Money market funds, interbank lending and the repurchase market would likely be the key sources of contagion for U.S. banks if Europe’s debt problems panic the credit markets, according to a July 21 article by Jeff Horwitz at the American Banker.
At his writing, markets didn’t seem to be worried, possibly viewing such a contagion as “too potentially disastrous to take seriously,” wrote Horwitz.
Still, memories of 2007-2008 are too vivid to dismiss the possibility.
From the American Banker article:
Observers need not look far back for an example of how contagion could play out. Defaults even on Europe’s periphery could quickly ensnare U.S. institutions in money market runs, interbank lending rate spikes and a collapsing repurchase market for short-term collateralized loans. A similar chain of events took place in the wake of Lehman Brothers’ collapse.
On repos Horwitz wrote:
Secured short-term lending in the repurchase market would also get hit. Any sovereign debt considered unsafe would become ineligible for use as collateral, and haircuts on even high-quality collateral would rise. (This also would be an echo of what happened in 2008, when mortgage-backed collateral was frozen out and institutions began demanding a margin of safety on loans secured by U.S. treasuries.)
With liquidity in short supply, hedge funds and others dependent on bank funding for leverage might be pushed into fire sales, exacerbating pricing and liquidity concerns.
Since the near-meltdown of the repurchase market in 2008 helped spark U.S. government intervention, industry groups and the New York Fed have worked to make the system more secure. Inter-day credit risks have been limited, reducing the possibility of a run on a tri-party repo provider. Collateral requirements are stricter, and transparency into the quality of collateral is improving.
But should the stability of large European banks become suspect, even researchers at the entity overseeing the market don’t expect they would afford much protection.
While the changes to repos are “substantial improvements,” a New York Fed white paper concluded last year, “These recommendations will not make tri-party repo financing ‘stable’ in the face of events that give rise to concerns with counterparty credit standing.”
Congratulations to Horwitz for being one of the rare U.S. journalists who is willing to use the r-word (repo) and explain why it matters.