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Using taxes, fees or haircuts to reform repo

Americans don’t hear much debate these days on ways to avoid having to bail out the repurchase market again.

That’s a problem, because Congress is not likely to act on an issue the American public is not paying attention to.

That said, analysts continue to examine and discuss potential repo reforms.

Here is a roundup of recent studies on using taxes and haircuts to reform the financial markets, including repos.

On taxes:

Analysts have proposed various ways to use taxes to reduce excessive risk-taking by financial institutions and to cover the costs of future financial crises. Typically, these taxes would be levied on certain instruments and transactions, including repos. Only one such fee has been implemented so far:  The FDIC levy on FDIC-insured bank liabilities, including repurchase agreements.

For a summary of financial transaction tax proposals, see:

September 2010, “Financial Sector Taxation: The IMF’s Report to the G-20 and Background Material” by Stijn Claessens, Michael Keen, Ceyla Pazarbasioglu, an International Monetary Fund report.

For an examination of ways such a tax might be collected, even in the shadow banking sector, see:

August 2011, “Taxing Financial Transactions: An Assessment of Administrative Feasibility” by John D. Brondolo,  International Monetary Fund Working Paper.

For a discussion of issues raised by German Chancellor Angela Merkel’s and French President Nicolas Sarkozy’s August 16 proposal for a European financial transaction tax, see:

August 18, “Ten questions about the Financial Transaction Tax that need answering” by Richard Partington, Financial News.

On haircuts:

Mandatory haircuts are another frequently proposed reform.

A “haircut” is the amount of collateral a borrower places with the lender over and above the amount of the loan. The more excess collateral that a lender requires, the higher the haircut. Some analysts propose requiring a minimum haircut, similar to requiring a downpayment on a mortgage, as a way of controlling risk.

For a discussion of haircuts, see:

July 2011, “Report to Congress on Secured Creditor Haircuts,” Financial Stability Oversight Council.

August 1, 2011, “Haircuts” by Andrew G Haldane. Remarks by Mr Andrew G Haldane, Executive Director, Financial Stability, of the Bank of England and member of the Financial Policy Committee, summarising a forthcoming paper in the Journal of Monetary Economics, “Complexity, Concentration and Contagion.”

Haldane discusses important elements of the financial crisis, including the dangerous interconnectedness caused by financial institutions’ excessive borrowing from and lending to each other:

Secured financing became an increasingly important source of credit in both bank and non-bank markets over the past decade. In the US, the repo market financed roughly half of the growth in investment banks’ balance sheets between 2002 and 2007. In the UK, the securitisation market trebled in size over the same period. Those were the heady days of summer. Since then the US repo market has shrunk by 40%, while the UK securitisation market remains frozen.

Pro-cyclicality in the haircuts applied to secured financing transactions in turn amplified the cycle in credit. Thin haircuts made it cheaper for banks to mobilise collateral to finance borrowing when the credit cycle was in the upswing, adding momentum to the upward pendulum of asset prices and credit. And fat haircuts immobilised collateral when the credit cycle reversed, exaggerating the downward pendulum swing.

A further factor amplifying these swings came from the fact that much of the secured financing took place within the financial sector. In the run-up to crisis, banks and near-banks entered into secured financing transactions with one another, inflating both counterparties’ balance sheet. In the UK, fully two-thirds of the trebling in balance sheets between 2002 and 2007 can be explained by expanding claims on other parts of the financial system.

Also dangerous is the concentration of banking in a few giant companies too complex and opaque to understand, Haldane said.

The likelihood of such systemic liquidity crises depends critically on two key structural characteristics of the financial system – the two c’s: concentration and complexity. The greater the concentration within the financial system, the greater the potential for systemic collapse as larger banks spread a disproportionate amount of financial pain around a densely networked financial system.

A greater degree of system complexity has a similar effect, creating more channels for contagion and heightening banks’ incentives to hoard liquidity when the weather worsens.

The two c’s are very much features of today’s financial system. On the face of it, that bodes ill for future systemic crises.

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