Repos and Shadow Banking Summary


Paul Harding, Chairman of Derivatives Documentation Limited, has written the following brief summary note on repos and shadow banking and would like to share it with you.

Regulators around the world are currently examining what they call “shadow banking”.  The European Commission estimates that shadow banking represents 25-30% of the world’s financial sector and is aiming to put forward a set of proposals on shadow banking in general by the end of 2012 for enactment in 2013.

Shadow banking has been defined as “non-banks performing bank-like functions”.  As its name implies shadow banking is subject to little or no regulation.  The Financial Stability Board which is implementing G20 financial reform commitments is reviewing whether repo and securities lending could constitute shadow banking activities because these markets are used by both traditional banks and shadow banks e.g. hedge funds and special purpose vehicles.  Regulators are concerned about the following matters as far as repo is concerned but these concerns can also cover other products:-

  • Scale of shadow banking
  • Regulatory coverage gaps
  • Scope for regulatory arbitrage
  • Complexity
  • Lack of transparency
  • Interconnectedness between shadow banks
  • Mispricing of risk
  • Reliance of the repo market on institutional cash balances which can be fickle and move elsewhere quickly
  • No official safety net for the repo market
  • Fluctuating margin requirements - Low in good times but high in bad times when asset prices fall. Regulators are considering the need for minimum margin levels at all times.

ICMA disagrees that repo is a risky component of shadow banking.  It sees repo as an essential pillar of a liquid capital market providing collateralised funding and that frequent margining rather than minimum margining is the better way to deal with shock events.

US regulators are considering significant regulatory reform of the US repo market which is not really regulated at all at present.  In Europe the market is far more regulated but we will need to wait and see what additional requirements the European Commission wants when it publishes its proposals at the end of 2012.