Adapt to survive
The negative impact of regulatory reforms on repo market activity may be a case of ‘collateral damage’, but banks must nevertheless adjust to the new reality.
One of the first lessons of the financial crisis was that few people fully understood the intricate web of relationships between financial market participants. As such, many post-crisis reforms have focused on making the industry simpler and more transparent. But untangling a web is no easy task, especially when it is also being relied upon to support economic growth. Europe’s repo market sits at the heart of its wholesale financial markets. As a result, it has been affected by many of the ongoing regulatory reforms. But this core role also means it is relied on to channel funding to the wider European economy, a critical function when recovery remains slow, and subject to reversal.
European authorities are aware of the tensions between supporting economic recovery and reforming the finance sector. The European Commission’s Capital Markets Union (CMU) initiative – officially launched in September 2015– aims to ensure that Europe offers a wide range of accessible and transparent financing options to growing companies that have historically relied on bank lending. Policy-makers are also aware of the repo market’s role as a mechanism for transmitting monetary policy in the pursuit of wider macro-economic objectives, particularly after market participants provided valuable guidance to support the recycling of securities bought up in the European Central Bank’s (ECB) quantitative easing programme.
The significance of repo
Nevertheless, many believe the negative impact of regulatory reform on such a crucial part of Europe’s economic and financial infrastructure has not received due attention. “In light of the recent regulatory changes that are restraining repo market activity, one might well conclude that regulators and central banks don’t understand the wider significance of repo to the wholesale financial markets. It is clear that the product is not regarded as essential,” says Godfried De Vidts, chair of the International Capital Market Association’s European Repo Committee.
De Vidts believes the liquidity squeeze on interbank repo activity may hamper transmission of euro-zone monetary policy in future. “The US Federal Reserve transacts with money market funds, but the ECB can only use banks to transmit monetary policy. Without decent levels of interbank repo liquidity, Europe is walking a fine line. The shadow banking system could play a role, but this sector is being squeezed by regulatory change too. The cumulative impact of regulation on the repo market is contrary to what the commission is trying to achieve through CMU,” he adds.
Balance sheet restrictions
Intentionally or not, a host of reforms have had the effect of lowering bank appetite for repo market activity. Partly due to its multi-faceted nature, the repo market has been impacted by efforts to constrain bank balance sheets (Basel III), restrain proprietary trading activities (Volcker) and impose robust resolution and recovery regimes. “The overall response to Basel III has been an intense focus on the allocation of scarce balance sheet resources. Limitations on capital, leverage and funding all act as a constraint on business. Overall, the effect is to make banks rethink what businesses they want to be in,” says Steven Hall, banking partner, KPMG LLP in the UK.
Balance-sheet intensive repo business may be less profitable under Basel III, but the core role of the repo markets in many banks’ funding strategies means a threat to repo is also a potential threat to other business lines. Already, limited access to balance sheet is causing a latent gap between supply and demand in the repo market, but Greg Markouizos, head of fixed income finance at Citi, sees a more fundamental reshaping of the market by a combination of regulatory forces, ranging from the newer measures under the Basel III framework – the Net Stable Funding Ratio (NSFR), and total loss-absorbing capacity requirements – to the extra layer of capital rules imposed on globally systematically important banks from a resolution and recovery perspective.
This changes the nature of repo market participation because it shifts banks’ focus from their assets to their liabilities, specifically the quality and composition of underlying collateral and type of counterparty. This is leading to an increased appetite for longer-term transactions with non-financial counterparts, for example. “Rather than simply reducing securities finance and repo activity, banks’ responses will be more nuanced, choosing counterparts based on regulatory capital treatment and entering transactions on the ability to extend the tenor of their liabilities,” says Markouizos.
Transformation of the repo
The fact that repo is so intimately linked to so many other elements of the financial markets may be a blessing as well as a curse. In short, banks may have to adjust their approach to repo market activity, but they still must have access. Writing in the International Financial Law Review, Andy Hill director of market practice and regulatory policy at the International Capital Market Association, describes post-crisis reforms as transforming rather than squeezing the life out of the repo market, changing the incentives, with consequences for liquidity, but having the overall effect of turning repo desks into utilities for the management of liquidity and collateral.
Hill suggests this direction of travel is being forced by further waves of regulatory change: the NSFR will make short-dated repos more expensive for banks; mandatory buy-ins under the Central Securities Depository Regulation pose new risks for liquidity providers; the EU Bank Recovery and Resolution Directive may stymie securities lending through ‘stay provisions’ for repo; and the Financial Stability Board may impose new restrictions on collateral repo use.
While this may not prompt an exit from repo market activity, it will hasten decisions on whether to migrate to a liquidity and collateral allocation utility model or try to find alternative ways of delivering balance sheet, albeit based on higher costs and a closer alignment of client-bank collateral and liquidity requirements.
Long-standing market participants that value the ability of the repo market and its expert trading desks to serve as clearing houses for otherwise mismatched needs or risks might regret what is lost in its transformation. But the adjustments – as well as the influx of new liquidity from non-traditional sources – may yet enable the market to continue to serve its many traditional purposes.
The CMU could bring relief and recognition to the repo market, but its participants must also adapt to the new reality. Asked recently whether the post-crisis regulatory pressures was too severe for banks to fill their wider role in the European economy, Yves Mersch, member of the executive board of the ECB, said: “Banks need to respond adequately to the challenges by reinventing themselves and reinvigorating their business models.”