Fed Paper on Repo Exposes Inadequacy of Financial Reforms

I’m late to write on a terrific and largely unnoticed paper presented at the Federal Reserve Board’s research conference on “Central Banking: Before, During and After the Crisis” in late March (hat tip Michael C). “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncu could be more accurately titled, “What Financial Reform Missed.”

As Richard Bookstaber in his book The Demon of Our Own Design pointed out before the crisis, in a tightly coupled system like our modern financial markets, the most important step in reducing risk is reducing the tight coupling, meaning the ability of processes to move forward so quickly that they can’t be interrupted. The circuit breakers introduced in the wake of the 1987 crash are an example of a mechanism that reduces tight coupling. Bookstaber warned that in tightly coupled systems, measures implemented to reduce risk that failed to address the tight coupling typically wound up increasing risk (as indeed took place in the runup to the crisis).

Thus if you were to take a Bookstaber view of the world, you’d look first at reducing the interconnectedness of the financial system, and the biggest culprit is counterparty exposures. And it isn’t hard to make a case that the biggest source of counterparty exposures is repo financing. For newbies, Repo is short for “sale with agreement to repurchase.” In a repo, a party that owns a high-quality bond borrows against it in a pawn shop-like procedure, by selling it to another party with an agreement to buy it back it at a specified future date, including interest. Repos are typically overnight, and funds can thus
be readily redeemed if the repo lender decides not to renew the repo. (Operationally, it’s more complicated than that, since most repos are “tri-party repos” with banks like JP Morgan or Bank of New York acting as middlemen). Needless to say, the big global banks rely heavily on repo to finance their securities positions and collateralize their derivatives exposures.

The authors politely point out that the new Dodd Frank resolution powers would have done squat to prevent chaos in the wake of the Lehman implosion. Readers may recall that one disaster-in-the-making was the run on money market funds triggered when the Reserve Fund, a fund that invested heavily in Lehman commercial paper, broke the buck, leading investors to start to withdraw funds from other money market funds en masse. Money market funds are major providers of repo funding; the resulting run on repo would have been tantamount to a run on the major dealer banks. Not only would the Orderly Liquidation Authority under Dodd Frank have been unable to address the panicked withdrawals from money market funds, it is also unable to deal with other aspects of the Lehman failure (insolvency proceedings outside the US, some of which had systemic impact, the panic surrounding which hedge funds were caught with accounts frozen in the collapse of Lehman’s London broker-dealer).

And this is only the beginning of the critique of the OLA. The authors identify other shortcomings: the process may not move quickly enough, leading to anticipatory runs, not just on the firm at risk but also similar firms; counterparties of insolvent firms could lose money (what a concept!) and therefore contagion risk remains.

The paper argues that risk is better viewed as existing on the level of systemically important assets and liabilities rather than at the firm level. This is a fundamental repudiation of the current regulatory regime, which focuses on individual institutions and looks primarily to having higher levels of capital and liquidity as the way to insure systemic safety. But given the way prices of assets and liabilities can move adversely in a short time, even the increased risk buffers set forth in US and international regulation look to be inadequate. Stanford professor Anat Admati maintains that banks should hold 20% equity; Steve Waldman has argued for 30%.

Acharya and Öncu instead call for developing resolution mechanisms across a large range of markets:

Systemically important liabilities (SILs) can be defined broadly as those liabilities of highly-leveraged entities that are assets of other highly-leveraged entities and therefore when faced with haircuts in case of default would trigger runs on other entities. Examples of SILs include deposits, repos and over-the-counter (OTC) derivatives. Similarly, systemically important assets (SIAs) can be defined broadly as those assets that are either SILs of other highly-leveraged entities or potentially illiquid, high risk assets financed through SILs. Examples of SIAs include exposures to SIFIs [systemically important financial institiions], asset-backed commercial paper (ABCP) and risky repo collaterals such as mortgage-backed securities (MBSs). To the extent possible, the set of mechanisms should be expanded to cover as many classes of systemically important assets and liabilities as possible.

The authors argue for reducing risk in each of these areas via a variety of mechanisms: central clearing with adequate margining, deposit insurance, resolution mechanisms targeted to each asset type. The advantage is that by addressing only the systemically dangerous parts of financial firm balance sheets, the other pieces can be handled through existing legal/regulatory mechanisms.

They propose creating a repo resolution authority. Right now, effectively all repo is exempt from automatic stay in bankruptcy. In practical terms, that means repo lenders can grab the collateral when a firm fails. The authors would restrict that mechanism to only the very best collateral, namely Treasuries and agencies. The rest would be subject to the repo resolution authority, which would give a quick payout based on a conservative estimate of the collateral value. The authority would liquidate it in reasonably short order (target of six months) and would pay out more or claw funds back based on the actual amount realized).

Even if you don’t necessarily agree with the conclusions (the authors make a strong case as to why their proposal is less bad than alternatives), it’s worth reading for its history of the repo market and discussion of the role repo played in the crisis (I have a minor quibble in that it treats the fall in the value of repo collateral as driven by liquidity concerns, when in fact AAA CDOs were grossly overvalued prior to the crisis and correctly went to 95%+ haircuts when Lehman failed, which turned out to be a pretty good estimate of what they were ultimately worth).

It is nevertheless frustrating to see a useful paper like this appear so long after the reform horse has left the barn. Once again, complexity, opacity, and leverage have worked to the advantage of the banks. The authorities were caught flat-footed during the crisis, and reform proposals were wheeled into place when no real investigations had taken place. We are likely to bear the consequences of this rush to judgment sooner rather than later.