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33. Is repo a source of unstable short-term funding?
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One of the concerns expressed by policy-makers and regulators about ‘shadow banking’ (ie market finance) is the possible instability of the wholesale funding on which the shadow banking system is seen to rely. This includes repo (see question 35). The argument is that, while wholesale liabilities such as repo are like the deposits issued by traditional banks, they are riskier because:
  • Institutions funding in the wholesale markets are seen as more dependent on these sources of financing than traditional banks are on deposits.
  • Wholesale funding is considered less regulated.
  • The wholesale market is 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, it is reliant on private sector balance sheets (eg back-up lines for ABCP, credit guarantees, and CDS provided by insurers, credit derivative product companies and credit hedge funds). In systemic crises, private credit and liquidity support could prove ineffective, as providers are unable to perform due to stress on their own balance sheets.
  • The wholesale market mainly intermediates institutional cash balances, whereas the traditional banking system is more reliant on retail money. Institutional cash has been described as “well-informed, herd-like and fickle”.
  • Regulators are concerned about the complexity of the financial market, because complex systems are in theory less transparent and may be inherently unstable.
Consequently, wholesale funding is seen as inherently fragile and prone to runs on confidence. It is often compared with the free banking system of the 19th and early 20th century US.

The proposition that repo is a source of wholesale funding is fundamentally misleading. The liquidity risk which is being identified is not intrinsic to the instrument but is largely a function of the asset and liability management strategies of borrowers (funding liquidity risk) and therefore largely an issue about the appropriate regulation of financial institutions.

Although the average term to maturity of repo has traditionally been short, this has merely reflected the character of supply and demand. The average term of repo has been lengthening. There is nothing inherent in repo that requires it to be short term. The ICMA’s semi-annual survey of the European repo market shows that the proportion of short-dated repo (terms of one month or less) have decreased from some two-thirds of outstanding value of repos to about half. In addition, forward repos, which often start one or more months in the future, account for about 8% of the survey. Repo with only one day to maturity is less than 20%.

It is also important to recognise that reliance on retail deposits and other sources of funding guaranteed or otherwise underpinned by official safety nets passes ultimate liability for ‘regulated’ markets to the public sector. In contrast, collateralised funding like repo, if prudently managed, in particular by selecting high-quality assets, is largely self-insured.

In addition, in practice, the repo market possesses important inbuilt stabilising mechanisms, in particular, widespread use of CCPs, which reduce risk exposures and liquidity-hoarding incentives by providing a creditworthy counterparty and by multilateral netting. The impact of CCPs in the repo market has been extended by access being opened through post-trade registration of transactions executed directly or via a voice-broker, rather than just electronically. Some 70% of European repo market turnover may be cleared through CCPs.

The proposition that complex systems can exhibit unstable behaviour is uncontentious. There is little doubt that the decomposition by the market of the process of credit intermediation, formerly monopolised by banks, into a chain of discrete operations has increased complexity in some parts of the financial market (at least to the extent of lengthening intermediation chains). However, 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.

Moreover, the interbank market, both secured and unsecured, may in fact have become less complex, as well as relatively less important. Since about 1996, there has been a sectoral shift in interbank markets such as Eurodollars, away from interbank lending (including repo) and into lending to non-bank customers such as US securities firms and other non-bank financial institutions. Interbank lending declined from 66-75% to below half. At the same time, the configuration of the interbank market has been simplified by the introduction of electronic trading in spot FX, bank mergers and the re-organisation of global liquidity operations into hub-and-spoke structures in which all dealing is booked through one centre. The case for greater interbank complexity is not proven.

Finally, it is worth noting that, during the global financial crisis, although the repo market was not free of stress, it continued to function, in sharp contrast to the unsecured money market, which largely evaporated. Papadia & Välimäki point out that, between 2008 and 2011, the unsecured eurozone money market shrank by EUR 327 billion, forcing the ECB into exceptional emergency lending in order to prevent a seizure of the financial system and serious damage to the real economy. In fact, the ECB lent EUR 115 billion. But growth in the repo market contributed another EUR 212 billion, without which, the burden on the ECB would have been dramatically greater.

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