Tuesday, July 20, 2010
Abstract: Funding liquidity risk has played a key role in all historical banking crises. Nevertheless, a measure based on publicly available data remains so far elusive. We address this gap by showing that aggressive bidding at central bank auctions reveals funding liquidity risk. We can extract an insurance premium from banks' bids which we propose as measure of funding liquidity risk. Using a unique data set consisting of all bids in the main refinancing operation auctions conducted at the ECB between June 2005 and October 2008 we find that funding liquidity risk is typically stable and low, with occasional spikes, especially around key events during the recent crisis. We also document downward spirals between funding liquidity risk and market liquidity. As measurement without clear definitions is impossible, we initially provide definitions of funding liquidity and funding liquidity risk.
Download here: www.bis.org/publ/work316.htm
Wednesday, July 14, 2010
European Repo Market White Paper Emphasises Importance Of Repo And Urges Reform Of Market Infrastructure
(Press Release) ICMA’s European Repo Council (ERC) has today published a White Paper on the European repo market, including the role of short-selling, the problem of settlement failures and the need for reform of the market infrastructure. It emphasises the importance of the repo market for the efficiency and stability of the financial system.
The White Paper was commissioned by ICMA’s ERC in response to current regulatory considerations which will impact the repo market. There is concern that regulatory initiatives should not constrain the capacity of the repo market in Europe at a time when increasing demands are being made on it, both by the regulators themselves in terms of proposals for enhanced collateral management to reduce risk and by governments in terms of increased debt issuance.
Proposals relating to the restriction of short-selling would have unintended consequences for the securities market, which will increase costs and risks for issuers and investors.
There is also an urgent need for action to remove the barriers to the efficient cross-border transfer of securities posed by the settlement infrastructure. The paper highlights infrastructure problems which have caused fails in the system in recent difficult market conditions and suggests solutions.
The White Paper was written by Richard Comotto of the ICMA Centre drawing on extensive interviews with market participants, regulators and clearing systems.
Godfried De Vidts, Chairman of the ERC commented: “The White Paper will make an important contribution to the debate that is needed amongst policy makers, assisting them to make informed decisions. The support from the market, in the form of the ERC Committee and the ERC Operations Committee, allowed the author to produce this comprehensive document in a comparatively short time, demonstrating the commitment of the repo community of the ERC to continue working on a meaningful debate to solve repo related issues. We welcome more in-depth, constructive discussions with all concerned and trust they will lead to a well-functioning secured funding market that will continue to be an important brick in the building of a more robust financial market environment.”
The main issues which the ERC White Paper addresses are:
Role and functioning of the repo market: The White Paper emphasises the important role played by the repo market in providing secure and efficient cash funding, and as a means of borrowing securities, which underpins bond market liquidity. Repo is also a key tool for central bank operations. At a time when governments are depending on markets to distribute large quantities of debt, regulation which affects the repo market could have serious consequences for sovereign debt issuance. It also explains how some of the more arcane features of that market (ie negative repo rates) form a normal part of market operation.
Short selling: In response to the Greek crisis regulators are discussing how to control short-selling and in particular naked short-selling. The repo market provides the borrowing facilities that support short-selling. The paper describes the essential role of short-selling, and outlines the likely costs and risks of regulatory restrictions. The argument is made that short-selling is not a problem but a necessary and desirable market activity for a well-functioning and liquid securities market, and that “abusive” short-selling is rare and should be tackled through existing market abuse regulations. The paper supports reporting of short positions to regulators to assist them in monitoring short-selling and identifying potential abusive behaviour. The cost of suppressing a normal market activity would be serious unintended consequences for market efficiency and liquidity at a time when governments are seeking to use those markets to issue large amounts of debt. The damage to the repo market would also derail the regulators’ proposals to encourage increased collateral management as a means of containing credit risk.
Clearing and settlement: The White Paper proposes that official action is needed by regulators to remove barriers to clearing and settlement in Europe, which may have contributed to problems experienced during recent market turbulence; and suggests reforms. It details interconnectivity barriers between national Clearing and Settlement Depositories in various Eurozone countries and the International Clearing and Settlement Depositories (ICSDs) used by international investors.
The European repo market White Paper is available from ICMA’s website
Thursday, July 8, 2010
Abstract: The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.
We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.
Download here: www.newyorkfed.org/research/staff_reports/sr458.html