For many years, we have been extremely focused on shadow banking and most specifically the repo markets (recently here and here). Most market participants will do through their trading life ignorant of the fact that the leverage in this market is what drives their assets up or down in most cases (because understanding something new is so ‘old normal’) even if it remains a major potential catalyst for problems ahead. The regulators get it though (kinda). As Barclays notes, changes to the risk-weightings of low-risk assets in the repo markets means US banks will need to deleverage by raising $30bn of fresh capital or reducing their (mostly low risk) assets by $598bn – not chump change in a market dominated by the Fed (and one that some have already raised default and liquidity concerns about).
The proposed simple leverage rule has the unusual effect of requiring banks with a high proportion of lower risk assets to de-leverage relative to peers
Repo lending is a low margin business with bid-ask spreads of only a few basis points for the safest collateral
Banks run matched repo books; they simultaneously borrow against securities (repo) and lend against securities (reverse repo), inflating the balance sheet while using only a small amount of the bank’s own funds
Repo relies on leverage to generate an attractive ROE, and even a small reduction in leverage could have a large effect on returns, causing banks to exit the business
The eight banks affected by the FDIC leverage proposal together have $1.1 trillion of repo liabilities
To comply five of the eight banks must de-leverage
Three of the five banks have repo books larger than the required asset reduction
Virtuously, Regulators may see a smaller repo market as reducing risks posed by flighty lenders and “fire sales”
But viciously, Repo supports collateral value and liquidity but its sudden withdrawal can do the opposite, as seen in 2008
As is clear, liquidity is cloesly related to repo; this is a problem since the ability of dealers to short securities can impact Treasury pricing and spread products (long-dated corporate issuance) will become more expensive since it is typically hedge via short Treasuries. Lastly, Mortgage REITs may be significantly impacted as owners of MBS will finance their portfolios via repo.