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30. Do changes in haircuts/margins exacerbate pro-cyclicality?
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’Pro-cyclicality‘ means a propensity to amplify cycles of financial activity. Policy-makers and regulators have expressed concern that increases in haircuts and initial margins demanded by collateral-takers (including buyers in repos) in response to a cyclical deterioration in credit and liquidity conditions, while rational for the individual parties, may, in aggregate, worsen the problem for the market as a whole. On the other hand, reductions in haircuts and initial margins in response to a cyclical improvement in credit and liquidity conditions may fuel market exuberance.

The postulated dynamic driving pro-cyclicality is a haircut-asset valuation spiral. In a down-cycle, haircuts/initial margins are increased in response to an initial loss of confidence, perhaps following bad news. In the manner of a credit multiplier in reverse, this reduces the liquidity of market users, who sell assets in response. Asset sales reduce the value of and increase the risk on collateral, as well as eroding the net worth of borrowers, causing haircuts/initial margins to be increased again. And so on. In an up-cycle, haircuts/initial margins are reduced in response to growing confidence. This improves the liquidity of market users, who buy assets in response. Asset purchases boost the value of and reduce the risk on collateral, as well as enhancing the net worth of borrowers, causing haircuts/initial margins to be decreased again. And so on.

This scenario underpins a broader claim that the market crisis of 2007-09 was essentially, if not entirely, a “run on repo”. The main proponents have been two US academics, Gorton and Metrick (see question 34). However, they based their hypothesis on a single set of data on collateral haircuts taken on structured securities by a single anonymous US broker-dealer. This type of collateral constitutes a very small part of the repo market. It is naïve to extrapolate events in this narrow sector to the entire global repo market without any calibration of the importance of such collateral. Such an extrapolation of the Gorton-Metrick hypothesis has been refuted by the evidence of other studies, including that gathered by a Study Group of the Committee on the Global Financial System (CGFS) at the BIS, which observed that haircuts were generally stable during the 2007-09 crisis and that credit was very largely tightened by the reduction or closing of credit limits and the shortening of lending. Nevertheless, the Gorton-Metrick thesis has spawned proposals for mandatory minimum haircuts as a macroprudential regulation to dampen the pro-cyclicality mistakenly ascribed to haircuts and initial margins (as well as to reduce leverage). A detailed discussion of the role of Haircuts and initial margins in the repo market was published by the ICMA in February 2012.

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