European Union regulators may impose tougher collateral requirements on repurchase agreements on concerns that such trades might lead to unsustainable debt levels that threaten market stability.
The European Commission is weighing the measure as part of proposals to rein in risky financial activities that take place outside the regular banking system, according to a document obtained by Bloomberg News. Michel Barnier, the EU’s financial services commissioner, is scheduled to publish the plans next week.
Repurchase agreements, contracts where one investor agrees to sell a security and then buy it back at a future date and a fixed price, are a “central issue,” according to the document. The EU is working with global regulators to identify “regulatory gaps and inconsistency between jurisdictions,” including for collateral management.
The trades, known as repos, are one of several so-called shadow banking activities being targeted by the Group of 20 nations on concerns they may be used to evade a clamp-down on excessive risk taking. The Financial Stability Board, which brings together regulators, G-20 central bankers and finance ministry officials, said last year that shadow banks may create “an opportunity for regulatory arbitrage.”
Curbing shadow banks “marks a significant step up” by regulators in “the quest to eliminate or substantially reduce destabilizing factors in the system,” said Etay Katz, a partner at law firm Allen & Overy LLP in London.
“For banks and other regulated financial institutions this will unfortunately yield yet more restrictions on their funding profiles,” Katz said in an e-mail.
Tougher rules on the collateral that investors must give to back repo transactions may be needed be prevent high debt levels that “can increase the fragility of the financial sector and be a source of systemic risk,” the EU document says.
The FSB has estimated that shadow banking activities were worth around $60 trillion in 2010. This figure would represent 25 to 30 percent of the total financial system, according to the EU document.
In addition to repurchase agreements, the document identifies exchange traded funds, special purpose vehicles, and money market funds as other possible “shadow-banking entities and activities” that may need tougher rules.
Barnier will publish the draft plans next week and may seek to have new rules in place by the start of 2013, according to an EU official who declined to be identified because the talks are private.
An “overly aggressive” approach to regulating shadow banking could worsen the supply of credit to companies, said Richard Reid, research director for the London-based International Centre for Financial Regulation.
A bankruptcy examiner’s report found that Lehman Brothers’ Holdings Inc., the lender whose collapse in 2008 sparked a financial crisis, used so-called Repo 105 transactions to move as much as $50 billion off its balance sheet temporarily to show investors it wasn’t carrying too much debt.
“Shadow banking entities present serious challenges for the competent authorities in the European Union and elsewhere,” according to the EU document. Other measures being weighed by the commission include adopting rules that would make it easier to wind up shadow banks that fail.