Defence against the dark arts: repurchase agreements

It is interesting that the ECB is relying on long term repurchase operations to get the financial system back on an even keel. The question is, will this operation have the desired result? Probably not, is the answer if the financial system is still in a deleveraging cycle.

Back in 2008 there was an interesting article by the Federal Reserve Bank of New York titled “Liquidity, Monetary Policy, and Financial Cycles” that in a round about way sheds light on financial system liquidity and repurchase agreement dynamics.

“…the chief tool used by institutions to adjust their leverage is collateralized borrowing and lending—in particular, repurchase agreements (repos) and reverse repurchase agreements (reverse repos), transactions in which the borrower of funds provides securities as collateral”

“….the growth rate of repos is closely related to the degree of ease in monetary policy…. One implication of the link between repo growth and monetary policy is that the short-term rate targeted by policymakers (the federal funds rate in the United States) may be a key price variable in its own right…..our results suggest that the policy rate—through its effects on the cost of leverage—may be an important determinant of the expansion and contraction of balance sheets and the liquidity of the financial system…..Financial system liquidity emerges as the crucial concept that ties balance sheet management, asset prices, and monetary policy together.”

“Pro-cyclical leverage offers a window on the notion of financial system liquidity. …chain of events that follows a rise in asset prices during a boom or, alternatively, a decline in asset prices during a downturn…..a “boom” scenario in which the assets held widely by market players and intermediaries with pro-cyclical leverage increase in price….price increase will boost the equity or net worth of these institutions…. When balance sheets become stronger, leverage falls….institutions…..respond to the erosion of leverage by raising leverage upward…..borrow more, then use the proceeds to buy more of the assets they already hold…..increased demand for the asset tends to put upward pressure on its price, there is the potential for a feedback effect: the stronger balance sheets lead to greater demand for the asset, and this outcome in turn raises the asset’s price and further strengthens the balance sheets.”

“During downturns, the mechanism works in reverse. Consider a scenario in which asset prices decline. Then, the net worth of institutions will fall faster than the rate at which their assets decrease in value. As the institutions’ balance sheets weaken, their leverage will increase. Since these institutions are targeting pro-cyclical leverage, however, they must attempt to reduce leverage in some way—in some cases, quite drastically.”

While the article focussed on investment banks, the dynamics apply to the entire financial system. Given that current financial system leverage had been built up over decades and the still obvious signs of excess debt, we remain in a deleveraging cycle: this means asset values are more likely to be exposed to heightened risk of decline or default and therefore banks will continue to look to rebuild balance sheets and reduce leverage. Repurchase agreements in the current environment will more likely be used only to manage the risks of the transition to smaller balance sheets and lower leverage.

At the moment European banks can no longer get the necessary funding from the money markets or other banks and the introduction of transition type repurchase agreements are necessary. But this does not solve the problem of governments and the hope that banks will use the repurchase agreements to buy high yielding sovereign debt. The only way we can do this, is to encourage moral hazard and to coerce banks to increase leverage against their better instincts.  On this point a good reference on the issue of moral hazard within the Eurozone is the report Europe on the Brinkby Peter Boone and Simon Johnson.

As such, longer term repurchase agreements (the new 3 year terms) should reduce immediate funding stress and aid liquidity management, but may not necessarily help with lending, solvency or sovereign debt issues.

Other reading:

Securitized Banking and the Run on Repo / Regulators Consider Requiring Banks to Disclose More About Debt Levels / Off balance sheet repo risks come back to bite / Repurchase agreements, securities lending, gold swaps and gold loans: An update / Europe on the Brink

Leave a Reply