I listened in to the first hour of a very interesting conversation on the Modern Money Network about the Alcimos vs. ECB case where Alcimos contests the legality of the ECB’s refusal to fulfil its LOLR function for Greek banks. A lot of that conversation revolved around the ECB’s (lack of) mandate for financial stability. Two observations:

1. The “ECB has no mandate for financial stability’ argument needs to be confronted with the fact that the ECB’s policies have financial stability implications. In a paper Cornel Ban and I have written, soon to be published in the Journal of Common Market Studies, we argue that the ECB’s collateral framework is pro-cyclical – that is, the risk management practices that it adopted from private repo market participants can and have sharpened liquidity spirals in Europe, with damaging consequences for periphery sovereigns. The ECB marks to market daily, makes margin calls daily, and has repeatedly hiked haircuts, just like  private shadow banks have done in crisis (and let’s not forget, the reason why the FSB has made reform of repo markets a priority for global financial stability).  This is why the various rounds of LTROs failed to stabilise European financial markets (LTROs are basically long-term repos, with the pro-cyclical risk management framework inbuilt) and why OMTs should be viewed as a commitment to preserve market liquidity in the markets where the very large European repo market sources collateral  – government bond markets.
2. The ‘mandate’ argument is spurious: the ECB has repeatedly interfered in the fiscal affairs of Member States, most recently opposing publicly the FTT plans. More importantly, it has invoked financial stability arguments to oppose the FTT, particularly on the repo market. As the Financial Times reported, Benoît Cœuré, ECB executive board member, said in 2013:

 “We’re willing to engage constructively with governments and the European Commission to ensure that the tax has no   negative impact on financial stability”

The ECB cannot cherry-pick when and how it cares about financial stability. Given its independence, it should most certainly not interfere in tax decisions of elected governments by invoking financial stability while simultaneously threatening to let the Greek banking system go because it has no financial stability mandate! It’s like someone putting their house on fire and deciding not to worry about it because they are not the officially-designated firemen.

The collapse of Lehman Brothers brought out of its obscurity the repo market, where financial institutions borrow against collateral (and temporarily transfer title of that collateral to lender). As its bankruptcy examiner reported, ‘six weeks before it went bankrupt, Lehman Brothers Holdings Inc. was effectively out of securities that could be used as collateral to back the short-term loans it needed to survive’. Gorton and Metrick famously termed Lehman’s collapse a run on the repo market.

Lehman’s collapse put the repo market on the regulatory map. Long gone were the days where central bankers thought repo were risk free funding instruments. In early 2008, discussing tensions in US financial markets, then chairman of US Fed Ben Bernanke mused:

  ‘remarkably, some financial institutions have even experienced pressures in rolling over maturing repurchase agreements     (repos). I say “remarkably” because, until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations’

By 2012, under a G20 mandate, the Financial Stability Board had identified repo markets as markets systemic to shadow banking, and created a separate work stream to design a regulatory regime that would address systemic repo fragilities. Reform would combine two sets of measures: improved transparency and structural measures that would curtail – or at least dampen – links between leverage, asset prices and cyclical liquidity – or, in Mark Carney’s words – ‘the cycle of excessive borrowing in economic booms that cannot be sustained when liquidity dissipates in core fixed-income markets’.

On both fronts, there is little, or uneven, progress.

Consider first transparency. The EU – with a repo market estimated to be similar in size to the US – leads the way. In the US, the Office for Financial Research (that once housed Zoltan Pozsar), recently deplored the voluntary reporting standards, warning that a ‘lack of a common data standard for identifying counterparties presents a substantial challenge in monitoring cross-market and cross-border exposures’. Indeed, the New York Fed identified six data points necessary for policy makers to get a systemic view of repo markets: ‘principal amount, interest rate (or lending rate for securities lending transactions), collateral type, haircut, tenor, and counterparty’. The voluntary reporting standards cover few of these.  In contrast, EU institutions have recently (June 2015)  reached a political compromise on Reporting and Transparency of Securities Financing Transactions (another name for repos). Expected to pass the last hurdle in October 2015 in the European Parliament, the Reporting requirements go beyond the six data points to include specific information about reuse and substitutability.

in comparison to the US, the European transparency rules appear nothing short of impressive. If and when put in practice (ESMA still needs to design the reporting template), the new rules will provide regulators (unfortunately not yet academics) with unprecedented granular detail of systemic repo connections. Yet behind this achievement lies a critical political compromise.  The European Parliament agreed to drop from its March 2015 draft Regulation the structural measures envisaged by the FSB (minimum haircuts).

This compromise illustrates well the little progress in designing structural measures to regulate repo markets. Initially, the FSB envisaged minimum haircuts to be applied to repo contracts regardless of counterparty and collateral. By Oct. 2014, it restricted its recommendations to a small subset of the repo universe (particularly for Europe, where banks dominate) where non-banks engage in repos with non-government collateral. The bulk of repo transactions – 80% against government collateral – will at best be monitored (in Europe), but not directly regulated. And the future looks even bleaker. The European Commission’s Capital Market Union plans highlight the importance of ‘collateral fluidity’, a clever way of saying repo markets should continue to be self-regulating.

What explains this growing reluctance to regulate repos? Political economists studying the regulation of finance typically look for ‘regulatory capture’ or ‘the power of finance’. This makes the repo industry lobby – the ICMA European Repo Council – sound rather powerful in European and global politics. While this may play a role, I argue in a paper just out in Journal of European Public Policy,  something more interesting, and more structural, is at play.

The paper asks how come that the repo market was the first to go off the table at the European FTT negotiations. It traces the history of the self-regulating repo market back to the Financial Collateral Directive of 2002, and to Alberto Giovannini, a very important figure in the recent history of European finance. During the early years of the Euro, the European repo market was a project designed by large European and US banks and supported by the Commission and the ECB, the two latter convinced that the specific mechanics of the repo would make its integration an engine for broader financial integration in Europe. This pre-crisis ‘repo bargain’ came under questioning at the height of the European crisis, when Germany and France suddenly linked repos to short-selling and systemic risk. With support from the two large member states, the Commission (controversially) included the repo market in the FTT, and defended it throughout the negotiations for enhanced cooperation. Yet by 2013 the Commission remained the lonely voice against a growing consensus – quietly supported by the ECB – that taxing the repo market would harm liquidity in government bond markets and hamper the transmission of monetary policy. Besides legitimate questions of the ECB’s interference in the fiscal affairs of member states, the debates on taxing the repo market demonstrate vividly the ambiguities that regulators face in reforming little understood markets – the conceptual confusions around ‘liquidity’ a case in point.

Rather than simply invoking an ‘all-powerful’ repo lobby, what matters in understanding the regulatory politics around repo markets is to trace clearly, and settle conceptually, the stakes that both governments and central banks have in the repo market.

 Daniela Gabor