Time to Reduce Repo Run Risk

Jennifer Taub is an associate professor at Vermont Law School. Her book “Other People’s Houses” (Yale University Press) will be published in May.

At a recent conference in Boston, Thomas Hoenig, the vice chairman of the Federal Deposit Insurance Corporation, and Sheila Bair, the former chairwoman of the agency, cautioned about the systemic risk stemming from the way banks lever up through the short-term wholesale funding markets.

They are right to warn us.

The banks remain dangerously interconnected and vulnerable to sudden runs because of their dependence on short-term, often overnight borrowing through the multitrillion-dollar repurchase agreement, or repo, market.

Let’s recall. The collapse of investment banks Bear Stearns and Lehman Brothers in 2008 were each precipitated by repo runs. Before it failed, Bear depended on $50 billion in overnight repo loans that it used to finance the majority of its mortgage-linked securities. A week before it collapsed, Lehman had $200 billion in overnight repo loans. Rescuing Bear through the JPMorgan purchase involved an unprecedented Fed commitment to absorb up to $29 billion in losses. And the Lehman bankruptcy kicked off a $300 billion-single-week run on money market funds and widespread panic.

Yet since then, little has been done to reduce the repo run risk for the now bigger financial firms that survived the crisis.

A repo is essentially a collateralized loan. With a repo, an investment bank in need of cash might sell $1 billion in securities (referred to as collateral) to a cash-rich entity like a money market mutual fund. At the outset, the money fund would pay the bank slightly less than $1 billion, a haircut. Under the agreement, the investment bank would buy back the securities at a specific date -- as early as the next morning. The money fund would be paid back the cash it lent plus a percentage. With matched-book repo, a dealer in one transaction acts as buyer, bringing in collateral, then sells that same collateral to a counterparty, profiting on the spread. Repo and other similar securities financing transactions such as securities lending enable banks to grow excessively large, leveraged and interconnected.

When trust is strong and cash plentiful, repos are rolled over. When trust reasonably erodes, or there is a panic, cash is demanded from the repo borrowers who might have to sell the collateral or relinquish it. This leads to fire sales by the borrower and others with similar securities and downward asset price spirals. Indeed, the Federal Reserve Bank of New York has repeatedly warned of the repo “fire sale” risk.

Particular repo reform measures proposed during the Dodd-Frank legislative process landed on the cutting room floor. This included a proposal put forward by Senator Bill Nelson, Democrat of Florida, to end the special protection for repo lenders in bankruptcy.

To reduce repo run risk, a specific statutory provision to roll back the bankruptcy safe harbors is ideal. We should not wait for its enactment, however. Dodd-Frank contains many tools the regulators can use right now.

For one, the Federal Reserve has been signaling that it plans to act like a chaperone and is focused on the partygoers who have been spiking the punch. As the New York Fed stated in an update posted on its website in February, “in the absence of a market-based solution . . . regulators may be forced to use the tools they have to take steps to reduce this risk.”

In a November speech at an event sponsored by Americans for Financial Reform, a Fed governor, Daniel K. Tarullo, provided a glimpse of a “more comprehensive set of measures” that may soon materialize in rule-making. Such an approach could include “financial actors not subject to prudential regulatory oversight,” could cover matched books and is likely to involve higher capital requirements.

Whatever route is taken, it is important that certain outcomes are achieved. Short-term repo borrowing by banks with collateral other than Treasury obligations should be substantially curtailed. And the Fed’s annual stress tests should include maturity mismatch and funding liquidity risk by including in the stress scenarios possible short-term wholesale funding runs based on the 2008 financial crisis.

Blaming the higher cost of capital, dealers are retreating and threatening to pull back more from the repo market. This could be good, because short-term repo borrowing would thus shrink or become more stable. And they are not the only game in town for cash-rich repo lenders. For example, the Fed has established a reverse repo facility with 94 money market funds.

With the Fed now deploying securities in its huge bond portfolio in these reverse repos, it may be well positioned to take away the punch bowl.