FSB: Securities Lending, Repos Pose Numerous Stability Risks
April 26 2012 - 5:30PM
Dow Jones News
The Financial Stability Board said Friday it had identified
numerous risks to the safety of the financial system in the global
market for securities lending, a vital cog in the machinery of most
of the world's biggest markets.
At any time of any trading day, there are trillions of dollars
tied up in lending and repurchase deals, mainly thanks to a big
increase in collateralized borrowing in the world's biggest money
markets, the FSB said. It warned that in many cases, securities
lending and repo transactions help to raise the overall level of
leverage in the financial system, making it more fragile.
At the same time, the structure of the market is often opaque,
helping to conceal from regulators and from market participants the
risks that are thus created.
The FSB made its comments in an interim report as part of its
mandate to reduce the risks generated by "shadow banking," the
creation of credit by entities that aren't regulated as banks.
"Shadow banks" played a large part in the creation of bubble
conditions before the crisis struck in 2007, by creating massive
leverage outside the official and more tightly regulated banking
sector.
After absorbing comments on its work, the FSB is due to
recommend new regulatory measures for shadow banks to the Group of
20 largest industrialized and emerging economies by the end of this
year.
The FSB's report was far from a blanket condemnation of the
practice of securities lending.
"Liquid securities financing markets are...critical to the
functioning of underlying cash, bond, securitization and
derivatives markets," it acknowledged.
One of the most crucial functions of securities lending is that
market participants often borrow securities for the purpose of
shorting them--a process which itself is widely considered crucial
for keeping markets properly liquid.
However, the FSB expressed concern that the ability to lend
securities against cash collateral, and subsequently to re-deploy
that collateral in other credit markets, effectively allows
virtually any entity with a large portfolio to act like a bank,
exposing itself to both credit and liquidity risks.
The temptation to do just that has risen sharply for many big
portfolio players such as life insurers and pension funds, because
loose monetary policy since the collapse of the U.S. investment
bank Lehman Brothers in 2008 has driven down the returns they can
earn on low-risk assets such as government bonds. Lending a part of
their portfolio out in return for a fee adds precious few more
basis points of yield for companies that are now struggling to meet
their policyholders' expectations.
The FSB appeared particularly worried by the issue of
rehypothecation, by which participants reinvest the proceeds of
short sales, or cash collateral taken against loaned securities, to
create new investment positions. At least until the crisis, it was
common for the same collateral to be levered many times over
through long "re-pledging chains," of which nobody had a proper
overview.
Such practices not only raise the overall level of risk in the
system, but also the level of interconnectedness, making it more
likely that the collapse of one counterparty will have consequences
for the whole system. The FSB cited both Lehman and AIG Inc.
(AIG).
Although it didn't play up the risk, the FSB also noted a
relatively high degree of concentration in certain segments of the
market. Nearly two-thirds of the European repo market, for example,
is accounted for by only 10 banks.
-By Geoffrey T. Smith, Dow Jones Newswires +44 207 842 9941;
geoffrey.smith@dowjones.com
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