The exemption means that when a repo borrower goes bankrupt, the repo lender does not have to join the other creditors dividing up the remains.
The purpose of the exemption was to prevent troubles at a bankrupt company from infecting the financial system. In other words, the purpose was to prevent systemic risk.
But some experts claim the exemption increased systemic risk, because it spurred lenders to do more repo lending, it let repo lenders ignore risk in their lending decisions, and it protected them from their bad decisions.
Enrico Perotti, professor of international finance at the University of Amsterdam, thinks it’s probably impossible to repeal the exemption, but he thinks banks at least should have to pay for it.
From his October 2010 paper for the Centre for Economic Policy Research:
The natural question is: “How did bank funding become so fragile?”
Liquidity risk grew explosively in the last decade with disintermediation, globalisation and relaxed Fed policy since 2001. The process accelerated in the last years, with the explosive growth of the repo market, which shortened maturity to its logical extreme, namely overnight. But why did repo financing explode so fast?
An important cause lies in new bankruptcy privileges created in 2005 in both the US and Europe under heavy bank lobbying. These privileges were granted to overnight secured credit and derivatives, and essentially allowed these lenders to ‘front run’ all other investors in case of default. This made such lending safer for the lenders, and thus cheap for the borrowers. The result was fantastic growth of unstable funding to the detriment of stability. A funding source which can front run all other lenders, and thus bear no risk is not just cheap, it is unconcerned about credit risk. Thus, short-term funding first enabled excess credit for both banks and shadow banks, acting as steroids to feed the securitisation wave, then rushed out scot free, leaving inattentive regulators and taxpayers to pick up the losses.
Perotti explains his tax idea:
It is certainly legitimate for some investors to insist on an extraordinary level of protection. Yet if in systemic events this construction shifts risk to other parties and ultimately to the financial system, it is appropriate that they pay for the privileges.
He suggests taxing the bankruptcy exceptions by a “significant amount,” perhaps 10 basis points.
On another point, Perotti thinks higher capital requirements, as proposed by Basel III, would have been helpful during the financial crisis, but he doubts they could have stopped the run on the repurchase market.
Higher capital ratios would have been helpful but are surely not enough to contain runs when 90% of funding has a funding maturity of just a few days.