New capital and liquidity rules are forcing banks to pull back from a vibrant market that has allowed them access to inexpensive overnight funding.
With the decline in funding volumes come potential outcomes that impact the $2.591 trillion market for money market mutual funds.
There are ripple effects, says Joseph Abate, a money market strategist at Barclays PLC in New York. The first ripple effect is there is a significant shortage of safe assets for cash-long investors to buy.
During the past two years, banks have been steadily reducing the volume of repurchase agreements, known as repos, that have served as a significant source of liquidity but which regulators see as an unreliable funding source for banks during crisis periods.
In this situation, money market funds may find themselves scrambling to find enough repo, which forces the funds to use an overnight reverse repo facility run by the Fed. This also keeps interest rates down on bills and other short-duration instruments as well.
That may or may not be a bad thing. However, it does create a disconnect in the market, says Abate. Such a disconnect in the market could have significant drawbacks. If there is not enough to buy, you artificially bid up the price of assets. You also encourage banks and others to create assets that meet that demand but that are not government safe assets, says Abate.
The pullback has been spurred by the federal banking regulatory agencies, which have targeted repos in new capital, leverage and liquidity rules in an effort to reduce banks reliance on short-term wholesale funding. The new regulations have driven up the cost of repos and reduced the return on assets in the high-volume, low-margin business.
The decline in the repo market is fundamentally shifting the makeup of the wholesale funding market in both positive and negative ways, according to market strategists and research analysts.
I know where the Fed [Federal Reserve Board] is coming from on this. The origin of the last financial crisis was this over-reliance on short-term funding. The funding disappeared. There were asset fire sales associated with its unwinding, says Abate. But there are other things worth noting, which is the reduction in balance sheet flexibility at dealers makes it harder to get in and out of positions, which means that in a sell-off, the market has to sell off even more to compensate for the lack of flexibility.
The impacts of a smaller repo market go beyond the role of banks that own dealers, however.
Its been a long, steady and substantial 20% slide in repo activity from the recent peak of $2.18 trillion in the collateral value of repos in November 2012 to $1.74 trillion in July 2014, according to the Federal Reserve Bank of New York with more likely to come.
The implementation of new Basel III regulations is expected to put further downward pressure on the repo market. Since the regulators first proposed a supplemental leverage ratio for the largest banks last summer, the repo market has declined by $750 billion as of July 2014, according to estimates from Goldman Sachs. Though the new leverage ratio will not go into effect until January 2018, Tier 1 leverage capital becomes a binding constraint under the Feds annual stress tests of major banks beginning next year.
NOT COMING BACK
As a result, the drawback from the repo market by banks is likely to be permanent, according to a research note published in April by Goldman Sachs. Banks are re-evaluating their balance sheet in light of the supplemental leverage ratio and the fact that it is viewed by the Fed as a binding constraint, according to the note.
After Goldman completed its own review of its balance sheet in response to new regulatory requirements, the company decreased collateralized agreement assets on its balance sheet by $52.5 billion during the first six months of the year, according the companys 10-Q.
More regulatory restrictions on the repo market could be forthcoming beyond those already in the pipeline. Right now we have a holding company leverage ratio and insured depository leverage ratio but not a specific limitation on the dealer, says Brian Smedley, director of U.S. rates research at Bank of America Merrill Lynch in New York.
But regulators have already floated ideas for specific limitations on broker-dealers. The Federal Reserve Bank of New York held a conference in New York on wholesale funding Aug. 13. In his keynote address, Eric Rosengren, president of Federal Reserve Bank of Boston, called for a higher capital standard specifically for banks that own broker-dealers. Fed Chairman Janet Yellen and Governor Daniel Tarullo have also called for higher capital levels at banks that rely on wholesale funding.
Commissioner Kara Stein of the Securities and Exchange Commission, meanwhile, called for haircuts on securities lending and repos in the SECs net capital regime for dealers in remarks she delivered at the Peterson Institute of International Economics in June.
It simply doesnt make sense to argue that even high quality assets have zero risk. This defies lessons learned from the recent financial crisis and basic principles of finance, she said. We need to address the stability and resiliency of our short-term funding markets comprehensively, and I hope you will join me in the effort.
Minimum repo haircuts on various types of collateral by either the Fed or the SEC would presumably be used to reduce leverage in the repo market, which probably have a negative effect on volumes in the market, says Smedley.
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