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29. What has been the regulatory response in the repo market to the Great Financial Crisis?
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The international regulatory response to the Great Financial Crisis that erupted in 2007 has been co-ordinated by the G-20’s Financial Stability Board (FSB). The FSB identified a number of financial stability risks in the use of securities financing transactions (SFTs), which it defines to include repo, securities lending, commodities lending and margin lending. These have been grouped into risks (1) affecting the regular banking system, (2) arising in the so-called ‘shadow banking’ sector, and (3) spanning both sectors. Shadow banking is defined as market finance involving credit intermediation or ‘bank-like’ activities by non-banks.

1    Risks to regular banking

Those risks arising from SFTs which are seen as threats to the regular banking system have been addressed through broad reforms of the Basel international banking supervision regime.
  • The Leverage Ratio was introduced to stop the build-up of excessive leverage in the market by imposing a simple backstop to the traditional Basel risk-weighted capital calculations, which the FSB believe did not accurately reflect the degree of leverage in the financial system due to defects in risk modelling and data, and regulatory arbitrage. The ratio is between Tier 1 capital and exposures calculated from balance sheet positions in: traditional instruments like deposits; SFT like repo; derivatives; and other off-balance sheet positions such as guarantees. For the purpose of calculating the Leverage Ratio, positions are not risk-weighted, no account is taken of collateralisation and there are severe restrictions on netting positions other than in derivatives.
  • The Liquidity Coverage Ratio (LCR) was introduced to tackle market liquidity risk --- the possibility of the whole market drying up --- by ensuring firms have a stock of high-quality liquid assets (HQLA) to sell or repo out which provides a buffer that is sufficient to cover projected net cash outflows during a hypothetical 30-day market crisis. To calculate the stock of HQLA available to a firm, the authorities list which assets qualify as HQLA and grade them by quality, prescribing haircuts and concentration limits for lower-grade HQLA. To calculate projected net cash outflows in a stressed market, the authorities prescribe: (1) inflow factors to be applied to each type of asset and in-the-money off-balance sheet position (ie all receivables) maturing within 31 days to estimate the extent to which these positions are not likely to be rolled over or extended; and (2) run-off factors to be applied to each type of liability and out-of-the-money off-balance sheet position (ie all payables) maturing within 31 days to estimate the extent to which these positions are not likely to be rolled over or terminated. The available stock of HQLA must exceed any excess of estimated receivables over estimated payables.
  • The Net Stable Funding Ratio (NSFR) is being introduced to address funding liquidity risk --- arising because of asset-liability mismatches between long-term assets and short-term liabilities and because of wholesale funding of leveraged non-banks by banks --- by ensuring that firms have sufficient sources of ‘stable’ funding to sustain the financing of their assets and off-balance sheet positions during a year-long market crisis. Each type of asset and in-the-money off-balance sheet position is prescribed a required stable funding weight, which measures its expected liquidity in a crisis and the importance attached by the authorities to this type of asset continuing to be financed. Each type of liability and out-of-the-money off-balance sheet position is prescribed an available stable funding weight, which measures the likelihood of it being able to be rolled over during a crisis. The amount of available stable funding must exceed the amount of required stable funding for each legal entity.
2    Pure shadow banking risks
  • The FSB was concerned that non-banks can use repos to conduct the ‘bank-like’ activities of maturity and liquidity transformation outside the regular banking system and beyond the reach of prudential liquidity and capital regulation. This means the financing of longer-term and/or less liquid assets with leveraged short-term and more liquid ‘money-like’ liabilities. But if the assets being financed become very illiquid or lose value, their worth as collateral will be reduced or disappear altogether, forcing non-banks to seek other sources of financing. In contrast to banks, non-banks are generally not directly or permanently supported by any official safety net (deposit insurance or guarantees, and access to central banks as lenders of last resort). Instead, they are reliant on private sector guarantees (such as back-up lines for asset-backed commercial paper (ABCP), credit guarantees, and credit default swaps (CDS) provided by insurers, credit derivative product companies and credit hedge funds). In systemic crises, private credit and liquidity support can prove ineffective, as providers are unable to perform due to stress on their own balance sheets, potentially leading to bank-like runs on confidence. These are thought by the FSB to be more likely in shadow banking because the wholesale or institutional cash which finances this sector, in contrast to the retail cash which finances much of regular banking, is seen as unstable (being described as ‘well-informed, herd-like and fickle’). Moreover, shadow banks are seen as more dependent on wholesale sources of financing than traditional banks are reliant on retail deposits. Consequently, wholesale funding is seen as inherently fragile. It is often compared with the free banking system of the US in the 19th and early 20th century. And, whereas banks are subject to a well-developed system of prudential regulation, the shadow banking system and funding through wholesale market instruments like repo are seen by the FSB as being subject to less stringent, or no, oversight.
  • The vulnerability of shadow banking to a run on confidence can be accentuated by excessive leverage built up through the repetitive use of repos (eg repoing out assets for cash to buy more assets, which can then be repoed out for more cash and so on).
3    Risks spanning regular and shadow banking
  • Fluctuations in the value of assets driven by the financial cycle tend to be self-reinforcing. Thus, falling asset values reduce the net worth, creditworthiness and borrowing capacity of borrowers, who may as a result be forced to deleverage, which would amplify the fall in asset values and so on. Rising asset values would trigger the opposite process. The propensity for cycles to reinforce themselves is called pro-cyclicality. Regulators are concerned that collateralised financing, including repo, may be more pro-cyclical than traditional unsecured wholesale financing because of the direct relationship of borrowing capacity to the value of the assets used as collateral and because additional feedback loops are introduced by collateral management procedures such as haircuts and variation margining, which can create feedbacks that amplify financial cycles, alternately accentuating up-cycles and down-cycles. The concern is that a surge in confidence is reflected in rising asset prices, reduced or reversed variation margin calls and shallower haircuts, all of which increase firms’ net worth, creditworthiness and borrowing capacity, which will tend to increase asset purchases and boost asset prices, so reinforcing the up-cycle. A collapse in confidence, on the other hand, will trigger a fall in asset prices, increased variation margin calls and deeper haircuts, or even the exclusion of assets from the pool of eligible collateral, which decreases firms’ net worth, creditworthiness and financing capacity, which will tend to decrease asset purchases and depress asset prices, so reinforcing the down-cycle. In addition, inadequate collateral management practices at some firms, such as infrequent variation margin calls and insufficient haircuts, particularly for illiquid collateral, can amplify pro-cyclicality by encouraging firms to belatedly and dramatically tighten up lending practices after a crisis has broken. This was believed to have happened in the US MBS market during the Great Financial Crisis. Pro-cyclicality may also be amplified by the increased sensitivity of market participants to counterparty credit risk in stressed conditions, which may intensify strains already present in markets.
  • If a run on repo in the shadow banking sector is accompanied by defaults, non-bank lenders may be forced into a fire sale of long-term assets taken as collateral. The driver may be liquidity needs, regulatory restrictions on holding longer-term assets or limited collateral management capacity among non-bank lenders. For example, money market mutual funds can take long-term bonds as collateral in repo but cannot hold them directly as investments so must immediately sell off any bonds received as a result of a default. Such fire sales would amplify market stress and spread problems outside the shadow banking sector by impacting the wider asset markets.
  • The impact of a run on repo in the shadow banking sector may be propagated by the increased interconnectedness of large market participants arising from the formation of chains of collateral re-use. These chains are potential channels of contagion down which sudden losses of confidence and failures to deliver re-used collateral may be propagated. The risk of contagion could be increased by the scale of exposures created by excessive leverage. Although variation margining and netting after default should normally minimise the risk, these safeguards could be overwhelmed by sudden jumps in collateral value between variation margining or legal challenges to netting agreements. There is also concern that complex interconnected systems are inherently unstable.*
  • Regulators believe that the lack of instrument-specific data has contributed to the opacity of the repo market, which has prevented their detection of emerging risks. Opacity is believed to be increased by the complexity of chains of re-use.
4    Measures to address the systemic risks arising from repos

The FSB set out three approaches to tackling possible systemic risk arising from repos:
  • improvements in transparency
  • improving market practice with regard to collateral management
  • reinforcing repo market structure
4.1    Improvements in transparency

4.1.1  Increasing regulatory reporting

The FSB decided that regulatory authorities need more information to help detect and monitor systemic risks as they are building up. Their concern is that direct exposures between large institutions would mean the failure of one institution would destabilise other large institutions by making them more vulnerable to a liquidity shortage, particularly if their repo financing was excessively short-term. To monitor such risks, they proposed the collection of more granular data on repo (and other SFTs) between large international financial institutions, in order to detect major bilateral linkages as well as common exposures to and dependencies on countries, sectors and financial instruments. They envisaged leveraging the work of the FSB Data Gaps Group, which had been established to build a consistent global framework to pool and share data on major bilateral credit linkages between large international financial institutions. The FSB proposed to aggregate national and regional data to provide a consistent global picture of exposures.

For repo, the FSB working group on SFTs identified two alternative sets of potentially useful data: eight transaction-level data elements to be collected by national or regional trade repositories; or seven firm-level data elements that could also be collected by survey or regulatory reporting.  

In the EU, regulatory reporting of repo has been mandated under the Securities Financing Transactions Regulation (SFTR), which dramatically expands the FSB’s data list. In part, this reflects the authorities belief that they need to ‘learn’ about the repo market through research and because some authorities originally (but incorrectly) believed that the necessary data was readily available from central securities depositories (CSDs). The ECB and Bank of England have imposed separate money market reporting regimes in advance of SFTR.

The FSB propose to publish some aggregated information from the data they collect.

4.1.2  Improvements in corporate disclosure

The FSB also saw a need for accounting standards bodies to improve the disclosure about repo (and other SFT) activities in firms’ financial statements, including greater consistency in reporting across firms and jurisdictions, speedier publication, more detail and measurement of risk rather than just nominal size. The FSB proposed a ‘sources and uses of securities collateral’ statement (from whence collateral is received and to where it is despatched) as well as more qualitative information on counterparty concentration, maturity profile, composition of collateral, haircuts, re-use of collateral, client business and credit exposures, all broken down by type of SFT.

4.1.3  Improvements in reporting by fund-managers to end-investors

The FSB believed that investors should be informed frequently of the degree to which investment managers leverage their portfolios through the use of repo in order for them to be able to better select investments on the basis of risk.  They recommended the reporting of the amount of repo, repo maturity profile, repo currencies, repo rates, the top 10 collateral issues, types of collateral, collateral maturity profile, top 10 counterparties and location, re-use of collateral, use of CCPs or tri-party agents, number of custodians and holdings of assets by each, and use of segregated or omnibus accounts.

4.2    Improving market practice with regard to collateral management

4.2.1  Mandatory minimum haircuts for risky collateral assets in SFTs with the shadow banking sector

The FSB argued that collateral haircuts calculated over a whole financial cycle would remove the need for firms to increase haircuts when market conditions deteriorated, thus reducing pro-cyclicality. Higher haircuts were also seen as useful in restraining the build-up of leverage by progressively reducing the financing potential of collateral each time it is re-used.

The FSB proposal, since adopted by the Basel Committee on Banking Supervision, was for a set of floors under haircuts applied to non-centrally cleared repos against non-government bonds through which regulated financial intermediaries provide finance to shadow banks. The scope of the proposal includes collateral swaps constructed of back-to-back repo and reverse repo, as well as securities lending against cash collateral (unless the use of cash is restricted) and securities lending against non-cash collateral (unless the collateral cannot be re-used). After consultation, the haircuts were set in line with the standard supervisory haircuts applied under the Basel regime for the calculation of risk-weighted capital requirements.

Discussion is continuing on whether to extend the scope of mandatory minimum haircuts to all market participants, to include sovereign bonds and to use the floors as macro-prudential tools by changing them anti-cyclically in response to evolving financial conditions.

4.2.2  Minimum standards for methodologies to calculate haircuts

The FSB recommended that firms should calculate haircuts to cover, at a high level of confidence, the maximum expected decline in the market price of a collateral asset over a conservative liquidation horizon taking account of how much longer it would take transactions to be closed out in stressed conditions and the possible widening of bid-offer spreads. The price observation period should cover a least one past stress period.

It was also recommended that risks other than collateral price volatility should be taken into account by firms when calculating haircuts, such as large concentrations of collateral, wrong-way risk and any currency mismatches between cash and collateral, as well as the specific characteristics of each type of collateral, including asset type, issuer credit risk, structure, price sensitivity and residual maturity. Haircuts should also take account of the frequency of valuation and variation margining.

4.2.3  Minimum regulatory standards for valuation and management of collateral

The FSB recommended that firms should be subject to minimum regulatory standards in their jurisdictions which:
•    restrict them to taking collateral which they could hold after a counterparty default without breaching legal or regulatory restrictions and which they are able to value, manage and liquidate in an orderly way;
•    require them to have contingency plans to deal with the failure of their largest counterparties in both normal and stressed markets;
•    require at least daily marking-to-market and variation margining of material net exposures.

4.3    Reinforcing repo market structure


4.3.1  Mandatory central clearing of SFT   

In the aftermath of the Great Financial Crisis, proposals were made for the mandatory central clearing across CCPs of all repos, similar to the mandatory central clearing of standardised OTC derivatives. However, the FSB recognised that there were problems in trying to impose a blanket requirement for central clearing across all parts of the repo market. They also believed that there were sufficiently strong incentives for central clearing already in place in the inter-dealer market for high-quality collateral but that repos with customers and against lower quality collateral would be difficult to clear. It was left to regional and national jurisdictions to assess the situation in their own markets.

4.3.2  Amending bankruptcy law treatment of repo

The FSB considered academic arguments that repo should lose its exemption from the automatic stay on the enforcement of collateral and other measures imposed by insolvency regimes. Some academics claimed that the so-called safe harbour status conferred on repo by its exemption increases its ‘money-like’ status, which encourages the rapid growth of cheap but potentially unstable short-term funding; is likely to trigger fire sales after a default; and reduces the incentive of creditors to monitor counterparty credit risk (see question 3).

The problem with this proposal was that only repos in the US are specifically exempt from the insolvency regime. In other jurisdictions, including Europe, repo works by means of the transfer of title to collateral, so restrictions on the disposal of collateral would interfere with basic property rights. It is worth noting that a stay on enforcement of collateral has since been imposed in most jurisdictions under recovery and resolution regimes but only for a very short period while the authorities assess the possibility of rescuing, reorganising or breaking up a systemically-important firm in distress in an orderly manner.

4.3.3  Repo resolution authorities

The FSB also examined academic proposals for an official body to buy collateral at market prices less pre-defined haircuts from the repo creditors of a firm in default and subsequently sell off the collateral in an orderly manner when the market recovered, with profits or losses being attributed to the creditors. The FSB decided the practical and legal challenges were too great.



* Attempts to model financial networks as a basis for regulatory analysis and prescription need to be treated with caution. Work to date is entirely theoretical and not calibrated against any real interbank market. The results of theoretical modelling are very sensitive to parameters such as the degree to which banks will withdraw credit lines from other banks in a crisis. This is usually set to 100%, whereas anecdotal evidence suggests withdrawal tends to be gradual and only becomes total immediately prior to a default. When this parameter is relaxed, the impact on models tends to be dramatic.


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