The reason is not the two banks’ financial health but because they play a key part in a little-known section of financial plumbing, known as the tri-party repurchase or ‘repo’ market. This system channels funding throughout large parts of the financial system.
BoNY and JPM are the two main custodian or clearing banks in the US and as such look after the vast majority of the tri-party repo, which investment banks have relied on heavily to fund their balance sheets.
As Bear teetered on the brink of collapse in March, the Federal Reserve created the Primary Dealer Credit Facility, which became in effect a backstop for all investment banks using tri-party repo.
On Tuesday, Ben Bernanke, Fed chairman, said the PDCF, which was originally put in place for six months, would probably be extended beyond the year-end, adding that regulators were intent on improving how tri-party repo works.
“We have been working with market participants to develop a contingency plan should there ever occur a loss of confidence in either of the two clearing banks that facilitate the settlement of tri-party repos,” said Mr Bernanke.
Louis Crandall, economist at Wrightson ICAP said: “The vulnerability of the tri-party repo system has been a recurring theme among Federal Reserve and Treasury officials in recent weeks,” A potential problem with such a system is that the counterparty risk of billions of dollars worth of funding agreements is concentrated in the hands of two main players.
“Risk concentrations of this sort are under heavy scrutiny by the regulators,” says Mr Crandall.
A tri-party repo transaction writes Michael Mackenzie features a custodian bank, which acts as an intermediary and alleviates the administrative burden between two parties engaging in a repo agreement. It works very well using Treasuries and also features the use of lower quality assets. The over-reliance on repo using assets such as mortgages sparked an old fashioned run on Bear Stearns, as investors cut their repo funding.
Tri-party was very popular in recent years with Bear Stearns and other investment banks as it allowed them to finance their balance sheets with short term funding.
However, as soon as market sentiment turned negative on lower quality or more complex assets, such as mortgage-related securities, investors who fund these repo agreements began to pull their money out.
As such investors deserted Bear Stearns
In tri-party repo, the custodian bank helps to administer a repo agreement between two parties. An investor places its money with the custodian bank, which in turn lends it to another institution and then assets are pledged as collateral for the loan.
The reliance of banks on overnight funding through the repurchase of low quality assets to investors, as illustrated by Bear, becomes dangerous when markets turn volatile.
Scott Skyrm, senior vice-president at Newedge, a repo broker, said: “If a dealer or bank cannot get funding from customers via tri-party accounts, they will go to the Fed for the PDCF. In one way, the Fed is now taking the counterparty risk away from the clearing banks.” After reaching a borrowing peak of $38bn in late March, use of the PDCF has steadily dwindled. Last week’s average daily borrowing was $1.7bn and settled at zero on July 2.
Another concern is that both the custodian bank and cash investor rely on the other to monitor and price the collateral that has been pledged.
Mr Crandall said: “Recent financial engineering fiascos have shown that things can fall through the cracks more easily when responsibility for risk-management is divided among different agents.”
Mr Bernanke added that “a stronger financial system may require changes in the way borrowers and lenders use these markets, as well as in the settlement infrastructure operated by the clearing banks.”
Mr Skyrm said some of the key issues surrounding tri-party repo “are business decisions which should be made by businesses”. He added: “A bank should decide itself whether to let BoNY or Chase to price their collateral or do it themselves.”
For now, Mr Crandall said “the Fed is still not anxious to impose solutions on the market as it is still trying to decide what they may be.”