One of the most daunting challenges in the wake of the financial crisis is figuring out what to do with the systemic risk posed by the repo market, a complex arena in which funds travel fast through complex networks of securities-financing transactions inside and outside the financial system, sometimes reaching warp speed through the wonders of rehypothecation. Several critical new repo rules are brewing, and we today sent clients an in-depth analysis of one particularly important initiative: the FSB’s final framework and proposed haircuts for this sector. Like the EU’s new, broader regime aimed at curbing shadow banks, this one is supposed to work as a result of still more sanctions on banks that are supposed to choke off the risky “shadow” sector. The FSB calls this “indirect” regulation; I call it ineffective and, worse, perverse. Regulators have forgotten that, the harsher the light shone into one corner of a room, the deeper grow the shadows in the others.
My concerns are not so much that still more capital and liquidity standards for the biggest banks will exact still more misery on the already-struggling sector. Although defending big banks isn’t exactly popular, it’s worth asking just how many rules for how many different goals implemented through varying layers of differing capital and liquidity standards make sense. But, I digress.
The real problem with “indirect” regulation is that it won’t work. There are four reasons for this: first, the FSB can fulminate all it likes, but it can’t make countries tow the line on capital and liquidity rules for repos, leading to widely differing rules that will exacerbate already worrisome regulatory arbitrage. Second, it isn’t at all clear that the new capital and liquidity rules will choke off shadow repo exposures – quite possibly, they’ll only make them riskier because some exposures (e.g., sovereigns) have no minimum haircuts – worsening concentration risk – while others have low ones likely to be offset by higher risk positions. Third, the haircuts are premised on the systemic-risk solution the FSB hopes results from new central counterparty (CCP) requirements, even though CCPs could actually worsen risk through ill-regulated concentrations. And, perhaps most importantly, bank exposures aren’t the real worry regarding repos – it’s the lack of an orderly resolution regime that ensures risk lands where it’s supposed to under stress. Without a workable repo resolution regime, one can lard all the capital one wants on banks and, even if it sticks (which it won’t), it doesn’t matter when the next big one shakes the financial system’s foundations.
The FSB in fact recognizes this. It’s trying several ways to address repo resolution. First, it’s issued a consultation on new resolution standards governing CCPs and other financial-market utilities. As FedFin’s analysis of this describes, the proposal raises many unanswered questions – not least among them how the new resolution fund is supposed to step in under stress or how it would be funded or even work. Thus, while one might hope CCPs can be readily resolved without taxpayer bail-out, there’s presently no way to know for sure.
The FSB has also tried its hand at a consultation paper on resolution protocols for firms that hold client assets (also analyzed in-depth for FedFin clients in a report a week ago). However, large swaths of the repo arena are outside its reach because title is transferred when assets are rehypothecated, essentially putting clients at risk for sins in which they play no part and about which they may well have no prior notice.
Recognizing how weak this reed is, the FSB’s new framework suggests work on a “Repo Resolution Authority” or RRA. It notes the need for this because most insolvency regimes (including those in the U.S. and E.U.) exempt repos from the automatic stays that would otherwise give regulators a chance to prevent panic when firms falter. Without this automatic stay, repo counterparties can and indeed do head for the hills when the first sign of trouble shows – a prime driver for the interbank credit crisis that made the 2008 whirlwind such a near-death experience. Repos were safe, but all else was nearly lost.
So, right the FSB is – for a meaningful end to TBTF, one needs a robust resolution framework for CCPs and repos and coverage under some form of automatic stay. Indeed, proposals to do so-called “Chapter 14” Bankruptcy Code revisions in the U. S. have already been proposed. But, instead of engaging with these ideas and picking one for substantive action, the FSB instead says figuring all this out is just too darn hard. Citing “practical” impediments to constructing an RRA, it says thinking hard about it now should not be a priority.
So, back to the new “indirect” rules in which banks are to shoulder one more burden in hopes it solves problems regulators think too daunting for them to take on by themselves. How nice to be a nonbank.