The Four Horsemen of the Repo Apocalypse

The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.

In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.

Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”

So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.

Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.

Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.

The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:

Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.

Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.

The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.

The Financial Crisis supposedly changed everything. It apparently changed nothing.

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