it blew up. They kept on saying, you’re doing this, you’re doing that, and Security Pacific would write back and say – we appreciate your kind note, but frankly, we are Security Pacific – you don’t seem to understand that – and please keep in touch. That was the end of that. What are you going to do about it?”

*****

… when banks were in trouble in the early 1990s, they loaded up with mortgage paper. With loans to strong companies and loans to weak companies carrying equal capital allocations, banks were tempted to lend to weaker companies, who would pay more for the money. And banks became adept at setting up “special purpose vehicles” financed by people who would otherwise buy loan packages from them, which could originate loans with guarantees from the banks, and greatly reduce the required capital allocation against credit risk.

*****

To the extent that the (bank) examination does have an adversarial component it rests on the fact that the examiner’s task is to form a view of whether in fact the bank can carry out its plans as presented. Who are the counterparties for the “credit derivatives” which save the bank from defaulting borrowers? How much funding will be lost with a decline of value in the bonds temporarily owned by those with whom the bank has “repurchase agreements?” What protection does the bank have against severe fluctuations in the value of long-dated currency options? Will the models work?

*****

One comes back to the simple truth that leverage is dangerous, whether it is excessive margin in the stock market or inadequate capital in banks or daisy chains of repurchase agreements that monstrously enlarge the structures that can be raised on small foundations.

*****

The fact is that large American banks keep four sets of books: one for the internal management information system, which hopes to keep the bosses informed of what’s happening; one for the regulators; one for the Internal Revenue Service; and one for the stock holders.

Peter Fisher, who runs the desk that makes flesh of the Federal Open Market Committee words says that “Every time somebody publishes a period-end balance sheet, required by the SEC, it’s a lie.”

*****

Greenspan, who was a fierce defender of bank secrecy in his first years at the Federal Reserve, has become a public proponent of greater transparency. … But the fact is that in the area where the activities of banks are the most opaque – over-the-counter two-party derivatives trading – the Fed has stood with the industry to fight off meaningful disclosure. Even disclosure to the examiners has been curtailed, as banks are permitted to determine the riskiness of their own portfolios for purposes of measuring capital adequacy.

A major reason why the banking system has become increasingly opaque is the regulators’ encouragement of bilateral “netting” arrangements, by which two parties that have several derivatives deals with each other can simply compare their winning and losing positions and establish a net number for that moment in time.

*****

We live in a time when the Pandora’s box of capitalism, so feared for so long, releases mostly good things, and people will, as David Frost suggested, think well of the Fed.

Yet it can blow up. … The tragedy for all of us would be if the Fed’s and the Treasury’s and the Congress’s reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don’t know what they’re doing.

This post is a transcript of  a 12-minute talk RepoWatch editor Mary Fricker gave at the annual conference of Investigative Reporters & Editors in Boston June 15, 2012. 

Shadow banking was the epicenter of the financial crisis. Almost no reporters understood it then and not many understand it now. But it is important because it probably provides half the credit in this country, and we’ve seen how dangerous it can be, so we need to know how to cover it going forward.

(Slide 1)

To give you an overview, I’m going to describe five steps to shadow banking, starting with the step you already know, about home loans. As I go along, I’ll suggest some local stories you can do as soon as you get back to work.

But first let’s ask: What is banking?

“Banking” is what a bank does when it borrows short term, like from a depositor, and lends long term, like for a 30-year mortgage. That’s dangerous, because if lots of the depositors suddenly get scared and demand their money back right now – this is called a run on the bank – the bank can’t repay them because its money is tied up in 30-year mortgages. Pretty soon the depositors can force the bank into bankruptcy.

That’s why we have FDIC insurance – so depositors will feel safe and not run on their banks.

Shadow bankers make loans, too, like traditional banks do. But shadow bankers don’t get their money from depositors. They borrow it from Wall Street.

For Wall Street lenders to feel safe, they usually lend for brief periods, often just overnight, and they take securities as collateral, mainly U.S. treasuries, bonds and stocks.

For shadow banking to work, there must be securities.

If Wall Street lenders lose faith in those securities and panic, they will demand their money back. That’s a lot like a run on a bank. If the shadow bank can’t pay back the money, right now, the Wall Street lenders can force it into bankruptcy.

That’s what happened in 2007 and 2008.

Little has changed. It could happen today. It’s happening in Europe right now.

So shadow banking is banking that happens outside traditional deposit-based banking. (Its name came from economist and PIMCO executive Paul McCulley during remarks at the Fed’s annual symposium in Jackson Hole, Wyoming, in August 2007, and it has since been widely adopted by economists.)

Who are these shadow bankers and Wall Street lenders?

(Slide 2)

Here’s a list:

Asset management firms
Bank holding companies
Banks, investment
Banks, traditional
Companies, public and private
Exchange-traded funds
Hedge funds
Insurance companies
Money market funds
Mortgage servicers
Municipalities
Mutual funds
Pension plans
Private equity firms
Securities dealers
Securities lenders
Securitizing firms
Sovereign wealth funds
University endowments
Fannie Mae and Freddie Mac
Federal Home Loan Banks
Federal Reserve and other central banks

If you cover any of the institutions on this list, you need to be watching their shadow banking. Most make financial reports that are public. In our handout are several examples.

These are mostly giant institutions. Many are both borrowers and lenders on the shadow banking market. Notice that traditional banks are also shadow bankers.

Much of the action in shadow banking is driven by the institutions that have big pools of cash they need to invest – like money market funds, insurance companies, hedge funds, pension plans, municipalities, even university endowments.

The purpose of shadow banking is to get those big pools of money down to the consumers and businesses who want to borrow it. I’ll show you how that’s done, in the five steps I’m going to tell you about.

Where do these companies get their big pools of money?

From you, and from your readers and viewers. At IRE we always say Follow the Money. In shadow banking, the money comes from you and your readers – in money market funds, pension plans and so on – and it goes to you and your readers, when you buy a house or a car, or get a student loan, for example.

With that as background, here are the five steps of shadow banking that I want to tell you about:

(Slide 3)

1. Make loans.
2. Make securities (this is called securitization).
3. Sell securities.
4. Insure securities.
5. Keep securities to lend and repo.

Along the way, we’ll talk about six kinds of shadow-banking transactions*:

(Slide 4)

1. Asset-backed securities – ABS
2. Collateralized debt obligations – CDO
3. Asset-backed commercial paper – ABCP
4, Credit default swaps – CDS
5. Securities lending – SecLend
6. Repurchase agreement – Repo

(Slide 5)

Step One: Make loans.

First, a company makes a loan to a consumer or a business. Mostly what you’ve heard about was home loans, because they’re the ones that blew up. But there were also lots of other kinds of loans.

(Slide 6)

Here’s a list:**

Aircraft leases
Auto loans
Auto leases
Commercial real estate
Computer leases
Consumer loans
Credit card receivables
Equipment leases
Equipment loans
Franchise loans
Healthcare receivables
Health club receivables
Home equity loans
Insurance receivables
Intellectual property cash flows
Manufactured housing loans
Mortgages, commercial
Mortgages, residential
Motorcycle loans
Music royalties
RV loans
Small business loans
Student loans
Trade receivables
Time share loans
Tax liens
Viatical settlements

Companies making these loans are traditional banks, mortgage lenders, finance companies, credit card companies, and others.

Step Two: Make securities.

The company that makes the loan sells it to another company that I’m going to call a securitizing firm. There are many different kinds.

(Slide 7 )

Here’s a list:

Conduit
Special purpose entity – SPE
Special purpose vehicle – SPV
Structured investment vehicle – SIV
Trust
Variable interest entity – VIE

These firms have mainly one purpose: Pool a bunch of loans together and make securities backed by the loans.

The securities are called asset-backed securities. In a more complicated form, they’re called collateralized debt obligations or CDOs. CDOs were responsible for many of the losses in the financial crisis. A lot of these securitizing firms are offshore, but you may have one near you. I do.

Step Three: Sell securities.

Where does the securitizing firm get the money to buy the loans from the lending company? Mainly it sells three things.

First and second, it sells the asset-backed securities and the CDOs.

What few of us understood until it was too late was that a lot of the buyers are big investment banks and traditional banks. So when the crisis hit, the big banks got stuck with the losses. If real investors had been buying these things, and lost money, who cares? Investors lose billions of dollars every day. But when banks lose billions of dollars, that’s a crisis.

If you cover banks, you need to be watching their financial statements for this.

The third way the securitizing firm gets money is this: It sells asset-backed commercial paper, which is a kind of IOU that it promises to buy back real soon, probably tomorrow. Many of the buyers of this asset-backed commercial paper were money market funds. In the crisis, they panicked, and they stopped buying it. That was called a run on the asset-backed commercial paper market, and it was a big reason for the financial crisis.

If you cover money market funds or personal finance, you need to be watching for this.

Step Four: Insure securities.

By this point in our steps, a lot of companies own asset-backed securities, CDOs, and asset-backed commercial paper. The securitizing firms own some, and they’ve sold a lot to others. Companies that own securities often buy derivatives called credit default swaps to protect themselves. Credit default swaps pay off when securities default. They’re like insurance. Companies that don’t own securities also buy credit default swaps, to speculate. Often the same company both buys and sells these swaps.

That’s one reason shadow banking is so interconnected. AIG was the most famous collapse caused in part by credit default swaps.

Step Five: Keep securities to lend and repo.

Now if you’re a big company or bank sitting there holding a lot of securities, probably including U.S. Treasuries but also asset-backed securities, CDOs and asset-backed commercial paper – you’re collecting the interest payments, and you’re protected by credit default swaps – your busy mind will start trying to think of ways to use those securities to make more money.

In shadow banking there are two main ways: Securities lending and repurchase or “repo” agreements.

In securities lending, companies briefly lend securities to other shadow bankers in exchange for cash, often just for overnight. AIG lost almost as much money on its securities lending as it did on its credit default swaps.

In a repurchase agreement, companies use securities as collateral to get a loan from another shadow banker, often just for overnight.

Now, at this step in shadow banking something interesting happens. In a securities lending transaction or in a repurchase transaction, somebody gives cash and gets back securities. Whoever gets the securities can re-use them as collateral to get their own repo loan. Then the second repo lender can re-use the same securities as collateral to get a repo loan for themselves. And so on.

(Slide 8)

This is a daisy chain where the same securities become collateral for several loans. It’s called rehypothecation. It’s another reason that shadow banking is so interconnected.

Although repo loans are often made just for overnight, usually that loan gets renewed day after day. But at any time the repo lender can call the loan.

Companies that borrow on the repurchase market are often in danger, because their lenders can disappear overnight. We should be watching financial statements for repurchase loans.

In the financial crisis, repo lenders freaked out over the quality of the home loans that were in the securities that they’d taken as collateral. They called their loans. Some economists have called this a Run on Repo. Bernanke and Geithner have said this was the thing that scared them the most during the financial crisis.

(Slide 9)

And that’s the basics of shadow banking. It can get a lot more complicated than that, but that’s the basics.

Since the crisis, shadow banking has fallen by more than one-fourth. This is an important reason our economy is struggling and it’s hard to get a loan. But shadow banking will be back.

That’s the end of my 10 minutes. But I’d like to take just two more minutes to tell you a little bit about repo, which is my specialty. 

The repurchase market

Repos are the heart and soul of shadow banking, because they’re usually the cheapest way for big borrowers to get quick cash and the safest way for big lenders to lend.

Before the crisis, when shadow bankers bought asset-backed securities, CDOs, asset-backed commercial paper or credit default swaps, they often paid for them by getting a repo loan.

At the time of the crisis, at least $5 trillion was changing hands every day on the U.S. repurchase market. The main borrowers were companies like Countrywide, Bear Stearns and Lehman Brothers. The main lenders were, and still are, prime money market funds.

The Federal Reserve also has an interest in repos, because it has conducted its monetary policy transactions largely on the repurchase market, as do most central banks.

In the U.S., the securities that companies use as collateral for a repo loan are usually U.S. Treasuries and other government-backed securities. So the lender feels safe. But in the lead-up to the financial crisis, more and more of the collateral was asset-backed securities, CDOs, and asset-backed commercial paper.

Today the repo market is 40 percent smaller, in part because of the bad economy but also because there are not as many securities to use as collateral.

But bankers are out there right now looking for the next great repo collateral.

It better be safe. We need to be watching this. I hope you’ll start developing your sources right now.

*-These are securities for sale:
1. Asset-backed securities – ABS
2. Collateralized debt obligations – CDO
-This is a borrowing of cash pretending to be a security for sale:
3. Asset-backed commercial paper – ABCP
-These are derivatives:
4, Credit default swaps – CDS
-This is a loan of securities:
5. Securities lending – SecLend
-This is a borrowing of cash pretending to be a sale of securities
6. Repurchase agreement – Repo

**From “Securitization” by Yale University professors Gary Gorton and Andrew Metrick.

Updated June 18, 2012

RepoWatch recommends the following reports.

Search for the topics that interest you: DataWatch, International repo market, Money market funds, Regulation, Repurchase transactions, Securitization, Shadow banking, Too big to fail, and Tri-party repo. Items are arranged chronologically, within topics that are listed alphabetically.

DataWatch

“3-Tier System Recommended for Issuing Global Identifiers” by Tom Steinert-Threlkeld, Securities Technology Monitor, June 8:

The Financial Stability Board will recommend to the G-20 industrial nations that a three-tier structure involving local registration authorities be established for registering and issuing 20-character codes that will identify participants in financial transactions, worldwide. …

A central database of the identifiers is seen as fundamental to helping regulators watch for risks to the global financial system. A 20-character code has been set out as the basis for the code, known as a Legal Entity Identifier, by the International Organization for Standardization; and, backed by the FSB, which has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies. …

A number of different technology and communications organizations are expected to vie to operate the Central Operating Unit.

“A Global Legal Entity Identifier for Financial Markets” by the Financial Stability Board, June 8:

The FSB strongly supports rapid implementation of the global LEI system. Early delivery of  the system would advance multiple G-20 financial market initiatives and benefits to the global regulatory community as well as to the private sector.

The FSB recommends adoption of an implementation plan with the goal of establishing an independent, open, fair and transparent global LEI system by the end of 2012 with the system independently functional by March 2013. …

The attached report sets out the recommendations and implementation plan.

International repo market

“In Europe, Banks Borrowing to Stay Ahead of the Tide,” news analysis by Landon Thomas Jr., The New York Times, June 10, 2012:

At the root of the issue is a simple fact: just like the countries in which they operate, most European banks are highly leveraged entities. They are heavily dependent on borrowed money to operate day to day, whether making loans or paying interest to depositors.

For decades, the loans that European banks made to individuals, corporations and their own spendthrift governments far exceeded the deposits they were able to collect — the money that typically serves as a bank’s main source of ready funds. To plug this funding gap, which analysts estimate to be about 1.3 trillion euros, European banks borrowed heavily from foreign banks and money market funds. That is why European banks have an average loan-to-deposit ratio exceeding 110 percent — meaning that on any given day, they owe more money than they have on hand.

Money Market Funds

“Liquidity in European Money Market Funds – Structural Improvement But at a Cost” by Charlotte Quiniou, Alastair Sewell, and Richard Woodrow, Fitch Raings, May 2012:

European Money Market Funds have improved their liquidity profile following the 2008 crisis and the subsequent amendments to regulation and rating agencies’ guidelines. This improved liquidity acts as a buffer to the volatility in investors’ flows. It nevertheless comes at an opportunity cost for those investors who have part of their foreseeable liquidity needs with relatively longer term horizons and therefore do not take full advantage of the liquidity mutualisation offered by short-term MMFs. …

All else being equal, highly liquid portfolios will have lower yields than less liquid ones. Maintaining a high degree of liquidity costs about 20bp to 30bp of yield to a fund …

Regulation

“U.S. Moves Forward on Implementing Global Bank Rules” by Yalman Onaran and Jesse Hamilton, Bloomberg News, June 8:

The Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency yesterday published a revised version of rules that were decided in 2009, dictating for instance how much capital banks need to back mortgage-linked securities. The regulators also proposed another set of rules that will translate for U.S. lenders a more fundamental overhaul of the capital regime drawn up by the Basel Committee on Banking Supervision in 2010.

Each Basel committee nation must write rules comporting with the decisions of the 27-member body, and the 2009 revisions were supposed to take effect last year. U.S. regulators were delayed as they merged the Basel regime with the 2010 Dodd-Frank Act and had been criticized by the European Union for falling behind. …

The Fed estimated the banking industry would face a capital shortfall of almost $60 billion if the proposed capital buffers of Basel III were in effect today. That compares with a Basel committee survey’s finding that the largest global banks would confront a $639.5 billion shortfall if forced to have a 7 percent core capital buffer last year. The regulators anticipate U.S. banks could meet their 2019 requirement by retaining earnings rather than raising capital.

“Protecting citizens from bank failures” by the European Commission, June 6:

The global financial crisis has demonstrated that a problem with one bank can quickly spread to the rest of the economy and to other countries. It has also become clear that EU countries don’t have the right rules in place to properly manage failing banks.

In many cases EU governments have had to spend taxpayers’ money to shore up some of the bigger banks and prevent harm to millions of customers and the financial system.

To fill in the gap, the Commission is proposing a common framework of rules to help EU countries and national regulators respond quickly and effectively to a banking crisis.

The measures would also help reduce the impact a bank failure could have on the stability of the financial markets, and limit the cost to taxpayers if a bailout became necessary.

They would shift the burden of restructuring costs and responsibility to the bank’s shareholders, creditors and any employees responsible for mismanagement.

See the Financial Times’ report on the European Commission’s proposed framework here.

“Artfully Dodging the Liquidity Coverage Ratio in Securities Lending and Repo” by Securities Finance Monitor, May 29:

Banks everywhere are focusing on the Liquidity Coverage Ratio provisions in Basel III. The provisions don’t kick in until 2015, but the observation period is in full swing and no one wants to tell their management that they missed the target.

The epicenter of the ratio at many institutions is the repo business. They can best manage the measurement and control the flows.

And, it wouldn’t be the finance sector if a number of tricks innovations hadn’t emerged to soften the blow.

Repurchase Transactions

“Moody’s Reviews Push Funds Away From Other Repo, Says JP Morgan” by Crane Data, June 11:

As of this writing, Moody’s has yet to conclude its ratings review of Global Capital Market’s Institutions and to many money market participants, this is the main event as these institutions are often the largest borrowers in the money markets, particularly through the repo market.

According to our estimates using money market fund holdings data (including government money market funds), Global Capital Market’s Institutions counterparties represented about $510 billion or 89 percent of total repo held by money market funds.

“MF Global caught up in deals tangle” by Tracy Alloway, Financial Times,   June 5:

When an industry taskforce set up by the Federal Reserve decided last year to reduce the window in which short-term “repo” trades were unwound it hoped to reduce risk in the financial system.

Instead, it might have helped push MF Global, the ill-starred broker-dealer, closer to collapse, according to a report by the bankruptcy trustee released on Monday….

The tangle of repo transactions, in the words of one unnamed MF Global executive, helped lead to a “liquidity asphyxiation” which overwhelmed the broker-dealer.

“The run on MF Global: Report of the Trustee’s Investigation and Recommendations,” bankruptcy of MF Global Inc., by trustee James W. Giddens, June 4, 2012:

Want to see what a run on repo looks like from the inside?

On October 24, Moody’s Investors Service downgraded MF Global’s credit rating to near-junk status. Then, on October 25, MF Global held its third quarter earnings call during which it announced the $119 million write-off of deferred tax assets, signaling increased doubt about near-term prospects for profitability. The next day, S&P put MF Global on “Credit Watch Negative,” and on October 27,  Moody’s cut MF Global to junk status. Together with the downgrades of MF Global’s credit rating and growing concerns about the large sovereign debt portfolio, this news contributed to a major loss of market confidence.

A classic run on the bank ensued as customers sought to withdraw their property from their MF Global Inc. accounts, while counterparties and exchanges demanded increased collateral or margin. At the same time, other counterparties declined to do business with MF Global altogether, leaving it with illiquid securities that it could not finance in the repo market or elsewhere. The rush to meet funding needs for collateral, margin and customer liquidations led to billions of dollars in securities sales, draws on credit facilities, and a web of inter-company transactions across MF Global affiliates. MF Global’s computer systems and employees had difficulty keeping up with the unprecedented volume of transactions. Some transactions were recorded erroneously or not at all. So-called “fail” transactions, where either the buyer or seller failed to deliver the cash or the security, respectively, were more than five times greater than the normal volume that week. It was, in the words of one former MF Global executive, a “liquidity asphyxiation.” …

Management estimated a loss of approximately $1 billion over the course of three to four weeks. Instead, a loss of at least one and one half times that amount occurred in a matter of a few days. The simultaneous occurrence of a customer “run on the bank” and unwinds of repo counterparty and proprietary positions within a three-day timeframe overwhelmed the Firm.

The mitigating factors were also overly optimistic. The speed at which events transpired was beyond management’s predictions – the worst-case scenario played out in the span of only a few days. Reality unfolded vastly more quickly than the assumptions and timing laid out in the presentation, which anticipated that MF Global had sufficient liquidity to survive a “severe stress event” for at least one month.

An example of the financial interconnectedness of a securities dealer’s affiliates:

The reto-to-maturity structure was as follows. MF Global UK purchased the sovereign bonds from counterparties, the trades for which settled on the LCH (clearing house). MF Global UK then sold the bonds to MF Global Inc., although the bonds remained in MF Global UK’s LCH account. MF Global Inc. recorded the bonds on its books, classifying them as securities owned in MF Global Inc.’s long inventory book. Subsequently, MF Global Inc. entered into an intercompany repo with MF Global UK (which showed a reverse repo to MF Global Inc.). Each intercompany repo was governed by the global master repurchase agreement between MF Global UK and MF Global Inc. dated July 19, 2004, as amended. On completion of the repo-to-maturity with MF Global Inc., MF Global UK entered into a further repo-to-maturity with another counterparty that also settled through the LCH.

(Update: New York Times columnist Floyd Norris gives a superior explanation of MF Global accounting, based on the Giddens report. See “Accounting Backfired at MF Global,” June 7.)

A different bankruptcy trustee, for MF Global’s holding company, issued his own detailed report June 4. It focuses on technical aspects of the case and spends less time explaining MF Global operations.

“The Eurepo curve spells trouble” by Simon Hinrichsen, Financial Times, Alphaville blog, May 29:

Sandy Chen at Cenkos has drawn our attention to an interesting development in the repo market: the Eurepo curve has inverted….

As Sober Look noted on Friday, inverted repo curves mean stress in the market, and looking at the shift in the Eurepo curve in the last month, the level of stress has gone up considerably…

“The repo market awaits” by Greg Canavan, The Daily Reckoning, May 24:

You can take comfort in the knowledge that this global mess we call a financial system is all about the banks. Successive Greek bailouts (not to mention Ireland and Portugal) were about protecting undercapitalised and essentially insolvent banks.

We’re not exactly breaking news here. But we feel we must continue to shout into the wind and maintain that this slow motion implosion of the global economy is all about the banks. …

If you think that’s overstating the issues, just give it time…you’ll see what we mean.

Because while you’re focusing on Greece or China or something else tangible, the real danger lies where you can’t see. It’s deep in the plumbing of the financial system…the repo market and derivatives. We’re convinced that the next blow-up will come from deep within the bowels of the financial system.

Securitization

“Securitisation market seeks SP clearing carve” by Risk.net, June 12:

The International Swaps and Derivatives Association said the cost of securitisation likely will increase unless special-purpose vehicles receive an exemption for clearing swaps they transact. Some regulators have said reviving the securitisation market could help stabilise the banking industry. “If SPVs are required to clear, it would make them a whole lot less viable,” said Richard Metcalfe, global head of policy at ISDA in London. “You would have to add the cost of posting margin and other clearing costs. You could add that cost to the client, but it has to come out of somebody’s pocket.” (Summary provided by the Global Financial Markets Association’s SmartBriefs.)

“European ABS industry looks to rebrand” by Mary Watkins, Financial Times, June 12:

Europe’s securitisation industry has officially launched a new labelling system that aims to revive the fortunes of a financial product that some dubbed as toxic during the US subprime crisis.

The Prime Collateralised Securities project will award a stamp of approval to high quality European asset backed securities that meet a set of criteria in terms of quality, transparency, simplicity and standardisation.

“Regulators may intervene in securitised market” by Huw Jones, Reuters, June 7:

Global regulators may intervene and iron out differences in how the United States and European Union have cracked down on lax underwriting of securitised debt, as the market shows little sign of a real revival to help fragile banks.

The International Organisation of Securities Commissions (IOSCO) said in a report for public consultation on Thursday that securitization was a valuable funding technique and an efficient means of diversifying risk. …

IOSCO said the EU and U.S. approaches appear similar but the exemptions allowed in the United States for very high quality assets may give it an advantage over Europe….

Few other countries in the world have or plan to introduce retention rules.

“China authorizes loan-backed securities” by Gao Changxin, China Daily, June 4:

China has reopened the gate on loan-backed securities, after suspending a trial in the aftermath of the global financial crisis.

China’s central bank, the People’s Bank of China, has authorized a 50 billion yuan ($7.85 billion) quota for the country’s lenders to securitize their loans. Lenders are required to submit securitization plans for regulatory approval. The quota is expected to be fulfilled by year-end and more quotas are likely to be authorized in the future.

“Afme prepares for launch of securitisation kitemark” by Farah Khalique, Financial News, May 14:

The Association for Financial Markets in Europe is planning to launch its securitisation kitemark scheme, aimed at reviving Europe’s ailing asset-backed securities market, in the third quarter of the year. The Prime Collateralised Securities Initiative will identify products that meet industry best practice criteria and will be granted and maintained by an independent third party.

Shadow banking

“Banks seek to offload risk on insurers” by Lisa Pollack, Financial Times, June 12:

Now when and where did that last happen…

In Tuesday’s Financial Times, Brooke Masters reported on a rather novel approach that some banks are trying to take in order to reduce their capital requirements. The trick is to reduce the predicted loss that would be experienced if a borrower were to default. This is effectively done by getting an insurer to guarantee the future value of the collateral held as security for the loan.

The collateral in question is, however, no ordinary collateral. It’s intangible, like patents, for example….

From this one naturally draws parallels to the monoline insurance companies’ forays into derivatives on US subprime mortgages. It turns out that particular asset class was also rather hard to value correctly — something that only became evident to many in the industry after a systemically risky amount of contracts had been written by the likes of AIG, Ambac, MBIA, and so on.

Indeed FT Alphaville is reminded of the original Fed approval for credit default swaps to reduce regulatory capital — something that the original inventors of the contracts (JPMorgan) had lobbied hard for. That led to many (unforeseen) things…

“Shadow Banking After the Financial Crisis,” a speech by Federal Reserve Board Governor Daniel K. Tarullo, June 12:

Today I want to focus on the development of a regulatory reform agenda for the shadow banking system. As those who have been following the academic and policy debates know, there are significant, ongoing disagreements concerning the roles of various factors contributing to the rapid growth of the shadow banking system, the precise dynamics of the runs in 2007 and 2008, and the relative social utility of some elements of this system. …

However, as it is neither necessary nor wise to await such conclusions in order to begin implementing a regulatory response, I will follow my discussion of the vulnerabilities created by shadow banking with some suggestions for near- and medium-term reforms….

Let me then suggest three more-or-less immediate steps that regulators here and abroad should take, as well as a medium-term reform undertaking.

First, we should create greater transparency with respect to the various transactions and markets that comprise the shadow banking system. For example, large segments of the repo market remain opaque today….

Second, the risk of runs on money market mutual funds should be further reduced through additional measures to address the structural vulnerabilities that have persisted even after the measures taken by the SEC in 2010 to improve the resilience of those funds. …

A third short-term priority is to address the settlement process for triparty repurchase agreements. Some progress has been made since 2008, but clearly more remains to be done.

In the medium term, a broader reform agenda for shadow banking will first need to address the fact that there is little constraint on the use of leverage in some key types of transactions. One proposal is for a system of haircut and margin requirements that would be uniformly applied across a range of markets, including OTC derivatives, repurchase agreements, and securities lending.

“The other fiscal cliff issu(-ance)” by Cardiff Garcia, Alphaville blog, Financial Times, June 8:

Most of the fear of what might happen if the US goes over the proverbial fiscal cliff has concentrated on the size of the economic drag it would produce.

But as you might have guessed for a blog that has long worried about the effects of a decline in safe assets on trust in financial intermediation, shadow banking liquidity, collateral shortfalls in money markets, etc… we also think it’s important to look at what it would mean for the corresponding decline in US Treasury issuance.

“Shadow-Bank Rules A Banking Union Cornerstone, Barnier Says” by Ben Moshinsky, Bloomberg News, June 7:

Proposals on shadow banking and the structure of lenders’ retail and investment arms are priorities this year as the European Union pushes toward a banking union, said Michel Barnier, the bloc’s financial services chief….

The commission “must ensure that the new financial regulation does not push certain banking activities toward the non-regulated sector,” Barnier said. Shadow banking, which includes money-market funds, securitizations and off-balance- sheet investment vehicles, represents as much as 30 percent of the entire financial system, he said.

“Shadow banking not that shadowy, says Cantor” by Securities Finance Monitor, June 4:

Cantor Fitzgerald is starting a repo conduit called Institutional Secured Funding. For those who aren’t familiar with repo conduits, they are classic shadow banking. Traditional repo conduits allow securities dealers to obtain financing for the weird, wonderful and illiquid by repo’ing in those assets and issuing asset-backed commercial paper (ABCP) to fund themselves.

(RepoWatch editor’s note: Here’s a link to the Cantor press release, courtesy of Securities Finance Monitor.)

“Cantor Plans To Enter Shrinking Shadow Banking” by Jody Shenn and Lisa Abramowicz, Bloomberg News, June 1:

Cantor Fitzgerald LP joins a growing number of financial firms offering a new version of asset-backed commercial paper that will be backed by repurchase agreements, thereby turning short-term repos into longer-term ABCP. 

Regulations are fueling some ABCP funds, with banks such as JPMorgan Chase & Co. and Barclays Plc setting up conduits to use on their own to convert repurchase-agreement, or repo, borrowing into commercial paper. New York-based Cantor’s fund, known as Institutional Secured Funding, will be open to multiple banks. …

Turning the repo into commercial paper before selling it broadens the types of buyers and makes it easier to trade. Banks also need to find financing with longer maturities amid changing regulations pending under international rules known as the Basel III accord, Roever (Alex Roever, JPMorgan’s head of short-term fixed-income strategy) said….

The assets being placed in the conduit remain on the bank’s balance sheet under accounting rules, as they would with repo agreements with other counterparties, and buyers of the commercial paper see a full list of what they are and at what prices they’re held, he said. Eligible securities include equities, U.S. corporate bonds and convertibles, Fitch said in an October report.

The Deloitte Shadow Banking Index, “Shedding light on banking’s shadows,” Deloitte Center for Financial Services, by John Kocjan, Don Ogilvie, Adam Schneider, and Val Srinivas, May 29, 2012. See press release for summary of this report.

The purpose of the Deloitte Shadow Banking Index is to define and quantify the sector over time, including its components. This ongoing effort is designed to more closely measure size, importance, effect of market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.

Too big to fail

“Derivatives and U.S. Corporations – Six Firms Continue to Dominate as Dodd-Frank Act Lurks” by Olu Sonola, Eileen Fahey, and Brian Yoo, Fitch Ratings, June 7:

Six financial services firms dominate the amount of derivative assets and liabilities carried on the balance sheets of U.S. corporates, according to a Fitch Ratings review of 100 large companies across all major industry groups.

The six firms – JP Morgan Chase & Co., Bank of America Corp., Goldman Sachs Group Inc., Citigroup Inc., Morgan Stanley, and Wells Fargo & Co. – hold an excess of 75% of the total derivative assets and liabilities in the sample reviewed by Fitch. The notional amount of all derivatives held by the 100 companies was approximately $300 trillion at year-end 2011. This has remained steady – between $290-$300 trillion – since 2009.

The notional amount of credit derivatives fell to $21.6 trillion at year-end 2011 from $36 trillion in March 2009, a 40% decline….

The Dodd-Frank Act will significantly chance the regulatory landscape of over-the-counter derivatives for both financial and non-financial firms. Fitch believes that in spite of some end-user exemptions, non-financial firms will experience increased collateral requirements and costs to comply with new regulations.

“If We Can’t Understand Them, We Should Just Break Them Up” by Rep. Brad Miller, Huffington Post, May 24:

I’ve skimmed some informed discussions at economics blogs about how JPMorgan Chase lost $2 billion and counting on their “synthetic credit portfolio.” But educated guesses are still guesses, the next big problem in the financial system will be entirely different, and to be honest, it all gives me a headache. …

So how do we avoid this grim future created by financial practices beyond the ken of lesser mortals like congressmen and regulators?

We can just break the biggest banks up. A bank would almost certainly be easier to understand, both for the bank’s managers and for safety and soundness regulators, if there is less to understand. And if a smaller bank’s management and regulator don’t understand a risk in shadow banking or derivative markets, the risk may bring the bank down, but it probably won’t lead to a “deflationary collapse” of the economy.

There is little that a $2.3 trillion bank can do that ten $230 billion banks can’t do as well or better, and banks the size of JPMC are far more than ten times the problem.

Last week Senator Sherrod Brown and I introduced the SAFE Banking Act to break up the biggest banks into banks that are small enough and simple enough to fail without bringing the financial system down. The biggest banks probably think that’s an infantile idea, and that Americans won’t support that solution to “too big to fail” banks.

Surprise, surprise, surprise.

Tri-party repo

“Disagreeing with Duffie: central US tri-party clearing utility not the right choice right now” by Securities Finance Monitor, June 5:

Two weeks ago we published on Professor Darrell Duffie’s article “Replumbing our Financial System: Uneven Progress.” Since then we’ve given the matter some more thought and want to comment on whether US tri-party repo should be centralized at a government-backed utility work, and would this be better or worse than current market practice. …

Our question is, in whatever form is central clearing for US tri-party repo the right thing to advocate? We think that the answer is no …

As financial markets convulse over the European Union once again, RepoWatch would like to remind its readers that at the heart of the problem lies the repurchase market.

Yes, some European countries spent too much money and now are burdened with too much debt. So let’s look at where they got that money.

They got it in part by selling bonds to banks, which then used the bonds as collateral to get cheap repo loans and other short-term debt for themselves. Then they used this new money to pay for the bonds and to make more loans, including on U.S. real estate. 

This finance chain fueled prosperity in Europe for a decade, ever since the European Monetary Union was founded in 1999 with repos as a fundamental instrument of monetary policy. 

It was easy for governments to borrow and easy for banks to build up substantial short-term debt – all on the assumption that the European Central Bank and the European Union would never let a country fail because the impact on banks and the financial markets would be catastrophic. 

Now many lenders are jittery, threatening to flee or already gone. Sovereign debt values are falling. Banks are choking, and some are relying on central banks for survival.  Financial armageddon looms ….

There’s something drearily familiar about all this. Homeowners in the U.S. and other countries borrowed too much money because they could, thanks to securitization and repos. American college students borrowed too much money because they could. European governments borrowed too much money because they could. Giant banks borrowed too much money because they could. And then one day they couldn’t. 

Economists Peter Boone and Simon Johnson explained the flaw in the European market in “Europe on the Brink,” in July 2011 and updated their thinking May 28, 2012, with “The End of the Euro: A Survivor’s Guide.” 

From “Europe on the Brink”:

Key rules regarding money creation in the euro area explain the current dangerous situation.

Since its founding, the European Central Bank has used repurchase operations as a major tool of monetary policy. In practice, this means that the 7,856 banks (monetary financial institutions at the end of 2010) in the euro area are able to buy sovereign debt of any euro area member nation and then present these to national central banks, which act on behalf of the ECB, as collateral for new finance. The ECB set collateral rules that made short–term paper more attractive than long–term paper (Buiter and Sibert 2005, 7-14).

Initially the Bank also treated all nations equally, regardless of credit ratings. Later it adjusted collateral requirements for nations to reflect their credit ratings, although these adjustments were minor.

As a result of this system, it became very profitable for banks to buy short–term government paper and deposit that paper with the ECB in return for loans. The margin between the returns on the government paper and ECB lending rates became profit for the commercial banks.

This system generated three major developments that have contributed to the build–up of risk.

First, the ECB repo system made government bonds highly liquid, because a buyer could always turn to the Bank for funds. This increased market access for smaller European nations that would otherwise have had difficulty issuing a great deal of debt.

Second, while the ECB did not promote this explicitly, investors grew confident, with good reason, that the Bank and the European Union would never let a sovereign fail. There were good reasons to believe this. All major European banks built up substantial portfolios of short–term sovereign debt and sovereigns, in turn, issued more of this debt. It became very clear that sovereign defaults could be catastrophic for the banking system, and so would be very unlikely to occur.

Finally, the system became even more dangerous as many banks went on a credit expansion spree. European banks issued short–term bonds in order to finance additional long–term loans. This was possible because the balance sheets of banks were filled with assets that could be used as collateral at the ECB. Investors concluded that banks would not have liquidity problems given their ECB access, and they assumed that if solvency issues arose, governments or shareholders would be prepared to inject capital to prevent defaults.

Read RepoWatch’s August 15, 2011, review of the Boone/Johnson report and comments from others here.

Boone is a visiting senior fellow at the London School of Economics and a former investment banker. Johnson is a professor of entrepreneurship at MIT’s Sloan School of Management and a former IMF economist. Both are senior fellows at the Peterson Institute for International Economics.