Banks Blaming Regulators for Repo Squeeze May Have Their Proof

  • German general collateral rate plunged at end of 2015
  • Leverage rules responsible for securities shortage, banks say

Banks have been complaining for years that regulation is damaging Europe’s 5.6 trillion-euro ($6.1 trillion) market for borrowing and lending securities, without much proof. Now, they say they have evidence to back up their claims.

Repurchase agreements, an essential component in the functioning of financial markets, showed a sharp drop in the availability of securities to use as collateral for short-term loans. The result was the general collateral rate for German debt plummeted in the final week of 2015 before recovering in the first weeks of January.

The decline was caused by a change in the leverage-ratio rule on capital requirements, said Nicola Danese, head of fixed-income financing for Europe, the Middle East and Africa at JPMorgan & Chase Co. It also suggests a dearth of high-quality assets might be a regular occurrence when banks report their financial positions.

“If on key quarter-end or year-end dates banks don’t need cash and they try to manage their balance sheet, they’re less likely to lend out liquid bonds,” said Danese. “This might contribute to some collateral shortage on those dates.”

Vital Market

Known as repos, the agreements are vital because they allow traders to finance positions in the broader fixed-income market. Banks have warned that if it doesn’t function efficiently, then liquidity in secondary markets may dry up. A breakdown in repos played a key role in the financial crisis in 2008.

The leverage-ratio rule is being adopted under the Basel III regulations, which aim to prevent a repeat of that crisis. It forces banks to employ a minimum amount of capital to fund their assets and penalizes transactions that involve large amounts of low-return securities, such as repos.

Evidence of the squeeze has shown up in general collateral rates, which measure the cost to a bank of lending out securities in repos. A negative rate shows banks received money from the agreements. In normal times, the rate is positive: it costs the institution money to lend out the bond in order to take in cash and free up its balance sheet.

The rate for German debt fell to minus 0.78 percent on Dec. 31 from minus 0.44 percent a week earlier. It was at minus 0.34 percent on Feb. 2. The drop in the euro-area average rate was more muted. It fell as low as minus 0.38 percent on Jan. 4 from minus 0.2 percent at the end of November, according to ICAP Plc data.

ECB Effect

Exacerbating the shortage of the high-quality securities needed for collateral is the European Central Bank’s quantitative-easing program. Of the 60 billion euros of debt purchased under QE each month, the largest single portion is made up of German bunds.

In Germany, “the squeeze is already there, that’s for sure,” said Godfried De Vidts, chairman of the International Capital Market Association’s European Repo and Collateral Council. “Otherwise the rates wouldn’t have been so expensive at the end of the year.”

Banks have stepped up their use of the ECB’s securities-lending programs to get hold of German and Italian debt since November. The programs are designed as a backstop for the repo market when banks can’t access the bonds they need there.

Eugene McGrory, who heads the European repo business at BNP Paribas SA, describes the leverage-ratio rule as a “blunt, crude instrument.” It’s hurting repos more than any other market and participants are concerned regulation has gone too far, he said.

Blunt Instrument

“You see that over particularly volatile periods, around what you’d call balance-sheet intensive periods” such as quarter-end, McGrory said on a panel at Clearstream Banking SA’s global securities-financing summit in Luxembourg last week. “Some degree of illiquidity is starting to show up in the market.”

Bankers at the annual general meeting of the ICMA’s European Repo and Collateral Council in Luxembourg on Jan. 27 called for a pause to regulation to give enough time to adapt and understand the consequences before more rules are implemented.

The new rules include the Net Stable Funding Ratio, which is being implemented under Basel III and requires banks to maintain a certain level of liquidity to cover their liabilities.

“We need to deliver what’s in the pipeline before filling the pipeline with more,” Marc Bayle, the ECB’s director general of market infrastructure and payment, said at the ICMA meeting.

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