A trigger for the next GFC?

A potentially troubling development which is playing out was outlined recently in the latest BIS Annual Economic Report, namely the use of repos by banks to “window dress” their balance sheet optics to appear more favourable at regular reporting dates, such as year- or quarter-ends.

Repurchase agreements, aka repo, are a legitimate financing mechanism, usually used for raising short term funding by banks.

Where repos become problematic is when they are used to unduly increase balance sheet leverage, i.e. the debt to equity ratio (for instance to take a leveraged interest rate risk position) or are used to disguise the true level of borrowings.

In a process called a reverse-repo, banks can lend money to buy securities, which they then repo to raise more cash, which they then use to buy more securities, which in turn they then repo to get more cash, which they …you get the picture.

One result is that repos allow banks to increase their leverage, expanding their balance sheet without a commensurate increase in supporting capital.

You may recall that Lehman Brothers’ use of “Repo 105” to disguise their balance sheet and solvency weakness and to cover up losses at quarter-end, ultimately led to their demise in Sep-08 and was considered the trigger for the GFC.

Disguising problems

Around balance sheet reporting dates, by repoing a security and getting markedly less that what they were worth - the "105" in Repo 105 refers to the fact that the assets were worth at least 105 per cent of what Lehman was getting for them.

Lehman could record the transaction as if it had been a true sale of the bond, even though under the terms of the repo they had to repurchase it in the second leg of the transaction.

Funds raised from ‘selling’ the security would be deployed to pay off some of its other debts, i.e. “window dress” the balance sheet so it appeared they had less debt than they actually had.

Once the reporting date had passed, they would borrow more money to repurchase the security which they had contracted to repurchase in the original repo.

So why is this relevant or a concern now, you may ask?

Well, to avoid this over leveraging and potential misrepresentation of balance sheet debt levels, the BIS introduced stricter standards around leverage, namely the Basel III Leverage Ratio.

However, in the recent Economic Report the BIS has called out that “window-dressing in repo markets is material,” and is particularity prevalent for euro area banks where such exposures are recorded at quarter-end.

Big volumes

Indeed, the volume of usage is steadily increasing.

“Since early 2015, with the beginning of Basel III leverage ratio disclosure, the amplitude of swings in euro area banks’ repo volumes has been rising – with total contractions by major banks up from about US$35 billion to more than US$145 billion at year-ends.” Which indicate they are up to something.

Conversely, where averages are used for the period, i.e. for US and UK banks, the use of repos is more consistent.

We know than many European banks are still challenged by their levels of NPLs and that greater transparency as to their real levels of debt, solvency and balance sheet resilience is critical.

Use of accounting constructs to mask this is of great concern and would seriously erode the co-ordinated prudential regulatory action since the GFC to strengthen the financial sector.

It’s entirely plausible that further issues in the Euro banking space give rise to contagion issues in the global financial system and could trigger a relapse of the GFC, or a new version of it.

Aussie banks

Closer to home, Australian banks also use repos to massage their balance sheets for reporting purposes.

Although this does manifest in repo costs edging higher toward the end of each quarter -  declining once the new period begins - they're certainly not in the league of their Euro cousins and definitely don't warrant concern as to balance sheet robustness.

What we have seen is that banks in the Australian market have deposited more bonds into the repo market, which is absorbing available cash and pushing interest rates higher.

The other implication is that as rates for secured lending increases, this also pushes up unsecured funding rates - leading to a general lift in banks’ funding costs.

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