"Runs still threaten the repurchase market: 2014 in review"

From RepoWatch:

As 2014 comes to a close,  it’s tempting to try to assess how much systemic risk has been wrung out of the repurchase market by six years of reforms.

A fair summary would be: Much proposed but little imposed.
In fact, there’s still disagreement on what to do.

One way to analyze the progress might be to see how well the reforms mimic three key programs that have stabilized commercial banking since the 1930s:  (1) Federal Reserve loans to help troubled but still-solvent banks, (2) FDIC insurance to protect depositors, and (3) regulation to make banks financially stronger.

This method for analyzing progress – comparing repo reform to bank reform – has merit because the underlying problem was the same, both for banks in the decades leading up to the 1930s and for the repurchase market in 2007 to 2009: financial panic and runs on banks.

– In the early 20th century, lenders (depositors) lost faith in the solvency of their borrowers (commercial banks) and suddenly demanded their money back. But the banks didn’t have the money any more. They had re-used it to make loans and investments. This created a panic that threatened to bankrupt the commercial banks and the economy.

– In the early 21st century, lenders (on the repurchase market) lost faith in the solvency of their borrowers  (investment banks) and suddenly demanded their money back. But the banks didn’t have the money any more. They had re-used it to make loans and investments. This created a panic that threatened to bankrupt the investment banks and the economy.
As Federal Reserve Governor Daniel Tarullo, the governor with the most responsibility for post-crisis reforms, explained in a November 20 speech  about progress that’s being made toward preventing runs:

The financial turbulence of 2008 was largely defined by the dangers of runs–realized, incipient, and feared. Facing deep uncertainty about the condition of counterparties and the value of assets serving as collateral, many funding markets ground to a halt, as investors refused to offer new short-term lending or even to roll over existing repos and similar extensions of credit. In the first instance, at least, this was a liquidity crisis. Its fast-moving dynamic was very different from that of the savings and loan crisis or the Latin American debt crisis of the 1980s. The phenomenon of runs instead recalled a more distant banking crisis–that of the 1930s.

The structure of the repurchase market makes it particularly vulnerable to runs. Here’s how that works.

On the repurchase market, lenders make short-term loans to borrowers. Because these repo loans are only for overnight or for just a few days, the lenders can quickly withdraw in times of trouble, by refusing to renew the old loan or to make a new one. The lender just suddenly demands its money back.

We’re talking big money here.  More than $3 trillion is outstanding on the U.S. repurchase market every day, compared to less than $300 billion that typically trades daily on the U.S. stock markets. The $3 trillion flows throughout the financial markets, making its way to investors, corporations, businesses, governments, pension plans, insurance companies, and speculators.

If that flow stops, commerce stops.

Repo lenders are almost any large pool of money, like money market funds, hedge funds, government and corporate treasuries, pension plans, and endowments. Repo borrowers are almost any large participants in the financial markets, but especially investment banks and their broker-dealer operations....MUCH MORE

HT: commentator JF at the Economist's View post "Financial Innovation and Risk Management".