FSB Publishes Interim Report on Securities Lending and Repos Workstream

The FSB Workstream on Securities Lending and Repos ("Workstream") under the FSB Shadow Banking Task Force has published an interim report on its findings and progress. The mission of the Workstream is to present, by the end of 2012, policy recommendations to strengthen regulation of securities lending and repos within the context of the shadow banking system.  In order to inform its decision on proposed policy recommendations, the Workstream has reviewed current market practices through discussions with market participants, and existing regulatory frameworks through a survey of regulatory authorities.  This interim report identifies a number of securities lending and repo issues that might pose risks to financial stability, and positions repo and securities lending in within the shadow banking framework, laying out the Workstream's focus as it develops its recommendations.


Based on its findings thus far, the Workstream will focus its attention on four areas of securities lending and repo within the context of shadow banking:

1. Borrowing through repo financing markets, including against securitised collateral, which creates leverage and facilitates maturity and liquidity transformation. Repo allows banks as well as non-banks – such as securities broker-dealers, pension funds, and (to a greater extent before the crisis) conduits and investment vehicles – to create short-term, collateralised liabilities. Because repo financing is typicallyshort-term but collateralised with longer-maturity assets, it often has embedded risks associated with maturity transformation. It can also involve liquidity transformation depending on the type of securities used as repo collateral.
   
   
2. The extent to which leveraged investment fund financing leads to  maturity transformation and leverage;
   
   
3. The chain of transactions through which the cash proceeds from short sales are used to collateralise securities borrowing and then reinvested by securities lenders, into longer-term assets, including repo financing. This activity can mutate from conservative reinvestment of cash in “safe” collateral into more risky reinvestment of cash collateral in search of greater investment returns (prior to the crisis, AIG wa an extreme example of such behaviour).
   
   
4. Collateral swaps (also known as collateral downgrades/upgrades) involving lending of high-quality securities (e.g. government bonds) against the collateral of lower- quality securities (e.g. equities, ABSs), often at longer maturities and with wide collateral haircuts. Banks then use the borrowed securities to obtain repo financing, which can further lengthen transaction chains, or hold them to meet regulatory liquidity requirements.