Monday, April 23, 2012

FSB Takes Aim at Repo Funding


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

As capital requirements and structural reforms of banks and financial institutions fall into place, global financial regulators are renewing their efforts to bring shadow banking and securitized credit extension under some form of regulatory discipline.  Though shadow banking has many facets needing attention, in an April 19 address at Johns Hopkins University, Lord Turner, head of the UK's Financial Services Authority announced that regulation of repo funding mechanisms would be a priority for the Financial Stability Board this year, and in particular the FSB’s Standing Committee on Supervisory and Regulatory cooperation (SRC), of which he is the chair.

In his April 19 address, Lord Adair Turner set forth how and why the wave of financial innovation in the area of securitized credit ended in the financial crash of 2008 and assessed whether financial innovation has a tendency to be less valuable than innovation in other sectors of the economy.

It was the innovative activities going on outside the traditional banking system that put the entire system in jeopardy, Lord Turner observed, pointing out that initial stages of the financial crisis did not concern commercial banks per se, but rather institutions and activities in what we now refer to as the shadow banking system.


The development of shadow banking  entailed large scale and multifaceted financial innovation, pursued with great energy by highly skilled and highly paid people, which has had a severely adverse social welfare effect – producing first an unsustainable credit boom, and then a recession, negative equity and unemployment.  What was privately profitable, at least in the short term, was not socially optimal, as a result of market imperfections, myopia, and important divergences between what is rational at the level of the individual economic agent, and what is optimal in terms of collective systemic macro effects.  It is difficult to think of any wave of innovations  in any other sector of the economy, about which we would be likely to reach such a negative judgement.


He characterized the crisis originating in the shadow banking sector as being best understood as a ‘run on repo’ rather than as a run on traditional bank deposits.  With short-term secured financing markets, such as repo playing such a central role in both the traditional and the shadow banking systems, it was changes in required haircuts in the repo market in 2008 that were among the most important drivers of the financial crisis. That is, the way in which central counterparties and other financial institutions increased margin requirements unilaterally on repo transactions as underlying assets declined in value set off a cascading set of crises across the global financial landscape.

According to Turner and leading economists and academics, any solution to making the shadow banking system permanently more stable, will require extending to secured financing markets, such as repo, the disciplines of regulation, deposit insurance and/or restricted institutional charters which have applied in the past to banks.   To this end, Turner announced that he intends, among other things, to pursue though the FSB and SRC constraints on shadow bank credit and money equivalent creation. To begin with, he hopes to impose some reforms through ‘asset-equity’ controls at the contract level regarding minimum initial haircuts.  In other words, these reforms could involve regulators determining the level of discount applied to assets posted as security by the intermediaries through which a growing proportion of repo transactions are routed.

Short term secured financing like repo is central to the shadow banking system.  It creates an extremely complex web of short-term secured funding markets linking money market mutual funds, banks, investment bank broker-dealers, hedge funds and asset managers seeking to earn additional return via securities lending. Therefore, any effort to regulate shadow banking must necessarily address the regulation of repo, and Lord Turner has made it clear that repo is precisely where he intends the process to begin.

The role of repo haircuts in the financial crisis is hotly disputed, with some arguing quite convincingly that the extent to which repo haircuts contributed to the severity and extent of the financial crisis is wildly overstated. There is also great controversy regarding the extent to which banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs. It is likely that there will be strong resistance to these premises for regulation and Lord Turner's more interventionist approach.
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