UNLESS REGULATORS TREAD CAREFULLY, CRITICS charge, they could damage a finely tuned market that reduces risk in the financial system. This safety valve is the market for repurchase agreements, or repos, which has rebounded sharply from its 2008 lows. By letting banks borrow cash from one another using a broad range of collateral that avoids concentration in a narrow group of assets by any single firm, the repo market makes financial shocks less likely. But analysts and market participants fear that forthcoming Basel III liquidity rules will leave repo borrowers and lenders dangerously reliant on a thin selection of securities blessed by regulators. “Banks, not regulators, should be judges of liquidity,” says Richard Comotto, a visiting fellow with the ICMA Center at the U.K.’s University of Reading. The center was founded in 1991 with funds from the International Capital Market Association.
The repo market took a beating during the financial crisis, when worries about the creditworthiness of collateral swiftly but temporarily slashed deal volumes. By December 2008 the value of outstanding European repo contracts had fallen 29 percent compared with the previous June, from €6.50 trillion ($10.02 trillion) to €4.63 trillion, according to the European Repo Council, an arm of Zurich-based ICMA. But as of last December, the market had all but regained its precrisis size by rebounding 34 percent, to €6.20 trillion.
Now repo faces a new foe in Basel III’s liquidity coverage ratio, which national banking regulators will introduce by 2015. The LCR is one of the most hotly debated rules to emerge from the Basel Committee on Banking Supervision, the international body leading efforts to tighten bank capital and liquidity requirements. The liquidity ratio calls for banks to hold enough “high-quality liquid assets” to match any net cash outflows over a 30-day period.
Earlier this year the Basel committee agreed to revisit the LCR, taking note of “specific concerns regarding the pool of high-quality liquid assets,” and to publish any modifications by the end of 2012. But bankers have become increasingly doubtful that the committee will make major changes. Although cash lenders can use assets held as repo collateral to help meet the ratio, the committee deems that equities don’t count as high-quality and liquid assets.
The Basel committee and the Federal Reserve System, which will implement Basel III in the U.S., had no comment. The ICMA Center’s Comotto acknowledges the challenge of creating standardized liquidity rules. “My sympathy is with the regulators,” he says. “They face an impossible task.”
Repo experts say the new rule will make counterparties more reluctant to lend cash for equities, pushing up the interest rates demanded for such deals, which are currently well below unsecured wholesale funding rates. “We may see cash lenders swapping equities for fixed income because equities cannot count toward their ratio,” says Staffan Ahlner, managing director of global collateral management at Bank of New York Mellon Corp. in London.
Given the right safeguards, there’s no objective case for excluding prime equities on liquidity or quality grounds, says David Schraa, Washington-based regulatory counsel at the Institute of International Finance, a trade body for financial institutions. Prime equities — those included in major indexes — were quite liquid during the credit crisis, Schraa notes. The rules encourage banks to favor highly rated government bonds, despite the fact that the euro zone debt crisis has shattered assumptions about the creditworthiness of those securities. “The high-quality liquid definition is too narrow,” Schraa contends. “It will cause excessive concentration in sovereign bonds, which is of questionable wisdom.”
Some skeptics go further by asking if regulators should be in the business of setting such standards. Because markets constantly change, “any attempt by the regulators to define a high-quality liquid asset will inevitably be wrong,” says Hugh Carney, senior counsel at the American Bankers Association in Washington.
Repo participants have already reacted by shifting more funding into deals with a duration of more than 30 days, says the ICMA Center’s Comotto. This gives them a clearer picture of cash and asset holdings over the period covered by the LCR than would a plethora of shorter contracts. In the year through December 2011, contracts longer than 30 days rose from 25 percent to 36 percent of outstanding repo volume, the European Repo Council reports. But even if short-term deals dwindle, repo volumes will increase over time, predicts Greg Markouizos, head of Citigroup’s London finance desk. Markouizos cites financial institutions’ growing desire to seek safety through collateralized lending.
Outside the repo world, what’s the upshot for bank treasuries? “The liquidity charge the treasury department allocates to business lines for holding on to assets that don’t count toward the ratio will inevitably go up,” says David Sunstrum, regulatory affairs specialist at the IIF.
The ABA’s Carney warns of unintended hazards if regulators pressure banks to hold a certain proportion of lower-yielding assets: “You’re pushed into taking greater risks with the remaining assets in your portfolio, in the chase for yield.” By suppressing one risk, Basel III may simply create another. • •
