Banks Retreat From Market That Keeps Cash Flowing

By Dow Jones Business News, 
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By Ryan Tracy

WASHINGTON--A critical part of the plumbing that keeps money flowing through the financial system is experiencing turmoil as new regulations prompt banks to step back from the multitrillion-dollar "repo" market.

The large and opaque market for repurchase agreements helps keep finance and trading moving, allowing hedge funds, investment banks and other financial firms to borrow and lend short-term funds, often overnight.

But there have been increasing signs of trouble. Big banks, which act as middlemen between borrowers and lenders, have been pulling back. In recent weeks, senior bankers have said they are reluctant to participate in the market because of regulatory requirements that make repo trading more expensive.

Goldman Sachs Group Inc. reduced its repo activity by about $42 billion in the first six months of this year, citing capital requirements. Barclays PLC cut back lending through repos and similar agreements by roughly $25 billion, to $289 billion in the first half of the year.

Bank of America Corp. and Citigroup Inc. made first-half reductions in repo lending of about $11.4 billion and about $8 billion, respectively. J.P. Morgan Chase & Co.'s repo lending stayed roughly flat.

Repos function as short-term loans, which are backed by collateral, such as a U.S. government bond. Borrowers agree to sell the bonds to another party for cash, with the promise to repurchase the bond at a slightly higher price some time in the future.

Borrowers are often hedge funds and lenders are typically money-market funds. The banks' pullback could make it harder for hedge funds to borrow, and money-market funds may have fewer places to invest. Investors generally may find it harder to find a trading partner for hedges or short sales.

Risks posed by the repo market are the focus of a conference on Wednesday sponsored by the Federal Reserve Bank of New York.

The diminishing role of banks in repos "could exacerbate swings in markets when interest rates rise" or other financial turbulence emerges, said Barclays analyst Joseph Abate.

Regulators say the changes are positive. Before the crisis, many Wall Street firms relied heavily on repos for cash. But they lost access to those funds when investors panicked about the value of mortgage bonds and the solvency of firms like Lehman Brothers Holdings Inc. that relied on repos for cash.

New rules are "a constraint, but one that facilitates financial stability in the long run," said Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig.

Banks said privately they don't intend to abandon clients in repo markets. But there are signs their reluctance to facilitate huge amounts of repo activity is contributing to increased volatility.

In June, a relatively high number of repo transactions tied to U.S. Treasurys "failed," or didn't close because one of the parties didn't provide the bond, according to research firm Wrightson ICAP.

Though the so-called fail rate was far below crisis levels, the development raised eyebrows. The Treasury Department asked about the issue before its quarterly meeting with big Treasury-market players on Aug. 5, said a person familiar with the matter.

At the meeting inside the Hay Adams Hotel near the White House, one private-sector adviser told Treasury officials that market middlemen "have declined in number and capacity, making the system less able to deal with unexpected volatility," according to meeting minutes.

Bank pullbacks have shrunk the pool of securities available for repo trades with U.S. Treasurys as collateral, leading to smaller transactions. "There is a shortage of collateral," said Joe Lynagh, who oversees $18 billion in money-market funds at T. Rowe Price. "Because that trend is continuing, you could see more funds rely more on the Fed" for investing their cash.

Investors said there is such high demand for certain types of bonds that some firms are accepting negative interest rates on the cash they are lending in exchange for the in-demand collateral. As of Tuesday, the rate to borrow five-year Treasury notes maturing in 2019 in the repo market was minus 0.25 percentage points--in other words, financial firms were willing to pay bondholders for the privilege of lending them cash.

Some worry that the Federal Reserve is about to exacerbate the problems as it pulls back from its bond-buying program. The Fed is testing a plan to put the brakes on money sloshing around the financial system by seeking to attract that cash, which otherwise may have gone into the repo market.

The upheaval may reshape how the financial system's plumbing functions and is fueling worries about how markets will respond to the next crisis.

The Fed has expanded its role in the repo market as it tests out a new monetary-policy tool aimed at controlling short-term interest rates.

The central bank is sitting on more than $4 trillion in bonds as part of a program to stimulate the economy and has been testing borrowing against some of those bonds in return for cash to drain money from the economy.

The New York Fed's repo-trading desk accepted a daily average of $121.3 billion of repurchase agreements in July, up from $73 billion in January. Money-market mutual funds have been especially big players in this "reverse repo" pilot program, giving funds a safe place to park cash.

Large market participants like money-market funds are increasingly trading from the Fed, rather than with banks--a move Fitch Ratings attributes to comfort with the central bank, better terms and regulatory changes that are altering how financial firms participate in the market.

There are signs the Fed is growing uncomfortable with its repo market presence.

At a Senate hearing last month, Fed Chairwoman Janet Yellen voiced concerns that the Fed could "become too large or play too prominent a role" and could provide "a safe haven that could cause flight from lending to other participants in the money markets."

Katy Burne contributed to this article.


  (END) Dow Jones Newswires
  08-12-142023ET
  Copyright (c) 2014 Dow Jones & Company, Inc.


This article appears in: Mutual Funds

Referenced Stocks: BAC , BCS , BCY , C , GS

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