Banks’ over-reliance on overnight repo is “absurd”

Perotti

Enrico Perotti, professor of international finance at the Amsterdam Business School, wants to tax banks that repo, to discourage “the current absurd over reliance on overnight repo markets.”

He is highlighting the following papers on his web site.

From The Governance of Macro Prudential Taxation, 2010:

With hindsight, the most glaring gap in Basel II was its neglect of unstable short term funding.

Rapid capital withdrawals was the primary source of propagation in the last crisis. This occurred in combination with opaque assets. …

A systemic levy which targets unstable funding should focus on uninsured short term liabilities (including repo’s). Wholesale funding allowed the massive expansion in securitized lending, yet escaped before bearing any losses.

A liquidity risk levy charges intermediaries relying on fragile funding for the negative externality they create for others, when they make fire sales to repay rapid withdrawals of funding.

Such levies also charge intermediaries ex ante for the de facto insurance of uninsured liabilities, though without creating an explicit insurance promise.

Liquidity charges are aimed at future incentives, discouraging rapid asset growth funded by investors bearing no risk.

It aims at increasing maturity from the current absurd over reliance on overnight repo markets, thus increasing financial resilience to shocks.

They should be scaled by bank size, to tackle the too-large-to-fail problem, and by interconnectedness, to control intermediaries which cannot be easily extricated from others.

Liquidity charges would discourage intermediaries from scaling up their balance sheet via huge proprietary trading desks, without imposing Glass Steagall restrictions. It is essentially an opportunity cost to discourage large scale, uninformed carry trade strategies invested in securities that earn on average a risk premium without providing any useful monitoring.

This should be distinguished from informed bank lending, a useful maturity transformation task by delegated monitors (banks) which deserves public support.

  From Liquidity Risk Charges as a Macroprudential Tool of October 2009:

Systemic risk is propagation risk. In a systemic crisis, an initial shock spreads beyond its own market, start a vicious spiral of price shocks and disrupt the real economy.

We have learned that liquidity runs are a primary cause of propagation. Banks that suffer rapid withdrawals of short- whosale funding cause rapid fire sales in a panic, forcing others in fire sales, and propagating the shock.

Accordingly, we propose to introduce liquidity risk charges as a macro prudential policy tool. Taxing short uninsured term funding is aimed at making banks internalize the negative systemic effects of fragile funding strategies. A macro prudential authority can manage the charges to prevent excess build up of liquity risk during good times.

Perotti was the lead speaker at a financial conference in London June 1 on the future of funding for banks. The conference was sponsored by the International Centre for Financial Regulation, a trade association based in London, and the University of Chicago Booth School of Business.