Banking on Bonds, Part 2

This is the second of two excerpts from a recent paper on the role of “repurchase agreements” (or “repos”) in the eurozone crisis, co-authored Daniela Gabor and Cornel Ban. 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.

This part 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. Part 1, explaining repos are and their growing importance, is available here. The full text is available on the GEGI website.

Collateral Damage in the European Sovereign Debt Crisis

Daniela Gabor and Cornel Ban

The financial crisis which erupted in 2007 has fragmented the GC repo market in Eurozone government bonds … There is consequently a German GC market, a French GC market and so on, but there is no longer a eurozone GC market, except for oneday repos, where credit risk is minimal. (European Repo Council, 2013)

While US scholars and policy-makers have dedicated close attention to the run on US repo markets following Lehman Brothers’ collapse (Gorton and Metrick, 2012; Krishnamurthy et al., 2014) and the FSB (2012) put repo markets on its shadow banking agenda, scholarship on the systemic fragilities in European repo markets is in its infancy. Although the crisis reversed the Europeanization of sovereign collateral, as suggested in the quote above, the few studies dealing with European repo markets (Mancini et al., 2013; Boissel et al., 2014) do not engage with the impact on collateral markets.

The paucity of research on this topic is striking considering that by 2012, Portugal, Greece and Ireland provided 0.1 per cent of total repo collateral, sharply down from the 3.5 per cent share in 2008 (see Figure 2), and that Eurex (a large CCP) eliminated GIP government bonds from its GC Pooling basket (Mancini et al., 2013). Repo participants also reduced the use of German government bonds, for the opposite reason: in times of uncertainty, investors become reluctant to part with highly liquid assets.

Thus, the insight from the US-based literature on repo markets that government bonds preserve their high-quality collateral status in crisis, when repo lenders stop accepting privately issued securities, does not apply to Europe (Pozsar, 2014). The eurozone crisis shows that governments are also vulnerable to repo market tensions because the private rules that govern collateral and the incentives of systemic repo market participants are inherently destabilizing.

In the eurozone crisis, Member States faced not only destabilizing repo market dynamics, but also a central bank whose collateral policies were pro-cyclical at critical junctures. This clashes with the conventional description of the ECB’s crisis interventions, which emphasizes that its measures helped stabilize repo and collateral markets (ECB, 2010; Drudi et al., 2012; BIS, 2011). The narrative goes like this: throughout 2008 and 2009, the ECB acted counter-cyclically by extending the pool of eligible collateral (lowering the credit rating threshold from A! to BBB!), a measure meant to help leveraged European banks facing severe funding problems (ECB, 2015a). This allowed banks to take ‘bad’ collateral to the ECB’s long-term lending facilities and use high-quality collateral in private repos. Policy action contained potential runs in periphery collateral markets, restoring confidence in the collateral qualities of GIIPs government debt. The several long-term refinancing operations (LTROs) enabled banks to fund government debt portfolios, increasing demand and therefore liquidity in those markets. The OMT finally dealt with unfounded fears of a eurozone break-up in 2012.

A repo lens complicates this account. When examined through collateral practices, the ECB’s crisis interventions were often pro-cyclical. At critical moments, the central bank made margin calls, raised haircuts and tightened collateral standards. Indeed, in those moments the ECB behaved just like a private repo market participant – a ‘shadow bank’ – that disregards the systemic implications of its collateral practices.

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