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Basel III Measures May Heighten Repo Volume, Risks, Fitch

Risks may rise in the U.S. market for borrowing and lending securities if tougher global bank regulation increases some types of trading of repurchase agreements, according to Fitch Ratings.

Capital and liquidity rules for banks, known as Basel III, were enacted by international regulators in 2010 in a move to help protect the world’s economy after the worst worldwide financial crisis in decades following the collapse of the U.S. subprime mortgage market. Basel III regulations, which need to be implemented by 2019, require some banks to hold more capital.

“Stricter bank regulations, such as Basel III, could push some bank-intermediated activities, particularly those involving riskier exposures subject to higher capital charges, into the shadow banking sector,” New York-based Fitch analysts Kellie Geressy-Nilsen, Martin Hansen and Robert Grossman wrote today in a report. “During the U.S. credit crisis, repo markets were linked to both illiquidity-driven price volatility, particularly for securities that lost acceptability as collateral, and to funding challenges faced by some dealers that faced diminished market access.”

Repo Trading

Repos are transactions used by the Federal Reserve’s primary dealers for short-term funding. They typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to lenders, which often are money-market mutual funds.

The Fed has been seeking to strengthen the tri-party repo market, which approached collapse in 2008 as Lehman Brothers Holdings Inc. went bankrupt. The central bank intensified its effort after a private-sector Tri-Party Repo Infrastructure Reform Task Force that it sponsored issued a final report in February said more time and effort were needed.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry’s clearing banks.

“There is a focus on the possibility of increased banking regulation incentivizing the shadow banking market, particularly high-risk activity that attracts higher capital charges under Basel III,” said Grossman, managing director of macro credit research at Fitch in New York and one of the report’s authors, in a telephone interview today. “Repos are a significant part of the shadow banking market and that is why we are trying to highlight the potential liquidity risks.”

Shadow Warnings

Global regulatory authorities have warned that shadow banks, such as structured-investment vehicles, hedge funds and money-market mutual funds could be used to evade regulators’ attempts to clamp down on excessive risk-taking in the wake of the global credit crunch and subsequent lender bailouts. The shadow-banking system had liabilities of about $16 trillion in the first quarter of 2010, the New York Fed said in a report that year.

Bank of Canada Governor Mark Carney, chairman of the Financial Stability Board charged by Group of 20 leaders to coordinate global financial reform and monitor progress, said in November that the FSB will help design regulations for the market-based financing, referring to the shadow banking system.

Prime money-market funds’ investments include banks’ certificate of deposits, commercial paper, repurchase agreements and short-term notes and deposits.

“Given their inherent leverage, short tenor, and relatively opacity, repo markets remain a potential channel for liquidity risks during market distress,” the Fitch report said.

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