Banks are swapping assets in a bid to transform illiquid assets into liquid, highly rated assets that are eligible for repo. But do regulators fully understand the implications and fears that banks are repeating the mistakes of past, and just who has all the repos?
Simple and sensible ideas operating in financial markets all too easily become layered, opaque and dangerous, at least in times of stress. The assumption is made that new technologies and transactions will improve efficiency and enable investment that otherwise might not have happened, with an assumed benefit to the economy. Instead, Lehman Brothers’ collapse and the financial crisis alerted us to complex securitisations, hidden leverage, mispriced risk, the ‘who-is-exposed-to-what?’ fears in over-the-counter (OTC) markets, as well as amazing ignorance of the big picture and asymmetry of information and contract terms.
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Some of this is being fixed (not always without unintended consequences) but more things are coming to light as we peer into the abyss of the eurozone sovereign debt crisis.
Return of the repo
Questions are being posed over zero-risk weight and sovereign exemptions in regulation. This applies not just in the confines of the eurozone monetary union but more widely as the debt and growth crisis unfolds with the pro-cyclical interaction of banks and sovereigns. With a liquidity squeeze in full swing, that friend of illiquid assets – the repo or repurchase agreement – is being greatly employed.
Repos – a simple idea by which party A hands ownership of a financial asset to party B in return for cash and contracts to buy it back at the expiry of a given time – are widely used between private entities and with central banks. Of course, party B gets paid for its trouble either by haircutting the asset in the cash it hands over or getting an enhanced payment back.
Is this a sale or is it not? If it is treated as a sale – conveniently removing it from the books – it also includes a forward contract to buy back, essentially binding together a complex financial derivative with a simple sell trade. This forward contract might be influenced by the price of the underlying asset, maybe even creating a margin call if the underlying asset price falls.
Do current accounting standards capture all the subtleties, and do auditors and regulators understand the full implications? Have manoeuvres such as Lehman’s Repo 105 really been consigned to the dustbin of history?
The ‘sweepo-repo’
It is also reported that the recent hunt for liquidity has brought about asset swaps between banks, with pools of similar assets being swapped. The assets are typically sub-investment grade, but after the swap the pools somehow gain a higher rating – and then they become eligible for repo.
There are two issues here. The first question (with echoes of the financial crisis) is where does this seemingly magical added value come from? The second question is – irrespective of whether the asset features anywhere on the balance sheet – who is on the hook for what at the end of the day?
Indeed, this all looks a bit too familiar and could be dubbed originate-to-repo; or more colourfully the mop and swap, 'sweepo-repo' where dubious assets are swept up, swapped and repo-ed, somehow having gained a higher and often investment grade rating.
Logically, repurchase agreements should really be considered not as a sale and repurchase but as a type of secured lending. And there is nothing wrong with the basic tenet that a relatively illiquid asset (of value) should be used as a security for cash. It is then easy to stretch the cash to something else and hence a chain begins and the potential for a complex web.
Where should the repo go?
Next is the question: should the repo-ed (but actually ‘lent’) asset leave the balance sheet of the lending bank? The financial risk is borne by the party committed to buying back the asset, ie. the lending bank. Here we are back to the problem of the 2008 financial crisis with huge counterparty risk and unclear balance sheets: repo is an easy method to remove items from a balance sheet, replacing them with a hard-to-price contract which falls into the ‘dangerous’ category during times of stress. It is also reported that some of the assets escape being on any balance sheet at all.
This is not an appropriate use of central bank money and, like the zero-risk weighting, eventually has to be addressed for as long as Europe’s monetary union is not truly one-size-fits-all
In the regulatory sense, the response should follow the pattern established for securitisation and OTC. Transparency and understanding is a key starting point. There are rules now for originate-to-distribute, so too should there be for originate-to-repo. The validity of removing assets on repo from the balance sheet should be challenged – at the very least a clear treatment reflecting the re-purchase contract risk must exist. It must be put beyond doubt that they are not being used as a method to tidy up balance sheets before audit. Repos and securities lending should be reported. Indeed, here there may be a case to have a repository for aggregate information, rather as for OTC derivatives. These latter two points could well be dealt with in EU legislation that is on the table and I have already made suggestions.
Now, it is no secret that the interaction of zero sovereign risk and the ability to repo with the European Central Bank (ECB) provided a mechanism for leverage when the yields on periphery sovereign bonds have been higher than the rates charged by the ECB. This is not an appropriate use of central bank money and, like the zero-risk weighting, eventually has to be addressed for as long as Europe’s monetary union is not truly one-size-fits-all.
Flat capital
Worldwide the emphasis on liquidity following the 2008 financial crisis has driven regulatory capital more towards sovereign debt, and with a zero cost of capital, the cost of arbitrage – defined by the use of Tier 1 capital – between sovereign yields and ECB financing has been low. As a magnified result, the sovereign debt crisis has led to a situation where banks and sovereign states remain in thrall to one another. It is unlikely that the steps to aid separation of banks and sovereigns can or will be taken in any fulsome way at the present time: shaking the bank-sovereign conglomerate is deemed too risky in its delicate form within the eurozone. But, like the too-big-to-to fail issue, it is ignored at our peril.
Recapitalising banks is on-going, whether through bail-outs or easy lending, for example, loosening collateral requirements for repo. Sovereigns are being bailed out by quantitative easing and equivalent measures. The buck stops with the public, with tax-payers and consumers at the end of the line for everything. They quite rightly demand tighter regulation. Seriously though – do they really want more of the same of fancy craftwork around risk weights and bank models?
Basel has seen the light in one respect by proposing leverage ratios as a backstop, even though there seem to be hard luck casualties with that too. Moving forward we should have a much more transparent system of measuring how the real economy is being served. Right now, when growth is precious, the combined activity of regulation and banking choices threatens small and medium-sized enterprise (SME) funding and trade finance, two activities both essential to and best placed to deliver growth. One solution would be to apply minimum ‘flat capital’ charges for portfolios of activities specific to growth. This would mean, for example, keep up your SME and trade finance portfolios or have idle capital. Interfering yes – so too is interference the market craves from central bank intervention and fiscal policy – but it's the economy stupid!
Sharon Bowles is a member of the European Parliament and chair of the Economics and Monetary Affairs Committee
