Repo Market Atrophy Seen Accelerating With Leverage Measures

The market for borrowing and lending securities risks shrinking further and seeing increased volatility as regulators heighten bank-leverage standards.

The biggest U.S bank-holding companies will face greater restrictions on borrowing power than their overseas competitors as they meet a demand to hold capital equal to at least 5 percent of total assets under rules adopted April 8 to curtail financial-system risk. The Federal Reserve, one of the regulators, also proposed leverage-calculation revisions, including stricter criteria for excluding repurchase-agreement, or repo, transactions from banks’ total assets.

“Moving to a leverage constraint, even while allowing some form of netting, is going to meaningfully increase the capital intensity of the repo business for some banks,” Brian Smedley, an interest-rate strategist at Bank of America Corp. in New York, said in a telephone interview. “Over time, it will likely cause a widening of bid-ask spreads, particularly in Treasury repo, resulting in leveraged counterparties paying higher rates for repo financing and short-term investors earning lower rates on their cash.”

In a repo agreement, one party provides cash to another in exchange for a security as collateral. The market is used by the Fed’s 22 primary dealers primarily to finance holdings, and money-market mutual funds are the typical providers of cash.

‘Some Limitations’

The Fed’s proposal on calculating leverage, which is subject to public comment, calls for different criteria for figuring leverage ratios than banks use now under U.S. generally accepted accounting principles, known as GAAP.

“This puts some limitations on a firm’s ability to offset repo liabilities against reverse-repo exposures when compared to the GAAP rules that the market has been operating under for repo netting,” said Smedley of Bank of America, which is a primary dealer.

The 5 percent leverage rule was approved by the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.

The requirement, which will apply to eight lenders, surpasses the 3 percent minimum set in a global agreement by the Basel Committee on Banking Supervision.

Compliance “is likely to cap the size of repo balance sheets, putting downward pressure on short-term rates,” Andrew Hollenhorst, fixed-income strategist at the primary dealer Citigroup Inc. in New York, wrote in a client note yesterday.

‘Reduce Liquidity’

Fed Governor Daniel Tarullo acknowledged in a memo to policy makers on April 4 that the leverage measure “could affect the equilibrium level of interest rates or reduce liquidity in short-term funding markets.”

“However, the Federal Reserve has a flexible and diverse policy toolkit that can offset most, if not all, unwanted pressures that may develop as a result of the supplementary leverage ratio, and so any effect likely would be limited,” wrote Tarullo, the Fed official who’s responsible for financial regulation.

While a Fed fixed-rate reverse-repo facility created last year “can help the Fed successfully target a given short-term repo rate regardless of the regulatory pressure on repo balance sheets, it cannot in our view ‘fully offset most, if not all’ of the reduction in liquidity in short-term funding markets,” Citigroup’s Hollenhorst wrote in his note.

Possible Tool

Use by cash lenders of the facility, which is being tested as a possible tool for the Fed’s eventual tightening of monetary policy, has already increased. About $242 billion was posted to the facility on March 31, the largest amount yet.

The facility currently offers a rate of 0.05 percent and is open to the Fed’s tri-party reverse repo counterparties, which includes money-market mutual funds, government-sponsored entities, banks and the Fed’s primary dealers.

Transactions in the tri-party repo market have declined 18 percent in the past year to an average $1.61 trillion in outstanding securities each day as of February, from $1.96 trillion in December 2012, data compiled by the Fed show. In a tri-party agreement, 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.

While the repo netting guidelines “are better than they could have been,” they’re not ideal, Josh Galper, the managing principal of securities-finance consultant Finadium LLC in Concord, Massachusetts, said in a phone interview.

‘Middle Ground’

“Regulators are trying to figure out what is the correct middle ground between the gold standard for risk management, which would actually choke off the real economy, and the point where the real economy gets what it needs,” Galper said.

Given the leverage measures, “the repo market will continue to contract without a further evolution in the market structure,” Galper said.

Reduced dealer activity in the repo market, combined with the Fed holding its benchmark interest-rate target at virtually zero since 2008, helped drive repo rates down in recent years.

The rate for borrowing and lending Treasuries for one day in the repo market averaged 0.075 percentage points over the past year, according to a general-collateral finance repo index provided on a one-day lag by the Depository Trust & Clearing Corp. That compares with a 0.127 percent average over the past three years. The overnight Treasury general collateral repurchase agreement rate closed yesterday at 0.07 percent, according to ICAP Plc, the world’s largest inter-dealer broker.

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