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16. Does repo encourage lending to risky counterparties?
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Collateralisation does not change the probability of default of a counterparty, so collateral taken from risky counterparties is more likely to be tested by a default and may turn out to be worth less than expected due to fluctuations in price and the impact of liquidation. Consequently, collateral should be treated only as insurance against the default of the seller, not as a simple substitute for his credit risk. This means that the primary exposure in a repo remains counterparty credit risk. Repo does not avoid the need for conventional credit risk management and does not justify lending to parties deemed unsuitable for unsecured lending. Rather, repo is intended to reduce the risk of lending to existing counterparties and make more efficient use of the capital supporting such lending. The principle should be that the decision to use repo to mitigate the credit risk on a counterparty is taken after the decision on whether to extend any credit to that counterparty (ie the decision on whether to extend credit to a counterparty should not be driven by the decision to use repo). The primary importance of counterparty credit risk was confirmed during the Great Financial Crisis by the refusal of parties to roll over repos with Bear Stearns in March 2008, when doubts had arisen about the firm’s solvency, despite the firm having substantial holdings of US Treasuries to use as collateral.


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