The BIS says banks’ unwillingness to intermediate in the repo market could create problems in times of stress.
Repo markets have contracted too much the BIS says, which has led to constraints in availability and the possibility of making things worse in times of financial stress. In its report on “Repo market functioning,” the Bank for International Settlements’ Committee on the Global Financial System says that financial regulations in some cases has undermined the repo market by discouraging banks to be involved.
The repo market allows banks and others to “monetize assets as part of their liquidity management” and to “cover any temporary shortfalls in cash flows.” An impaired repo market “makes it more difficult for investors to monetize assets in response to a shock.”
“The use of repo markets … can play a particularly important role during periods of market stress, when it may provide a means for institutions to raise cash without selling assets,” the BIS explains. “For this purpose, banks hold large amounts of government bonds, partly in response to recent prudential liquidity regulation.”
But banks have stepped away from the market or largely curtailed their role in the markets mainly due to new rules. These rules include stricter standards like the leverage ratio and the G-SIB capital surcharge — for some banks – which requires them to hold capital in proportion to the size of their balance sheets. The new banking rules also include “taxes and fees for financial institutions that are based on the size of their balance sheets.”
The BIS thus concludes that a reduction in the ability of repo markets to fulfil its function as a salve in times of liquidity stress “might, in principle, have serious implications for financial stability.” But the BIS also suggests this might be less likely as a smaller repo market creates “less dependence on repos,” which would then “limit the build-up of vulnerabilities.”
“Excessive use of repos can indeed weaken the financial system by facilitating the use of short-term funding and the build-up of leveraged positions backed by collateralized borrowing,” the BIS says. “It can also increase the interconnectedness within the financial system. In periods of stress, market participants become more sensitive to perceived counterparty risk and the value of the collateral can also be affected, thus amplifying the procyclical effects of leverage.”
Ultimately, “these risks need to be weighed against the benefits of having more constrained repo markets,” the BIS says.