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16. Does repo encourage lending to risky counterparties?
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Collateralisation should not make lenders indifferent to the identity of their counterparties. This is because collateral is not perfect. The value of even the best assets fluctuates and the liquidation of even the best collateral in response to an event of default, particularly an insolvency, can be delayed by unexpected operational and legal problems. Moreover, collateralisation does not change the probability of default of a counterparty, so collateral taken from risky counterparties is likely to be tested by a default and may turn out to be worth less than expected. Consequently, collateral should be treated only as insurance against the default of the repo seller, not as a substitute for his credit risk. This means that the primary exposure in a repo remains counterparty credit risk. Consequently, repo does not replace conventional credit risk management and does not allow 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 credit  to that counterparty, not that the decision on whether to extend credit to a counterparty is taken after the decision to use repo and is dependent on the use of repo.


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