Kling doubts repo can be completely fixed, puts focus on interest-rate risk

Arnold Kling

Since the next financial crisis is not likely to mimic the last one, how might RepoWatchers use their understanding of shadow finance to spot the next trouble area?

Economist Arnold Kling, a scholar at the Mercatus Center at George Washington University, told RepoWatch he’s worried about interest-rate risk:

I am not inclined to view the repo market as something that can be fixed so that everything is all right.  I see the problem as not so much how the market operates per se.  Instead, I am concerned with what institutions do with that market.  So even if somebody developed clearing and settlement rules that were highly robust, the risk of repo lending would not disappear. 

I think of the repo market as having two types of uses.  The “good” use is to allow investment banks to hold “small” inventories of long-term securities in which they are making markets.  The “bad” use is to allow various institutions to try to profit from taking interest-rate risk by carrying long-term securities with very short-term funding.

In theory, those uses are different, but in practice they bleed into one another.  My concern is that interest-rate risk will ultimately be distributed in such a way as to deliver profits to private participants and concentrate risks with taxpayers.  So my inclination would be to try to impose position limits and capital requirements at institutions that take a lot of interest-rate risk, no matter how they take it.

My worry is that the next big meltdown will come from some firm that becomes the AIG of interest-rate risk.  That is, it becomes the firm that everyone goes to in order to dump their “tail risk” on interest rates.  Possibly that will involve repo lending.  But it could easily involve exotic derivatives of some sort.  So that’s another reason that I don’t think regulators can just focus on the repo market.