Repos are not only one of the financial instruments with crucial importance for funding. They primarily played a significant role to the recent financial crisis as well. Hence, the question is, whether Basel III and the Dodd-Frank Act successfully mitigate instabilities in repo markets.
Within this analysis and by reviewing key studies, I am going to explain two statements: Firstly, how Gorton and Metrick (2012) empirically verified that the repo functioned as a crisis trigger, and secondly, how Valderrama (2010) modeled an economic framework to deduce several constrictions for regulators. These researches build the base for the evaluation of repo regulations. I explain why capital requirements and CCPs are the most effective preventive policies to reduce both counterparty credit risk and systemic liquidity risk associated with repos. Under a libertarian evaluation approach, specifically the CCP framework constitutes an effective element and starting point for regulatory haircuts and liquidity ratios.
Table of Contents
1. INTRODUCTION
2. SECURITIZED BANKING
2.1. The repurchase agreement
2.1.1. Characteristics
2.1.2. Market and volumes
2.2. The repo’s transformation
2.2.1. In the pre-crisis period
2.2.2. During times of instabilities and distress
2.3. The contribution of shadow banking and repos to the crisis
2.3.1. Short-term funding and shadow banking risks
2.3.2. Repo risks as a cause of instabilities
3. STUDIES ON REPO RISKS
3.1. Counterparty risk and the run on repos
3.1.1. ABX indices and the LIB-OIS spread
3.1.2. Data and empirical tests
3.1.3. Discussion
3.2. Margin calls and bankruptcies in the repo market
3.2.1. The model
3.2.2. Model results
3.2.3. Discussion
4. REGULATIONS
4.1. Basel III
4.1.1. Prevention of a run on repo
4.1.2. Reduction of liquidity risks
4.2. The Dodd-Frank Act
4.2.1. Prevention of a run on repo
4.2.2. Reduction of liquidity risks
4.3. Discussion and outlook
4.3.1. Summarizing evaluation
4.3.2. Political recommendation
4.3.3. The future of repos
5. CONCLUSION
Research Objectives and Key Themes
This study investigates the role of repurchase agreements (repos) within the shadow banking system and their contribution to financial market instabilities during the 2007-2009 crisis. The primary research goal is to evaluate whether current regulatory measures, specifically the Basel III accord and the Dodd-Frank Act, effectively mitigate counterparty and systemic liquidity risks associated with the repo market.
- The historical transformation from traditional banking to securitized shadow banking.
- Empirical analysis of repo market risks, focusing on haircuts, margin calls, and bank failures.
- Technical evaluation of Basel III capital requirements and liquidity ratios using economic models.
- The impact of the Dodd-Frank Act's resolution mechanisms and central clearing requirements.
Excerpt from the Book
1. Introduction
In ancient China, collateralized loans have been used probably even before 1,000 BC, but with the Federal Reserve introducing repurchase agreements (or repos) in 1917 (Acharya, et al., 2010), secured loans became more complex. During the 20th century, repos gained in importance until right before the recent financial crisis, when they were seen as “perhaps the most important financial instrument in the world, after the basic cash equity and bond product” (Choudhry, 2006, p. 3). In addition, repos were considered of high relevance for short-term funding (Mancini, et al., 2014), as an essential requirement for liquid derivatives markets (ICMA, 2013), and even as the predominant instrument in the shadow-banking system (Penney, 2011). The combination of this central economic role with the findings of Gorton and Metrick (2012), whereby the withdrawals from the repo market triggered the financial instabilities, lays out the reasons of the financial crisis. Two factors describe the connection between the crisis and repos in the most appropriate way. Firstly, the run on shadow banks and repos initiated the financial crisis. Secondly, systemic liquidity shocks had already destabilized the market prior to the crisis, and worsened the development later on.
Summary of Chapters
1. INTRODUCTION: Provides the historical context of repos and frames the research question regarding their role as a crisis trigger and the effectiveness of subsequent regulations.
2. SECURITIZED BANKING: Analyzes the transition from traditional to securitized banking and outlines the mechanics of repurchase agreements and their systemic importance.
3. STUDIES ON REPO RISKS: Discusses technical literature regarding counterparty risk, the run on repos, and how margin calls and haircuts contribute to systemic instability.
4. REGULATIONS: Evaluates Basel III and the Dodd-Frank Act through technical analysis, focusing on their impact on counterparty and liquidity risk mitigation.
5. CONCLUSION: Synthesizes the findings, suggesting that while regulation reduces risk, it requires independent academic evaluation to avoid counterproductive effects.
Keywords
Repos, Shadow Banking, Financial Crisis, Basel III, Dodd-Frank Act, Haircuts, Margin Calls, Counterparty Risk, Liquidity Risk, Systemic Risk, Securitization, Financial Regulation, Central Counterparties, LIB-OIS Spread, Financial Instability
Frequently Asked Questions
What is the fundamental focus of this research?
The work focuses on the role of repurchase agreements (repos) in the shadow banking sector and their significant contribution to the financial crisis of 2007-2009.
What are the central themes discussed?
The core themes include the mechanics of repo funding, the transformation of banking systems, the empirical evidence linking repo market dynamics to financial crises, and the regulatory oversight provided by Basel III and the Dodd-Frank Act.
What is the primary goal of this investigation?
The primary goal is to determine if current regulations, specifically Basel III and the Dodd-Frank Act, effectively mitigate systemic risks and liquidity issues inherent in repo transactions.
Which scientific methodology is employed?
The paper utilizes a combination of empirical reviews, analyzing studies such as those by Gorton and Metrick (2012), and technical analysis based on macroeconomic frameworks, notably the model by Valderrama (2010).
What topics are covered in the main section?
The main section covers the history and characteristics of repos, empirical studies on repo risks (such as the LIB-OIS spread and margin calls), and a detailed evaluation of regulatory instruments like capital requirements and central clearing.
What key terms characterize this analysis?
The analysis is characterized by terms such as shadow banking, systemic liquidity, counterparty credit risk, repo haircuts, margin calls, and pro-cyclicality.
How do Repo 105 transactions relate to this study?
The study examines the excessive use of Repo 105 by institutions like Lehman Brothers as an accounting maneuver to artificially deleverage, which contributed to market instability and loss of trust.
Why is the LIB-OIS spread considered a significant measure?
It is used as a crucial proxy for counterparty risk and market liquidity, signaling the lender's doubt regarding the solvency of borrowing banks during periods of financial distress.
What is the conclusion regarding central counterparties (CCPs)?
The author concludes that while CCPs can concentrate and potentially reduce counterparty risk, they also present concentrated liquidity risks that may not necessarily solve systemic problems during extreme market stress.
- Arbeit zitieren
- Sebastian Bieder (Autor:in), 2014, The Repo as a Part of Shadow Banking. An Empirical and Regulatory Discussion, München, GRIN Verlag, https://www.grin.com/document/301171
