This is the first of two excerpts from a recent paper, co-authored by Daniela Gabor and Cornel Ban and published in the Journal of Common Market Studies, on the role of “repurchase agreements” (or “repos”) in the eurozone crisis. Gabor is an associate professor in the Faculty of Business and Law at the University of Western England-Bristol. Ban is an assistant professor of International Relations and Co-Director of the Global Economic Governance Initiative at Boston University.
Part 1 explains what repos are and how their importance has grown in recent years. Part 2, to be posted next week, describes the behavior of the European Central Bank in the repo market—for example, tightening the standards for use of repos as borrowing collateral by embattled private banks—which had a perverse (pro-cyclical) impact in the eurozone crisis. The full paper is available on the GEGI website.
Part 1: How Repos Work
Daniela Gabor and Cornel Ban
The ‘repurchase agreement’ (often referred to as ‘repo’) has become a key financial device for contemporary capitalism. Though the legal and formal definitions of a repo transaction can make it sound quite complex, it most simply can be thought of as a (usually short-term) secured loan. In a repo transaction one institution (the lender) agrees to buy an asset from another institution (the borrower) and sell the asset back to the borrower at a pre-agreed price on a pre-agreed future date (a day, a week or more). The lender takes a fee (repo interest rate payment) for ‘buying’ the asset in question and can sell the asset in the case that the borrower does not live up to the promise to repurchase it. The fundamental purpose of this circular transaction is to lend and borrow funds (and, in some cases, securities). While financial institutions use it to raise finance, central banks use it in monetary policy.
To illustrate, suppose Deutsche Bank (DB), acting as a borrower, sells assets to a buyer (Allianz), acting as a lender, and commits to repurchasing those assets later (see Figure 1). Allianz becomes the temporary owner of the assets, which also serve as collateral, and Deutsche Bank has temporary access to cash funding. DB and Allianz also agree that the purchase price is less than the market value of collateral (€100) – in this case a 5 per cent difference, known as a haircut. This provides a buffer against market fluctuations and incentivizes borrowers to adhere to their promise to buy securities back. In our example, DB provides €100 worth of collateral to ‘insure’ a loan of €95. When the repurchase takes place, DB pays €95 plus a ‘fee’ or interest payment in exchange for the assets it had sold.