Avoiding the shadows
Iain Morse reports on the growing use of real-time collateral management
In a fractious and accusatory environment, the UK Financial Stability Board's interim report on Securities Lending and Repos (27 April 2012) is likely to be widely read, to have a role in shaping regulatory policy. It deserves study. The press release accompanying the report states that lending "may constitute an important element in the shadow banking system". Shadow banking can be variously defined. Paul Tucker, deputy governor of the Bank of England has it as "credit intermediation involving leverage and maturity transformation that occurs outside or partly outside the banking systems".
Gordon Brown, when UK prime minister, told the US Congress in 2009 that "you don't need a shadow banking system", and that we should "outlaw shadow banking". When not denouncing ‘casino banking' politicians and central bankers have been prepared to blame ‘shadow banking' for the financial crisis. Whoever is to blame, it won't be the politicians or central bankers.
Nevertheless, the report is workmanlike and thorough. It classifies the market into four main, inter-linked segments. The first is lending by institutional investors to banks and broker-dealers against cash or collateral security.
Second, comes the financing of leveraged investment funds (hedge funds) long positions by banks and broker dealers using both reverse repo and margin lending secured against assets held with the prime broker, as well as securities lending to hedge funds by prime brokers to cover short positions.
Third is an inter-dealer segment comprising primarily government bond repo transactions between banks and broker dealers that are usually cleared by central counterparties (CCPs). Linked to this is a fourth segment: repo transactions primarily by banks and broker dealers to borrow cash from cash-rich entities including central banks, retail banks, money market funds, securities lenders and, on an increasing basis, with non-financial corporations.
The report identifies five key factors that have contributed to the growth of these markets. First, there is demand by risk-averse institutions for cash-like instruments to support their primary investment objectives of preserving principal and liquidity. Then come the financing needs of financial intermediaries such as banks and broker
Third is the growth of investment strategies that use leverage and involve short selling.
Next is the increased need for banks and broker dealers to gain access to securities for the purpose of optimising the collateralisation of repos, securities loans and derivatives (collateral mining).
Finally, there are securities lenders and their agents seeking to enhance investment returns.
The report also identifies a series of activities as constituting "potentially important elements of the shadow banking system". These start with repo financing by non-bank entities to create short-term, money-like liabilities, often collateralised by longer-term securities.
Then there is leveraged investment fund financing that may lead to further leverage and maturity transformation.
Next is securities lending cash-collateral reinvestment - the use of cash proceeds from short sales to collateralise securities borrowing and then re-invested by securities lenders into longer-term assets. This constitutes a long credit intermediation chain with maturity transformation.
Finally, there are collateral swaps (collateral up/downgrades), which may further lengthen transaction chains or allow banks to meet liquidity needs.
Seven issues are seen as arising from these activities, which might pose risks to financial stability and merit ‘further investigation'. These start with opaque complexity, a lack of transparency which undermines the role of policymakers, which we can read as politicians and regulators. Procyclicality of system leverage and interconnectedness, the second issue, is seen as having the potential to influence the leverage, complexity and level of risk-taking within the financial system in a potentially destabilising manner. Consequent to this, collateral re-use can reinforce procyclicality.
There are also potential risks arising from the fire-sale of collateral assets, a scenario alluded to in the report; non-defaulting counterparties might sell collateral securities after a default in order to realise cash, or buy back lent securities with the possibility that this could, in turn, trigger further collateral fire sales. Potential risk might also develop where agent lenders offer indemnities to their customers against the risk of borrower default. Another area of concern is the re-investment of cash collateral; lenders can ‘effectively perform bank-like activities'. Finally there may be poor collateral valuation and management practices ‘as seen in the early stage of the financial crisis'.
Boiled down, there are two key areas of risk arising from lending in the report. First, there is a form of deposit multiplication, increasing the volume of money and credit in the financial system without clear oversight. Second, there is risk seen as arising from ‘train crashes' where failure runs down chains of serially-linked operations but where the first and last may not otherwise be directly connected; counterparty failure leading to fire sales is the most obvious example.
There has already been comments on the report from Tucker and European Commissioner Barnier. Tucker has suggested that only banks should be permitted to use client monies and unencumbered assets to finance their own business and that non-banks should segregate the same, although they might be permitted to margin lend. He has also suggested greater market transparency might be facilitated by the introduction of a trade repository with open access to aggregate data. Also, that regulators should be able to set minimum haircut or margin levels for the collateralised financing markets.
"This is sensible enough, although it may increase costs somewhat," says Stuart Catt, associate at Mercer's Sentinel Group.
Barnier seems less temperate. He has grouped lending with rehypothecation and repurchasing "which can lead to excessive risk-taking, sheep-like behaviour…. and excessive volatility in liquidity provision. These practices, left unchecked, played a decisive role in the difficulties faced by AIG, Bear Stearns and Lehman Brothers."
Whether everyone would wholly agree with this allocation of blame is open to question. His remarks are a reminder that in some quarters of the EU lending is seen as a source of deep systemic risk and will be regulated accordingly.
Meanwhile, how is the industry faring? "Volumes and margins are down. We have 95% of pre-crunch supply but only 60-70% of demand; there is a surfeit of lenders," says Catt. Unsurprisingly, there is plenty of emphasis on risk. "Beneficial owners are now scrutinising every aspect of risk and reward in their lending programmes," notes Martin Seagrott, head of marketing at lending software provider 4Sight. Demand for better reporting, including exact data on lending and repo programmes and on what is being lent are top of menu. "One outcome of this is a drive for consolidation; buy-side firms want a single system for lending, repo and derivatives collateral management activities," he adds.
Collateral and its management is now a key issue. "Cash as collateral is highly unfavourable for beneficial owners, while the supply of G8 investment grade paper is shrinking," concludes Catt. This is driving lenders to look for improved collateral management systems. "The key word here is optimisation. Collateral management systems need to suggest the most efficient collateral to pledge and receive at an enterprise level," notes Seagrott. Real-time collateral management is already with us and set to become more widespread.