Regulators at the Bank for International Settlements in Basel, Switzerland, published a report in September on ways that the clearing and settlement of repo transactions can be improved in light of the crisis in 2008.
Washington, D.C. bank consultant Karen Petrou told her clients in a newsletter September 24 that the Basel study was likely to influence the Financial Stability Oversight Council’s thinking as it decides how to regulate financial institutions it believes could destabilize the U.S. financial markets.
Among her comments:
Although little remarked upon in the press, they (repos) are a vital part of financial-market infrastructure. Thus, we think repos are sure to be fingered as a systemic-risk activity once the FSOC gets down to work. The new repo regulatory regime will have far-reaching impact on both clearing banks – at considerable strategic risk in the short term – and on the financial system – poised for renewed crises if the repo rules aren’t right….
Repos played a major role in the Lehman debacle because the market had – and sadly still has – few internal checks to corral counterparty flight when a major financial firm falters. And, when the repo market freezes, the rest of us get frostbite. One reason global finance went catatonic in the fall of 2008 was the sudden collapse of the repo market, which forced all of the players in it to cover bets with funds that otherwise would have supported liquidity throughout the global financial system.
The Basel study identified seven issues that analysts felt could affect the resilience of repo markets and discussed ways clearing banks, central counterparties and other structures could improve repo markets:
(1) the risks related to the extension of significant amounts of intraday credits within some repo settlement arrangements;
(2) the lack of transparency of some repo infrastructure roles, responsibilities, practices and procedures;
(3) concerns regarding protection against counterparty credit risk in repo transactions;
(4) inadequate capabilities for liquidating repo collateral in the event of a cash borrower’s default;
(5) the inefficient use of (high-quality) collateral due to constraints within repo clearing and settlement arrangements;
(6) procyclical effects of certain risk management practices; and
(7) a lack of transparency in the repo market.