RSS feedsThe financial markets have used repos for many years. Banks holding securities, such as government or corporate bonds, lend them to other players in the market as collateral for short-term cash raising. The securities provide a medium by which their lender can put them into play to increase the yield they earn. Conversely, the borrower can use the repo structure to position cash, usually for short periods, confident that it is secured.
The latest semi-annual report from the International Capital Markets Association shows that the European repo market is worth about e5.3 trillion (£3.6 trillion) in outstanding contracts. The data was drawn from 74 separate financial groups, most of which were banks. The market looks set to grow much larger, however, as the Basle II Capital Accord, which sets minimum capital requirements for banks, takes effect.
“At the moment, the spread between the short-term secured and unsecured deposit markets is quite narrow,” explains Godfried DeVidts of Fortis Bank, who is also chairman of the committee of the European Repo Council. “But with Basle II coming and the focus of the banks on capital use, there is a push by some banks to attract corporates that hold investment portfolio bonds as guarantee for cash advances. This may turn out to be cheaper for the corporate and it will be better for the banks’ capital ratios as well.”
Highly rated
Clearly, the securities offered by the corporate need to be more highly rated than the corporate borrower itself, but if this is the case the repo market can offer an economic route to meeting short-term funding needs. It may also offer the opportunity to up the return that the securities provide to their current owner.
Basle II will differ from the current Basle I environment in a number of ways. At present AAA-rated mortgage-backed bonds comport a 100% capital weighting; this will fall to 20% when Basle II comes into play. This means the return on lending against such security will become five times more capital-efficient than it is at the moment from a bank’s view.
The other side of the coin is that lending unsecured to a relatively low-rated corporate borrower will remain at 100%, making it less attractive to bank lenders. In practical terms, the price of short-term unsecured corporate borrowing will be likely to rise once Basle II takes effect.
This is why DeVidts and other market professionals believe that the repo market will open up to the corporate market as never before. Another relevant, if somewhat technical aspect of Basle II, is that banks will be required to individually explain and justify to their regulator their risk management systems and calculation of their capital requirement. As there are likely to be significant differences between how banks and their respective regulators in various countries work this out, this may produce different pricing structures for the same types of lending operations. It will, therefore, pay corporates to shop around for the best deal if they choose to access the repo market.
Heralding the arrival of this potentially uneven playing field, financial information provider Bloomberg announced what it termed “Europe’s first multi-bank request-for-quote electronic trading system for repurchase agreements.” This will enable market participants, including corporates, to identify each other and securely quote prices and terms. This may bring more liquidity to the market, especially if more corporate treasurers become involved, which, in large measure, they have not done to date.
Short-term options
Although, in principle at least, corporates could use repos for funding at terms of as long as five years, practically speaking, there would be more economical ways to access cash of this tenure. It seems more likely that the preponderance of corporate deals would be done at the short end with maturities from overnight up to one month and with fewer out to three months duration.
The long-awaited European implementation of Basle II is scheduled to start on 1 January 2007 with a year to bed down after that. In the meantime, banks will probably run introductory sessions for their customers to explain the features and benefits of the repo market.
“I would say to corporates that have bond portfolios, ‘keep your eyes open; it may be an advantage to you,’” says DeVidts. He adds that corporates are also becoming more careful about counter-party risk and that if they are investors it might be worth considering the repo market instead of depositing unsecured.
In the bigger picture, just how influential Basle II will be in dictating lending and borrowing behaviour among banks and corporates remains to be seen. This is likely to become a lot clearer during the course of this year.
