Systemic Risks in Repo Markets

Transcription

1 Systemic Risks in Repo Markets Somnath Chatterjee CCBS, Bank of England 8, November 2013

2 Outline Repo markets introduction Pro-cyclicality Role of Collateral UK banks aggregate repo activity Margin flows under a 100 bps rates shock Comparing securities lending and repo lending

3 Introduction (1) what is repo used for Financing long positions Covering short positions Risk taking by banks matched book desks

4 Introduction (2) who uses repo? Repo is used by hedge funds, securities dealers and the investment banking arms of commercial banks to fund their long positions and cover shorts Funding comes from non-bank cash providers or commercial banks An inter-dealer market exists to intermediate repo and take incremental risk

5 Introduction (3) General observations Repo contracts favour cash providers Haircuts dependent on collateral and counterparty credit quality Collateral provider must post margin against falls in value Both of these features contribute to pro-cyclicality Cash: 100 Funder Fundee Securities: haircut

6 Pro-cyclicality (1) Haircut levels are based on the volatility/liquidity of the underlying instrument and the credit quality of the borrower As markets rise and volatility falls, haircuts fall: leverage can increase. A positive feedback mechanism. As markets fall and volatility rises, haircuts rise: leverage falls. An adverse feedback mechanism

7 Pro-cyclicality (2) Are haircuts the true leverage constraint? Even without haircuts, repo is an inherently pro-cyclical funding tool As collateral values rise more leverage is available As collateral values fall cash borrowers must post more collateral or other margin In the latter case repo acts as a mechanical contingent claim on the cash borrowers balance sheet.

8 Pro-cyclicality (3): implications The requirement to post additional margin against declining alters the credit quality of the cash borrower (MF Global) Strategies or institutions that depend on repo may be inherently weaker than those who use unsecured funding Is this reflected in current regulation? If not should there be a change.

9 What do we need to know? What leverage and maturity transformation is being generated through repo Against what instruments Haircuts Pro-cyclical? Do they constrain leverage? How do cash and collateral providers manage their leverage and maturity transformation?

10 ISSUES If gross exposure then net exposure Collateral call, liquidity implication If collateral value then net exposure Top up collateral call, liquidity implication Assets become less good quality collateral as their value declines Systemic liquidity drain possible if an asset is widely used as collateral

11 Repo reuse Reuse, aka rehypothecation Some one posts something to me I take it, and post it on to someone else Collateral Poster RePoster Exposure Exposure

12 COLLATERAL CHARACTERISTICS: REPO Collateral form Repo: often a high quality liquid bond Reuse Commonplace Often very short term SYSTEMIC MARKET Key bank liquidity management tool Key central bank monetary policy transmission tool

13 COMPARE OTC DERIVATIVES AND REPO MARKET OTC Derivatives Initial margin Variation margin funds varying exposure Key motivation for trade is often risk transfer Repo Haircut Daily repo rolls funds varying balance sheet Key motivation for the trade is often funding so key market for institutions without access to deposit funding

14 RUN ON REPO Bank run (before deposit insurance) Doubts arise over the safety of a bank Depositors withdraw available funds Bank fails due to liquidity risk It cannot liquidate assets fast enough to meet the demand for funds Repo run Doubts arise over the safety of a repo counterparty Funders refuse to roll repos and/or demand much higher haircuts Counterparty fails due to liquidity risk It cannot liquidate assets fast enough to meet the demand for funds

15 EVIDENCE FROM LEHMAN Source: Valukas report Lehman was heavily reliant upon wholesale financing sources to fund a substantial portion of its balance sheet every 24 hours using overnight repos Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate

16 Re-use of collateral Collateral-based operations involve the intensive re-use of collateral, so that it supports as large as possible a volume of financial transactions. Dealer banks source capital. They receive it from parties that require funding, or from agents that want to enhance their return by renting out their assets as collateral. The collateral is pledged to other parties to obtain funding or support other contracts. This starts a system of repeated re-use of collateral where a single unit can support multiple transactions.

17 Repeated use of collateral in a dynamic chain. Source: IMF

18 Mapping the UK Financial System Linking sectors financial balance sheets to draw a map of the UK financial system Secured financing market (repo in particular) is a key interlinkage as it: - represents a significant source of funding for banks and nonbanks - supports liquidity in secondary asset markets Data availability is very patchy Built a UK-resident bank repo book balance sheet by combining imperfectly over-lapping data from a large number of sources

19 UK-resident deposit-taking banks aggregate repo activity at end-2011 Liabilities (repo) Assets (reverse repo) Net assets (reverse repo - repo) Central bank PNFC and Government UK-resident banks Intra-group UK-resident non-banks Other CCP CCP Other Non-residents: Non-banks Banks Banks Non-banks billions billions Sources: Bank of England and Bank calculations Large part of activity appears to be with foreign banks

20 UK-resident deposit-taking banks aggregate repo activity at end-2011 bn Reverse Repo Repo Total intra group BoE 0 13 UK resident banks UK resident non banks o/w CCP o/w other* UK PNFC and sovereign 3 9 Non residents: Banks Non banks o/w CCP o/w MMF's 0 54 o/w Foreign CB's 0 8 o/w other* Colour-coding key FSA Regulatory return data. MFSD Data. Blank cells indicate that no data is available. Crane data has been used to construct repo activity against US MMFs (goverment security collateral only) By assumption - the ratio of banks repo borrowing from and lending to hedge funds is assumed to be in the same proportion as the ratio of hedge funds aggregate repo lending and borrowing, taken from the FSA's Hedge Fund Survey Lower bound. FSA Top-30 repo counterparty exposures have been used to construct a lower bound Upper bound. MFSD country specific repo exposures have been used to construct an upper bound. bn Reverse Repo Repo Other Non Banks* o/w Hedge Funds o/w Sovereigns 23 o/w Corporates 10 o/w ICPF's 11 o/w Other AMs 6 o/w Residual** Sources: Bank of England and Bank calculations

21 Concentration of UK-resident banks repo activity Sources: Bank of England and Bank calculations Activity is concentrated within a handful of firms

22 New European Systemic Risk Board data ESRB data collection exercise on the re-use of non-cash collateral through securities financing transactions Major European banks asked to provide data on the value of collateral received / posted, broken down by counterparty sector and collateral type, as at end-feb 2013 Differences versus mapping-exercise data sources: - Values reflect collateral values (including hair-cuts) - Data includes Barclays large US matched repo book - Excludes some large UK-resident subsidiaries (e.g. JPM) and all UK-resident branches of foreign banks (e.g. DB) Despite these differences the stories are broadly similar...

23 ESRB data: UK-resident Banks aggregate repo activity by counterparty type Liabilities (repo) Assets (reverse repo) Net assets (reverse repo - repo) Other non-banks ICPFs Hedge Funds MMFs PNFC and UK gov CCP Credit institutions Central Banks billions billions Source: ESRB and Bank calculations. a) Sample consists of: Barclays and RBS; and UK subsidaries of HSBC, Standard Chartered, BoA-ML, Goldman Sachs, Morgan Stanley, Nomura and UBS. Gross repo is large (mainly interbank: bilateral and CCP-cleared), aggregate net repo is small, HFs are large non-bank users of repo

24 ESRB data: UK-resident Banks aggregate repo activity by counterparty and collateral type Liabilities (repo) Assets (reverse repo) Net assets (reverse repo - repo) Other non-banks ICPFs Hedge Funds MMFs Government & agency debt Covered bonds & ABS Bank and corporate bonds Equities Other PNFC and UK gov CCP Credit institutions Central Banks billions billions Source: ESRB and Bank calculations. a) Sample consists of: Barclays and RBS; and UK subsidaries of HSBC, Standard Chartered, BoA-ML, Goldman Sachs, Morgan Stanley, Nomura and UBS. Mainly Government and Agency debt Interbank and bank versus HF collateral-types most diverse

25 Variation margin flows under a 100bps rates shock Apply simple pricing formula to collateral types: Bonds: Equities:

26 Variation margin flows under a 100bps rates shock Apply simple pricing formula to collateral types: Bonds: Equities: Where, T = average maturity of underlying asset class Z = credit spread, r = zero-coupon sovereign yield, N =100 and C is calibrated so that bond is priced to par Where, D = dividends per share, g = growth rate of D r = 1-year zero-coupon sovereign yield, erp is calibrated so that equity is priced to current prices

27 Variation margin flows under a 100bps rates shock bn Other Equities Bank and corporate bonds Covered bonds & ABS Government & agency debt Banks Central banks CCPs Hedge funds MMFs ICPFs PNFCs and Soverigns Other non-banks Gross flows driven by interbank, hedge funds and other non-bank repo activity backed by government and agency debt Net flows do not (on the surface) appear particularly worrying

28 Variation margin flows under a 100bps rates shock bn Other Equities Bank and corporate bonds Covered bonds & ABS Government & agency debt Banks Central banks CCPs Hedge funds MMFs ICPFs PNFCs and Soverigns Other non-banks A concern might be that the shock to rates coincides with a fall in risk appetite and an increase in demand for some high-quality collateral Difficulty in sourcing this additional collateral May be exacerbated if collateral is tied up in repo chains

29 Comparing securities lending and repo Practical differences: haircuts Repo: Cash borrowers over-collateralise their counterparty with securities ( 100 of collateral to receive 90 of cash)... because the trades are typically motivated by one counterparty s desire for funding Securities lending: Securities borrowers over-collateralise their counterparty with cash ( 100 of cash to receive 90 of securities)... because the trades are typically motivated by one counterparty s desire to source specific securities

30 Comparing securities lending and repo Practical differences: motivation, participants and trade terms Feature Securities lending Repo Motivation Participants Trade terms Driven by one counterparty s desire to source specific securities Short-covering, financing and collateral transformation, hedging Yield enhancement, fee generation Beneficial owners: include non-bank financial companies, e.g. insurers and pension funds Others: agent lenders, banks, brokerdealers, hedge funds Transactions over 1 year are unusual Often open/callable rather than fixed-term Precise trade terms depend on lender Driven by one counterparty s desire for funding Liquidity management, financing, collateral transformation, hedging Sourcing collateral for other transactions (e.g. margining OTC derivatives) Banks and broker-dealers Asset managers including MMFs, hedge funds Insurance companies, corporate treasury departments Transactions over 1 year are more common CCP-cleared: standardised collateral/term Tri-party / bilateral (<1 year): collateral mutually agreed by counterparties, some uniformity Tri-party / bilateral ( 1 year): more tradespecific, often outside standard GMRA terms