Tuesday, 28 January 2014

Repo Pros and Cons



I was discussing repos with someone the other day.  The issue was whether the use of repos was a good thing or not.

In a repo, one party (the borrower) sells securities to another (the lender) and simultaneously agrees to buy them back at a later date at a fixed price.  This is similar to borrowing money and providing the securities as collateral, as the borrower gets the use of cash for a period of time at a known cost, whilst retaining full exposure to the risks and rewards of the securities.

There are a few differences.  With a repo, the lender has full use of the securities and can sell them or use them as collateral himself.  Also, the amount of securities is adjusted (usually daily) for changes in the market value, so that the value of the collateral tracks the amount of cash provided apart from intra-day movements.  (The value of the collateral to be maintained is typically slightly higher than the amount of cash).

Concerns have been raised about pro-cyclicality of repo finance and its potential to exacerbate market price movements.   If the price of securities falls, the borrower is required to provide more securities as collateral.  This reduces the overall amount that can be borrowed against the total portfolio, forcing the borrower to reduce his overall holdings.  This forced sale of securities pushes down the price yet further.   In this sense, repos seem to create a hard-wired feedback loop.

Whilst this is certainly an important issue to be aware of, the point I want to make here is that this is a function of leverage, not repos specifically.  Compared with the same level of borrowing, but on an unsecured basis, repos are better.  Credit risk is a deadweight loss to the economy.  The uncertainty associated with the exposure has negative utility for the lender, but no positive utility for the borrower.  Use of collateral to reduce this risk therefore has an overall benefit.  Repos provide a very efficient way of using collateral.

So, a repo will in general always be better than an unsecured borrowing.  The problem with repos is that, because of these same advantages, they allow greater leverage.  It is the extra leverage that creates the additional risks to financial stability, not the structure of the repos themselves.

If there is concern about financial stability, the ideal solution would be to limit the amount that is borrowed, but to allow that as much of that borrowing as possible to be structured as repo or other secured borrowing.

5 comments:

  1. Overnight repos are the natural holding for money funds, since they have minimal credit risk and no interest rate risk.

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  2. Nick, when you say that the ideal solution would be to limit the amount borrowed, I'm left wondering how you hope that that could come about. It presupposes the possibility of some wise, all-powerful, regulator. In reality we are always going to have captured/confused/overstretched regulators. That is why I still think we need to have a lending system that has no room for fragility; an idiot proof system where all of the potential risks are born in a transparent manner and priced in to the provision of finance.
    You say that credit risk is a deadweight. The real risk is the unavoidable underlying enterprise risk. It is impossible to magic away enterprise risk by using debt financing. All it does is to shift that enterprise risk away from the creditors and onto other people (ultimately the tax payer when bail outs happen). In fact equity financing creates LESS enterprise risk because a struggling company does not go bankrupt so fast if it has less debt.

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    1. All I'm really trying to do here is point out that the issue is leverage, and that to the extent that repos are problematic , it is only through their impact on leverage. I don't think this is at odds with what you are saying.

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    2. I'm still left thinking that the whole point is that we wouldn't typically get that sort of damaging lending if there was not a layer of financial alchemy protecting the creditors from the risk. Doing away with the alchemy would eliminate the problem. To my mind that offers the best hope for avoiding financial crises. For what its worth, Warren Mosler has said that secured lending is a key problem and needs to be avoided:
      http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html
      "Banks should not be allowed to accept financial assets as collateral for loans."

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    3. Actually the quote highlights the point I'm making quite well. Stopping banks taking collateral doesn't necessarily stop the lending against financial assets. If you stopped banks taking collateral, but they still lend the same, that would be a worse position. So the only benefit is from the reduced leverage.

      I do agree though that preventing use of financial collateral would probably reduce overall leverage to some extent.

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