The 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.”
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
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.
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.
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