The systemic risk of the repo system

By Felix Salmon
February 23, 2010
Tyler Cowen has a copy of Gary Gorton's new paper, and likes it. The excerpt he gives us raises a serious point about fragilities in the banking system: banks fund themselves in the repo market so much that they need about $12 trillion of collateral just to keep ticking over. So if you implement a 20% haircut on repos, banks would need to raise $2 trillion, which is impossible.


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Tyler Cowen has a copy of Gary Gorton’s new paper, and likes it. The excerpt he gives us raises a serious point about fragilities in the banking system: banks fund themselves in the repo market so much that they need about $12 trillion of collateral just to keep ticking over. So if you implement a 20% haircut on repos, banks would need to raise $2 trillion, which is impossible.

The first thing to note here is that no one is proposing a 20% haircut on repos. There’s a school of thought which says that the Miller-Moore amendment does that, but it doesn’t. And in any case, the Miller-Moore amendment only comes into effect after a bank has failed — it’s entirely a question of who takes the associated losses, and has nothing to do with the amount of capital that banks need to hold against their repo-funding operations.

More generally, Gorton suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”, writes Cowen. I suspect this is true, but I also hope that Gorton doesn’t go on to advocate some kind of government backstop of the repo market. He wanted the government to start insuring securitizations in an earlier paper, and that was a very bad idea; regulating and insuring the repo market would be equally misguided.

The real underlying problem here is the treacherous state of denial in which the bond market generally finds itself 99% of the time. Participants in the repo markets know that there are risks there, but they ignore them, because ignoring the risks creates a smooth funding mechanism and allows credit to flow much more easily. Then, when there’s a credit panic and everybody becomes alive to the risks, everything grinds to a chaotic halt.

When the government started insuring deposits, it did so to protect both to protect depositors and to protect banks from runs: if depositors are insured, they don’t engage in runs on banks. Nowadays, as banks have moved away from deposits and towards repos as a funding source, deposit insurance still protects depositors; it just doesn’t prevent bank runs as well as it used to. And yes, that’s a systemic risk, which any systemic-risk regulator needs to be alive to. Whether anything can be done about it, on the other hand, is another question entirely.

Update: Gorton’s paper can be found here.

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