Author: Daniela Gabor

The ECB as lender of last resort….or on the short memory of central bankers

ECB President Draghi speaks to France's Central Bank Governor Noyer and ECB Member of Executive Board Praet in Barcelona

Peter Praet, member of the Executive Board of the ECB, gave an interesting speech on the ECB’s lender of last resort (LOLR) activities in crisis on February 10, 2016.

The ECB, he argued, had a two-folded approach: a ‘monetary approach’ LOLR and a ‘credit approach’ LOLR.

The ‘monetary’ LOLR, following the classic advice from Walter Bagehot, lent European banks base money (reserves) if these banks had acceptable collateral. The purpose:

to create new reserves, on demand, for cash-stripped banks with viable business models, and thus to help these banks go through an emergency liability substitution operation without being forced to make large- scale fire sales of assets that would lead to insolvency

This approach, he suggests, was used in the first phase of the crisis, immediately after Lehman, when banks became reluctant to lend to each other, and in the second phase, the European sovereign debt crisis. In his account, the ECB bears no responsibility for either, the crisis being rather a combination of the confidence fairy and the sovereign-bank loop, somehow only ‘diabolical’ in Europe:

The second phase of the crisis came as a consequence of a much more targeted and disruptive loss of confidence: the sovereign debt crisis. This was special to Europe; it brought on the development of redenomination risk and thereby threatened the integrity of our currency. Banks’ exposures to selected governments came under intense market scrutiny and entire national banking systems lost access to wholesale funding.

The ‘credit’ approach involved the provision of emergency liquidity assistance – the now famous ELA. In contrast to the ‘monetary’ LOLR, this involves a more discretionary approach, whereby national central banks assume the responsibility, and the potential costs, for supporting banks without eligible collateral.

Imagine that Praet decides to read his own research before writing this speech. He chooses a 2008 paper he wrote with Valerie Herzberg, entitled ‘Market liquidity and banking liquidity’, while both were at Bank of Belgium. Here is a copy-paste of their arguments:

  1. Interbank funding is itself becoming increasingly dependent on market liquidity as a growing proportion of interbank transactions is carried out through repurchase agreements.
  2. This increasing reliance on secured operations means that (European) banks are mobilising a growing fraction of their securities portfolio as collateral.
  3. Banks are increasingly mobilising their traditional government and corporate bond portfolios to finance less liquid, but higher yielding forms of assets that again can be reused as collateral.
  4. In periods of stress, margin and collateral requirements may increase if counterparties have retained the right to increase haircuts or if margins have fallen below certain thresholds.
  5. Asset liquidity may no longer depend on the characteristics of the asset itself, but rather on whether vulnerable counterparts have substantial positions that need liquidating.

This, we argue with Cornel Ban in our paper ‘Banking on bonds’, is the untold story of the European sovereign debt crisis. Not a story of a confidence fairies and redenominations risks, but of rapidly growing European repo markets before the crisis (1 above), of European banks mobilizing their portfolios of European government debt as collateral (2 and 3), of runs on collateral markets, including the government bond markets of the European periphery (4), that reflected more the funding pressures of large banks involved in US shadow banking than the fiscal probity of sovereigns (5). The European sovereign debt crisis was a story of fragile collateral in market-based banking, rather than the convenient eruption of redenomination risk.

More importantly, we argue, the ECB increased stress in collateral markets exactly as Praet predicted in point 4: in its lender of last resort operations, the ECB increased margin and collateral requirements, made margin calls, and in general worsened funding conditions at critical junctures in the crisis, both for European banks and European sovereigns.

Thus, we show that the ECB has played a critical role in trying to energize the integration of national repo markets in the Eurozone in the early 2000s. It decided to treat all Eurozone governments as equal collateral for its collateral framework – the terms on which it lends, via repo operations, against collateral. With this, it hoped private repo markets would follow suit, and accelerate integration of European financial markets. Anticipating objections that this effectively encouraged fiscal indiscipline in Europe (objections so loudly formulated by 2005 by Willem Buiter that Trichet was forced to defend the ECB’s collateral decisions in the European Parliament), the ECB adopted the risk practices of repo market participants: daily mark-to-market, margin calls and haircuts.

In doing so, the ECB could argue that its collateral policies had no substantive impact on government bond markets for two reasons. First, banks had little incentive to use government bonds to borrow from the central bank, since its repos carried higher haircuts than private repo transactions (where haircuts were zero for government debt) and ECB-held collateral could not be re-used in the repo market. Second, the ECB stressed that its collateral policie accommodated market views of credit quality. If markets distrusted Germany, its bonds would fall in market value. Like any repo market participant, the ECB would mark German collateral to market and make margin calls. Rather than disrupt, the ECB argued that its collateral policies reinforced private market discipline.

Screen Shot 2016-02-11 at 17.26.17

By trying to strike a delicate balance between its financial integration priorities and its independence, the ECB made a radical departure from how central banks in EMU countries had previously managed lending operations, including lender of last resort. These central banks rarely marked to market and never made margin calls when lending to banks (except the Dutch central bank), and few used initial haircuts.

Screen Shot 2016-02-11 at 17.00.12

By 2012, the ECB recognized that market collateral practices matter, but refused to include its own practices in that analysis. Vitor Constâncio noted that ‘the decline in collateral values translates in additional collateral calls possibly compounded with higher haircuts and margins requirements. A system in which financial institutions rely substantially on secured lending tends to be more pro-cyclical than otherwise’. He could have added: ‘ a system in which the central bank relies substantially on secured lending tends to be more pro-cyclical than otherwise’. The graph below is illustrative – it shows that the ECB was making increasingly large margin calls throughout 2012, and those calls only diminished once it announced OMT.

Screen Shot 2016-02-11 at 17.01.05

Short memory vs. politics and accountability? Had Praet followed through with his 2008 analysis, he would have had to make the ECB an active actor in the crisis. The dominant narrative that he reproduces in his 2016 speech –  that it miraculously came to the rescue of inept governments in the periphery – does not hold under scrutiny of his 2008 predictions. The European public – including governments – would have good reason to hold ECB accountable for its disruptive role in the European crisis.


China’s economy at a crossroads

With impecable timing, we are organising a one day conference on China in Copenhagen, on January 26. The blurb below, program and registration here.

Since the global financial crisis, it is becoming increasingly apparent that China matters for the stability and growth of the world economy. Yet questions of how, why and to what extent have not been settled. Pessimists predict a hard landing that will spread deflationary pressures across the world, while optimists retain their faith in the ability of China to learn from its experiments and keep the engine running. In this conference, we engage regulators, academics and market participants in a conversation that explores critical questions of macroeconomic rebalancing, debt and currency management, RMB internationalization, monetary policy and capital account liberalization.

Christopher Balding, Peking University, HSBC Business School
Luke Deer, Post-Doctoral Research Fellow, University of Sydney
Daniela Gabor, Associate Professor, University of West England
Tao Guan, Senior Fellow at CF 40, former Director-General of Balance of Payments Department, State Administration of Foreign Exchange (SAFE)
Patrick Hess, Senior Financial Market and China Expert, European Central Bank
Hu Hongbo, First Political Secretary, Chinese Embassy of Copenhagen
Yang Jiang, Senior Researcher, Danish Institute for International Studies
Zhang Jun, Director of China Centre for Economic Studies, Fudan University
Annina Kaltenbrunner, Lecturer, Leeds University Business School
George Magnus, Associate at Oxford University’s China Centre
Allan von Mehren, Chief Analyst and Head of International Macro, Danske Bank
Anders Svendsen, Chief Analyst, Emerging Markets Division, Nordea
Niels Thygesen, Professor Emeritus, University of Copenhagen
Jakob Vestergaard, Senior Researcher, Danish Institute for International Studies
Ming Zhang, Director, Department of International Investment, Institute of World Economics and Politics, Chinese Academy of Social Sciences (CASS), Beijing


Central banks have to get off the liquidity death star before they can destroy it


Streetwise Professor warns that clearing and collateral mandates create a ‘sort of liquidity death star’ because collateral-based funding (through repo markets) creates systemic liqudity vulnerabilities: margining leads to spikes in demand for liquidity, that in turn forces sales in illiquid markets, with further price volatility and margining. The mechanics of fire-sales and liquidity illusions are well known to regulators since Lehman (read Tarullo here), though the solution – clearing houses – doesn’t do away with the problem since it increase reliance on collateral sourced through repo markets.

Two further points.

  1. Central banks cannot fight the liquidity death star until they get off it. For a central bank to fight the liquidity death star, the Professor argues, it will need to ease collateral constraints by expanding the definition of ‘good’ collateral. This, of course, was the first measure that central banks across the world took after Lehman. But accepting ‘bad’ collateral won’t solve liquidity problems as long as central banks’ extraordinary lending relies on the same collateral practices that created (funding and market) liquidity problems in the first place.

Since the late 1980s, central banks have increasingly used repos to implement monetary policy, lending against collateral    instead of outright purchases of government bonds (the traditional form of open market operations). The turn to repos in monetary policy implementation prompted central banks to adopt the collateral risk management practices used by repo markets – the graph below shows that as the ECB took over from national central banks, it marked the beginning of a new regime for lender of last resort, where ECB marks collateral to market, and calls margin on a daily basis*.

Screen Shot 2015-10-26 at 06.44.06

Consider this scenario. When liquidity demand spikes and collateral constraints tighten, financial institutions turn to central banks. As good lenders of last resort seeing the death star approaching, central banks lend against ‘bad’ collateral.  But at the same time,  to protect themselves against credit risk, central banks mark-to-market and call margin if that ‘bad’ collateral falls in market price. Central bank margining means that a financial institution borrowing from the central bank against bad collateral faces the same funding pressures that it would experience in private funding markets.  This is exactly what happened to European banks during the sovereign debt crisis – with ECB making large margin calls at the height of the crisis in 2012.  The traditional crisis intervention – providing banks with funding liquidity – becomes pro-cyclical.

Screen Shot 2015-10-26 at 06.44.54

The money view – developed by Perry Mehrling and others – provides important insights. A crisis of market-based finance needs central banks to be much more than lender of last resort. As  dealers, or market-makers of last resort, central banks need to support the monetary quality of collateral-based liabilities, that is, to support (collateral) market liquidity. This is what OMTs did in Europe. A much messier world of central banking, as Mario Draghi well knows.

2. The repo ‘paradox’ – the growing post crisis collateral-based regulatory regime has not been matched by significant regulation of repo markets. At global level, the FSB has watered down plans to impose minimum (through the cycle) haircuts on all collateral – including government bonds. Latest plans leave out repos between banks and repos with government collateral. There is little left after that. In Europe, the Commission and Parliament have finally agreed on transparency requirements for repo markets, without any structural regulations. With the Capital Markets Union plans in full swing, transparency is as far as Europe will go.

Daniela Gabor

*for more on the ECB and the European repo market, read Gabor, D. and C. Ban (2015) Banking on bonds, Journal of Common Market Studies

Capital Markets Union: the view from London

Today, I attended a CMU event organised by Bruegel and HM Treasury at Westminster. The keynote address from the City Minister Harriet Baldwin was followed by a panel with market participants (the buy side – asset managers and insurers – and a credit rating agency), a Commission official and a Treasury official. The view from the government: UK a staunch supporter, celebrating the CMU as an excellent initiative of the type that Brussels and the EU should be generating more often. Having a UK Commissioner in charge of CMU clearly helps. Beyond the consensus ‘CMU is a good idea’ and between the lines, I noticed three issues.

  1. ‘It is our strong belief that institutional change is not required to achieve the objectives of the CMU. Single supervision would not add anything’

This is one of the sensitive points in CMU, and a lot of energy spent in documents and meetings to pretends that’s not the case. Although the Commission and several member states (see the 5 presidents report) would prefer to create a supranational regulator for integrated capital markets, UK opposes it strongly. According to this view, ESMA – the candidate for a pan-European regulator – is best placed to ensure that national regulators implement supervision effectively. In the context of the Brexit referendum, ‘the last thing we need is institutional change’ captures well the British politics of the CMU.

Is there a danger that European states repeat the pre-crisis mistakes with cross-border banking? The banking crisis demonstrated that the prevailing regulatory nationalism  was ill suited to deal with the coordination issues between home and host regulators. Ask any Eastern European banking supervisor.

The pessimistic British response to this question points to the foot dragging on the institutional architecture of the Banking Union. The hesitations and compromises there are steadily eroding (market) confidence in the ability of European politicians to create strong pan-European regulatory bodies. The optimistic view is that supervisory convergence that harmonizes rules would be enough to put the CMU on strong foundations.

One of the panelists questioned the premise of the optimistic view that for a single market it is enough to have common rules (and I would add, a rather fuzzy notion of ‘convergence’). In accounting, the application of rules (international standards) is not uniform – the fragmented enforcement of rules effectively entrenches the type of cross-border barriers that CMU aims to remove. The Commission recognises the validity of this point but is prepared to put the question aside because it wishes to avoid politically divisive topics.

So instead of calibrating the regulatory architecture to integrated markets, CMU envisages as next step a comprehensive review of post-crisis regulation. Given the complaints from the industry on the post Lehman ‘regulatory tsunami’ (loud and clear at this event too), expect this ‘proportionate regulation’ agenda to accelerate the process of watering down regulation that is already unfolding.

Recall this argument when your UK pension fund with exposure to German SME securitisation takes a massive hit due to large defaults in a market illiquid during crisis. And pray that ECB has normalised ABS purchases.

  1. ‘CMU will not harmonize borrowing costs for SMEs until there is a mechanism for rebalancing sovereign risks in Europe’

Market participants typically focus their CMU interventions either on deploring ‘regulatory tsunamis’ or identifying CMU areas that would improve synergies of their business model. In an unusual departure from the script, one panelist sought to make constructive criticisms. And it picked the elephant in the CMU room: government bond markets.

It is surely a measure of the creative genius of European regulatory politics that a project on furthering the integration of debt markets manages to say nothing about the largest debt markets in Europe (in Eurozone, EUR 6.8 trillion out of EUR 14 trillion outstanding in August 2015). Before Lehman and the sovereign debt crisis, the European agendas for financial integration used to stress the critical role that government bond markets play in financial markets, as proxy for risk-free interest rates, benchmark and hedging instrument for positions in other fixed income markets, and reserve ‘safe’ asset. The ECB made the integration of sovereign bond markets a priority, and used its lending collateral framework to accelerate it (by treating all Euro sovereigns as identical in terms of credit risk). The 2002 Collateral Directive was designed with the same ambition in mind – to allow private financial institutions to raise funding cross-border regardless of what sovereign collateral they use.

So can we have integrated capital markets with fragmented government bond markets? One of the panelists argued that  securitisation performance across countries reflects credit differences between sovereigns (the graph below, in a rather bad photo, mea culpa). So much for reviving the European securitisation market.


Yet the CMU authorities have tended to fudge this question because answers are as politically divisive as the issue of supranational regulator. If CMU was to make government bond markets a priority, what would concrete policy measures look like? Put differently, if CMU is about persuading German savers to give money to Portugese corporations without a bank in between*, what would it take to persuade that German saver to give money to the Portugese government? Or even more complicated, how much would a Portuguese SME need to pay a German saver to borrow when that saver is reluctant to lend to the Portuguese government?

Here the CMU official supporters answer the usual European way – not a priority to think about it.

  1. ‘ As public policy makers we have to deal with competing objectives, and balance them carefully. The FTT / CMU is a good example’

Private finance agreed that the FTT plans are at odds with CMU. Putting the FTT genie back in the bottle has been a priority, particularly for the European banking lobby**.

Yet the FTT genie has proven more resilient than many expected. Recent statements suggest a new impetus to finish negotiations, as France independently decided to extend its own FTT to intraday trades. This raises interesting questions of coordination between DG FISMA, that is designing CMU, and DG Taxud, that designed and (still) defends the FTT in the working groups of the 11 member states. The best that the former can do is to follow negotiations closely and ensure that member states are aware that the tax should minimize impact on market liquidity and NEVER EVER include the repo market.

The repo market has always enjoyed a privileged position in the minds of European regulators – particularly the ECB***. The Green Paper on CMU made some oblique references to it, stressing the importance of collateral fluidity to ensure that securitization activities can be funded in cross-border repo markets. ‘Fluid’ collateral appeals to the pre-crisis image of the repo market as an engine for financial integration that led European regulators to endorse the creation of a market architecture governed entirely by private rules. Since the crisis, we know that private architectures creates systemic vulnerabilities – this is why the FSB has identified repo markets as markets systemic to shadow banking. Yet so far the only reform European regulators are prepared to contemplate has been increased transparency of repo transactions, despite warnings from the ECB that ‘The interaction between CMU and shadow banking reform needs to be addressed. This interaction is not addressed in the Commission’s Green Paper, but it is relevant.’

The priority remains funding for SMEs. Repo, shadow banking, government bonds, and supranational regulation, are not a priority of CMU. The art of political compromise in Europe rests precisely on that ability to postpone critical questions. If we try very hard to ignore these questions they may go away.

* best translation I’ve heard of the CMU ambitions.

** the EBF response to the CMU Action Plan stresses that ‘ If European lawmakers are indeed serious about CMU, they also need to recognise the importance of liquidity in financial markets. Proposals such as the Financial Transaction Tax (FTT) and Bank Structural Reform (BSR) are at odds with the objectives of CMU. Dropping these proposals will greatly enhance the chances of success for CMU’.

*** for those interested in the FTT on repo markets, you can read more here: A step too far? The European FTT on shadow bankingJournal of European Public Policy 

Daniela Gabor

Putting the Capital Markets Union on sustainable foundations

Last week, the European Commission launched its Action Plan for a European Capital Markets Union (CMU). By European standards, this ‘most significant EU proposal for the last 10 years’ has proceeded at rapid pace under the leadership of the British Commissioner Lord Hill. For those attuned to the complexities of European politics, the CMU is a peace offering from Brussels (Berlin/Frankfurt) designed to showcase the strategic benefits that UK (and its City) enjoys from EU membership. Its (referendum) politics aside, the CMU’s ambitions are great: SME financing and job creation, growth via capital markets. Yet, we argue, if the CMU is to make a substantial and lasting contribution to investment and job creation in Europe, it must be accompanied by reforms that address systemic risk in securities-based financial systems and enhance pan-European supervision of securitization and repo markets.

The crisis of European banking after the collapse of Lehman was a crisis of market-based banking. European banks engaged in structured finance and other off-balance sheet activities were threatened by insolvency in 2008, leading to significant bail-out costs for European sovereigns. According to IMF research, 18 out of the 25 TBTF European banks vulnerable due to their trading activities required bailouts after 2008.  Since, as the IMF put it, ‘the vast majority of global finance is intermediated by a handful of large, complex financial institutions’,  initial regulatory efforts focused on reforming banks that had migrated to leveraged, interconnected, market-based activities. This also involved – through the FSB – global initiatives to curtail banks’ involvement in shadow banking, particularly in securitization and repo markets.

In this context, it is remarkable to see the growing consensus that growth in Europe requires more market-based finance. The European Commission makes the following case:  banks are still repairing balance sheets, new regulatory regimes increase their costs, making lending – to SMEs and other businesses – expensive. Allowing banks to engage more in capital market lending via securitisation, and to fund it in short-term money markets, would improve lending conditions in Europe, restarting growth. Those familiar with Perry Mehrling and Zoltan Pozsar’s work will recognise this ‘money market funding of capital market lending‘ as shadow banking.

Ironically, all evidence suggests that a Capital Markets Union is unlikely to improve SME financing. It’s unclear how much European SMEs are constrained not by limited access to finance, but by shortage of customers (i.e, demand). Stefanie Schulte, from RWGV, a German cooperative banks association, argues that even in the United States, the country upheld by the Commission as the model country in terms of capital markets, SME loan securitization is small and supported by public guarantees.  Here in Europe, when Germany recently tried to help SMEs issue bonds, the result was a wave of defaults and insolvencies. That experience suggests that the policy goal should not be to to reduce SME’s reliance on bank lending, but to nurture competitive and viable relationship banking. The argument of an over banked Europe compared to US is also bogus, Schulte argues:

   U.S. Federal Deposit Insurance Corporation (FDIC) counts more than 6400 credit institutions, among them thousands of small, privately owned, regionally active community banks. Community banks provide almost half of all small business loans in the U.S. In addition to this, there are more than 6000 credit unions. Per 1 million citizens, there are more than 40 banks and credit unions in the U.S. Now compare this to Europe: Here, Germany is one of the few countries with a relatively high density of banks. There are nearly 23 banks, credit cooperatives and savings banks per 1 million [German] citizens.

Four issues are essential to address for a sustainable CMU:

First, it is of paramount importance that key principles of “good securitisation” are not watered-down through pressure from large, international banks. Insisting that banks have a “skin in the game” is meant to avoid the perverse incentives that led to the global financial crisis. At the levels discussed now, however, risk retention requirements are too small to matter. Similarly, ongoing industry pressure to include synthetic forms of securitization in the CMU framework completely undermines the key notion of “simple” securitisation. The current ambiguity on whether to allow tranching in the forms of securitisation that are to be deemed ‘high quality’ also severely undermines the notion of simple and transparent securitization – since tranching by its very nature renders securitized products complex and opaque. A sustainable CMU must stand firm on the core principles – allowing only truly simple securitization in the framework, and insisting on substantial risk retention on the part of issuers. If it does not, it risks undermining rather than enhancing prosperity and growth in Europe.

Second, the CMU is likely to further increase the systemic importance of large banks in capital markets. Until recently, regulators in Europe were contemplating banking separation reforms to address the problem of too-big-to-fail banks. With the CMU, TBTF banks are likely to become larger still, as they will play key roles in reviving securitisation as issuers and market-makers. For their market-making activities, banks rely on collateralized funding markets, where borrowing against collateral makes leverage cheapest. So when the CMU speaks of the importance of “collateral fluidity”, it is essentially saying that we should ensure that collateral based funding for large banks remains unregulated although there is compelling evidence since the global financial crisis that banks run on each other in wholesale funding markets. Two implications result from this: (1) the sustainable CMU must abandon the notion of “freely flowing” collateral, instead adopting the (already watered down) minimum haircut requirements framework developed by the FSB and (2) serious banking separation reform must be pursued in parallel.

Third, regulators should take note that national supervisory regimes for capital markets are neither converging nor consistent. A pan-European agency that regulates European capital markets directly will be necessary to mitigate the cross-border nature of systemic risk in integrated capital markets, just as the Banking Union proved indispensable to adequately supervise large, cross-border European banks. Integrated capital markets are still vulnerable to sudden shifts in market liquidity, as the global financial crisis demonstrated that even very large markets can see liquidity evaporating rapidly. Without a pan-European regulator that can take countercyclical measures, it is difficult to see how systemic risks arising from European capital markets could be effectively addressed. An institutions-based regulatory regime – the one we have been building since 2008 – is ill suited to address (capital) market fragilities. A sustainable CMU must recognize that integrated capital markets cannot have segmented regulation.

Fourth, the action plan unveiled last week promotes a private Capital Markets Union. While the Commission has been reluctant to spell out the implications for government bond markets, it is important to recognize that the cornerstone of financial systems, government bond markets, have been (further) segmented by first the banking and then the sovereign debt crisis. Recent improvements are mainly due to the ECB’s quantitative easing (QE) and OMT commitments. Yet such unconventional monetary policies are designed to be temporary, while Europe has seen growing pressures for revisiting the preferential regulatory treatment of government bonds. Alberto Giovannini, one of the early architects of the European financial architecture, reminds us that ‘a very large proportion of the securities-based financial system requires means of transactions, and riskless government securities are best candidates’. How can capital markets function without risk-free sovereigns? Credit ratings and market liquidity will matter even more, thus sharpening the existing asymmetries between ‘periphery’ and ‘core’ (read Germany) governments.  Since the latter are more inclined to run budget surpluses, the second answer is exactly what brought us the 2008 crisis of shadow banking: private sector takes over the provision of ‘safe assets’.  A sustainable CMU should aim to eradicate existing asymmetries in market liquidity so that integrated government bond markets support the convergence in the costs of market funding for businesses across Europe.

Daniela Gabor and Jakob Vestergaard

The essay is based on ongoing joint work. We are grateful for comments from Vincenzo Bavoso and Frédéric Hache.

Alcimos vs ECB, financial stability edition

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.

7 years after Lehman and little to show for it on the repo front


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

Confessions of a deficit denier

Guest Post

The phrase ‘deficit denier’ is thrown around as an insult almost on a par with the denial of major historic disasters. As an event I clearly cannot deny the existence of a budget deficit at the present time, nor deny that there have been budget deficits for the vast majority of my lifetime.

I am though a ‘deficit denier’ in two important respects. The first is that I (and many others) deny the proposition that the budget deficit is the ‘most important economic problem’ facing the UK. Think of the economic problems facing us – poverty, unemployment, need for a greener economy and tackling climate change, low productivity growth, current account deficit, lack of housing etc.— against which any budget deficit problem fades into near insignificance. Even if the budget deficit is regarded as an issue, it should be seen as a sign of imbalances in the rest of the economy, and it is those imbalances which need to be addressed. When the deficit rose sharply in late 2008 and into 2009 it reflected the imbalances, at that time particularly the collapse of investment and of consumer demand. At present a growing imbalance is the current account deficit, and it is that deficit which needs to be addressed.

The second denial concerns the need to eliminate the budget deficit as the end point of fiscal policy. The austerity brigade promote the view that government budgets have to be balanced or in surplus (as now proposed by Osborne). And some anti-austerity campaigners still adhere to some need to eliminate the budget deficit, even if it is the sense of St Augustine ‘Lord, grant me chastity and continence; but not yet.’ Let us first recognise that to some degree growth would reduce the budget deficit, notably as tax revenues rise, and that allowing recovery to continue would allow the deficit to fall. The usual rule of thumb is that a 1 per cent increase in output would reduce budget deficit by the order of 0.5 per cent of GDP. Hence it would appear that 8 per cent higher output would be sufficient to clear the present budget deficit. However, growth which continued (and did not just represent a recovery from recession) and which involved growth of productivity and real wages would lead to public expenditure being higher as public sector wages linked with private sector wages and pensions and other transfer payments indexed to wages. In that setting the deficit would only be significantly reduced with growth if public sector wages and pensions were reduced relative to private sector wages.

The appropriate target for the budget position (whether deficit or surplus) is to ensure that fiscal policy is consistent with the achievement of high and sustainable levels of employment which we could recognize as full employment. How big or small such a deficit (or surplus) would be clearly depends on what is happening elsewhere in the private sector – what is the levels of investment and savings, what is the scale of exports, imports and the current account position. The calculation of the necessary budget position is not an easy one to make, and the budget position so required shifts over time. It is also not an easy view point to put across. But, to coin a phrase, there is no alternative if high levels of employment are to be achieved.

Malcolm Sawyer


Repo confusions

Yesterday’s Google Alert on repo markets showed a confusing picture:

Screen Shot 2015-06-26 at 09.55.34

The Reuters piece looks at the US repo market. Dealers and banks there are anxious about the spillovers of the potential Greek default (remembering Lehman triggered a run in repo) and this anxiety shows in higher repo rates.

The Bloomberg article talks about the impact that the shrinking Danish repo market has on the covered bond market. Declining use of repos by banks harms liquidity in the secondary covered bond market, and threatens Danish banks’ liquidity buffers. Bloomberg cites the Danish central bank and local banks common view that regulation is discouraging\ banks’ use of repos, with unexpected consequences for the rest of the financial sector. As banks return to being more like banks (relationship based) and less like (repo) market players, financial stability suffers.

The FT piece paints a very different picture. In contrast to the US, European banks and money market funds do not seem to be concerned about the financial stability implications of the Greek negotiations. The problem in European repo markets is how to get rid of your cash – as with negative bond yields, money market funds now have others to lend cash to them. The culprit, in this story, is the ECB, who charges banks on their reserve accounts, and thus distorts short-term money markets ‘driving our traders absolutely mad’.

There are several interesting questions arising from this comparative picture:

1. How come Greek tensions manifest in US, but not European repo markets? Is it about the exposure of US to European markets, about the time horizon for tightening, or some form of inexplicable European optimism for a Greek solution ?

2. How can we account for, and separate, the impact of unconventional monetary policy  and regulation on the repo markets? Bloomberg portrays the Danish central bank as unwilling to accept its contribution to repo contraction, whereas the FT piece has traders complaining about the ECB.

This last question is fundamental given that repo markets are systemic to shadow banking. The FSB has recognised this since 2009, but its attempts to reform repos – to transform a market governed by private rules into a market governed by public rules (on haircuts) – have been watered down considerably. The European Commission and the ECB are also going down the same route, now content with simply imposing Transparency and Reporting Requirements (although some exceptions will also apply there) without trying to change margining practices that are inherently fragile. The Capital Markets Union (CMU) project also stresses that there is a trade-off between regulation and a well functioning repo market.

Thus, the argument that regulation shrinks the repo market and constrains’ banks ability to act as market makers is very useful for delaying and defeating measures to regulate the market and bring it out of the shadows. When central banks start tightening, it may come to haunt them.

3. What are the broader consequences of increasingly organising the financial system around markets and market liquidity, as the CMU aims, in turn reliant on repo markets that not even the repo lobby knows much about?

The Capital Markets Union: faith in finance restored, contract with finance rewritten?

source: Finance Watch

source: Finance Watch

Things are changing in European finance. Recent proposals by the European Commission turn post-crisis thinking on the regulation of shadow banking on its head. After Lehman regulators around the world agreed to curtail banks’ involvement in shadow banking, but recent policy initiatives frame shadow banking not as a source of systemic risk but as a crucial prerequisite for restoring sustainable growth in Europe. The Capital Markets Union (CMU) proposals aim to transform shadow banking into stable market-based finance, linking investors and savers with growth and employment. As the consultation phase has come to an end, it is clear that the CMU agenda will revive the two markets systemic to shadow banking – securitization markets and repo markets (where banks borrow short term against collateral). Two concerns arise. First, in its current form, the CMU is unlikely to advance its stated objectives. Second, the CMU risk undermining other efforts to regulate (shadow) banking.

The CMU vision is securitisation-led growth, where tradable debt connects institutional investors with entrepreneurs in SMEs and elsewhere. Since European banks need to reverse the excessive pre-crisis expansion, market-based financing alone can meet the capital needs of companies throughout Europe. Revived securitisation markets are expected to free up bank balance sheets, create liquid mediums for institutional investors to hold; and spur SME lending and infrastructure investment.

However, the CMU is unlikely to achieve much vis-a-vis these objectives if it creates new and sharpens existing sources of financial instability. If “simple, transparent securitisation” is the panacea, why haven’t markets embraced it already? Could it be the opaque legal engineering and tranching that makes securitised products attractive to investors? In this perspective, recent suggestions that public bodies -such as the European Investment Bank –  could guarantee junior and mezzanine tranches of synthetic securitisation suggests that the concept of ‘simple, transparent’ securitisation may be loose its original intent, and socialise private risks (again).

Furthermore, where securitised products are funded through repo markets, systemic risk increases. If collateral is allowed to flow freely, as envisaged by the CMU, well-known effects of procyclicality and interconnectedness will increase considerably.

The CMU’s rethinking of shadow banking encourages us to think of market liquidity as a key prerequisite of financial market efficiency and economic growth. But recent crisis experience shows that market liquidity easily evaporates in times of crisis. This is why regulators have recognised that the complex, volatile market liquidity and excessive leverage funded in repo markets are two sides of the same coin. Freely flowing collateral would make liquidity more not less fragile. This is why the Financial Stability Board (FSB) has proposed a framework for reducing the systemic vulnerabilities of the repo-liquidity nexus.

Although the CMU ostensibly aims to reduce banks’ dominance in European finance, it risks achieving the opposite. Bank separation proposals are currently at risk because the banking industry is gently persuading policymakers that such measures would undermine its role as market makers and providers of market liquidity. Since the CMU increasingly organise European finance around market liquidity, it may inadvertently increase the systemic importance of banks.

Assuming that the CMU is irreversible, we urge careful thinking on three issues. First, how can new securitisation be organised so as to best promote transparency and contain systemic risks? A pan-European regulatory agency tasked with standard-setting and prudential oversight could prove essential. Direct supervision of European capital markets should not be considered an ”unhelpful distraction” that adds little to well-functioning national supervision, when national supervisory approaches are far from either convergent or consistent. On the contrary, it is worrying that European member states dismiss the cross-border nature of systemic risk only six years after the crisis of global finance. It is worth remembering that the same arguments about national supervision of large European banks left member states woefully unprepared for the crisis of European banking after Lehman.

Second, the CMU should be accompanied by fundamental reforms of European repo markets, adopting the original FSB proposals (universal minimum haircuts) that targeted the sources of procyclicality and excessive leverage across all types of securities financing transactions. Otherwise, the reporting and transparency framework proposed by European regulators will have limited structural impact. Last but not least, European regulators would be well-advised to consider the desirability of less liquid markets that create incentives for buy-to-hold investors.

Daniela Gabor and Jakob Vestergaard