The key developments in banking in the past 30 years are the rise of securitization and collateralized finance, primarily repurchase agreements, according to Lorenzo Bini Smaghi, a member of the executive board of the European Central Bank, speaking at the Barclays Global Inflation Conference in New York City June 14.
Even though these are the elements that failed in the financial crisis of 2007-2008, Smaghi believes collateralized finance will become even more important to worldwide financial markets in the future. If securitization does not revive, sovereign debt could become the leading collateral for repurchase agreements, he said.
From his speech:
The core of financial intermediation has moved from depository institutions – commercial banks – to a hybrid aggregate of institutions and functions, which is broadly referred to as the shadow banking system. The rise of the shadow banks, their ups and their downs, are inseparably connected with a key financial innovation of the last 30 years: securitization. …
Why was securitization so essential to the expansion of shadow banks? The short answer to this question is that shadow banking serves as an intermediary for wholesale finance. In this segment of the financial system, lenders have large – and lumpy – financial resources to place with intermediaries for short periods of time, with no protection from formal deposit insurance mechanisms. This lack of formal insurance – since deposits are too large to be eligible for protection under national laws – calls for an informal or – I should rather say – market-based system of protection. This is precisely what the securitization of assets can do: it can give financial intermediaries enough tradable securities to pledge as collateral for the large – lumpy – loans that they receive in the wholesale shadow-banking segment of their activities. …
In order to finance the large increase in their securitization business the banking system had to draw on a larger pool of financial resources than retail deposits could offer. But that shift also caused, independently, an increase in securitization because the lending of large sums to shadow banks needed – and needs – marketable collateral….
So, securitization received a formidable boost as banks used it to generate the securities which were required to finance its overall business….
A large portion of the financing of the shadow banking system takes the form of repurchase agreements (repos), which work much like deposits. The wholesale lender deposits a large sum with the shadow bank for a very short term, perhaps overnight. As this callable claim cannot be covered by formal deposit insurance, it needs to be protected by collateral. …
Data on activity in the repo market are limited. But we know the volumes are large. The business model of the hedge fund industry relies on financing their highly-leveraged activities via the repo market. Repo activity will therefore exceed their already substantial leverage positions. Moreover, as reflected in the recent analysis of Gorton and Metrick (2009), information can also be gleaned from the balance sheets of broker dealers and investment banks. For example, approximately 80 percent of the balance sheet of investment banks such as Lehman Brothers and Bear Stearns in 2007 – that is, before the the crisis – was funded by volatile, short-term instruments. It was this balance sheet structure that, in the end, made these two banks extraordinarily vulnerable to a sudden withdrawal of liquidity in the wholesale funding market and which ultimately led to their demise. Note that more than one-third of this short-term debt was collateralised, that is acquired in the repo market.
To sum up, we have seen the relentless rise of collateralised finance. …
Collateral is likely to play a growing role in the functioning of capital markets. Demand for collateral is thus likely to increase. But, given the collapse of securitization activity during the crisis, we could imagine that the current decline in the creation of securitized assets might become a permanent feature of the new landscape. There will be fewer asset-backed securities created out of bank books.
Sovereign debt will certainly be widespread. It will probably replace asset-backed securities in the collateralisation of secured lending.
In this approach, Smaghi takes a different view from economists like Carolyn Sissoko who worry about the false sense of security that collateral gives repo lenders.
From Sissoko’s “The legal foundations of financial collapse” published October 6, 2009:
Financial markets are likely to be healthier when uncollateralized contracts are the norm. In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty.
When unsound counterparties are shunned, the business of well-managed firms grows and the business of poorly managed firms shrinks.
Thus in an environment with uncollateralized contracts the natural dynamics of the financial system will tend to reduce leverage and promote stability. This stands in stark contrast to the dynamics generated by a financial system that relies on collateral.
Sissoko acknowledges that the repurchase market is far too large to disrupt by preventing major banks from participating. Instead, she recommends doing away with the bankruptcy exemption that favors repo lenders over many other creditors if their borrower files for bankruptcy.
Collateral is intrinsic to the market for repurchase agreements and this market is far too large to disrupt by prohibiting the participation of large financial institutions. On the other hand after the recent turmoil, it should not be difficult to remove the safe harbor protection for repos of less liquid assets – effectively, it is advisable to repeal those sections of the 2005 Bankruptcy Act that apply to repurchase agreements. The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets. As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.