Article 10.3 Terms laid down for taming shadow bank risk

Sam Fleming and Tracy Alloway

Financial Times October 14, 2014

Global regulators have taken a landmark step towards taming risk in a key seg­ment of the shadow banking system, outlining tougher rules on collateral for short­term lending which will affect both banks and non-bank players.

Shadow banks have emerged as a key regulatory concern as risk migrates out of the traditional banking sector into more thinly policed reaches of the financial markets.

Shadow banks can include a broad array of institutions engaged in bank-like activ­ities, among them hedge funds, private equity groups and money market funds.

The Financial Stability Board, an umbrella group of regulators, on Monday night published a framework imposing minimum requirements on the collateral needed when such firms borrow money from banks through short-term loans secured by stocks or bonds.

The global standards are intended to stop excessive lending, and so avoid a repeat of the reckless behaviour that helped precipitate the financial crisis of 2008. They also take aim at a key segment of the shadow banking world, known as the repur­chase, or ‘repo’, market.

This emerged as a prime area of weakness during the crisis and regulators are said to be concerned about the potential impact that a ‘fire sale’ of assets used as collat­eral for loans could have on the wider financial system.

Crucially, the FSB’s minimum floors for repo transactions are higher than initial proposals made in August last year, following calls for tough standards from US regulators.

In a significant step, the FSB said it would also consult on applying the standards to deals struck between non-banks, rather than simply limiting them to repo trans­actions undertaken between banks and non-banks.

However, the FSB rules would still fail to capture transactions that use govern­ment bonds as collateral, focusing instead on private debt and stocks, amid anxiety from some governments about the potential impact on sovereign debt markets.

The FSB now wants a minimum 1.5% ‘haircut’ for corporate bonds with a maturity of between one and five years, up from 1% before, and a 6% haircut for equities, instead of 4% previously. The latter would mean that a borrower would have to post $106 of equity collateral for a $100 loan.

The FSB also set out non-numerical standards aimed at tackling the risk that hair­cuts get whittled away in benign market conditions. Mark Carney, chairman of the FSB and Bank of England governor, said the rules marked a ‘big step forward’ in the global shadow banking agenda.

Daniel Tarullo, chairman of the FSB Standing Committee on Supervisory and Regulatory Co-operation, added: ‘Securities financing transactions such as repos are important funding tools for a wide range of market participants, including non­bank financial firms.

‘The implementation of the numerical haircut floors on securities financing trans­actions will reduce the build-up of excessive leverage and liquidity risk by non­banks during peaks in the credit and economic cycle.’

The FSB stressed that market participants should continue to set higher haircuts than the official requirements where prudent. The FSB said firms had expected only a ‘minimal’ impact on market volume from its proposals.

The FSB added that the haircut floors could in future be raised and lowered as part of efforts to lean against fluctuations in the financial cycle, but that this would require further work.

The repo market has already been under pressure from new rules that make it more expensive for banks to broker the transactions or undertake their own repo borrowing. While many in the market concede that runs in the repo market were a prime cause of Lehman Brothers’ collapse in 2008, they also warn that limiting the repo market could affect liquidity in a long list of financial assets.

Source: Fleming, S. and Alloway, T.

Tri-party repo

Many repo markets are based on bilateral deals between borrower and lender. But a common form in the US is the tri-party repo (TPR), where an interme­diary, a custodian, acts for both seller and purchaser and undertakes all admin­istrative tasks. There are two custodian banks, Bank of New York Mellon and JPMorgan, which help to administer a repo agreement between two parties. Lenders place money with the custodian bank, which in turn lends it through a repo to another institution. Such a model functions well when liquid assets such as Treasuries are being used, as this type of collateral can easily be sold.

During the credit boom, which peaked in the first half of 2007, the type of collateral being pledged for cash in repo transactions steadily migrated away from Treasuries and towards other assets such as private label mortgages, cor­porate bonds and equities. This reflected the drive by investors to boost their returns, gaining higher interest when lending against poorer quality collateral. Tri-party was very popular with investment banks as it allowed them to finance their balance sheets with short-term funding. However, as soon as market sen­timent turned negative on lower-quality or more complex assets, investors that had funded these repo agreements began to pull their money out. That sparked a run on the investment banks. The vulnerabilities of this system were highlighted with the near-failure of Bear Stearns six months before Lehman's demise. Article 10.4 illustrates the concerns of US authorities about the TPR market.